Management of Financial Institutions : Intro, Chapter 1, Chapter 2

Treasury Strips: Vauling Bonds as a package of cash flows

- Developed in the early 1980's. Not sold directly by the US Treasury but created by banks. - "strip off" indivdiaul coupon interest payments and pricnipal payments on treasruy bonds, creating "interst only" and "pricnipal only" zero coupon bonds. - took advantage of the insight that bonds should be priced as a package of cash flows with each cash flow discounted at the appropairate 0 coupon rate. - Avoids the "reinvestment risk" assoicated with coupon bonds

Characterisitcs of Commerical Banks

- Essential to the payment system - Highly leveraged relative to other firms. - Highly regulated relative to other firms - More explicit focus on stakeholders other than shareholders required - Assets typically have a high downside and low upside (one good reason for bankers to be conservative) - Engage in liquidity transformation (borrow short and lend long) - Economies of scale more important here than in other industries

International Money Markets

- Eurocurrency money market is the money market in which foreign currency dominated deposits are borrowed and lent by banks. - Eurocurrency market transactions do not need to involve the Euro - The Eurodollar market, the market in which US dollar deposits held outside the US are traded among multinational banks, is by far the bigget eurourrency market - The rate offered for sale of Eurodollar and othe Eurocurrency funds is the London Interbank Offered Rate (LIBOR)

FDIC Amount

- FDIC: 250,000 per account. Banks that join the FDIC's temporary liquidity guarantee program could also purchase unlimited deposit insurance for noninterest-bearing transaction accounts.

Maintaing Monetary Stability and the Integrity of the Payments System: Role of the Central Bank in the Economy

- Fed is responsible for both - 3 Fundamental Functions: 1.) Conduct the nation's monetary policy 2.) Provide and maintain an effective and efficent payments system 3.) Surpervise and regulate depository insitution operations - All are for maintainig monetary and economic stability and prosperity - Decentralized central bank with reserve banks and branches in 12 districts across the country - Serves as lender of last resort - Monetary policy tools: 1.) Open market operations: Sale or purhcase of US government securities in the "open market." Its most fleixble means of carrying out its policy objectives. Purhcisng securities increase liquidity (reserves) in the banking system by increasing depository insitution balances at the Fed; Fed open market sales of securities decrease depository insituion reserves and liquidity by lowering deposit balances at the Fed. 2.) Changes in discount rate: Rasing the discount rate discourages borrowing. 3.) Changes in Reserve requirements: 4.)

Dodd Frank

- Gives federal regulators the ability to take over and liquidate large bank holding companines and other nonbank financial insituions if they are a threat to the country's financial stability; requires complex financail insituions to have a "funeral plan" in place. Created the Consumer Financial Protection Bureau; Created national underwriting standards for residental mortages - Repelaed regulation Q, which prohibited interest on demand deposits. - Permenately extended minimum deposit insurance to 250,000 - Prohibits banking entites from engaging in proprietary trading - Authorizes the SEC to impose a fiduary duty on brokers who give investment advice to clients - Certain hedge fund managers have to register with the SEC as investment advisors

Book Notes: How Do Banks Differ

- Global banks: BOA, Citigroup, and JP Morgan; have a wide range of products and services for government, business, and individuals. They effectively combine commerical and investment banking and offer a wide range of insurance and fianancal services as well. - Super REgional: smaller in size but have extensive operations in specific regions of the country. Fewer global operations and less nontradtional banking services. May have some investment banking but usally target niche markets. Ex. Wells Fargo, PNC - Community banks: Banks that operate in limited geogrpahic areas in the US. Some offer various financial services and are expanding across the US, beocming national banks. Some operate in a small, specific area. Typically focus on lending to small commerical businesses, individuals, and firms involved in agriculture. Grow ar modest rates so that most fudning comes from deposits. Focuses on realtionship banking. Often make decisons on loan granting, etc locally. - After the 08 Crisis, many regulators and analyst expect the number of indepnent banking organizations to fall sharply due to isssues wih subprime mortages and commerical real estate. The US no longer has any large investment banks. Bear sterns and Lehman Brothers failed; BOA took Meryl Lench. Goldman Sachs and Morgan Stantley converted to BHCs.

Why is a Middleman needed? (2 main reasons)

- Sometimes sophisicated traders with extra funds do transact with firms and other entities in need of funds through "private placements." - Banks, the "middleman," usually provide benefits to both parties: 1. They reduce transaction costs 2. The banks can provide speical expertise that is expensive to develop and maintain

A bond may have one of the following options embeded in its structure.

1. Call option: issuer can redeem (buy back) the bond at a set price at a set time 2. Put option: can demend they redeem bond at cash price at a certain time in the future. 3. Conversion option: Can convert into common stock

TExtbook questions: Chapter 2 5.) 6.)

5.)

Maturity influences bond price sensitivty

Short and long term bonds exhibit different price volitility. - For bonds paying the same coupon rate, long term bonds change proporinately more in price than do short-term bonds for a given rate change. - Longer term bondholders receive the periodic interest payments longer than short term bondholders. This longer term has a greater impact on price changes in bonds due to interest rate changes.

T or F, since the crisis, the largest banks have captured a greater share of financial assets?

True. The 5 largest US banks: JP Morgan, BOA, Citibank, US Bank, and Wells increased their total share of banking assets.

Textbook Questions - Explain how a OBHC differs from a MBHC. How do each of these differ from a financial services holding company? - Define transactions banking and relationship banking. Which types of finacnail instiutions most aggresivley pursue eah of these business models. Why?

- BHC is essentially a shell organization that owns and manages subsiduary firms. An orgaization that owns or holds a controlling interest in one or more commerical banks is a BHC. One Bank BHC control only one bank, where as Multi-BHC control more than one bank. The motivation behind the BHC is the firm's desire to combine the bank's activites with other finanial services activites to better compete. FHC are distinct. Company can form a BHC, FHC, or both. FHC can engage in a wide variety of financail activites not permitted in the bank or BHC. Some of these include insruance and securites underwriting actitives, commerical and merchant banking, and investments - 1. Transactions banking involves the provision of transactions services such as checking accounts, credit card loans, and mortgage loans that occur with high frequency and exhibit standardized features. Because the products are highly standardized, they can be evaluated mechanically and require little human input to manage. For example, the decision to make a credit card loan is typically based on an individual's credit score. This score can be readily used to grade the riskiness of the borrower. Lenders that generate sufficient volumes of transactions for these standardized products can offer them globally with limited investment in human capital. Thus, the transactions model encourages the use of technology to offer standardized products at prices low enough to discourage small firms from offering the same products. Banks that emphasize transactions banking are generally large and compete across extensive geographic and product markets.Relationship banking emphasizes the personal relationship between the banker and customer. For example, the key feature of a loan that is relationship driven and not transactions driven is that the lender adds real value to the borrower during the credit granting process. In addition to the provision of funds, the lender may provide expertise in accounting, business, and tax planning. Loans to smaller firms are more difficult to credit score because they are not standardized. With relationship loans, lending institutions generally charge higher rates and often hold the loans in portfolio. They also aggressively market noncredit products and services to such customers in order to lock in the relationship. The familiarity between borrower and lender and convenience of completing transactions without starting the information search over encourages both the bank and customer to maintain the relationship over time. Borrowers will pay for the assurance that funds will be advanced as they are needed with minimal repetitive negotiations.

Bank Holding Company Act of 1956 and Gramm-Leach-Biley Act

- Bank Holding Company Act of 1956: assigned regulatory responsibility to the Federal Reserve for these companines, while leaving the supervision of banks within holding companines in the hands of traditional regulators. Also stipulates that the Board of Govenors must approve all holding company formations and acquisitions; aquisitons are normally granted unless its demonstrated that it would substanitally reduce competiton in the banking market. - Gramm-Leach-biley Act: also gave regulatory responsibility over financial holding companines to the Fed.

