Financial Economics
FDIC and Failed Banks
(a) Payoff method - Bank fails, FDIC pays on insured deposits, creditors receive a share of liquidated assets (b) Purchase and assumption method - bank is reorganized typically by a merger. No creditor or depositor loses.
Buyer vs. seller of a contract
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Impact of screening and monitoring on credit risk
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Multiple regulatory agencies
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Restrictive Covenants
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What is the role of net worth and collateral?
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Restrictions on banks
1. Asset restrictions 2. Leverage ratio and capital requirements 3. Supervision and regulation 4. Accounting
Key points of Financial Reform Act of 2010 (Dodd-Frank)
1. Consumer Financial Protection Bureau 2. Financial Services Oversight Council 3. Orderly Liquidation Authority 4. Office of Financial Research 5. Improvements to Regulation of financial firms 6. Regulation of Hedge Funds 7. Wall Street transparency and accountability 8. Investor Protections and Improvements to the Regulation of Securities 9. Federal Reserve Provisions 10. Mortgage Reform and Anti-Predatory Lending Act 11. Transfer of Powers to the Comptroller, FDIC and the FED
Three empirical features of the yield curve (interest rates)
1. Positive slope 2. Common comovement of yields at different maturities (so yields move up or down simultaneously) 3. When short term yields are low, the yield curve tends to be upward sloping. When short term yields are high (relative to the average), yields curves tend to be downward sloping.
What are ways to mitigate adverse selection
1. Private production and sale of information - there is a free rider problem in that those who don't pay for the information can benefit from it. Therefore the private sector will provide less information than is efficient. 2. Government regulation: standardized accounting procedures and disclosure rules. 3. Screening by financial intermediaries 4. Use of collateral and net worth as a signaling device.
Discount Loans
A discount loan is a loan arrangement where the interest and any other related charges are calculated at the time the loan is granted. At the same time, the total of the interest and other charges are subtracted from the face amount of the discounted loan. Instead of receiving the face value of the loan, the borrower receives the reduced amount, but is still responsible for repaying the full face value of the loan.
Correspondent Bank
A financial institution that provides services on behalf of another, equal or unequal, financial institution. A correspondent bank can conduct business transactions, accept deposits and gather documents on behalf of the other financial institution. Correspondent banks are more likely to be used to conduct business in foreign countries, and act as a domestic bank's agent abroad.
Futures contracts
A futures contract is similar to a forward contract except there is daily resettlement and the trades are organized through an exchange such as the Chicago Board of Trade. To enter into a futures contract, you must join the exchange and deposit funds in a margin account Suppose you enter into a futures contract, taking a long position. The asset being traded is something like a non callable bond with a certain coupon rate and certain length of time until maturity. The contract you enter into when taking a long position is one where you agree to buy a fixed amount x of a bond, which may be a dollar amount, for example the face value of the bond. The price of the contract will fluctuate with interest rates. From the point of view of the exchange, this is a zero-sum game and the exchange takes no risk. • If the futures price rises, then the short position losses and the long position gains.
Penny Benny (PBGC)
A government insurer of pension funds. Operates like the FDIC, paying a maximum of $54,000 per individual per year. Company pays a premium, but mispriced - premiums should be much higher to reflect true default risk.
Mutual fund
A type of professionally managed collective investment scheme that pools money from many investors to purchase securities A reduced portfolio risk is achieved through the use of diversification, as most mutual funds will invest in anywhere from 50 to 200 different securities - depending on their focus (also asset diversification comes without all the commission charges) Mutual funds are common and easy to buy. They typically have low minimum investments (some around $2,500) and they are traded only once per day at the closing net asset value (NAV). This eliminates price fluctuation throughout the day and various arbitrage opportunities that day traders practice. In mutual funds the fees are classified into two categories: shareholder fees and annual fund-operating fees. The shareholder fees, in the forms of loads and redemption fees, are paid directly by shareholders purchasing or selling the funds. Can depreciate/fluctuating returns Difficulty they pose for investors interested in researching and evaluating the different funds. Unlike stocks, mutual funds do not offer investors the opportunity to compare the P/E ratio, sales growth, earnings per share, etc. (how do you know which fund is best?)
What did AIG do with the credit default swap market?
