Global Issues: The Financial Crisis 62
Summary 64
Appendix 2A
Financial Statement Analysis Using a Return on Equity (ROE) Framework 69 (www.mhhe.com/saunders9e)
Appendix 2B
Commercial Banks’ Financial Statements and Analysis 69 (www.mhhe.com/saunders9e)
Appendix 2C
Depository Institutions and Their Regulators 69 (www.mhhe.com/saunders9e)
Appendix 2D
Technology in Commercial Banking 69 (www.mhhe.com/saunders9e)
Chapter Three Financial Services: Finance Companies 70
Introduction 70
Size, Structure, and Composition of the
Industry 70
Balance Sheet and Recent Trends 74
Assets 74
Liabilities and Equity 79
Industry Performance 80
Regulation 82
Global Issues 84
Summary 84
Chapter Four
Financial Services: Securities Firms
and Investment Banks 86
Introduction 86
Size, Structure, and Composition of the Industry 88
Balance Sheet and Recent Trends 98
Recent Trends 98
Balance Sheet 102
Regulation 103
Global Issues 107
Summary 111
Chapter Five
Financial Services: Mutual Fund and Hedge Fund Companies 114
Introduction 114
Size, Structure, and Composition of the Mutual Fund Industry 115
Historical Trends 115 Different Types of Mutual Funds 118 Mutual Fund Objectives 123
Investor Returns from Mutual Fund Ownership 125 Mutual Fund Costs 129
Balance Sheet and Recent Trends for the Mutual Fund Industry 132 Money Market Funds 132 Long-Term Funds 134
Hedge Funds 140
Types of Hedge Funds 141
Fees on Hedge Funds 146
Offshore Hedge Funds 146
Regulation of Hedge Funds 147
Summary 148
Chapter Six
Financial Services: Insurance
Companies 151
Introduction 151
Life Insurance 152
Size, Structure, and Composition of the Industry 152
Balance Sheet and Recent Trends 156
Regulation 159
Property–Casualty Insurance 161
Size, Structure, and Composition of the Industry 161
Balance Sheet and Recent Trends 163
Regulation 172
Global Issues 172
Summary 174
Chapter Seven
Risks of Financial Institutions 177
Introduction 177
Interest Rate Risk 178
Credit Risk 180
Liquidity Risk 182
Foreign Exchange Risk 184
Country or Sovereign Risk 186
Market Risk 187
Off-Balance-Sheet Risk 188
Technology and Operational Risks 190
Insolvency Risk 192
Other Risks and the Interaction of Risks 193
Summary 194
PART TWO
MEASURING RISK 199
Chapter Eight
Interest Rate Risk I 200
Introduction 200
The Level and Movement of Interest Rates 201
The Repricing Model 203
Rate-Sensitive Assets 205
Rate-Sensitive Liabilities 206
Equal Changes in Rates on RSAs and RSLs 209
Unequal Changes in Rates on RSAs and RSLs 210
Weaknesses of the Repricing Model 213 Market Value Effects 213
Interest Rate Risk II 231
Introduction 231
Duration: A Simple Introduction 232
A General Formula for Duration 234
The Duration of Interest-Bearing Bonds 236
The Duration of Zero-Coupon Bonds 238
The Duration of Consol Bonds (Perpetuities) 238
Features of Duration 239
Duration and Maturity 239
Duration and Yield 240
Duration and Coupon Interest 240
The Economic Meaning of Duration 241
Semiannual Coupon Bonds 245
Duration and Interest Rate Risk 246
Duration and Interest Rate Risk Management on a Single Security 246
Duration and Interest Rate Risk Management on the Whole Balance Sheet of an FI 249
Immunization and Regulatory Considerations 256
Difficulties in Applying the Duration Model 257
Duration Matching Can Be Costly 257
Immunization Is a Dynamic Problem 257
Large Interest Rate Changes and Convexity 258
Summary 260
Appendix 9A
The Basics of Bond Valuation 269 (www.mhhe.com/saunders9e)
Appendix 9B
Incorporating Convexity into the
Duration Model 269
Chapter Ten
Credit Risk: Individual Loan Risk 279
Introduction 279
Credit Quality Problems 281
Types of Loans 283
Commercial and Industrial Loans 283
Real Estate Loans 286
Individual (Consumer) Loans 287
Other Loans 289
Calculating the Return on a Loan 289
The Contractually Promised Return on a Loan 290
The Expected Return on a Loan 293
Retail Versus Wholesale Credit Decisions 294
