FM & I Chapter 13 - 23

Chapter 13: Regulation of Commercial Banks

Commercial Banks: Ngân hàng thương mại

 liquidity: tính thanh khoản

price-risk reduction: giảm thiểu rủi ro về giá cả

moral hazard: mối nguy hiểm về đạo đức

credit allocation: định vị tín dụng

.Commercial banks provide many unique services

.information, liquidity, price-risk reduction, transaction cost, maturity intermediation, and payment services

.money supply transmission, credit allocation, intergenerational wealth transfers, and denomination

intermediation

.Failure to provide these services can be costly to both users and suppliers of funds

.Government deposit insurance liability creates moral hazard

.Accordingly, commercial banks are regulated at the federal (and sometimes state) level

Commercial Bank Regulation

.Safety and soundness regulation: qui định về an toàn và lành mạnh

equity capital levels: mức độ vốn cổ đông

monitoring and surveillance: giám sát và theo dõi

.assets must be diversified: cannot make loans greater than 10% of their equity capital to any one borrower

.must maintain adequate equity capital levels to protect against insolvency risk

.provision of guarantee funds such as the Deposit Insurance Fund (DIF) protects depositors in the event of default and prevents bank runs

.monitoring and surveillance: banks must submit (publicly accessible) quarterly reports and are subject to on-site examinations

limit systemic risk: giới hạn rủi ro hệ thống

accountability: trách nhiệm giải trình

Commercial Bank Regulation

.Dodd-Frank Act of July 2010 (Wall Street Reform and Consumer Protection Act)

.Promote better supervision of financial firms by creating a new Financial Services Oversight Council chaired by the Treasury and including the heads of the primary federal regulators to limit systemic risk

.Increasing regulation of securitization processes by requiring more transparency, stronger regulations of credit ratings agencies, and increasing the percentage of loan sales that must be retained by originators

.Dodd-Frank Act of July 2010 (Wall Street Reform and Consumer Protection Act)

.Increase regulation of OTC derivatives and gives the Federal Reserve additional authority over the nation’s payment mechanisms

.Establish the Consumer Financial Protection Agency (CFPA)

.Dodd-Frank Act of July 2010 (Wall Street Reform and Consumer Protection Act)

emergency lending facilities: các tiện ích cho vay khẩn cấp

lack of disclosure, malfeasance, and breach of fiduciary responsibility: thiếu sự phơi bày ra, viên chức không làm đúng những gì mà pháp luật quy định, vi phạm trách nhiệm được ủy thác 

.Establish new methods to resolve problems in nonbanks that may present systemic risks and improve the Fed’s accountability in its emergency lending facilities

.Increase international regulatory standards and cooperation, primarily by increasing capital requirements at U.S. and non-U.S. banks

.Investor protection regulation

.Protects investors against unfair treatment such as insider trading, lack of disclosure, malfeasance, and breach of fiduciary responsibility

Consumer Protection Regulation

.Protects investors against unfair treatment such as insider trading, lack of disclosure, malfeasance, and breach of fiduciary responsibility

.Consumer Financial Protection Agency (Dodd-Frank)

.Created to protect consumers from unfair, deceptive and abusive practices, and improve

transparency in dealing with consumers: Được tạo ra để bảo vệ người tiêu dùng khỏi sự thực hiện không công bằng, dối trá và lạm dụng, và cải thiện sự trong sáng trong giao tiếp với người tiêu dùng. 

abolish: hủy bỏ, tiêu hủy.

Consumer Protection Regulation

.A 2010 bill on credit card practices effectively limits card issuer’s ability to increase interest rates in the first year a card is obtained, limits fees and penalties for missed payments, and abolishes universal default penalties

.Monetary policy regulation

.the Central Bank (the Federal Reserve) directly controls the quantity of notes and coin (i.e., outside money) in the economy

.however, the bulk of the money supply is held as bank deposits, called inside money

.regulators require cash reserves to be held at commercial banks

.Credit allocation regulation

.Community Reinvestment Act (CRA) of 1977: regulators encourage (and often require) lending to socially important sectors of the economy (e.g., housing and farming)

.Lending:

.The object is to prevent redlining and similar discriminatory practices as well as to encourage lending to disadvantaged groups

.Encourage banks to lend to startups and engage in loans to micro businesses

low or moderate income individuals: các cá nhân thu nhập thấp và trung bình.

.Use of innovative or flexible lending practices to assist low or moderate income individuals

.Credit allocation regulation (cont.)

involvement with: sự dính dáng, liên quan đến.

.Investment:

The institution’s involvement with qualified programs that assist certain people or areas

.Service:

The extent to which the institution provides banking services to the community and their willingness to

accommodate to area needs .Separate usury laws cap interest rates that can be charged on loans

.Entry and chartering regulation

.the entry of commercial banks is regulated

.the permissible activities of commercial banks are defined by regulators

the charter values of banks: vốn điều lệ của ngân hàng.

