The Effective Use of Capital

The Effective Use of Capital
Bank Management, 6th edition. Timothy W. Koch and S. Scott MacDonald Copyright © 2006 by South-Western, a division of Thomson Learning The Effective Use of Capital Chapter 9

Why Worry About Bank Capital?
Capital requirements reduce the risk of failure by acting as a cushion against losses, providing access to financial markets to meet liquidity needs, and limiting growth Bank capital-to-asset ratios have fallen from about 20% a hundred years ago to around 8% today

Trends in Bank Capital: 1934 - 2004

Risk-Based Capital Historically, the minimum capital requirements for banks were independent of the riskiness of the bank Prior to 1990, banks were required to maintain: a primary capital-to-asset ratio of at least 5% to 6%, and a minimum total capital-to-asset ratio of 6%

Risk-Based Capital Primary Capital Common stock
Perpetual preferred stock Surplus Undivided profits Contingency and other capital reserves Mandatory convertible debt Allowance for loan and lease losses

Risk-Based Capital Secondary Capital Total Capital
Long-term subordinated debt Limited-life preferred stock Total Capital Primary Capital + Secondary Capital Capital requirements were independent of a bank’s asset quality, liquidity risk, interest rate risk, operational risk, and other related risks

The Basel Agreement In 1986, U.S. bank regulators proposed that U.S. banks be required to maintain capital that reflects the riskiness of bank assets The Basel Agreement grew to include risk-based capital standards for banks in 12 industrialized nations Regulations apply to both banks and thrifts and have been in place since the end of 1992

The Basel Agreement A bank’s minimum capital requirement is linked to its credit risk The greater the credit risk, the greater the required capital Stockholders' equity is deemed to be the most valuable type of capital Minimum capital requirement increased to 8% total capital to risk-adjusted assets Capital requirements were approximately standardized between countries to ‘level the playing field'

The Basel Agreement Risk-Based Elements of the Plan
Classify assets into one of four risk categories Classify off-balance sheet commitments into the appropriate risk categories Multiply the dollar amount of assets in each risk category by the appropriate risk weight This equals risk-weighted assets Multiply risk-weighted assets by the minimum capital percentages, currently 4% for Tier 1 capital and 8% for total capital

Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Category 1 & 2

Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Category 3 & 4

Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Off Balance Sheet

General Description Of Assets In Each Of The Four Risk Categories

Regional National Bank (RNB), Off-balance Sheet Conversion Worksheet

Summary of Risk Categories and Risk Weights for Risk-based Capital Requirements

What Constitutes Bank Capital?
Capital (Net Worth) The cumulative value of assets minus the cumulative value of liabilities Represents ownership interest in a firm Total Equity Capital Equals the sum of: Common stock Surplus Undivided profits and capital reserves Net unrealized holding gains (losses) on available-for-sale securities Preferred stock

Risk-based capital standards …two measures of qualifying bank capital
Tier 1 (Core) Capital Equals the sum of: Common equity Non-cumulative perpetual preferred stock Minority interest in consolidated subsidiaries, less intangible assets such as goodwill Tier 2 (Supplementary) Capital Cumulative perpetual preferred stock Long-term preferred stock Limited amounts of term-subordinated debt Limited amount of the allowance for loan loss reserves (up to 1.25 percent of risk-weighted assets)

What Constitutes Bank Capital?
Leverage Capital Ratio Equals: Tier 1 capital divided by total assets net of goodwill and disallowed intangible assets and deferred tax assets Regulators are concerned that a bank could acquire practically all low-risk assets such that risk-based capital requirements would be virtually zero To prevent this, regulators have also imposed a 3 percent leverage capital ratio

Risk-based Capital Ratios For Different-sized U. S
Risk-based Capital Ratios For Different-sized U.S. Commercial Banks, 1995–2004

FDICIA and Bank Capital Standards
The Federal Deposit Insurance Improvement Act (FDICIA) focused on revising bank capital requirements to: Emphasize the importance of capital Authorize early regulatory intervention in problem institutions Authorized regulators to measure interest rate risk at banks and require additional capital when it is deemed excessive. The Act required a system for prompt regulatory action It divides banks into categories according to their capital positions and mandates action when capital minimums are not met

Minimum Capital Requirements across Capital Categories

Provisions for Prompt Corrective Action

Tier 3 Capital Requirements for Market Risk
Many large banks have increased the size and activity of their trading accounts, resulting in greater exposure to market risk 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 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 standards now require all banks with significant market risk to measure their market risk exposure and hold sufficient capital to mitigate this exposure A bank is subject to the market risk capital guidelines if its consolidated trading activity equals 10% or more of the bank’s total assets or $1 billion or more in total dollar value Banks subject to the 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

Capital Requirements for Market Risk Using Internal Models
Value-at-Risk (VAR) An internally generated risk measurement model to measure a bank’s market risk exposure It estimates the amount by which the value of a bank’s position in a risk category could decline due to expected losses in the bank’s portfolio because of market movements during a given period, measured with a specified confidence level

What is the Function of Bank Capital?
For regulators, bank capital serves to protect the deposit insurance fund in case of bank failures Bank capital reduces bank risk by: Providing a cushion for firms to absorb losses and remain solvent Providing ready access to financial markets, which provides the bank with liquidity Constraining growth and limits risk taking