Retail 294
Wholesale 295
Measurement of Credit Risk 296
Default Risk Models 297
Qualitative Models 297
Quantitative Models 300
Newer
Chapter Eleven
Credit Risk: Loan Portfolio and
Concentration Risk 331
Introduction 331
Simple Models of Loan Concentration Risk 332
Loan Portfolio Diversification and Modern
Portfolio Theory (MPT) 334
Moody’s Analytics Portfolio Manager Model 337
Partial Applications of Portfolio Theory 340
Regulatory Models 344
Summary 345
Appendix 11A
CreditMetrics 350
Appendix 11B
CreditRisk+ 354
Chapter Twelve
Liquidity Risk 357
Introduction 357
Causes of Liquidity Risk 358
Liquidity Risk at Depository Institutions 359
Liability-Side Liquidity Risk 359
Asset-Side Liquidity Risk 363
Measuring a DI’s Liquidity Risk Exposure 365
New Liquidity Risk Measures Implemented by the Bank for International Settlements 369
Liquidity Planning 375
Liquidity Risk, Unexpected Deposit Drains, and Bank Runs 376
Bank Runs, the Discount Window, and Deposit Insurance 377
Liquidity Risk at Other Types of Financial Institutions 378
381 Appendix 12A
Sources and Uses of Funds Statement,
J. P. Morgan Chase, March 2015 387
(www.mhhe.com/saunders9e)
Appendix 12B
Illustrative Template for the LCR 388
Chapter Thirteen
Foreign Exchange Risk 391
Introduction 391
Foreign Exchange Rates and Transactions 391
Foreign Exchange Rates 391
Foreign Exchange Transactions 392
Sources of Foreign Exchange Risk Exposure 395
Foreign Exchange Rate Volatility and FX Exposure 399
Foreign Currency Trading 400
FX Trading Activities 401
Foreign Asset and Liability Positions 403
The Return and Risk of Foreign Investments 403
Risk and Hedging 405
Multicurrency Foreign Asset–Liability Positions 409
Interaction of Interest Rates, Inflation,
And Exchange Rates 410
Purchasing Power Parity 411
Interest Rate Parity Theorem 412
Summary 414
Chapter Fourteen
Sovereign Risk 422
Introduction 422
Credit Risk Versus Sovereign Risk 426
Debt Repudiation Versus Debt Rescheduling 428
Country Risk Evaluation 429
Outside Evaluation Models 430
OECD Country Risk Classifications 431
Internal Evaluation Models 433
Using Market Data to Measure Risk: The Secondary Market for LDC and Emerging Market Debt 442
Summary 444
Appendix 14A
Mechanisms for Dealing with Sovereign Risk Exposure 448 (www.mhhe.com/saunders9e)
Chapter Fifteen
Market Risk 449
Introduction 449
Calculating Market Risk Exposure 453
The RiskMetrics Model 453
The Market Risk of Fixed-Income Securities 454
Foreign Exchange 457
Equities 458
Portfolio Aggregation 459
Historic (Back Simulation) Approach 462
The Historic (Back Simulation) Model versus RiskMetrics 465
The Monte Carlo Simulation Approach 466
Expected Shortfall 470
Regulatory Models: The BIS Standardized Framework 473
Partial Risk Factor Approach 474
The BIS Regulations and Large-Bank Internal
Models 477
Summary 479
Chapter Sixteen
Off-Balance-Sheet Risk 485
Introduction 485
Off-Balance-Sheet Activities and FI Solvency 486
Returns and Risks of Off-Balance-Sheet Activities 490
Loan Commitments 493
Commercial Letters of Credit and Standby Letters of Credit 496
Derivative Contracts: Futures, Forwards, Swaps, and Options 499
Forward Purchases and Sales of When-Issued
Securities 502
Loans Sold 503
Non–Schedule L Off-Balance-Sheet Risks 504
Settlement Risk 504
Affiliate Risk 505
The Role of OBS Activities in Reducing Risk 506
Summary 508
Appendix 16A
A Letter of Credit Transaction 512
(www.mhhe.com/saunders9e)
Chapter Seventeen
Technology and Other Operational Risks 513
Introduction 513
What Are the Sources of Operational Risk? 516
Technological Innovation and Profitability 516
The Impact of Technology on Wholesale and Retail
Financial Service Production 519
Wholesale Financial Services 519
Retail Financial Services 520
Advanced Technology Requirements 522
The Effect of Technology on Revenues and Costs
523
Technology and Revenues 525
