Banking exam ch 11-15

Sales of Insurance-Related Products

•Banks can use their branches to sell insurance ▫Over 100 banks today sell their own insurance products in the United States •Types of insurance products sold today: ▫Life insurance policies ▫Property/casualty insurance policies •Life insurance underwriters and property/casualty insurance underwriters manage their respective risks

Structure of Funds Approach

- a bank's deposits and other sources of funds divided into categories. For example: -▫'Hot Money' Liabilities (volatile liabilities) ▫Vulnerable Funds ▫Stable Funds (core deposits or core liabilities) ▫Liquidity Manager Set Aside Liquid Funds According to Some Operating Rule ▫For example, the manager may decide to set up ▫A 95 percent liquid reserve behind all hot money funds (less any required legal reserves held behind hot money deposits) ▫30 percent in liquid reserves for vulnerable deposit and nondeposit liabilities ▫15 percent or less in liquid reserves for stable (core) funds sources total liquidity requirement combines both loan and deposit liquidity requirements expected liquidity requirement

Sources and Uses of Funds Approach

- loans and deposits must be forecast for a given liquidity planning period - TREND COMPONENT - SEASONAL COMPONENT - CYCLICAL COMPONENT - the estimated change in loans and deposits must be calculated for the same planning period - the liquidity manager must estimate the bank's net liquid funds by comparing the estimated change in loans to the estimated change in deposits - when the two sides don't match, we have a liquidity gap estimated liquidity deficit or surplus for the coming period = estimated change in deposits - estimated change in loans

Regulatory Approach to Evaluating Capital Needs

-Research Evidence: Research has been conducted on the issue of whether the private marketplace or government regulatory agencies exert a bigger effect on bank risk taking ▫Most studies find that the private marketplace is probably more important than government regulation in the long run ▫Recently government regulation appears to have become nearly as important as the private marketplace -Especially in the wake of the great credit crisis of 2007-2009 ▫We are not at all sure market disciplining works as well for small and medium-size insured depository institutions ▫Some of the most pertinent information needed to assess a bank's risk exposure is known only to government regulators ▫Research has found that increased capital does not materially lower a bank's failure risk

The essence of liquidity management problems for financial institutions

1.Rarely are demands for liquidity equal to the supply of liquidity at any particular moment in time▫The financial firm must continually deal with either a liquidity deficit or a liquidity surplus. 2.There is a trade-off between liquidity and profitability: The more resources are tied up in readiness to meet demands for liquidity, the lower is that financial firm's expected profitability (other factors held constant)

Even if central banks imposed no reserve requirements, managers of depository institutions would still have a demand for cash reserves

All depository institutions at one time or another need immediately available funds to handle customer withdrawals, meet new loan demand, and satisfy other emergency cash needs

transaction deposit

An account used primarily to make payments for purchases of goods and services

Raising Capital Externally

If a financial firm does need to raise capital from outside sources, it has several options: 1.Selling common stock 2.Selling preferred stock 3.Issuing debt capital 4.Selling assets 5.Leasing facilities 6.Swapping stock for debt securities ▫The choice of which method to use is based on their effects on a financial firm's earnings per share

The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace

Liquidity managers should closely monitor the following market signals: 1.Public confidence 2.Stock price behavior 3.Risk premiums on CDs and other borrowings 4.Loss sales of assets 5.Meeting commitments to credit customers 6.Borrowings from the central bank

The Cost of Different Deposit Accounts

Managers of depository institutions would prefer to sell only the cheapest deposits to the public but it is predominantly public preference that determines which types of deposits will be created

economies of scale and economies of scope

Other potential benefits from offering multiple services include economies of scale and economies of scope •Economies of scope refer to a situation in which the joint costs of producing two or more services in one firm are less than the combined cost of producing each of these services through separate firms •For example, if a single financial firm produces two services (S1 and S2), instead of producing only one service (S1), using the same resources, its cost of production (C) may be lower as follows As a result, expanding the number of financial services offered may result in more intensive use of resources, reducing overall costs and widening a multiservice firm's profit margin

Regulatory Approach to Evaluating Capital Needs

Reasons for Capital Regulation 1.To limit risk of failures 2.To preserve public confidence 3.To limit losses to the government and other institutions arising from deposit insurance claims

Pricing Based on the Total Customer Relationship and Choosing a Depository

Related to the idea of targeting the best customers for special treatment is the notion of pricing deposits according to the number of services the customer uses ▫Customers who purchase two or more services may be granted lower deposit fees compared to the fees charged customers having only a limited relationship to the offering institution In theory, relationship pricing promotes greater customer loyalty and makes the customer less sensitive to the prices posted on services offered by competing financial firms

Several new capital rules created recently by U.S. regulatory agencies were mandated by the FDIC Improvement Act of 1991

