Solution Manual for Financial Institutions Management: A Risk Management Approach, 8th Edition
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Chapter 01 - Why Are Financial Institutions Special? 1 - 1 Solutions for End - of - Chapter Questions and Problems: Chapter One 1. What are five risks c ommon to all financial institutions? Default or credit risk of assets, interest rate risk caused by maturity mismatches between assets and liabilities, liability withdrawal or liquidity risk, un derwriting risk, and operating risks. 2. Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world with out financial ins titutions . In a world without FIs the users of corporate funds in the economy would have to directly approach the household savers of funds in order to satisfy their borrowing needs. This process would be extremely costly because of the up - front information costs faced by potential lenders. Cost inefficiencies would arise with the identification of potential borrowers, the pooling of small savings into loans of sufficient size to finance corporate activities, and the assessment of risk and investment opportunities. Moreover, lenders would have to monitor the activities of borrow ers over each loan's life span. The net result would be an imperfect allocation of resources in an economy. 3. Identify and explain three economic disincentives that would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial institutions . Investors generally are averse to directly purchasing securities because of (a) monitoring costs, (b) liquidity costs, a nd (c) price risk. Monitoring the activities of borrowers requires extensiv e time, expense, and expertise. As a result, households would prefer to leave this activity to others, and by definition, the resulting lack of monitoring would increase the riskiness of investing in corp orate debt and equity markets. The long - term nature of corporate equity and debt securities would likely eliminate at least a portion of those households willing to lend money, as the preference of many for near - cash liquidity would dominate the extra r eturns which may be available. Finally , the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume. 4. Identify and explain the two functions FIs perform that would enable the smooth flow of funds from household savers to corporate users. FIs serve as conduits between users and savers of funds by providing a brokerage function and by engaging in an asset transformation function. The brokerage function can benefit both savers and users of funds and can vary according to the firm. FIs may provide only transaction services, such as discount brokerages, or they also may offer advisory services which help reduce information costs, such as full - line firms like Merrill Lynch. The asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers, and using the proceeds to purchase the primary securities of corporatio ns. Thus, FIs take on the costs associated with the purchase of securities.
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Chapter 01 - Why Are Financial Institutions Special? 1 - 2 5. In what sense are the financial claims of FIs considered secondary securities , while the financial claims of commercial corporations are considered primary securities ? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers? F unds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claims, which are considered primary securities, are purchased by FIs whose financial claims therefore are co nsidered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securiti es of commercial corporations. However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs, and price risk of placing the investments directly with the commercial corporation are reduced because of the efficiencies of the FI. 6. Explain how financial instituti ons act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process? By putting excess funds into financial institutions, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is util ized properly by the borrower. In this sense , depositors have delegated the FI to ac t as a monitor on their behalf. Further, t he FI can collect information more efficiently than individual investors. T he FI can utilize this information to create new products, such as commercial loans, that continuall y update the information pool. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate provider s and users of funds in the economy. 7. What are five general areas of FI specialness that are caused by providing various services to sectors of the economy? First, FIs collect and process information more efficiently than individual savers. Second, FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securiti es such as equities and bonds. Third, by diversifying the asset base FIs provide secondary securities with lower price risk condi tions than primary securities. Fourth, FIs provide economies of scale in transaction costs because assets ar e purchased in larger amounts. Finally, FIs provide maturity intermediation to the economy which allows the introduction of additional types of investment contracts, such as mortgage loans, that are financed with short - term deposits. 8. What are agency costs? How do FIs solve the information and related agency costs experienced when household savers invest directly in secu rities issued by corporations? Agency costs occur when owners or managers take actions that are not in the best interests of the equity investor or lender. These costs typically result from the failure to adequately monitor t he activities of the borrower. If no other lender performs these tasks, the lender is subject to agency costs as the firm may not satisfy the covenants in the lending agreement. Because the FI invests
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Chapter 01 - Why Are Financial Institutions Special? 1 - 3 the funds of many small savers, the FI has a greater incentive to collect information and monitor the activities of the borrower. 9. How do large financial institutions solve the problem of high information collection costs for lenders, borrowers, and financial markets? One way financial institutions solve this problem is that th e y develop of secondary securities that allow for improveme nts in the monitoring process. An example is the bank loan that is renewed more quickly than long - term debt. The renewal process updates the financial and operating information of the firm more frequently, thereby reducing the need for restrictive bond covenants that may be difficult and costly to implement. 10. How do FIs alleviate the problem of liquidity risk faced by investors who wish to buy se curities issued by corporations? Liquidity risk occurs when savers are not able to sell their securities on demand. Commercial banks, for example, offer deposits that can be withdrawn at any time. Yet , the banks make long - term loans or invest in illiquid assets because they are able to diversify their portfolios and better monitor the performance of firms that have borrowed or issued securities. Thus , individual investors are able to realize the benefits of investing in primary assets without accepting the liquidity risk of direct investment. 11. How do financial institutions help individual savers di versify their portfolio risks? Which type of financial institution is best able to achieve this goal? Money placed in any financial institution will result in a claim on a more diversified portfolio. Banks lend money to many different types of corporate, con sumer, and government customers. I nsurance companies have investments in many different types of assets. Investment s in a mutual fund may generate the greatest diversification benefit because of the fund’s investment in a wide array of stocks and fixed income securities. 12. How can financial institutions invest in high - risk assets with funding provided by low - risk liabilities from savers? Diversification of risk occurs with investments in assets whose returns are not pe rfectly positively correlated. One result of extensive diversification is that the average risk of the asset base of an FI will be less than the average risk of the as sets in which t he individual has invested. Thus , individual investors realize some of the returns of high - risk assets without accepting the corresponding risk characteristics. 13. How can individual savers use financial institutions to reduce the transaction costs of investing in financial assets? By pooling the assets of many small investors, FIs can gain economies of scale in transaction costs. This benefit occurs whether the FI is lending to a corporate or retail customer, or purchasing assets in the money and capital markets. In either case, operating activities that are
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Chapter 01 - Why Are Financial Institutions Special? 1 - 4 designed to deal in large volumes typically are more efficient than those activities designed for small volumes. 14. What is maturity intermediation ? What are some of the ways in which the risks of maturity intermediation are managed by financial in stitut i on s? If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by matching their asset and liability maturities through on - and off - balance sheet hedging activities and flexible ac cess to the financial markets. For example, the FI can offer the relatively short - term liabilities desired by households and also satisfy the demand for long - term loans such as home mortgages . By investing in a portfolio of long - and short - term assets that have variable - and fixed - rate components, the FI can reduce maturity risk exposure by utilizing liabilities that have similar variable - and fixed - rate characteristics, or by using futures, options, swaps, and other derivative products. 15. What are five areas of inst itution - specific FI specialness and which types of institutions are most likely to be the service providers? First, commercial banks and other depository institutions are key players for the transmission of monetary policy from the central ba nk to the rest of the economy. Second, specific FIs often are identified as the major source of financ ing for c ertain sectors of the economy. For example, savings i ns titutions traditionally serve the credit needs of the residential real estate market. Third, life insurance companies and pension funds commonly are encouraged to provide mechanisms to trans fer wealth across generations. Fourth, depository institutions efficiently provide payment servi ces to benefit the economy. Finally, mutual funds provide denomination intermediation by allowing small investors to purchase pieces of assets with large minimum sizes such as negotiable CDs and commercial paper issues. 16. How do depository institutions such as commercial banks assist in the implementation and transmission of monetary policy? The Federal Reserve Board can directly involve commercial banks in the implementation of monetary policy through changes in the reserve requirements and the di scount rate. The open market sale and purchase of Treasury securities by the Fed involves banks in the implementation of monetary policy in a less direct manner. 17. What is meant by credit allocation regulation? What social benefit is this type of regulation intended to provide? Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of the economy which are consid ered to be socially important. These may include housing and farming. Presumably the provision of credit to make houses more affordable or farms more viable leads to a more stable and productive society.