Technology and Costs 525
Technology and the Evolution of the Payments
System 530
Risks That Arise in an Electronic Transfer
Payment System 533
Other Operational Risks 538
Regulatory Issues and Technology and Operational Risks 540
Summary 542
PART THREE
MANAGING RISK 545
Chapter Eighteen
Liability and Liquidity Management 546
Introduction 546
Liquid Asset Management 546
Monetary Policy Implementation Reasons 547
Taxation Reasons 547
The Composition of the Liquid Asset Portfolio 548
Return-Risk Trade-Off for Liquid Assets 549
The Liquid Asset Reserve Management Problem for U.S. Depository Institutions 549
Undershooting/Overshooting of the Reserve Target 554
Managing Liquid Assets Other than Cash 558
Liability Management 559
Funding Risk and Cost 559
Choice of Liability Structure 560
Demand Deposits 560
Interest-Bearing Checking (NOW) Accounts 561
Passbook Savings 563
Money Market Deposit Accounts (MMDAs) 563
Retail Time Deposits and CDs 564
Wholesale CDs 564
Federal Funds 565
Repurchase Agreements (RPs) 566
Other Borrowings 567
Liquidity and Liability Structures for U.S.
Depository Institutions 568
Liability and Liquidity Risk Management
In Insurance Companies 570
Liability and Liquidity Risk Management
In Other Financial Institutions 571
Summary 571
Appendix 18A
Federal Reserve Requirement Accounting 575 (www.mhhe.com/saunders9e)
Appendix 18B
Bankers’ Acceptances and Commercial Paper as Sources of Financing 575 (www.mhhe.com/saunders9e)
Chapter Nineteen
Deposit Insurance and Other
Liability Guarantees 576
Introduction 576
Bank and Thrift Guaranty Funds 577
The Causes of the Depository Fund Insolvencies 579
The Financial Environment 579
Moral Hazard 580
Panic Prevention Versus Moral Hazard 581
Controlling Depository Institution Risk
Taking 581
Stockholder Discipline 582
Depositor Discipline 587
Regulatory Discipline 592
Non-U.S. Deposit Insurance Systems 593
The Discount Window 594
Deposit Insurance versus the Discount Window 594
The Discount Window 594
Other Guaranty Programs 597
National Credit Union Administration 597
Property–Casualty and Life Insurance
Companies 597
The Discrepancy between the Market and Book Values
of Equity 616
Arguments against Market Value Accounting 617
Capital Adequacy in the Commercial Banking
And Thrift Industry 619
Capital 624
Credit Risk–Adjusted Assets 624
Calculating Risk-Based Capital Ratios 625
Capital Requirements for Other Financial Institutions 643
Securities Firms 643
Life Insurance 644
Property–Casualty Insurance 646
Summary 648
Appendix 20A
Internal Ratings-Based Approach to Measuring
Credit Risk–Adjusted Assets 656
Appendix 20B
Methodology Used to Determine G-SIBs’
Capital Surcharge 658
(www.mhhe.com/saunders9e)
Chapter Twenty-One
Product and Geographic Expansion 659
Introduction 659
Product Diversification 660
Segmentation in the U.S. Financial Services
Industry 661
Commercial and Investment Banking Activities 661
Banking and Insurance 664
Commercial Banking and Commerce 665
Nonbank Financial Service Firms and Banking 665
Nonbank Financial Service Firms and Commerce 667
Activity Restrictions in the United States
Versus Other Countries 668
Issues Involved in the Diversification of Product Offerings 668
Safety and Soundness Concerns 669
Economies of Scale and Scope 671
Conflicts of Interest 671
Deposit Insurance 673
Regulatory Oversight 673
Competition 674
Domestic Geographic Expansion 675
Regulatory Factors Affecting Geographic
Expansion 676
Insurance Companies 676
Thrifts 677
Commercial Banks 677
Cost and Revenue Synergies Affecting
Domestic Geographic Expansion by Merger and
Acquisition 680
Cost Synergies 680
Revenue Synergies 681
Merger Guidelines for Acceptability 682
Other Market- and Firm-Specific Factors Affecting
Domestic Geographic Expansion Decisions 685
Global and International Expansions 685
U.S. Banks Abroad 686
Foreign Banks in the United States 690