How Much Capital is Adequate?
Regulators prefer more capital Reduces the likelihood of bank failures and increases bank liquidity Bankers prefer less capital Lower capital increases ROE, all other things the same Riskier banks should hold more capital while low-risk banks should be allowed to increase financial leverage

How much is “enough” capital?
A “well capitalized” bank: ≥ 5% Core (leverage) capital ≥ 6% Tier 1 risk-based capital ≥ 10 % total risk-based capital Clearly, additional capital is needed for higher risk assets and future growth. Full Year: 2004 Source: FDIC

Weakness of the Risk-Based Capital Standards
Standards only consider credit risk Ignores interest rate risk and liquidity risk It ignores: Changes in the market value of assets Unrealized gains (losses) on held-to-maturity securities The value of the bank’s charter The value of deposit insurance 99% of banks are considered “well capitalized” in Not a binding constraint for most banks

The Effect of Capital Requirements on Bank Operating Policies
Limiting Asset Growth The change in total bank assets is restricted by the amount of bank equity Where TA = Total Assets EQ = Equity Capital ROA = Return on Assets DR = Dividend Payout Ratio EC = New External Capital

Maintaining Capital Ratios With Asset Growth: Application

Operating Policies Effect on Capital Requirements
Changing the Capital Mix Internal versus External capital Change Asset Composition Hold fewer high-risk category assets Pricing Policies Raise rates on higher-risk loans Shrinking the Bank Fewer assets requires less capital

Characteristics of External Capital Sources
Subordinated Debt Advantages Interest payments are tax-deductible No dilution of ownership interest Generates additional profits for shareholders as long as earnings before interest and taxes exceed interest payments Disadvantages Does not qualify as Tier 1 capital Interest and principal payments are mandatory Many issues require sinking funds

Common Stock Advantages Qualifies as Tier 1 capital It has no fixed maturity and thus represents a permanent source of funds Dividend payments are discretionary Losses can be charged against equity, not debt, so common stock better protects the FDIC

Common Stock Disadvantages Dividends are not tax-deductible, Transactions costs on new issues exceed comparable costs on debt Shareholders are sensitive to earnings dilution and possible loss of control in ownership Often not a viable alternative for smaller banks

Preferred Stock A form of equity in which investors' claims are senior to those of common stockholders Dividends are not tax-deductible Corporate investors in preferred stock pay taxes on only 20 percent of dividends Most issues take the form of adjustable-rate perpetual stock

Trust Preferred Stock A hybrid form of equity capital at banks It effectively pays dividends that are tax deductible To issue the security, a bank establishes a trust company The trust company sells preferred stock to investors and loans the proceeds of the issue to the bank Interest on the loan equals dividends paid on preferred stock The interest on the loan is tax deductible such that the bank deducts dividend payments Counts as Tier 1 capital

Leasing Arrangements Many banks enter into sale and leaseback arrangements Example: The bank sells its headquarters and simultaneously leases it back from the buyer The bank receives a large amount of cash and still maintains control of the property The net effect is that the bank takes a fully depreciated asset and turns it into a tax deduction

Capital Planning Process of Capital Planning
Generate pro formal balance sheet and income statements for the bank Select a dividend payout Analyze the costs and benefits of alternative sources of external capital

Capital Planning: Forecast Performance Measures For A Bank With Deficient Capital Ratios

Federal Deposit Insurance
Federal Deposit Insurance Corporation Established in 1933 Coverage is currently $100,000 per depositor per institution Original coverage was $2,500 Initial Objective: Prevent liquidity crises caused by large-scale deposit withdrawals Protect depositors of modes means against a bank failure. The large number of failures in the late 1980s and early 1990s put pressure on the FDIC by slowly depleting the reserve fund

FDIC RESERVE RATIOS, FUND BALANCE, AND INSURED DEPOSITS

The Deposit Insurance Funds Act of 1996 (DIFA)
Included both a one-time assessment on SAIF deposits to capitalize the SAIF fund Mandated the ultimate elimination of the BIF and SAIF funds by merging them into a new Deposit Insurance Fund

Risk-Based Deposit Insurance
FDIC insurance premiums are based on a risk-based deposit insurance system The deposit insurance fund reserve ratios are maintained at or above the target Designated Reserve Ratio of 1.25% of insured deposits Deposit insurance premiums are assessed as basis points per $100 of insured deposits

Over 90% of all BIF-insured institutions pay no assessments
The Current Assessment Rate Schedule For BIF Insured And SAIF-insured Institutions Over 90% of all BIF-insured institutions pay no assessments Subgroup A - Financially sound institutions Subgroup B - Institutions that demonstrate weaknesses that could result in significant deterioration of the institution Subgroup C - Institutions that pose a substantial probability of loss to the BIF or SAIF

Federal Deposit Insurance
Problems with Deposit Insurance Deposit insurance acts similarly to bank capital In banking, a large portion of borrowed funds come from insured depositors who do not look to the bank’s capital position in the event of default A large number of depositors, therefore, do not require a risk premium to be paid by the bank since their funds are insured Normal market discipline in which higher risk requires the bank to pay a risk premium does not apply to insured funds

Problems with Deposit Insurance
Too-Big-To-Fail Many large banks are considered to be “too-big-to-fail” As such, any creditor of a large bank would receive de facto 100 percent insurance coverage regardless of the size or type of liability

Deposit insurance has historically ignored the riskiness of a bank’s operations, which represents the critical factor that leads to failure Two banks with equal amounts of domestic deposits paid the same insurance premium, even though one invested heavily in risky loans and had no uninsured deposits while the other owned only U.S. government securities and just 50 percent of its deposits were fully insured. The creates a moral hazard problem.