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Chapter 01 - Why Are Financial Institutions Special? 1 - 5 18. Which intermediaries best fulfill the intergenerati onal wealth transfer function? What is this wealth transfer process? Life insurance companies and pension funds often receive special taxation relief and other subsidies to assist in the transfer of wealth f rom one generation to another. In effect, the wealth transfer process allows for the accumulation of wealth by one generation to be transferred directly to one or more younger generations by establishing life insurance policies and trus t provisions in pension plans. Often this wealth transfer process avoids the full marginal tax treatment that a direct payment would incur. 19. What are two of the most important payment services provi ded by financial institutions? To what extent do these services efficiently provide benefits to the economy? The two most important payment services are check cleari ng and wire transfer services. Any breakdown in these systems would produce gridlock in the payment system with resulting harmful effects to the economy at both the domestic and potentially the international level. 20. What is denomination intermediation? How do FIs assist in this process? Denomination intermediation is the process whereby small investors are able to purchase pieces of assets that normally are so ld only in large denominations. Individual savers often invest small amounts in mutual funds. The mutual funds pool these small amounts and purchase a well diversified portfolio of assets. Therefore , small investors can benefit in the returns and low risk which these assets typically offer. 21. What is negative externality ? In what ways do the existence of negative externalities justify the extra regulatory attention received by financial institutions? A negative externality refers to the action by one party that has an adverse e ffect on another party who is not par t of the original transaction. For example, in an industrial setting, smoke from a factory that lowers surrounding property values may be viewed as a negative externalit y. For financial institutions, one concern is the contagion effect that can arise when the failure of one FI can cast doubt on the solvency of other FIs . 22. If financial markets operated perfectly and costlessly, would there be a need for financial in s titutions ? To a certain extent, financial institutions exist because of financial market imperfections. If information is available costlessly to all participants, sa vers would not need FI s to act as either their broke rs or their delegated monitors. However, if there are social benefits to intermediation, such as the transmission of monetary policy or credit allocation, then FIs would exist even in the absence of financial market imperfections.
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Chapter 01 - Why Are Financial Institutions Special? 1 - 6 2 3 . Why are FIs among the most regulat ed sectors in the world? When is the net regulatory burden positive? FIs are required to enhance the effic ient operation of the economy. Successful financial in s ti tut i on s provide sources of financing that fund economic growth opportunit ies that ultimately raise the overa ll level of economic activity. Moreover, successful financial institutions provide transaction services to the economy that facilitate trade and wealth accumulation. Conversely, distressed FIs create negative externalities for the enti re economy. That is, the adverse impact of an FI failure is greater than just the loss to shareholders and other privat e claimants on the FI's assets. For example, the local market suffers if an FI fails and other FIs also may be thrown into financial di stress by a contagion effect. Therefore, since some of the costs of the failure of an FI are generally borne by society at large, the government intervenes in the management of these institutions t o protect society's interests. This intervention takes the form of regulation. However, the need for regulation to minimize social costs may impose private costs to the FI s that would not exist without regulation. This additional private cost is defined as a net regulatory burden. Examples include the cost of holding excess capital and/or excess reserves and the extra costs of providing information. Although they may be socially beneficial, these costs a dd to private operating costs. To the extent that these additional costs help to avoid negative externalities and to ensure the smooth and efficient operation of the economy, the net regulatory burden is positive. 2 4 . What forms of protection and regulation do regulators of FIs impose to ensure their safety and soundness? Regulators have issued several guidelines to insure the safety and soundness of FIs: a. FIs are requi red to diversify their assets. For example , banks cannot lend more than 10 percent of their equity to a single borrower. b. FIs are required to maintain minimum amounts of capital to cushion any unexpected losses. In the case of banks, the Basle standards require a minimum core and supplementary capital based on the size of an FIs’ risk - adjusted assets. c. Regulators have set up guaranty funds such as D IF for commercial banks, SIPC for securities firms, and state guaranty funds for insurance firms to protect individual investors. d. Regulators also engage in periodic monitoring and surveillance, such as on - site examinations, and request periodic information from the FIs. 2 5 . In the transmission of monetary policy, what is the difference between inside money and outside money ? How does the Federal Reserve try to contr ol the amount of inside money? How can this regulatory position create a cost for the depository institutions?
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Chapter 01 - Why Are Financial Institutions Special? 1 - 7 Outside money is that part of the money supply directly produced and controlled by the Fed, fo r example, coins and currency. Inside money refers to bank deposits not d irectly controlled by the Fed. The Fed can influence this amount of money by adjusting reserve requirement and discount rate policies. In cases where the level of required reserves exceeds the level considered optimal by the FI, the inability to use the excess reserves to generate revenue may be considered a tax or cost of providing intermediation. 2 6 . What are some examples o f credit allocation regulation? How can this attempt to create social bene fits create costs to a private institution? The qualified thrift lender test (QTL) requires thrifts to hold 65 percent of their assets in residential mortgage - related asset s to retain the thrift charter. Some states have enacted usury laws that place maximum restrictions on the interest rates that can be charged on mo rtgages and/or consumer loans. These types of restrictions often create additional operating costs to the FI and almost certainly reduce the amount of profit that could be realized without such regulation. 2 7 . What is the purpose of the Home Mortgage Disclosure Act? What are the social benefits desired from the legislation? How does the implementation of this legislation create a net regulatory burden on financial institutions? The HMDA was passed by Congress to prevent discr imination in mortgage lending. The social benefit is to ensure that everyone who qualifies financially is provided the opportunity to purchase a house should they so desire. The regulatory burden has been to require a written statement indicating the reasons why credit was or was not granted. 28 . What legislation has been passed specifically to protect investors who use investment banks directly or indi rectly to purchase securities? Give some examples of the types of abuses for which protection is provided. The Securities Acts of 1933 and 1934 and the Investment Company Act of 1940 were passed by Congress to protect investors against possible abuses such as insider trading, lack of disclosure, outright malfeasance, and breach of fiduciary responsibilities. 29 . How do regulations regarding barriers to entry and the scope of permitted activities affect the charter value of financial institutions? The profitability of existing firms will be increased as the direct and indirect costs of est ablishing competition increase. Direct costs include the actual physical and financial costs of establishing a business. In the case of FIs, the financial costs include raising the necessary minimum capital to receive a charter. Indirect costs include permission from regulatory aut horities to receive a charter. Again in the case of FIs this cost involves acceptable leadership to regulators. As these barriers to entry are stronger, the charter value for existing firms i s higher.
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Chapter 01 - Why Are Financial Institutions Special? 1 - 8 3 0 . What reasons have been given for the growth of investment companies at the expense of “traditional” banks and insurance companies? The recent growth of investment companies can be attributed to two major factors: a. Investors have demanded increased acces s to direct investment in securities markets. Investment companies allow investors to take positions in securities markets while still obtaining the risk diversification, monitoring, and transactional efficiency benefits of financial inter mediation. Some experts would argue that this growth is the result of increased sophistication on the part of investors . O thers would argue that the ability to use these markets has caused the increased investor awareness. The growth in these assets is inarguable. b. Recent episodes of financial distress in both the banking and insurance industries have led to an increase in regulation and governmental oversight, thereby increasing the net regulatory burd en of “traditional” companies. As such, the costs of intermediation have increased, which increases the cost of providing services to customers. 3 1 . What events resulted in banks’ shift from the traditional banking model of “originate and hold” to a model of “originate and distribute?” As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of “originate and hold” to “originate to distribute.” In the traditional model, banks take short term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return - risk tradeoffs, banks shifted to an underwriting model in which they originated or warehoused loans, and then quickly sold them. Indeed, most large banks organized as financial service holding companies to facilitate these new activities. More recently activities of shadow banks, nonfinancial service firms that perform banking services, have facilitated the change from the originate and hold model of commercial banking to the originate and distribute banking model. These innovations removed risk from the balance sheet of financial institutions and shifted risk off the balance sheet and to other parts of the financial system. Since the FIs, acting as underwriters, were not exposed to the credit, liquidity, and interest rate risks of traditional banking, they had little incentive to screen and monitor activities of borrowers to whom they originated loans. Thus, FIs failed to act as specialists in risk measurement and management.