Trend in The Structure of Banks

- Banking Industry has consolidated: managers seek economies of scale and use technology to offer products and services across markets

Valuing bonds as a package of cash flows: Consider a 3 year maturity, 9.4% coupon with 6 remaining semi annual payments of 470 and one principal payment of 10,000 at maturity.

- Bonds should be viewed as a package of 7 seperate cash flows. - Bond will be priced as a package of 0 coupon instrumets with a different disocunt rate applied to each payment. Frist option discounted at 6 month rate, 2nd one year rate, etc - See calculation: All togther worth 10,021 after disocunting each payment - If all coupons were disocunted at the 3 year rate of 4.7% semi anually, the bond would be priced at 10,000 and somone would earn a riskless profit by buying it, stripping the payments, and selling them individually as interst only and principal only strips. - If it were priced at less than 10,021, someone could earn a riskless profit by selling the bond short and buying strips.

Key Federal Legislation: Community Reinvestment Act of 77, Depository Insitutions Deregulation and Monetry Control Act ; Financial Institutions Reform, Recovery, and Enforcement Acts of 89; Riegle-Neal Interstate Banking and Effeciency Act of 94

- COmmunity Reinvestment Act passed in 77, which prevents a depository insitution from acquiring another insitution of the parent recieves a poor CRA evaluation (means its not doing enough to ensure that its credit and services are avaliable to all members of the defined community). - Depository Insitutions Deregulatoin and Monetary Control Act: Passed in 1980, removing interest rate ceilings and authorized commerical banks and savings institutions to pay interest on checking accounts through the use of negotiable order - Put FDIC in charge of insurance for S and L; formed Resolution Trust Corporation (RTC) to dispose of assets of failed instituions. Attempted to "clean up" after the savings and laon crisis. - Riegle-Neal Interstate Banking and Efficency Act of 1994: permits adaquetely capitalized bank holding companines to aquire banks in any state, repealing the provison of the Bank Holding Company Act of 56

General obervations on bank loans

- Can be fixed or floating rate - Have a wide range of maturites...from overnight to several decades - Can be secured or unsecured - Some are amortized (some of the princple is repaid with each payment) - Banks may keep the loans that they make on their balance sheet, or they may sell or securitixe them

Unresolved Regulaotry Issues: Capital adaquecy; regulatory reform

- Capital Adaquecy: requirements that banks have enough equity on their balance sheets to absorb losses before depositors experience losses and deposit insuance has been tapped; downside to requiring more capital is that it can restrict lending - regulation of depository insutions is highly fragmented

CAMELS Rating

- Capital adaquency: ability to maintain cpaital cosumerate with the nature and extent of all types of risk and management's ability to identify, measure, monitor, and control those risk - Asset quality: reflects exsitign credit risk with loan and investment portfolio and off-balance sheet activites - Management: Adaquecy of management and the board in managing risk - Earngings: reflects the quality and trends in earnings and factors that may affect their stability - Liquidity: - Sensitivty to market risk: reflects the dgree to which changes in interest rates, forgein exchange rates, commodity prices and equity capital can adversely affect earnigns and economic capital

Capital or Solvency Risk

- Capital risk: the potential decrease in the market value pf the assets below the market value of the liability - Not considred a seperte risk because all the other risk affect a bank's solvency - A firm is formally insolvent when its net worth is negative - Other firms can continue to operate when insolvent as long as they can pay liabilites that come due

Balance Sheet: Laibilites and Equity: Common and preferred stock

- Common and preferred stock are listed at par value while the surplus account reperesents proceeds in excess of par - REtained earnings profit they've earned thats been retained instead of paid out as dividend - minority interest in consolidated subsidaries is the noncontorlling interst in minority subsiduaries

Balance Sheet: Liabilites and Equitty: Core Deposits; Voailte liabilites

- Core Deposits: consists of demand deposits deposits less than the FDIC limit (250,000). Primry idea behind this is that its the most stable for a bank.....their backup against the bank run; the more core deposits, the less risk of a bank run. - Volatile Liabilites: consist of Jumbo CDs, deposits in foreign offices, etc. These are the assets that are more in risk in the event of a bank run.

"Too Big to Fail" crated two classes of banks: large (creditors and deposiotrs have defacto protection) and small (creditors and unisured depositors may incur loss)

- Creates a moral hazard to not gaurd adaquetely agaisnst risk - Dodd Frank was inteded to end "Too Big to Fail," but the outcome is questionable

Bonds

- Debt securites with long term maturirtes (greater than one year) - Issued by government and corproations - US government bond market is the largest bond market in the world - In US, interest on municipals is tax exempt - Some may pay floating, but most pay a fixed rate.

08 Financial Crisis

- Enabled by reckless lending on residental real estate in the US. - Increasing home ownership was a public policy goal - There was no record of a sharp decline in housing prices. - Mortage loan defaults caused many US banks, like Wachovia, to become insolvent - Crisis spread throughout the world due to the sale of complex securities backed by US mortage loans - AAA rating on these securites contributed to the perception that they were safe - US treasury and Federal Reserve effectively bailed out the banking sector by providing unlimited liquidity during the crisis - Insitutions that were bailed out did eventually repay the government in full

Reasons for depository institution regulation: Monetary Stability; Maintain the Integrity of the Naiton's PAyments System; Protect consumers from abuses from credit garnering instituions

- Fed attemps to control the growth in the banking systems liquidity (and hence the naiton's money supply) and to influence the interest rates. - Payment system revolves around depository instituions. As long as regulators ensure that banks clear checks and settle noncash payments in a fiar and predincatible way, participants will have confidence that the payments media can be used to effect transactions. Important for electronic commerce systems like Paypal. - REgulations ensure that borrowers have equal credit opportunites and no discirmination that would violate the Civil Rights Act. Must disclose why a borrower is denied and loan, and must report key borrowing and savings rates

Monetary policy

- Federal Reserve bank is the central bank in the US and is responsible for conducting monetary policy - Fed cannot directly control employment and price level. It can however, control the money supply and interest rates, which control the price of money - The more money created through banks making loans, the more businesses and consumers invest and spend, and the higher GDP and employment are likely to be. This also leads to increasing prics, and hence, higher inflation.

Balance Sheet: Liabilites and Equity; Other Borrowings

- Federal funds sold and securites sold under repurhcase agreements - Brokered deposits - Deposits held in foreign offices - Federal Home Loan Bank Borrowings - Banker's acceptances - Suboridanted notes and debentures.

Comparative Price Sensitivty

- Following formula provides an approximation of the relationship between the change in market interest rates and the % change in bond price. % change in price= duration formula/1+i X i - Modified duration: commonly used by practioners to describe the same relationship. Duration formula/1+i -

Book Notes: Financial Holding Companines

- Glass-Stegall Act: effectively seperated commerical banking from investment banking. However, it left open the possiblity of banks engaging in investment activites through a section 20 affiliate so long as the bank wasn't "principally engaged" in these activites. Commericla banks also received permission from the Federal REserve to underwrite and deal in securites and several banks set up the necessary section 20 subsisuaries. Gramm-Leach-Biley Act of 99 then repaled the restrictions on banks afflicating with securities firms under the Glass Segal Act and allow3d afflications between banks and insurance underwriters. - FHC are distrinct entities. A company can form a BHC, FHC, or both. Primary advantage is that the entity can engage in a wide range of financial activites not permitted in a bank or BHC, including insurance and securites underwriting and agency activites, merchant banking, and insurance company portfolio investment activities. Activites "complementary" to financial activites are also authorized. Primary disadvantage is that the Fed may not permit a company to form a FHC if any one of its insured depository institution subsiduaries is not well capitalized or well managed or did not at least recieve a satisfcaorty rating in its most recent CRA exam.