.the barriers to entry and the scope of permissible activities allowed affects the charter values of banks and the size of the net regulatory burden

.The net regulatory burden is the difference between the costs of regulations and the benefits

for the producers of financial services

.Regulators

.Federal Deposit Insurance Corporation (FDIC)

.Office of the Comptroller of the Currency (OCC)

.Federal Reserve System (FRS)

.Financial Services Oversight Council (FSOC)

.Consumer Financial Protection Agency (CFPA)

.State agencies

.The facets of regulatory structure

.regulation of product and geographic expansion

.provision and regulation of deposit insurance

.balance sheet regulation

.off-balance-sheet regulation

.consumer protection

Product Segmentation Regulation

.Commercial banking vs. investment banking

.commercial banking involves deposit taking and lending

.investment banking involves underwriting, issuing, and distributing securities

.the Glass-Steagall Act of 1933 imposed a rigid separation between commercial and investment banks

.by 1987 commercial banks were allowed to engage in limited investment banking activity through Section 20 affiliates

.the Financial Services Modernization Act (FSMA) of 1999 repealed Glass-Steagall

Product Segmentation Regulation

.Commercial banking vs. investment banking

underwriting: sự bảo hiểm, sự bao tiêu.

affiliate: chi nhánh.

.Financial crisis defacto eliminated the separation of commercial and investment banking

Product Segmentation Regulation

.Commercial banking vs. insurance underwriting

.the Bank Holding Company Act (BHCA) of 1956 restricted insurance companies from owning or being affiliated with commercial banks

.the FSMA of 1999 now allows bank holding companies to open insurance underwriting affiliates and also allows insurance companies to open banks

.Commercial banks and commerce

.the BHCA of 1956 restricts commercial firms from acquiring banks

.the 1970 Amendment to the BHCA requires banks to divest (xử lý, bán ra) nonbank related subsidiaries

Geographic Expansion Regulation

.Restrictions on intrastate banking

.most banks used to be unit banks—i.e., banks with single offices

.by 1997 only six states restricted intrastate (trong phạm vi 1 tiểu bang) branching

.Restrictions on interstate banking

.the McFadden Act of 1927 (amended in 1933) restricted national banks from branching across state lines

.as a result, the largest banks were set up as multibank holding companies (MBHCs)

.an MBHC is a parent banking organization that owns a number of individual bank subsidiaries

Geographic Expansion Regulation

.Douglas Amendment to the BHCA of 1956

.let states regulate MBHC expansion

.subsidiaries established prior to the passage of the amendment were considered grandfathered and not

subject to the law

.1970 Amendment to the BHCA of 1956 restricted the nonbank activities that one-bank holding companies (OBHCs) could engage in

.an OBHC is a parent banking organization that owns one bank subsidiary and nonbank subsidiaries

.Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

.allows consolidation of out-of-state bank subsidiaries into a branch network and allows interstate mergers and acquisitions

Deposit Guarantee Funds

.The Federal Deposit Insurance Corporation (FDIC)

.The FDIC was created in 1933 during the Depression to restore public confidence in the banking system. The initial insurance limit was $2,500; this amount was periodically increased to $100,000, where it remained until the financial crisis of 2007-2008 when it was increased to $250,000

.Other laws of the 1930s limited competition among banks

.Regulation Q specified maximum interest rates on deposits and prevented competition on deposit rates

Deposit Guarantee Funds

.System worked extremely well until 1979; from October 1979 to October 1982 the Fed let interest rates rise dramatically

.Led to disintermediation—i.e., the withdrawal of deposits from depository institutions and their reinvestment elsewhere

Deposit Guarantee Funds

.Increasing competition and record high interest rates reduced industry profitability, particularly at thrifts (tiết kiệm)

.Problems were exacerbated (làm trầm trọng/tệ hại hơn) by a policy of regulatory forbearance (cho khất nợ/ cho hoãn nợ)—i.e., a policy of not closing economically insolvent depository institutions, but allowing their continued operation

Deposit Guarantee Funds

.The demise (sự chuyển nhượng, di tặng) of the Federal Savings and Loan Insurance Corporation (FSLIC)

.the FSLIC insured savings institutions from 1934 to 1989

.savings institutions failures in the 1980s led to an insolvent FSLIC by 1989, which led to two major reforms:

.The FDIC Improvement Act (FDICIA) of 1991 restructured the Bank Insurance Fund (BIF)

.The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989

.dissolved the FSLIC and transferred its management to the FDIC

.created the Savings Association Insurance Fund (SAIF)

Deposit Guarantee Funds

.The FDIC introduced risk-based deposit insurance premiums in January of 1993

.by 1996 the safest institutions insured by the BIF paid no deposit insurance premiums

.by 1997 the safest institutions insured by the SAIF paid no deposit insurance premiums

.by the early 2000s over 90% of depository institutions were in the “safe” category that paid no deposit insurance premium

.In March 2005 the BIF and the SAIF were merged into one Deposit Insurance Fund (DIF)

.In January 2007 the FDIC began a more aggressive insurance system where all institutions pay into the fund

Balance Sheet Regulation

.Liquidity regulation

.banks must hold minimum levels of reserves against net transaction accounts .ensures that banks can meet required payments on liability claims such as deposit withdrawals

.see Appendix 13C for more details

.Capital adequacy regulation

.since 1987 U.S. commercial banks have faced two different capital requirements

.Tier (bậc) I capital risk-based ratio

.Total capital (Tier I + Tier II) risk-based ratio

Balance Sheet Regulation

.Capital adequacy regulation (continued)

.Tier I capital is composed of the book value of common equity plus an amount of perpetual (vĩnh viễ) preferred stock plus minority equity interests held by the bank in subsidiaries minus goodwill

