Money & Banking Assignment Sec 4

9.a. If the bank is worried about "liquidity", it will try to hold more _________________________________

"Excess" reserves at the Fed and cash

16. An attempt by banks and others to get around regulatory capital requirements by keeping assets on the bank's books that have the same risk-based capital requirement but are really relatively risky, while reducing or taking off their books low risk (and lower return) assets is the definition for "__________________________________________________________________"

"Regulatory Arbitrage" This has occurred with high risk loans, securitized assets, and with the use of apparent hedges through derivatives. Most recently it has possibly appeared with the Special Investment Vehicle write-downs taken by Citigroup and other financial institutions where they were exposed to the SIVs but not on the balance sheet.

15a. The belief that the largest banks and other financial institutions cannot be allowed to collapse or the entire financial system might be threatened; thus belief or reaction in the market by banks and depositors that the government will always rescue such a big bank (or other institution) is known as the concept of the "__________________________________________________"

"too big to Fail syndrome"

15b."What issue may encourage the large banks to expand and take more risks than they should because of the apparent regulatory support (e.g. FDIC insurance backing or a Fed cash infusion) if a problem arises.

"too big to fail syndrome"

Liability Management Biggest Risks

*No credit risk (Its the bank's credit.) 1. Interest rate risk (both income gap and duration risk) 2. Matching assets, net interest margin, leverage/net capital and regulatory risks.

20. Give 2 reasons "non-interest" income and off balance sheet items have grown as a source of bank operating income. (Please do not just give examples but give reasons why the banks have grown non-interest income.)

1&2. Banks do not need to hold reserves at the Fed or excess capital against many types of activities involving non-interest income, making it a more efficient source of income. 3. Lower capital required by non-interest income means a higher ROE, higher stock price, etc. **8 more.

3. "Universal banking" involves (circle correct):

1. A commercial bank providing a full range of services including banking, securities trading, real estate, insurance, etc. 2. Can lead to conflicts of interest

19. Both the systematic risk section of the Dodd-Frank act in the US and the Basel III reforms to the Basel Accords for big international banks made two tougher balance sheet requirements on banks, which were:

1. Additional capital requirements for the banks 2. Additional liquidity for the banks

1. At the beginning of this section of the course and in one of the case studies we discuss Porter's five forces and some of the other external forces that affect the banking business. Please name five of these forces that can affect the banking business and specific banks:

1. Bargaining power of suppliers 2. Bargaining power of buyers 3. Threats of new entrants 4. Threat of substitution 5. Competitive rivalry within the industry 6. Economic & Market Influences 7. Political & regulatory influences 8. Social Influences 9. Chartering & Licensing 10. Changes & innovation in tech 11. Barriers to entry & exit from the industry.

4. Name two of the possible conflicts of interest that can arise in universal banking:

1. Being both a direct lender and responsible for research/credit assessment to outside investors-especially where the bank is also helping sell securities. 2. Acting as a research organization assessing the value or credit of a company while also acting as an advisor or underwriter selling the company's securities to the public. 3. Acting as an advisor and a consultant to more than one company and then apparently having to represent one side only in a negotiation, merger/acquisition, etc. 4. Being responsible for both selling securities to the public and acting as a fiduciary in buy/sell/hold in the banks own accounts, trust accounts and other customer accounts. 5. Conflicts in the pricing, fees, and resulting relationships in roles as a depository institution, lender, advisor, underwriter, research provider, etc. which could be to the financial disadvantage of one customer versus another or one of these services versus another. **Additional Info

10. All of us have a "balance sheet" and some items and the order of items on a balance sheet are often somewhat similar regardless of who we are talking about. Banks are both similar and different to individuals or other companies on balance sheet items. Please give at least 6 examples of bank assets in order from most liquid to least liquid:

1. Cash Items & Reserves 2. US Government & Agency Securities 3. State & Local Government Securities 4. Other Public Securities (e.g. publicly traded corporate securities.) 5. Commercial & Industrial Loans 6. Real Estate Loans 7. Interbank loans 8. Other loans and private placements 9. Other assets (e.g. physical property-branches & Equipment.