AIG sold a lot of CDs, was not able to anticipate the negative shock (kind of like an insurance company that insured an entire town and then a tornado wiped it out) There is no insurance in the CD market (i.e. insurance companies can reinsure in case of correlated event they won't go bankrupt) Most banks, though, were not all that bad off, because they were simultaneously on both sides of the CDS trade. Most banks and hedge funds would buy CDS protection on the one hand and then sell CDS protection to someone else at the same time. When a bond defaulted, the banks might have to pay some money out, but they'd also be getting money back in. They netted out. Exception: AIG was on only one side of the trade - never bought CDSs, only sold CDS are largely over-the-counter instruments. That means they're not traded on an exchange. One bank just agrees with another bank to do a CDS deal. There's no reliable central repository of information. Process in early 2000s was still very sloppy, no central authority (Dodd Frank created one) Still no international regulation A lot of people expected "blow-up" of the CD market and a lot of people made money off the financial crisis
Required Reserve Ratio
Adequately capitalized banks are required to have a no lower than 4% Tier 1 capital ratio and a no lower than 8% total capital ratio IF you raise capital/asset ratio, which choices will the bank pursue? May pursue the second option of asset expansion if good business environment If uncertain business environment, asset liquidation (a) For banks with net transactions accounts less than $11.5 million, the required reserve ratio is zero. (b) For banks with net transactions accounts more than $11.5 million and less than $71 million, the required reserve ratio is 3 percent. (c) For banks with net transactions accounts greater than $71 million, the required reserve ratio is 10 percent.
Adverse Selection
Adverse selection can occur when one counter-party in a transaction has private information relevant to the other counterparty. Adverse selection is a problem typically occuring before the transaction is made. Adverse selection occurs in loans between the bank and the borrower. It is typically a problem in the in- surance industry. Adverse selection is likely a problem with securitization.
Options: put/call and pricing theories
An option is a contract giving the buyer the right to buy or sell the underlying financial instrument at a specified priced, called the exercise or strike price. A call option gives the contract holder the right to buy a fixed amount of an asset by a certain date, called the expiration date at a fixed price. A put option gives the holder the right to sell an asset by the expiration date at the strike price. profit = x(qt+j − q ̄) − c When qt+j > q ̄ the option is said to be in-the-money. For a European option, the only choice is whether to exercise the option at the expiration date. An American option is more complicated because the holder must forecast the time where qt+j − q ̄ is maximized over the life of the option. A put option is the right to sell the amount x at the strike price. If the market price qt+j falls below the strike price, the contract is in-the-money and the profit is profit = x(q ̄− qt+j) − c Essentially you are able to buy the amount x at a low price in the market and then turn around to sell x at the high strike price
Liability Management
Attract long term low interest rate liabilities Minimize costs (interest payments) of attracting funds
Role of separation of banking and financial services
Avoid conflict of interest Examples: underwriting and research in an investment bank
Graham-Leach-Bliley 1999
Banks started losing market share in the late 1970s and this accelerated in the 1980s. There were a series of laws moving toward deregulation under both Democratic and Republican administrations. Deregulation culminated with the Gramm-Leach Bliley Act of 1999. This act repealed Glass-Steagall and removed the separation of banking and securities industries. i.e. Gramm-Leach Bliley allowed banks to now sell insurance products.
Credit Risk vs. Interest Rate Risk
Bonds are often classified as "low risk" or "high risk," but this is only half of the story. There are actually two kinds of risk: interest rate risk and credit risk. These are two distinct types of risk that can have a very different impact on various asset classes within the bond market. Interest rate risk is the vulnerability of a bond or fixed income asset class to movements in prevailing interest rates. Bonds with elevated interest rate risk tend to perform well when rates are falling, but they will underperform when interest rates are rising (bond prices fall as interest rates rise) As a result, rate-sensitive securities tend to perform best when the economy is slowing, since slower growth is likely to lead to falling rates. Credit risk, on the other hand, is a bond's sensitivity to default, or the chance that a portion of the principal and interest will not be paid to investors. Individual bonds with high credit risk will do well when their underlying financial strength is improving, but they will weaken when their finances deteriorate. Entire asset classes can also have high credit risk; these tend to do well when the economy is strengthening and underperform when it is slowing. Government bonds are considered completely free of credit risk, but highly sensitive to changes in interest rates Corporate Bonds: Corporate bonds present a hybrid of interest rate and credit risk. Since corporate bonds are priced on their "yield spread" versus Treasuries - or in other words, the yield advantage they provide relative to government bonds - movements in government bond yields have a direct impact on the yields of corporate issues. At the same time, many corporations are seen has being less financially stable than the typical government, so they also carry credit risk.
Effect of different accounting methods
Book value (historical) versus fair value (marking to market). Book value may under or overvalue the collateral underlying a loan. Fair value (Mark-to-market) reflects current market conditions but may increase volatility.