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Chapter 01 - Why Are Financial Institutions Special? 1 - 9 3 2 . How did the boom in the housing market in the early and mid - 2000s exacerbate FI’s transition away from their role as specialists in risk measurement and management ? T he boom (“bubble”) in the housing markets began building in 2001, particularly after the terrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial markets by providing liquidity to FIs. For example, the Federal Reserve lowered the short - term money market rate that banks and other financial institutions pay in the Federal funds market and even made lender of last resort funds available to non - bank FIs such as investment banks. Perhaps not surprisingly, low interest rates and the increased liquidity provided by Central banks resulted in a rapid expansion in consumer, mortgage, and corporate debt financing. Demand for residential mortgages and credit card debt rose dramatically. As the demand for mortgage debt grew, especially among those who had previously been excluded from participating in the market because of their poor credit ratings, FIs began lowering their credit quality cut - off points. Moreover, to boost their earnings, in the market now popularly known as the “subprime market,” banks and other mortgage - supplying institutions often offered relatively low “teaser” rates on adjustable rate mortgages (ARMs) at exceptionally low initial interest rates, but with substantial step - up in rates after the initial rate period expired two or three year later and if market rates rose in the future. Under the traditional banking structure, banks might have been reluctant to so aggressively pursue low credit quality borrowers for fear that the loans would default. However, under the originate - to - distribute model of banking, asset securitization and loan syndication allowed banks to retain little or no part of the loans, and hence the default risk on loans that they originated. Thus, as long as the borrower did not default within the first months after a loan’s issuance and the loans were sold or securitized without recourse back to the bank, the issuing bank could ignore longer term credit risk concerns. The result was deterioration in credit quality, at the same time as there was a dramatic increase in consumer and corporate leverage. The following questions and problems are based on material in Appendix 1 B to the Chapter. 3 3 . What are the tools used by the Federal Reserve to implement monetary policy? The tools used by the Federal Reserve to implement its monetary policy include open market operations, the discount rate, and reserve requirements. Open market operations are the Federal Reserves’ purchases or sales of securities in the U.S. Treasury securities market. The discount rate is the rate of interest Federal Reserve Banks charge on “emergency” or “lender of last resort” loans to depository institutions in their district. Reserve requirements determine the minimum amount of reserve assets (vault cash plus bank deposits at Federal Reserve Banks) that depository institutions must maintain by law to back transaction deposits held as liabilities on their balance sheets. This requirement is usually set as a ratio of transaction accounts, e.g., 10 percent. 3 4 . Suppose the Federal Reserve instructs the Trading Desk to purchase $1 billion of securities. Show the result of this transaction on the balance sheets of the Federal Reserve System and commercial banks.
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Chapter 01 - Why Are Financial Institutions Special? 1 - 10 For the purchase of $1 billion in securities, the balance sheet of the Federal Reserve System and commercial banks is shown below. Change in Federal Reserve’s Balance Sheet Assets Liabilities Treasury securities + $1 b Reserve account of + $1 b securities dealers’ banks ---------------------------------------------------------------------------------------------------- Change in Commercial Bank Balance Sheets Assets Liabilities Reserve accounts + $1 b Securities dealers’ demand + $1 b at Federal Reserve deposit accounts 3 5 . Explain how a decrease in the discount rate affects credit availability and the money supply. Changing the discount rate signals to the market and the economy that the Federal Reserve would like to see higher or lower rates in the economy. Thus, the discount rate is like a signal of the FOMC’s intention regarding the tenor of monetary policy. For example, raising the discount rate “signals” that the Fed would like to see a tightening of monetary conditions and higher interest rates in general (and a relatively lower amount of borrowing). Lowering the discount rate “signals” a desire to see more expansionary monetary conditions and lower interest rates in general. 3 6 . What changes di d the Fed implement to its discount window lending policy in the early 2000s ? I n January 2003, the Fed implemented changes to its discount window lending that increased the cost of borrowing but eased the terms. Specifically, three lending programs are now offered through the Feds discount window. Primary credit is available to generally sound depository institutions on a very short - term basis, typically overnight, at a rate above the Federal Open Market Committee's (FOMC) target rate for federal funds. Primary credit may be used for any purpose, including financing the sale of fed funds. Primary credit may be extended for periods of up to a few weeks to depository institutions in generally sound financial condition that cannot obtain temporary funds in the financial markets at reasonable terms. Secondary credit is available to depository institutions that are not eligible for primary credit. It is extended on a very short - term basis, typically overnight, at a rate that is above the primary credit rate. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution. Secondary credit may not be used to fund an expansion of the borrower’s assets. The Federal Reserve's seasonal credit program is designed to assist small depository institutions in managing significant seasonal swings in their loans and deposits. Seasonal credit is available to depository institutions that can demonstrate a clear pattern of recurring intra - yearly swings in funding needs.
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Chapter 01 - Why Are Financial Institutions Special? 1 - 11 Eligible institutions are usually located in agricultural or tourist areas. Under the seasonal program, borrowers may obtain longer term funds from the discount window during periods of seasonal need so that they can carry fewer liquid assets during the rest of the year and make more funds available for local lending. With the change, discount window loans to healthy banks would be priced at 1 percent above the fed funds rate rather than below as it generally was in the period preceding January 2003. Loans to troubled banks would cost 1.5 percent above the fed funds rate. The changes were not intended to change the Fed ’ s use of the discount window to implement monetary policy, but significantly increase the discount rate while making it easier to get a discount window loan. By increasing banks = use of the discount window as a source of funding, the Fed hopes to reduce volatility in the fed funds market as well. The change also allows healthy banks to borrow from the Fed regardless of the availability of private funds. Previously, the Fed required borrowers to prove they could not get funds from the private sector, which put a stigma on discount window borrowing. With the changes, the Fed will lend to all banks, but the subsidy of below fed fund rate borrowing will be gone. 3 7 . Bank Three currently has $600 million in transaction deposits on its balance sheet. The Federal Reserve has currently set the reserve requirement at 10 percent of transaction deposits. a. Suppose the Federal Reserve decreases the reserve requirement to 8 percent . S how the balance sheet of Bank Three and the Federal Reserve System just before and after the full effect of the reserve requirement change. Assume Bank Three withdraws all excess reserves and gives out loans, and that borrowers eventually return all of these funds to Bank Three in the form of transaction deposits. Panel A: Initial Balance Sheets Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------- Bank Three Assets Liabilities Loans $540m Transaction deposits $600m Reserve deposits 60m at Fed
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Chapter 01 - Why Are Financial Institutions Special? 1 - 12 Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------------- Bank Three Assets Liabilities Loans $690m Transaction deposits $750m ($75 0m - $60 m ) ($60 m x 0.08) Reserve deposits 60m at Fed b. Redo part (a) using a 12 percent reserve requirement. Panel A: Initial Balance Sheets Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------- Bank Three Assets Liabilities Loans $540m Transaction deposits $600m Reserve deposits 60m at Fed Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------------- Bank Three Assets Liabilities Loans $440m Transaction deposits $500m ($500m - $60m) ($60m x 0.12) Reserve deposits 60m at Fed
