GESTIN BANCARIA Master en Banca y Finanzas Cuantitativas (QF),
2007 Santiago Carb Valverde Universidad de Granada
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2 TEMA 1 LA INDUSTRIA DE SERVICIOS FINANCIEROS: LAS ENTIDADES
DE DEPSITO TEMA 2 POR QU SON ESPECIALES LOS INTERMEDIARIOS
BANCARIOS? TEMA 3 GOBIERNO Y ESTRUCTURA ORGANIZATIVA DE LA BANCA
TEMA 4 LA INTERMEDIACIN FINANCIERA: LA ACTIVIDAD CREDITICIA TEMA 5
TCNICAS DE CONCESIN DE CRDITO: SCREENING, CREDIT SCORING Y
MONITORING TEMA 6 EL RIESGO DE CRDITO: RIESGO EN LOS PRSTAMOS
INDIVIDUALES Y EN CARTERA DE CRDITO TEMA 7 EL RIESGO DE TIPO DE
INTERS: MODELOS DE MADURACIN, DE DURACIN Y DE REPRICING TEMA 8 EL
RIESGO DE MERCADO TEMA 9 EL RIESGO DE LIQUIDEZ
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3 Santiago Carb Valverde Universidad de Granada [email protected]
Materiales docentes en: http://www.ugr.es/local/scarbo
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4 Esquema de trabajo: Transparencias en ingls Presentaciones de
papers en clase Examen final Referencia bsica: SAUNDERS, A. Y M.M.
CORNETT (2000): FINANCIAL INSTITUTIONS MANAGEMENT: A MODERN
PERSPECTIVE, 4 EDICIN, MCGRAW HILL, NEW YORK, ESTADOS UNIDOS.
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Tema 1 LA INDUSTRIA DE SERVICIOS FINANCIEROS: LAS ENTIDADES DE
DEPSITO
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7 Why study Financial Markets and Institutions? They are the
cornerstones of the overall financial system in which financial
managers operate Individuals use both for investing Corporations
and governments use both for financing They are the cornerstones of
the overall financial system in which financial managers operate
Individuals use both for investing Corporations and governments use
both for financing
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8 Overview of Financial Markets Primary Markets versus
Secondary Markets Money Markets versus Capital Markets Foreign
Exchange Markets Primary Markets versus Secondary Markets Money
Markets versus Capital Markets Foreign Exchange Markets
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9 Primary Markets versus Secondary Markets Primary Markets
markets in which users of funds (e.g. corporations, governments)
raise funds by issuing financial instruments (e.g. stocks and
bonds) Secondary Markets markets where financial instruments are
traded among investors (e.g. Bolsa Madrid, NYSE, NASDAQ) Primary
Markets markets in which users of funds (e.g. corporations,
governments) raise funds by issuing financial instruments (e.g.
stocks and bonds) Secondary Markets markets where financial
instruments are traded among investors (e.g. Bolsa Madrid, NYSE,
NASDAQ)
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10 Money Markets versus Capital Markets Money Markets markets
that trade debt securities with maturities of one year or less
(e.g. Spanish Government bonds, U.S. Treasury bills) Capital
Markets markets that trade debt (bonds) and equity (stock)
instruments with maturities of more than one year Money Markets
markets that trade debt securities with maturities of one year or
less (e.g. Spanish Government bonds, U.S. Treasury bills) Capital
Markets markets that trade debt (bonds) and equity (stock)
instruments with maturities of more than one year
12 Capital Market Instruments Outstanding, 1990-1999 ($Bn)
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13 Foreign Exchange Markets FX markets deal in trading one
currency for another (e.g. dollar for yen) The spot FX transaction
involves the immediate exchange of currencies at the current
exchange rate The forward FX transaction involves the exchange of
currencies at a specified date in the future and at a specified
exchange rate FX markets deal in trading one currency for another
(e.g. dollar for yen) The spot FX transaction involves the
immediate exchange of currencies at the current exchange rate The
forward FX transaction involves the exchange of currencies at a
specified date in the future and at a specified exchange rate
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14 Overview of Financial Institutions (FIs) Institutions that
perform the essential function of channeling funds from those with
surplus funds to those with shortages of funds (e.g. banks,
thrifts, insurance companies, securities firms and investment
banks, finance companies, mutual funds, pension funds)
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15 Flow of Funds in a World without FIs: Direct Transfer Users
of Funds (Corporations) Suppliers of Funds (Households) Financial
Claims (Equity and debt instruments) Cash Example: A firm sells
shares directly to investors without going through a financial
institution
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16 Flow of Funds in a world with FIs: Indirect transfer Users
of Funds FI (Brokers) FI (Asset transformers) Suppliers of Funds
Financial Claims (Equity and debt securities) Financial Claims
(Deposits and Insurance policies)
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17 Types of FIs Commercial banks depository institutions whose
major assets are loans and major liabilities are deposits Thrifts
and savings banks depository institutions in the form of savings
banks, savings and loans, credit unions, credit cooperatives
Insurance companies financial institutions that protect individuals
and corporations from adverse events Commercial banks depository
institutions whose major assets are loans and major liabilities are
deposits Thrifts and savings banks depository institutions in the
form of savings banks, savings and loans, credit unions, credit
cooperatives Insurance companies financial institutions that
protect individuals and corporations from adverse events
(continued)
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18 Securities firms and investment banks financial institutions
that underwrite securities and engage in securities brokerage and
trading Finance companies financial institutions that make loans to
individuals and businesses Mutual Funds financial institutions that
pool financial resources and invest in diversified portfolios
Pension Funds financial institutions that offer savings plans for
retirement Securities firms and investment banks financial
institutions that underwrite securities and engage in securities
brokerage and trading Finance companies financial institutions that
make loans to individuals and businesses Mutual Funds financial
institutions that pool financial resources and invest in
diversified portfolios Pension Funds financial institutions that
offer savings plans for retirement
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19 Services Performed by Financial Intermediaries Monitoring
Costs aggregation of funds provides greater incentive to collect a
firms information and monitor actions Liquidity and Price Risk
provide financial claims to savers with superior liquidity and
lower price risk Monitoring Costs aggregation of funds provides
greater incentive to collect a firms information and monitor
actions Liquidity and Price Risk provide financial claims to savers
with superior liquidity and lower price risk (continued)
Slide 20
20 Transaction Cost Services transaction costs are reduced
through economies of scale Maturity Intermediation greater ability
to bear risk of mismatching maturities of assets and liabilities
Denomination Intermediation allow small investors to overcome
constraints imposed to buying assets imposed by large minimum
denomination size Transaction Cost Services transaction costs are
reduced through economies of scale Maturity Intermediation greater
ability to bear risk of mismatching maturities of assets and
liabilities Denomination Intermediation allow small investors to
overcome constraints imposed to buying assets imposed by large
minimum denomination size
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21 Services Provided by FIs Benefiting the Overall Economy
Money Supply Transmission Depository institutions are the conduit
through which monetary policy actions impact the economy in general
Credit Allocation often viewed as the major source of financing for
a particular sector of the economy (e.g. farming and real estate)
Money Supply Transmission Depository institutions are the conduit
through which monetary policy actions impact the economy in general
Credit Allocation often viewed as the major source of financing for
a particular sector of the economy (e.g. farming and real estate)
(continued)
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22 Intergenerational Wealth Transfers life insurance companies
and pension funds provide savers with the ability to transfer
wealth from one generation to the next Payment Services efficiency
with which depository institutions provide payment services
directly benefits the economy Intergenerational Wealth Transfers
life insurance companies and pension funds provide savers with the
ability to transfer wealth from one generation to the next Payment
Services efficiency with which depository institutions provide
payment services directly benefits the economy Services Provided by
FIs Benefiting the Overall Economy
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23 Risks Faced by Financial Institutions Interest Rate Risk
Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk
Off-Balance-Sheet Risk Technology Risk Operation Risk Country or
Sovereign Risk Insolvency Risk Interest Rate Risk Foreign Exchange
Risk Market Risk Credit Risk Liquidity Risk Off-Balance-Sheet Risk
Technology Risk Operation Risk Country or Sovereign Risk Insolvency
Risk
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24 Regulation of Financial Institutions FIs provide vital
financial services to all sectors of the economy; therefore, their
regulation is in the public interest In an attempt to prevent their
failure and the failure of financial markets overall FIs provide
vital financial services to all sectors of the economy; therefore,
their regulation is in the public interest In an attempt to prevent
their failure and the failure of financial markets overall
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25 Globalization of Financial Markets and Institutions
Financial Markets became more global as the value of stocks traded
in foreign markets soared Foreign bond markets have served as a
major source of international capital Globalization also evident in
the derivative securities market Financial Markets became more
global as the value of stocks traded in foreign markets soared
Foreign bond markets have served as a major source of international
capital Globalization also evident in the derivative securities
market
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26 Factors Leading to Significant Growth in Foreign Markets The
pool of savings from foreign investors has increased International
investors have turned to U.S. and other markets to expand their
investment opportunities Information on foreign investments and
markets is now more accessible (e.g. internet) Some mutual funds
allow ability to invest in foreign securities with low transaction
costs Deregulation has enhanced globalization of capital flows The
pool of savings from foreign investors has increased International
investors have turned to U.S. and other markets to expand their
investment opportunities Information on foreign investments and
markets is now more accessible (e.g. internet) Some mutual funds
allow ability to invest in foreign securities with low transaction
costs Deregulation has enhanced globalization of capital flows
Slide 27
Tema 2 POR QU SON ESPECIALES LOS INTERMEDIARIOS BANCARIOS?