Moral hazard problem, whereby bank managers have an incentive to increase risk. For example, suppose that a bank had a large portfolio of problem assets that was generating little revenue. Managers could use deposit insurance to access funds via brokered CDs in $100,000 blocks. They might invest the funds in risky assets knowing that any profits would offset losses on the problem assets. Losses would be absorbed by the insurance fund in the event of default.

Deposit insurance funds were always viewed as providing basic insurance coverage Historically, there has been fundamental problem with the pricing of deposit insurance Premium levels were not sufficient to cover potential payouts The FDIC and FSLIC were initially expected to establish reserves amounting to 5 percent of covered deposits funded by premiums Actual reserves never exceeded two percent of insured deposits as Congress kept increasing coverage while insurance premiums remained constant The high rate of failures during the 1980s and the insurance funds demonstrate that premiums were inadequate

Historically, premiums were not assessed against all of a bank’s insured liabilities Insured deposits consisted only of domestic deposits while foreign deposits were exempt. Too-big-to-fail doctrine toward large banks means that large banks would have coverage on 100 percent of their deposits but pay for the same coverage as if they only had $100,000 coverage as smaller banks do This means that regulators were much more willing to fail smaller banks and force uninsured depositors and other creditors to take losses.

Percentage Of Failed Commercial Banks By Uninsured Depositor Treatment, 1986–1996

BASEL II Capital Standards
The Basel Accord’s approach to capital requirements was primarily based on credit risk, it did not address operational or other types of risk Three Pillars of Regulation Minimum Capital Requirements Supervisory Review Market Discipline

Credit Risk Banks are allowed to choose between two approaches to calculate minimum capital External Credit Assessments Rating Agencies Internal Rating Systems The bank’s own assessment

Operational Risk The risk of loss resulting from inadequate or failed internal processes, people, systems, for from external events Example: 9/11/01 Look at occurrences of fraud

Trading Book (Including Market Risk) Management must demonstrate an ability to value the positions with an emphasis on marking-to-market exposures

Supervisory Review and Market Discipline Banks should have a process for assessing overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies

Supervisory Review Banks should have a process for assessing overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels Supervisors should: Review and evaluate banks’ internal capital adequacy assessments and strategies Expect banks to operate with capital above the minimum regulatory ratios Intervene at an early stage to prevent capital from falling below regulatory minimums

Market Discipline Regulators will encourage market discipline for banks by forcing disclosure of key information pertaining to risk Market participants will be provided with information regarding specific risk exposures, risk assessment practices, actual capital, and required capital so that they can assess the adequacy of capital

Managing the Investment Portfolio
Bank Management, 6th edition. Timothy W. Koch and S. Scott MacDonald Copyright © 2006 by South-Western, a division of Thomson Learning Managing the Investment Portfolio Chapter 13

The Investment Portfolio
Most banks concentrate their asset management efforts on loans Managing investment securities is typically a secondary role, especially at smaller banks Historically, small banks have purchased securities and held them to maturity

Large banks, in contrast, not only buy securities for their own portfolios, but they also: Manage a securities trading account Manage an underwriting subsidiary that helps municipalities issue debt in the money and capital markets

Historically, bank regulators have limited the risk associated with banks owning securities by generally: Prohibiting banks from purchasing common stock (for income purposes) Limiting debt instruments to investment grade securities Increasingly, banks are pursuing active strategies in managing investments in the search for higher yields

Dealer Operations and the Securities Trading Account
When banks purchase securities, they must indicate the underlying objective for accounting purposes: Held-to-Maturity Trading Available-for-Sale

Held to Maturity Securities purchased with the intent and ability to hold to final maturity Carried at historical (amortized) cost on the balance sheet Unrealized gains and losses have no impact on the income statement

Securities purchased with the intent to sell them in the near term Carried at market value on the balance sheet with unrealized gains and losses included in income

Available for Sale: Securities that are not classified as either held-to-maturity securities or trading securities Carried at market value on the balance sheet with unrealized gains and losses included as a component of stockholders’ equity

Banks perform three basic functions within their trading activities: Offer investment advice and assistance to customers managing their own portfolios Maintain an inventory of securities for possible sale to investors Their willingness to buy and sell securities is called making a market Traders speculate on short-term interest rate movements by taking positions in various securities

Banks earn profits from their trading activities in several ways: When making a market, they price securities at an expected positive spread Bid Price the dealer is willing to pay Ask Price the dealer is willing to sell Traders can also earn profits if they correctly anticipate interest rate movements

Objectives of the Investment Portfolio
A bank’s investment portfolio differs markedly from a trading account Objectives of the Investment Portfolio Safety or preservation of capital Liquidity Yield Credit risk diversification Help in manage interest rate risk exposure Assist in meeting pledging requirements

Accounting for Investment Securities FASB 115 requires security holdings to be divided into three categories Held-to-Maturity (HTM) Trading Available-for-Sale The distinction between investment motives is important because of the accounting treatment of each