.Tier II capital includes secondary capital resources such as loan loss reserves and convertible and subordinated debt

.Risk-adjusted assets include both on- and off-balance-sheet assets whose values are adjusted for approximate credit risk

.Total risk-based capital ratio is equal to the sum of Tier I and Tier II capital divided by risk-adjusted assets

.Tier I (core) capital ratio is equal to Tier I capital divided by risk-adjusted assets

Balance Sheet Regulation

.Capital adequacy regulation (continued)

.since 1991 banks have also been assessed based on their capital-to-assets (i.e., leverage) ratio

.capital-to-assets ratio = core capital ÷ total assets

.does not account for market values, riskiness of assets, or off-balance-sheet activities

.since December 1992 regulators must take Prompt Corrective Action (PCA) if and when a bank falls outside of the “well capitalized” zone

.risk-based capital ratios were phased in by Bank for International Settlement (BIS) countries (the U.S. included) by 1993 under the Basel Accord

Balance Sheet Regulation

Basel II had three main ideas or pillars to help ensure the safety and soundness of the financial system:

. Pillar 1:

.Update regulatory capital requirements for credit, market and operational risk

.Credit risk could be measured through the bank.s own internal rating and credit scoring models

. Pillar 2:

.Emphasized separate regulatory evaluation process in addition to capital requirements and stressed the importance of a bank’s internal control procedures

.Pillar 3:

.Promote disclosure of the institution.s capital structure, risk exposure, and capital adequacy

Balance Sheet Regulation

.Capital adequacy regulations have been updated and generally strengthened by Basel II and Basel III accords

.Basel III capital requirements after transition period:

Off-Balance-Sheet Regulation

.Banks earn fee income with off-balance-sheet (OBS) activities

.By engaging in OBS activities, banks can avoid regulatory costs such as reserve requirements, deposit insurance premiums, and capital adequacy requirements

.Banks must report notional values of OBS activity on Schedule L

.OBS activity is incorporated into the total risk-based capital ratio and the Tier I capital ratio, but not the leverage ratio

Foreign vs. Domestic Regulation

.Regulation of U.S. banks in foreign countries

.the Overseas Direct Investment Control Act of 1964 restricted U.S. banks. ability to lend to U.S. corporations to make foreign investment

.the North American Free Trade Agreement (NAFTA) of 1994 enabled U.S. banks to expand to Mexico and Canada

.a 1997 agreement between 100 countries (under the World Trade Organization (WTO)) began dismantling (phá hủy, triệt phá) barriers inhibiting (ngăn chặn, kiềm chế) foreign direct investment into emerging countries

Foreign vs. Domestic Regulation

.Regulation of foreign banks in the U.S.

.the International Banking Act (IBA) of 1978 declared foreign banks are to be regulated the same as national domestic banks

.foreign banks are subject to Federal Reserve examinations

.the Foreign Bank Supervision Enhancement Act (FBSEA) of 1991 gave additional powers to the Federal Reserve

.Fed must approve new subsidiary, branch, agency, or representative offices of foreign banks in the U.S.

.Fed has the authority to close foreign banks operating in the U.S.

.only foreign banks with access to the FDIC (the Federal Deposit Insurance Corporation= Công ty bảo hiểm Tiền gửi Liên bang) can accept consumer deposits

.state-licensed foreign branches are regulated as national branches

Chapter 16: Securities Firms and Investment Banks

Securities Firms and Investment Banks (IBs)

.Investment banks (IBs) help corporations and  governments raise capital through debt and equity

security issues in the primary market

.underwriting is assisting in the issue of new securities

.IBs also advise on mergers and acquisitions (M&As= Sáp nhập & Thu mua) and  corporate restructuring

.Securities firms assist in the trading of securities in secondary markets

.broker-dealers assist in the trading of existing securities

Securities Firms and Investment Banks (IBs)

.The size of the industry is usually measured by the equity capital of firms rather than total asset size

.Equity capital in the industry in 2010 was $214.5 billion

.The number of firms in the industry changed due to economies of scale and scope, losses with the economy, scandals at some firms, and regulations that allowed both

inter- and intra-industry mergers

.As with commercial banks, consolidation (sự vững chắc, sự thống nhất) has largely occurred through mergers and acquisitions

Securities Firms and Investment Banks (IBs)

.Commercial bank holding companies that operate diversified national full-line firms

.service both retail and wholesale customers by acting as broker-dealers

.service corporate customers by underwriting security issues

.National full-line firms specializing in corporate finance

.The second largest group of firms are full-service firms that specialize in corporate finance or primary market activity (i.e., focus less on secondary market activities)

Securities Firms and Investment Banks (IBs)

.Large investment banks

.Have only limited branch networks concentrated in major cities and service primarily financial institution clients

.Smaller specialized firms such as:

.regional investment bankers (sometimes labeled ‘boutiques’)

.discount brokers

.Internet brokers

.venture capital firms: Công ty kinh doanh vốn nhiều rủi ro.