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28 Why Are Financial Intermediaries Special? Objectives:
Develop the tools needed to measure and manage the risks of FIs.
Explain the special role of FIs in the financial system and the
functions they provide. Explain why the various FIs receive special
regulatory attention. Discuss what makes some FIs more special than
others.
30 FIs Specialness Without FIs: Low level of fund flows.
Information costs: Economies of scale reduce costs for FIs to
screen and monitor borrowers Less liquidity Substantial price
risk
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31 With FIs Cash HouseholdsCorporations Equity & Debt FI
(Brokers) FI (Asset Transformers) Deposits/Insurance Policies
Cash
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32 Financial Structure Puzzles: a way to explain the role of
FIs stocks are not the most important source of external financing
for businesses issuing debt and equity is not the main way that
businesses finance operations indirect financing is more important
than direct financing banks are the most important source of
external funds for businesses financial industry is one of the most
heavily regulated industries only large, well-known firms have
access to the securities markets collateral is an important part of
debt contracts for businesses and households debt contracts are
complex and often contain many restrictions for the borrower
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33 Transaction Costs information and other transaction costs in
financial system can be substantial How do transaction costs affect
investing? How can financial intermediaries reduce transaction
costs?
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34 Asymmetric Information one party to a transaction has better
information to make decisions than the other party asymmetric
information in financial market causes two main problems adverse
selection moral hazard
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35 Adverse Selection asymmetric information problem that occurs
prior to a transaction examples of adverse selection result of
adverse selection is that lenders may decide not to make loans if
they can not distinguish between good and bad credit risks
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36 Moral Hazard asymmetric information problem that occurs
after a transaction risk that borrower will undertake risky
activities that will increase the probability of default result of
moral hazard is that lenders may decide not to make a loan
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37 Lemons Problem idea presented in article by George Akerlof
in terms of lemons in used car market used car buyers are unable to
determine quality of car - good car or lemon? What amount is buyer
willing to pay for this used car of unknown quality? How can buyer
improve information on quality?
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38 Lemons Problem in Stock and Bond Market asymmetric
information prevents investors from identifying good and bad firms
What price will these investors pay for stock? Who has better
information about the firm? Which firms will come to the market for
financing under these conditions?
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39 Principal-Agent Problem define the principal-agent problem
Who is the principal and who is the agent? What problem does a
separation of ownership and control cause? How could we prevent
principal-agent problem?
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40 Solutions to Financing Puzzles lemons or adverse selection
problem tells why marketable securities are not the primary source
of financing situation is similar in corporate bond market tells
why stocks are not the most important source of external
financing
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41 More Solutions to Financial Structure Puzzles importance of
financial intermediaries explains importance of indirect financing
explains why banks are most important source of external financing
explains why markets are only available to large, well-known
firms
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42 Functions of FIs Brokerage function Acting as an agent for
investors: e.g. Merrill Lynch, Charles Schwab Reduce costs through
economies of scale Encourages higher rate of savings Asset
transformer: Purchase primary securities by selling financial
claims to households These secondary securities often more
marketable
Slide 43
43 Role of FIs in Cost Reduction Information costs: Investors
exposed to Agency Costs Role of FI as Delegated Monitor (Diamond,
1984) Shorter term debt contracts easier to monitor than bonds FI
likely to have informational advantage
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44 Services Performed by FIs Monitoring Costs Liquidity and
Price Risk Transaction Cost Services Maturity Intermediation
Denomination Intermediation
46 Regulation of FIs Regulation is not costless Net regulatory
burden. Safety and soundness regulation Monetary policy regulation
Credit allocation regulation Consumer protection regulation
Investor protection regulation Entry regulation
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47 Changing Dynamics of Specialness Trends in the United States
Decline in share of depository institutions. Increases in pension
funds and investment companies. May be attributable to net
regulatory burden imposed on depository FIs. Technological changes
affect delivery of financial services and regulatory issues
Potential for regulations to be extended to hedge funds Result of
Long Term Capital Management disaster
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48 Future Trends Weakening of public trust and confidence in
FIs may encourage disintermediation Increased merger activity
within and across sectors Citicorp and Travelers, UBS and Paine
Webber More large scale mergers such as J.P. Morgan and Chase, and
Bank One and First Chicago Growth in Online Trading Increased
competition from foreign FIs at home and abroad Mergers involving
worlds largest banks Mergers blending together previously separate
financial services sectors
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Tema 3 GOBIERNO Y ESTRUCTURA ORGANIZATIVA DE LA BANCA
Slide 50
It is the ability to foretell what is going to happen tomorrow,
next week, next month, and next year. And to have the ability
afterwards to explain why it didnt happen. Sir Winston
Churchill
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51 What are Financial Intermediaries (FIs)? Financial
Securities: contingent claims on future cash flows debt, equity,
derivatives, hybrids. All firms liabilities & net worth are
predominately comprised of financial securities. But most firms
hold real assets such as inventory, plant & equipment,
buildings. FIs assets are predominately comprised of financial
securities.
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52 Transparent, Transluscent and Opaque FIs
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53 What Services Do FIs Provide? Information Liquidity Reduced
Transaction Costs Transmission of Monetary Policy Credit Allocation
Payment Services Intergenerational Wealth Transfer
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54 FIs are the most regulated of all firms Safety and Soundness
Regulation Deposit Insurance Monetary Policy Regulation Reserve
Requirements Credit Allocation Regulation (eg., mortgages) Consumer
Protection Regulation Community Reinvestment Act, Home Mortgage
Disclosure Act, Truth in Lending Protection Investor Protection
Regulation Entry Regulation
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55 Types of FIs Depository Institutions Insurance Companies
Securities Firms and Investment Banks Mutual Funds Finance
Companies Distinctions blurred by the Gramm- Leach-Bliley Act of
1999 that created Financial Holding Companies (FHCs).
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56 Features Common to Most FIs High Amount of Financial
Leverage Low equity/assets ratios. Capital requirements.
Off-balance sheet items Contingent claims that under certain
circumstances may eventually become balance sheet items (ex.
Derivatives, commitments) Revenue: Interest Income & Fees
Costs: Interest Expenses and Personnel
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57 Depository Institutions Commercial Banks: accept deposits
and make loans to consumers and businesses. Money Center Banks:
Citigroup, Bank of NY, BankOne, Bankers Trust (Deutschebank), JP
Morgan Chase and HSBC Bank USA. Savings Associations (S&Ls)
Qualified Thrift Lender (QTL) mortgages must exceed 65% of thrifts
assets. Savings Banks Use deposits to fund mortgages & other
assets. Credit Unions and Credit cooperatives Nonprofit mutually
owned institutions (owned by depositors).
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58 Overview of Depository Institutions In this segment, we
explore the depository FIs: Size, structure and composition Balance
sheets and recent trends Regulation of depository institutions
Depository institutions performance
Slide 59
59 Products of FIs Comparing the products of FIs in 1950, to
products of FIs in 2003: Much greater distinction between types of
FIs in terms of products in 1950 than in 2003 Blurring of product
lines and services over time Wider array of services offered by all
FI types
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60 Specialness of Depository FIs Products on both sides of the
balance sheet Loans Business and Commercial Deposits
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61 Other outputs of depository FIs Other products and services
1950: Payment services, Savings products, Fiduciary services By
2003, products and services further expanded to include:
Underwriting of debt and equity, Insurance and risk management
products
Slide 62
62 Size of Depository FIs Consolidation has created some very
large FIs Combined effects of disintermediation, global
competition, regulatory changes, technological developments,
competition across different types of FIs
Slide 63
63 Largest Depository Institutions in the US Citigroup$1,208.9
J.P. Morgan Chase* 770.9 Bank of America** 736.4 Wells Fargo 393.9
Wachovia 388.0 Bank One* 326.6 Washington Mutual 275.2 Fleet
Boston** 200.2 U.S. Bancorp 188.8 SunTrust Banks 181.0 Total Assets
($Billions)
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64 Organization of Depository Institutions Commercial Banks
Largest depository institutions are commercial banks. Differences
in operating characteristics and profitability across size classes.