Conflict of interest in universal banking
Commercial banking and securities industry. Example - a bank may give a loan on favorable terms if it holds stock in the company
National Bank Act of 1863
Created a system of federally chartered banks
Federal Reserve Act 1913
Created the Federal Reserve
Credit Rationing
Credit rationing refers to the situation where lenders limit the supply of additional credit to borrowers who demand funds, even if the latter are willing to pay higher interest rates. It is an example of market imperfection, or market failure, as the price mechanism fails to bring about equilibrium in the market.
What explains the differences in yields for instruments maturing at the same date?
Default risk: riskier bonds should have higher yield rates Liquidity: more liquid assets have lower yield rates Differences in taxation
Pensions (defined contribution vs. defined benefit, funded vs. underfunded)
Defined benefit: Your employer pays. But you do have to put your own money into a defined contribution plan like a 401(k) or a 403(b). Obviously, a defined benefit plan is a much better deal for you. Because defined benefit plans are more costly for employers than defined contribution plans, most of them have - you guessed it - scaled back dramatically or eliminated these plans altogether in recent years. Underfunded: An employer managed retirement plan that uses the employer's current income to fund pension payments as they become necessary. This is in contrast to an advance funded pension plan where an employer sets aside funds systematically and in advance to cover any pension plan expenses such as payment to retirees and their beneficiaries.
Financial crisis and adverse selection
During the financial crisis, there was a "run" on financial institutions, meaning investors wanted to sell securities issued by the financial institutions, especially mortgage-backed securities (MBS). One reason investors wanted to sell MBS was concern about the quality of the underlying mortgages. As long as asset values were rising, so the value of the collateral backing the securities was rising, the quality of the borrowers, in particular the adverse selection, didn't matter. Once asset prices started to fall, holders of asset- backed securities were uncertain about the quality of the borrowers and the quality of the collateral backing the securities and, quite rationally, wanted to move their money into something safe and liquid.
Why there is consolidation in banking
Economies of scope and economies of scale
Economies of Scope
Economies of scope often create a conflict of interest. An example is an auditing firm. The auditing firm collects information about a firm. The information is useful not only for the audit but also to a consulting firm. It is natural for the auditing firm to then act as a consultant. The problem is it creates a conflict of interest.
Off-balance sheet activities
Engage in derivatives trading to hedge against interest rate and credit risks. Use off balance sheet activities to generate income.
Regulatory Forbearance
Failure of officials to enforce the laws This is a principal agent problem in which the tax-payer is the principal and the agent is the regulator. The regulator has more information than the tax-payer and may have different incentives, such as not wanting to regulate oneself out of a job, not wanting to call problems to the industry you are regulating and the revolving door problem.
Asset Transformation
Financial institutions generally borrow short-term at variable rates and lend long-term at fixed rates This leaves them vulnerable to insufficient liquidity and "runs" Since yields on loans (source of income for bank/assets) are generally above yields paid on deposits (the cost of funds/liabilities), they generate a profit
Asset Management
Find assets with high expected return and low risk. Tradeoff between specialization and diversification. Manage interest risk: term structure of assets and fixed versus flexible rates Originate loans, engage in screening and monitoring Buy and sell assets Hedging against risk: credit and interest rate risk Generate revenue in the form of interest payments and fees on services such as maintaining escrow accounts
Fannie Mae and Freddie Mac
Government sponsored enterprises Federal National Mortgage Association: Fannie Mae Federal Homeowners Mortgage Corporation: Freddie Mac Buy mortgages from banks, bundle them into mortgage-backed securities and then sell them Enormous: Implicitly guaranteed by the government, too big to fail Problems they posed in the past are still present
What is a hedge fund?
Hedge fund is a pool of investors with less than 100 members, investors have to be very rich (net worth of $50 million), rules about how long you have to keep your money in the pool, invest around the world In the past, before Dodd Frank, hedge funds were not regulated
Shadow banking system
Hedge funds, conduits, SIV, money funds, monoline insurers, and investment banks Avoidance of regulation (branch banking laws)
Reasons for dual banking system
Historical Federalism versus Jeffersonians (states' rights vs. federal rights) The US has a dual banking system and overlapping regulatory agencies, meaning banks are regulated at the federal and state levels. The result is multiple regulators with sometimes inconsistent regulations, a confusing array of reporting requirements, and a good deal of waste and inefficiency. The regulatory agencies particularly have problems keeping up with financial innovation.
Why is so much of financing indirect and not direct?