Requires federal regulators to take Prompt Corrective Action (PCA) when an insured depository institution's capital falls below acceptable levels

Choosing among Alternative Nondeposit Sources

The demand for nondeposit funds is determined basically by the size of the gap between the institution's total credit demands and its deposits and other available monies •Gap is based on: -Current and projected demand and investments the bank desires to make -Current and expected deposit inflows and other available funds •Size of this gap determines the need for nondeposit funds

The Customer Relationship Doctrine

The first priority of a lending institution is to make loans to all those customers from whom the lender expects to receive positive net earnings Thus, lending decisions often precede funding decisions: All loans and investments whose returns exceed their cost and whose quality meets the lending institution's credit standards should be made If enough deposits are not immediately available to cover these loans and investments, then management should seek out the lowest-cost source of borrowed funds available to meet its customers' credit needs During the collapse of the subprime mortgage market in the 2007-2009 business recession, regulators found that many mortgage lenders went overboard in approving loans, falling well below normal industry standards with little or no documentation

Basel I

The original Basel capital standards are known today as Basel I▫Various sources of capital were divided into two tiers: ▫Tier 1 (core) capital: -Common stock and surplus, undivided profits (retained earnings), qualifying noncumulative perpetual preferred stock, minority interest in the equity accounts of consolidated subsidiaries, and selected identifiable intangible assets less goodwill and other intangible assets ▫Tier 2 (supplemental) capital: -Allowance (reserves) for loan and lease losses, subordinated debt capital instruments, mandatory convertible debt, intermediate-term preferred stock, cumulative perpetual preferred stock with unpaid dividends, and equity notes and other long-term capital instruments that combine both debt and equity features ▫In order for a bank to qualify as adequately capitalized, it must have: 1.A ratio of core capital (Tier 1) to total risk-weighted assets of at least 4 percent 2.A ratio of total capital (the sum of Tier 1 and Tier 2 capital) to total risk-weighted assets of at least 8 percent, with the amount of Tier 2 capital limited to 100 percent of Tier 1 capital

legal reserves

Those assets that law and central bank regulation say must be held during a particular time period

expected liquidity requirement (ch 11)

prob of outcome A * (estimated liquidity surplus or deficit in outcome A) + prob of outcome B * (estimated liquidity surplus of deficit in outcome B)

net liquidity position (L)

various sources of liquidity demand and supply come together to determine each financial firm's net liquidity position at any moment in time supplies of liquidity (incoming deposits + revs from sale of nondeposit services +customer loan repayments + sales of assets + borrowings from the money market ) - demands on the firm for liquidity (deposit withdrawls - volume of acceptable loan requests - repayments of borrowings - other op exp - div payments to stockholders) Liquidity Deficit is Lt < 0 and Liquidity Surplus is Lt > 0

Demands for Liquidity

-Customer deposit withdrawals -Credit requests from quality loan customers -Repayment of nondeposit borrowings -Operating expenses and taxes -Payment of stockholder dividends

Supplies of Liquid Funds

-Incoming customer deposits -Revenues from the sale of nondeposit services -Customer loan repayments -Sales of bank assets -Borrowings from the money market

There are mandatory public disclosures on the part of depository institutions selling insurance products that stipulate:

1.An insurance product or annuity is not a deposit or other obligation of a depository institution or its affiliate 2.An insurance product or annuity sold by a depository institution in the United States is not insured by the FDIC, any other agency of the U.S. government, the depository institution itself, or its affiliates 3.Insurance products or annuities may involve investment risk and possible loss of value 4.U.S. depository institutions cannot base granting loans on the customer's purchase of an insurance product or annuity from a depository institution or any of its affiliates or on the customer's agreement not to obtain an insurance product or annuity from an unaffiliated entity These disclosures must be made both orally and in writing before completion of the sale of an insurance product

liquidity indicator approach

1.Cash position indicator 2.Liquid securities indicator 3.Net federal funds and repurchase agreements position 4.Capacity ratio 5.Pledged securities ratio 6.Hot money ratio 7.Deposit brokerage index 8.Core deposit ratio 9.Deposit composition ratio 10.Loan commitments ratio

Types of Capital in Use

1.Common stock 2.Preferred stock 3.Surplus 4.Undivided profits 5.Equity reserves 6.Subordinated debentures 7.Minority interest in consolidated subsidiaries 8.Equity commitment notes

Pillars of Basel II

1.Minimum capital requirements for each bank based on its own estimated risk exposure from credit, market, and operational risks 2.Supervisory review of each bank's risk-assessment procedures and the adequacy of its capital to ensure they are "reasonable" 3.Greater public disclosure of each bank's true financial condition so that market discipline could become a more powerful force compelling excessively risky banks to lower their risk exposure