1. Name three of the key risks against which a bank must protect itself (please be more specific than things like "economic risks")

1. Credit/Default Risk: The risk of a loan or security going into default. 2. Interest Rate Risk: Maintaining a positive net interest margin between the bank's funding and lending. 3. Liquidity/Reserves Risk: Having enough cash to fill all needs and prevent a "run on the bank". 4. Asset/Liability Management Risks: The appropriate matching and management of assets & liabilities. 5. Capital Adequacy Risk: Maintaining enough capital to absorb unexpected losses and fulfill regulatory requirements. 6. Regulatory Risk: Risk of changes in regulation such as a change in reserve requirements.

5. Please name three reasons electronic banking and virtual banks are unlikely to entirely replace physical branches anytime soon.

1. Depositors appear reluctant to "trust" the security of their funds in I-banks. 2. I-Bank customers seem concerned that their transactions are truly secure and private. 3. Empirical evidence shows that long-term savings products and various loans are purchased or made more often face-to-face. 4. Technology glitches are still present 5. Internet-only banks have experienced relatively low revenue growth (discouraging additional investment) ***For similar reasons it is unlikely the use of "cash" will disappear: convenience, near universal acceptance, lack of fees, etc.

12. Please name three of the four key bank regulators we discussed:

1. Federal Reserve: All banks must have reserves on deposit at the Fed, in addition specific oversight of bank holding companies, banks with discount loans, etc. 2. Comptroller of the Currency: Charters & oversees nationally chartered banks. 3. FDIC: Oversees all banks covered by deposit insurance 4. State banking regulators: Oversees state chartered banks

5. Among the current issues with banking is the growth of the "shadow banking system" Please name three of the financial entities that make up the "shadow banking system"

1. Hedge Funds 2. Money funds 3. Investment Banks 4. Special Purpose Vehicles 5. Securitization 6. Monolines: A company specializing in a single type of financial service, such as consumer credit, home mortgages, or a sole class of insurance.

3. In the 2008-2010 financial crisis, some banks and other financial institutions, like Washington Mutual, faced potential huge deposit withdrawals by customers who become nervous about the safety of their deposits. This loss of deposits can cause significant problems in funding assets like loans and having adequate reserves on deposit at the Federal Reserve. Name two ways the banks may be able to protect themselves from the disruption caused by this deposit outflow (liquidity risk):

1. Holding excess reserves so they still have plenty of reserves despite the loss of deposits. 2. Temporarily borrowing excess reserves from the Fed or from other banks via discount loans or Fed Funds borrowing. 3. Selling securities (assets: Typically gov securities) to raise cash & reserves to offset the loss of deposits. 4. Reducing the need for deposits and reserves by reducing assets (e.g. "calling in" loans/liability management.

8. These new "financial derivatives" have also created new risks. Please name 3 concerns with "derivatives":

1. Ignorance: The instruments can be quite complex such that many investors, including many of those participating in the derivatives markets and their regulators, do not understand the instruments they are trading. 2. Potential lack of liquidity (No willing buyer/seller or "counter-party" when you wish to transact to get into or out of a derivative position.) 3. Default risk in counterparties, particularly as the dollar amounts and number of counterparties have grown. Many times, through a long stream of offsetting trades, the actual final counterparty in unknown. ***4 more

5. The two principal drivers of innovations in banking (and virtually all financial intermediaries and markets) over the last 30 years have been:

1. Improvement in information technology 2. Search for profits by banks and other financial institutions

25. If they are specifically trying to address issues in managing volatile interest rates, what is something they might do:

1. Make more adjustable rate loans, which puts the risk of changing interest rates more on the borrower rather than the bank. 2. Sell or reduce loans or assets with greater relative interest rate risk. 3. Shorten the duration of the banks loan portfolio (shorter loans to reduce length of