Notable differences in ROE and ROA as well as the spread Thrifts
S&Ls Savings Banks Credit Unions Mix of very large banks with
very small banks
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65 Functions & Structural Differences Functions of
depository institutions Regulatory sources of differences across
types of depository institutions. Structural changes generally
resulted from changes in regulatory policy. Example: changes
permitting interstate branching Reigle-Neal Act (1994) in the US In
Spain, deregulation in 1989 concerning savings banks
operations
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66 Commercial Banks Primary assets: Real Estate Loans: $2,272.3
billion C&I loans: $870.6 billion Loans to individuals: $770.5
billion Investment security portfolio: $1,789.3 billion Of which,
Treasury bonds: $1,005.8 billion Inference: Importance of Credit
Risk
70 Structure and Composition Shrinking number of banks: 14,416
commercial banks in 1985 12,744 in 1989 7,769 in 2004 Mostly the
result of Mergers and Acquisitions M&A prevented prior to
1980s, 1990s Consolidation has reduced asset share of small
banks
Slide 71
71 Structure & Composition of Commercial Banks Financial
Services Modernization Act 1999 Allowed full authority to enter
investment banking (and insurance) Limited powers to underwrite
corporate securities have existed only since 1987
Slide 72
72 Composition of Commercial Banking Sector Community banks
Regional and Super-regional Access to federal funds market to
finance their lending activities Money Center banks Bank of New
York, Deutsche Bank (Bankers Trust), Citigroup, J.P. Morgan Chase,
HSBC Bank USA declining in number
Slide 73
73 Balance Sheet and Trends Business loans have declined in
importance Offsetting increase in securities and mortgages
Increased importance of funding via commercial paper market
Securitization of mortgage loans
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74 Some Terminology Transaction accounts Negotiable Order of
Withdrawal (NOW) accounts (cuenta a la vista) Money Market Mutual
Fund Negotiable CDs (certificados de depsito): Fixed-maturity
interest bearing deposits with face values over $100,000 that can
be resold in the secondary market.
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75 Off-balance Sheet Activities Heightened importance of
off-balance sheet items Large increase in derivatives positions is
a major issue Standby letters of credit Loan commitments
When-issued securities Loans sold
Slide 76
76 Trading and Other Risks Allied Irish / Allfirst Bank $750
million loss (2001) National Australian Bank $450 million loss
(2004) Failure of the U.K. investment bank Barings The Bankruptcy
of Orange County in California.
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77 Other Fee-generating Activities Trust services Correspondent
banking Check clearing Foreign exchange trading Hedging
Participation in large loan and security issuances Payment usually
in terms of noninterest bearing deposits
Slide 78
78 Key Regulatory Agencies FDIC and the Office of the
Comprotroller of the Currency in the US. European Central Bank
National central banks National Governments Regional
Governments
Slide 79
79 Web Resources For more detailed information on the
regulators, visit: http://www.ecb.int http://www.bde.es
http://www.fdic.gov http://www.occ.treas.gov
http://federalreserve.gov
Slide 80
80 Banking and Ethics Some cases for the US: Bank of America
and Fleet Boston Financial 2004 J.P. Morgan Chase and Citigroup
2003 role in Enron Riggs National Bank and money laundering
concerns 2003
Slide 81
81 Savings Institutions Comprised of: Savings and Loans
Associations Savings Banks Effects of moral hazard and regulator
forbearance. Quite a debate worldwhile.
Slide 82
82 Savings Institutions: Recent Trends Industry is smaller
overall Intense competition from other FIs mortgages for example
Concern for future viability in certain countries.
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83 Credit Unions Nonprofit depository institutions owned by
member-depositors with a common bond. Exempt from taxes and
Community Reinvestment Act (CRA) in the US. Expansion of services
offered in order to compete with other FIs. Very important in
certain European countries (Germany, Spain).
Slide 84
84 Global Issues Near crisis in Japanese Banking Eight biggest
banks reported positive six- month profits China Deterioration,
NPLs (nonperforming loans) at 50% levels Opening to foreign banks
(WTO entry) German bank problems in early 2000s Implications for
future competitiveness
Slide 85
85 Largest Banks in the World
Slide 86
Tema 4 LA INTERMEDIACIN FINANCIERA: LA ACTIVIDAD CREDITICIA.
Anlisis por tipos de instituciones
Slide 87
87 Commercial Banks Represent the largest group of depository
institutions measured by asset size. Perform functions similar to
those of savings institutions and credit unions - they accept
deposits (liabilities) and make loans (assets) Liabilities include
nondeposit sources of funds such as subordinated notes and
debentures Loans are broader in range, including consumer,
commercial, international, and real estate Represent the largest
group of depository institutions measured by asset size. Perform
functions similar to those of savings institutions and credit
unions - they accept deposits (liabilities) and make loans (assets)
Liabilities include nondeposit sources of funds such as
subordinated notes and debentures Loans are broader in range,
including consumer, commercial, international, and real estate
Slide 88
88 Differences in Balance Sheets Depository Institutions
Nonfinancial Firms Assets Liabilities Loans Deposits Deposits Loans
Other financial financial assets assets Other Other non-
liabilities non- liabilities financial and financial and assets
equity assets equity Depository Institutions Nonfinancial Firms
Assets Liabilities Loans Deposits Deposits Loans Other financial
financial assets assets Other Other non- liabilities non-
liabilities financial and financial and assets equity assets
equity
Slide 89
89 Commercial Bank Balance Sheet Assets Total cash assets. $
253.8 4.8% U.S. gov securities $ 801.4 Other. 391.6 Investment
securities.. 1,193.0 22.6% Interbank loans. 223.0 Loans exc.
Interbank 3,314.3 Comm. and Indust..$ 948.5 Real estate 1,343.0
Individual. 496.4 All other 526.4 Less: Reserve for losses 58.7
Total loans $3,478.6 66.0% Other assets.. 347.6 6.6% Total assets..
$5,273.0 Assets Total cash assets. $ 253.8 4.8% U.S. gov securities
$ 801.4 Other. 391.6 Investment securities.. 1,193.0 22.6%
Interbank loans. 223.0 Loans exc. Interbank 3,314.3 Comm. and
Indust..$ 948.5 Real estate 1,343.0 Individual. 496.4 All other
526.4 Less: Reserve for losses 58.7 Total loans $3,478.6 66.0%
Other assets.. 347.6 6.6% Total assets.. $5,273.0
Slide 90
90 Commercial Bank Balance Statement (liabilities) Liabilities
and Equity Transaction accounts $ 667.4 12.8% Nontransaction
accounts... 2,688.5 54.4% Total deposits $3,355.9 Borrowings
1,006.0 21.3% Other liabilities.. 462.3 2.8% Total liabilities..
$4,824.2 Equity 448.8 8.7% *Aggregate balance sheet and percentage
distributions for all U.S. commercial banks as of May 26, 1999 in
billions of dollars Liabilities and Equity Transaction accounts $
667.4 12.8% Nontransaction accounts... 2,688.5 54.4% Total deposits
$3,355.9 Borrowings 1,006.0 21.3% Other liabilities.. 462.3 2.8%
Total liabilities.. $4,824.2 Equity 448.8 8.7% *Aggregate balance
sheet and percentage distributions for all U.S. commercial banks as
of May 26, 1999 in billions of dollars
Slide 91
91 The importance of lending (I) The history of banking
institutions is the history of lending itself. Banks solve
asymmetric information problems through lending. The relevance of
lending is not exclusive of commercial banks. It is even more
important at other depository instituions (in relative terms).
Slide 92
92 The importance of lending (II) Lending and the resolution of
asymmetric information problems are usually studied within an IO
perspective. A large amount of contracts is needed to achieve
efficiency and to solve asymmetric information problems: relevance
of scale and scope economies and efficiency.