Types of Banks by Trade Area and Scope

- Global banks: offer a wide array of products and services globally. - Super regional banks: smilar to global banks but smaller in size and market penetration (ex. PNC bank) - Community banks: banks under a billion in assets

Transaction vs Relationship Banking: Transaction Banking

- High Frequency Trnasction Services (checking accounts, credit cards, and mortage loans) with standardized features that require little human input to manage. - Lenders that generate sufficent volume of these transactions can offer them globally with little investment in human capital. - Encourages use of technology to to offer products at prices low enough to discourage small compeitotrs. - These banks are genrally large, economices of scale being key in this market.

Why a middleman is needed: reduce transaction costs

- If an economy had 3 prospective lenders and 3 prospective borrowers. Each lender would need to screen each borrower, requiring 9 interviews each. If a bank were involved, only 6 interviews would be needed. Without a bank and with more lenders and borrowers, the number of interviews increases. - Deposits and payments: conducting transactions with currency and coins is costly because of the probabilty of misplacing the money or having it stolen. Also costly to store and count currency. This is why a lot of stores are willing to accept extra fees from paying with credit and debit cards. Banks provide depositors with transaction accounts and lines of credit (credit cards) that enable them to pay their bills easily. Deposits can earn interest on checkings and savings accounts and still use the money in them when necessary. - Diversification: Banks provide a low cost for individuals and insituitons to diversify their assets and holdings. Low transaction costs with mutal funds, for example, to buy large quantites of a very large range of assets, pool them, and then sell shares for individuals. Banks do the same thing by taking advnatae of their low transaction costs to pool deposits and lend to a large number of firms and other entities. This provides depositors with less risk than if they were lending to a single entity.

Interest on Reserves

- In 08, legislation was passed allowing the Fed to pay interest on bank reserves. This reduced the opporunity cost of banks holding reserves. - The interest rate charged on reserves is currently the princpal tool that the Fed uses to meet its target for the Federal Funds Rate. - With interest rates paid on reserves and Quantative easing and the large increase in reserves as a result, expansionary open market operations are not as effective and minimum reserve requirements are not currently the major constraint on bank lending

Transactions Banking Vs Relatinship Banking Business Models

- Increase in size leads towards a lesser focus on relationships and greater focus on the volume of transactions. - Securitization: A feature of the transactions banking model. refers to the process of pooling a group of assets with similar features (ex. credit cards loans or mortages) and issuing securites that are collaterilzed by the assets. Investment banks issues securities with the cash flows from the assets pledged to make the debt service payments. The securites are sold to investors who recieve the cash flows from the loans net of servicing, gaurentee, and trust fees. The entire process adds liquidity to the market becasue the loan originators regularly repeat the process, knowing investors will demand the securiteis. - The 08 crisis demonstrated that this Orginate to Distrubute (OTD) approach to lending seperated loan origination from ownership. The flaw is that lenders who originated the loans knew they would not own the long term loans. Lenders were tpyically paid according to the volume of loans orignated and were not penelzaied if borrowers defaulted. Ratings agencies, such ad Moodies and S&P and Fitch, were effectively partners with the loan orignators and security underwriters, as such they overrated the secureness of these securites.

Glass Stegal Act of 33; Gramm-Leach-Biley Act

- Manadated the seperation of commerical banking, investment banking, and insruance activity. Stock Market speculaiton caused many banks to fail in the Depression Era - Gramm-Leach-Biley Act of 99: essentially repaled the glass stegal act of 33 and modified the Bank Holdign Company Act of 56 to create a new financial holding company structure authorized to engage in insurance, real estate, and other activites "complimentary" to banking

General Observations on Bank Funding

- Many bank liabilites carry short term maturites....this sometimes results in banks being vulnerable to increase in interest rates - Many commercial bank deposits are FDIC insured and carry below market interest rates. - Banks operate with less equity capital than nonfinancial companines, which increases financial leverage and the violaity of earnings.

Aggregate Proftiability Measures: Net Interest Margin, Spread, Burden RAtio; effiectnvy ratio

- Net Interest Margin (see fomula): is a summary measure of the net interest return on income-producing assets - Spread: the measrue of the rate spread or funding differential on balance sheet items that pay or earn interest - Burden Ratio: measures the amount of noninterest expense covered by fees, services charges, securites gains, and other income as a fractional of total assets - Efficentcy Ratio: measrures a bank's ability to control noninterest expense relative to total revenue net of interest expnese

Measuring duration of a zero coupon bond

- No interim cash flows with a zero coupon security. Only payment for a zero coupon bond is the face value at maturity - **See calculation** - Calculation for a zero coupon bond is equal to its maturity

Are the financial statements of BHC and FHC informative of understanding the banks that they own?

- No. - Bank financial statements in this section come from United Bank Performance reports. UBPR are produced FFIEC....a council of several regulatory bodies. - Statements in the UBPR are consolidated, which explains why the income statement of PNC, National Association (PNC's bank in its holding company) refers to income from investment and insurance

Liquidity Risk (continued): What do non-cash liquid assets primairly consist of?

- Noncash liquid assets primairly consist of unpledged, marketable short term securites, federal funds sold, and securites purchased under agreement to resell - Some securities are pledged against certain types of deposits, such as government deposits. Pledged securites cannot be sold without a release - Banks with a large amount of funding from core deposits have lower liquidity risk than banks without them

Managing Risk and Returns: Creidt Risk: Preperation for losses

- Noncurrent loans are 90 days or more past due - Loan loss allowance should at least equal noncurrent loans - GAAP and call reporting guidelines require adaquete reserve to cover the known and inherent risk in the portfolio - Banks that lend in a narrow geographic area or to a certain industry have concentration risk - Insituoins in high loan growth areas may assume greater risk due to less rigorous loan procedures - Country risk is the risk inherent in making loans to certain countries

Noninterest expenses

- Personal, occupncy, and other opeating expenes -

Goals of Monetary Policy

- Primary goal of monetary policy in the US is table prices and full employment. - Inflaiton: sustained rise in the general price level; opposite is true for deflation - If inflaiton is too high, people are less eager to hold money, because it no longer functions well as a store of value. In extreme cases of hyperinflation, people might not be willing to accept money in return for goods - If there is deflation, people will hoard money in anticipation of lower prices in the future. If this bheavior becomes too widespread, the economy slows and employment falls

Other bank assets:

- Residual assets of small amounts, including bank premises and equipment, other real estate owned (OREO), investment in unconsolidated subsiduaires and other assets - OREO can be a problem because it represents collateral on unpaid loans - Commerical banks own relatively few fixed assets - Banker's acceptances are negotiable instrumets guarnetting payment to the owner and are often used in trading goods.