Asset Management Biggest Risks

1. Managing credit and interest rate risks. 2. Liquidity and net interest margin

11. What are, some of the key issues in banks' asset and liability management (name three):

1. Managing liquidity in both assets & liabilities to meet obligations 2. Managing credit risks on assets and probable uses of funding, including: Making loans & buying securities with relatively high returns and low (acceptable risk) Diversification of loans and sources of funding Change pricing, sell down or hedge with derivatives to manage asset growth and excess risks. 3. Managing interest rate risk on both assets & liabilities: Use of derivatives, change pricing or terms of loans and deposits. 4. Managing capital reserves to cover risks/to stay in regulatory compliance while minimizing capital for ROE. 5. Managing dividends, net interest margins and other sources and uses of cash to maintain asset/liability balance and capital. 6. Managing inflow and holdings of deposits and CDs with to obtain favorable interest rates (for Net Interest Margin or NIM) and through other means (e.g. penalties for early withdrawals 7. Maximizing Net Interest margin and ROE by opportunistically issuing securities such as commercial paper, debt, sub debt, capital notes or preferred stock at favorable times and favorable rates. 8. Maintaining liquidity, reserves and capital by borrowing Fed Funds or at the Discount Window.

6. Please name two of the concerns with the "shadow banking system"?

1. Not subject to the same safety and soundness regulations as depository banks 2. High financial leverage (sometimes even more than banks which have 5% equity) which magnify profits & losses. 3. Reliance on short term funding like commercial paper but investing in longer assets, like mortgage pools. 4. Subject to credit risk and market risk (Sudden loss of value on their underlying assets.) and especially liquidity risk, particularly in a financial downturn. 6. No "lender of last resort" like banks have therefore more vulnerable to financial market swings and yet still tied to the commercial banking markets through securitization, etc.

7. Bank Asset/Liability and Capital Management. Banks engage in certain activities to manage their balance sheet and profitability. The 4 major activities are:

1. Primarily Asset management 2. Primarily Liability Management 3. Could be both Asset and Liability Management 4. Primarily capital management that can specifically enhance (increase) ROE (return on equity)

18. Please name four ways in which a bank seeks to protect itself from credit risk:

1. Screening 2. Covenants & Monitoring 3. Long-Term Customer Relationships 4. Collateral 5. Compensating Balances 6. Credit Rationing 7. Conditional Loan Commitments ***Definitions in sec 4 Assignment, #18

24. If a bank has too much or too little capital and wants to manage it, name something they might do:

1. Sell additional Stock or retire stock to raise or lower capital. 2. Change dividends to change retained earnings. 3. Change asset growth (and thus liability growth affecting both the capital balance as a % of assets and the fundamental need to cover both those possible asset losses and the liabilities that need to be repaid.

9. We briefly discussed banks and financial crises. Please name two of the typical causes of financial crises for banks, such as the problems arising for banks and others in the US Europe the past several years and during the financial crisis:

1. Significant innovation or liberalization which is not well managed or regulated 2. Asset price booms and busts (e.g. the housing market) often including huge leveraging (e.g. "credit booms") ***4 more

2. While the current regulatory framework is designed to protect consumers and maintain stability of financial institutions and markets, some argue that the regulatory protections encourages just the sort of practices that they are designed to protect against. What is one of the moral and adverse selection hazards which may actually be encouraged by the current US bank regulatory framework?

1. Too big to fail syndrome: May encourage the large banks to expand and take more risks than they should because of the regulatory support. (e.g. FDIC insurance or Fed cash infusion.) if a problem arises. 2. Lack of deposit market discipline for overly aggressive/risky banks as consumers/depositors are negligent in assessing risk since: with FDIC insurance, the depositor knows he/she will suffer no significant losses. 3. Current protections may specifically encourage actions adverse to regulators by both depositors and potential bank manipulators. Deposit insurance and other support like the Fed borrowing window can encourage the promise of quick (and sometimes unrealistic, overly risky or illegal) returns for extremely aggressive or fraudulent management (the "crooks") who simply want to raise funds for such purposes. Depositors searching for the highest returns may take funds out of conservative institution and move the funds to these risky institutions who promise such higher returns, but whose managements are engaged in ultimately detrimental activities.

15. Interest rates and managing net interest margins at the bank ______________ (5 parts)

1. is one of the key risks faced by a bank 2. is one of the key goals of asset & liability management 3. became much more critical when rates started fluctuating much more in the late 1960s and 1970s 4. is particularly difficult because most banks "borrow short and lend long" 5. has given rise to a massive market in derivatives and options

16. Checkable deposits, a traditional source of low cost funds for banks, have declined dramatically in importance, falling from over 60% of bank liabilities several decades ago to less than ______________________%__ today.