Slide 93
93 Economies of Scale and Scope Economies of scale - the degree
to which a firms average unit costs of producing financial services
fall as its output of services increase Economies of scope - the
degree to which a firm can generate cost synergies by producing
multiple financial service products Megamerger - the merger of
banks with assets of $1 billion or more X efficiencies - cost
savings due to the greater managerial efficiency of the acquiring
firm Economies of scale - the degree to which a firms average unit
costs of producing financial services fall as its output of
services increase Economies of scope - the degree to which a firm
can generate cost synergies by producing multiple financial service
products Megamerger - the merger of banks with assets of $1 billion
or more X efficiencies - cost savings due to the greater managerial
efficiency of the acquiring firm
Slide 94
94 Measuring Economies of Scale AC i = TC i S i Where: AC i =
Average costs of the ith bank TC i = Total costs of the ith bank S
i = Size of the bank measured by assets, deposits or loans AC i =
TC i S i Where: AC i = Average costs of the ith bank TC i = Total
costs of the ith bank S i = Size of the bank measured by assets,
deposits or loans
Slide 95
95 Economies of Scale and the Effect of Technology Improvement
Average Cost Old Technology AC 1 New Technology AC 2 Size 0 Average
Cost Old Technology AC 1 New Technology AC 2 Size 0
Slide 96
96 Economies of Scope By offering more services to a given
customer; revenue can be enhanced costs can be reduced Cost
economies of scope investments in one financial service (such as
lending) may reduce costs to produce financial services in other
areas (such as securities underwriting or brokerage) Revenue
economies of scope By offering more services to a given customer;
revenue can be enhanced costs can be reduced Cost economies of
scope investments in one financial service (such as lending) may
reduce costs to produce financial services in other areas (such as
securities underwriting or brokerage) Revenue economies of
scope
Slide 97
97 Bank Size and Activities Large banks have easier access to
capital markets and can operate with lower amounts of equity
capital Large banks tend to use more purchased funds (such as fed
funds) and have fewer core deposits Large banks lend to larger
corporations which means that their interest rate spread is
narrower the difference between lending and deposit rates Large
banks are more diversified and generate more noninterest income
Large banks have easier access to capital markets and can operate
with lower amounts of equity capital Large banks tend to use more
purchased funds (such as fed funds) and have fewer core deposits
Large banks lend to larger corporations which means that their
interest rate spread is narrower the difference between lending and
deposit rates Large banks are more diversified and generate more
noninterest income
Slide 98
98 Industry Performance Provision for loan losses - bank
managements recognition of expected bad loans for the period Net
charge-offs - actual losses on loans and leases Net operating
income - income before taxes and extraordinary items Provision for
loan losses - bank managements recognition of expected bad loans
for the period Net charge-offs - actual losses on loans and leases
Net operating income - income before taxes and extraordinary
items
Slide 99
99 Thrift Institutions and Savings & Cooperative Banks
Savings Associations concentrated primarily on residential
mortgages Savings Banks large concentration of residential
mortgages commercial loans corporate bonds corporate stock Credit
Unions consumer loans funded with member deposits Savings
Associations concentrated primarily on residential mortgages
Savings Banks large concentration of residential mortgages
commercial loans corporate bonds corporate stock Credit Unions
consumer loans funded with member deposits
Slide 100
100 IN THE US: Regulator forbearance - a policy of the FSLIC
not to close economically insolvent FIs, allowing them to continue
in operation IN EUROPE: More variety and diversity. All sorts of
savings banks and credit cooperative structures (private, public,
semi-public). Mutual organization - an institution in which the
liability holders are also the owners: THE CASE OF PROXIMITY
BANKING: COMMUNITY BANKS IN THE US SAVINGS BANKS IN EUROPE IN THE
US: Regulator forbearance - a policy of the FSLIC not to close
economically insolvent FIs, allowing them to continue in operation
IN EUROPE: More variety and diversity. All sorts of savings banks
and credit cooperative structures (private, public, semi-public).
Mutual organization - an institution in which the liability holders
are also the owners: THE CASE OF PROXIMITY BANKING: COMMUNITY BANKS
IN THE US SAVINGS BANKS IN EUROPE
Slide 101
101 Financial Statements of Commercial Banks Report of
condition - balance sheet of a commercial bank reporting
information at a single point in time Report of income - income
statement of a commercial bank reporting revenues, expenses, net
profit or loss, and cash dividends over a period of time Retail
bank - one that focuses its business activities on consumer banking
relationships Wholesale bank - one that focuses its business
activities on commercial banking relationships Report of condition
- balance sheet of a commercial bank reporting information at a
single point in time Report of income - income statement of a
commercial bank reporting revenues, expenses, net profit or loss,
and cash dividends over a period of time Retail bank - one that
focuses its business activities on consumer banking relationships
Wholesale bank - one that focuses its business activities on
commercial banking relationships
Slide 102
102 Assets Four major subcategories cash and balances due from
other depository institutions vault cash, deposits at the Federal
Reserve, deposits at other FIs, and cash items in the process of
collection investment securities interest-bearing deposits at other
FIs, fed funds sold, RPs, U.S. Treasury and agency securities,
securities issued by states and political subdivisions, mortgage-
backed securities, and other debt and equity securities loans and
leases other assets premises and fixed assets, real estate owned,
investments in unconsolidated subsidiaries, intangible assets,
other fees receivable Four major subcategories cash and balances
due from other depository institutions vault cash, deposits at the
Federal Reserve, deposits at other FIs, and cash items in the
process of collection investment securities interest-bearing
deposits at other FIs, fed funds sold, RPs, U.S. Treasury and
agency securities, securities issued by states and political
subdivisions, mortgage- backed securities, and other debt and
equity securities loans and leases other assets premises and fixed
assets, real estate owned, investments in unconsolidated
subsidiaries, intangible assets, other fees receivable
Slide 103
103 Liabilities NOW account - negotiable order of withdrawal
account, similar to a demand deposit with minimum balance MMDAs -
money market deposit accounts with retail savings accounts and
limited checking account (IN THE US) Other savings deposits - other
than MMDAs (IN EUROPE): basically customer (savings and term)
deposits) NOW account - negotiable order of withdrawal account,
similar to a demand deposit with minimum balance MMDAs - money
market deposit accounts with retail savings accounts and limited
checking account (IN THE US) Other savings deposits - other than
MMDAs (IN EUROPE): basically customer (savings and term)
deposits)
Slide 104
104 Liabilities Negotiable instrument - an instrument whose
ownership can be transferred in the secondary market Purchased
funds - rate-sensitive funding sources of the bank (ej. cesiones
temporales de activos). Negotiable instrument - an instrument whose
ownership can be transferred in the secondary market Purchased
funds - rate-sensitive funding sources of the bank (ej. cesiones
temporales de activos).
Slide 105
105 Equity Capital Preferred and common stock (listed at par
value) Surplus or additional paid-in capital Retained earnings
Regulations require banks to hold a minimum level of equity capital
to act as a buffer against losses from their on- and off-balance
sheet assets Preferred and common stock (listed at par value)
Surplus or additional paid-in capital Retained earnings Regulations
require banks to hold a minimum level of equity capital to act as a
buffer against losses from their on- and off-balance sheet
assets
Slide 106
106 Off-Balance-Sheet Assets and Liabilities Contingent assets
and liabilities that may affect the future status of the FIs
balance sheet OBS activities grouped into 5 major categories Loan
commitments - contractual commitment to loan to a firm a certain
maximum amount at given interest rate terms up-front fee - fee
charged for making funds available through a loan commitment
back-end fee - fee charged on the unused component of a loan
commitment (continued) Contingent assets and liabilities that may
affect the future status of the FIs balance sheet OBS activities
grouped into 5 major categories Loan commitments - contractual
commitment to loan to a firm a certain maximum amount at given
interest rate terms up-front fee - fee charged for making funds
available through a loan commitment back-end fee - fee charged on
the unused component of a loan commitment (continued)
Slide 107
107 Loans Sold (securitization) loans that a bank originated
and then sold to other investors that may be returned (with