Basel required a banker to divide each contract's risk exposure into two categories

1.Potential market risk exposure 2.Current market risk exposure ▫Once the replacement cost of a contract is determined: ▫The estimated potential market risk exposure amount is added to the estimated current market risk exposure to derive the total credit-equivalent amount of each derivative contract ▫This total is multiplied by the correct risk weight, to find the equivalent amount of risk-weighted assets represented by each contract

many tasks capital performs

1.Provides a cushion against the risk of failure 2.Provides funds to help institutions get started 3.Promotes public confidence 4.Provides funds for growth 5.Regulator of growth 6.Regulatory tool to limit risk exposure

Nondeposit Funding Sources: Factors to Consider

1.The relative costs of raising funds from each source 2.The risk (volatility and dependability) of each funding source 3.The length of time (maturity or term) for which funds are needed 4.The size of the institution that requires more funds 5.Regulations limiting the use of alternative funds sources

U.S. bank regulators created capital-adequacy categories for implementing PCA:

1.Well capitalized 2.Adequately capitalized 3.Undercapitalized4.Significantly undercapitalized 5.Critically undercapitalized

nontransaction deposit

An account whose primary purpose is to encourage the bank customer to save rather than make payments

Raising Capital Internally

Dividend Policy: The board of directors and management must agree on the appropriate retention ratio and dividend payout ratio ▫Key factor - How fast the financial firm can allow its assets to grow so that its current ratio of capital to assets is protected from erosion

Factors in Choosing among the Different Sources of Reserves

In choosing which source of reserves to draw upon to cover a legal reserve deficit, managers must carefully consider several aspects of their institution's need for liquid funds: 1.Immediacy of need 2.Duration of need 3.Access to the market for liquid funds 4.Relative costs and risks of alternative sources of funds 5.The interest rate outlook 6.Outlook for central bank monetary policy 7.Rules and regulations applicable to a liquidity source

An individual depository institution has little control over its prices in a financial marketplace that approaches perfect competition

It is the marketplace, not the individual financial firm, that ultimately sets prices ▫Financial institutions, like most other businesses, are price takers, not price makers

In pricing deposit services, management is caught in a dilemma

It needs to pay a high enough interest return to attract and hold customer funds, but must avoid paying an interest rate so costly it erodes any potential profit margin

the ownership of deposits

The dominant holder of bank deposits inside the United States is the private sector

• Long-Term Nondeposit Funds Sources : ▫The nondeposit sources of funds discussed to this point are mainly short-term borrowings ▫However, many financial firms also tap longer-term nondeposit funds stretching well beyond one year ▫Examples include mortgages issued to fund the construction of buildings and capital notes and debentures ▫These longer-term nondeposit funds sources have remained relatively modest over the years due to regulatory restrictions and the augmented risks associated with long-term borrowing ▫Also, because most assets and liabilities held by depository institutions are short- to medium-term, issuing long-term indebtedness creates a significant maturity mismatch

• Long-Term Nondeposit Funds Sources :

Several problems and risks are associated with sales of investment products

•Current U.S. regulations require that customers must be told orally (and sign a document indicating they were so informed) that investment products are: 1.Not insured by the Federal Deposit Insurance Corporation (FDIC) 2.Not a deposit or other obligation of a depository institution and not guaranteed by the offering institution 3.Subject to investment risks, including possible loss of principal

Alternative Nondeposit Sources of Funds

•Federal Funds Market •Repurchase Agreements •Borrowing from Federal Reserve Banks •Advances from the Federal Home Loan Bank •Negotiable CDs •Eurocurrency Deposit Market •Commercial Paper •Long-Term Nondeposit Funds Sources •The usage of nondeposit sources of funds has risen •Larger institutions rely on the nondeposit funds market as a key source of short-term money to meet loan demand and unexpected cash emergencies

Information Flows within the Financial Firm

•Financial firms have become more and more like pure information-gathering, information-processing, and information-dispersing businesses •The Gramm-Leach-Bliley Act of 1999 allowed financial-service companies to share customer information among their affiliated firms and also with independently owned third parties provided customers did not expressly say "no" to (or "opt out" of) having their personal data distributed to others •Protecting customer privacy became increasingly more important

Why Financial Firms Often Face Significant Liquidity Problems

•Imbalances between maturity dates of their assets and liabilities •High proportion of liabilities (especially demand deposits and money market borrowings) are subject to immediate repayment •Sensitivity to changes in interest rates: -May affect customer demand for deposits -May affect customer demand for loans •Central role in the payment process, reputation and public confidence in the system

selling investment products to consumers

•In recent years many of the largest business and household depositors have moved their funds out of deposits at banks and thrift institutions into investment products ▫Stocks, bonds, mutual funds, annuities, and similar financial instruments