10%

4. Definition of a virtual bank:

A bank that has no physical branches, but exists only on the internet or through services offered through other institutions (e.g. access to ATMs). These banks can accept deposits, sell CDs, make loans & mortgages, offer ATM cards for access to cash, provide payment services and checking accounts, etc.

3. Checking accounts and other depository accounts, are ________________________________ on a bank's balance sheet and are thus a basic source of __income / expense__ for the bank.

A liability Expense

Equity and surplus is _________________ for the bank and is ____________ on the bank's balance sheet.

A source of funds capital

Bank ATMs are ________________ for the bank and is ____________ on the bank's balance sheet.

A use of Funds An asset

Credit card balances are _______________ for the bank and is ____________ on the bank's balance sheet.

A use of Funds An asset

Mortgage loans are __________________ for the bank and is ____________ on the bank's balance sheet.

A use of Funds An asset

Reserves at the Fed are _______________ for the bank and is ____________ on the bank's balance sheet.

A use of Funds An asset

13. Most simply the CAMELS process is what? _________________________________________________________

An audit of the banks by regulators

7. A bank's balance sheet, like most balance sheets, including yours and mine, shows that total ____assets_____________ equals total ___________________________ plus __________________________.

Assets Liabilities Capital (or Equity)

2. How do banks participate in "asset transformation"?

Banks take deposits and they invest in riskier assets like commercial loans. In other words, they take deposits or other funds from many individuals and through pooling risk (diversification) and expertise are able to re-deploy these funds into new portfolios of assets with apparently more risk per asset, but lower overall risk, and therefore relatively higher net returns for both the banks and for its depositors.

If in this process they regulator discovers the banks doing something the banks should not be doing, the regulator can issue what kind of 'order'? "________________________________________________________________________________"

Cease and Desist

26. Review: Outside the US the largest source of new funds in most countries is _____________________________________But in the US the largest source of funds over the last 30 years or so has been _____________________________________

Commercial banks non-bank loans (like securitizations)

___________________ Entering into interest rate derivatives

Could be both Asset and Liability Management

12. True / False Banks fail when the value of the bank's assets fall below the value of the bank's reserves.

False ***Look at reason why.

28. True / False Credit card balances are a source of financing for the bank and are thus liabilities on the bank's balance sheet.

False ***Look at why

22. True / False A small change in ROE can make a big change in ROA for the bank.

False **Look at Why.

26. True / False Because of the multiplier effect, as a bank's equity increases the equity multiplier also goes up.

False **Look at why

29. True / False A banks assets are its source of funds.

False (No source of funds like deposits are liabilities)

5. True / False A bank's liabilities, like checking accounts, are the basic source of income for a bank.

False (Something the bank owes to depositors) and typically the bank pays for such deposits if only in operating costs for maintaining them.

27. True / False Checking accounts are a source of funds for the bank and are therefore and asset on the bank's balance sheet.

False No 'sources' of funds like checking accounts are a liability-the bank owes this money back to depositors.

20. True / False Banks hold excess capital in case they run into liquidity problems.

False No, excess capital is to cover losses not short term liquidity issues-excess reserves at the Fed & extra cash on hand is what covers liquidity risk.

19. True / False Borrowing from the Fed is generally cheaper for banks than borrowing over night from other banks.

False No, recall the Fed's 'discount rate' is typically set at least to basis points higher than the target 'Fed Funds' rate on laons between banks. The current discount rate is 75 basis points, while the target Fed Funds rate is 0-25 basis points.

13. True / False Banks borrow from the Federal reserve at the "Fed Funds" rate.

False No, the Fed lends directly to banks at the "discount rate" "fed funds" are what banks use to lend to each other through lending or borrowing excess reserves at the Fed.

12. Given a bank's return on assets, the __higher / lower__ the bank capital, the __higher / lower__ the return (ROE) for the owners of the bank. .

Higher & Lower or Lower & Higher With higher bank capital leads to a lower ROE or Lower capital then higher ROE Key Tradeoff: High capital (safety in large equity balance to cover losses) versus high ROE (e.g. lower capital/fewer shares outstanding so each shareholder gets higher profit per share.)