If a firm could raise funds through direct finance, then it would prefer to do so because direct finance is cheaper and less restrictive. Most firms do not have the option because of asymmetric information. Financial intermediaries develop expertise in screening borrowers, appraising collateral, and monitoring.
Reasons behind the decline of banking
Increased competition and financial innovation
Reinsurance
Insurance that is purchased by an insurance company (the "ceding company") from one or more other insurance companies (the "reinsurer") directly or through a broker as a means of risk management For an example of a reason for purchasing reinsurance, assume an insurer sells 1,000 policies, each with a $1 million policy limit. Theoretically, the insurer could lose $1 million on each policy - totaling up to $1 billion. It may be better to pass some risk to a reinsurer as this will reduce the ceding company's exposure to risk.
Erosion of Glass Steagall
Introduction of new financial technology and instruments More competition for funding Banks started losing market share in the late 1970s and this accelerated in the 1980s. There were a series of laws moving toward deregulation under both Democratic and Republican administrations. Deregulation culminated with the Gramm-Leach Bliley Act of 1999. This act repealed Glass-Steagall and removed the separation of banking and securities industries.
Equity Capital
Invested money that, in contrast to debt capital, is not repaid to the investors in the normal course of business. It represents the risk capital staked by the owners through purchase of a company's common stock (ordinary shares). Funds raised by issuing shares in return for cash or other considerations. The amount of share capital a company has can change over time because each time a business sells new shares to the public in exchange for cash, the amount of share capital will increase. Share capital can be composed of both common and preferred shares. For example, suppose ABC Inc. raised $2 billion from its initial public offering. Over the next year, the total value of its shares increases to $5 billion. In this case, the value of the share capital is still only $2 billion because ABC Inc. had received only $2 billion from the sale of its securities to the investing public.
Interest rate volatility
Lead to adjustable rate mortgages and use of derivatives to hedge against risk
Loan Loss Reserves
Let's assume Bank XYZ has made $10,000,000 of loans to various companies and individuals. Though Bank XYZ works very hard to ensure that it lends only to people who can repay their loans (and repay them on time), inevitably some will default, some will fall behind, and some will have to be renegotiated. Bank XYZ knows this and estimates that 1% of its loans, or $100,000, will probably never come back to it. This $100,000 estimate is Bank XYZ's loan loss reserve, and it records this reserve as a negative number on the asset portion of its balance sheet. If and when Bank XYZ decides to write all or a portion of a loan off, it will remove the loan from its asset balance and also remove the amount of the write-off from the loan loss reserve. The amount deducted from the loan loss reserve may be tax deductible for Bank XYZ.
Four Principles of Bank Management
Liquidity Management Asset Management Liability Management Capital Management (Off-balance activities)
How did information technology innovations change banking
Lowered transactions costs and the costs of acquiring information: debit cards, bank credit cards, electronic banking
Capital Adequacy Management (esp. tradeoff between ROE and insolvency)
Maintain required capital-asset ratio Shareholders' desired rate of return on equity Maintain loan loss reserve ratio (retained earnings) in the event of an asset write-off The equity multiplier is higher the more leveraged the institution (i.e. low capital/asset ratio, high liability/asset ratio) Hence shareholders want the company to be highly leveraged, but not go bankrupt.
Economies of Scale
Many activities, such as a car loan, can be standardized, lowering the cost per transaction. One of the benefits of financial intermediaries
Regulatory Arbitrage
Many examples of regulatory arbitrage: international banks build headquarters in a country where regulatory environment is very business friendly (Seychelles, Mahonia, Caymans) Risk weighted assets: Huge variation in actual risk within each risk category Incentive to take as much risk within each category to get higher interest rate Risk differences are enormous: OECD countries: German bonds have a zero weight (no bankruptcy risk) and earn low interest, also includes governments like Greece, Spain, Portugal (governments whose bonds are viewed as risky, pay very high interest rates) If you want to maximize interest earnings: you will lend to Greece, Spain, Portugal You're able to take on a lot of risk/comply with the regulations Risk weights: A. Zero weight: (little default risk) Reserves and government securities from OECD countries B. 20 percent weight: Claims on banks in OECD countries C. 50 percent weight: Municipal bonds and residential mortgages D. 100 percent weight: Loans to consumers and corporations
What are ways to mitigate moral hazard?