Interest may be compounded at different intervals

- Same formulas, but use an adjustment that converts the stated annual interest rate to a perioidc rate coinciding with the compounding interval - Number of periods=n X number of comouding periods in a year. FV= PV(1+i)^(n)(m)

Bank Assets: Investment securites (short and long term)

- Short term securities: maturites of one year or less and are primarily for liqudity needs. REturns fluctuate with changes in money market condition. Shorter time period and less risk means less interest than long term securites. T Bills, short term municpal securites, etc - Long term securites: have secuirites of more than one year and may generate nontaxable interest (for municipals). US Treasury Notes and bonds, mortage backed securities, and small amounts for foreign and corporate bonds

Quantative Easing

- The Crisis of 08 resulted in the loss of much wealth and spending power that the Fed realized that a Federal Funds Rate of 0% would not be low enough to create spending and investment to stablize employment and output. - Therefore, the Fed responded with quantative easing (QE), which essentially involved very large scale expansionary open-market operatons beyond the level to bring the Federal Funds Rate down to 0% - One result of quantative easing is that banks were left with very large amounts of excess reserves

Duration

- The measure of the effective time to maturity for a security that incorporates the timing and size of all promised cash flows - Securtiy's duration also provides info about the change in market value as a result as a result of the change in interest rates (remeber...greater the duration, greater the price sensitivty) - These two ways of looking at duration are consistent because the prices of securites with more time remaining to maturity and lower coupons tend to be more senstive to changes in interst rates

Why a Middleman is Needed: Special Expertise (Evaluating risk,

- There are obvious advnatges in expertise in evaluating the risk of borrowers. Borrowers typically know more about their own prospects and ability to pay then lenders (Asymetric informaiton). Asymetric information leads to: 1. Adverse Selection: problem that exsists before the transaction occurs.....potential borrowers most likley to produce adverse outcomes are the ones most likely to seek a loan (ex. bankrupt firm seeking out a loan to stay afloat) 2. Moral Hazard: Problem that arises after a transaction has been completed. In banking, there is a concern that they'll think they are "too big to fail" and will be bailed out if they take uncessary risk. People might also lend too much to a bank if they think its too big to fail.

Book Notes: 08 Crisis

- To help get more borrowers for mortages and the desire for greater fee income, many leaders designed home loans that did not require borrowers to make sufficently large monthly principal and interest payments. Ex. In many cases, home mortage loans were purposely designed for and made to individuals whose income was insufficent for making the minimum payments that would eventually pay off the loan (subprime borrowers). The expectation was that either incomes would increase over time or the property value would rise sufficently to cover future payments. - As home prices started to decline, many institutions involved in housing finance began to realize losses from home mortage defaults. Initally, several small mortage banks failed. - In 08, Bear Sterns collapsed and was bought by JP Morgan. Lehman Borthers collapsed, followed by the collapse of countrywide, Washingotn Mutual, Wachovia. Each was absorbed by Bank of America, JP Morgan, and Wells Fargo. - GOldman Sachs and Morgan Stanley converted to BHC

Income Statement: Total Revenue; Total Expense

- Total interest income, noninterest income and realized securites gains (or losses) - Interest expense, noninterst expense, and provison for loan losses (comparible to cost of goods sold and operating expenses)

Money Market Paricipants

- US Treasruy - Federal Reserve - Commerical banks - Money Market mutual funds - Borkers and dealers - Non-financial corporations - Other financail insituons - indivdiauls

Bank assets: Noninterst cash and due from banks

- Valut cash: held to meet customer withdrawls - Deposits held at Fed: depsoits held to meet legal requirements, etc - Balances at other financial insitutions: held primarily to purhcase services - Items in Process of colleciton: checks drawn on other baks that have be presented but not yet cleared

Legal and repurtion risk

- risk that unenforacble contracts, lawsuits, or adverse judgements could disrupt or negatively affect the operations, profitability, condition or solvency of the insitution - risk that negative publicity, true or untrue, can adversely affect a bank's customer base or bring forth costly lititgation that negatively affects profitiability

Check Clearing for the 21st Century Act of 04; Troubled Asset Relief Proram of 08; TARP Capital Purhcase Program of 08; Dodd Frank Act

-Created a framework to eliminate paper checks. Allowed for the electronic clearing of checks - Created a fund to allow the US treasury to purchase distressed assets from financial insituoins. - allowed the treasury to invest in the bank's preferred stock; both of these 08 measures were emergency measures during the financial crisis

Types of Financial Institutions (3)

1. Depository Institutiions: - Commerical banks: can lend to consumers, businesses, or government - Savings instutions: Mostly mortage lending - Credit Unions: mostly consumer loans, some mortage lending 2. Life Insurance Companines: - Collect premiums and invest them in securites and other assets - Sell annuites and invest proceeds in securites and other assets 3. Pension and Mutal Funds - Pension: pools assets of employees and invest in diversified assets - Mutual funds: Similar to pensions but open to all invesotrs 4. Investment banks: help companines to sell securites in the financial market. Act as dealers and brokers and advise on mergers 5. Finance companines: issue loans but do not accept deposits 6. Others: venture capital funds, private equit funds, etc.

Non-interst Income activites (8)

1. Fiduary activites 2. Deposit service charges 3. Trding, venture captial, and securitization income 4. Investment banking, advisroy, brokerage, and underwiritng fees and comiisions 5. Insurance comission fees and income 6. Net servicing fees 7. Net gains and losses on sales of loans 8. Other net gains or losses

3 Main subfields of Finance

1. Investments/Investments Analysis: Managing money for investors. Investors are individuals who save in the present and wish to grow their savings to increase their wealth in the future. 2. Financial Services: Also caled banking, since thats who's primairly doing it. Playing the middleman between savers with excess funds to invest and firms that need to borrow funds to grow their business. 3. Corporate Finance: Managing money for a non-financial firm.

Balance Sheet: 4 Categories of bank assets

1. Loans: the major asset....generate the amount of income before expenses and taxes 2. Investment Securites: held to earn interest, help meet liquidity needs, manage interest rate risk, or speculate on interest rate movements. 3. Noninterest cash and due from banks: currency and cash held in vaults, deposits held at Fed, and other insitutions and cash items held in the process of collection 4. Other assets: redicual assets of realtively small amounts, like equipment

Interest expense (and interest income for the same 3) may vary for 3 reasons

1. Rate effects mean interest cost differ between banks - banks pay different risk premiums indicating how the market percieves their asset quality and overall risk; banks time their borrowings differently, which impacts rates; banks use different maturites, which impacts rates. 2. Composite effects because the mix of liabilites differs 3. Volume effects reconzie that the amount of interest expense is based on liabilites

Important Money Market Instrumets (6)

1. Treasury bills: short term obligations issued by the US government. These are practically defualt risk free, are highly liquid, and have little interest rate risk. There is strong international demand for these investments, as they are "safe haven" investments. 2. Federal Funds: short-term unsecured loans between banks in the US. Banks with extra reserves lend federal funds,while banks with defficent reserves borrow federal funds. Multimillion dollar loans may be arranged in mimutes. These are single payment loans. 3. Repurchase agreements: the sale of a security (most commonly a treasury security) with an agreement to buy the security back at a specified price in the future. These "repo" transactions are the economic equivalent of collateralized loans, because if the party selling the security (borrower) defaults on the obligation to buy it back, .the party buying the security (lender) keeps the collateral. Repo can be as short as overnight. Repo rates are typically lower than federal funds loans because repo loans are secured. Amount that can be borrowed in a typical transaction is typically less than the amount of the repo transaction. This protects the lender in case the collateral loses value of the security used as collateral and the amount of the repo loan is called the haircut

6 Major catergories of loans

1. agriculture 2. Real estate 3. Commerical 4. Individual 5. Other loans in domestic offcies 6. Loans to foreign offices

Types of Banks

1.) Independent Banks: a single organizaton that accepts depoits and makes loans. Not part of a holding company. Most community banks are independent banks. 2.) BHC (Bank Holding Companines): Own controlling interest in one or more controlling banks. Holding company is the parent and the bank is the subsiduary. One-bank holding copanines control only one bank. Multibank Holding Companines control at least two commerical banks; some treat subsiduaries like branches, others allow subsisuares to operate quasi indpenetly. - Can aquire nonbank subsidiaries offering products and services closely related to banking (ex. Finance companines and data processing companines). Orignal motivation for BHC was to avoid restrictions on banks opening branches in different states. Primary motivation is to broaden scope of products being offered.