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Chapter 01 - Why Are Financial Institutions Special? 1 - 13 3 8 . Which of the monetary tools available to the Federal Reserve is most often used? Why? The Federal Reserve uses mainly open market operations to implement its monetary policy. A djustments to the discount rate are rarely used because it is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes and because in addition to their effect on the money supply, discount rate changes often have great effects on the financial markets. Further, because changes in the reserve requirements can result in unpredictable changes in the money base (depending on the amount of excess reserves held by banks and the willingness of the public to redeposit funds at banks instead of holding cash (i.e., they have a preferred cash - deposit ratio)), the reserve requirement is rarely used by the Federal Reserve as a monetary policy tool. The unpredictability comes from at least two sources. First, there is uncertainty about whether banks will actually convert excess reserves (created from a decrease in the reserve requirement) into new loans. Second, there is uncertainty about what portion of the new loans will be returned to depository institutions in the form of transaction deposits. Thus, like the discount window rate, the use of the reserve requirement as a monetary policy tool increases the probability that a money base or interest rate target set by the FOMC will not be achieved. 39 . Describe how expansionary activities conducted by the Federal Reserve impact credit availability, the money supply, interest rates, and security prices. Do the same for contractionary activities. Expansionary Activities: We described three monetary policy tools that the Fed can use to increase the money supply. These include open market purchases of securities, discount rate decreases, and reserve requirement decreases. All else constant, when the Federal Reserve purchases securities in the open market, reserve accounts of banks (and thus, the money base) increase. When the Fed lowers the discount rate, this generally results in a lowering of interest rates in the economy. Finally, a decrease in the reserve requirements, all else constant, results in an increase in reserves for all banks. In two of the three cases (open market operations and reserve requirement changes), an increase in reserves results in an increase in bank deposits and assets. One immediate effect of this is that interest rates fall and security prices to rise. In the third case (a discount rate change), the impact of a lowering of interest rates is more direct. Lower interest rates encourage borrowing. Economic agents spend more when they can get cheaper funds. Households, business, and governments are more likely to invest in fixed assets (e.g., housing, plant, and equipment). Households increase their purchases of durable goods (e.g., automobiles, appliances). State and local government spending increases (e.g., new road construction, school improvements). Finally, lower domestic interest rates relative to foreign rates can result in a drop in the (foreign) exchange value of the dollar relative to other currencies. As the dollar’s (foreign) exchange value drops, U.S. goods become relatively cheaper compared to foreign goods. Eventually, U.S. exports increase. The increase in spending from all of these market participants results in economic expansion, stimulates additional real production, and may cause inflation to rise. Ideally, the expansionary policies of the Fed are meant to be conducive to real economic expansion (economic growth, full employment, sustainable international trade) without price inflation. Indeed, price stabilization can be viewed as the primary objective of the Fed.
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Chapter 01 - Why Are Financial Institutions Special? 1 - 14 Contractionary Activities: We also described three monetary policy tools that the Fed can use to decrease the money supply. These include open market sales, discount rate increases, and reserve requirement increases. All else constant, when the Federal Reserve sells securities in the open market, reserve accounts of banks (and the money base) decrease. When the Fed raises the discount rate, interest rates generally increase in the open market. Finally, an increase in the reserve requirement, all else constant, results in a decrease in excess reserves for all banks. In all three cases, interest rates will tend to rise. Higher interest rates discourage credit availability and borrowing. Economic participants spend less when funds are expensive. Households, business, and governments are less likely to invest in fixed assets. Households decrease their purchases of durable goods. State and local government spending decreases. Finally, a decrease in domestic interest rates relative to foreign rates may result in an increase in the (foreign) exchange value (rate) of the dollar. As the dollar’s exchange rate increases, U.S. goods become relatively expensive compared to foreign goods. Eventually, U.S. exports decrease. The decrease in spending from all of these market participants results in economic contraction, (depressing additional real production) and causes prices to fall (causing the rate of inflation to fall).
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Chapter 02 - Financial Services: Depository Institutions 2 - 1 Solutions for End - of - Chapter Questions and Problems: Chapter Two 1. What are the differences between community banks, regional banks, and money - center banks? Contrast the business activities, location, and markets of each of these bank groups. Community banks typically have assets under $1 billion and serve consumer and small busine ss customers in local markets. In 20 12 , 9 1 . 5 percent of the banks in the United States were classified as community banks. However, these banks held only 9.0 percent of the as sets of the banking industry. In comparison with regional and money - center banks, community banks typically hold a larger percentage of assets in consumer and real estate loans and a smaller percentage of assets in co mmercial and industrial loans. These banks also rely more heavily on local deposits and less heavily on borrowed and international funds. Regional banks range in size from several billion dollars to several hun dred billion dollars in assets. The banks normally are headquartered in larger regional cities and often have offices and branches in locations throughout large portions of the United States . Although these banks provide lending products to large corporate customers, many of the regional banks have developed sophisticated electronic and branching services to consu mer and residential customers. Regional banks utilize retail deposit bases for funding, but also develop relationships with large corporate customers and international money centers. Money center banks rely heavily on nondeposit or borrowed sources of funds. Some of these banks have no re tail branch systems and most money center banks are major participant s in foreign currency markets. These banks compete with the larger regional banks for large commercial loans and with international banks for i nternational commercial loans. Most money center banks have headquarters in New York City. 2. Use the data in Table 2 - 5 for banks in the two asset size groups (a) $100 million - $1 billion and (b) more than $10 billion to answer the following questions. a. Why have the ratios for ROA and ROE tended to increase for both gro ups over the 1990 - 2006 period , decrease in 2007 - 2009 , and increase in 2010 - 2012 ? Identify and discuss the primary variables that affect ROA and ROE as they relate to these two size groups. The primary reason for the improvements in ROA and ROE from 1990s through 200 6 may be related to the continued strength of the macroeconomy that allowed b anks to operate with reduced bad debts , or loan charge - off problems. In addition, the continued low interest rate environment provided relatively low - cost sources of funds, and a shift toward growth in fee income provided additional sources of revenue in many product lines. Finally, a growin g secondary market for loans allowed banks to control the size of the balance shee t by securitizing many assets. You will note some variance in performance in the last three years as the effects of a softer economy and rising interest rates were felt in the financial industry.
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Chapter 02 - Financial Services: Depository Institutions 2 - 2 In the late 2000s, the U.S. economy experienced its strongest recession since the Great Depression. Commercial banks’ performance deteriorated along with the economy. As mortgage borrowers defaulted on their mortgages, financial institutions that held these “toxic” mortgages and “toxic” credit derivatives (in the form of mortgage backed securities) started announcing huge losses on them. Losses from the falling value of OBS securities reached over $1 trillion worldwide through 2009. B igger banks held more o f these toxic assets and, thus, experienced larger losses in income in 2008 . As a result, they tended to see lower , and even negative, ROAs and ROEs during this period. Losses resulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown of the world’s financial and economic systems. As the economy recovered in 2010 - 2012, ROA and ROE returned closer to their pre - crisis levels. The recovery occurred quicker for bigger banks that received more government assistance and monitoring throughout the crisis. The biggest banks’ ROAs and ROEs returned to positive by 2009, while the smaller banks’ ROAs and ROEs remained negative until 2010. b. Why is ROA for the smaller banks generally larger than ROA for the large banks? Small banks historically have benefited from a la rger spread between the cost of funds and the rate on assets, each of which is caused by the less severe competi tion in the localized markets. In addition, small banks have been able to control credit risk more efficiently and to operate with less overhead expense than large banks. c. Why is the ratio for ROE consistently larger for the large bank group? ROE is defined as net income divided by total equity, or ROA times the ratio of assets to equity. Because large banks typically operate with less equity per dollar of assets, net income per dollar of equity is larger. d. Using the information on ROE decomposition in Appendix 2A, calculate the ratio of equity to total assets for each of the two bank gr oups for the period 1990 - 20 12 . Why has there been such dramatic change in the values over this time period, and why is there a difference in the size of the ratio for the two groups?
