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Bank Management, 6 th edition. Management Timothy W. Koch and S. Scott Mac. Donald Bank Management, 6 th edition. Management Timothy W. Koch and S. Scott Mac. Donald Copyright © 2005 by South-Western, a division of Thomson Learning PRICING FIXED-INCOME SECURITIES Chapter 4

Future value and present value n PV(1+i) = FV 1 n Example: 1, 000 Future value and present value n PV(1+i) = FV 1 n Example: 1, 000 PV and 1, 080 FV means: n i = $80 / $1, 000 = 0. 08 = 8% n If we invest $1, 000 at 8% for 2 years: n $1, 000 (1+0. 08) = $1, 080 (1. 08) = $1, 166. 40

In general, the future value is… n FVn = PV(1+i)n n Alternatively, the yield In general, the future value is… n FVn = PV(1+i)n n Alternatively, the yield can be found as: n i = [FVn / PV](1/n) - 1 n Example: $1, 000 invested for 6 years at 8%: n FV 6 = $1, 000(1. 08)6 = $1, 586. 87 n Example: Invest $1, 000 for 6 years, Receive $1, 700 at the end of 6 years. n What is the rate of return? i = [$1, 700 / $1, 000](1/6) - 1 = 0. 0925

Future value and present value …multiple payments n The cumulative future value of a Future value and present value …multiple payments n The cumulative future value of a series of cash flows (CFVn) after n periods is: n CFVn =CF 1(1+i)n +CF 2(1+i)n-1 +. . . +CFn(1+i) n The present value of a series of n cash flows: n PV = [CF 1 / (1+i)] + [CF 2 / (1+i)2] + [CF 3 / (1+i)3]. . . +[CFn / (1+i)n] n Example: n rate of interest = 10%, what is the PV of a security that pays $90 at the end of the next three years plus $1, 000 at the end of three years? n PV = 90/(1. 1) + 90/(1. 1)2 + 1090/(1. 1)3 = $975. 13

Simple interest versus compound interest n Simple interest is interest that is paid only Simple interest versus compound interest n Simple interest is interest that is paid only on the initial principal invested: n simple interest = PV x (i) x n n Example, simple interest: n if i = 12% per annum, n = 1 and principal of $1, 000: n simple interest = $1, 000 (0. 12) 1 = $120 n Example, interest is paid monthly: n monthly simple interest = $1, 000 (0. 12 / 12) 1= $10 n Compounded interest is interest that is paid on the interest: n n PV (1 + i/m)nm = FVn and PV = FVn / (1 + i/m)nm

Compounding frequency n Example: $1, 000 invested for 1 year at 8% with interest Compounding frequency n Example: $1, 000 invested for 1 year at 8% with interest compounded monthly: n FV 1 = 1, 000 (1 + 0. 08/12)12 = 1083. 00 n The effective annual rate of interest, i* can be calculated from: n i* = (1 + i/m)m - 1 n In this example: n i* = (1 + 0. 08/12)12 - 1 = 8. 30%

The effect of compounding on future value and present value The effect of compounding on future value and present value

Bond prices and interest rates vary inversely n Consider a bond which pays semi-annual Bond prices and interest rates vary inversely n Consider a bond which pays semi-annual interest payments of $470 with a maturity of 3 years. n If the market rate of interest is 9. 4%, the price of the bond is: n n If the market rates of interest increases to 10%, the price of the bond falls to $9, 847. 73: n

How do I calculate these values? 1. Figure out how to input these values How do I calculate these values? 1. Figure out how to input these values into your financial calculator • Easy and Quick • Can lead to reliance on faulty numbers if you enter values improperly • What happens, if you are like me, and you lose the calculator manual in a few months? 2. Use the formula for the annuity portion + lump sum: PVA = • Still prone to entry error, but doable on any calculator and in any introductory Finance text.

On the prior page, “i” represents the periodic rate. Here is the general formula: On the prior page, “i” represents the periodic rate. Here is the general formula: With r = annual rate and m = number of times per year compounded, such as 12 for monthly. For Future Value of an Annuity:

Price and yield relationships for optionfree bonds that are equivalent except for the feature Price and yield relationships for optionfree bonds that are equivalent except for the feature analyzed

In general n Par Bond n Yield to maturity = coupon rate n Discount In general n Par Bond n Yield to maturity = coupon rate n Discount Bond n Yield to maturity > coupon rate n Premium Bond n Yield to maturity < coupon rate

Relationship between price and interest rate on a 3 -year, $10, 000 option-free par Relationship between price and interest rate on a 3 -year, $10, 000 option-free par value bond that pays $470 in semiannual interest For a given absolute change in interest rates, the percentage increase in a bond’s price will exceed the percentage decrease. $’s This asymmetric price relationship is due to the convex shape of the curve-plotting the price interest rate relationship. 10, 155. 24 = +$155. 25 10, 000. 00 = -$152. 77 9, 847. 73 Bond Prices Change Asymmetrically to Rising and Falling Rates 8. 8 9. 4 10. 0 Interest Rate %

The effect of maturity on the relationship between price and interest rate on fixedincome, The effect of maturity on the relationship between price and interest rate on fixedincome, option free bonds $’s For a given coupon rate, long-term bonds price changes proportionately more in price than do short-term bonds for a given rate change. 10, 275. 13 10, 155. 24 10, 000. 00 9, 847. 73 9, 734. 10 9. 4%, 3 -year bond 9. 4%, 6 -year bond 8. 8 9. 4 10. 0 Interest Rate %

The effect of coupon on the relationship between price and interest rate on fixedincome, The effect of coupon on the relationship between price and interest rate on fixedincome, option free bonds % change in price For a given change in market rate, the bond with the lower coupon will change more in price than will the bond with the higher coupon. + 1. 74 + 1. 55 0 - 1. 52 - 1. 70 9. 4%, 3 -year bond Zero Coupon, 3 -year bond 8. 8 9. 4 10. 0 Interest Rate %

Duration and price volatility n Maturity simply identifies how much time elapses until final Duration and price volatility n Maturity simply identifies how much time elapses until final payment. n It ignores all information about the timing and magnitude of interim payments. n Duration is a measure of effective maturity that incorporates the timing and size of a security's cash flows. n Duration captures the combined impact of market rate, the size of interim payments and maturity on a security’s price volatility.

Duration versus maturity 1. ) 1000 loan, principal + interest paid in 20 years. Duration versus maturity 1. ) 1000 loan, principal + interest paid in 20 years. 2. ) 1000 loan, 900 principal in 1 year, 100 principal in 20 years. 1000 + int 1 |----------|---------| 0 10 20 900+int 2 100 + int |---------|---------| 0 1 10 20 What is the maturity of each? 20 years What is the "effective" maturity? 2. ) = [(900/100) x 1]+[(100/1000) x 20] = 2. 9 yrs Duration, however, uses a weighted average of the present values.

Duration …approximate measure of the price elasticity of demand n Price elasticity of demand Duration …approximate measure of the price elasticity of demand n Price elasticity of demand = % in quantity demanded / % in price n Price (value) changes n Longer duration larger changes in price for a given change in i-rates. n Larger coupon smaller change in price for a given change in i-rates.

Duration …approximate measure of the price elasticity of demand n Solve for Price: n Duration …approximate measure of the price elasticity of demand n Solve for Price: n P @ -Duration x [ i / (1 + i)] x P n n Price (value) changes n Longer maturity/duration larger changes in price for a given change in i-rates. n Larger coupon smaller change in price for a given change in i-rates.