Chapter 6 Questions: 10.) Consider 4% US Treasury note that has a 10,000 face value and matures 10 years from today. Note pays interest semianually. The current market interst rate on this bond is 3%. Would you expect it to be discont, premium, or par?Calculate acutal price using PV fomrula 11.) Treasury security carries a fixed 3% annual coupon rate and matures in exactly 2 years. Treasruy is currently priced at 10,000 par value to yield 3% to marutity. Assume that you can buy the bond and strip the coupons and final pricnpal payment and sell each of them as a zero coupon security. Given the following zero coupon rates, what price would you get for this purchase and subqseunt sales? 6 month: 2.2% coupon yield; 1 year:2.6%; 18 month: 2.9%; 2 year: 3.6% 13.) What is the duration of a bond with a par value of 10,000 that has coupon rate of 3.5% anually and a final maturity of two years? Assume required rate of return is 4% compounded semi anually. What is the duration of a 2 year 0 coupon bond that pays 10,000 at maturity and is priced to yield 4% with semiannual compounidng? Why do the durations differ?

10.) Premium. USe financial calculator. 10,858 11.) 9,889.14. You would lose 110 form this transaction. To make a profit, you could sell the security for 10,000 and buy each of the zero coupons for a total of 9,889.14. To make a profit of 110.14 13.)

Chaptern 2 Questions 12.) Much of the intense compeitiont in the financial services industry comes from products that are the most standaried, such as mortages, automobile loans, money market accoounts, etc. These products wll offer very low profit margins. If you managed a small community bank today, devise a stradegy to compete in this envrioment. 13.) What are the issues surroucinding "too big to fail". Is it possible for congress to simply outlaw TBTF insitutoins? Why or why not?

12.) A small community bank cannot earn above-average returns on these low-margin products/services today because of competition. It must develop other loan products or services that can be offered at profitable margins. This might be some specialized form of lending tied to a specific type of loan or industry, it might be emphasizing originating loans and selling them to long-term investors, while retaining servicing, or it might be offering non-credit products that competitors don't successfully offer within their trade area. Management might also focus on how these services are delivered. Many start-up operations in today's environment invest little in offices and branches and offer the bulk of their services over the internet, via telephone, or via banking representatives going to the customers' places of businesses with their laptops. This potentially controls costs and allows greater room for competitive investments. 13.) 1. One issue with Too Big to Fail is that it creates two classes of bank: large banks where all depositors have unlimited de facto protection, and small banks where those with deposits over $250,000 may incur losses. Many argue that Too Big to Fail gives larger financial institutions a funding advantage over smaller banks and an incentive to take on additional risk and consider this disparate treatment inherently unfair. It is also argued that Too Big to Fail encourages moral hazard. Simply "outlawing" Too Big to Fail is easier said than done.Given the concentration of banking assets and the interconnectedness of the financial sector, the failure of one large bank would create a domino effect that could take down the entire financial system.The solution is to create the proper incentives for appropriate bank risk management practices.

Chapter 6 Questions: 2. If you invest 20,000 in a security today, how much will it be worth in 6 years? It pays 6 % compounded monthly. 3. What is the effective interest rate of 10% compounded quaterly versus 10% compounded monthly? 4. Consdier a 15,000 loan with interest at 12% compounded monthyl nd 24 paymwnts. How much will the loan payment be? Set up an amortization schedule for the first 4 months, indicating the amount and timing of principle and interest payments? 5. How much would you be willing to pay today for an investment that will return 6,800to you 8 years from today if your required rate of return is 12%? 9.) You want to buy a new car, but you know that the most you can afford for payments is 375 per month. You want 48 month financing and you can arrange such a loan at 6%, compounded monthly. You having nothing to trade and no down payment. The most expensive car you can purchase is 1.) An old junker for 4,000, 2.) Honda Civic for 10,000 3.) Ford Escort for 14,000 4.) Camry for 17,000 5.) Infini for 24,000

2. Using financial calculaiton, 28,640 3. SEE card 4. PMT=706.10. 1.) Interest of first payment: (0.1)(15,000)=150; principle=556 2.) 3.) 5. ) 2,746.4 9.) Using financial calculator: P/Y = 12 N = 48 I/Y = 6 PMT =-375 PV = ? = -15,967.62 Can afford the Ford Escort

Important money market instrumets (continued)

4. Commercial paper: unsecured short-term corporate debt inssued to raise short term funds. Issuers usally have high credit ratings. Generally sold in large demoninations with maturities between 1 and 270 days. Usally sold to investors indirectly between brokers and dealers. Is usally held by investors until maturity and has no active secondary markets. 5. Negotiable certificates of deposits (CDs): a bank-issued fixed maturity, interest-bearing time deposit that specifies the interest rate and maturity date. They are sellable in the secondary market. Range in demoniations of 100,000 to 10 million, 1 million being the most common. Are often purchased by money market mutual funds. 6. Banker's acceptance: A time draft payable to seller of goods, with payment garunteed by the bank. Used in interanitonal trade transactons to finance trade in goods that have yet to be shipped from foregin exporter (seller) to a domestic importer (buyer). Foreign exporters prefer that banks act as payment garuntors before sending goods to importers. These are bearer instrumets, and are thus sellable in the secondary market.

Chapter 2 Questions 5.) Federal deposit insurance used to cover a maximum of 40,000 per elidgible account. It was later raised to 100,000 per account and is now 250,000 per elidgible account. What cost and/or risk does this pose to the FDIC. 6.) What does the acronym camels refer to in a commerical bank examination? What are the most important facets of an examination? 9.) Outline the major provisons of the Graham-Leach Biley Act. Many experts consider this act to favor large bank holding copanines. What are advantafes and disadvatges to this bill to some of the largest commericla banks and savings instituions? What impact, if any, do you think it had on the financial crisis? 12.) 13.)

5.) When congress increased the limit to 100,000, it expanded the range of services and lines of business that commercial banks and thrifts could offer. Many insitutions grew that deposits at an incredible rate simply by buying funds through brokerage houses. As such, they would pay the broker whatever was necessary simply to sell large amounts of full insured deposits to customers. The insitutions then speculated with the funds. FDIC often had to clsoe these banks and pay the depsotiors upon failure. 6.) Most bank failures reflect bad loans. Bad loans arise from poor loan underwriting, inadqeute polices and lending prcatices, etc. Bank examinaiton identifies whether such polices are in place and examines asset quality. 9.) Allowed banks to offer services in a wide range of areas and go into new lines of business. Large isnituoins with the greatest amount of capital have been agressivley exapnindg across geogrpahical and business service lines. Though they don't have the same amount of capital, but they can enter new markets and offer some new services to a lesser extent. Smaller banks are now giving way to mergers and aquisiotns. SOme say that this "too complex to suceeed" mentality is what led to the 08 crisis.

Bank Asset: Loan and Lease Allowance

A contra asset reserve account that reconizes that some loans won't be repaid. Its subtraced from gross loans and leases to obtain the net loan amount

Asset Utilization

A measure of the insituion's ability to generate total revenue - See formula - The greater the AU, the greater the bank's ability to generate income from the assets it owns. -

Primary advantage of operating as a bank or BHC.........

Acess to FDIC. - FDIC charges banks at a premium for the insurance, which ensures which ensures qualified deposit holders that the FDIC will garuntee the principal amount of each deposit up to the maximum allowed, even if the bank fails. This allows despository insitutions to pay low rates on insured deposits and ensures that such deposits are relatively stable in times of crisis.

