Fin 413 Test 3

What are Swaps?

- Agreement between two parties (counterparties) to exchange specified periodic cash flows for a period of time in the future based on some underlying instrument or price - Great tool for managing risk

Goal of Basel III?

- Distinguish among credit risks of assets on balance sheet - Identify credit risk inherent in instruments off the balance sheet (by using risk-adjusted assets in denominator) - Then, use risk-weighted assets to determine the minimum amount of capital that banks must hold in order to reduce the risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset.

What does the FDIC do?

- Ensures the deposits of commercial banks - Conducts bank examinations - Acts as the receiver and liquidator when an insured bank closes

Advantages of securitization

- FI's can reduce liquidity risk, interest rate risk, and credit risk of their loan portfolios - FI's generate income from origination and service fees

Key Differences between forwards and futures

- Forwards: bilateral contracts subject to counterparty risk; have a fixed price over the contract's life - Futures: exchange guarantees against counterparty and default risk; mark to market daily; price is adjusted each day as price of asset changes and approaches expiration

What are Shadow Banks?

- Non-bank firms that provide banking-like services Provide loans, savings accounts/vehicles - NOT BANKS - Financed similar to banks: are uninsured commercial paper that may or may not be backstopped by liquidity lines from real banks

Derivatives Examples

- Securitized assets - Options - Foreign currency future - Interest rate swaps and futures - Credit derivatives Credit default swaps

Mortgage Characteristics

- collateral - down payment -insured vs. conventional

What does Contractionary Monetary Policy do?

- shifts credit supply from banks to Shadow Banks, which attenuates the effectiveness of the bank lending channel of monetary policy

What are Commercial Bank's major assets and liabilities?

-Assets: Loans Liabilities: federally insured deposits therefore considered depository institutions

Why do we care about Commercial Banks consolidating?

-Bank mergers generate frictions in credit markets, which have economic and social implications! •The competitiveness of the local banking market and credit conditions are linked to economic activity, urban development, and crime -That is, access to/availability and terms of credit supports economic activity and entrepreneurship, which drives labor and income opportunities -And, the economic vitality of a community is negatively related with crime rates

Five generic types of swaps

-Interest rate -Currency -Credit risk -Commodity -Equity

Banks' asset-liability characteristics and operations give rise to risk potentials:

-Liquidity risk -Credit risk -Interest rate risk (Insolvency Risk)

Major concern with Shadow Banks

-Pose systemic risk... •Systemic risk: possibility that a company-level event could trigger severe instability or collapse an entire industry or economy

Do large commercial banks provide Foreign Exchange services?

-Yes! Banks buy and sell foreign currency to provide their customers with the ability to: - Make international goods and services transactions - Invest in foreign securities - Hedge against FX risk Banks buy and sell foreign currency for their own purposes as well, so that they can: - Invest in foreign securities - Raise deposits in foreign markets - Hedge against their own FX risks - Speculate in foreign currencies

Commercial banks generally rely on two key sources of funds to support their operations:

1.Deposits: Interest-bearing and non-interest-bearing 2.Borrowed funds

Deposits placed at a bank by its customers can take the forms of:

1.Transaction accounts: checkable accounts that are demand deposits and NOW accounts (negotiable order of withdrawal; interest bearing checking account, typically req's 7 days notice to withdrawal) 2.Time deposits: typically household savings accounts with small balances (e.g., less than $250,000) that are non-transaction accounts 3.Large time deposits: typically deposits of $250,000 or more that take the form of negotiable certificates of deposit (CDs) that can be resold to investors in the secondary (money) market

What are futures and forward markets?

Agree to transaction now; exchange occurs in the future

What are spot markets?

Agree to transaction now; exchange occurs now

What is the bank for international settlements (international financial institution) that develops regulatory programs for member institutions?

Basel

Secondary Mortgage Markets

Can be risky for FI's to hold mortgages which they have originated FI's remove mortgages from balance sheets through one of two mechanisms Pooling them and selling them in secondary market Securitizing them: issuing securities backed by newly originated mortgages

The largest group of financial institutions in terms of total assets are what?

Commercial Banks

Forward Market

Commercial banks, IB's, broker-dealers, act as principal and agent Each contract negotiated by FI and customer Participants exposed to counterparty risk Credit forward: forward agreement that hedges against an increase in default risk on a loan after the loan rate is determined and the loan is issued by the bank

The risk that loans are not repaid

Credit Risk

What is currency depreciation?