Measuring duration n In general notation, Macaulay’s duration (D): n Example: 1000 face value, Measuring duration n In general notation, Macaulay’s duration (D): n Example: 1000 face value, 10% coupon, 3 year, 12% YTM

Measuring duration n If YTM = 5% 1000 face value, 10% coupon, 3 year, Measuring duration n If YTM = 5% 1000 face value, 10% coupon, 3 year, 5% YTM

Measuring duration n If YTM = 20% 1000 face value, 10% coupon, 3 year, Measuring duration n If YTM = 20% 1000 face value, 10% coupon, 3 year, 20% YTM

Measuring duration n If YTM = 12% and Coupon = 0 1000 face value, Measuring duration n If YTM = 12% and Coupon = 0 1000 face value, 0% coupon, 3 year, 12% YTM 1000 |-------|-------| 0 1 2 3

Compare price sensitivity n Duration allows market participants to estimate the relative price volatility Compare price sensitivity n Duration allows market participants to estimate the relative price volatility of different securities: n Using modified duration: modified duration = Macaulay’s duration / (1+i) n We have an estimate of price volatility: %change in price = modified duration x change in i

Comparative price sensitivity indicated by duration n P = - Duration [ i / Comparative price sensitivity indicated by duration n P = - Duration [ i / (1 + i)] P n P / P = - [Duration / (1 + i)] i where Duration equals Macaulay's duration.

Valuation of fixed income securities n Traditional fixed-income valuation methods are too simplistic for Valuation of fixed income securities n Traditional fixed-income valuation methods are too simplistic for three reasons: 1. 2. 3. Investors do not hold securities until maturity Present value calculations assumes all coupon payments are reinvested at the calculated Yield to Maturity Many securities carry embedded options, such as a call or put, which complicates valuation since it is unknown if the option will be exercised.

Total return analysis n Market participants attempt to estimate the actual realized yield on Total return analysis n Market participants attempt to estimate the actual realized yield on a bond by calculating an estimated total return = [Total future value / Purchase price](1/n) - 1

Total return for a 9 -year 7. 3% coupon bond purchased at $99. 62 Total return for a 9 -year 7. 3% coupon bond purchased at $99. 62 per $100 par value and held for 5 -years. Assume: semiannual reinvestment rate = 3% after five years; a comparable 4 -year maturity bond will be priced to yield 7% (3. 5% semiannually) to maturity n Coupon payment: 10 x $3. 65 = $36. 50 n Interest-on-interest: $3. 65 [(1. 03)10 -1] / 0. 03 - $36. 50 = $5. 34 n Sale price after five years: n Total future value: $36. 50 + $5. 34 + $101. 03 = $142. 87 n Total return: [$142. 87 / $99. 62]1/10 - 1 = 0. 0367 or 7. 34% annually

Money market yields n Interest rates for most money market yields are quoted on Money market yields n Interest rates for most money market yields are quoted on a different basis. n In particular, some money market instruments are quoted on a discount basis, while others bear interest. n Some yields are quoted on a 360 -day year rather than a 365 or 366 day year.

But, before we begin, it is also important to use time value of money But, before we begin, it is also important to use time value of money for less than one year. Start with an annualized rate of 6%. Other descriptions include an effective annual yield (EAY), or an effective annual rate (EAR). So, the question becomes how to convert to annual rate to a periodic rate. Let’s start with monthly: (1 + X)12 = (1. 06) so X = [(1. 06)1/12] – 1 So, X = 0. 0048675, or 0. 48675%, or 48. 68 basis points per month.

Now, let’s figure out how much 100, 000 is worth for one month at Now, let’s figure out how much 100, 000 is worth for one month at an annualized rate of 6%. 100, 000(1. 0048675) =$100, 486. 75 What about 2 months? 100, 000(1. 0048675)2 =$100, 975. 87 Another, and easier way to do this is 100, 000(1. 06)(2/12) = =$100, 975. 87 So, in general, FV = PV(1+EAR)(h/n) And, of course PV = FV/(1+EAR)(h/n) Where h = # of periods and n = the # of total periods in a year

If the interest rate is a nominal rate, also referred to as a stated If the interest rate is a nominal rate, also referred to as a stated rate, you treat this differently: Suppose we have a nominal rate of 6%, but paid monthly for the same $100, 000. Then, FV = 100, 000(1 +. 06/12) = $100, 500 And for 2 months, 100, 000(1. 005)2 = 101, 002. 50. Notice the difference compared to using an EAY or EAR is about $27 more interest for this example.

Money market securities do not often use time value of money techniques when calculating Money market securities do not often use time value of money techniques when calculating prices or interest. The curious student might ask why? The answer lies in the fact that most money market securities were created before the invention of electronic calculators and it is easier to divide and multiply, and calculate interest rates on a 360 day year since it is more easily divisible by 12, 6, 4, and 3.

360 -day versus 365 -day yields n Some securities are reported using a 360 360 -day versus 365 -day yields n Some securities are reported using a 360 year rather than a full 365 day year. n This will mean that the rate quoted will be 5 days too small on a standard annualized basis of 365 days. n To convert from a 360 -day year to a 365 -day year: n i 365 = i 360 (365/360) n Example: one year instrument at 8% nominal rate on a 360 -day year is actually an 8. 11% rate on a 365 -day year: n i 365 = 0. 08 (365/360) = 0. 0811

Discount yields n Some money market instruments, such as Treasury Bills, are quoted on Discount yields n Some money market instruments, such as Treasury Bills, are quoted on a discount basis. n This means that the purchase price is always below the par (or maturity) value. n The difference between the purchase price and par value at maturity represents interest. n The pricing equation for a discount instrument is: idr = [(Pf - Po) / Pf] (360 / h) where idr = discount rate Po = initial price of the instrument Pf = final price at maturity or sale, h = number of days in holding period.

The bond equivalent rate on discount securities n The problems of a 360 -day The bond equivalent rate on discount securities n The problems of a 360 -day year for a rate quoted on a discount basis can be handled by converting the discount rate to a bond equivalent rate: (ibe) n ibe = [(Pf - Po) / Po] (365 / h) n Example: consider a $1 million T-bill with 182 days to maturity, price = $964, 500. The discount rate is 7. 02%, idr = [(1, 000 - 964, 500) / 1, 000] (360 / 182) = 0. 0702 The bond equivalent rate is 7. 38%: idr = [(1, 000 - 964, 500) / 964, 500] (365 / 182) = 0. 0738 The effective annual rate is 7. 52%: i* = [1 + 0. 0738 / (365 / 182)](365/ 182) - 1 = 0. 0752

Yields on single-payment interestbearing securities n Some money market instruments, such as large negotiable Yields on single-payment interestbearing securities n Some money market instruments, such as large negotiable CD’s, Eurodollars, and federal funds, pay interest calculated against the par value of the security and make a single payment of interest and principal at maturity. n Example: consider a 182 -day CD with a par value of $1, 000 and a quoted rate of 7. 02%. Actual interest paid at maturity is: n n n (0. 0702)(182 / 360) $1, 000 = $35, 490 The 365 day yield is: i 365 = 0. 0702(365 / 360) = 0. 0712 The effective annual rate is 7. 24%: i* = {1 + [0. 0712 / (365 / 182)]}(365/182) - 1 = 0. 07244

Summary of money market yield quotations and calculations n Simple Interest is: n Discount Summary of money market yield quotations and calculations n Simple Interest is: n Discount Rate idr: n Money Mkt 360 -day rate, i 360 n Bond equivalent 365 day rate, i 365 or ibe: n Effective ann. interest rate, Definitions Pf = final value Po = initial value h=# of days in holding period Discount Yield quotes: Treasury bills Repurchase agreements Commercial paper Bankers acceptances Interest-bearing, Single Payment: Negotiable CDs Federal funds

Bank Management, 6 th edition. Management Timothy W. Koch and S. Scott Mac. Donald Bank Management, 6 th edition. Management Timothy W. Koch and S. Scott Mac. Donald Copyright © 2005 by South-Western, a division of Thomson Learning Funding the Bank and Managing Liquidity Chapter 8

The composition of bank liabilities n There are many different types of liabilities. n The composition of bank liabilities n There are many different types of liabilities. n Some offer transaction capabilities with relatively low or not interest. n Others offer limited check writing capabilities but pay higher interest rates. n Liabilities with long-term fixed maturities generally pay the highest rates. n Customers who hold each instrument respond differently to interest rate changes.