Shortcomings of Restrictive Bank Regulation

Although desinged to preserve the safety and soundness of banking system, regulation cannot accomplish all of its goals (ex. Regulation doesn't prevent bank failures. Cannot eliminate risk in the economic enviroment, Cannot make manages act ethically, etc). Regulation serves as a guideline for sound operating policies. - The traditional approach of restricting the geographic and product scope of banking activites had three drawbacks: 1. Assumes that the markets for commerical bank products, largely bank loans and deposits, could be protected and that other firms could not encroach upon these markets. Not surprisingly, investmnet banks, hybrid financial companines, insurance firms, and others found ways to provide these same services across diffeent geogrpahic areas. This left commerical banks unable to diversify their product scope and thus compete. 2. Discriminated against US-based firms vs foreign-based firms. Ex. Prior regulations prohibited US commerical banks from underwriting (issue new stocks or bonds) securities for firms in the US. Foreign banks dont have this restirction and can do both 3. Historical legiaslaiotn penalizies customers who dont have acess to the reange of products they demand

Duration example: Find the McCaulay's duration (duration) of a bond with annual coupon payments, 10% annual coupon rate, face value of 10,000, 4 years to maturity, and a YTM of 8%.

Answer: 3.5 years

Book Notes: BHCs

Any organizatoin holding a controlling interest (ownership or indirect control via the power to vote more than 25% of the voting shares in a bank) in one or more commerical banks - Holding Company obtains fianacing from stockholders and creditors and uses the proceeds to buy stock in other companines, makeloans, and purchase securites. - Holding compnay is the parent, and the banks are the subsisuaries. If parent owns at least 80% of their stock, it files a consolidated tax return. - OBHC: Control only one bank and typically arise when the owners of an exsisting bank exchange their shares of stock for stock in the holding company. - MBHC: Control at least 2 commercial banks. - Large organizations generally become OBHC or MBHC to control a bank and provide tradtional banking services. Also want to combine the bank's capibilites with the financial activites of their nonbank financial subsiduaires in order to better compete nation wide. - OBHC structure: Board of directors on top, Parent company under them, Subsiaury banks operate like an indpentn bank, having a president and line officers (but decisoins still have to be reconciled with nonbank subsiduaries - MBHC structure: Board of direcots on top, parent copanh under, and some operate as closely knit units with the managment of each subsizaury unit reporting daily to the parent compnay (making subsiduaires effectively branches); important decisons must be approved by others outside the local community (ex. loan officer having to get approval for all loans over 100,000 from regional holding company representative). Other MBHCs allow mangers of subsisauries to retain key decison making authority and to operate quasi independently; this makes it more difficult to realize eoncomies of scale and some benefits of size are lost. Advanatge is they retain close ties to their local communites.

Open Market Operations

Bank lending creates money, and banks need reserves to lend. - The bank can also drain reserves from the banking system by selling treasruy bonds - These transactions are referred to as open market opertions, their most important monetary policy tool

S Corporation Banks

Banks also differ in termss of their federal income tax treatment. in 97, the US congress passed legislation that allowed some banks to operate as S Corps. S Corps have favorable tax treatment, because they do not pay any income tax. The firm allocates income to shareholders on a pro rata (% of ownership) basis, and each indivdiaul owner pays tax at their personal rate. - Primary requirement for S corp status is that the underlying bank must have no more than 100 shareholders. - Concentrated ownership may also reduce agency problems and subsquently improve risk management practices. - S Corps are generally smaller in size and assets than C corps. - Managers are more likely onwers and may monitor risks more closely.

Organizational Structure

Banks obviously differ in their basic organizational structure as well as in the lines of business they enter. - Independent banks have less flexibility compared with BHCs. Even BHCs differ in terms of the number of banks under their umbrella, and in terms of the number and breath of activites engaged in by their nonbank subsiduaires. - Some banks have chosen to emphaize the nontraditonal banking componets along with their banking operations. BB&T, for example, has entered the insurance business aggressively and now has one of the largest insuance operations of any type of financial services company. State Farm is now growing its banking operations by buying midsize banks

Future and PV: single payment

Cash today is worth more than the same amount of cash in the future. - A security purchased for 1,000 promises to pay 1,080 exactly one year later. - 1,000 is the PV, and 1,080 is the FV. - If the second year 8% is paid on the 1,080 balance, you'll be earning interest on the intial principle and the interest from the year before (compound interest) - If you could have 30,000 now or 37,500 in 2 years with an oppourintiy cost of money of 8%, the 37,500 would be worth 32,150 today, so take the latter.

Role of Depsotory Insituoins in the economy?

Commerical banks, as well as other depository insituons, play an important role in economic growth. On the marco level, the are the primary conduit of the Fed's monetary policy. On a micro level, they represent the primary source of credit to most small businsesses and many indivdiuals. - Fundamental shift in the strucure of financial insitutions since 1980: deposotiry insitutions share of financial assets has systemically declined since 1980. There's competiton from less regulated financial firms that compete in the same general product line. Some still have better revenues, however, since some of their activity is "off the balance sheet" through securization.

Open Market Operations: Contractionary Monetary Policy

Contrationary monetary policy: If worried about inflation, the Fed would sell treasruy bonds. The increase supply of reserves also increases the Federal Funds Rate. The result is that there is not as much money bidding for goods and services, so inflaiton can be held in check. - Expansionsary monetary policy: If worried about unemployment or deflation, they wouldbuy treasuries from banks, which increased bank reserves and money supply. Increased supply of reserves would decrease federal funds rate. The result was more money bidding for goods and services.

Farm Credit System

Created in 1916 to support the credit needs of agriculture in rural America. Its a government sponsored enterprise that effectively makes many types of loans to the agriculture industry, as well as on land and homes in rural America. - Many community bankers in rural areas view FCBS as having a competitve advnatage because they are effecitively funded at defualt risk-free Treasury rates, which lowers their borrowing cost, whike not paying taxes on their profits.

Goals and Functions of Depository Institution Regulation: 5 reaons for depository institution regulation

Depository instituons are the most heavily regulated financial institutions in the US - 5 Reaons for Depository Institution Regulation: 1. Ensure safety and soundness of financial institutions 2. Provide an efficent and competitve financial system 3. Provide monetary stability 4. Maintain the integreity of the nation's payment system 5. Protect conusmers from abuse from credit-granting insitutions

After a major financial crisis, the US has passed various regulations....what has this led to prior to the 70's?

Developing a banking system with a large number of small depository institutions, a relatively short list of products and services they could offer, and narrow geogrphic areas in which they could compete. - This was inteded to reduce competiton and speculation in the financial industry

Measuring Duration: Duration's calculation (WRITE ON CARD)

Duration is calcualted by taking a weighted average of the time until the expected cash flows from a security will be recieved

Transaction Banking vs Relationship Banking: Relationship Banking

Emphasizes personal relationship between bank and customer. - Lender adds value to borrower in credit granting process and may also provide expertist in other areas such as accounting, business, and tax planning - Other services are agressively marketed to ensure relationships - Lending instutions generally charge higher rates and and often hold the loans in a portfolio. - Borrowers pay for the assurance that funds will advanced as needed with minimal repetitve negotations. - Customers also follow favorite bankers to other banks

Targeting the federal funds rate

Fed doesn't establish an explicit target for money supply, but they instead target the interest rate, which is the price of money. This is because the money supply is difficult to measure with precision, but its relatively easy to measure if they hit their target interest rate. - The interest rate that they speciically target is the Federal Funds Rate

Bank Assets: Repo agreement

Federal funds are short term unsecured loans bdtween banks. For lender, balance sheet calls them "federal funds sold," and for buyer, balance sheet calls them "federal funds borrwoed"

Product Restrictions: Depository institutions vs nondepository institutions

Federal resrve regulates specific actiivtes of commerical banks, BHCs, and FHCs. - For safety and soundness: regulations from FR restrict interlocking relationships among directors of banks and between banks and securities firms to ensure indepence, and restricing the terms of loans to insiders, such as directors, bank officers, and shareholders.