recourse) to the originating institution in the future recourse -
the ability to put an asset or loan back to the seller should the
credit quality of that asset deteriorate Derivative Contracts
futures, forward, swap, and option positions taken by the FI for
hedging or other purposes Loans Sold (securitization) loans that a
bank originated and then sold to other investors that may be
returned (with recourse) to the originating institution in the
future recourse - the ability to put an asset or loan back to the
seller should the credit quality of that asset deteriorate
Derivative Contracts futures, forward, swap, and option positions
taken by the FI for hedging or other purposes
Slide 108
108 Income Statement Interest Income Interest Expenses Net
Interest Income Provision for Loan Losses Noninterest Income
Noninterest Expense Income before Taxes and Extraordinary Items
Income Taxes Extraordinary Items Net Income Interest Income
Interest Expenses Net Interest Income Provision for Loan Losses
Noninterest Income Noninterest Expense Income before Taxes and
Extraordinary Items Income Taxes Extraordinary Items Net
Income
Slide 109
109 The Direct Relationship between the Income Statement and
the Balance Sheet N M NI = r n A n - r m L m - P + NII - NIE - T
n=1 m=1 where NI = Banks net income A n = Dollar value of the banks
nth asset L m = Dollar value of the banks nth liability r n = Rate
earned on the banks nth asset r m = Rate paid on the banks nth
liability P = Provision for loan losses NII = noninterest income
earned, including OBS NIE = noninterest expenses incurred T = Banks
taxes N = number of assets the bank holds M = number of liabilities
the bank holds N M NI = r n A n - r m L m - P + NII - NIE - T n=1
m=1 where NI = Banks net income A n = Dollar value of the banks nth
asset L m = Dollar value of the banks nth liability r n = Rate
earned on the banks nth asset r m = Rate paid on the banks nth
liability P = Provision for loan losses NII = noninterest income
earned, including OBS NIE = noninterest expenses incurred T = Banks
taxes N = number of assets the bank holds M = number of liabilities
the bank holds
Slide 110
110 Financial Statement Analysis Using a Return on Equity
Framework Time series analysis - analysis of financial statements
over a period of time Cross-sectional analysis - analysis of
financial statements comparing one firm with others Return on
equity (ROE) - measures overall profit- ability of the FI per
dollar of equity ROE = Net income Total Assets Total Assets Total
equity capital = ROA EM Time series analysis - analysis of
financial statements over a period of time Cross-sectional analysis
- analysis of financial statements comparing one firm with others
Return on equity (ROE) - measures overall profit- ability of the FI
per dollar of equity ROE = Net income Total Assets Total Assets
Total equity capital = ROA EM
Slide 111
111 Return on Assets and Its Components Return on Assets (ROA)
- measures profit generated relative to the FIs assets ROA = Net
Income Total operating income Total operating income Total assets =
PM (profit margin) AU (assets utilization) Return on Assets (ROA) -
measures profit generated relative to the FIs assets ROA = Net
Income Total operating income Total operating income Total assets =
PM (profit margin) AU (assets utilization)
Slide 112
112 Profit Margin Profit Margin (PM) - measures the ability to
pay expenses and generate income from interest and noninterest
income Interest expense ratio = Interest expense Total operating
income Provision for loan loss ration = Provision for loan losses
Total operating income Noninterest expense ratio = Noninterest
expense Total operating income Tax Ratio = Income taxes Total
operating income Profit Margin (PM) - measures the ability to pay
expenses and generate income from interest and noninterest income
Interest expense ratio = Interest expense Total operating income
Provision for loan loss ration = Provision for loan losses Total
operating income Noninterest expense ratio = Noninterest expense
Total operating income Tax Ratio = Income taxes Total operating
income
Slide 113
113 Asset Utilization Asset utilization (AU) - measures the
amount of interest/ noninterest income generated per dollar of
total assets AU = Total operating income = Interest + Noninterest
Total assets income income ratio ratio Asset utilization (AU) -
measures the amount of interest/ noninterest income generated per
dollar of total assets AU = Total operating income = Interest +
Noninterest Total assets income income ratio ratio
Slide 114
114 Net Interest Margin Net interest margin - interest income
minus interest expense divided by earning assets Net interest = Net
interest income margin Earning assets = Interest income - Interest
expense Investment securities + Net loans and leases Net interest
margin - interest income minus interest expense divided by earning
assets Net interest = Net interest income margin Earning assets =
Interest income - Interest expense Investment securities + Net
loans and leases
Slide 115
115 Spread Spread - the difference between lending and deposit
rates spread = Interest income - Interest expense Earning assets
Interest-bearing liabilities Spread - the difference between
lending and deposit rates spread = Interest income - Interest
expense Earning assets Interest-bearing liabilities
Slide 116
116 Overhead Efficiency Overhead efficiency - a banks ability
to generate noninterest income to cover noninterest expenses
Overhead efficiency = Noninterest income Noninterest expense
Overhead efficiency - a banks ability to generate noninterest
income to cover noninterest expenses Overhead efficiency =
Noninterest income Noninterest expense
Slide 117
Tema 5 Tcnicas de concesin de crdito: screening, credit scoring
y monitoring
Slide 118
118 Risks Faced by Financial Intermediaries Credit Risk
Liquidity Risk Interest Rate Risk Market Risk Off-Balance-Sheet
Risk Foreign Exchange Risk Country or Sovereign Risk Technology
Risk Operational Risk Insolvency Risk Credit Risk Liquidity Risk
Interest Rate Risk Market Risk Off-Balance-Sheet Risk Foreign
Exchange Risk Country or Sovereign Risk Technology Risk Operational
Risk Insolvency Risk
Slide 119
119 Market Risk Incurred in trading of assets and liabilities
(and derivatives). Examples: Barings & decline in ruble. DJIA
dropped 12.5 percent in two-week period July, 2002. Heavier focus
on trading income over traditional activities increases market
exposure. Trading activities introduce other perils as was
discovered by Allied Irish Banks U.S. subsidiary, AllFirst Bank
when a rogue trader successfully masked large trading losses and
fraudulent activities involving foreign exchange positions
Slide 120
120 Market Risk Distinction between Investment Book and Trading
Book of a commercial bank Heightened focus on Value at Risk (VAR)
Heightened focus on short term risk measures such as Daily Earnings
at Risk (DEAR) Role of securitization in changing liquidity of bank
assets and liabilities
Slide 121
121 Credit Risk Risk that promised cash flows are not paid in
full. Firm specific credit risk Systematic credit risk High rate of
charge-offs of credit card debt in the 1980s, most of the 1990s and
early 2000s Credit card loans (and unused balances) continue to
grow
Slide 122
122 Implications of Growing Credit Risk Importance of credit
screening Importance of monitoring credit extended Role for dynamic
adjustment of credit risk premia Diversification of credit
risk
Slide 123
123 Off-Balance-Sheet Risk Striking growth of off-balance-sheet
activities Letters of credit Loan commitments Derivative positions
Speculative activities using off- balance-sheet items create
considerable risk
Slide 124
124 Technology and Operational Risk Risk that technology
investment fails to produce anticipated cost savings. Risk that
technology may break down. CitiBanks ATM network, debit card system
and on-line banking out for two days Wells Fargo Bank of New York:
Computer system failed to recognize incoming payment messages sent
via Fedwire although outgoing payments succeeded
Slide 125
125 Technology and Operational Risk Operational risk not
exclusively technological Employee fraud and errors Losses
magnified since they affect reputation and future potential Merrill
Lynch $100 million penalty
Slide 126
126 Country or Sovereign Risk Result of exposure to foreign
government which may impose restrictions on repayments to
foreigners. Often lack usual recourse via court system. Examples:
Argentina Russia South Korea Indonesia Malaysia Thailand.
Slide 127
127 Country or Sovereign Risk In the event of restrictions,
reschedulings, or outright prohibition of repayments, FIs remaining
bargaining chip is future supply of loans Weak position if currency
collapsing or government failing Role of IMF Extends aid to
troubled banks Increased moral hazard problem if IMF bailout
expected
Slide 128
128 Liquidity Risk Risk of being forced to borrow, or sell
assets in a very short period of time. Low prices result. May
generate runs. Runs may turn liquidity problem into solvency
problem. Risk of systematic bank panics. Example: 1985, Ohio
savings institutions insured by Ohio Deposit Guarantee Fund
Interaction of credit risk and liability risk Role of FDIC (see
Chapter 19)
Slide 129
129 Insolvency Risk Risk of insufficient capital to offset
sudden decline in value of assets to liabilities. Continental
Illinois National Bank and Trust Original cause may be excessive
interest rate, market, credit, off- balance-sheet, technological,
FX, sovereign, and liquidity risks.