Accounting for Investment Securities A change in interest rates can dramatically affect the market value of a security The difference between market value and the purchase price equals the unrealized gain or loss on the security; assuming a purchase at par: Unrealized Gain/Loss = Market Value – Par Value

Accounting for Investment Securities Assume interest rates increase and bond prices fall: Held-to-Maturity Securities There is no impact on either the balance sheet or income statement Trading Securities The decline in value is reported as a loss on the income statement Available-for-Sale Securities The decline in value reduces the value of bank capital

Safety or Preservation of Capital A primary objective of the investment portfolio is to preserve capital by purchasing securities when there is only a small risk of principal loss. Regulators encourage this policy by requiring that banks concentrate their holdings in investment grade securities, those rated Baa (BBB) or higher.

Liquidity Commercial banks purchase debt securities to help meet liquidity requirements Securities with maturities under one year can be readily sold for cash near par value and are classified as liquid investments In reality, most securities selling at a premium can also be quickly converted to cash, regardless of maturity, because management is willing to sell them

Investment Portfolio for a Hypothetical Commercial Bank
Liquidity

Yield To be attractive, investment securities must pay a reasonable return for the risks assumed The return may come in the form of price appreciation, periodic coupon interest, and interest-on-interest The return may be fully taxable or exempt from taxes

Diversify Credit Risk The diversification objective is closely linked to the safety objective and difficulties that banks have with diversifying their loan portfolios Too often loans are concentrated in one industry that reflects the specific economic conditions of the region Investment portfolios give banks the opportunity to spread credit risk outside their geographic region and across different industries

Help Manage Interest Rate Exposure Investment securities are very flexible instruments for managing a bank’s overall interest rate risk exposure Banks can select terms that meet their specific needs without fear of antagonizing the borrower They can readily sell the security if their needs change

Pledging Requirements By law, commercial banks must pledge collateral against certain types of liabilities. Banks that borrow via repurchase agreements essentially pledge part of their government securities portfolio against this debt Public deposits Borrowing from the Federal Reserve Borrowing from FHLBs

Composition of the Investment Portfolio
Money market instruments with short maturities and durations include: Treasury bills Large negotiable CDs Bankers acceptances Commercial paper Repurchase agreements Tax anticipation notes.

Capital market instruments with longer maturities and duration include: Long-term U.S. Treasury securities Obligations of U.S. government agencies Obligations of state and local governments and their political subdivisions labeled municipals Mortgage-backed securities backed both by government and private guarantees Corporate bonds Foreign bonds

Characteristics of Taxable Securities
Money Market Investments Highly liquid instruments which mature within one year that are issued by governments and large corporations Very low risk as they are issued by well-known borrowers and a active secondary market exists Banks purchase money market instruments in order to meet liquidity and pledging requirements and earn a reasonable return

Characteristics of Taxable Securities
Capital Market Investments Consists of instruments with original maturities greater than one year Banks are restricted to “investment grade” securities, those rated Baa (BBB) or above; i.e., no junk bonds If banks purchase non-rated securities, they must perform a credit analysis to validate that they are of sufficient quality relative to the promised yield .

Money Market Investments
Repurchase Agreements (Repos) A loan between two parties, with one typically either a securities dealer or commercial bank The lender or investor buys securities from the borrower and simultaneously agrees to sell the securities back at a later date at an agreed-upon price plus interest Essentially are collateralized federal funds transactions

Repurchase Agreements (Repos) The minimum denomination is generally $1 million, with maturities ranging from one day to one year The rate on one-day repos is referred to as the overnight repo rate and is quoted on an add-on basis assuming a 360-day year $ Interest = Par Value x Repo Rate x Days/360 Longer-term transactions are referred to as term repos and the associated rate the term repo rate

Treasury Bills Marketable obligations of the U.S. Treasury that carry original maturities of one year or less They exist only in book-entry form, with the investor simply holding a dated receipt Investors can purchase bills in denominations as small as $1,000, but most transactions involve much larger amounts

Treasury Bills Each week the Treasury auctions bills with 13-week and 26-week maturities Investors submit either competitive or noncompetitive bids With a competitive bid, the purchaser indicates the maturity amount of bills desired and the discount price offered Non-competitive bidders indicate only how much they want to acquire

Treasury Bills Treasury bills are purchased on a discount basis, so the investor’s income equals price appreciation The Treasury bill discount rate is quoted in terms of a 360-day year: Where DR = Discount Rate FV = Face Value P = Purchase Price N = Number of Days to Maturity

Treasury Bills Example: A bank purchases $1 million in face value of 26-week (182-day) bills at $990,390. What is the discount rate and effective yield? The discount rate is: The true (effective) yield is:

Certificates of Deposit Dollar-denominated deposits issued by U.S. banks in the United States Fixed maturities ranging from 7 days to several years Pay yields above Treasury bills. Interest is quoted on an add-on basis, assuming a 360-day year

Eurodollars Dollar-denominated deposits issued by foreign branches of banks outside the United States The Eurodollar market is less regulated than the domestic market, so the perceived riskiness is greater.