.exchange floor specialists

.dealers in off exchange trading

Lines of Business

.Investment banking

.first time debt and equity issues occur through initial public offerings (IPOs)

.new issues from a firm whose debt or equity is already traded are called seasoned equity offerings (SEOs)

.a private placement is a securities issue that is placed with one or a few large institutional investors

.public offerings are offered to the public at large

.IBs act only as an agent in best efforts underwriting

.IBs act as principals in firm commitments

Lines of Business

.Venture capital (VC) is a professionally managed pool of money used to finance new (i.e., start-up)

and often high-risk firms

.VC usually purchases an equity stake in the start-up

.usually become active in management of the start-up

.institutional venture capital firms find and fund the most promising new firms

.venture capital limited partnerships

.financial venture capital firms

.corporate venture capital firms

.Private equity investments

.Private equity (PE) differs from VC in funds sources and in types of investments

.PE firms raise funds by selling securities rather

than commingling private funds

.PE firms often acquire established existing firms rather than purchase start-ups

.Market making involves the creation of secondary markets for an issue of securities

.agency transactions are two-way transactions on behalf of customers

.with principal transactions market makers seek to profit for their own accounts

.Investment banks managed $88 trillion in derivatives securities in 2010

.Trading involves taking an active net position in an asset

.Position trading involves relatively long-term positions in assets

.Pure arbitrage (buôn chứng khoán) involves attempts to profit from price discrepancies (không nhất quán)

.Risk arbitrage involves attempts to profit by forecasting information releases

.Program trading is the simultaneous (xảy ra đồng thời) buying and selling of at least 15 different stocks valued at $1 million or more

.Trading (continued)

.Stock brokerage (nghề môi giới) involves trading on behalf of customers

.Electronic brokerage offers customers direct access, via the internet, to the trading floor

.Investing involves managing pools of assets such as closed- and open-end mutual funds (đầu tín thác từ A đến Z).

.as agents

.as principals

.Cash management involves deposit-like accounts such as money market mutual funds (MMMFs) that

offer check writing privileges

.Merger and acquisition (M&A = sáp nhập và thu mua) assistance

.M&A activity brings large fees to bankers

.M&A business remains very cyclical (tuần hoàn theo chu kỳ) and depends on the economy

.Other Service Functions

.Security custodian (người canh chừng) services

.Clearance and settlement services: Dịch vụ giải quyết và thanh toán tại ngân hàng hối đoái.

.Escrow (điều kiện có giao kèo do bên thứ ba giữ để làm bằng chứng) services, research and advice on divestitures (tái bố trí tài sản), and asset sales

Industry Performance

.Industry trends depend heavily on the state of the stock market and the economy

.Commission income fell after the 1987 stock market crash and the 2001-2002 stock market decline

.Improvements in the U.S. economy in the mid-2000s led to increases in commission income but income fell with the stock market in 2006-2008 because of rising oil prices and the subprime (thứ cấp) mortgage collapse

Industry Performance

.Performance (continued)

.Revenues and profits fell record amounts in 2008, but rebounded (hồi phục) sharply in 2009

.Industry employment fell sharply

.Low interest rates and strong stock market helped fuel profit recovery

Regulation of Securities Firms and Investment Banks (IBs)

.The Securities and Exchange Commission (SEC) is the primary regulator of the securities

industry

.The National Securities Markets Improvement Act (NSMIA) of 1996 reaffirmed federal (over state)

authority

.Even so, state attorneys generally intervene through securities-related investigations that have led to many highly publicized criminal cases

Regulation of Securities Firms and Investment Banks (IBs)

.The Sarbanes-Oxley Act (SOX) of 2002

.created an independent auditing oversight (giám sát, giám thị) board under the SEC

.increased penalties for corporate wrongdoers

.forced faster and more extensive (bao quát) financial disclosure

.created avenues of recourse for aggrieved (buồn phiền) shareholders

.The SEC sets rules governing underwriting and trading activity

.SEC Rule 144A defines boundaries between public offerings and private placements

.Two self-regulatory organizations oversee the day-to-day regulation of trading practices

.the New York Stock Exchange (NYSE)

.the Financial Industry Regulatory Authority (FINRA)

.The U.S.A. Patriot Act became effective in 2003

.firms must verify identities of customers

.firms must maintain records of identities of customers

.firms must verify customers are not on suspected terrorist lists

.Investors in the industry are protected by the Securities Investor Protection

Corporation (SIPC)

.protects investors against losses of up to $500,000 due to securities firm failures (but not against poor investment decisions)

.created following passage of the Securities Investor Protection Act in 1970

.Under the Dodd-Frank Act, the Financial Services Oversight Council (FSOC) has oversight of systemic risk of the industry

.More investment advisors will have to be registered with either the SEC or state advisors

.Securitization (chứng khoán hóa) markets should now have more oversight and originators (người tạo thành) will have to retain a greater interest in loans that will be resold

.More derivatives regulation is expected as well

.The government can also mandate (ủy nhiệm, ủy thác) higher capital requirements for larger and for interconnected firms

.Conclusion: Government oversight of industry practices has increased as a result of the bill

.Executive compensation restrictions imposed (lạm dụng, lợi dụng) by the Obama administration

.Strengthen the independence of the compensation committee from senior management

.Shareholders now also have a non-binding (không ràng buộc) vote on executive compensation packages

.Administration has a say on executive pay for firms that accepted bailout money (tiền cứu trợ tài chính).

Global Issues

.Securities firms and investment banks are by far the most global of any group of financial institutions

.U.S. firms are increasingly looking to expand their business abroad—particularly into China and India

.Increase in cross-border strategic alliances: gia tăng liên minh chiến lược xuyên biên giới.