Bonds prices change asyematricallly to rising and falling rates

For a given absolute change in interest rates, the % change in the opriton free bond's price will exceed the % decrease. - For the same change in interest rates, bondholder's will recieve a greater capital gain when rates fall than the capital loss when rates rise for all option free bonds (see visual on slide 19)

Size of the Coupon Influences Price Sensitivity

High coupon and low coupon bonds exhibit different price violitility. - Given two bonds with the same par value that are priced to yield the same yield to maturity, the % change in price of the bond with the lower coupon will be greater than the % change in a higher coupon, given a change in market interest rates

Commerical banks, savings insituions, and credit union charters

Historically, commerical baks, savings associations, and creidit unions have eached served a different purpose and a different market. - Commerical banks: mostly specialize in short term business credit but also make consumer loans and mortages. They are stock corporations whose primary purpose is to maximize shareholder wealth. - Savings Institutions: Have historiclaly specialized in real estate lending (ex. mortages). Called "thrifts" because they orignally offered only savings or time deposits to attract funds....they now offer a wide range of financial services. Most owned by shareholders, but some are owned by their depositors and borrowers. Maintiain 65% of their assets in redidenal housing to mainatain their savings insituion status. - Credit Unions: nonprofit insituions whose purpose was to encourage savings and provide loans at low costs for members. Members own and control the insitution.

The US's dual banking system in respect to charters...

Individual States, as well as the federal government, issue bank charters. - OCC charters national commerical banks, whereas individual states issue state commerical and savings banks and all depoisotry insitutoins. Same logic applies to national and state credit unions. - Soruce of the charter determines how the insution is regulated. - National vs State charter: agency that charters the insitution is the bank's primary regulator. All banks obtain FDIC insurance as part of the process. National Banks are only regulated by federal agencies, whereas state chartered also have a primary federal regulaor.....Federal Reserve is primary regulaotr of an FDIC insured state bank that is a memebr of the Fed, wehre the primary regualtor of a non-fed memebr bank is the FDIC. - REgualtory agncies conduct periodic on site examinations to asses a bank's condition and monitor compliance with banking laws. Issue regulations, take enforcement actions, and close insitions if they fail.

Income Statement: Interest income and interest expense; Net Inteet Income

Interest income is the sum of interest and fees earned on all assets - An income statement shown on a tax equivalent basis means that Interest Expense is the sum of all interest paid on interest-bearing liabilites. Net Interest Income: Gross interest income-gross interest expense

Primary Disadvanatge of Operating as a Bank....

Its subject to regulation as a bank. - Subject to safety and soundness exams to acess to risk management and compliance exams which monitor appropraite customer service. - Prior to the financial crisis, investment banks avoided most regulation, which allowed them to operate with lower equity capital per dollar of risk assets and enter lines of business not generally avaliable to commerical banks, such as proprietary trading - Of the big 5 investment banks before the crisis, only two (Goldman Sachs and Morgan Stanley) are still indepenent, and they are now both financial holding companines

Holding Company Financial Statements

MBHC expansion enables banks to diversify their operations by competing i different geogrphic and product markets. Diversification reduces the risk of failure by stabilizing earnings. Parent company typically provides the operating stradegy for the entire organization and provides services for which it charges fees. It assists bank subsiduaires in asset and liability management, loan review, data processing, and business developemnt and may provide debt and equity funding. - The consolidated financial statements of a holding company and its subsidares reflect or consolidate perforamnce.

What is the Money Market?

Market for debt instrumets with the following characterisitcs: - original maturites of one year or less - Issued by high-quality entites that require short-term funds. - Little or no chance of principal loss - Often have active secondary markets to provide liquidity - Most Money Market Instrumets not included in the defintion of money, but but they are genrally very east to convert into money

Exepnse Ratio: Noninterest Expense

Measures of personal, occupancy and other operating expenses as a % of total overhead indicate cost effectncies or disadvantages - Ratios are consructed to allow comparisns between different sized banks - May also vary based on composition of liabilites - Banks with large amounts of transaction deposits have greater relative overhead costs. Ex. Cost of operating branches

What are the functions of money? M1? M2? Monetary Base?

Money is a medium of exchange, a store of value, a unit of account. - In the US, one common defintion of money is M1, which consists of currency and coins in cirrculation + demand deposits. These can be used to purchase goods and services. -M2 is a slightly broader definition that also includes savings, deposits, and retail in money markets and mutual funds. These are easy to convert into checking depsoti or currency. - Monetary base consist of all currency and coins and reserves held on deposit by commercial banks at the federal reserve. The Fed and other central banks conduct monetary policy by changing the price and quantity of these reserves.

Income statement: Net Operating income

Net interst income- burden (noninterst expense-noninterst income)-provision for loan losses + secuites gains-taxes

Supervision and Examination: CAMELS system

OCC and FDIC acess the overal quality of a banks conditoin accoridng to the CAMELS system. - CAMELS: Capital Adequacy, Asset Quality, Management Quality, Earnings Quality, Liquidity Quality, and Sensitivity to Market Risk

Operational Risk

Possibility that operating expenses might vary siginficantly from what was expected - May occur as a result of: business disruptions, transaction processing errors, inadaquete information systems, breaches in internal controls,client liability

Managign Risk and Returns: Credit Risk (FORMULAS)

Potential variation in net income from loan nonpayment or deferred payment - Change in Allowance for Loan Losses= Starting balance-(gross credit losses-recoveries) + provision for credit losses + other adjustments - Net credit losses: Gross credit losses (charge offs) - recoveries (loans that were previously written off during the period but were collected

Net income on income statement

Pre-tax net operating income-all taxes-net income to all noncontrolling interest

Reasons for depository institution regulation: Ensure competitiveness and efficiency

Prevents concentration of depository insitution resources that would enable a lack of competition, but still allow firms to alter their product mix and delivery sytem. - Traditoinally been accomplished by limiting mergers and aquisitions that reduce competitiveness, as well as limitations on the fraction of deposits that any one insitution can control in a single state

Financial Holding Companies

Primary advantage is entity can engage in a wide range of financial activites not permitted in the Bank or BHC, including: - underwriting and selling insurnance and securites - both commerical and merchant banking (private equity) - investment activites - FHC can own a bank or bank holding company: each of these companines owns subsisuaries, while the parent FHC owns other subsiduaries directly.

Reaons for depository institution regulation: Ensure safety and soundness of financial insitutions

Primary purpose is to maintian domestic and international confidence, protect depositors (and tapayers), and maintain financail stability - This ensure that financial insutions can be efficent by ensuing that the system is reliable and that insitutions will willingly extend credit. - Traditionally been accomplished by limiting risk-taking at individual institutions, limiting entry and exit, and the Fed being a lender of last resort

Effeicent and Competitive Financial System

Product restrictions, barriers to entry, and restrictions on mergers and teh degree of branching can clearly enhance safety and soundness, but they also hinder competition. Effective financial regulation requires a balance between safety & soundness and competitoin.