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Chapter 02 - Financial Services: Depository Institutions 2 - 3 ROE = ROA x (Total Assets/Equity) Therefore, (Equity/Total Assets) = ROA/ROE $100 million - $1 Billion Over $10 Billion Year ROE ROA TA/Equity Equity/TA ROE ROA TA/Equity Equity/TA 1990 9.95% 0.78% 12.76 7.84% 6.68% 0.38% 17.58 5.69% 1995 13.48% 1.25% 10.78 9.27% 15.60% 1.10% 14.18 7.05% 2000 13.56% 1.28% 10.59 9.44% 14.42% 1.16% 12.43 8.04% 2001 12.24% 1.20% 10.20 9.80% 13.43% 1.13% 11.88 8.41% 2003 12.80% 1.27% 10.08 9.92% 16.3 7 % 1.42% 11. 53 8. 6 7% 2006 12. 2 0% 1.2 4 % 9. 8 4 10.16 % 1 3 . 4 0 % 1.3 5 % 9.9 3 10.0 7 % 2007 10.34% 1.06% 9.75 10.25% 9.22% 0.92% 10.02 9.98% 2008 3.68% 0.38% 9.68 10.32% 1.70% 0.16% 10.62 9.41% 2009 - 0.15 % - 0.01 % 15 . 00 6.67 % 1. 44 % 0.1 5 % 9.71 10.29% 2010 3.35% 0.36% 9.31 10.75% 6.78% 0.75% 9.60 10.42% 2012 8.36% 0.78% 10.72 9.33% 8.97% 1.01% 8.88 11.26% The growth in the equity to total assets ratio has occurred primarily because of the increased profitability of the entire banking indus try and (particularly during the financial crisis) the encouragement of regulators to increase the amount of equity financing in the banks. Increased fee income, reduced loan loss reserves, and a low, stable interest rate environment have produced the increased profitability which in turn has allowed banks to increase equity through retained earnings. Smaller banks tend to have a higher equity ratio because they have more limited asset growth opportunities, generally have less diverse sources of funds, and historically have had greater profitability than larger banks. 3. What factors caused the decrease in loan volume relative to other assets on the balan ce sheets of commercial banks? How has each of these factors been related to the change and development of the financial services industry during the 1990s and 2000s? What strategic changes have banks implemented to deal with changes in the financial services environment? Corporations have utilized the commercial paper markets with increased frequency rather than borrow from banks. In addition, many banks have sold loan packages directly into the capital markets (securitization) as a method to reduce balance sheet risks and to improve liquidity. Finally, the decrease in loan volume during the early 1990s and 2000s was due in part to the short recession in 2001 and the much stronger recession and financial crisis in 2007 - 2009. Further, a s deregulation of the financial services industry o cc u rr ed during the 1990s, the position of banks as the primary financial services p rovider erode d . Banks of all sizes have increased the use of off - balance - sheet activities in an effort to ge nerate additional fee income. Letters of credit, futures, options, swaps , and other derivative products are not reflected on the balance sheet, but do provide fee income for the banks.
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Chapter 02 - Financial Services: Depository Institutions 2 - 4 4. What are the major uses of funds for commercial banks in the United States ? What are the primary risks to a ban k caused by each of the s e ? Which of the risks is most critical to the continuing operation of a bank? Loans and investment securities continue to be the primary a ssets of the banking industry. Commercial loans are relatively more important for the larger banks, while consumer, small business loans, and residential mortgages are more important for small banks. Each of these types of loans creates credit, and to varying extents, liquidity risks for the banks. The security portfolio normally is a source of liquidity and interest rate risk, especially with the increased u se of various types of mortgage - backed s ecurities and structured notes. In certain environments, each of these risks can create operational and performance problems for a bank. 5. What are the major sources of funds for commercial banks in the United States ? How is the landscape for these funds changing and why? The primary sources of funds ar e deposits and borrowed funds. Small banks rely more heavily on transaction, savings, and retail time deposits, while large banks tend to utilize large, negotiable time deposits and nondeposit liabilities such as federal fu nds and repurchase agreements. The supply of nontr ansaction deposits is shrinking because of the increased use by small savers of higher - yiel ding money market mutual funds. 6. What are the three major segments of deposit funding? How are thes e segments changing over time? Why? What strategic impact do these changes have on the profitable operation of a bank? Transaction accounts include deposits that do not pay interest and NOW accounts that pay interest. Retail savings accounts include passbook savings accounts and small , nonnegotiable time deposits. Large time deposits include negotiable certificates of deposits that can be re sold in the secondary market. The importance of transaction and retail accounts is shrinking due to the direct investment in money market mutual fund s by individual investors. The changes in the deposit markets coincide with the efforts to constrain the growth on the asset side of the balance sheet. 7. How does the liability maturity structure of a bank’s balance sheet compare with the maturity str ucture of the asset portfolio? What risks are created or intensified by these differences? Deposit and nondeposit liabilities tend to have shorter maturit ies than assets such as loans. The maturity mismatch creates varying degrees of interest rate risk and liquidity risk. 8. The following balance sheet accounts (in millions of dollars) have been taken from the annual report for a U.S. bank. Arrange the accounts in balance sheet order and determine the value of total assets. Based on the balance sheet structure, would you classify this bank as a community bank, regional bank, or money center bank?
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Chapter 02 - Financial Services: Depository Institutions 2 - 5 Assets Liabilities and Equity Cash $ 2,660 Demand deposits $ 5,939 Fed funds sold 110 NOW accounts 12,816 Investment securities 5,334 Savings deposits 3,292 Net loans 29,981 Certificates of deposit (under $100,000) 9,853 Intangible assets 758 Other time deposits 2,333 Other assets 1,633 Short - term b orrowing 2,080 Premises 1,078 Other liabilities 778 Total assets $41,554 Long - term debt 1,191 Equity 3,272 Total liab. and equity $41,554 This bank has funded the assets primarily with transaction and sa vings deposits. The certificates of deposit could be either reta il or corporate (negotiable). The bank has very little ( 5 percent) borrowed funds. On the asset side, about 72 percent of total assets is in the loan portfolio, but there is no informati on about the type of loans. The bank actually is a small regional bank with $41.5 billion in assets, but the asset structure could easily be a community bank if the numbers were denominated in millions, e.g., $41.5 million in assets. 9. What types of activities are normally classified as off - balance - sheet (OBS) activities? Off - balance - sheet activities include the issuance of guarantees that may be called into play at a future time, and the commitment to lend at a future time if the borrower desires. a. How does an OBS activity move onto the balance sheet as an asset or liability? The activity becomes an asset or a liability upon the occurrence of a contingent event, which may not be in the control of the bank. In most cases , the other party involved with the original agreement will call upon the bank to honor its original commitment. b. What are the benefits of OBS activities to a bank? The initial benefit is the fee that the bank charg es when making the commitment. If the bank is required to honor the commitment, the normal interest rate structure will apply to the commitment as it moves onto the balance sheet. Since the initial commitment does not appear on the balance sheet, the bank avoids the need to fund the asset w ith either deposits or equity. Thus , the bank avoids possible additional reserve requirement balances and deposit insurance premiums , while improving the earnings stream of the bank. c. What are the risks of OBS activities to a bank?