7. Banks helped create a number of new financial instruments: swaps, futures, options and derivatives to help hedge the risks in their portfolios. What does "hedging" risk mean / how does it work?

Historically banks would try to protect themselves from certain risks by entering into swaps, futures or other contracts or derivatives which offset certain risks in their portfolios (e.g. entering into interest rate swaps to offset floating rate interest rate risk with a fixed contract or one to set a more fixed rate over a longer term.) In other circumstances this is seen as taking a "short" position to offset a "long" position (e.g. a risk or position which you currently own.)

23. While not so in the last few years, typically over most of history the largest specific operating expense for a bank has been __________________________________________The largest specific income item for banks is ________________________________________

Interest expense Interest income ***This is what makes the "net interest Margin" for the bank so important.

With everything that has happened since 2007, this percentage held by non-US banks has probably grown: __larger__/__smaller__

Larger

6a. Most of the large banks have about 5% in equity and 'borrow' (through deposits, time deposits, or selling bonds) about 95% debt - money they owe others. What is the term we learned for having a limited amount of capital and using borrowing to fund most the liability side of your balance sheet: "_______________________________________________"

Leverage

6. Definition of leverage ratio and what is typically the maximum for banks with the current core capital requirements:

Leverage Ratio=Capital / Assets  To be well capitalized a bank's ratio must exceed 5% (or be less than a max of 19:1 ratio/equity multiplier for liabilities to equity. Usually this measure is modified to look at the capital requirement on "risk-adjusted assets". Due to the financial crisis, it is likely the capital requirements for banks will continue to increase and thus the leverage ratio will decrease.

Define Leverage

Leverage can be expressed as either the percentage capital (equity) divided by asset base (most common and for use on this problem) or by the percentage debt (total debt or total liabilities) divided by asset base. Banks are generally required to have at least 5% core capital (equity divided by total assets) which can equate to debt leverage of 95% (total debt or total liabilities divided by total assets).

8.On its balance sheet, the primary source of bank funds are ___________________________________________. (Please give the specific line item on the general bank balance sheet in the text and power point.)

Non-transaction deposits (Mostly term deposits like CDs)

___________________ Credit scores on new loans

Primarily Asset Management

___________________ Issuing new subordinated bonds for the bank in a low interest rate environment

Primarily Liability Management

___________________ expansion of overnight loan markets giving the ability to acquire funds quickly

Primarily Liability Management

___________________ Growing off balance sheet activities

Primarily capital management that can specifically enhance (increase) ROE (return on equity)

1. Banks engage in off-balance sheet activities to generate income and enhance their (circle one) ROE / asset base___.

ROE ***By definition 'off balance sheet' would not affect asset base.

14. Refraining (not taking action) by a regulator in exercising a regulatory right to close or put insolvent banks, savings and loans or other regulated financial institutions out of business is the definition of "______________________________________________".

Regulatory Forebearance

Checking accounts are ________________ for the bank and is ____________ on the bank's balance sheet.

Source of Funds a liability

Fed Discount loans are ________________ for the bank and is ____________ on the bank's balance sheet.

Source of Funds a liability

Time deposits (CDs) are ______________ for the bank and is ____________ on the bank's balance sheet

Source of Funds a liability

18. What international "accord" helped establish some supervisory process, capital requirements and market discipline aimed particularly at large internationally active banks, which has recently been revised given the crisis of the last two years and is likely to take on more importance with further revisions in the future: _____________________________________

The Basel Accords

6b. We talk of banks having a high "leverage" What is "leverage" in financial terms?

The amount of capital (usually simply equity) relative to assets in a company, or sometimes just how much debt a company has. Typically measured by capital/total assets. 20:1 or 5% capital:assets is a relatively high ratio.

14. Definition of net interest margin

The difference between interest income & interest expense as a percentage of assets of a bank. (Key ratio of the largest income item to historically the largest expense item for a typical bank.)