Supervision and Examination

Regulators periodically examine individual depository insitutions and provide supervisory directives that request changes in operating policy. This is to ensure safety and soundness for the purpose of preventing a bank failure and it having to be backed up by the FDIC. - As mentioned, its assesed accoridng to the CAMELS system. - Asset quality: relative volume of problem loans and loan losses. If repayment prospects are poor, regulators may force them to reconize the loss and build up reserve in support of the losses - Management Quality: Quality of seniors officers awareness and control of the depository insituion's policies and performance. - Liquidity Risk: evaluated in terms of the composition of funding, avaliability of liquid assets to sell or use as collateral against new borrowings, and the effectiveness of the bank's contengency funidng plan - Sensivity to Market Risk: looks at managments ability to identifty, measure, monitor, and control price risk. MArket risk mainly means senstiivty to icome and equity to interest rates. Larger financial insituons have active trading portfolios and some exposure to equitites and are more senetive to changes in the market. - Once exam is complete, reccomendations will be made. May be a Memorandum of Understanding (formal regulatory document that identifies specifc problems and perscribes corrective actions), Consent Order (Says bank should stop certain activites and pursue specific remedies to exsisitng problems, or a Cease and Desist Order (formal order to stop an unfair practice under full penealty of law). May also punish certain activites through Civil Money Penealites or Fines

Market Risk:

Risk to earnigns or equity from adverse movement in market rates or prices. - Interest rate risk is the potential variability in an insitution's net interest income and market value of equity due to changes in market interest rates - Often analyzed using GAP analysis - An asset or liability is rate sensitive if managmenet expects it to be repriced (rate change) within a certain time period. -

Liquidity Risk

Risk to earnings and equity from the bank's inability to timely meet payments or obligations by liquidating assets or raising required funding - Market liqudity risk is the inability of the institution to easily unwind or offset specific exposures without signfiicant losses from inadaquete market depth or market distrubances - Banks attempt to minimize holdings of cash and nonliquid assets (money market instrumets) due to the oppounirty cost of holding them....they pay very low rates of interest.

Too Big to Fail Banks

The Fed and US Treasury took unique steps to prevent an economic collapse. Emergency credit was provided to institutions that faced serious funding problems. - Generally, the institutions that recieved the greatest loans, gurantees, and equity investments were the nation's largest instituions. - At the same time, bank regulaotrs allowed many smaller banking organizatoins that found themseleves in trouble to fail, thereby whiping out stockholder's investments and generating losses to the FDIC insurnace fund. - Market particpants and analyst qucikly labled the fact that the largest instutions recieved the greatest and immediate government aid as "Too Big to Fail." Regulaors and government officals argued that these firms were too connected to other large firms, and a failure would lead to a collapse of the global financial system and ultimately to a severe recession. - Studies show that TBTF firms contiue to have an implicit government garuntee, which produces lower borrowing costs and lower operating costs.

Different Channels for Delivering Banking Services

The following comparisoin of delivery channels demonstrates some of the key issues: 1. Branch Banking: Many banks have pursued strategies to expand their physical presence by operating extensive branch bank networks. A branch bank is a retail outlet in which customers can douct their business face to face with representatives. Two most common are brick and mortar and in-store branches: Brick and Mortar typically offer a complete set of banking services including loans, deposits, and money management/trust services. 2. ATMs: Computerizied telecommunications systems that offer limited banking services without direct human involement. 3. Internet Banking: Most banks allow customers to acess their account info and conduct routine banking business via secured Web sites. Avdnatage is that its convient for cusotmers (primary appeal), and the main disadvantage is that its easier for thieves to acess. 4. Call Centers: Intneded to benefit retail cusomters. COnsists of a centralized location dsinged for a bank's employees to recieve and transmit calls, mainly used for inqurires, debt collection, and telemarketing. 5. Mible Bannking: The bascially online banking with a mobile device like a cell phone or tablet instead of a computer. - Different delivery channels appeal to different types of customers. Typically younger prefer channels that offer the greatest convience so that they never have to enter a building. Older customers prefer face to face contact.

Market Risk: Equity and Security Price Risk; froeign exchange rates

The potential risk of loss associated with trading account portfolios. Value-at-risk or sensitivty analys is often used to analyze this risk. - Foreign exchange risk is the risk to an insitution from adverse movements in foreign exchange rates.

EAR

The true annual rate that reflects the effect of compounding....Effective annual rate (EAR). - EAR=(1+nominal rate/m)^m-1 - The EAR is greater than the annual rate when interest if compounded more frequently than anually - APR: Annual Percentage Rate. This is a nominal rate, so the EAR is higher than the APR with more frequent than annual compounding. - Nominal annual rate=stated annual rate=APR

Why is Wall Street so obssed with the Fed?

To some degree, money-market instrumets are subsitutes for each other, so the Fed excercises over all short-term rates. Money Market instrumets such as treasury bills compete with stocks and bonds. Other things equal, higher rates on liquid, short-term, risk-free or nearly risk-free money market instrumets drive up required rates of returns on stocks and bonds and drive up their prices. - Secondly, contractionary policy by the Fed that reduces the money supply reduces consumer spending and business investment. This tends to reduce profits for business, which is particularly bad for stocks and some corporate bonds

Balance sheet: liabilites and stockholder's equity (demand deposits, money market and savings accounts; time deposits )

Transaction accounts - Demand deposits: checking accounts that may or may not pay interest. With Dodd Frank's repeal of Regulaiton Q, preventing interest on checking accounts, there is little difference between interest checking accounts and Negotiable order of withdrawl and automatic transfers of savings. These type of accounts were formually used to get around regulation Q. - Money market and savings accounts: pay market rates but regulation D limits the number of checks and automatic withdrawls. to no more than 6 each month. - Time deposits: time deposits below insruance limit are called small CDs and carry early withdrawl penealites. Those above negotiable insruance limit are called jumbo CDs and are negotiable; can be bought and sold in secondary market, maturites range from 1 month to 5 years, typically 1 million in face value

Universal Banking

Universal Banking refers to a structure for financial services company in which the copnay offers a broad range of financial products and services. - Preseumed advantage of universal banking was the ability to cross sell products to customers. Participation in diverse products and services would preseumably increase the informtion advnatgae and allow bank to serve customers more efficently at better prices. - No concensus on whether universal banking is sucesssful. US firms that tried to achieve the goal of a "one-stop financail market" have not outperformed more traditonal competitors. - Whether the universal banking model works is still an open question. Critics argue that management cannot sucessfully operate such widely diverse lines of business (Too complex to suceed?). Primary advatage is that these organizations might be deemed "too big to fail." and thus effectively garuntee their exsistence in times of crisis.

FDIC

Up to 250,000 per depositor per issued commerical bank and savings insitution, per account ownership catergory. - Depositry insutions pay premiums for insured deposits into the Deposit insurance fund....amount depends on the FDICs reserve and the percieved quality of the insituion. - FDIC acts as the primary federal regulator of state chartered banks that dont belong to the federal reserve system - FDIC is the reciever of failed insituion; declares an insituion insolvent and either liquidates or sells it to redeem insurance deposits.

Bond prices and interest rates (**look up formula on slide**)

Vary inversely when bonds trade on secondary market - If coupon rate is higher than market interest rate, it will trade at a premium (prie higher than par value). If coupon rte lower than marekt, reverse is true. - Ex. bond 10,000 face value, fixed semi-annual interest payments of 470 that matures in 3 years. - Semi annual coupon rate is 4.7% (470/10,000); 9.4% anually - If market rate is 4.7%, it sales for face value. - If market rate rises to 5%, semi anually, it sells for a disount, and vice versa (see fmroula to determine exectly how much)

Banker's acceptances Examples: - Ex. Weylan-Yutami wants to purhcase a generator from a chinese space outpost. The outpost things they're a fruad and won't accept payment from them.

Weylan-Yutami would deposit the purchase price plus a small fee at JP Morgan Chase and obtains a banker's acceptance that obligates the bank to pay the purchase price in 3 months. This is analogus to a post-dated check and is an unconditonal liability of JPM. Weylan transfers the banker's acceptance to the outpost and can either hold onto it and redeem it at face value in 3 months or sell it in a secondary market.

Asset Utilization: Noninterest income

fees, fiduary activity, service charges, trading revenues, and other noninterest income - May be scewed by substiatnial nonreoccuring items, such as a large trading gain or loss - Tax payments also impact ROA

Yeild to maturity=coupon rate - yield to matur>coupon rate - Yield to maturity<copoun rate

par value, disocunt, premium selling prices.

Test: Federal funds purchased...

when you're the borrower of federal funds