Advantages and Disadvantages of
International Expansion 692
Advantages 692
Disadvantages 693
Summary 694
Chapter Twenty-Two
Futures and Forwards 698
Introduction 698
Forward and Futures Contracts 700
Spot Contracts 700
Forward Contracts 700
Futures Contracts 702
Forward Contracts and Hedging Interest
Rate Risk 703
Hedging Interest Rate Risk with Futures
Contracts 704
Microhedging 704
Macrohedging 705
Routine Hedging versus Selective Hedging 705
Macrohedging with Futures 706
The Problem of Basis Risk 713
Hedging Foreign Exchange Risk 715
Forwards 715
Futures 716
Estimating the Hedge Ratio 719
Hedging Credit Risk with Futures and Forwards 722
Credit Forward Contracts and Credit Risk
Hedging 723
Futures Contracts and Catastrophe Risk 725
Regulation of Derivative Securities 725
Summary 727
Appendix 22A
Microhedging with Futures 734
(www.mhhe.com/saunders9e)
Chapter Twenty-Three
Options, Caps, Floors, and Collars 735
Introduction 735
Basic Features of Options 735
Buying a Call Option on a Bond 736
Writing a Call Option on a Bond 737
Buying a Put Option on a Bond 738
Writing a Put Option on a Bond 738
Writing Versus Buying Options 739
Economic Reasons for Not Writing Options 739
Regulatory Reasons 741
Futures versus Options Hedging 741
The Mechanics of Hedging a Bond or Bond Portfolio 742
Hedging with Bond Options Using the Binomial Model 743
Actual Bond Options 747
Using Options to Hedge Interest Rate Risk
On The Balance Sheet 749
Using Options to Hedge Foreign Exchange Risk 754
Hedging Credit Risk with Options 755
Hedging Catastrophe Risk with Call Spread
Options 756
Caps, Floors, and Collars 757
Caps 758
Floors 761
Collars 762
Caps, Floors, Collars, and Credit Risk 765
Summary 765
Appendix 23A
Microhedging with Options 772 (www.mhhe.com/saunders9e)
Chapter Twenty-Four
Swaps 773
Introduction 773
Swap Markets 774
Interest Rate Swaps 775
Macrohedging with Swaps 780
Currency Swaps 783
Fixed-Fixed Currency Swaps 783
Fixed-Floating Currency Swaps 785
Credit Swaps 786
Total Return Swaps 788
Pure Credit Swaps 790
CDS Indexes 790
Swaps and Credit Risk Concerns 791
Netting and Swaps 792
Payment Flows Are Interest, Not Principal 793
Standby Letters of Credit 793
Summary 793
Appendix 24A
Setting Rates on an Interest Rate Swap 799
Chapter Twenty-Five
Loan Sales 803
Introduction 803
The Bank Loan Sales Market 804
Definition of a Loan Sale 804
Types of Loan Sales 804
Types of Loan Sales Contracts 806
Trends in Loan Sales 807
The Buyers and the Sellers 808
Why Banks and Other FIs Sell Loans 813
Reserve Requirements 813
Fee Income 814
Capital Costs 814
Liquidity Risk 814
Factors Affecting Loan Sales Growth 814
Access to the Commercial Paper Market 814
Customer Relationship Effects 815
Legal Concerns 815
BIS Capital Requirements 815
Market Value Accounting 815
Asset Brokerage and Loan Trading 816
Government Loan Sales 816
Credit Ratings 816
Purchase and Sale of Foreign Bank Loans 816
Summary 817
Chapter Twenty-Six
Securitization 819
Introduction 819
Mechanisms Used to Convert On-Balance-Sheet
Assets to a Securitized Asset 820
The Pass-Through Security 823
GNMA 824
FNMA 824
FHLMC 825
The Incentives and Mechanics of Pass-Through
Security Creation 825
Prepayment Risk on Pass-Through Securities 831
Prepayment Models 835
Government Sponsorship and Oversight of FNMA and Freddie Mac 843
The Collateralized Mortgage Obligation (CMO) 845
Creation of CMOs 846
Class A, B, and C Bond Buyers 848
Other CMO Classes 848
The Mortgage-Backed Bond (MBB) or Covered Bond 849
Innovations in Securitization 851
Mortgage Pass-Through Strips 851
Securitization of Other Assets 854 Can All Assets Be Securitized? 855 Summary 857 Appendix 26A
1. Why Are Financial Institutions Special? 2
2. Financial Services: Depository Institutions 26
3. Financial Services: Finance Companies 70
4. Financial Services: Securities Firms and Investment Banks 86