Sales of Investment Banking Services

•One banking service that has been prominent, but volatile, is investment banking •Many leading U.S. banks recently either acquired or formed their own investment banking affiliates in order to serve corporations and governments around the world ▫For example, JP Morgan Chase's acquisition of Bear Stearns •Leading investment banks in the world today: ▫Citigroup ▫JP Morgan Chase ▫Morgan Stanley ▫Goldman Sachs ▫Credit Suisse ▫UBS ▫Nomura Securities ▫Deutsche Bank ▫Raymond James ▫Banc of America Securities

Truth in Savings Act

•Passed in November 1991 •Consumers must be informed of the deposit terms before they open a new account •Depository institutions must disclose: ▫Minimum balance to open ▫Minimum to avoid fees ▫How the balance is figured ▫When interest begins to accrue ▫Penalties for early withdrawal ▫Options at maturity ▫The APY

Basic (Lifeline) Banking: Key Services for Low-Income Customers

•Should every adult citizen be guaranteed access to certain basic financial services, such as a checking account or personal loan? •A recent survey found that a substantial segment of the U.S. population is either: ▫"Unbanked" -No deposits or loans of any kind ▫"Underbanked"-Having access to some critical services but not others •Among the "underbanked" are those families relying on expensive payday loans, check cashing firms, pawnshops, and money order services to pay their bills •Racial and ethnic minorities are substantially more likely than the general population to be "underbanked"

Estimating Liquidity Needs

•Sources and Uses of Funds Approach •Structure of Funds Approach •Liquidity Indicator Approach •The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace

pricing deposits at cost plus profit margin

•The Glass-Steagall Act of 1933 - Federal limits on interest rates paid on deposits: ▫The Depository Institutions Deregulation Act of 1980 •Deregulation has brought more frequent use of unbundled service pricing as greater competition has raised the average real cost of a deposit for deposit-service providers •This means that deposits are usually priced separately from other services: -Cost-plus pricing formula unit price charged the customer for each deposit services = op exp per unit of deposit services + estimated OH exp allocated to the deposit service function + planned profit margin from each services unit sold

strategies for liquidity managers

•Think about what is a liquid asset?-Liquid assets have a ready market, stable price and are reversible •Identify strategies for liquidity management -Asset Liquidity Management or Asset Conversion Strategy -This strategy calls for storing liquidity in the form of liquid assets (T-bills, fed funds loans, CDs, etc.) and selling them when liquidity is needed Borrowed Liquidity or Liability Management Strategy -This strategy calls for the bank to purchase or borrow from the money market to cover all of its liquidity needs Balanced Liquidity Strategy -The combined use of liquid asset holdings (Asset Management) and borrowed liquidity (Liability Management) to meet liquidity needs

Transaction (Payment or Demand) Deposits

▫Making payment on behalf of customers ▫One of the oldest services ▫Provider is required to honor any withdrawals immediately ▫Hottest item in the transaction deposit field today appears to be the mobile check deposit ▫Designed principally for customers on the move, carrying camera-equipped smart phones

Trust Services as a Source of Fee Income

•Trust services is the management of property owned by customers, such as securities, land, buildings, and other assets ▫Among the oldest nondeposit services that banks and some of their closest competitors offer parts of the financial firm •Trust departments often generate large deposits because they manage property for their customers •Deposits placed in a bank by a trust department must be fully secured •Popular kinds of trusts: ▫Living trusts ▫Testamentary trusts ▫Irrevocable trusts ▫Charitable trusts ▫Indenture trusts •Establishment of fiduciary relationship is critical

The Alleged Benefits of Financial-Services Diversification

•When two or more different industry types merge with each other, this strategic move is called convergence •One possible benefit is the relatively low correlation that may exist between cash flows or revenues generated by the sale of traditional industry products versus the sale of nontraditional products ▫But because streams of revenue from different product lines may move in different directions at different times, the overall impact of combining these different industries and products under one roof may be to stabilize combined cash flows and profitability ▫The risk of failure might also be reduced •This potential consequence of the convergence of two or more financial-service industries is called the product-line diversification effect

Gramm-Leach-Bliley

•With passage of the Gramm-Leach-Bliley (GLB) Act of 1999, the full range of investment banking services was opened up for adequately capitalized and well-managed commercial banking firms •Research studies suggest that investment banking revenue and profitability are positively, but not highly, correlated with commercial banking revenues and profitability ▫There may be some significant product-line diversification effects •It is not yet clear that the benefits alleged from this new service dimension have offset the costs and risks involved