Chapter 19:

Types of Risks Incurred by Financial Institutions

Risks at Financial Institutions

.One of the major objectives of a financial institution’s (FI’s) managers is to increase the FI’s

returns for its owners

.Increased returns typically come at the cost of increased risk, which comes in many forms:

.credit risk

.liquidity risk

.interest rate risk

.market risk

.off-balance-sheet risk

o foreign exchange risk

o country or sovereign risk

o technology risk

o operational risk

o insolvency risk: rủi ro không trả được nợ

Credit Risk at FIs

.Credit risk is the risk that the promised cash flows from loans and securities held by FIs may not be paid in full

.FIs that make loans or buy bonds backed by a small percentage of capital

.Thus, banks, thrifts, and insurance companies can be significantly hurt by even minor amounts of loan losses

.Many financial claims issued by individuals or corporations have:

.limited upside return

.large downside risk with a low probability

.A key role of FIs involves screening and monitoring loan

applicants to ensure only the creditworthy receive loans

.FIs also charge interest rates commensurate (tương ứng) with the riskiness of the borrower

Credit Risk at FIs

.Credit risk (cont.)

.the effects of credit risk are evidenced by net charge-offs (tiền khấu hao thuần)

.the Bankruptcy Reform Act of 2005 makes it more difficult for consumers to declare bankruptcy

.FIs can diversify away some individual firm-specific credit risk, but not systematic credit risk

.firm-specific credit risk is the risk of default for the borrowing firm associated with the specific types of project risk taken by that firm

.systematic credit risk is the risk of default associated with general economy-wide or macroeconomic conditions affecting all borrowers

Commercial Bank Charge-Off Rates

Personal Bankruptcy Filings & NCOs

Effect of Credit Risk on Equity

Value

Liquidity Risk at FIs

.Liquidity risk is the risk that a sudden and unexpected increase in liability withdrawals or

unexpected loan demand may require an FI to liquidate assets in a very short period of time and at

low prices

.Day-to-day withdrawals and loan demand are generally predictable

.FIs may hold liquid assets and/or rely on purchased funds

.Purchased funds include short-term borrowings such as federal funds loans and brokered deposits

Liquidity Risk at FIs

.Liquidity risk (continued)

.Unusually large withdrawals by liability holders can create liquidity problems, in

these cases:

.The cost of purchased and/or borrowed funds rises for FIs

.The supply of purchased or borrowed funds declines

.FIs may be forced to sell less liquid assets at “fire-sale” prices

Effect of Deposit Withdrawal

.$15 million deposit withdrawal, met with liquidating $10 million cash assets and liquidation of $10

million of nonliquid assets at „fire sale. price of $5 million

.Note the effect on equity

Interest Rate Risk at FIs

.Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched and interest rates are volatile

.Asset transformation involves an FI issuing secondary securities or liabilities to fund the purchase of primary securities or assets

.If an FI.s assets are longer-term than its liabilities, it faces refinancing risk

.the risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments

.If an FI.s assets are shorter-term than its liabilities, it faces reinvestment risk

.the risk that the returns on funds to be reinvested will fall below the cost of funds

Interest Rate Risk at FIs

 An FI has $100 million of fixed earning assets that mature in 2 years. The assets earn an average of 7%.

These are funded by 6 month CD liabilities paying 4%.

What is the bank.s net interest margin (NIM)?

.NIM = [(7% – 4%)*$100 million] / $100 million = 3%

.How does the NIM change if in 6 months interest rates increase 100 basis points?

.The 2-year assets will still be earning 7%, but the new 6-month CDs will have to pay 5%:

.New NIM = [(7% – 5%)*$100 million] / $100 million = 2%

Interest Rate Risk at FIs

.Interest rate risk (cont.)

.All FIs face price risk (or market value risk)

.The risk that the price of the security changes when interest rates change

.FIs can hedge or protect themselves against interest rate risk by matching the maturity of their assets and liabilities

.This approach is inconsistent with their asset transformation function

.They may match the rate sensitivity of their assets and liabilities

.They may match the duration of their assets and liabilities

Market Risk at FIs

.Market risk is the risk incurred in trading assets and liabilities due to changes in

interest rates, exchange rates, and other asset prices

.Closely related to interest rate and foreign exchange risk

.Adds trading activity—i.e., market risk is the incremental risk (rủi ro về tiền lãi) incurred by an FI (in addition to interest rate or foreign exchange risk) caused by an active trading strategy

Market Risk at FIs

.Market risk (cont.)

.FIs. trading portfolios are differentiated from their investment portfolios on the basis of time horizon

and liquidity

.trading assets, liabilities, and derivatives are highly liquid

.investment portfolios are relatively illiquid and are usually held for longer periods of time

.Declines in traditional banking activity and income at large commercial banks have been

offset by increases in trading activities and income

Banking Book and Trading

Book Accounts

Market Risk at FIs

.Market risk (cont.)

.Declines in underwriting and brokerage income at large investment banks have been offset by

increases in trading activity and income

.Certain types of MFs such as REITS are also exposed to market risk

.FIs are concerned with fluctuations in trading account assets and liabilities

.Value at risk (VAR) and daily earnings at risk (DEAR) are measures used to assess market risk exposure

Market Risk at FIs

.Market risk (cont.)