Slide 130
130 Credit Risk Management An FIs ability to evaluate
information and control and monitor borrowers allows them to
transform financial claims of household savers efficiently into
claims issued to corporations, individuals, and governments An FI
accepts credit risk in exchange for a fair return sufficient to
cover the cost of funding (e.g., covering the cost of borrowing, or
issuing deposits) An FIs ability to evaluate information and
control and monitor borrowers allows them to transform financial
claims of household savers efficiently into claims issued to
corporations, individuals, and governments An FI accepts credit
risk in exchange for a fair return sufficient to cover the cost of
funding (e.g., covering the cost of borrowing, or issuing
deposits)
Slide 131
131 Credit Analysis Real Estate Lending residential mortgage
loan applications are among the most standardized of all credit
applications Two considerations the applicants ability and
willingness to make timely interest and principal repayments the
value of the borrowers collateral GDS (gross debt service) ratio -
gross debt service ratio calculated as total accommodation expenses
(mortgage, lease, condominium, management fees, real estate taxes,
etc.) divided by gross income TDS (total debt service) ratio -
total debt ratio calculated as total accommodation expenses plus
all other debt service payments divided by gross income Real Estate
Lending residential mortgage loan applications are among the most
standardized of all credit applications Two considerations the
applicants ability and willingness to make timely interest and
principal repayments the value of the borrowers collateral GDS
(gross debt service) ratio - gross debt service ratio calculated as
total accommodation expenses (mortgage, lease, condominium,
management fees, real estate taxes, etc.) divided by gross income
TDS (total debt service) ratio - total debt ratio calculated as
total accommodation expenses plus all other debt service payments
divided by gross income
Slide 132
132 Credit Scoring Credit scoring system a mathematical model
that uses observed loan applicants characteristics to calculate a
score that represents the applicants probability of default
Perfecting collateral ensuring that collateral used to secure a
loan is free and clear to the lender should the borrower default
Foreclosure taking possession of the mortgaged property to satisfy
a defaulting borrowers indebtedness Power of sale taking the
proceedings of the forced sale of property to satisfy the
indebtedness Credit scoring system a mathematical model that uses
observed loan applicants characteristics to calculate a score that
represents the applicants probability of default Perfecting
collateral ensuring that collateral used to secure a loan is free
and clear to the lender should the borrower default Foreclosure
taking possession of the mortgaged property to satisfy a defaulting
borrowers indebtedness Power of sale taking the proceedings of the
forced sale of property to satisfy the indebtedness
Slide 133
133 Credit Scoring Consumer (individual) and Small-business
lending techniques for scoring consumer loans very similar to
mortgage loan credit analysis but more emphasis placed on personal
characteristics such as annual gross income and the TDS score
small-business loans more complicated and has required FIs to build
more sophisticated scoring models combining computer-based
financial analysis of borrower financial statements with behavioral
analysis of the owner Consumer (individual) and Small-business
lending techniques for scoring consumer loans very similar to
mortgage loan credit analysis but more emphasis placed on personal
characteristics such as annual gross income and the TDS score
small-business loans more complicated and has required FIs to build
more sophisticated scoring models combining computer-based
financial analysis of borrower financial statements with behavioral
analysis of the owner
Slide 134
134 Ratio Analysis Historical audited financial statements and
projections of future needs Calculation of financial ratios in
financial statement analysis Relative ratios offer information
about how a business is changing over time Particularly informative
when they differ either from an industry average or from the
applicants own past history Historical audited financial statements
and projections of future needs Calculation of financial ratios in
financial statement analysis Relative ratios offer information
about how a business is changing over time Particularly informative
when they differ either from an industry average or from the
applicants own past history
Slide 135
135 Calculating Ratios Liquidity Ratios Current Ratio = Current
assets Current liabilities Quick ratio = Cash + Cash equivalents +
Receivables Current liabilities (continued) Liquidity Ratios
Current Ratio = Current assets Current liabilities Quick ratio =
Cash + Cash equivalents + Receivables Current liabilities
(continued)
Slide 136
136 Asset Management Ratios Number of days sales = Accounts
receivable x 365 in receivables Credit sales Number of days =
Inventory x 365 in inventory Cost of goods sold Sales to working =
Sales capital Working capital Sales to fixed = Sales assets Fixed
assets Sales to total assets = Sales Total assets Asset Management
Ratios Number of days sales = Accounts receivable x 365 in
receivables Credit sales Number of days = Inventory x 365 in
inventory Cost of goods sold Sales to working = Sales capital
Working capital Sales to fixed = Sales assets Fixed assets Sales to
total assets = Sales Total assets (continued)
Slide 137
137 Debt and Solvency ratios Debt-asset ratio = Short-term
liabilities + Long-term liabilities Total assets Fixed-charge =
Earnings available to meet fixed charges coverage ratio Fixed
charges Cash-flow-to-debt = EBIT + Depreciation ratio Debt where
EBIT represents earnings before interest and taxes (continued) Debt
and Solvency ratios Debt-asset ratio = Short-term liabilities +
Long-term liabilities Total assets Fixed-charge = Earnings
available to meet fixed charges coverage ratio Fixed charges
Cash-flow-to-debt = EBIT + Depreciation ratio Debt where EBIT
represents earnings before interest and taxes (continued)
Slide 138
138 Profitability Ratios Gross margin = Gross profit Income to
Sales = EBIT Sales Sales Operating profit margin = Operating profit
Sales Return on assets = EAT Average total assets Return on equity
= EAT Dividend payout = Dividends Total equity EAT where EAT
represents earnings after taxes, or net income Profitability Ratios
Gross margin = Gross profit Income to Sales = EBIT Sales Sales
Operating profit margin = Operating profit Sales Return on assets =
EAT Average total assets Return on equity = EAT Dividend payout =
Dividends Total equity EAT where EAT represents earnings after
taxes, or net income
Slide 139
139 Common Size Analysis and After the Loan Analyst can divide
all income statement amounts by total sales revenue and all balance
sheet amounts by total assets Year to year growth rates give useful
ratios for identifying trends Loan covenants reduce risk to lender
Conditions precedent those conditions specified in the credit
agreement or terms sheet for a credit that must be fulfilled before
drawings are permitted Analyst can divide all income statement
amounts by total sales revenue and all balance sheet amounts by
total assets Year to year growth rates give useful ratios for
identifying trends Loan covenants reduce risk to lender Conditions
precedent those conditions specified in the credit agreement or
terms sheet for a credit that must be fulfilled before drawings are
permitted
Slide 140
140 Large Commercial and Industrial Lending Very attractive to
FIs because transactions are often large enough make them very
profitable even though spreads and fees are small in percentage FIs
act as broker, dealer, and adviser in credit management The
standard methods of analysis used for mid- market corporates
applied to large corporate clients but with additional
complications Financial ratios such as the debt-equity ratio are
usually key factors for corporate debt Very attractive to FIs
because transactions are often large enough make them very
profitable even though spreads and fees are small in percentage FIs
act as broker, dealer, and adviser in credit management The
standard methods of analysis used for mid- market corporates
applied to large corporate clients but with additional
complications Financial ratios such as the debt-equity ratio are
usually key factors for corporate debt
Slide 141
141 Altmans Z-Score Used for analyzing publicly traded
manufacturing firms Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 1.0X 5
where Z = an overall measure of the borrowers default risk X 1 =
Working capital/Total assets ratio X 2 = Retained earnings/Total
assets ratio X 3 = Earnings before interest and taxes/Total assets
ratio X 4 = Market value of equity/Book value of long-term debt
ratio X 5 = Sales/Total assets ratio The higher the value of Z, the
lower the default risk Used for analyzing publicly traded
manufacturing firms Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 1.0X 5
where Z = an overall measure of the borrowers default risk X 1 =
Working capital/Total assets ratio X 2 = Retained earnings/Total
assets ratio X 3 = Earnings before interest and taxes/Total assets
ratio X 4 = Market value of equity/Book value of long-term debt
ratio X 5 = Sales/Total assets ratio The higher the value of Z, the
lower the default risk
Slide 142
142 The KMV Model Banks can use the theory of option pricing to
assess the credit risk of a corporate borrower The probability of
default is positively related to: the volatility of the firms stock
the firms leverage A model developed by KMV corporation is being
widely used by banks for this purpose Banks can use the theory of
option pricing to assess the credit risk of a corporate borrower
The probability of default is positively related to: the volatility
of the firms stock the firms leverage A model developed by KMV
corporation is being widely used by banks for this purpose
Slide 143
143 Calculating the Return on a Loan A number of factors impact
the promised return that an FI achieves on any given dollar loan
the interest rate on the loan any fees relating to the loan the
credit risk premium on the loan the collateral backing the loan
other nonprice terms (such as compensating balances and reserve
requirements) A number of factors impact the promised return that
an FI achieves on any given dollar loan the interest rate on the
loan any fees relating to the loan the credit risk premium on the
loan the collateral backing the loan other nonprice terms (such as
compensating balances and reserve requirements)
Slide 144
144 Return on Assets (ROA) 1 + k = 1 + f + (L + m) 1 - (b(1 -
R)) where k = the contractually promised gross return on the loan f
= direct fees, such as loan origination fee L = base lending rate m
= risk premium b = compensating balances R = reserve requirement
charge 1 + k = 1 + f + (L + m) 1 - (b(1 - R)) where k = the
contractually promised gross return on the loan f = direct fees,
such as loan origination fee L = base lending rate m = risk premium
b = compensating balances R = reserve requirement charge
Slide 145
145 Risk-Adjusted Return on Capital (RAROC) Rather than
evaluating the actual or promised annual cash flow on a loan as a
percentage of the amount lent (ROA), the lending officer balances
the loans expected income against the loans expected risk RAROC =
One-year income on a loan/Loan (asset risk or capital at risk
Rather than evaluating the actual or promised annual cash flow on a
loan as a percentage of the amount lent (ROA), the lending officer
balances the loans expected income against the loans expected risk
RAROC = One-year income on a loan/Loan (asset risk or capital at
risk
Slide 146
Tema 6 EL RIESGO DE CRDITO: RIESGO EN LOS PRSTAMOS INDIVIDUALES
Y EN CARTERA DE CRDITO
Slide 147
147 Overview The aim is to discuss the existence of different
types of loans, and the analysis and measurement of credit risk on
individual loans. This is important for purposes of: Pricing loans
and bonds Setting limits on credit risk exposure
Slide 148
148 Credit Quality Problems Problems with junk bonds,
residential and farm mortgage loans. More recently, credit card and
auto loans. Crises in Asian countries such as Korea, Indonesia,
Thailand, and Malaysia. Default of one major borrower can have
significant impact on value and reputation of many FIs Emphasizes
importance of managing credit risk
Slide 149
149 Credit Quality Problems Over the early to mid 1990s,
improvements in NPLs (non-performing loans) for large banks and
overall credit quality. Late 1990s concern over growth in low
quality auto loans and credit cards, decline in quality of lending
standards. Exposure to Enron. Late 1990s and early 2000s: telecom
companies, tech companies, Argentina, Brazil, Russia, South Korea
New types of credit risk related to loan guarantees and
off-balance-sheet activities. Increased emphasis on credit risk
evaluation.