The percentage contribution of various sources of bank funds: a comparison of large versus The percentage contribution of various sources of bank funds: a comparison of large versus small banks: 1992 and 2001 (% of total assets)

The percentage contribution of various sources of bank funds: a comparison of large versus The percentage contribution of various sources of bank funds: a comparison of large versus small banks (continued): 1992 and 2001 (% of total assets)

General decline in core deposits n Transaction accounts have declined in favor of interest General decline in core deposits n Transaction accounts have declined in favor of interest bearing MMDA on small time deposits (less than $100, 000). n Bank reliance on liabilities other than core deposits, including federal funds purchased, securities sold under agreement to repurchase, Federal Home Loan Bank (FHLB) advances, borrowings from the Federal Reserve, and deposits in foreign offices declined over the period 1992– 2001 for large banks but increased for smaller banks. n Except for discount window borrowings, these funds all have large denominations and pay market rates. n They typically have relatively short-term maturities except for some FHLB advances that can extend as long as 20 years.

General decline in core deposits n. Banks use the term volatile liabilities to describe General decline in core deposits n. Banks use the term volatile liabilities to describe purchased funds from rate-sensitive investors n. The types of instruments include federal funds purchased, RPs, jumbo CDs, Eurodollar time deposits, foreign deposits, and any other large-denomination purchased liability. n. Investors in these instruments will move their funds if other institutions pay higher rates or if it is rumored that the issuing bank has financial difficulties.

Average annual cost of liabilities: a comparison of large versus small banks: 2001 Average annual cost of liabilities: a comparison of large versus small banks: 2001

Increased competition for bank funds n Perhaps the most difficult problem facing bank management Increased competition for bank funds n Perhaps the most difficult problem facing bank management is how to develop strategies to compete for funding sources. n First, bank customers have become much more rate conscious. n Second, many customers have demonstrated a strong preference for shorter-term deposits.

Information on the best rates is much easier to find today. Information on the best rates is much easier to find today.

Characteristics of small denomination liabilities n Instruments under $100, 000 are normally held by Characteristics of small denomination liabilities n Instruments under $100, 000 are normally held by individual investors and are not actively traded in the secondary market.

Accounts with transactions privileges n Most banks offer three different accounts with transactions privileges: Accounts with transactions privileges n Most banks offer three different accounts with transactions privileges: 1. 2. 3. demand deposits (DDAs), negotiable orders of withdrawal (NOWs) and automatic transfers from savings (ATS), and money market deposit accounts (MMDAs).

Demand deposit accounts …DDAs are non-interest-bearing checking accounts held by individuals, businesses, and governmental Demand deposit accounts …DDAs are non-interest-bearing checking accounts held by individuals, businesses, and governmental units n NOW account’s are DDA’s that pay interest. n Only individuals and nonprofit organizations can hold NOWs. n This is expected to change very soon.

Money market deposit accounts MMDAs …similar to interest bearing checking accounts but have limited Money market deposit accounts MMDAs …similar to interest bearing checking accounts but have limited transactions. n Provide banks an instrument competitive with money market mutual funds offered by large brokerages. n Limited to six transactions per month, of which only three can be checks. n Attractive to the bank because required reserves are zero while required reserves on DDAs and NOWs are 10 percent. n The bank can invest 100 percent of the funds obtained from MMDA but only 90 percent from checking and NOW.

Electronic money n Consider carefully the impact of technology in banking – almost all Electronic money n Consider carefully the impact of technology in banking – almost all products of the financial services industry can be provided electronically. n You can pay for goods electronically, apply and receive a loan electronically, even invest and transfer funds electronically.

It is estimated that cash accounted for 82. 3% of the total volume of It is estimated that cash accounted for 82. 3% of the total volume of payments in 2000 n Checks were the second largest in terms of volume at n n 10. 3% Electronic payments (ATM, credit cards and debit cards) accounted for 7. 4% of all payments. In terms of the value of transactions, however n cash accounted for only 0. 3% of the total value of transactions n checks were 10. 9% and n electronic payments (AMT, credit cards and debit cards) accounted for 2. 9%. The vast majority of large transactions were wholesale wire transfers such as CHIPS and Fed Wire transactions. Although cash dominates the “small” payment end of transactions, it represents a very small fraction of the total value of payments.

E-cash and e-checks are not Federal Reserve money but rather digital ‘tokens’ somewhat like E-cash and e-checks are not Federal Reserve money but rather digital ‘tokens’ somewhat like bus tokens or casino chips, only electronic versions. n Lauren Bielski in an August, 2000 ABA Banking Journal article argues that emoney “…is arguably more of an electronic instruction to pay than true ‘electronic money. ’”

Electronic money: smart cards n There are basically two types of smart cards: 1. Electronic money: smart cards n There are basically two types of smart cards: 1. 2. n n an intelligent smart card and a memory card. An intelligent smart card contains a microchip with the ability to store and secure information, and makes different responses depending on the requirements of the card issuers specific application needs. Memory type cards simply store information, similar to the stored information on the back of a credit card.

Electronic funds transfer (EFT) …an electronic movement of financial data, designed to eliminate the Electronic funds transfer (EFT) …an electronic movement of financial data, designed to eliminate the paper instruments normally associated with such fund movement. n There are many types of EFTs including: n ACH, n POS, n ATM, n direct deposit, n telephone bill paying, n automated merchant authorization systems, and n pre-authorized payments.

Electronic funds transfer systems n Point of sale (POS) transaction …a sale that is Electronic funds transfer systems n Point of sale (POS) transaction …a sale that is consummated by payment for goods or services received at the point of the sale or a direct debit of the purchase amount to the customer’s checking account. n Automated clearing house (ACH) transaction …an electronically processed payment using a standard data format. n ACH payments are electronic payments of funds and government securities among financial institutions and businesses

Internet bill payment, telephone bill payment, automatic deposits, and bank drafts n Although these Internet bill payment, telephone bill payment, automatic deposits, and bank drafts n Although these types of payments seem to be electronic, paper checks are still often written on the customer’s behalf and mailed to the business. n These types of payments will most likely become completely electronic in the near future.

Functional cost analysis n The Federal Reserve System conducts a survey called the Functional Functional cost analysis n The Federal Reserve System conducts a survey called the Functional Cost Analysis Program to collect cost and income data on commercial bank operations. n According to functional cost analysis data, demand deposits are the least expensive source of funds.

Functional cost analysis classifies checkprocessing activities as either deposits (electronic and non-electronic), withdrawals (electronic Functional cost analysis classifies checkprocessing activities as either deposits (electronic and non-electronic), withdrawals (electronic and non-electronic), transit checks deposited, transit checks cashed, account opened or closed, on-us checks cashed or general account maintenance (truncated and non-truncated) n Electronic transactions …those that occur through automatic deposits, Internet and telephone bill payment, ATM’s and ACH transactions. n Non-electronic …those transactions conducted in person or by mail.

Functional cost analysis check-processing n Transit checks deposited are defined as checks drawn on Functional cost analysis check-processing n Transit checks deposited are defined as checks drawn on any bank other than the subject bank. n On-us checks cashed are checks drawn on the bank’s customer's account. n Deposits represent checks or currency directly deposited in the customer's account. n Account maintenance refers to general record maintenance and preparing and mailing a periodic statement. n A truncated account is a checking account in which the physical check is ‘truncated’ at the bank; i. e. , checks are not returned to the customer. n Official check issued would be for certified funds. n Net indirect costs are those cost not directly related to the product such as salaries to manage the bank or general overhead cost applicable to all products at the bank.