Commercial Paper Unsecured promissory notes issued by corporations Proceeds are use to finance short-term working capital needs The issuers are typically the highest quality firms Minimum denomination is $10,000 Maturities range from 3 to 270 days Interest rates are fixed and quoted on a discount basis Small banks purchase large amounts of commercial paper as investments

Bankers Acceptances A draft drawn on a bank by firms that typically are importer or exporters of goods Has a fixed maturity, typically up to nine months Priced as a discount instrument like T-bills

Capital Market Investments
Treasury Notes and Bonds Notes have a maturity of years Bonds have a maturity greater than 10 years Most pay semi-annual coupons Some are zeros or STRIPS Sold via closed auctions Rates are quoted on a coupon-bearing basis with prices expressed in thirty-seconds of a point, $31.25 per $1,000 face value

Treasury STRIPS Many banks purchase zero-coupon Treasury securities as part of their interest rate risk management strategies The U.S. Treasury allows any Treasury with an original maturity of at least 10 years to be “stripped” into its component interest and principal pieces and traded via the Federal Reserve wire transfer system. Each component interest or principal payment constitutes a separate zero coupon security and can be traded separately from the other payments

Treasury STRIPS Example Consider a 10-year, $1 million par value Treasury bond that pays 9 percent coupon interest semiannually ($45,000 every six months) This security can be stripped into 20 separate interest payments of $45,000 each and a single $1 million principal payment, or 21 separate zero coupon securities.

U.S. Government Agency Securities Composed of two groups Members who are formally part of the federal government Federal Housing Administration Export-Import Bank Government National Mortgage Association (Ginnie Mae)

U.S. Government Agency Securities Composed of two groups Members who are government-sponsored agencies Federal Home Loan Mortgage Corporation (Freddie Mac) Federal National Mortgage Association (Fannie Mae) Student Loan Marketing Association (Sallie Mae) Default risk is low even though these securities are not direct obligations of the Treasury; most investors believe there is a moral obligation. These issues normally carry a risk premium of about 10 to 100 basis points.

Callable Agency Bonds Securities issued by government-sponsored enterprises in which the issuer has the option to call the bonds prior to final maturity Typically, there is a call deferment period during which the bonds cannot be called The issuer offers a higher promised yield relative to comparable non-callable bonds The present value of this rate differential essentially represents the call premium

Callable Agency Bonds Banks find these securities attractive because they initially pay a higher yield than otherwise similar non-callable bonds The premium reflects call risk If rates fall sufficiently, the issuer will redeem the bonds early, refinancing at lower rates, and the investor gets the principal back early which must then be invested at lower yields for the same risk profile

Conventional Mortgage-Backed Securities (MBSs) Any security that evidences an undivided interest in the ownership of mortgage loans The most common form of MBS is the pass-through security Even though many MBSs have very low default risk, they exhibit unique interest rate risk due to prepayment risk As rates fall, individuals will refinance

GNMA Pass-Through Securities Government National Mortgage Association (Ginnie Mae) Government entity that buys mortgages for low income housing and guarantees mortgage-backed securities issued by private lenders

Structure of the GNMA Mortgage-Backed Pass-Through Security Issuance Process

FHLMC Federal Home Loan Mortgage Corporation (Freddie Mac) FNMA securities Federal National Mortgage Association (Fannie Mae) Both are: Private corporations Operate with an implicit federal guarantee Buy mortgages financed largely by mortgage-backed securities

Privately Issued Pass-Through Issued by banks and thrifts, with private insurance rather than government guarantee

Prepayment Risk on Mortgage-Backed Securities
Borrowers may prepay the outstanding mortgage principal at any point in time for any reason Prepayments generally occur because of fundamental demographic trends as well as movements in interest rates Prepayments typically increase as interest rates fall and slow as rates increase Forecasting prepayments is not an exact science

Prepayment Risk on Mortgage-Backed Securities
Example: Current mortgage rates are 8% and you buy a MBS paying 8.25% Because rates have fallen, you paid a premium to earn the higher rate With rates only .25% lower, it is unlikely individuals will refinance If rates fall 3%, there will be a large increase in prepayments due to refinancing If the prepayments are fast enough, you may never recover the premium you paid

Prepayment risk on mortgage-backed securities
Measures the value of the MBS if the prepayment rate remains at 6% regardless of the level of mortgage rates. The value of the MBS if the pre-payment rate varies from 6% Prepayment risk on mortgage-backed securities Pre-payment experience is low on new mortgages, increases through five years then declines. Pre-payment rates increase sharply when mortgage rates fall

Unconventional Mortgage-Backed Securities
Collateralized Mortgage Obligations (CMOs) Security backed by a pool of mortgages and structured to fall within an estimated maturity range (tranche) based on the timing of allocated interest and principal payments on the underlying mortgages Tranche: The principal amount related to a specific class of stated maturities on a collateralized mortgage obligation. The first class of bonds has the shortest maturities

Collateralized Mortgage Obligations (CMOs) CMOs were introduced to circumvent some of the prepayment risk associated with the traditional pass-through security CMOs are essentially bonds An originator combines various mortgage pools to serve as collateral and creates classes of bonds with different maturities

Collateralized Mortgage Obligations (CMOs) The first class, or tranche, has the shortest maturity Interest payments are paid to all classes of bonds but principal payments are paid to the first tranche until they have been paid off After the first tranche is paid, principal payments are made to the second tranche, etc

