Financial Institutions Management

Cover
Financial Institutions Management: A Risk Management Approach
Dedication
About the Authors
Preface
Acknowledgments
Brief Contents
Contents
Part One: Introduction
Chapter One: Why Are Financial Institutions Special?
Introduction
Financial Institutionsí Specialness
FIs Function as Brokers
FIs Function as Asset Transformers
Information Costs
Liquidity and Price Risk
Other Special Services
Other Aspects of Specialness
The Transmission of Monetary Policy
Credit Allocation
Intergenerational Wealth Transfers or Time Intermediation
Payment Services
Denomination Intermediation
Specialness and Regulation
Safety and Soundness Regulation
Monetary Policy Regulation
Credit Allocation Regulation
Consumer Protection Regulation
Investor Protection Regulation
Entry Regulation
The Changing Dynamics of Specialness
Trends in the United States
Global Trends
Summary
Appendix 1A: The Financial Crisis: The Failure of Financial Services Institution Specialness
Appendix 1B: Monetary Policy Tools
Chapter Two: Financial Services: Depository Institutions
Introduction
Commercial Banks
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends
Other Fee-Generating Activities
Regulation
Industry Performance
Savings Institutions
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends
Regulation
Industry Performance
Credit Unions
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends
Regulation
Industry Performance
Global Financial Performance
Summary
Appendix 2A: Financial Statement Analysis Using a Return on Equity (ROE) Framework
Appendix 2B: Commercial Banks' Financial Statements and Analysis
Chapter Three: Financial Services: Finance Companies
Introduction
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends
Assets
Liabilities and Equity
Industry Performance
Regulation
Global Issues
Summary
Chapter Four: Financial Services: Securities Firms and Investment Banks
Introduction
Size, Structure, and Composition of the Industry
Key Activities
Balance Sheet and Recent Trends
Recent Trends
Balance Sheet
Regulation
Global Issues
Summary
Chapter Five: Financial Services: Mutual Fund and Hedge Fund Companies
Introduction
Size, Structure, and Composition of the Mutual Fund Industry
Historical Trends
Different Types of Mutual Funds
Mutual Fund Objectives
Investor Returns from Mutual Fund Ownership
Mutual Fund Costs
Balance Sheet and Recent Trends for the Mutual Fund Industry
Money Market Funds
Long-Term Funds
Regulation of Mutual Funds
Global Issues in the Mutual Fund Industry
Hedge Funds
Types of Hedge Funds
Fees on Hedge Funds
Offshore Hedge Funds
Regulation of Hedge Funds
Summary
Chapter Six: Financial Services: Insurance Companies
Introduction
Life Insurance
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends
Regulation
Property-Casualty Insurance
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends
Regulation
Global Issues
Summary
Chapter Seven: Risks of Financial Institutions
Introduction
Interest Rate Risk
Credit Risk
Liquidity Risk
Foreign Exchange Risk
Country or Sovereign Risk
Market Risk
Off-Balance-Sheet Risk
Technology and Operational Risks
Risk of Digital Disruption and Fintech
Insolvency Risk
Other Risks and the Interaction of Risks
Summary
Part Two: Measuring Risk
Chapter Eight: Interest Rate Risk I
Introduction
The Level and Movement of Interest Rates
The Repricing Model
Rate-Sensitive Assets
Rate-Sensitive Liabilities
Equal Changes in Rates on RSAs and RSLs
Unequal Changes in Rates on RSAs and RSLs
Weaknesses of the Repricing Model
Market Value Effects
Overaggregation
The Problem of Runoffs
Cash Flows from Off-Balance-Sheet Activities
Summary
Appendix 8A: The Maturity Model
Appendix 8B: Term Structure of Interest Rates
Chapter Nine: Interest Rate Risk II
Introduction
Duration: A Simple Introduction
A General Formula for Duration
The Duration of Interest-Bearing Bonds
The Duration of Zero-Coupon Bonds