Small time deposits n Small time deposits have denominations under $100, 000, specified maturities Small time deposits n Small time deposits have denominations under $100, 000, specified maturities ranging from seven days to any longer negotiated term. n Banks can control the flow of deposits by offering only products with specific maturities and minimum balances and varying the relative rates paid according to these terms.

Service charges n For many years, banks priced check handling services below cost. n Service charges n For many years, banks priced check handling services below cost. n While competition may have forced this procedure, it was acceptable because banks paid below-market rates on most deposits. n Because banks now pay market rates on deposits, they want all customers to pay at least what the services cost. n For most customers, service charges and fees for banking services have increased substantially in the 1990 s.

Individual transaction account pricing Individual transaction account pricing

Interest cost and net cost of transaction accounts n The average historical cost of Interest cost and net cost of transaction accounts n The average historical cost of funds is a measure of average unit borrowing costs for existing funds. n Average interest cost for the total portfolio is calculated by dividing total interest expense by the average dollar amount of liabilities outstanding. n Average historical interest costs for a single source of funds can be calculated as the ratio of interest expense by source to the average outstanding debt for that source during the period.

Interest costs alone, however, dramatically understate the effective cost of transaction accounts. 1. First, Interest costs alone, however, dramatically understate the effective cost of transaction accounts. 1. First, transaction accounts are subject to legal reserve requirements of up to 10 percent of the outstanding balances, invested in non-earning assets (federal reserve deposits or vault cash). n This effectively increases the cost of transactional accounts because a reduced portion of the balances can be invested. n Non transactional accounts have no reserve requirements and hence are cheaper, ceteris paribus, because 100 percent of the funds can be invested. 2. Second, transaction accounts are subject to processing costs. 3. Third, certain fees are charged on some accounts to offset noninterest expenses and this reduces the cost of these funds to the bank.

Calculating the net cost of transaction accounts n Annual historical net cost of bank Calculating the net cost of transaction accounts n Annual historical net cost of bank liabilities is historical interest expense plus noninterest expense (net of noninterest income) divided by the investable amount of funds: n A regular checking account that does not pay interest has $20. 69 in transaction costs, charges $7. 75 in fees, an average balance of $5, 515, 5% float would have a net cost of: Required reserves on transactions account are 10%.

Characteristics of large denomination liabilities n In addition to small denomination deposits, banks purchase Characteristics of large denomination liabilities n In addition to small denomination deposits, banks purchase funds in the money markets. n Money center and large regional banks effect most transactions over the telephone, either directly with trading partners or through brokers. n Smaller banks generally deal directly with customers and have limited access to national and international markets. n Because customers move their investments on the basis of small rate differentials, these funds are labeled ‘hot money’ or volatile liabilities.

Jumbo CDs …large, negotiable certificates of $100, 000 or more are referred to as Jumbo CDs …large, negotiable certificates of $100, 000 or more are referred to as jumbo CDs. n Jumbo CDs are: n issued primarily by the largest banks. n purchased by businesses and governmental units. n CDs have grown to be the one of the most popular hot-money, large-source financing used by banks. n n n have a minimum maturity of 7 days. interest rates are quoted on a 360 -day year. Insured up to $100, 000 per investor per institution. n Banks issue jumbo CDs directly or indirectly through dealers and brokers (brokered deposits).

Immediately available funds n Two types of balances are immediately available: 1. deposit liabilities Immediately available funds n Two types of balances are immediately available: 1. deposit liabilities held at Federal Reserve Banks and 2. certain ‘collected’ liabilities of commercial banks that may be transferred or withdrawn during a business day on order of the account holder.

Federal Funds purchased n The term federal funds is often used to refer to Federal Funds purchased n The term federal funds is often used to refer to excess reserve balances traded between banks. n This is grossly inaccurate, given reserves averaging as a method of computing reserves, different nonbank players in the market, and the motivation behind many trades. n Most transactions are overnight loans, although maturities are negotiated and can extend up to several weeks. n Interest rates are negotiated between trading partners and are quoted on a 360 -day basis.

Security repurchase agreements …(RPs or Repos) are short-term loans secured by government securities that Security repurchase agreements …(RPs or Repos) are short-term loans secured by government securities that are settled in immediately available funds n Technically, the loans embody a sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest. n In most cases, the market value of the collateral is set above the loan amount when the contract is negotiated. n This difference is labeled the margin.

Foreign Office Deposits …most large U. S. commercial banks compete aggressively in international markets Foreign Office Deposits …most large U. S. commercial banks compete aggressively in international markets n They borrow from and extend credit to foreign-based individuals, corporations, and governments. n In recent years international financial markets and multinational businesses have become increasingly sophisticated to the point where bank customers go overseas for cheaper financing and feel unfettered by national boundaries. n Transactions in short-term international markets often take place in the Eurocurrency market. n Eurocurrency …financial claim denominated in a currency other than that of the country where the issuing institution is located. n The most important Eurocurrency is the Eurodollar

Eurodollar liabilities …transactions in short-term international markets take place in the Eurocurrency market. n Eurodollar liabilities …transactions in short-term international markets take place in the Eurocurrency market. n The term Eurocurrency refers to a financial claim denominated in a currency other than that of the country where the issuing institution is located. n Eurodollar, a dollar-denominated financial claim at a bank outside the United States.

Individual retirement accounts …savings plans for wage earners and their spouses n The primary Individual retirement accounts …savings plans for wage earners and their spouses n The primary attraction of IRAs is their tax benefits. n Each wage earner can invest up to $5, 000 in 2008 ( if < 49) or $6000 if > 50 of earned income annually in an IRA. n Prior to 1987, the principal contribution was tax-deductible, and any accumulated earnings in the account were taxdeferred until withdrawn. n The Tax Reform Act of 1986 removed the tax- deductibility of contributions for individuals already covered by qualified pension plans if they earned enough income.

Federal Home Loan Bank Advances n The FHLB system is a government-sponsored enterprise created Federal Home Loan Bank Advances n The FHLB system is a government-sponsored enterprise created to assist in home buying. n The FHLB system is one of the largest U. S. financial institutions, rated AAA (Aaa) because of the government sponsorship. n Any bank can become a member of the FHLB system by buying FHLB stock. n If it has the available collateral, primarily real estate related loans, it can borrow from the FHLB. n n n Gramm-Leach-Bliley made it easier for smaller banks to borrow for non-real estate related loans. GLB allows Banks with less than $500 million in assets to use long-term advances for loans to small businesses, small farms and small agri-businesses. The act also established a new permanent capital structure for the FHLBs with two classes of stock authorized, redeemable on 6 -months and 5 -years notice. n FHLB borrowings, or advances, have maturities as short as 1 day or as long as 10 years.

Greater competition for funds and the authorization of new uses for FHLB advances has Greater competition for funds and the authorization of new uses for FHLB advances has resulted in rapid growth in the number of banks with FHLB borrowing and the dollar amount of these borrowings. 250 4500 $ Billions of FHLB Advances Outstanding Number of Commercial Banks with FHLB Advances 200 3750 3000 150 2250 100 1500 50 750 0 0 Dec- Dec- Dec- Dec 91 92 93 94 95 96 97 98 99 00 01 Number of CB with FHLB Advances $ Billions of FHLB Advances Outstanding Commercial Banks With FHLB Advances

A recent trend is banks using longerterm FHLB advances as a more permanent source A recent trend is banks using longerterm FHLB advances as a more permanent source of funding. n The interest compares favorably with the cost of jumbo CDs and other purchases liabilities. n The range of potential maturities allows banks to better manage their interest rate risk. n The interesting issue is whether these advances are truly a permanent source of funds and thus comparable to core deposits, or whether they are hot money.