Types of CMOs Planned Amortization Class CMO (PAC) A security that is retired according to a planned amortization schedule, while payments to other classes of securities are slowed or accelerated Least risky of the CMOs Objective is to ensure that PACs exhibit highly predictable maturities and cash flows Z-Tranche Final class of securities in a CMO, exhibiting the longest maturity and greatest price volatility These securities often accrue interest until all other classes are retired

CMOs’ Advantages over MBS Pass-Throughs Some classes (tranches) exhibit less prepayment risk; some exhibit greater prepayment risk Appeal to investors with different maturity preferences by segmenting the securities into maturity classes

Stripped Mortgage-Backed Securities More complicated in terms of structure and pricing characteristics Example: Consider a 30 year, 12% fixed-rate mortgage There will be 30 x 12 (360) payments (principal plus interest Loan amortization means the principal only payments are smaller in the beginning: P1 < P2 < … < P360 Interest only payments decrease over time: I1 > I2 > … > I360

Asset-Backed Securities
Conceptually, an asset-backed security is comparable to a mortgage-backed security in structure The securities are effectively “pass-throughs” since principal and interest are secured by the payments on the specific loans pledged as security Two popular asset-backed securities are: Collateralized automobile receivables (CARS) CARDS Securities backed by credit card loans to individuals

Other Investments Corporate and Foreign Bonds Mutual Funds
At the end of 2004, banks held $560 billion in corporate and foreign bonds Mutual Funds Banks have increased their holdings in mutual funds to over $25 billion in 2004 Mutual fund investments must be marked-to-market and can cause volatility on the values reported on the bank’s balance sheet

Characteristics of Municipal Securities
Municipals are exempt from federal income taxes and generally exempt from state or local as well General obligation Principal and interest payments are backed by the full faith, credit, and taxing authority of the issuer Revenue Bonds Backed by revenues generated from the project the bond proceeds are used to finance Industrial Development Bonds Expenditures of private corporations

Summary of Terms for a Municipal School Bond

Money Market Municipals Municipal notes provide operating funds for government units Banks buy large amounts of short-term municipals They often work closely with municipalities in placing these securities Capital Market Municipals Includes general obligation bonds and revenue bonds

Credit Risk in the Municipal Portfolio Until the 1970s, few municipal securities went into default Deteriorating conditions in many large cities ultimately resulted in defaults by: New York City (1975), Cleveland (1978), Washington Public Power & Supply System (WHOOPS) (1983)

Liquidity Risk Municipals exhibit substantially lower liquidity than Treasury or agency securities The secondary market for municipals is fundamentally an over-the-counter market Small, non-rated issues trade infrequently and at relatively large bid-ask dealer spreads Large issues of nationally known municipalities, state agencies, and states trade more actively at smaller spreads

Liquidity Risk Name recognition is critical, as investors are more comfortable when they can identify the issuer with a specific location Insurance also helps by improving the rating and by association with a known property and casualty insurer

Municipals are less volatile in price than Treasury securities This is generally attributed to the peculiar tax features of municipals The municipal market is segmented On the supply side, municipalities cannot shift between short- and long-term securities to take advantage of yield differences because of constitutional restrictions on balanced operating budgets Thus long-term bonds cannot be substituted for short-term municipals to finance operating expenses, and Capital expenditures are not financed by ST securities

Municipals are less volatile in price than Treasury securities The municipal market is segmented. On the demand side, banks once dominated the market for short-term municipals Today, individuals via tax-exempt money market mutual funds dominate the short maturity spectrum

Establishing Investment Policy Guidelines
Each bank’s asset and liability or risk management committee is responsible for establishing investment policy guidelines These guidelines define the parameters within which investment decisions help meet overall return and risk objectives Because securities are impersonal loans that are easily bought and sold, they can be used at the margin to help achieve a bank’s liquidity, credit risk, and earnings sensitivity or duration gap targets

Establishing Investment Policy Guidelines
Investment guidelines identify specific goals and constraints regarding: Return Objective Composition of Investments Liquidity Considerations Credit Risk Considerations Interest Rate Risk Considerations Total Return Versus Current Income

Active Investment Strategies
Portfolio managers can buy or sell securities to achieve aggregate risk and return objectives Investment strategies can subsequently play an integral role in meeting overall asset and liability management goals Unfortunately, not all banks view their securities portfolio in light of these opportunities

Many smaller banks passively manage their portfolios using simple buy and hold strategies The purported advantages are that such a policy requires limited investment expertise and virtually no management time; lowers transaction costs; and provides for predictable liquidity

Other banks actively manage their portfolios by: Adjusting maturities Changing the composition of taxable versus tax-exempt securities Swapping securities to meet risk and return objectives Advantage is that active portfolio managers can earn above-average returns by capturing pricing discrepancies in the marketplace Disadvantages are: that managers must consistently out predict the market for the strategies to be successful, and high transactions costs

The Maturity or Duration Choice for Long-Term Securities
The optimal maturity or duration is possibly the most difficult choice facing portfolio managers It is very difficult to outperform the market when forecasting interest rates Some managers justify passive buy and hold strategies because of a lack of time and expertise Other managers actively trade securities in an attempt to earn above average returns