Value at Risk (VaR) Models Responding to Market Risk

▫A statistical framework for measuring a bank portfolio's exposure to changes in market prices or market rates over a given time period, subject to a given probability ▫VaR Example: A bank estimates its portfolio's daily average value at risk is $100 billion over a 10-day interval with a 99 percent level of confidence ▫If this VaR estimate of $100 billion is correct, losses in portfolio value greater than $100 billion should occur less than 1 percent of the time

Advances from Federal Home Loan Banks

▫Allows institutions (home mortgage lenders) to use home mortgages as collateral for advances ▫A way to improve the liquidity of home mortgages and encourage more lenders to provide credit ▫Number of loans has increased dramatically in recent years ▫Maturities range from overnight to more than 20 years ▫Federal Home Loan Bank (FHLB) System has 12 regional banks ▫Has federal charter and can borrow cheaply and pass savings on to institutions

Development and Sale of Large Negotiable CDs

▫An interest-bearing receipt evidencing the deposit of funds in the bank for a specified period of time for a specified interest rate ▫It is considered a hybrid account since it is legally a deposit ▫Types of Negotiable CDs ▫Domestic CDs. ▫Euro CDs ▫Yankee CDs ▫Thrift CDs ▫Fixed-rate CDs ▫Variable-rate CDs

The Basel Agreement on International Capital Standards: A Continuing Historic Contract Among Leading Nations

▫An international agreement on new capital standards ▫Designed to keep their capital positions strong ▫Reduce inequalities in capital requirements among different countries ▫Promote fair competition ▫Catch up with recent changes in financial services and financial innovation ▫In particular, the expansion of off-balance-sheet commitments▫Formally approved in July 1988 ▫Included countries such as: The United States, Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and Luxembourg

Annuity Investment Products

▫Annuities are a hedge against living too long and outlasting one's savings ▫Fixed annuities promise a customer who contributes a lump sum of savings a fixed rate of return over the life of the annuity contract ▫Variable annuities allow investors to invest a lump sum of money in a basket of stocks, mutual funds, or other investments under a tax-deferred agreement, but there may be no promise of a guaranteed rate of return ▫Recently a new type of annuity contract has appeared, the equity-index annuity: -Combines the features of both fixed and variable annuities ▫One advantage for financial firms selling this service is that annuities often carry substantial annual fees ▫One significant disadvantage with annuities sold through depository institutions is they typically compete with selling deposits

Basel II

▫Bankers found ways around many of Basel I's restrictions ▫Capital arbitrage: Instead of making banks less risky, parts of Basel I seemed to encourage banks to become more risky ▫Basel I represented a "one size fits all" approach to capital regulation ▫It failed to recognize that no two banks are alike in terms of their risk profiles ▫Basel II set up a system in which capital requirements would be more sensitive to risk and protect against more types of risk than Basel I ▫Basel II would be gradually phased in for the largest international banks

the composition of deposits

▫Bankers would generally prefer a high proportion of transaction deposits (including regular checking or demand accounts) and low-yielding time and savings deposits ▫These accounts are among the least expensive of all sources of funds and often include a substantial percentage of core deposits

Bank Capital Standards and Market Risk

▫Basel I failed to account for market risk ▫The losses a bank may suffer due to adverse changes in interest rates, security prices, and currency and commodity prices ▫The risk weights on bank assets were designed primarily to take account of credit risk (not market risk) ▫In an effort to deal with these and other forms of market risk, in 1996 the Basel Committee approved a modification to the rules ▫Permitted the largest banks to conduct risk measurement and estimate the amount of capital necessary to cover market risk ▫Led to a third capital ratio (Tier 3)

A Dual (Large-Bank, Small-Bank) Set of Rules

▫Basel II was designed to operate under one set of capital rules for the handful of largest multinational banks and another set for more numerous smaller banking firms ▫Regulators were concerned that smaller banks could be overwhelmed by: -The heavy burdens of gathering risk-exposure information -Performing complicated risk calculations ▫Basel II anticipated that smaller institutions would be able to continue to use simpler approaches in determining their capital requirements and risk exposures, paralleling Basel I rules

Basel III: Another Major Regulatory Step Underway, Born in Global Crisis

▫Basel II was never fully implemented ▫Had to move toward Basel III in order to prevent future crises ▫Key issue in Basel III: Determining the volume and mix of capital the world's leading banks should maintain if their troubled assets generate massive losses ▫Capital requirements laid down in Basel I and II apparently were inadequate in the face of the latest credit crash ▫Bankers found ways to hold both less capital in total and a weaker mix of kinds of capital

federal funds market

▫Borrowing from Federal Reserve Banks ▫Immediately available reserves are traded between financial institutions and usually returned within 24 hours ▫Deposits with correspondent banks and demand deposit balances of security dealers and governments can be used for loans to institutions

commercial paper market

▫Commercial paper consists of short-term notes, with maturities normally ranging from three or four days to nine months, issued by well-known companies to raise working capital ▫Industrial Paper - purchase inventories ▫Finance Paper - Issued by finance companies and financial holding companies ▫The notes are generally sold at a discount from face value through security dealers or through direct contact with the issuing company ▫This funds source tends to be high in volume and moderate in cost but also volatile in available capacity and subject to credit risk ▫Recently foreign banks have accelerated their mining of both European and American paper markets despite the pressures of the Great Recession