Mitigate in PA problem: (a) Monitoring - production of information. Often a free rider problem: small shareholders vs large shareholders (b) Government regulation (c) Financial intermediation such as venture capitalist model Mitigate in loans: (a) Require borrower to have own net worth invested in project so borrower has an incentive to improve chances of success of a project (b) Monitoring and enforcement of restrictive covenants i. Restrict from risky ventures ii. Desirable activities like the purchase of insurance iii. Maintain collateral iv. Provision of information - for example compensating balances
Venture Capital Firm
Money provided by investors to startup firms and small businesses with perceived long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies or ventures with limited operating history, which cannot raise funds by issuing debt. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity.
Why was there more competition for deposits?
Mutual funds, money market funds
Short vs. long position
One side of the contract takes a short position while the other takes a long position. A short position means the agent will deliver a fixed amount of a security or commodity on a specified date. A long position means the agent has agreed to buy a fixed amount of the security or commodity on the maturity date.
Volcker rule
Part of Dodd-Frank Asserts full institutional separation of investment banking services from commercial banking. Forced loans sold for securitization, to have 5% of value kept on balance sheet (this is no longer the case) Often referred to as a ban on proprietary trading by commercial banks, whereby deposits are used to trade on the bank's own accounts, although a number of exceptions to this ban were included in the Dodd-Frank law
How can debt and equity minimize the effects of asymmetric information?
Pecking order theory starts with asymmetric information as managers know more about their companies prospects, risks and value than outside investors. Asymmetric information affects the choice between internal and external financing and between the issue of debt or equity. There therefore exists a pecking order for the financing of new projects. Asymmetric information favours the issue of debt over equity as the issue of debt signals the boards confidence that an investment is profitable and that the current stock price is undervalued (were stock price over-valued, the issue of equity would be favoured). The issue of equity would signal a lack of confidence in the board and that they feel the share price is over-valued. An issue of equity would therefore lead to a drop in share price. This does not however apply to high-tech industries where the issue of equity is preferable due to the high cost of debt issue as assets are intangible
Sarbanes-Oxley 2002
Prohibits conflicts of interests increased supervision by SEC, including independence of audits by accounting firms. Made it unlawful for an accounting firm to provide non-audit services to a client contemporaneously, increased criminal charges for white-collar crime, and required CEO, CFO and auditors to verify information and disclosures.
Asset restrictions
Promote diversification, limit on asset holdings such as common stock
Rate of Return on Assets
ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment". ROA tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or the ROA of a similar company. For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit Assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company
Hedging
Reduce or eliminate risk by taking offsetting position To offset or hedge against that risk, the airline can enter into an agreement where it promises to pay a fixed price per gallon for fuel during the next six months. Typically an agreement would specify a quantity (the number of gallons of fuel), the time period (6 months) and the price. The seller of the contract agrees to sell the fuel for this fixed price, regardless of what happens to the market price, and the airline, the buyer of the contract, agrees to buy it at that price.
"Too big to fail" and moral hazard
SIFIs create a moral hazard problem, if banks take on more risk and risk pays off, they reap the profits, if they fail the government bails them out Forcing banks to hold more capital? Being more leveraged (low capital/asset ratio and high liability/asset ratio) raises the rate of return on assets (equity) Financial consolidation has created problems. Larger institutions means there are more "Too big to fail" institutions and the increased complexity and variety of services results in the government safety net being extended to many activities, such as securities underwriting.
Glass Steagall 1933 and 1935
Separated commercial banking from the securities industry Created Federal Deposit Insurance Corporation Provided insurance on deposits (many but not all accounts are FDIC insured) Great deal of restrictions Money market accounts are not FDIC insured Glass Steagall 1933 and 1935- created the FDIC, deposit insurance, separated commercial banking from the securities industry, many other restrictions
Social Security - pay as you go
Social Security is largely a pay-as-you-go program. This means that today's workers pay Social Security taxes into the program and money flows back out as monthly income to beneficiaries. As a pay-as-you-go system, Social Security differs from company pensions, which are "pre-funded." In pre-funded retirement programs, the money is accumulated in advance so that it will be available to be paid out to today's workers when they retire. Social Security is funded through the Federal Insurance Contributions Act tax (FICA), a payroll tax. Employers and employees are responsible for making equal FICA contributions Social Security funds are not invested on behalf of beneficiaries. Instead, current receipts are used to pay current benefits (the system known as "pay-as-you-go"), as is typical of some insurance and defined-benefit plans.
Bank Management: Benefits of Specialization vs. Diversification
Specialization: In the lending arena, it means getting to know an industry or lending type, developing a network of contacts within it, understanding its specific credit and other banking needs - all good things. On matters related to business development, the specialists clearly have the edge. Diversification: protects against risk if one specialization fails A big bank can have it both ways: the revenue-enhancing and cost-saving advantages of specializing, without undue concern for concentration risk. That's because size essentially means being able to diversify across many specializations. What's a specialization for a community bank is just another line of business for a big bank.