19. One way banks managed their balance sheet was by originating assets and then selling them or securitizing them. This securitization market was largely shut down in the recent crisis, which is a key reason funds are not as available to many consumer and business borrowers. Please give the definition of securitization and give three examples of types of assets securitized by banks: (2 points) _____________________________________________________________________________________________________

The process of gathering illiquid assets into pools & structuring the claims on cash flows from the pools into marketable instruments. Example: Mortgage-backed securities, asset-backed credit card pools, auto loans, leases, and many types of receivables or short term corporate borrowings.

1. True / False Some experts, including the authors of this text, argue that the regulatory protections encourage just the sort of practices that those regulations are designed to protect against. In fact, they say, current protections may specifically encourage actions adverse to the regulators by both depositors and potential bank manipulators

True

10. True / False Under the discussion in the text and in class the typical maximum leverage allowed for a bank is about 19:1; another way of stating this is that the minimum core capital required is 5%.

True

11. True / False Many foreign banks in markets overseas have a huge advantage over US banks in that they have much smaller reserve requirements. In order to help US banks compete, the US government allows US banks to have Edge Act subsidiaries which are not subject to typical US regulation.

True

14. True / False A typical base rate at which banks outside the US lend to each other is LIBOR.

True

15. True / False The Federal Reserve can influence money supply by increasing bank reserves (excess reserves), which the banks can then use to lend or invest.

True

16. True / False Short term the money inflow from increasing excess reserves can increase lending, which increases economic activity and, presumably employment; but long term, without productivity gains, the higher money supply can cause inflation which can reduce these benefits and cause interest rates to rise hurting economic activity.

True

17. True / False Banks generally want to have some level of excess reserves, including cash, in case there is fluctuation in their deposit base or they are faced with a liquidity problem.

True

18. True / False Banks want to have some level of excess capital in case they face credit problems or other risk issues.

True

2. True / False The difference between interest income and interest expense as a percentage of assets of a bank is the net interest margin

True

21. True / False Banks hold excess reserves in case they run into liquidity problems.

True

23. True / False Mortgage loans are a use of funds for the bank and are an asset on the bank's balance sheet.

True

24. True / False Except for Edge Act entities, all domestic banks in the United states must hold reserves with the Federal Reserve.

True

25. True / False If a bank sells more equity, the return on equity to shareholders actually declines.

True

3. True / False The Federal Reserve sets reserve requirements and holds reserves for all US banks; and it has specific oversight of bank holding companies, while the SEC oversees securities companies. Recently the Fed took oversight of Goldman Sachs and Morgan Stanley.

True

30. True / False The Federal Reserve sets reserve requirements and holds reserves for all US banks; and it has specific oversight of bank holding companies.

True

4. True / False Among the issues in the recent crisis which have pushed these banks closer to failure are large deposit outflows, losses on subprime mortgages, and being forced to put some "off balance sheet" liabilities back on the balance sheet, lowering excess capital.

True

6. True / False . The most important single source of the changes in funds flow, supply and demand that have stimulated financial innovation has been the improvement in information technology.

True

7. True / False Some of the regulatory protections such as deposit insurance have been blamed for creating a lack of market discipline, allowing banks to be overly aggressive while banks' depositors are negligent in assessing risk.

True

8. True / False A key tradeoff in capital management at a bank is the tradeoff between safety (high capital) and ROE

True

9. True / False Foreign banks (non- US) banks hold a meaningful amount (over 10%) of all loans and deposits in the united states.

True

22. With the growth of international banking, by 2007 non-US banks held:

about 16% of all US banking assets

21. The largest 10% of US banks hold:

about 90% of all US bank assets

Mortgage loan, commercial and consumer loans and other loans by the bank, are _______________ on a bank's balance sheet and are a basic source of __income / expense__ for the bank.

an asset income

b. While if it is worried about credit defaults or other losses it will try to hold more _____________________________

capital

13. Managing the bank's capital is basically a tradeoff between having a higher ROA / ROE versus having more _________________________________________________________

capital (or excess capital) to cover losses/'safety' in ability to cover losses during a downturn for the bank.

2. Name at least 3 banking innovations discussed and how each of them specifically affected banking:

• Credit cards • Debit cards • Smart Cards • ATMs • Electronic Banking • Internet banking/virtual banking, Etc....