Key Risks in Banking and Financial Institutions' Management

▫Credit Risk ▫Liquidity Risk ▫Interest Rate Risk ▫Operational Risk ▫Exchange Risk ▫Crime Risk

Basel II and Credit Risk Models

▫Credit risk models: -Computer algorithms that attempt to measure a lender's exposure to default by its borrowing customers or to credit downgradings ▫Most credit risk models develop estimates based upon: -Borrower credit ratings -The probability those credit ratings will change -The probable amount of recovery should some loans default -The possibility of changing interest-rate spreads between riskier and less risky loans

Liability Management

▫During the 1960s and 1970s, the customer relationship doctrine spawned the liquidity management strategy known as liability management ▫The bank buys funds in order to satisfy loan requests and reserve requirements ▫It is an interest-sensitive approach to raising bank funds ▫It is flexible - The bank can decide exactly how much they need and for how long ▫The control mechanism to regulate incoming funds is the price of funds

Calculating Risk-Weighted Assets

▫Each asset item on a bank's balance sheet and each off-balance-sheet commitment it has made are multiplied by a risk-weighting factor ▫Designed to reflect its credit risk exposure ▫The most closely watched off-balance-sheet items are standby letters of credit and long-term, legally binding credit commitments .1) Compute the credit-equivalent amount of each off-balance-sheet (OBS) item 2) Multiply each balance sheet item and the credit-equivalent amount of each OBS item by its risk weight

The Eurocurrency Deposit Market

▫Eurocurrency deposits were developed originally in Western Europe to provide liquid funds that could be swapped among multinational banks or loaned to the banks' largest customers ▫Eurodollars are dollar-denominated deposits placed in bank offices outside the United States -Because they are denominated on the receiving banks' books in dollars rather than in the currency of the home country and consist of accounting entries in the form of time deposits, they are not spendable on the street like currency ▫Most Eurodollar deposits are fixed-rate time deposits -Floating-rate CDs (FRCDs) and floating-rate notes (FRNs) were introduced in an effort to protect banks and their Eurodepositors from the risk of fluctuating interest rates The Eurocurrency market is the largest unregulated financial marketplace in the world

Not all central banks impose legal reserve requirements on the depository institutions they regulate

▫For example, the Bank of England has not established official reserve requirements for its banks ▫There is a trend among central banks around the globe to eliminate, suspend, or at least make less use of the reserve requirement tool, in part because it is so difficult to control ▫A notable exception is the European Central Bank (ECB)

clearing balances

▫In addition to holding a legal reserve account at the central bank, many depository institutions also hold a clearing balance with the Fed to cover any checks or other debit items drawn against them ▫For example, suppose a bank had a clearing balance averaging $1 million during a particular two-week maintenance period and the Federal funds interest rate over this same period averaged 5.50 percent ▫Then it would earn a Federal Reserve credit of avg clearing balance * annualized feds funds rate * 14 days/360 days

Development and Sale of Large Negotiable CDs

▫Interest rates on fixed-rate CDs are quoted on an interest-bearing basis and the rate is computed assuming a 360-day year ▫Represent the majority of all large negotiable CDs issued ▫Example: Suppose a depository institution promises an 8 percent annual interest rate to the buyer of a $100,000 six-month (180-day) CD▫The depositor will have the following at the end of six months

Guidelines for Liquidity Managers

▫Keep track of all fund-using and fund-raising departments ▫Know in advance withdrawals by the biggest credit or deposit customers ▫Priorities and objectives for liquidity management should be clear ▫Liquidity needs must be evaluated on a continuing basis

Repurchase Agreements (RPs) as a Source of Funds

▫Less popular than Fed funds and more complex ▫Viewed as collateralized Fed funds transactions ▫With RPs, the purchaser of Fed funds provides collateral in the form of marketable securities, reducing the credit risk ▫Most domestic RPs are transacted across the Fed Wire system ▫An RP transaction is often for overnight funds ▫It may be extended for days, weeks, or even months ▫Major innovation in the RP market was the invention of General Collateral Finance (GCF) RPs

Nontransaction (Savings or Thrift) Deposits

▫Longer-Term ▫Higher Interest Rates Than Transaction Deposits ▫Generally Less Costly to Process and Manage

use of fed funds market to influence legal reserves

▫The cheapest source ▫But very volatile ▫Managers rely on the Fed funds target rate (the most volatile on the settlement date)