Passive Maturity Strategies
Laddered (or Staggered) maturity strategy Management initially specifies a maximum acceptable maturity and securities are evenly spaced throughout maturity Securities are held until maturity to earn the fixed returns

Passive Maturity Strategies
Barbell Maturity Strategy Differentiates investments between those purchased for liquidity and those for income Short-term securities are held for liquidity Long-term securities for income Also labeled the long and short strategy

Active Maturity Strategies
Active portfolio management involves taking risks to improve total returns by: Adjusting maturities Swapping securities Periodically liquidating discount instruments To be successful, the bank must avoid the trap of aggressively buying fixed-income securities at relatively low rates when loan demand is low and deposits are high

Active Maturity Strategies
Riding the Yield Curve This strategy works best when the yield curve is upward-sloping and rates are stable. Three basic steps: Identify the appropriate investment horizon Buy a par value security with a maturity longer than the investment horizon and where the coupon yield is higher in relationship to the overall yield curve Sell the security at the end of the holding period when time remains before maturity

Riding the Yield Curve Example
Initial conditions and assumptions: 5-year investment horizon yield curve is upward-sloping, 5-year securities yielding 7.6 % and 10-year securities yielding 8 %. Annual coupon interest is reinvested at 7%. Expected Total Return Calculation

Interest Rates and the Business Cycle
Expansion Increasing Consumer Spending Inventory Accumulation Rising Loan Demand Federal Reserve Begins to Slow Money Growth Peak Monetary Restraint High Loan Demand Little Liquidity

Interest Rates and the Business Cycle
Contraction Falling Consumer Spending Inventory Contraction Falling Loan Demand Federal Reserve Accelerates Money Growth Trough Monetary Policy Eases Limited Loan Demand Excess Liquidity

Passive Strategies Over the Business Cycle
One popular passive investment strategy follows from the traditional belief that a bank’s securities portfolio should consist of primary reserves and secondary reserves This view suggests that banks hold short-term, highly marketable securities primarily to meet unanticipated loan demand and deposit withdrawals Once these primary liquidity reserves are established, banks invest any residual funds in long-term securities that are less liquid but offer higher yields

A problem arises because banks normally have excess liquidity during contractionary periods when loan demand is declining and the Fed starts to pump reserves into the banking system Interest rates are thus relatively low.

Banks employing this strategy add to their secondary reserve by buying long-term securities near the low point in the interest rate cycle Long-term rates are typically above short-term rates, but all rates are relatively low With a buy and hold orientation, these banks lock themselves into securities that depreciate in value as interest rates move higher

Active Strategies Over the Business Cycle
Many portfolio managers attempt to time major movements in the level of interest rates relative to the business cycle and adjust security maturities accordingly Some try to time interest rate peaks by following a counter-cyclical investment strategy defined by changes in loan demand and the yield curve’s shape

Active Strategies Over the Business Cycle
The strategy entails both expanding the investment portfolio and lengthening maturities at the top of they business cycle, when both interest rates and loan demand are high Note that the yield curve generally inverts when rates are at their peak prior to a recession Alternatively, at the bottom of the business cycle when both interest rates and loan demand are low, a bank contracts the portfolio and shorten maturities

The Impact of Interest Rates on the Value of Securities with Embedded Options
Issues for Securities with Embedded Options Callable agency securities or mortgage-backed securities have embedded options To value a security with an embedded option, three questions must be addressed Is the investor the buyer or seller of the option? How and by what amount is the buyer being compensated for selling the option, or how much must it pay to buy the option? When will the option be exercised and what is the likelihood of exercise?

Price-Yield Relationship for Securities with Embedded Options

The Roles of Duration and Convexity in Analyzing Bond Price Volatility
Recall that the duration for an option-free security is a weighted average of the time until the expected cash flows from a security will be received

10, , ,000.00 Actual price increase is greater when interest rates fall for option free bonds. Price-yield curve Tangent line representing the slope at 10% 8% % Interest Rate %

From the previous slide, we can see: The difference between the actual price-yield curve and the straight line representing duration at the point of tangency equals the error in applying duration to estimate the change in bond price at each new yield For both rate increases and rate decreases, the estimated price based on duration will be below the actual price

From the previous slide, we can see: Actual price increases are greater and price declines less than that suggested by duration when interest rates fall or rise, respectively, for option-free bonds For small changes in yield the error is small For large changes in yield the error is large

As yields increase, duration for option free bonds decreases, once again reducing the rate at which price declines This characteristic is called positive convexity The underlying bond becomes more price sensitive when yields decline and less price sensitive when yields increase

Impact of Prepayments on Duration and Yield for Bonds with Options
Embedded options affect the estimated duration and convexity of securities For example, prepayments will affect the duration of mortgage-backed securities Market participants price mortgage-backed securities by following a 3-step procedure: Estimate the duration based on an assumed interest rate environment and prepayment speed Identify a zero-coupon Treasury security with the same (approximate) duration. The MBS is priced at a mark-up over the Treasury

Impact of Prepayments on Duration and Yield for Bonds with Options
The MBS yield is set equal to the yield on the same duration Treasury plus a spread The spread can range from 50 to 300 basis points depending on market conditions The MBS yields reflect the zero-coupon Treasury yield curve plus a premium

Total Return Analysis An investor’s actual realized return should reflect the coupon interest, reinvestment income, and value of the security at maturity or sale at the end of the holding period When a security carries embedded options, these component cash flows will vary in different interest rate environments