The Duration of Consol Bonds (Perpetuities)
Features of Duration
Duration and Maturity
Duration and Yield
Duration and Coupon Interest
The Economic Meaning of Duration
Semiannual Coupon Bonds
Duration and Interest Rate Risk
Duration and Interest Rate Risk Management on a Single Security
Duration and Interest Rate Risk Management on the Whole Balance Sheet of an FI
Immunization and Regulatory Considerations
Difficulties in Applying the Duration Model
Duration Matching Can Be Costly
Immunization Is a Dynamic Problem
Large Interest Rate Changes and Convexity
Summary
Appendix 9A: The Basics of Bond Valuation
Appendix 9B: Incorporating Convexity into the Duration Model
Chapter Ten: Credit Risk: Individual Loan Risk
Introduction
Credit Quality Problems
Types of Loans
Commercial and Industrial Loans
Real Estate Loans
Individual (Consumer) Loans
Other Loans
Calculating the Return on a Loan
The Contractually Promised Return on a Loan
The Expected Return on a Loan
Retail versus Wholesale Credit Decisions
Retail
Wholesale
Measurement of Credit Risk
Default Risk Models
Qualitative Models
Quantitative Models
Newer Models of Credit Risk Measurement and Pricing
Summary
Appendix 10A: Credit Analysis and Loan Underwriting
Appendix 10B: BlackñScholes Option Pricing Model
Chapter Eleven: Credit Risk: Loan Portfolio and Concentration Risk
Introduction
Simple Models of Loan Concentration Risk
Loan Portfolio Diversification and Modern Portfolio Theory (MPT)
Moodyís Analytics RiskFrontier Model
Partial Applications of Portfolio Theory
Regulatory Models
Summary
Appendix 11A: CreditMetrics
Appendix 11B: CreditRisk+
Chapter Twelve: Liquidity Risk
Introduction
Causes of Liquidity Risk
Liquidity Risk at Depository Institutions
Liability-Side Liquidity Risk
Asset-Side Liquidity Risk
Measuring a DI's Liquidity Risk Exposure
Liquidity Risk Measures
Liquidity Planning
Liquidity Risk, Unexpected Deposit Drains, and Bank Runs
Bank Runs, the Discount Window, and Deposit Insurance
Liquidity Risk at Other Types of Financial Institutions
Life Insurance Companies
Property-Casualty Insurers
Investment Funds
Summary
Chapter Thirteen: Foreign Exchange Risk
Introduction
Foreign Exchange Rates and Transactions
Foreign Exchange Rates
Foreign Exchange Transactions
Sources of Foreign Exchange Risk Exposure
Foreign Exchange Rate Volatility and FX Exposure
Foreign Currency Trading
FX Trading Activities
Foreign Asset and Liability Positions
The Return and Risk of Foreign Investments
Risk and Hedging
Multicurrency Foreign AssetñLiability Positions
Interaction of Interest Rates, Inflation, and Exchange Rates
Purchasing Power Parity
Interest Rate Parity Theorem
Summary
Chapter Fourteen: Sovereign Risk
Introduction
Credit Risk versus Sovereign Risk
Debt Repudiation versus Debt Restructuring
Country Risk Evaluation
Outside Evaluation Models
OECD Country Risk Classifications
Internal Evaluation Models
Using Market Data to Measure Risk: The Secondary Market for LDC and Emerging Market Debt
Summary
Appendix 14A: Mechanisms for Dealing with Sovereign Risk Exposure
Chapter Fifteen: Market Risk
Introduction
Calculating Market Risk Exposure
The RiskMetrics Model
The Market Risk of Fixed-Income Securities
Foreign Exchange
Equities
Portfolio Aggregation
Historic (Back Simulation) Approach
The Historic (Back Simulation) Model versus RiskMetrics
The Monte Carlo Simulation Approach
Expected Shortfall
Regulatory Models: The BIS Standardized Framework
The BIS Regulations and Large-Bank Internal Models
Summary
Chapter Sixteen: Off-Balance-Sheet Risk
Introduction
Off-Balance-Sheet Activities and FI Solvency
Returns and Risks of Off-Balance-Sheet Activities
Loan Commitments
Commercial Letters of Credit and Standby Letters of Credit
Derivative Contracts: Futures, Forwards, Swaps, and Options
Forward Purchases and Sales of When-Issued Securities
Loans Sold
Non-Schedule L Off-Balance-Sheet Risks
Settlement Risk
Affiliate Risk