Slide 150
150 Types of Loans: C&I (commercial and industrial) loans:
secured and unsecured Syndication Spot loans, Loan commitments
Decline in C&I loans originated by commercial banks and growth
in commercial paper market. Downgrades of Ford, General Motors and
Tyco RE (real state) loans: primarily mortgages Fixed-rate,
variable rates Mortgages can be subject to default risk when
loan-to-value declines.
Slide 151
151 *CreditMetrics (sistema patentado) If next year is a bad
year, how much will I lose on my loans and loan portfolio? VAR = P
1.65 Neither P, nor observed. Calculated using: (i)Data on
borrowers credit rating; (ii) Rating transition matrix; (iii)
Recovery rates on defaulted loans; (iv) Yield spreads.
Slide 152
152 * Credit Risk + (sistema patentado) Developed by Credit
Suisse Financial Products. Based on insurance literature: Losses
reflect frequency of event and severity of loss. Loan default is
random. Loan default probabilities are independent. Appropriate for
large portfolios of small loans. Modeled by a Poisson
distribution.
Slide 153
153 Credit risk measurement has evolved dramatically over the
last 20 years. The five forces made credit risk measurement become
more important than ever before: (i)A worldwide structural increase
in the number of bankruptcies. (ii)A trend towards
disintermediation by the highest quality and largest
borrowers.
Slide 154
154 (iii) More competitive margins on loans. (iv) A declining
value of real assets in many markets. (v) A dramatic growth of
off-balance sheet instrument with inherent default risk exposure,
including credit risk derivatives.
Slide 155
155 Responses of academics and practitioners: (i)Developing new
and more sophisticated credit-scoring/early-warning systems
(ii)Moved away from only analyzing the credit risk of individual
loans and securities towards developing measures of credit
concentration risk (iii)Developing new models to price credit risk
(e.g. RAROC) (iv)Developing models to measure better the credit
risk of off-balance sheet instruments
Slide 156
156 Measurement of the Credit risk of Off- balance Sheet
Instruments The expansion in off-balance sheet instrument such as
swaps, options, forwards, futures, etc. Default risk of the
instruments have been concerned. It has been reflected in the BIS
risk-based capital ratio. The models like KMV, OPM can be applied
to measure the probability of default on off-balance sheet
instruments.
Slide 157
157 Measurement of the Credit risk of Off- balance Sheet
Instruments (cont.) Differences between the default risk on loans
and off-balance sheet instruments: (i)Even if the counter-party is
in financial distress, it will only default on out-of-the-money
contracts. (ii)For any given probability of default, the amount
lost on default is usually less for off- balance sheet instruments
than for loans.
Slide 158
158 Measures of credit concentration risk The measurement of
credit concentration risk is also important Early approaches to
concentration risk analysis were based either on: (i)Subjective
analysis (ii)Limiting exposure in an area to a certain percent of
capital (e.g. 10%) (iii)Migration analysis
Slide 159
159 Measures of credit concentration risk (cont.) Modern
portfolio theory (MPT) - By taking advantage of its size, an FI can
diversify considerable amounts of credit risk as long as the
returns on different assets are imperfectly correlated increasingly
being applied to loans and other fixed income instruments
recently
Slide 160
160 Accounting based credit-scoring systems Four methodological
approaches to developing multivariate credit- scoring systems:
(i)The linear probability model (ii)The logit model (iii)The probit
model (iv)The discriminant analysis model
Slide 161
161 Other (newer) models of credit risk measurement Three
criticisms of accounting based credit-scoring models 1.Accounting
data fails to pick up fast- moving changes in borrower conditions
2.The world is inherently non-linear 3.They are only tenuously
linked to an underlying theoretical model
Slide 162
162 Other (newer) models KMV model (cont.) Step 2: calculate
distance to default (D) D = (A-B)/ A Step 3: calculate EDF A B EDF
(A
208 Repricing Gap Example AssetsLiabilities GapCum. Gap 1-day $
20 $ 30 $-10 $-10 >1day-3mos. 30 40 -10 -20 >3mos.-6mos. 70
85 -15 -35 >6mos.-12mos. 90 70 +20 -15 >1yr.-5yrs. 40 30 +10
-5 >5 years 10 5 +5 0
Slide 209
209 Repricing Gap Dollar GAPSpread Effect RRDirection of NII
Positive Increase NegativeIncreaseAmbiguous
PositiveDecreaseAmbiguous NegativeDecrease
NegativePositiveIncreaseAmbiguous NegativeIncreaseDecrease
PositiveDecreaseIncrease NegativeDecreaseAmbiguous
Slide 210
210 Applying the Repricing Model NII i = (GAP i ) R i = (RSA i
- RSL i ) r i Example: In the one day bucket, gap is -$10 million.
If rates rise by 1%, NII (1) = (-$10 million) .01 = -$100,000.
Slide 211
211 Restructuring Assets & Liabilities The FI can
restructure its assets and liabilities, on or off the balance
sheet, to benefit from projected interest rate changes. Positive
gap: increase in rates increases NII Negative gap: decrease in
rates increases NII Example: State Street Boston Good luck? Or Good
Management?
Slide 212
212 Repricing Model Problems with model: measures only
short-term profit changes not shareholder wealth changes maturity
buckets are arbitrarily chosen assets and liabilities within a
bucket are considered equally rate sensitive ignores runoffs
ignores prepayments
Slide 213
213 The Maturity Model Explicitly incorporates market value
effects. For fixed-income assets and liabilities: Rise (fall) in
interest rates leads to fall (rise) in market price. The longer the
maturity, the greater the effect of interest rate changes on market
price. Fall in value of longer-term securities increases at
diminishing rate for given increase in interest rates.
Slide 214
214 Maturity Model Leverage also affects ability to eliminate
interest rate risk using maturity model Example: Assets: $100
million in one-year 10-percent bonds, funded with $90 million in
one-year 10-percent deposits (and equity) Maturity gap is zero but
exposure to interest rate risk is not zero.
Slide 215
215 Duration Duration Weighted average time to maturity using
the relative present values of the cash flows as weights. Combines
the effects of differences in coupon rates and differences in
maturity. Based on elasticity of bond price with respect to
interest rate.
Slide 216
216 Duration and Duration Gap market-value based model for
managing interest rate risk more accurate measures of interest rate
risk exposure than simple maturity model duration gap considers
market values and maturity distributions of assets and liabilities
unlike repricing model duration measures average life of asset or
liability has economic meaning of interest sensitivity of that
assets or liabilitys value
Slide 217
217 Duration Duration D = n t=1 [CF t t/(1+R) t ]/ n t=1 [CF t
/(1+R) t ] Where D = duration t = number of periods in the future
CF t = cash flow to be delivered in t periods n= term-to-maturity R
= yield to maturity.
Slide 218
218 Duration Gap duration of asset portfolio or liability
portfolio is just weighted-average duration of each individual
asset or liability also the accounting identity holds A = L + E or
E = A - L when rates change, the change in the equity or net worth
is equal to the difference between the change in the MV of the
assets and liabilities instead of how we used maturity model, here
we want to relate sensitivity of net worth to its duration mismatch
instead of its maturity mismatch because duration is a more
accurate measure of interest rate sensitivity
Slide 219
219 Duration Gap assuming similar rate changes for assets and
liabilities
Slide 220
Tema 8 EL RIESGO DE MERCADO
Slide 221
221 Trading Risks Trading exposes banks to risks 1995 Barings
Bank 1996 Sumitomo Corp. lost $2.6 billion in commodity futures
trading 1997 market volatility in Eastern Europe and Asia 1998
continuation with Russian bonds AllFirst/ Allied Irish $691 million
loss Partly preventable with software Rusnak currently serving 7
year sentence for fraud Allfirst sold to Buffalo based M&T
Bank
Slide 222
222 Implications Emphasizes importance of: Measurement of
exposure Control mechanisms for direct market riskand employee
created risks Hedging mechanisms
Slide 223
223 Market Risk Market risk is the uncertainty resulting from
changes in market prices. Affected by other risks such as interest
rate risk and FX (foreign exchange) risk It can be measured over
periods as short as one day. Usually measured in terms of dollar
exposure amount or as a relative amount against some
benchmark.
Slide 224
224 Market Risk Measurement Important in terms of: Management
information Setting limits Resource allocation (risk/return
tradeoff) Performance evaluation Regulation BIS and Fed regulate
market risk via capital requirements leading to potential for
overpricing of risks Allowances for use of internal models to
calculate capital requirements
Slide 225
225 Calculating Market Risk Exposure Generally concerned with
estimated potential loss under adverse circumstances. Three major
approaches of measurement JPM RiskMetrics (or variance/covariance
approach) Historic or Back Simulation Monte Carlo Simulation
Slide 226
226 JP Morgan RiskMetrics Model Idea is to determine the daily
earnings at risk = dollar value of position price sensitivity
potential adverse move in yield or, DEAR = Dollar market value of
position Price volatility. Can be stated as (-MD) adverse daily
yield move where, MD = D/(1+R) Modified duration = MacAulay
duration/(1+R)
Slide 227
227 Confidence Intervals If we assume that changes in the yield
are normally distributed, we can construct confidence intervals
around the projected DEAR. (Other distributions can be accommodated
but normal is generally sufficient). Assuming normality, 90% of the
time the disturbance will be within 1.65 standard deviations of the
mean.