What is monoline insurance?
Specialize in credit insurance, especially important for the municipal bond market. Provide a guarantee of payment. separately capitalized insurance company formed for the purpose of insuring bonds
DIDMCA 1980
Start of deregulation: removal of ceilings on interest on deposits, uniform reserve requirements
Segmented Markets Theory
Stipulates that there is no necessary relationship between long and short-term interest rates. Furthermore, short and long-term markets fall into two different categories. Therefore, the yield curve is shaped according to the supply and demand of securities within each maturity length. Market segmentation theory maintains that the buyers and sellers in each of the different maturity lengths cannot be easily substituted for each other. An offshoot to this theory is that if an investor chooses to invest outside their term of preference, they must be compensated for taking on that additional risk. This theory deals with the supply and demand in a certain maturity sector, which determines the interest rates for that sector. It can be used to explain just about every type of yield curve an investor can came across in the market. An offshoot to this theory is that if an investor wants to go out of his sector, he'll want to be compensated for taking on that additional risk. This is known as the Preferred Habitat Theory. Under this theory, any type of yield curve can occur, ranging from a positive slope to an inverted one, as well as a humped curve. A humped curve is where the yields in the middle of the curve are higher than the short and long ends of the curve. The future shape of the curve is going to be based on where the investors are most comfortable and not where the market expects yields to go in the future.
Swaps
Suppose that Bank A holds a fixed-rate long-term mortgage at interest rate ia for 20 years. The payment stream generated from the mortgage is denoted xa,t, xa,t+1, . . . , xa,t+20 Bank A may wish to acquire some short-term floating rate assets while Bank B may wish to acquire some long-term fixed rate debt. First, let the differences in present values be computed as D = P Va − P Vb The banks can arrange a swap: essentially Bank A sends all payments on its fixed rate long term mortgage to Bank B while Bank B sends the payments on the short-term floating rate mortgage to Bank A. If the present values aren't equal (so D is nonzero), then one bank pays the other (if D < 0 then Bank A pays Bank B and conversely). There are two key points: • The fixed-rate long term mortgage stays on the balance sheet of Bank A. The short-term floating rate mortgage stays on the balance sheet of Bank B. • The payment streams are swapped: the advantage is that Bank A now has an income stream that is short-term and floating while Bank B has an income stream that is long-term fixed rate. Each bank will participate in the swap only if it is better off. The swap is an off-balance sheet transaction.
Changing the capital-asset ratio - what can a bank do?
Suppose the capital-asset ratio has been ten percent and a bank has a balance sheet with $100 loans, $10 equity and $90 deposits and other liabilities (debt). Assume now the central bank raises the capital-asset ratio to 20 percent. There are three ways the bank can comply with the new regulation: Asset liquidation Asset expansion Recapitalization
Conflict of interest in underwriting and research in investment banking
Suppose you're an underwriting for a new security, you have to make sure it sells, you turn around and give advice which is supposed to be independent from the underwriting (and based on your research) The best investments may not be the ones you're underwriting You have an incentive to misrepresent the quality of the securities you are underwriting Conflict of interest between research and underwriting There is supposed to be strict laws separating research and underwriting
Interest rate risk: mismatch in duration of assets and liabilities
Term structure risk: Maturity mismatches: Suppose an insurance company is earning 6% on an asset supporting a liability on which it is paying 4%. The asset matures in two years while the liability matures in ten. In two years, the firm will have to reinvest the proceeds from the asset. If interest rates fall, it could end up reinvesting at 3%. For the remaining eight years, it would earn 3% on the new asset while continuing to pay 4% on the original liability. Variable/Fixed: If fixed rate assets are financed with variable rate liabilities, the rate payable on the liabilities may rise while the rate earned on the assets remains constant.
Revolving door and government agencies phenomenon
The agent has different incentives, creating a conflict of interest, and more information than the principal. Regulatory forbearance can occur when the SEC attorney (the regulator) fails to enforce to the full extent of the law by closing the case and bringing no charges. The SEC employee may intend to move to the private sector in hopes of higher compensation (i.e. the industry he is regulating gives him incentives to be lenient given that it also has employment opportunities for him given the nature of his qualifications. (Revolving door) Also, failure to pursue the case allows the SEC to avoids scrutiny by the judicial sector, which may have called into question the competency of the SEC regulators and more generally highlighted the regulatory forbearance.