Types of Transaction Deposits

▫Noninterest-Bearing Demand Deposits: -Interest was prohibited by Glass-Steagall Act -One of the most volatile and unpredictable sources of funds -Most deposits are held by business firms ▫Interest-Bearing Demand Deposits: -Negotiable Orders of Withdrawal (NOW) -Money Market Deposit Account (MMDA) and Super NOW due to Garn-St Germain Depository Institution Act of 1982

Mutual Fund Investment Products

▫One of the most popular of the investment products ▫Each share in a mutual fund permits an investor to receive a pro rata share of any dividends or other forms of income generated by a pool of stocks, bonds, or other securities the fund holds ▫If a mutual fund is liquidated, each investor receives a portion of the net asset value (NAV) of the fund after its liabilities are paid off, based on the number of shares each investor holds ▫Proprietary funds versus nonproprietary funds

legal reserves

▫Only two kinds of assets can be used for this purpose: 1.Cash in the vault 2.Deposits held in a reserve account with the regional Fed ▫The reserve requirement in 2010 was 3 percent of the end-of-the-day daily average amount held over a two-week period, from $10.7 million up to $58.8 million The first $10.7 million have zero legal reserves The $58.8 million figure is known as the reserve tranche and changes every year based on deposit growth Transaction deposits over $58.8 million held by the same depository institution carried a 10 percent legal reserve requirement This annual legal reserve adjustment is designed to offset inflation

Types of Fed Funds Loan Agreements

▫Overnight Loans: -Negotiated via wire or telephone, returned the next day -Normally not secured by specific collateral ▫Term Loans -Longer term Fed funds contracts (several days, weeks, or months) Continuing Contracts -Automatically renewed each day -Normally between smaller respondent institutions and their larger correspondents

Types of Nontransaction Deposits

▫Passbook Savings Account ▫Statement Savings Deposit ▫Time Deposit (CD) ▫Retirement Savings Deposits: -Individual Retirement Account (IRA) - The Economic Recovery Tax Act of 1981 -Keogh Plan retirement accounts - available to self-employed persons -Roth IRA - The Tax Relief Act of 1997 allows non-tax-deductible contributions that can grow tax free and pay no tax on investment earnings when withdrawn -Default Option Retirement Plans - The Pension Protection Act of 2006

Several types of loans are available from the Fed's discount window

▫Primary Credit: -This loan is available for short terms and to institutions in sound financial condition -Rate is slightly higher than the federal funds rate ▫Secondary Credit: -These loans are available at a higher interest rate to institutions not qualifying for primary credit SeasonalCredit: -These loans cover longer periods than primary credit for small and medium institutions experiencing seasonal swings in deposits and loans

Basel III: Another Major Regulatory Step Underway, Born in Global Crisis

▫Proponents of Basel III called for greater total capitalization, stronger definition of what belongs in banks' capital accounts ▫Volcker Rule was proposed in the U.S. ▫Implementation of Basel III could take many years ▫Implementation would be phased in slowly, beginning in 2012 and possibly be completed close to 2019 ▫Basel III covers the capital, liquidity, and debt positions of individual international banks and also broader issues associated with global business cycles and systemic risks

defenses against risks

▫Quality Management ▫Diversification: ▫Geographic ▫Portfolio ▫Deposit Insurance ▫Owners' Capital

other options to influence legal reserves

▫Sell liquid securities ▫Draw upon excess correspondent balances ▫Enter into repurchase agreements for temporary borrowings ▫Sell new time deposits ▫Borrow in the Eurocurrency market

Examples of client questions that investment bankers can assist in answering:

▫Should we (the investment bank's clients) attempt to raise new capital? If so, how much, where, and how do we go about this fund-raising task? ▫Should our company enter new market areas at home or abroad? If so, how can we best accomplish this market-expansion strategy? ▫Does our company need to acquire or merge with other firms? Which firms and how? And when is the best time to do so? ▫Should we sell our company to another firm? If so, what is our company worth? And how do we find the right buyer?