The Role of OBS Activities in Reducing Risk
Summary
Appendix 16A: A Letter of Credit Transaction
Chapter Seventeen: Technology and Other Operational Risks
Introduction
Sources of Operational Risk
Information Technology (IT) Risks
Strategic Risk of IT
Cybersecurity Risk
Technology Vendor and Third-Party Risk
Data Management Risk
Risk of Ineffective Risk Management
The Effect of Technology on Revenues and Costs
Technology and Revenues
Technology and Costs
Technology and the Evolution of the Payments System
Risks That Arise in an Electronic Transfer Payment System
Regulatory Issues and Technology and Operational Risks
Summary
Chapter Eighteen: Risk of Digital Disruption and Fintech
Introduction
The Evolution of Fintech
Changing Relationship Between Banks and Fintechs
How Big Tech Is Transforming Fintech
The Types of Fintech Innovations
Payments, Clearing, and Settlement Services
Market Support Services
Credit, Deposit, and Capital-Raising Services
Investment Management Services
Regulatory Approaches to Fintech
Fintech Charters and Other Licenses
Regulating Big Techs
International Regulations
Summary
Part Three: Managing Risk
Chapter Nineteen: Liability and Liquidity Management
Introduction
Liquid Asset Management
Monetary Policy Implementation Reasons
Taxation Reasons
The Composition of the Liquid Asset Portfolio
Managing Liquid Assets Other than Cash
Liability Management
Funding Risk and Cost
Choice of Liability Structure
Demand Deposits
Interest-Bearing Checking (NOW) Accounts
Passbook Savings
Money Market Deposit Accounts (MMDAs)
Retail Time Deposits and CDs
Wholesale CDs
Federal Funds
Repurchase Agreements (RPs)
Other Borrowings
Liquidity and Liability Structures for U.S. Depository Institutions
Liability and Liquidity Risk Management in Insurance Companies
Liability and Liquidity Risk Management in Other Financial Institutions
Summary
Appendix 19A: Minimum Reserve Requirements
Appendix 19B: Bankersí Acceptances and Commercial Paper as Sources of Financing
Chapter Twenty: Deposit Insurance and Other Liability Guarantees
Introduction
Bank and Thrift Guaranty Funds
The Causes of the Depository Fund Insolvencies
The Financial Environment
Moral Hazard
Panic Prevention versus Moral Hazard
Controlling Depository Institution Risk Taking
Stockholder Discipline
Depositor Discipline
Regulatory Discipline
Non-U.S. Deposit Insurance Systems
The Discount Window
Deposit Insurance versus the Discount Window
The Discount Window
Other Guaranty Programs
National Credit Union Administration
PropertyñCasualty and Life Insurance Companies
The Securities Investor Protection Corporation
The Pension Benefit Guaranty Corporation
Summary
Appendix 20A: Calculation of Deposit Insurance Premiums
Appendix 20B: FDIC Press Release of Bank Failures
Appendix 20C: Deposit Insurance Coverage for Commercial Banks in Various Countries
Chapter Twenty-One: Capital Adequacy
Introduction
Capital and Insolvency Risk
Capital
The Market Value of Capital
The Book Value of Capital
The Discrepancy between the Market and Book Values of Equity
Arguments against Market Value Accounting
Capital Adequacy in the Commercial Banking and Thrift Industry
Credit Risk and Risk-Based Capital
Risk-Weighted Assets for Credit Risk
Interest Rate Risk, Market Risk, and Risk-Based Capital
Operational Risk and Risk-Based Capital
Summary
Appendix 21A: Internal Ratings-Based Approach to Measuring Risk-Weighted Assets
Appendix 21B: Methodology Used to Determine G-SIBs' Capital Surcharge
Appendix 21C: Capital Requirements for Other Financial Institutions
Chapter Twenty-Two: Product and Geographic Expansion
Introduction
Product Diversification
Segmentation in the U.S. Financial Services Industry
Commercial and Investment Banking Activities
Banking and Insurance
Commercial Banking and Commerce
Nonbank Financial Service Firms and Banking
Nonbank Financial Service Firms and Commerce
Activity Restrictions in the United States versus Other Countries