Measuring the cost of funds n Average historical cost n Versus the marginal cost Measuring the cost of funds n Average historical cost n Versus the marginal cost of funds

Average historical net cost …many banks incorrectly use the average historical costs in their Average historical net cost …many banks incorrectly use the average historical costs in their pricing decisions n They simply add historical interest expense with noninterest expense (net of noninterest income) and divide by the investable amount of funds to determine the minimum return required on earning assets. n Any profit is represented as a markup n The primary problem with historical costs is that they provide no information as to whether future interest costs will rise or fall. n Pricing decisions should be based on marginal costs compared with marginal revenues.

Marginal cost of bank funds n Marginal cost of debt …a measure of the Marginal cost of bank funds n Marginal cost of debt …a measure of the borrowing cost paid to acquire one additional unit of investable funds n Marginal cost of equity capital …a measure of the minimum acceptable rate of return required by shareholders. n Together, the marginal costs of debt and equity constitute the marginal cost of funds, which can be viewed as independent sources or as a pool of funds.

Costs of independent sources of funds n Unfortunately, it is difficult to measure marginal Costs of independent sources of funds n Unfortunately, it is difficult to measure marginal costs precisely. n Management must include both the interest and noninterest costs it expects to pay and identify which portion of the acquired funds can be invested in earning assets. n Conceptually, marginal costs may be defined as :

Example: Marginal costs of a hypothetical NOW account n Assume: n market interest rate Example: Marginal costs of a hypothetical NOW account n Assume: n market interest rate = 2. 5% n servicing costs = 4. 1% n acquisition costs = 1. 0% of balances n deposit insurance costs = 0. 25% of balances n percentage in nonearning assets = 15. 0% (10% required reserves and 5% float. ) n The estimated marginal cost is 9. 24%:

Cost of debt … the cost of long-term nondeposit debt equals the effective cost Cost of debt … the cost of long-term nondeposit debt equals the effective cost of borrowing from each source, including interest expense and transactions costs. n Traditional analysis suggests that this cost is the discount rate, which equates the present value of expected interest and principal payments with the net proceeds to the bank from the issue.

Example: Cost of subordinated notes n Assume the bank will issue: $10 million in Example: Cost of subordinated notes n Assume the bank will issue: $10 million in par value subordinated notes n paying $700, 000 in annual interest and n carrying a 7 -year maturity. n It must pay $100, 000 in flotation costs to an underwriter. n The effective cost of borrowing (kd), where t equals the time period for each cash flow, is 7. 19%: n

Cost of equity … conceptually, the marginal cost of equity equals the required return Cost of equity … conceptually, the marginal cost of equity equals the required return to shareholders n It is not directly measurable because dividend payments are not mandatory. n Still, several methods are commonly used to approximate this required return: 1. 2. 3. Dividend valuation model Capital asset pricing model (CAPM) Targeted return on equity model

Dividend valuation model …this model discounts the expected cash flows from owning stock in Dividend valuation model …this model discounts the expected cash flows from owning stock in determining a reasonable return to shareholders. n The cost of equity equals the discount rate (required return) used to convert future cash flows to their present value equivalent: where Dt = the dollar value of the expected dividend in period t ke = cost of equity, and t = time period n If dividends are expected to grow at a constant rate: Do = the expected % dividend yield g = the expected growth in earnings, dividend payments, and stock price appreciation.

Example: Cost of Bank Stock n A bank’s stock currently trades at: n $24 Example: Cost of Bank Stock n A bank’s stock currently trades at: n $24 per share and n pays a $1 annual dividend. n analysts’ forecasts the bank’s annual dividends will increase by an average 10 percent annually. n The estimated equity cost is 14. 58%:

Capital asset pricing model (CAPM) … this model relates market risk, measured by Beta Capital asset pricing model (CAPM) … this model relates market risk, measured by Beta ( ), to shareholders’ required returns. n Formally, the required return to shareholders (ke') equals the riskless rate of return (rf) plus a risk premium (r) on common stock reflecting nondiversifiable market risk: n The risk premium equals the product of a security’s Beta and the difference between the expected return on the market portfolio (km) and the expected riskless rate of return (rf). n Beta measures a stock’s historical price volatility relative to the price volatility of the market portfolio as:

Estimate the required return to shareholders for individual securities n Banks can use historical Estimate the required return to shareholders for individual securities n Banks can use historical b estimates and a projection of the market premium (km' - rf) to estimate the required return to shareholders for individual securities:

Example: …CAPM estimate for the bank’s cost of equity n Assume: n a bank’s Example: …CAPM estimate for the bank’s cost of equity n Assume: n a bank’s b estimate equals 1. 42 n assume the differential between the market return (km) and risk-free return (rf) is expected to average 5 percent, with the Treasury bill rate expected to equal 6 percent n The CAPM estimate for the bank’s cost of equity is: ke = 0. 06 + 1. 42 (0. 05) = 13. 1% n This cost of equity should be converted to a pretax equivalent, 19. 85, % assuming a 34% marginal tax rate.

Targeted return on equity model …investors require higher pretax returns on common stock than Targeted return on equity model …investors require higher pretax returns on common stock than on debt issues because of the greater assumed credit risk. n Many banks use a targeted return on equity guideline based on the cost of debt plus a premium to evaluate the cost of equity. n This return is then converted to a pretax equivalent yield. n It assumes that the market value of bank equity equals the book value of equity.

Cost of preferred stock: n Preferred stock has characteristics of debt and common equity. Cost of preferred stock: n Preferred stock has characteristics of debt and common equity. n It represents ownership with investors’ claims superior to those of common stockholders but subordinated to those of debtholders. n Like common stock, preferred stock pays dividends that may be deferred when management determines that earnings are too low. n The marginal cost of preferred stock (kp) can be approximated in the same manner as the return on common equity; however, dividend growth is zero: where Dp = contractual dividend payment, Pp = net price of preferred stock,

Trust preferred stock …a hybrid form of equity capital at banks n Trust preferred Trust preferred stock …a hybrid form of equity capital at banks n Trust preferred stock is recent innovation in capital financing. n Attractive because it effectively pays dividends that are tax deductible. n To issue the securities, a bank or bank holding company establishes a trust company. n The trust company sells preferred stock to investors and loans the proceeds of the issue to the bank. n Interest on the loan equals dividends paid on the preferred stock. n This loan interest is tax deductible such that the bank effectively gets to deduct dividend payments as the preferred stock. n The after tax cost of trust preferred stock would be: ktp = where Dtp = contractual dividend payment on trust preferred, Ptp = net price of trust preferred stock,

Weighted marginal cost of total funds: …the best cost measure for asset-pricing purposes is Weighted marginal cost of total funds: …the best cost measure for asset-pricing purposes is a weighted marginal cost of funds (WMC) n This measure recognizes both explicit and implicit costs associated with any single source of funds. n It assumes that all assets are financed from a pool of funds and that specific sources of funds are not tied directly to specific uses of funds.

WMC is computed in three stages. First, management must forecast the desired dollar amount WMC is computed in three stages. First, management must forecast the desired dollar amount of financing to be obtained from each individual debt source and equity. 2. Second, management must estimate the marginal cost of each independent source of funds. 3. Finally, management should combine the individual estimates to project the weighted cost, which equals the sum of the weighted component costs across all sources. n Each source’s weight (wj) equals the expected dollar amount of financing from that source divided by the dollar amount of total liabilities and equity and kj equals the single-source j component cost of financing: 1.

Forecast of the weighted marginal cost of funds …projected figures for community state bank Forecast of the weighted marginal cost of funds …projected figures for community state bank

Revised forecast of the weighted cost of funds Revised forecast of the weighted cost of funds

Banks face two fundamental problems in managing liabilities: 1. Uncertainty over what rates they Banks face two fundamental problems in managing liabilities: 1. Uncertainty over what rates they must pay to retain and attract funds and 2. Uncertainty over the likelihood that customers will withdraw their money regardless of rates.