.Market risk exposure has caused some highly publicized losses

.The failure of the 200-year old British merchant bank Barings in 1995

.$7.2 billion in market risk-related loss at Societe Generale in 2008

.The failure or forced buyouts of Bear Stearns, Lehman Brothers, Merrill Lynch, Wachovia, IndyMac, Countrywide, AIG, Washington Mutual and others as a result of problems in their on- and off-balance-sheet holdings of mortgage-related investments in 2007 and 2008

Off-Balance-Sheet Risks

.Off-balance-sheet (OBS) risk is the risk incurred by an FI as the result of activities related to

contingent (ngẫu nhiên) assets and liabilities

.Commercial banks alone held off-balance-sheet claims of $234.655 trillion in 2010

.OBS activity can increase FIs. interest rate risk, credit risk, and foreign exchange risk

.OBS activity can also be used to hedge (i.e., reduce) FIs. interest rate risk, credit risk, and foreign

exchange risk

Off-Balance-Sheet Risks

.Off-balance-sheet (OBS) risk (continued)

.Large commercial banks (CBs), in particular, engage in OBS activity

.The losses on OBS commitments in the financial crisis indicate that banks had excessive risks in

their derivatives activities and did not have sufficient capital to back these commitments

.Very complex derivatives sold by banks

.In some cases the securities were so complicated that ratings agencies and regulators had to rely on the bankers.

assessment of the riskiness of the securities

Off-Balance-Sheet Risks

.OBS risk (cont.)

.OBS activities can affect the future shape of FIs. balance sheets

.OBS items become on-balance-sheet items only if some future event occurs

.A letter of credit (LOC) is a credit guarantee issued by an FI for a fee on which payment is contingent on some future event occurring, most notably default of the agent that purchases the LOC

.Other examples include:

.loan commitments by banks

.mortgage servicing contracts by savings institutions

.positions in forwards, futures, swaps, and other derivatives held

by almost all large FIs

Foreign Exchange Risk

.Foreign exchange (FX) risk is the risk that exchange rate changes can affect the value of an FI.s assets and liabilities denominated in foreign currencies

.FIs can reduce risk through domestic-foreign activity/investment diversification

.FIs expand globally through:

.acquiring foreign firms or opening new branches in foreign countries

.investing in foreign financial assets

.returns on domestic and foreign direct and portfolio investment are not perfectly correlated

.underlying technologies of various economies differ

.exchange rate changes are not perfectly correlated across countries

Foreign Exchange Risk

.FX risk (cont.)

.A net long position in a foreign currency involves holding more foreign assets than foreign liabilities

.FI losses when foreign currency falls relative to the U.S. dollar

.FI gains when foreign currency appreciates relative to the U.S. dollar

.A net short position in a foreign currency involves holding fewer foreign assets than foreign liabilities

.FI gains when foreign currency falls relative to the U.S. dollar

.FI losses when foreign currency appreciates relative to the U.S. dollar

.An FI is fully hedged if it holds an equal amount of foreign currency denominated assets and liabilities (that have the same maturities)

Foreign Exchange Risk

 A U.S. FI lends ¥100 million when the ¥/$ exchange rate is ¥110. The interest rate is fixed at 9% and the loan is for one year. If, in a year, the exchange rate is ¥120 to the dollar, what is the bank.s dollar rate of return on the loan?

.The original dollar amount lent by the bank is:

.¥100,000,000 / ¥110 = $909,090.91

.In one year the borrower repays:

.(¥100,000,000 . 1.09) = ¥109,000,000

.In dollar terms this is now worth:

.¥109,000,000 / ¥120 = $908,333.33

Sovereign Risk at FIs

.Country or sovereign risk is the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments

.differs from credit risk of FIs. domestic assets

.with domestic assets, FIs usually have some recourse through bankruptcy courts—i.e., FIs can recoup some of their losses when defaulted firms are liquidated or restructured

.foreign corporations may be unable to pay principal and interest even if they would desire to do so

.foreign governments may limit or prohibit debt repayment due to foreign currency shortages or adverse political events

Sovereign Risk at FIs

.Country or sovereign risk (cont.)

.Thus, an FI claimholder may have little or no recourse to local bankruptcy courts or to an international claims court

.Measuring sovereign risk includes analyzing:

.the trade policy of the foreign government

.the fiscal stance of the foreign government

.potential government intervention in the economy

.the foreign government.s monetary policy

.capital flows and foreign investment

.the foreign country.s current and expected inflation rates

.the structure of the foreign country.s financial system

Technology and Operational Risk

.Technology risk and operational risk are closely related

.Technology risk is the risk incurred by an FI when its technological investments do not produce anticipated cost savings

.The major objectives of technological expansion are to allow the

FI to exploit potential economies of scale and scope by:

.lowering operating costs

.increasing profits

.capturing new markets

.Operational risk is the risk that existing technology or support systems may malfunction or break down

.The BIS defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events”

Insolvency Risk at FIs

.Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities

.Insolvency risk is a consequence or an outcome of one or more of the risks previously described:

.interest rate, market, credit, OBS, technological, foreign exchange, sovereign, and/or liquidity risk

.Generally, the more equity capital to assets an FI has, the less insolvency risk it is exposed to

.Both regulators and managers focus on capital adequacy as a measure of an FI.s ability to remain solvent