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Chapter 02 - Financial Services: Depository Institutions 2 - 6 The primary risk to OBS activities on the asset side of the bank involves the credit risk of the borrow er. In many cases the borrower will not utilize the commitment of the bank until the borrower faces a financial problem that may alter the cred it worthiness of the borrower. Moving the OBS activity to the balance sheet may have an additional impact on the interest rate and foreign exchange risk of the bank. Further, at the very heart of the financial crisis were losses associated with off - balance - sheet mortgage - backed securities created and held by FIs. Losses resulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown of the world’s financial and economic systems. 10. Use the data in Table 2 - 7 to answer the following questions. a. What was the average annual growth rate in OBS total commitments over the period from 1992 - 20 12 ? $ 2 3 6,9 45 . 3 = $10,0 75 . 8 (1+g) 20 g = 17 . 1 0 percent b. Which categories of contingencies have had the highest annual growth rates? Category of Contingency or Commitment Growth Rate Commitments to lend 7.33 % Fu ture and forward contracts 15.40 % Notional am ount of credit derivatives 43.94 % Standby contrac ts and other option contracts 16.52 % Commitment s to buy FX, spot, and forward 8.47 % Standby LCs and foreign office guarantees 10.77 % Commerc ial LCs - 0.74 % Securities borrowed 11.79 % Notional v alue of all outstanding swaps 2 3.10 % Credit derivatives gr e w at the fastest rate of 43.94 percent, yet they have a relatively low outstanding balance of $ 1 3 , 997.6 billion. The rate of growth in the swap s area has been the second strongest at 2 3.10 percent, the dollar volume is large at $ 1 35,555.8 billion in 20 12 . Option contracts grew at an annual rate of 16 . 52 percent with a dol lar value outstanding of $ 3 3 , 553 . 1 billion. Clearly the strongest growth involves derivative areas. c. What factors are credited for the significant growth in derivative securities activities by banks? The primary use of derivative products has been in the areas of interest rate, credit, and for eign exchange risk management. As banks and other financial institutions have pursued the use of these instruments, the international financial markets have responded by extending the variations of the products available to the institutions.
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Chapter 02 - Financial Services: Depository Institutions 2 - 7 11. For each of the following banking organizations, identify which regulatory agencies (OCC, FRB, FDIC, or state banking commission) may have some regulatory supervision responsibility. (a) State - chartered, nonmember, non - holding company bank. (b) Sta te - chartered, nonmember holding company bank (c) State - chartered member bank (d) Nationally chartered non - holding company bank. (e) Nationally chartered holding company bank Bank Type OCC FRB FDIC SB Com m (a) Yes Yes (b) Yes Yes Yes (c) Yes Yes Yes (d) Yes Yes Yes (e) Yes Yes Yes 12 . What are the main features of the Riegle - Neal Interstate Banking and Bra nching Efficiency Act of 1994? What major impact on commercial banking activity occurr ed from this legislation? The main feature of the Riegle - Neal Act of 1994 was the removal of ba rriers to inter state banking. In September 1995 bank holding companies were allowed to acquire banks in other states. In 1997, banks were allowed to convert out - of - state subsidiaries into branches of a single interstate bank. As a result, consolidations and acquisitions have allowed for the emergence of very large banks with branches across the country. 1 3 . What factors normally are given credit for the revitalization of the banking industry during the decade of the 1990s? How is Internet banking expected to provide benefits in the future? The most prominent reason was the lengthy economic expansion in both the U.S. and many global economies during the entire decade of the 1990s. This expansion was assisted in the U.S. by low and falling interest rates during the entire period. The extent of the impact of Internet banking remains unknown. However, the existence of this technology is allowing banks to open markets and develop products that did not exist prior to the Internet. Initial efforts focused on retail customers more than corporate customers. The trend should continue with the advent of faster, more customer friendly products and services, and the continued technology education of customers.
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Chapter 02 - Financial Services: Depository Institutions 2 - 8 1 4 . What factors are given credit for the strong performance of commercial banks in the early and mid - 2000s? The lowest interest rates in many decades helped bank performance on both sides of the balance sheet. On the asset side, many consumers continued to refinance homes and purchase new homes, an activity that caused fee income from mortgage lending to increase and remain strong. Meanwhile, the rates banks paid on deposits shrunk to all time lows. In addition, the development and more comfortable use of new financial instruments such as credit derivatives and mortgage - backed securities helped banks ease credit risk off the balance sheets. Finally, information technology has helped banks manage their risk more efficiently. 1 5 . What factors are given credit for the we a k performance of commercial banks in the late 2000s? In the late 2000s, the U.S. economy experienced its strongest recession since the Great Depression. Commercial banks’ performance deteriorated along with the economy. Sharply higher loss provisions and a very rare decline in noninterest income were primarily responsible for the lower industry profits. Things got even worse in 2008. Net income for all of 2008 was $10.2 billion, a decline of $89.8 billion (89.8 percent) from 2007. The ROA for the year was 0.13 percent, the lowest since 1987. Almost one in four institutions (23.6 percent) was unprofitable in 2008, and almost two out of every three institutions (62.8 percent) reported lower full - year earnings than in 2007. Total noninterest income was $25.6 billion (11 percent), lower as a result of the industry’s first ever full - year trading loss ($1.8 billion), a $5.8 billion (27.4 percent) decline in securitization income, and a $6.6 billion drop in proceeds from sales of loans, foreclosed properties, and other assets. Net loan and lease charge - offs totaled $38.0 billion in the fourth quarter, an increase of $21.7 billion (132.7 percent) from the fourth quarter of 2007, the highest charge - off rate in the 25 years that institutions have reported quarterly net charge - offs. As the economy improved in the second half of 2009, so did commercial bank performance. While rising loan - loss provisions continued to dominate industry profitability, growth in operating revenues, combined with appreciation in securities values, helped the industry post an aggregate net profit. Noninterest income was $4.0 billion (6.8 percent) higher than 2008 due to net gains on loan sales (up $2.7 billion) and servicing fees (up $1.9 billion). However, the industry was still feeling the effects of the long recession. Provisions for loan and lease losses totaled $62.5 billion, the fourth consecutive quarter that industry provisions had exceeded $60 billion. Net charge - offs continued to rise, for an 11th consecutive quarter.
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Chapter 02 - Financial Services: Depository Institutions 2 - 9 1 6 . How do the asset and liability structures of a savings institu tion compare with the asset and liability st ructures of a commercial bank? How do these structural differences affect the risks and operating perform ance of a savings institu tion? What is the QTL test? The savings institut ion industry relies on mortgage loans and mortgage - backed securities as the primary assets, while the commercial banking industry has a variety of loan products , including mortgage products. The large amount of longer - term fixed rate assets continues to cause interest rate risk, while the lack of asset diversity exposes the savin gs institution to credit risk. Savings institution s hold less cash and U.S. Treasury secur ities than do commercial banks. On the liability side, small time and saving deposits remain as the predominant source of funds for savings institution s, with s ome reliance on FHLB borrowing. The inability to nurture relationships with the capital markets also creates potential liquidity risk for the savings institution industry. The acronym QTL stand s for Qualified Thrift Lender. The QTL test refers to a minimum amount of mortgage - related assets that a savings institution must hold to maintain its charter as a savings institution . The amount currently is 65 percent of total assets. 1 7 . How do savings banks differ from savings associa tions? Differentiate in terms of risk, operating performance, balance sheet structure, and regulatory responsibility. The asset structure of savings banks is similar to the asset structure of savings associations with the exception that savings banks are allowed to diversify by holding a larger proportion o f corporate stocks and bonds. Savings banks rely more heavily on deposits and thus have a lower level of borrowed funds. Both are regulated at both the state and federal level, with deposits insured by the FDIC’s D IF. 1 8 . What happened in 1979 to cause the f ailure of many savings inst i tu tions during the early 1980s? What was the effect of this change on the operating statements of savings associations? The Federal Reserve changed its reserve management policy to combat the effects of inflation, a change which caused the interest rates on short - term deposits to increase dramatically more than the rates on long - term mortgages. As a result, for many savings institutions, the marginal cost of funds exceeded the average yield on assets . This caused a negative interest spread for the savings inst i tu tions. Further, because savings in s t i tu tions were constrained by Regulation Q on the amount of interest which could be paid on deposits, they suffered disintermediation, or deposit withdrawals, which led to severe liquidity pressures on the balance sheets. 19. How did the two pieces of regulatory legislation ─ the DIDMCA in 1980 and the DIA in 1982 ─ change the operating profitability of savings inst i tu tions in the early 1980s? What impact did these pieces of legislation ultimately have on the risk posture of the savings in s t i tu tion industry? How did the FSLIC react to this change in operating performance and risk?