Depreciation: country's currency falls in value relative to another country's - Domestic goods become cheaper for foreign buyers -- Foreign goods become more expensive for foreign sellers

What are leveraged instruments where participants put up a small amount of money and obtain the gain or loss on a much larger position?

Derivatives

Insured Mortgages

Federally Insured: originated by FI's but repayment guaranteed (for a fee) by FHA or VA - Borrowers must meet requirements - Very low or zero down payment

--- are markets in which one currency is exchanged for another, either today (in the spot market) or at a set time in the future (in the forward market)

Foreign Exchange Markets

What is it called when you exchange a non-standardized asset for cash?

Forward -Asset details, cash details, and expiration determined at time 0

What is it called when you exchange a standardized asset for cash?

Future -Expiration is standard - Transaction occurs in centralized market

Mortgage sales occur when?

Mortgage sales occur when an FI originates a mortgage and sells it to an outside buyer

What are mortgages?

Mortgages are loans to individuals (or businesses) to purchase a home, land, or other real property -The property purchased serves as the collateral backing the loan

Swap Market

Swap transactions are tailor-made, no standardized contract Counterparty risk

Provides depositors insurance that the bank has enough money, and if the bank somehow runs short, who steps in?

The Federal Deposit Insurance Corporation (FDIC) -To prevent the FDIC from stepping in too often, banks are required to hold cash and investment securities to make sure they can meet depositors' typical demands for their funds -Deposits insured up to $250,000 per account owner

Many financial institutions hold foreign-denominated assets and liabilities on their balance sheets. Why?

This creates FX risk (e.g., for a U.S. bank): - Foreign Assets: When US bank receives principal or interest payments in the form of foreign currency, the foreign currency must be converted to U.S. currency. - Foreign Liabilities: When US bank has to pay principal or interest in the form of foreign currency, U.S. currency must be converted to appropriate foreign currency.

What is currency appreciation?

a country's currency rises in value to other currencies

What is a financial security whose payoff is linked to another, previously issued security?

a derivative security

Swap is esentially

a group of forward contracts on interest rates arranged between two parties

What do credit default swaps do?

allow financial institutions to hedge credit risk -That is, the FI can "swap" its credit risk with that of another institution -Example: FI is concerned a borrower is going to default on his loan; the FI can buy a CDS from another FI/investor who agrees to reimburse the FI if the borrower defaults

What is a plain vanilla interest rate swap?

an exchange of fixed-interest payments for floating-interest payments by two counterparties

Banks are not only consolidating but also becoming what?

concentrated - Big banks now control most of the assets in the banking industry

What do you need to do to increase the value of currency?

decrease the money supply and increase interest rates

Why was Freddie Mac formed?

facilitate financing conventional mortgages by buying mortgages form smaller banks

What do you need to do decrease the value of currency?

increase the money supply or decrease interest rates (create inflation)

On-balance-sheet hedging

involves matching foreign assets and liabilities -As foreign exchange rates move, any decreases in foreign asset values are offset by decreases in foreign liability values (and vice versa)

Off-balance-sheet hedging

involves the use of forward contracts or other derivative securities -Forward contracts are entered into (at t = 0) that specify exchange rates to be used in the future (i.e., no matter what the prevailing spot exchange rates are at t > 0)

What is happening to the Commercial Bank industry?

it's consolidating - primarily driven by mergers and acquisitions (as opposed to bank failures) -In late 1980s and 1990s, regulations eased and allowed for interstate mergers -In 1994, the Reigle-Neal Act allowed for branching by banks across state lines

Commercial bank assets

long term loans: -Commercial & Industrial (Business) -Real Estate (commercial & residential) -Individual Loans (car loans, credit card loans) -Other loans short term investment securities: -Interest-bearing deposits at other financial institutions -Fed funds lent to other banks -Repurchase agreements -US Treasury & Agency securities

swap buyer

makes the fixed-rate payments in an interest rate swap transaction (no principal is exchanged between the buyer and seller)

Swap seller

makes the floating-rate payments in an interest rate swap transaction (no principal is exchanged between the buyer and seller) Application Used to alter cash flow characteristics of an institution's assets to better match assets and liabilities

The FDIC is the --- regulator to many banks and the --- regulator to all banks

primary secondary

Why was Fannie Mae established?

to buy mortgages from larger banks so they could lend to other mortgage borrowers; purchase, hold, and sell mort loans

Why do supervisors examine banks every 18 months?

to determine if they're safe and sound

Why are banks regulated?

to protect against disruptions to the services they perform and to protect government insured deposits - Safety and soundness exams - Deposit insurance - Minimum capital levels - Minimum liquidity requirements - Social regulations