Funding sources and interest rate risk: n During the 1980’s, most banks experienced a Funding sources and interest rate risk: n During the 1980’s, most banks experienced a shift in composition of liabilities away from demand deposits into interest-bearing time deposits and other borrowed funds. n This shift reflects three phenomena 1. 2. 3. n the removal of Regulation Q interest rate ceilings, a volatile interest rate environment and the development of new deposit and money market products. The cumulative effect was to increase the interest sensitivity of funding operations.

Reducing interest rate risk … one widely recognized strategy to reduce interest rate risk Reducing interest rate risk … one widely recognized strategy to reduce interest rate risk and the long-term cost of bank funds is to aggressively compete for core deposits. n Individuals are generally not as rate sensitive as corporate depositors. n Once a bank attracts deposit business, many individuals will maintain their balances through rate cycles as long as the bank provides good service and pays attention to them. n Such deposits are thus more stable than money market liabilities.

Funding sources and liquidity risk n The liquidity risk associated with all liabilities has Funding sources and liquidity risk n The liquidity risk associated with all liabilities has risen in recent years. n Depositors often simply compare rates and move their funds between investment vehicles to earn the highest yields. n The liquidity risk facing any one bank depends on the competitive environment. n Again, it is important to note the liquidity advantage that stable core deposits provide an acquiring bank.

Funding sources and credit risk n Changes in the composition and cost of bank Funding sources and credit risk n Changes in the composition and cost of bank funds can indirectly affect a bank’s credit risk by forcing it to reduce asset quality. n Example: banks that have substituted purchased funds for lost demand deposits have seen their cost of funds rise. n Rather than let their interest margins deteriorate, many banks make riskier loans at higher promised yields. n While they might maintain their margins in the nearterm, later loan losses typically rise with the decline in asset quality.

Funding sources and bank safety n Changes in the composition and cost of bank Funding sources and bank safety n Changes in the composition and cost of bank funds have clearly lowered traditional earnings. n This decrease slows capital growth and increases leverage ratios. n Borrowing costs will ultimately increase unless noninterest income offsets this decline or banks obtain new external capital. n Bank safety has thus declined in the aggregate.

Risk characteristics …when a bank is perceived to have asset quality problems, uninsured customers Risk characteristics …when a bank is perceived to have asset quality problems, uninsured customers move their deposits. Bank’s with asset quality problems must pay substantial premiums to attract funds or rely on regulatory agencies to extend emergency credit. n Liquidity risk associated with a bank’s deposit base is a function of many factors, including: 1. the number of depositors, 2. average size of accounts, 3. location of the depositor, and 4. specific maturity and rate characteristics of each account. n Equally important is the interest elasticity of customer demand for each funding source. n

Borrowing from the Federal Reserve. n Federal Reserve Banks are authorized to make loans Borrowing from the Federal Reserve. n Federal Reserve Banks are authorized to make loans to depository institutions to help them meet reserve requirements. n DIDMCA opened borrowing to any depository institution that offers transactions accounts subject to reserve requirements. n The borrowing facility is called the discount window. n Discount window loans directly increase a member bank’s reserve assets.

Federal Reserve policies distinguish among three types of loans. 1. 2. 3. Short-term adjustment Federal Reserve policies distinguish among three types of loans. 1. 2. 3. Short-term adjustment loans …made to banks with unexpected deposit outflow or overdrafts caused by computer problems Seasonal borrowing privilege …small banks are permitted to borrow if they can demonstrate that they experience systematic and predictable deposit withdrawals or new loan demand Extended credit …loans granted to banks experiencing more permanent deposit outflows, typically associated with a run on the bank

Federal Deposit Insurance n The Banking Act of 1933 established the FDIC and authorized Federal Deposit Insurance n The Banking Act of 1933 established the FDIC and authorized federal insurance for bank deposits up to $2, 500, today the amount has been set at $100, 000. n The Financial Institution Reform, Recovery, and Enforcement Act of 1989 (FIRREA) authorized the issuance of bonds to finance the bailout of the FSLIC and resources to close problem thrifts. n The Act also created two new insurance funds: 1. Savings Association Insurance Fund (SAIF) 2. Bank Insurance Fund (BIF). n It further created the Resolution Trust Corporation to handle failed thrifts.

Federal Deposit Insurance (continued) n The Federal Deposit Insurance Corp. Improvement Act (FDICIA) authorized: Federal Deposit Insurance (continued) n The Federal Deposit Insurance Corp. Improvement Act (FDICIA) authorized: n Risk-based deposit insurance premiums ranging from $0. 0 to $0. 27 per $100, depending on a bank’s capital position. n At the end 2001, the FDIC insurance fund exceeded the minimum 1. 25% of insured deposits, which meant that “well capitalized” banks paid no insurance premium. n At the end of 2001, over 92% of all banks were considered well capitalized. n Most expect that the economic problems of the early 2000’s will mean that bank’s are again assessed insurance premiums.

When an insured bank fails, the FDIC has five basic options… 1. 2. 3. When an insured bank fails, the FDIC has five basic options… 1. 2. 3. 4. 5. Purchase and Assumption n Bid’s are accepted by healthy banks for the failed bank’s good loans and other assets Open bank assistance n An acquiring bank is provided financial assistance by the FDIC in acquiring a failing bank Insured deposit assumption or transfer n Insured deposits are transferred to a health bank Bridge Bank n The FDIC will operate the bank for a short period of time until it can find the appropriate buyer Payout option n The FDIC immediately (one week) pays depositors the full amount of their insured funds

Bank Management, 6 th edition. Management Timothy W. Koch and S. Scott Mac. Donald Bank Management, 6 th edition. Management Timothy W. Koch and S. Scott Mac. Donald Copyright © 2005 by South-Western, a division of Thomson Learning THE EFFECTIVE USE OF CAPITAL Chapter 9

Why worry about bank capital? …capital reduces the risk of failure by acting as Why worry about bank capital? …capital reduces the risk of failure by acting as a cushion against losses and by providing access to financial markets to meet liquidity needs. A While bank capital-to-asset ratios averaged near 20% at the turn of the century, comparable ratios today are closer to 8 percent. 15. 00% Historical Trends in Bank Capital Growth Rate in Total Capital 13. 00% 11. 00% Total Capital to Total Assets 9. 00% 7. 00% 5. 00% 3. 00% 1. 00% 01 20 98 19 95 19 92 19 89 19 86 19 83 19 80 19 77 19 74 19 71 19 68 19 65 19 62 19 59 19 56 19 53 19 50 19 47 19 44 19 41 19 38 19 19 35 -1. 00%

Risk-based capital standards n During the last half of the 1980 s, for example, Risk-based capital standards n During the last half of the 1980 s, for example, all U. S. banks were required to meet a 5. 5% minimum primary capital requirement and a 6 percent minimum total capital requirement. n Primary capital consisted of stockholders equity, perpetual preferred stock, mandatory convertible debt, and loan loss reserves.

The Basle agreement n In 1986, U. S. bank regulators proposed that U. S. The Basle agreement n In 1986, U. S. bank regulators proposed that U. S. banks be required to maintain capital that reflects the riskiness of bank assets. n By 1988, the proposal had grown to include risk-based capital standards for banks in 12 industrialized nations according to the terms of the Basle Agreement. n Regulations were fully in place by the end of 1992.