Slide 228
228 Historic or Back Simulation Advantages: Simplicity Does not
require normal distribution of returns (which is a critical
assumption for RiskMetrics) Does not need correlations or standard
deviations of individual asset returns.
Slide 229
229 Historic or Back Simulation Basic idea: Revalue portfolio
based on actual prices (returns) on the assets that existed
yesterday, the day before, etc. (usually previous 500 days). Then
calculate 5% worst-case (25 th lowest value of 500 days) outcomes.
Only 5% of the outcomes were lower.
Slide 230
230 Estimation of VAR: Example Convert todays FX positions into
dollar equivalents at todays FX rates. Measure sensitivity of each
position Calculate its delta. Measure risk Actual percentage
changes in FX rates for each of past 500 days. Rank days by risk
from worst to best.
Slide 231
231 Weaknesses Disadvantage: 500 observations is not very many
from statistical standpoint. Increasing number of observations by
going back further in time is not desirable. Could weight recent
observations more heavily and go further back.
Slide 232
232 Monte Carlo Simulation To overcome problem of limited
number of observations, synthesize additional observations. Perhaps
10,000 real and synthetic observations. Employ historic covariance
matrix and random number generator to synthesize observations.
Objective is to replicate the distribution of observed outcomes
with synthetic data.
Slide 233
233 Regulatory Models BIS (including Federal Reserve) approach:
Market risk may be calculated using standard BIS model. Specific
risk charge. General market risk charge. Offsets. Subject to
regulatory permission, large banks may be allowed to use their
internal models as the basis for determining capital
requirements.
Slide 234
234 BIS Model Specific risk charge: Risk weights absolute
dollar values of long and short positions General market risk
charge: reflect modified durations expected interest rate shocks
for each maturity Vertical offsets: Adjust for basis risk
Horizontal offsets within/between time zones
Slide 235
Tema 9 EL RIESGO DE LIQUIDEZ
Slide 236
236 Causes of Liquidity Risk Two types of liquidity risk: when
depositors or insurance policyholders seek to cash in or withdraw
their financial claims when OBS commitments are exercised Fire-sale
price the price received for an asset that has to be liquidated
(sold) immediately Two types of liquidity risk: when depositors or
insurance policyholders seek to cash in or withdraw their financial
claims when OBS commitments are exercised Fire-sale price the price
received for an asset that has to be liquidated (sold)
immediately
Slide 237
237 Liability Side Liquidity Risk Core deposits deposits that
provide a relatively stable, long-term funding source to a bank Net
deposit drains the amount by which cash withdrawals exceed
additions; a net cash outflow can be managed two ways: purchased
liquidity management stored liquidity management Core deposits
deposits that provide a relatively stable, long-term funding source
to a bank Net deposit drains the amount by which cash withdrawals
exceed additions; a net cash outflow can be managed two ways:
purchased liquidity management stored liquidity management
(continued)
Slide 238
238 Liability Side Liquidity Risk Purchased liquidity federal
funds market repurchased (repo) agreement market issue additional
fixed-maturity CDs, notes, and/or bonds Stored liquidity can use or
sell off some of its assets (such as T- bills) utilize its stored
liquidity (i.e., cash in vault) Purchased liquidity federal funds
market repurchased (repo) agreement market issue additional
fixed-maturity CDs, notes, and/or bonds Stored liquidity can use or
sell off some of its assets (such as T- bills) utilize its stored
liquidity (i.e., cash in vault)
Slide 239
239 Measuring a Banks Liquidity Exposure Net liquidity
statement measures liquidity position by listing sources and uses
of liquidity Peer group ratio comparisons a comparison of its key
ratios and balance sheet features with those for banks of a similar
size and geographic location Liquidity index measures the potential
losses an FI could suffer from a sudden or fire-sale disposal of
assets compared to the amount it would receive at a fair market
value established under normal market conditions Net liquidity
statement measures liquidity position by listing sources and uses
of liquidity Peer group ratio comparisons a comparison of its key
ratios and balance sheet features with those for banks of a similar
size and geographic location Liquidity index measures the potential
losses an FI could suffer from a sudden or fire-sale disposal of
assets compared to the amount it would receive at a fair market
value established under normal market conditions
Slide 240
240 Calculation of the Liquidity Index N I = [(w i )(P i / P i
*)] i = 1 where w i = Percentage of each asset in the FIs portfolio
w i = 1 N I = [(w i )(P i / P i *)] i = 1 where w i = Percentage of
each asset in the FIs portfolio w i = 1
Slide 241
241 Financing Gap and the Financing Requirement Financing gap
the difference between a banks average loans and average (core)
deposits if the financing gap is positive, the bank must fund it by
using its cash and liquid assets and/or borrowing funds in the
money market Financing requirement the financing gap plus a banks
liquid assets the larger a banks financing gap and liquid asset
holdings, the higher the amount of funds it needs to borrow on the
money markets and the greater is its exposure to liquidity problems
Financing gap the difference between a banks average loans and
average (core) deposits if the financing gap is positive, the bank
must fund it by using its cash and liquid assets and/or borrowing
funds in the money market Financing requirement the financing gap
plus a banks liquid assets the larger a banks financing gap and
liquid asset holdings, the higher the amount of funds it needs to
borrow on the money markets and the greater is its exposure to
liquidity problems
Slide 242
242 Liquidity Planning Allows managers to make important
borrowing priority decisions Components of a liquidity plan
delineation of managerial details and responsibilities detailed
list of fund providers most likely to withdraw and the pattern of
fund withdrawals identification of the size of potential deposit
and fund withdrawals over various time horizons in the future sets
internal limits on separate subsidiaries and branches borrowing and
bounds for acceptable risk premiums to pay details a sequencing of
assets for disposal Allows managers to make important borrowing
priority decisions Components of a liquidity plan delineation of
managerial details and responsibilities detailed list of fund
providers most likely to withdraw and the pattern of fund
withdrawals identification of the size of potential deposit and
fund withdrawals over various time horizons in the future sets
internal limits on separate subsidiaries and branches borrowing and
bounds for acceptable risk premiums to pay details a sequencing of
assets for disposal
Slide 243
243 Deposit Drains and Bank Run Liquidity Risk Deposit drains
may occur for a variety of reasons concerns about a banks solvency
failure of a related bank sudden changes in investor preferences
Bank run a sudden and unexpected increase in deposit withdrawals
from a bank Bank panic a systemic or contagious run on the deposits
of the banking industry as a whole Deposit drains may occur for a
variety of reasons concerns about a banks solvency failure of a
related bank sudden changes in investor preferences Bank run a
sudden and unexpected increase in deposit withdrawals from a bank
Bank panic a systemic or contagious run on the deposits of the
banking industry as a whole
Slide 244
244 Deposit Insurance and Discount Window Deposits insured for
$100,000 Federal Reserve provides a discount window facility to
meet banks short-term nonpermanent liquidity needs loans made by
discounting short-term high-quality securities such as T-bills and
bankers acceptances with central bank leads to increased monitoring
from the Federal Reserve which acts as a disincentive for banks to
use for cheap funding Deposits insured for $100,000 Federal Reserve
provides a discount window facility to meet banks short-term
nonpermanent liquidity needs loans made by discounting short-term
high-quality securities such as T-bills and bankers acceptances
with central bank leads to increased monitoring from the Federal
Reserve which acts as a disincentive for banks to use for cheap
funding
Slide 245
245 Liquidity Risk and Insurance Companies Early cancellation
of a life insurance policy results in the insurer having to pay the
surrender value the amount that an insurance policyholder receives
when cashing in a policy early when premium income is insufficient
to meet surrenders, the insurer can sell liquid assets such as
government bonds Property-Casualty PC insurers have greater need
for liquidity due to uncertainty so ten to hold shorter term assets
Guarantee Programs for Life and PC Insurance Co. Early cancellation
of a life insurance policy results in the insurer having to pay the
surrender value the amount that an insurance policyholder receives
when cashing in a policy early when premium income is insufficient
to meet surrenders, the insurer can sell liquid assets such as
government bonds Property-Casualty PC insurers have greater need
for liquidity due to uncertainty so ten to hold shorter term assets
Guarantee Programs for Life and PC Insurance Co.
Slide 246
246 Liquidity Risk and Mutual Funds Open-end mutual funds must
stand ready to buy back issued shares from investors at their
current market price or net asset value If a mutual fund is closed
and liquidated, the assets would be distributed on a pro rata basis
Open-end mutual funds must stand ready to buy back issued shares
from investors at their current market price or net asset value If
a mutual fund is closed and liquidated, the assets would be
distributed on a pro rata basis