Issues Involved in the Diversification of Product Offerings
Safety and Soundness Concerns
Economies of Scale and Scope
Conflicts of Interest
Deposit Insurance
Regulatory Oversight
Competition
Domestic Geographic Expansion
Regulatory Factors Affecting Geographic Expansion
Insurance Companies
Thrifts
Commercial Banks
Cost and Revenue Synergies Affecting Domestic Geographic Expansion by Merger and Acquisition
Cost Synergies
Revenue Synergies
Merger Guidelines for Acceptability
Other Market- and Firm-Specific Factors Affecting Domestic Geographic Expansion Decisions
Global and International Expansions
U.S. Banks Abroad
Foreign Banks in the United States
Advantages and Disadvantages of International Expansion
Advantages
Disadvantages
Summary
Chapter Twenty-Three: Futures and Forwards
Introduction
Forward and Futures Contracts
Spot Contracts
Forward Contracts
Futures Contracts
Forward Contracts and Hedging Interest Rate Risk
Hedging Interest Rate Risk with Futures Contracts
Microhedging
Macrohedging
Routine Hedging versus Selective Hedging
Macrohedging with Futures
The Problem of Basis Risk
Hedging Foreign Exchange Risk
Forwards
Futures
Estimating the Hedge Ratio
Hedging Credit Risk with Futures and Forwards
Credit Forward Contracts and Credit Risk Hedging
Futures Contracts and Catastrophe Risk
Regulation of Derivative Securities
Summary
Appendix 23A: Microhedging with Futures
Chapter Twenty-Four: Options, Caps, Floors, and Collars
Introduction
Basic Features of Options
Buying a Call Option on a Bond
Writing a Call Option on a Bond
Buying a Put Option on a Bond
Writing a Put Option on a Bond
Writing versus Buying Options
Economic Reasons for Not Writing Options
Regulatory Reasons
Futures versus Options Hedging
The Mechanics of Hedging a Bond or Bond Portfolio
Hedging with Bond Options Using the Binomial Model
Actual Bond Options
Using Options to Hedge Interest Rate Risk on the Balance Sheet
Using Options to Hedge Foreign Exchange Risk
Hedging Credit Risk with Options
Hedging Catastrophe Risk with Call Spread Options
Caps, Floors, and Collars
Caps
Floors
Collars
Caps, Floors, Collars, and Credit Risk
Summary
Appendix 24A: Microhedging with Options
Chapter Twenty-Five: Swaps
Introduction
Swap Markets
Interest Rate Swaps
Realized Cash Flows on an Interest Rate Swap
Macrohedging with Swaps
Currency Swaps
Fixed-Fixed Currency Swaps
Fixed-Floating Currency Swaps
Credit Swaps
Total Return Swaps
Pure Credit Swaps
CDS Indexes
Swaps and Credit Risk Concerns
Netting and Swaps
Payment Flows Are Interest, Not Principal
Standby Letters of Credit
LIBOR Transition
Summary
Appendix 25A: Setting Rates on an Interest Rate Swap
Chapter Twenty-Six: Loan Sales
Introduction
The Bank Loan Sales Market
Definition of a Loan Sale
Types of Loan Sales
Types of Loan Sales Contracts
Trends in Loan Sales
The Buyers and the Sellers
Why Banks and Other FIs Sell Loans
Reserve Requirements
Fee Income
Capital Costs
Liquidity Risk
Factors Affecting Loan Sales Growth
Access to the Commercial Paper Market
Customer Relationship Effects
Legal Concerns
BIS Capital Requirements
Market Value Accounting
Asset Brokerage and Loan Trading
Government Loan Sales
Credit Ratings
Purchase and Sale of Foreign Bank Loans
Summary
Chapter Twenty-Seven: Securitization
Introduction
Mechanisms Used to Convert On-Balance-Sheet Assets to a Securitized Asset
The Pass-Through Security
GNMA
FNMA
FHLMC
The Incentives and Mechanics of Pass-Through Security Creation
Prepayment Risk on Pass-Through Securities
Prepayment Models
Government Sponsorship and Oversight of FNMA and Freddie Mac
The Collateralized Mortgage Obligation (CMO)
Creation of CMOs
Class A, B, and C Bond Buyers
Other CMO Classes
The Mortgage-Backed Bond (MBB) or Covered Bond
Innovations in Securitization
Mortgage Pass-Through Strips
Securitization of Other Assets
Can All Assets Be Securitized?
Summary
Appendix 27A: Fannie Mae and Freddie Mac Balance Sheets
Index