Terms of the Basle Agreement varied, primarily in terms of what constitutes capital, but Terms of the Basle Agreement varied, primarily in terms of what constitutes capital, but there are common elements. n Minimum capital requirement is linked to its credit risk as determined by the composition of assets. n Stockholders' equity is deemed to be the most critical type of capital. n Minimum capital requirement increased to 8% for total capital. n Capital requirements were approximately standardized between countries to 'Level the playing field. '

Risk-based elements of the plan n To determine minimum capital requirements, bank managers follow Risk-based elements of the plan n To determine minimum capital requirements, bank managers follow a four-step process: 1. Classify assets into one of four risk categories; 2. Classify off-balance sheet commitments and guarantees into the appropriate risk categories; 3. Multiply the dollar amount of assets in each risk category by the appropriate risk weight; this equals risk-weighted assets; and 4. Multiply risk-weighted assets by the minimum capital percentages, currently either 4 percent or 8 percent.

Regional National Bank (RNB), risk-based capital Regional National Bank (RNB), risk-based capital

Regional National Bank (RNB) Risk-based capital Regional National Bank (RNB) Risk-based capital

Regional National Bank (RNB) Risk-based capital (continued) Regional National Bank (RNB) Risk-based capital (continued)

General descriptions of the four risk categories General descriptions of the four risk categories

What constitutes bank capital? …according to accounting definition, capital or net worth equals the What constitutes bank capital? …according to accounting definition, capital or net worth equals the cumulative value of assets minus the cumulative value of liabilities, and represents ownership interest in a firm. n Total equity capital equals the sum of: n common stock, n surplus, n undivided profits and capital reserves, and n net unrealized holding gains (losses) on availablefor-sale securities and cumulative foreign currency translation adjustments, and n perpetual preferred stock

Risk-based capital standards …two measures of qualifying bank capital 1. Tier 1 or core Risk-based capital standards …two measures of qualifying bank capital 1. Tier 1 or core capital consists of (4% required): n n qualifying perpetual preferred stock, and n 2. common equity, minority interest in consolidated subsidiaries, less intangible assets such as goodwill. Tier 2 capital or supplementary capital (4% req. ): n allowance for loan loss reserves up to 1. 25 percent of risk-weighted assets, n preferred stock, and n mandatory convertible debt.

Leverage capital ratios n Regulators are also concerned that a bank could acquire so Leverage capital ratios n Regulators are also concerned that a bank could acquire so many low-risk assets that risk-based capital requirements would be negligible n hence, regulators have also imposed a 3 percent leverage capital ratio, defined as: n Tier 1 capital divided by total assets net of goodwill and disallowed intangible assets and deferred tax assets. n This capital requirement was implemented to prevent banks from operating with little or no capital, even though risk-based standards might allow it.

Risk-based capital ratios for different-sized U. S. Commercial banks Risk-based capital ratios for different-sized U. S. Commercial banks

FDICIA and bank capital standards n Effective December 1991, Congress passed the Federal Deposit FDICIA and bank capital standards n Effective December 1991, Congress passed the Federal Deposit Insurance Improvement Act (FDICIA) with the intent of revising bank capital requirements to: n emphasize the importance of capital and n authorize early regulatory intervention in problem institutions, and n authorized regulators to measure interest rate risk at banks and require additional capital when it is deemed excessive. n A focal point of the Act was the system of prompt corrective action, which divides banks into categories or zones according to their capital positions and mandates action when capital minimums are not met.

Five capital categories of FDICIA. n Not subject to regulatory directives regarding capital: 1. Five capital categories of FDICIA. n Not subject to regulatory directives regarding capital: 1. 2. well-capitalized and adequately capitalized banks n Subject to regulatory restrictions: 3. Undercapitalized, 4. significantly undercapitalized and 5. critically undercapitalized

Capital categories under FDICA Capital categories under FDICA

Prompt regulatory action under FDICIA Prompt regulatory action under FDICIA

Tier 3 capital requirements for market risk …many large banks have dramatically increased the Tier 3 capital requirements for market risk …many large banks have dramatically increased the size and activity of their trading accounts, resulting in greater exposure to market risk. n Market risk is the risk of loss to the bank from fluctuations in interest rates, equity prices, foreign exchange rates, commodity prices, and exposure to specific risk associated with debt and equity positions in the bank’s trading portfolio. n Market risk exposure is, therefore, a function of the volatility of these rates and prices and the corresponding sensitivity of the bank’s trading assets and liabilities.

Tier 3 capital requirements for market risk … risk-based capital requires banks with significant Tier 3 capital requirements for market risk … risk-based capital requires banks with significant market risk to measure their market risk exposure and hold sufficient capital to mitigate this exposure. n A bank is subject to market risk capital guidelines …if consolidated trading activity (the sum of trading assets and liabilities for the previous quarter) equals 10 percent or more of the bank’s total assets for the previous quarter, or $1 billion or more in total dollar value. n Banks subject to market risk capital guidelines must maintain an overall minimum 8 percent ratio of total qualifying capital to risk-weighted assets and market risk equivalent assets. n Tier 3 capital allocated for market risk plus Tier 2 capital allocated for market risk are limited to 71. 4 percent of a bank’s measure for market risk.

Value-at-risk n Market risk exposure is a function of the volatility of rates and Value-at-risk n Market risk exposure is a function of the volatility of rates and prices and the corresponding sensitivity of the bank's trading assets and liabilities. n The largest banks use a value-at-risk (VAR) based capital charge, estimated by using an internally generated risk measurement model.

The original Basel Accord’s approach to capital requirements was primarily based on credit risk. The original Basel Accord’s approach to capital requirements was primarily based on credit risk. n Although it set appropriate protections from a market- and credit-risk perspective, it did not address operational or other types of risk. n Operational risk itself is not new to financial institutions. n It’s the first risk a bank must manage, even before making its first loan or executing its first trade. n By 2005, a bank’s regulatory capital needs could increase significantly—up to 20 percent of total riskbased capital—as a result of its exposure to operational risk.

The new BASEL capital accord (BASEL II) and operational risk n September 11, 2001 The new BASEL capital accord (BASEL II) and operational risk n September 11, 2001 tragically demonstrated the need for banks to protect themselves against operational risk to their systems and people. n Starting in 2005, regulators will calculate capital according to the recently adopted Basel II Accord. n The new focus of Basel II is operational risk. n The focus is on the optimum use of capital in the technology and business process operations areas. n The Basel Committee defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events. ”

Functions of bank capital n Provides a cushion for firms to absorb losses and Functions of bank capital n Provides a cushion for firms to absorb losses and remain solvent. n Provides ready access to financial markets, guards against liquidity problems. n Constrains growth and limits risk-taking: TA / TA = EQ / EQ

Example: TA / TA = EQ / EQ n Assume ROA=1. 1%, 7% equity, Example: TA / TA = EQ / EQ n Assume ROA=1. 1%, 7% equity, DR=40%:

Weakness of risk-based capital standards n Current standards only account for credit and market Weakness of risk-based capital standards n Current standards only account for credit and market risk at large banks with extensive trading operations. n The new Basel II also accounts for operational risk. n Book value of capital is not the most meaningful measure of soundness. n Ignores changes in market values, unrealized gains or losses on held-to-maturity investments, bank charter value, and FDIC insurance. n Trading account securities must be marked-to-market and unrealized gains and losses reported on the income statement, but other bank assets and liabilities are generally listed at book value n Loan Loss Allowance, is anticipated default losses but does not generally take into account the change in value of the loans from changes in interest rates.

The effect of capital requirements on bank operating policies: limiting growth The effect of capital requirements on bank operating policies: limiting growth

External capital sources n Banks that choose to expand more rapidly must obtain additional External capital sources n Banks that choose to expand more rapidly must obtain additional capital from external sources, a capability determined by asset size. n Large banks tap the capital markets regularly, but small banks must pay a premium to obtain capital, if it is available at all. n Capital sources can be grouped into one of four categories: 1. 2. 3. 4. n subordinated debt, common stock, preferred stock, or trust preferred stock and leases. Each carries advantages and disadvantages.