5. Financial Services: Mutual Fund and Hedge Fund Companies 114
6. Financial Services: Insurance Companies 151
7. Risks of Financial Institutions 177
Why
Are
Financial Institutions Special?
Over the last 90 years, the financial services industry has come full cycle. Originally, the banking industry operated as a full-service industry, performing directly or indirectly all financial services (commercial banking, investment banking, stock investing services, insurance providers, etc.). In the early 1930s, the economic and industrial collapse resulted in the separation of some of these activities.
In the 1970s and 1980s, new, relatively unregulated financial services industries sprang up (mutual funds, brokerage funds, etc.) that separated financial services functions even further. As we entered the 21st century, regulatory barriers, technology, and financial innovation changes were such that a full set of financial services could again be offered by a single financial services firm under the umbrella of a financial services holding company. For example, J.P. Morgan Chase operates a commercial bank, J.P. Morgan Chase Bank, an investment bank, J.P. Morgan Securities (which also sells mutual funds), and an insurance company, J.P. Morgan Insurance Agency. During the 2008–2009 financial crisis, this financial services holding company purchased a savings institution, Washington Mutual, and several investment banks, including Bear Stearns. Not only did the boundaries between traditional industry sectors change, but competition became global in nature as well. For example, J.P. Morgan Chase is the world’s fifth largest financial services holding company, operating in 60 countries. Then came the late 2000s when the United States and indeed the world experienced a collapse of financial markets second only to that experienced during the Great
Depression. The financial crisis produced a major reshaping of all financial institution (FI) sectors and the end of many major FIs, e.g., Bear Stearns and Lehman Brothers. The result was a call by the Obama administration to again separate activities performed by individual FIs. As the competitive environment changes, attention to profit and, more than ever, risk becomes increasingly important. The major themes of this book are the measurement and management of the risks of financial institutions. Financial institutions (e.g., banks, credit unions, insurance companies, and mutual funds) perform the essential function of channeling funds from those with surplus funds (suppliers of funds) to those with shortages of funds (users of funds). In 2015, U.S. FIs held assets totaling more than $30.45 trillion. In contrast, the U.S. motor vehicle and parts industry (e.g., General Motors and Ford Motor Corp.) held total assets of $0.55 trillion. Although we might categorize or group FIs and the services they perform as life insurance companies, banks, investment banks, and so on, they face many common risks. Specifically, all FIs described in this chapter and Chapters 2 through 6 (1) hold some assets that are potentially subject to default or credit
risk and (2) tend to mismatch the maturities of their balance sheet assets and liabilities to a greater or lesser extent and are thus exposed to interest rate risk. Moreover, all FIs are exposed to some degree of liability withdrawal or liquidity risk, depending on the type of claims they have sold to liability holders. In addition, most FIs are exposed to some type of underwriting risk, whether through the sale of securities or the issue of various types of credit guarantees on or off the balance sheet. Finally, all FIs are exposed to operating risks because the production of financial services requires the use of real resources and back-office support systems (labor and technology combined to provide services).
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