Problems Accompanying the Implementation of Basel II

▫Some forms of risk had no generally accepted measurement scale -Operational Risk ▫How do we add up the different forms of risk exposure in order to get an accurate picture of a bank's total risk exposure? ▫What should we do about the business cycle? -Most banks are more likely to face risk exposure in the middle of an economic recession than they will in a period of economic expansion ▫For example, the Global credit crisis of 2007-2009 ▫Some have expressed concern about improving regulator competence

Example of what could happen to overall institutional risk by combining traditional and nontraditional financial services

▫Suppose a banking company decides to add insurance services to its existing product menu ▫It expects to earn a 12 percent average return from sales of its traditional banking products and a 20 percent return from selling or underwriting insurance services ▫These two service lines are equally risky in the variance of their cash flows (with a standard deviation of about 5 percent each) ▫The banking firm expects to receive 20 percent of its revenues from insurance sales and 80 percent from sales of traditional banking products ▫The cash flows from the two sets of services are negatively correlated over time with a correlation coefficient of -0.50 Offering both traditional and nontraditional banking services lowers the bank's standard deviation of its overall return

Capital Requirements Attached to Derivatives

▫The Basel I capital standards were adjusted to take account of the risk exposure banks may face from derivatives: ▫Futures, options, swaps, interest rate cap and floor contracts, and other instruments ▫Sometimes expose a bank to counterparty risk ▫The danger that a customer will fail to pay or to perform, forcing the bank to find a replacement contract with another party that may be less satisfactory

Borrowing from the Federal Reserve Banks

▫The Fed will make the loan through its discount window by crediting the borrowing institution's reserve account ▫Each loan made by the Federal Reserve banks must be backed by collateral acceptable to the Fed

The current system of accounting for legal reserves is called lagged reserve accounting (LRA)

▫The daily average amount of deposits and other reservable liabilities are computed using information gathered over a two-week period stretching from a Tuesday through a Monday two weeks later ▫This interval of time is known as the reserve computation period ▫The daily average amount of vault cash each depository institution holds is also figured over the same two-week computation period

calculating required reserves

▫The largest depository institutions must hold the largest percentage of legal reserves ▫Each reservable liability item is multiplied by the stipulated reserve requirement percentage to derive each depository's total legal reserve requirement

Key Investment Banking Services

▫Traditionally, the best-known and often the most profitable investment banking service is security underwriting ▫The purchase for resale of new stocks, bonds, and other financial instruments in the money and capital markets on behalf of clients who need to raise new money ▫One of the most profitable underwriting services - initial public offerings (IPOs) ▫Leveraged buyouts (LBOs): -Involve the acquisition of a company, usually by a small group of investors, and typically are funded by large amounts of debt ▫Recently, many investment banks jumped into the hedge fund business

Basel II and Credit Risk Models

▫Under Basel I, minimum capital requirements remained the same for most types of loans regardless of credit rating ▫Under Basel II, minimum capital requirements were designed to vary significantly with credit quality

Limitations and Challenges of VaR and Internal Modeling

▫VaR estimates and internal modeling are not perfect ▫Inaccurate VaR estimates can expose a bank to excessive risk so that its capital position may turn out not to be large enough to cover actual losses the bank faces ▫The portfolios of the largest banks are so complex with thousands of risk factors it may be impossible to consistently forecast VaRs accurately ▫Promote "backtesting" ▫Even if an individual bank is a good forecaster, there may still be trouble due to systemic risk

sweep accounts

▫Volume of legal reserves held at the Fed has declined in recent years largely due to sweep accounts ▫A contractual account between a bank and a customer that permits the bank to move funds out of a customer's checking account overnight in order to generate higher returns for the customer and lower reserve requirements for the bank: ▫Retail Sweep ▫Business Sweep ▫The sweeps market is likely to change in form and importance due to the recent passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2009

What deposit interest rate should the bank offer its customers? Using Marginal Cost to Set Interest Rates on Deposits

▫We need to know▫The marginal cost of moving the deposit rate from one level to another ▫The marginal cost rate, expressed as a percentage of the volume of additional funds coming into the bank

Investment banks today are wrestling with the question of what kind of financial firm they need to be in the future

▫What mix of services should they be offering to achieve high and sustained profitability? •A few commercial bank-investment bank combinations have shown promise for the future, despite ongoing struggles to fend off losses following a huge mortgage market meltdown in 2007-2009 •Recently both investment banks and commercial banks have been under intense pressure to raise large amounts of new capital •Many observers anticipate more mergers: ▫It is not clear that future commercial bank-investment bank combinations will consistently turn out well ▫One likely outcome is greater government regulation

conditional pricing: Using Marginal Cost to Set Interest Rates on Deposits

▫Where a depository sets up a schedule of fees in which the customer pays a low fee or no fee if the deposit balance remains above some minimum level, but faces a higher fee if the average balance falls below that minimum ▫Conditional pricing techniques vary deposit prices based on one or more of these factors 1.The number of transactions passing through the account (e.g., number of checks written, deposits made, wire transfers, stop-payment orders, or notices of insufficient funds issued) 2.The average balance held in the account over a designated period (usually per month) 3.The maturity of the deposit in days, weeks, months, or years ▫Deposit pricing policy is sensitive to at least two factors: 1.The types of customers each depository institution plans to serve 2.The cost that serving different types of depositors will present to the offering institution