Audit/Consulting Conflict of Interest
The auditing firm collects information about a firm. The information is useful not only for the audit but also to a consulting firm. It is natural for the auditing firm to then act as a consultant. The problem is it creates a conflict of interest. In America, accountants are barred from providing most non-audit services to firms they audit. (This rule was introduced after the collapse of Enron, whose auditor, Arthur Andersen, was thought to have gone easy on the crooked energy firm to protect its lucrative business advising it.) In other countries, however, the rules are less strict.
Moral Hazard
The borrower's behavior after the transaction affects the probability of success of the project. It also refers to situations where the agent does not bear the cost of the risk-taking activity. Moral hazard occurs after the transaction or agreement has been made. Essentially the behavior of one party can impact the probability of success of the project in a way other agents can't observe An example of moral hazard is a professional athlete who gets paid whether or not he is injured and decides to engage in risky activities. The risk-taking behavior lowers the probability of a successful season.
Margin accounts, margin requirement and marketing-to-market
The daily resettlement is called marking-to market. Margin account - this is an account with a minimum balance that must be maintained every day.
Expectations Theory
The hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Expectations theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today. This theory is sometimes used to explain the yield curve but has proven inaccurate in practice as interest rates tend to remain flat when the yield curve is normal. In other words, expectations theory often overstates future short-term interest rates. It is based on the idea that the two-year yield is equal to a one-year bond today plus the expected return on a one-year bond purchased one year from today. The one weakness of this theory is that it assumes that investors have no preference when it comes to different maturities and the risks associated with them. According to this theory, a rising term structure of rates means the market is expecting short-term rates to increase. So if the two-year rate is higher than the one-year rate, rates should rise. If the curve is flat, the market is expecting that short-term rates will remain low or hold constant in the future. A declining rate-term structure indicates the market believes that rates will continue to decline.
Forward contracts: why are they unpopular?
The interest rate forward contract specifies 1. the debt contract or financial instrument to be delivered at a specified date in the future, 2. the amount to be delivered, 3. the interest rate or price when it is delivered, 4. the date. You take a long position if you promise to buy the asset at the future date and you take a short position if you promise to sell the asset at the future date. Notice at the delivery date, the futures contract may be in the money for you but over the time period until the delivery date, you may experience some capital losses (which clearly are recovered by the delivery date if the contract is in the money). Suppose you are in a long position and you are losing money. The long position can easily be offset by taking an offsetting short position.
Credit Assessment/Rating Agencies Conflict of Interest
The issuer of the security pays the rating agency because of the free-rider problem with investors
Rate of Return on Equity
The rate of return on equity ROE depends on the equity multiplier EM = assets/equity times the rate of return on assets ROA, or ROE = EM × ROA The higher the equity multiplier EM, holding ROA fixed, the higher the return to equity. The equity multiplier is higher the more leveraged an institution. Hence shareholders want the company to be highly leveraged, but not go bankrupt.
What explains the common movements of interest rates over time?
The risk spread stays more or less stable unless something drives a change in the yield curve. If everything else is constant, that means that the whole curve moves up or down for the most part together. If you get a change in the shape of the yield curve, which is a plot of time until maturity on the x and yield on the y, that indicates the market is factoring in a risk or an opportunity they expect to materialize at some point in time. Interest rates change as market participants receive new information about these factors. Often, various interest rates move together in the same direction.
Principal-agent problems
The shareholders are the principals and the agent is the manager. The PA problem often occurs with equities because of the the separation of ownership and management. Management has more information that shareholders. This creates an incentive compatibility problem.
Discount Window/Lender of Last Resort
This is a loan from the Federal Reserve You don't want to incur costs of having to borrow if you're short of required reserves Trade-off: earning interest/being liquid Federal reserve acts as a lender of last resort The Fed will go through a complete audit of your activities to find out why a bank isn't being managed in a prude way
Liquidity Premium Theory
This theory states that investors want to be compensated for interest rate risk that is associated with long-term issues. Because of the longer maturity, there is a greater price volatility associated with these securities. The structure is determined by the future expectations of rates and the yield premium for interest-rate risk. Because interest-rate risk increases with maturity, the yield premium will also increase with maturity. Also known as the Biased Expectations Theory. Under this theory, the curve starts to get a little bit more bent. With an upward sloping yield curve, this theory really has no opinion as to where the yield curve is headed. It could continue to be upward sloping, flat, or declining, but the yield premium will increase fast enough to continue to produce an upward curve with no concerns about short-term interest rates. When it comes to a flat or declining term structure of rates, this suggests that rates will continue to decline in the short end of the curve given the theory's prediction that the yield premium will continue to increase with maturity.