Other Risks and Interactions

.Other risks and interactions among risks

.In reality, all of the previously defined risks are interdependent

.e.g., liquidity risk can be a function of interest rate and credit risk

.When managers take actions to mitigate one type of risk, they must consider such actions on other risks

.Changes in regulatory policy constitute another type of discrete or event-specific risk

.Other discrete or event-specific risks include:

.war, revolutions, sudden market collapses, theft, malfeasance, and breach of fiduciary trust and

.Macroeconomic risks include increased inflation, interest rate volatility, unemployment, and the recent financial crisis

Chapter 23:

Managing Risk off the Balance Sheet with Derivative Securities

Managing Risk off the Balance Sheet

.Managers are increasingly turning to off-balance-sheet (OBS) instruments such as forwards, futures, options, and swaps to hedge the risks their financial institutions (FIs) face

.interest rate risk

.foreign exchange risk

.credit risk

.FIs also generate fee income from derivative securities transactions

Managing Risk off the Balance Sheet

.A spot contract is an agreement to transact involving the immediate exchange of assets and

funds

.A forward contract is a negotiated agreement to transact at a point in the future with the terms of the

deal set today

.Any amount can be negotiated

.Not generally liquid, so each party must perform

.Counterparty default risk can be significant

.A futures contract is an exchange-traded agreement to transact involving the future exchange of a set amount of assets for a price that is fixed today

.Futures are liquid, most traders close their position before the delivery date so the underlying transaction may never take place

.Futures contracts are marked to market daily—i.e., the traders‘ gains and losses on outstanding futures contracts are realized each day as futures prices change

.Exchange clearinghouse stands behind all contracts so there is no counterparty default risk and trading is anonymous

Hedging with Forwards

.A naïve hedge (ngăn cách) is a hedge of a cash asset on a direct dollar-for-dollar basis with a forward (or futures) contract

.Managers can predict capital loss (.P) using the duration formula:

 where P = the initial value of an asset

 D = the duration of the asset

 R = the interest rate (and thus .R is the change in interest)

.FIs can immunize assets against risk by using hedging (phong tỏa) to fully protect against adverse (có hại) movements in interest rates

Hedging with Futures

.Microhedging is using futures (or forwards) contracts to hedge a specific asset or liability

.basis risk is a residual risk that occurs in a hedged position because the movement in an asset‘s spot

price is not perfectly correlated with the movement in the price of the asset delivered under a futures (or forwards) contract

.firms use short positions in futures contracts to hedge an asset that declines in value as interest rates rise

.Macrohedging is hedging the entire (leverage-adjusted) duration gap of an FI

Futures Gain and Loss and Hedging with Futures

Hedging Considerations

.Microhedging and macrohedging

.Risk-return considerations

.FIs hedge based on expectations of future interest rate movements

.FIs may microhedge, macrohedge, or even overhedge

.Accounting rules can influence hedging strategies

.in 1997 FASB required that all gains and losses from derivatives used to hedge must be recognized immediately

.U.S. companies must report derivative-related trading activity in annual reports

.futures contracts are not subject to risk-based capital requirements imposed by bank regulators (forward can be)

Hedging Considerations

.Routine hedging: In a full hedge or =routine hedge‘ the bank eliminates all or most of its risk exposure such as interest rate risk

.Most managers engage in partial hedging or what the text terms =selective hedging where some risks are reduced and others are borne by the institution

The Effects of Hedging

Options

.Buying a call option on a bond

.As interest rates fall, bond prices rise, and the call option buyer has a large profit potential

.As interest rates rise, bond prices fall, but the call option losses are no larger than the call option

premium

.Writing a call option on a bond

.As interest rates fall, bond prices rise, and the call option writer has a large potential loss

.As interest rates rise, bond prices fall, but the call option gains will be no larger than the call option

premium

.Writing a put option on a bond

.As interest rates rise, bond prices fall, and the put option writer has large potential losses

.As interest rates fall, bond prices rise, but the put option gains are bounded by the put option premium

Purchased and Written Put Option Positions

Options

.Many types of options are used by FIs to hedge

.exchange-traded options

.over-the-counter (OTC) options

.options embedded in securities

.caps, collars, and floors

.Buying a put option on a bond can hedge interest rate risk exposure related to bonds that are held as assets

.the put option truncates the downside losses

.the put option scales down the upside profits, but still leaves upside profit potential

.Similarly, buying a call option on a bond can hedge interest rate risk exposure related to bonds held on the liability side of the balance sheet

Caps, Floors, and Collars

.Buying a cap means buying a call option, or a succession of call options, on interest rates rather than on bond prices

.like buying insurance against an (excessive) increase in interest rates

.Buying a floor is akin to buying a put option on interest rates

.seller compensates the buyer should interest rates fall below the floor rate

.like caps, floors can have one or a succession of exercise dates

.A collar amounts to a simultaneous position in a cap and a floor

.usually involves buying a cap and selling a floor to offset cost of cap

Contingent Credit Risk

.Contingent credit risk is the risk that the counterparty defaults on payment obligations

.forward contracts and all OTC derivatives are exposed to counterparty default risk as they are nonstandard contracts entered into bilaterally

Swaps

.Swap agreements are contracts where two parties agree to exchange a series of payments over time

.There are several types of swaps:

.Interest rate swaps

.Parties agree to swap interest payments on a stated notional principal amount for a set period of

time (some are for more than 5 years) (No principal is usually exchanged)