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Chapter 02 - Financial Services: Depository Institutions 2 - 10 The two pieces of legislation allowed savings in s t i tu tions to offer new deposit accounts, such as NOW accounts and money market deposit accounts, in an effort to reduce the net withdrawal flow of deposits from the institutions. In effect this action was an attempt to reduce the liquidity problem. In addition, savings institutions were allowed to offer adjustable - rate mortgages and a limited amount of commercial and consumer loans in an attempt to improve the profitability performance of the industry. Although many savings institutions were safer, more diversified, and more profitable, the FSLIC did not foreclose many of the savings institutions which were insolvent. Nor did the FSLIC change its policy of assessing higher insurance premiums on companies that remained in high risk categories. Thus, many savings institutions failed, which caused the FSLIC to eventually become insolvent. 20 . How did the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 reverse some of the key features of earlier legislation? FIRREA rescinded some of the expanded thrift lending powers of the DIDMCA of 1980 and the Garn - St Germain Act of 1982 by instituting the qualified thrift lender (QTL) test that requires that all thrifts must hold portfolios that are comprised primarily of mortgages or mortgage products such as mortgage - backed securities. The A ct also required thrifts to divest their portfolios of junk bonds by 1994, and it replaced the FSLIC with a new thrift deposit insurance fund, the Savings Association Insurance Fund, which was managed by the FDIC. The FDICA of 1991 amended the DIDMCA of 1980 by introducing risk - based deposit insurance premiums in 199 3 to reduce excess risk - taking. FDICA also provided for the implementation of a policy of prompt corrective actions (PCA) that allows regulators to close banks more quickly in cases where insolvency is imminent. Thus , the ill - advised policy of regulatory forbearance should be curbed. Finally, the A ct amended the International Banking Act of 1978 by expanding the regulatory oversight powers over foreign banks. 2 1 . What is the “common bond” membership qualification under which credit unions have been formed and operated? How does this qualification affect the operational objective of a credit union? The common bond policy allows anyone who meets a specific membership requirement to become a member of the credit union. The requirement normally is tied to a place of employment or residence . Because the common bond policy has been loosely interpreted, implementation has allowed credit union membership and assets to grow at a rate that exceeds similar growth in the commercial banking industry. Since credit unions are mutual organizations where the members are owners, employees essentially use saving deposits to make loans to other employees who need funds.
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Chapter 02 - Financial Services: Depository Institutions 2 - 11 2 2 . What are the operating advantages of credit unions that have caused concern among commercial bankers? What has been the response of the Credit Union National Association to the bank s’ criticisms? Credit unions are tax - exempt organizations that often are provided office space by employers at no cost. As a result, because noninterest operating costs are very low, credit unions can lend money at lower rates and pay higher rates on savings deposits than can commercial banks. CUNA has responded saying that the cost to tax payers from the tax - exempt status is replaced by the additional social good created by the benefits to the members. 2 3 . How does the asset structure of credit unions compare with the asset structure of commercial banks and savings institution s? Refer to Tables 2 - 6 , 2 - 10 , and 2 - 1 3 to formulate your answer. The relative proportions of all three types of depository institutions are similar, with almost 30 percent of total assets held as investment securities and over 50 percent as loans. Savings institutions’ loans are predominantly mortgage related, nonmortgage loans of credit unions ar e predominantly consumer loans , and commercial banks hold more business loans than either savings institutions or credit unions . On the liability side of the balance sheet, credit unions differ from banks in that they have less reliance on large time deposits and they differ from savings institution s in that they have virtually no borrowings from any source. The primary sources of funds for credit unions are transaction and small time and savings accounts. 2 4 . Compare and contrast the performance of the worldwide depository institution s with those of major foreign countries during the financial crisis . Quickly after it hit the U.S., the financial crisis spread worldwide. As the crisis started, banks worldwide saw losses driven by their portfolios of structured finance products and securitized exposures to the subprime mortgage market. Losses were magnified by illiquidity in the markets for those instruments. As with U.S. banks, this led to substantial losses in their marked to market valuations. In Europe, the general picture of bank performance in 2008 was similar to that in the U.S. That is, net income fell sharply at all banks. The largest banks in the Netherlands, Switzerland and the United Kingdom had net losses for the year. Banks in Ireland, Spain and the United Kingdom were especially hard hit as they had large investments in mortgages and mortgage - backed securities. Because they focused on the domestic retail banking, French and Italian banks were less affected by losses on mortgage - backed securities. Continental European banks, in contrast to UK banks, partially cushioned losses through an increase in their net interest margins.
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Chapter 02 - Financial Services: Depository Institutions 2 - 12 A number of European banks averted outright bankruptcy thanks to direct support from the central banks and national governments. During the last week of September and first week of October 2008, the German government guaranteed all consumer bank deposits and arranged a bailout of Hypo Real Estate, the country’s second largest commercial property lender. The United Kingdom nationalized mortgage lender Bradford & Bingley (the country’s eighth largest mortgage lender) and raised deposit guarantees from $62,220 to $88,890 per account. Ireland guaranteed deposits and debt of its six major financial institutions. Iceland rescued its third largest bank with a $860 million purchase of 75 percent of the banks stock and a few days later seized the country’s entire banking system. The Netherlands, Belgium, and Luxembourg central governments together agreed to inject $16.37 billion into Fortis NV (Europe’s first ever cross - border financial services company) to keep it afloat. However, five days later this deal fell apart, and the bank was split up. The Dutch bought all assets located in the Netherlands for approximately $23 billion. The central bank in India stepped in to stop a run on the country’s second largest bank ICICI Bank, by promising to pump in cash. Central banks in Asia injected cash into their banking systems as banks’ reluctance to lend to each other led the Hong Kong Monetary Authority to inject liquidity into its banking system after rumors led to a run on Bank of East Asia Ltd. South Korean authorities offered loans and debt guarantees to help small and midsize businesses with short term funding. The United Kingdom, Belgium, Canada, Italy, and Ireland were just a few of the countries to pass an economic stimulus plan and/or bank bailout plan. The Bank of England lowered its target interest rate to a record low of 1 percent hoping to help the British economy out of a recession. The Bank of Canada, Bank of Japan, and Swiss National Bank also lowered their main interest rate to 1 percent or below. All of these actions were a result of the spread of the U.S. financial market crisis to world financial markets. The worldwide economic slowdown experienced in the later stages of the crisis meant that bank losses became more closely connected to macroeconomic performance. Countries across the world saw companies scrambling for credit and cutting their growth plans. Additionally, consumers worldwide reduced their spending. Even China’s booming economy slowed faster than had been predicted, from 10.1 percent in the second quarter of 2008 to 9 percent in the third quarter. This was the first time since 2002 that China’s growth was below 10 percent and dimmed hopes that Chinese demand could help keep world economies going. In late October, the global crisis hit the Persian Gulf as Kuwait’s central bank intervened to rescue Gulf Bank, the first bank rescue in the oil rich Gulf. Until this time, the area had been relatively immune to the world financial crisis. However, plummeting oil prices (which had dropped over 50 percent between July and October) left the area’s economies vulnerable. In this period, the majority of bank losses were more directly linked to a surge in borrower defaults and to anticipated defaults as evidenced by the increase in the amount and relative importance of loan loss provision expenses. International banks’ balance sheets continued to shrink during the first half of 2009 (although at a much slower pace than in the preceding six months) and, as in the U.S., began to recover in the latter half of the year. In the fall of 2009, a steady stream of mostly positive macroeconomic news reassured investors that the global economy had turned around, but investor confidence remained fragile. For example, in late November 2009, security prices worldwide dropped sharply as investors reacted to news that government - owned Dubai World had asked for a delay in some payments on its debt. Further, throughout the spring of 2010 Greece struggled with a severe debt crisis. Early on, some of the healthier European countries tried to step in and assist