Liquidity Management
Trade off between lower return on very liquid assets versus higher return on illiquid assets Maintain required reserve ratio Determine optimal excess reserves
Compensating Balances
Typically, the borrower is asked to maintain a specified balance in a low interest or noninterest-bearing account at the bank (creditor). The required balance usually is some percentage of the committed amount (say 2% to 5%). These are known as compensating balances a specified balance (usually some percentage of the committee amount) a borrower of a loan is asked to maintain in a low-interest or noninterest-bearing account at the bank. because they compensate the bank for granting the loan or extending the line of credit.
Accounting: Book value vs. Fair Value/Mark-to-Market Accounting
When assets and liabilities are recorded using book value on the balance sheet (so the value on the date of origination), fluctuations in interest rates and credit risk can cause the current market value to deviate from the book value. If the current market value of the asset or liability is used on the balance sheet, then it is called mark-to-market. During bad times, the book value tends to overestimate the value of the assets while, in good times, the book value tends to underestimate the value of the asset. Often liabilities, such as short term deposits, have fixed values. If marking to market is used, then during bad times, asset values generally fall and liabilities often remain unchanged or fall proportionately less. Hence, marking to market induces procyclical fluctuations in the balance sheet. If asset values fall while liabilities remain fixed, capital is adjusted downward. Hence, marking to market may also force institutions to try to raise capital during recessionary periods, when share prices tend to be lower. The financial regulators are aware of the problems with marking to market and the Treasury is supposed to conduct a study.
What is an investment bank?
a financial institution that assists individuals, corporations, and governments in raising financial capital by underwriting or acting as the client's agent in the issuance of securities (or both) No deposits
Carried interest
a share of the profits of an investment or investment fund that is paid to the investment manager in excess of the amount that the manager contributes to the partnership. As a practical matter, it is a form of performance fee that rewards the manager for enhancing performance Private equity funds only distribute carried interest to the manager upon successfully exiting an investment, which may take years. The customary hurdle rate in private equity is 7-8% per annum. In a hedge fund environment, carried interest is usually referred to as a "performance fee". Hedge funds, because they invest in liquid investments, are often able to pay carried interest annually if the fund has generated a profit for its investors.
Sovereign wealth funds
a state-owned investment fund investing in real and financial assets such as stocks, bonds, real estate, precious metals, or in alternative investments such as private equity fund or hedge funds. Sovereign wealth funds invest globally. Most SWFs are funded by revenues from commodity exports or from foreign-exchange reserves held by the central bank. Some sovereign wealth funds may be held by a central bank, which accumulates the funds in the course of its management of a nation's banking system; this type of fund is usually of major economic and fiscal importance. Other sovereign wealth funds are simply the state savings that are invested by various entities for the purposes of investment return, and that may not have a significant role in fiscal management. Sovereign wealth funds can be characterized as maximizing long-term return, with foreign exchange reserves serving short-term "currency stabilization", and liquidity management. Many central banks in recent years possess reserves massively in excess of needs for liquidity or foreign exchange management. Moreover it is widely believed most have diversified hugely into assets other than short-term, highly liquid monetary ones, though almost no data is publicly available to back up this assertion. Some central banks have even begun buying equities, or derivatives of differing ilk (even if fairly safe ones, like overnight interest rate swaps)
Supervision and regulation
chartering, assessment of risk management, call report, disclosure requirements
Leverage ratio and capital requirements
i. US requires 5 percent leverage ratio to be well capitalized ii. Basel Accord: Risk based capital requirements - capital must be 8 percent of risk-based capital. Risk-weighted assets leads to regulatory arbitrage iii. Too low capital increases moral hazard, especially with too big to fail policies
Why was there more competition for loans?
junk bond market, commercial paper market, securitization, rise of shadow banking system
Universal banking
no separation between banking and securities industry
Banknotes (issued by banks and redeemed for gold)
private currency
Collateral
something pledged as security for repayment of a loan, to be forfeited in the event of a default.
Securitization
transformation of otherwise illiquid assets into marketable securities
Private equity
venture capital firms and leveraged buyouts private equity is an asset class consisting of equity securities and debt in operating companies that are not publicly traded on a stock exchange. A private equity investment will generally be made by a private equity firm, a venture capital firm or an angel investor Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet. The majority of private equity consists of institutional investors and accredited investors who can commit large sums of money for long periods of time. Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as an IPO or sale to a public company.