.Currency swaps (Trao đổi tiền tệ)

.Parties agree to swap interest and principal payments in different currencies at a preset

exchange rate

Swaps

.Types of swaps (continued)

.Credit default swaps (aka credit swaps)

.Total return swap (TRS):

o A TRS buyer agrees to make a fixed rate payment to the seller plus the capital gain or minus the

capital loss on the underlying instrument

o In exchange, the TRS seller may pay a variable or a fixed rate of interest to the buyer

o Pure Credit Swap (PCS):

oThe swap buyer makes fixed payments to the seller and the seller pays the swap buyer only in the event of default. The payment is usually equal to par – secondary market value of the underlying instrument

Credit Swaps and the crisis

.Lehman Brothers and AIG sold credit default swaps worth billions of dollars in payments insuring mortgage-backed securities (MBS)

.When mortgage security values collapsed, required outflows at these firms far exceeded capital

.Other institutions invested more heavily in MBS because they were insured; exposure to mortgage

markets was more widespread than it would have been otherwise

.Credit swaps may cause lenders to make loans they would not otherwise make and earn fee income on other services offered to borrowers.

 Swaps

.There are also some less common types of swaps:

.commodity swaps

.equity swaps

.The market for swaps has grown enormously in recent years

.The notional value of swap contracts outstanding at U.S. commercial banks was more than $146.9

trillion in 2010

Swaps

.Hedging with interest rate swaps: An Example

.a money center bank (MCB) may have floating-rate loans and fixed-rate liabilities

.the MCB has a negative duration gap

.a savings bank (SB) may have fixed-rate mortgages funded by short-term liabilities such as retail deposits

.the SB has a positive duration gap

.accordingly, an interest swap can be entered into between the MCB and the SB either:

.directly between the two FIs

OR

.indirectly through a broker or agent who charges a fee to accept the credit risk exposure and guarantee the cash flows

Swaps

.A plain vanilla swap is:

.A standard agreement where one participant pays a fixed rate of interest and the other party pays a variable rate of interest on a stated notional principal; no principal is exchanged: Thỏa thuận mà một người tham gia trả cho một tỉ lệ tiền lãi và người khác trả tỉ lệ tiền lãi thay đổi trên phần vốn ước tính được đề cập; không có sự trao đổi về tiền vốn gốc. 

.The SB sends fixed-rate interest payments to the MCB

.thus, the MCB‘s fixed-rate inflows (các dòng vào) are now matched to its fixed-rate payments

.the MCB sends variable-rate interest payments to the SB

.thus, the SB‘s variable-rate inflows are now matched to its variable-rate payments

Swap Hedging Example Illustrated

Swaps

.Hedging with currency swaps: An Example

.Consider a U.S. FI with fixed-rate $ denominated assets and fixed-rate £ denominated liabilities (nợ được định rõ dước đơn vị tiền tệ cụ thể).

.Also, consider a U.K. FI with fixed-rate £ denominated assets and fixed-rate $ denominated liabilities

.The FIs can engage in a currency swap to hedge their foreign exchange exposure

.That is, the FIs agree on a fixed exchange rate at the inception of the swap agreement for the exchange of cash flows at some point in the future

.Both FIs have effectively hedged their foreign exchange exposure by matching the denominations

of their cash flows

Currency Swap Hedging Example Illustrated

Hedging with Credit Swaps

Pure Credit Swap

Credit Risk on Swaps

.The growth of the over-the-counter swap market was a major factor underlying the imposition of the BIS risk-based capital requirements

.the fear was that out-of-the-money counterparties would have incentives to default

.BIS now requires capital to be held against interest rate, currency, and other swaps

.Credit risk on swaps differs from that on loans

.Netting: only the difference between the fixed and the floating payment is exchanged between swap parties

.Payment flows are often interest and not principal

.Standby letters of credit are required of poor-quality swap participants

Comparing Hedging Methods

.Writing vs. buying options

.writing options limits upside profits, but not downside losses

.buying options limits downside losses, but not upside profits

.CBs are prohibited from writing options in some areas

.Futures vs. options hedging

.futures produce symmetric gains and losses

.options protect against losses, but do not fully reduce gains

.Swaps vs. forwards, futures, and options

.swaps and forwards are OTC contracts, unlike options and futures

.futures are marked to market daily

.swaps can be written for longer-time horizons

Regulation

.Regulators specify .permissible activities. that FIs may engage in

.Institutions engaging in permissible activities are subject to regulatory oversight

.Regulators judge the overall integrity of FIs engaging in derivatives activity based on capital adequacy regulation

.The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are the functional regulators of derivatives securities markets

Regulation

.The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have implemented uniform guidelines that require

banks to:

.establish internal guidelines regarding hedging activity

.establish trading limits

.disclose large contract positions that materially affect the risk to shareholders and outside investors

.As of 2000 the FASB requires all firms to reflect the marked-to-market value of their derivatives positions in their financial statements

.Prior to the Dodd-Frank Act, swap markets were governed by relatively little regulation—except indirectly at FIs through bank regulatory agencies

Regulation

.The Dodd-Frank Act of 2010 requires most OTC derivatives to be exchange-traded to  ensure performance by all parties

.The act also requires OTC derivatives be regulated by the SEC and/or the CFTC