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Chapter 02 - Financial Services: Depository Institutions 2 - 13 the debt ridden country. Specifically, in March 2010 a plan led by Germany and France to bail out Greece with as much as $41 billion in aid began to take shape. However, in late April Greek bond prices dropped dramatically as traders began betting a debt default was inevitable, even if the country received a massive bailout. The selloff was the result of still more bad news for Greece, which showed that the 2009 budget deficit was worse than had been previously reported, and as a result politicians in Germany began to voice opposition to a Greek bailout. Further, Moody’s Investors Service downgraded Greece’s debt rating and warned that additional cuts could be on the way. Greece’s debt created heavy losses across the Greek banking sector. A run on Greek banks ensued. Initially, between €100 and €500 million per day was being withdrawn from Greek banks. At its peak, the run on Greek banks produced deposit withdrawals of as high as €750 billion a day, nearly 0.5 percent of the entire €170 billion deposit base in the Greek banking system. Problems in the Greek banking system then spread to other European nations with fiscal problems, such as Portugal, Spain, and Italy. The risk of a full blown banking crisis arose in Spain where the debt rating of 16 banks and four regions were downgraded by Moody’s Investor Service. Throughout Europe, some of the biggest banks announced billions of euros lost from write downs on Greek loans. In 2011, Crédit Agricole reported a record quarterly net loss of €3.07 billion ($4.06 billion U.S.) after a €220 million charge on its Greek debt. Great Britain’s Royal Bank of Scotland revalued its Greek bonds at a 79 percent loss — or £1.1 billion ($1.7 billion U.S.) — for 2011. Germany’s Commerzbank’s fourth quarter 2011 earnings decreased by a €700 million due to losses on Greek sovereign debt. The bank needed to find €5.3 billion euros to meet the stricter new capital requirements set by Europe’s banking regulator. Bailed out Franco - Belgian bank Dexia warned it risked going out of business due to losses of €11.6 billion from its break - up and exposure to Greek debt and other toxic assets such as U.S. mortgage - backed securities. Even U.S. banks were affected by the European crisis. In late 2010, U.S. banks had sovereign risk exposure to Greece totaling $43.1 billion. In addition, exposures to Ireland totaled $113.9 billion, to Portugal totaled $47.1 billion, and to Spain $187.5 billion. Worldwide, bank exposure to these four countries totaled $2,512.3 billion. Default by small country like Greece cascaded into something that threatened the world’s financial system. Worried about the affect a Greek debt crisis might have on the European Union, other European countries tried to step in and assist Greece. O n May 9, 2010, in return for huge budget cuts, Europe's finance ministers and the International Monetary Fund approved a rescue package worth $147 billion and a “safety net” of $1 trillion aimed at ensuring financial stability across Europe. Through the rest of 2010 and into 2012, Eurozone leaders agreed on more measures designed to prevent the collapse of Greece and other member economies. In return, Greece continued to offer additional austerity reforms and agreed to reduce its budget deficits. At times, the extent of these reforms and budget cuts led to worker strikes and protests (some of which turned violent), as well as changes in Greek political leadership. In December 2011, the leaders of France and Germany agreed on a new fiscal pact that they said would help prevent another debt crisis. Then French President Nicolas Sarkozy outlined the basic elements of the plan to increase budget discipline after meeting with German Chancellor Angela Merkel in Paris. The pact, which involved amending or rewriting the treaties that govern the European Union, was presented in detail at a meeting of European leaders and approved. Efforts by the EU and reforms enacted by the Greek and other European country governments appear to have worked. As on December 18, 2012, Standard & Poor's raised its rating on Greek debt by six notches to B
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Chapter 02 - Financial Services: Depository Institutions 2 - 14 minus from selective default Tuesday. S&P cited a strong and clear commitment from members of the euro zone to keep Greece in the common currency bloc as the main reason for the upgrade. The questions and problems that follow refer to Appendix 2B . 25. The financial statements for First National Bank (FNB) are shown below: Balance Sheet - First National Bank Assets Liabilities and Equity Cash $ 450 Demand deposits $ 5,510 Demand deposits from other FIs 1,350 Small time deposits 10,800 Investments 4,050 Jumbo CDs 3,200 Federal funds sold 2,025 Federal funds purchased 2,250 Loans 15,525 Equity 2,200 Reserve for loan losses (1,125) Premises 1,685 Total assets $23,960 T otal liabilities/equity $23,960 Income Statement - First National Bank Interest Income $2,600 Interest expense 1,650 Provision for loan losses 180 Noninterest income 140 Noninterest expense 420 Taxes 90 a. Calculate the dollar value of FNB’s earning assets. Earning assets = investment securities + net loans = $4,050 + $2,025 + $15,525 – $1,125 = $20,475 b. Calculate FNB’s ROA. ROA = ($2,600 – $1,650 – $180 + $140 – $420 – $90)/$23,960 = 1.67% c. Calculate FNB’s asset utilization ratio. Asset utilization = ($2,600 + $140)/$23,960 = 11.44% d. Calculate FNB’s spread. Spread = ($2,600/$20,475) – ($1,650/($10,800 + $3,200 + $2,250)) = 2.54%
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Chapter 02 - Financial Services: Depository Institutions 2 - 15 26. Megalopolis Bank has the following balance sheet and income statement. Balance Sheet (in millions) Assets Liabilities and Equity Cash and due from banks $9,000 Demand deposits $19,000 Investment securities 23,000 NOW accounts 89,000 Repurchase agreements 42,000 Retail CDs 28,000 Loans 90,000 Debentures 19,000 Fixed Assets 15,000 Total liabilities $155,000 Other assets 4,000 Common stock 12,000 Total assets $183,000 Paid in capital 4,000 Retained earnings 12,000 Total liabilities and equity $183,000 Income Statement Interest on fees and loans $9,000 Interest on investment securities 4,000 Interest on repurchase agreements 6,000 Interest on deposits in banks 1,000 Total interest income $20,000 Interest on deposits 9,000 Interest on debentures 2,000 Total interest expense $11,000 Operating income $9,000 Provision for loan losses 2,000 Other income 2,000 Other expenses 1,000 Income before taxes $8,000 Taxes 3,000 Net income $5,000 For Megalopolis, calculate: a. Return on equity R eturn on equity = 5,000 m /28,000 m = 17.86% b. Return on assets R eturn on assets = 5,000 m /183,000 m = 2.73%
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Chapter 02 - Financial Services: Depository Institutions 2 - 16 c. Asset utilization A sset utilization = (20,000 m + 2,000 m )/183,000 m = 12.02% d. Equity multiplier E quity multiplier = 183,000 m /(12,000 m + 4,000 m + 12,000 m ) = 6.54X e. Profit margin P rofit margin = 5,000 m /(20,000 m + 2,000 m ) = 22.73% f. Interest expense ratio I nterest expense ratio = 11,000 m /(20,000 m + 2,000 m ) = 50.00% g. Provision for loan loss ratio P rovision for loan loss ratio = 2,000 m /(20,000 m + 2,000 m ) = 9.09% h. Noninterest expense ratio N oninterest expense ratio = 1,000 m /(20,000 m + 2,000 m ) = 4.55% i. Tax ratio T ax ratio = 3,000 m /(20,000 m + 2,000 m ) = 13.64%
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