Subordinated debt n Does not qualify as Tier 1 or core capital n Imposes Subordinated debt n Does not qualify as Tier 1 or core capital n Imposes an interest expense burden on the bank when earnings are low. n Subordinated debt offers several advantages to banks. n n interest payments are tax-deductible, generates additional profits for shareholders as long as earnings before interest and taxes exceed interest payments. n Subordinated debt also has shortcomings. n interest and principal payments are mandatory, default if not paid n many issues require sinking funds

Common stock n Common stock is preferred by regulators as a source of external Common stock n Common stock is preferred by regulators as a source of external capital. n It has no fixed maturity and thus represents a permanent source of funds. n Dividend payments are discretionary, n Losses can be charged against equity, not debt, so common stock better protects the FDIC. n Common stock is not as attractive from the bank's perspective due to its high cost because: n dividends are not tax-deductible, n transactions costs on new issues exceed costs on debt, and shareholders are sensitive to earnings dilution and possible loss of control in ownership.

Preferred stock n Preferred stock is a form of equity in which investors' claims Preferred stock n Preferred stock is a form of equity in which investors' claims are senior to those of common stockholders. n As with common stock, preferred stock pays nondeductible dividends n One significant difference is that corporate investors in preferred stock pay taxes on only 20 percent of dividends. n For this reason, institutional investors dominate the market. n Most issues take the form of adjustable-rate perpetual stock.

Trust preferred stock n Trust preferred stock is a hybrid form of equity capital Trust preferred stock n Trust preferred stock is a hybrid form of equity capital at banks. n It is attractive because it effectively pays dividends that are tax deductible. n To issue the security, a bank establishes a trust company. n The trust company sells preferred stock to investors and loans the proceeds of the issue to the bank. n Interest on the loan equals dividends paid on preferred stock. n The loan is tax deductible such that the bank deducts dividend payments. n As a bonus, the preferred stock counts as Tier 1 capital!!

Capital planning n Capital planning is part of the overall asset and liability management Capital planning n Capital planning is part of the overall asset and liability management process. n Bank management makes decisions regarding the amount of risk assumed in operations and potential returns. n The amount and type of capital required is determined simultaneously with the expected composition of assets and liabilities and forecasts of income and expenses. n The greater assumed risk and asset growth, the greater is required capital.

Capital planning: forecast performance measures for a bank with deficient capital ratios Capital planning: forecast performance measures for a bank with deficient capital ratios

Federal deposit insurance n The Banking Act of 1933 established the FDIC and authorized Federal deposit insurance n The Banking Act of 1933 established the FDIC and authorized federal insurance for bank deposits up to $2, 500. Today coverage stands at $100, 000 per account. n The initial objectives of deposit insurance were to prevent liquidity crises caused by large-scale deposit withdrawals and bank failure. n The large number of failures in the late 1980 s and early 1990 s put pressure on the FDIC by slowly depleting the reserve fund.

By the late 1990’s, the FDIC was well funded n The Financial Institution Reform, By the late 1990’s, the FDIC was well funded n The Financial Institution Reform, Recovery, and Enforcement Act of 1989 (FIRREA) authorized the issuance of bonds to finance the bailout of the FSLIC and provide resources to close problem thrifts. n The Deposit Insurance Funds Act of 1996 (DIFA) was enacted on September 30, 1996 1. 2. 3. Included both a one-time assessment on SAIF deposits to capitalize the SAIF fund Required the repayment of the Financing Corporation (FICO) bonds Mandated the ultimate elimination of the BIF and SAIF funds by merging them into a new Deposit Insurance Fund

Risk-based deposit insurance n FDIC insurance premiums are assessed based on a Risk-Based Deposit Risk-based deposit insurance n FDIC insurance premiums are assessed based on a Risk-Based Deposit Insurance system required by the FDIC Improvement Act of 1991 and adopted in September 1992. n These premiums are reviewed semiannually by the FDIC to ensure that: n n premiums appropriately reflect the risks posed to the insurance funds and that fund reserve ratios are maintained at or above the target Designated Reserve Ratio (DRR) of 1. 25 percent of insured deposits n Deposit insurance premiums are assessed as basis points per one hundred dollars of insured deposits.

FDIC reserve ratios, fund balance, and insured deposits Insurance Fund Balance as a Percent FDIC reserve ratios, fund balance, and insured deposits Insurance Fund Balance as a Percent of Total Insured Deposits 1. 75% BIF SAIF 1. 50% 1. 25% Target Ratio 1. 00% 0. 75% 0. 50% 0. 25% 0. 00% -0. 25% -0. 50% 1991 1992 1993 1994 1995 1996 Year 1997 1998 1999 2000 2001

At the beginning of 2002, over 93% of banks are listed in the lowest At the beginning of 2002, over 93% of banks are listed in the lowest category and pay no FDIC insurance premiums.

Problems with deposit insurance n Government backed deposit insurance provides for stability of the Problems with deposit insurance n Government backed deposit insurance provides for stability of the financial system by reducing or preventing banking panics and protecting the less sophisticated depositor — but this comes at a price.

Problems with deposit insurance …First, deposit insurance acts similarly to bank capital and is Problems with deposit insurance …First, deposit insurance acts similarly to bank capital and is a substitute for some functions of bank capital. n Investors or depositors look to the company’s capital as a safety net in the event of failure. n Lower capital levels mean firms must pay a risk premium to attract funds or they will find it difficult to borrow money. n A large portion of funds come from insured depositors who do not depend on the bank’s capital position n n A large number of depositors, therefore, do not require a risk premium to be paid by the bank. Normal market discipline which requires the bank to pay a risk premium does not apply to all providers of funds. n Some large banks are considered to be “too-big-to-fail”. n Creditors of a large bank would receive de facto 100% insurance regardless of the size or type of liability.

Problems with deposit insurance …Second, deposit insurance has historically ignored the riskiness of bank Problems with deposit insurance …Second, deposit insurance has historically ignored the riskiness of bank operations, which represents the critical factor that leads to failure. n Two banks with equal amounts of domestic deposits paid the same insurance premium, even though one invested heavily in risky loans and the other owned only U. S. government securities and just 50 percent of its deposits were fully insured. n This creates a moral hazard problem whereby bank managers had an incentive to increase risk. n For example, suppose that a bank had a large portfolio of problem assets that was generating little revenue. n Managers could use deposit insurance to access funds via brokered CDs in $100, 000 blocks.

Problems with deposit insurance … Third, deposit insurance funds were always viewed as providing Problems with deposit insurance … Third, deposit insurance funds were always viewed as providing basic insurance coverage. n Historically, there were three fundamental problems with deposit insurance pricing. n Premiums were not sufficient to cover potential payouts. n n n Deposit insurance coverage slowly increased from $15, 000 per account per institution in 1966 to $20, 000 in 1969, $40, 000 in 1974, and $100, 000 in 1980. n n The FDIC and FSLIC were expected to establish reserves of 5 percent of covered deposits funded by premiums. Reserves never exceeded 2% of insured deposits as Congress kept increasing coverage while premiums were constant. Customers could obtain multiple account coverage at a single institution by carefully structuring ownership of each account. High failure rates during the 1980 s and the insurance funds demonstrate that premiums were inadequate.

Problems with deposit insurance … The final historical problem with deposit insurance is that Problems with deposit insurance … The final historical problem with deposit insurance is that premiums were not assessed against all of a bank’s insured liabilities. n Many liabilities that the federal government effectively guaranteed should have required insurance premiums. n For example, insured deposits consisted only of domestic deposits while foreign deposits were exempt. n The argument was that U. S. banks would be less competitive with foreign bank competitors. n Too-big-to-fail doctrine means that large banks would have coverage on 100% of their deposits but pay as if they only had $100, 000 coverage as smaller banks do. n Regulators were much more willing to fail smaller banks and force uninsured depositors and other creditors to take losses.