Total Return Analysis If rates fall and borrowers prepay faster than originally expected: Coupon interest will fall Reinvestment income will fall The price at sale (end of the holding period) may rise or fall depending on the speed of prepayments

Total Return Analysis When rates rise Borrowers prepay slower
Coupon income increases Reinvestment income increases The price at sale may rise or fall

Total Return Analysis for a Callable FHLB Bond

Option-Adjusted Spread
The standard calculation of yield to maturity is inappropriate with prepayment risk Option-adjusted spread (OAS) accounts for factors that potentially affect the likelihood and frequency of call and prepayments Static spread is the yield premium, in percent, that (when added to Treasury zero coupon spot rates along the yield curve) equates the present value of the estimated cash flows for the security with options equal to the prevailing price of the matched-maturity Treasury

Comparative Yields on Taxable versus Tax-Exempt Securities
Interest on most municipal securities is exempt from federal income taxes and, depending on state law, from state income taxes Some states exempt all municipal interest Most states selectively exempt interest from municipals issued in-state but tax interest on out-of-state issues Other states either tax all municipal interest or do not impose an income tax

Capital gains on municipals are taxed as ordinary income under the federal income tax code This makes discount municipals less attractive than par municipals because a portion of the return, the price appreciation, is fully taxable When making investment decisions, portfolio managers compare expected risk-adjusted after-tax returns from alternative investments

After-Tax and Tax-Equivalent Yields Once the investor has determined the appropriate maturity and risk security, the investment decision involves selecting the security with the highest after-tax yield

After-Tax and Tax-Equivalent Yields Tax-exempt and taxable securities can be compared as: where Rm = pretax yield on a municipal security Rt = pretax yield on a taxable security t = investor’s marginal federal income tax rate

After-Tax and Tax-Equivalent Yields Example Let: Rm = 5.75% Rt = 7.50% Marginal Tax Rate = 34% The investor would choose the municipal because it pays a higher after tax return: Rm = 5.75% after taxes Rt = 7.50% ( ) = 4.95% after taxes

Marginal Tax Rates Implied in the Taxable - Tax-Exempt Spread If taxable securities and tax-exempt securities are the same for all other reasons then: t* = 1 - (Rm / Rt) where Rm = pretax yield on a municipal security Rt = pretax yield on a taxable security

Marginal Tax Rates Implied in the Taxable - Tax-Exempt Spread t* represents the marginal tax rate at which an investor would be indifferent between a taxable and a tax-exempt security equal for all other reasons Higher marginal tax rates or high tax individuals (companies) will prefer tax-exempt securities

Example Let: Rm = 5.75% Rt = 7.50% Marginal Tax Rate = 34% An investor would be indifferent between these two investment alternatives if her marginal tax rate were 23.33%

Municipals and State & Local Taxes The analysis is complicated somewhat when state and local taxes apply to municipal securities:

After-Tax Interest Earned on Taxable versus Exempt Securities
Comparison of After-Tax Returns on Taxable and Tax-Exempt Securities for a Bank as Investor After-Tax Interest Earned on Taxable versus Exempt Securities Taxable Municipal Par Value $ 10,000 $ 10,000 Coupon Rate 10.00% 8.00% Annual Coupon interest $ 1,000 $ 800 Federal income taxes (34%) $ 340 $0 After-tax income $ 660 $ 800 After-Tax Interest Earned Recognizing Partial Deductibility of Interest Expense Par Value $ 10,000 $ 10,000 Coupon Value $ $ Annual coupon interest $ 1,000 $ 800 Federal income taxes (34%) $ 340 $ - Polled interest expense (7.5%) $ 750 $ 750 Lost interest deduction (20%) $ - $ 150 Increased tax liability (34%) $ - $ 51 Effective after-tax interest income $ 660 $ 749

The Impact of the Tax Reform Act of 1986 (TRA 1986)
The TRA of 1986 created two classes of municipals Qualified Nonqualified Municipals After 1986, banks could no longer deduct interest expenses associated with municipal investments, except for qualified municipal issues

Qualified versus Non-Qualified Municipals Qualified Municipals Banks can still deduct 80 percent of the interest expense associated with the purchase of certain small issue public-purpose bonds (bank qualified) Nonqualified Municipals All municipals that do not meet the qualified criteria

Qualified versus Non-Qualified Municipals Municipals issued before August 7, 1986, retain their tax exemption; i.e., can still deduct 80 percent of their associated financing costs (grandfathered in)

Example: Implied tax on a bank’s purchase of nonqualified municipal securities (100% lost deduction) Assume t =34% 20% not deductible 7.5% pooled interest cost Rmuni = 7%

Strategies Underlying Security Swaps
Active portfolio strategies also enable banks to sell securities prior to maturity whenever economic conditions dictate that returns can be earned without a significant increase in risk When a bank sells a security at a loss prior to maturity, because interest rates have increased, the loss is a deductible expense At least a portion of the capital loss is reduced by the tax-deductibility of the loss

In general, banks can effectively improve their portfolios by: Upgrading bond credit quality by shifting into high-grade instruments when quality yield spreads are low Lengthening maturities when yields are expected to level off or decline Obtaining greater call protection when management expects rates to fall

In general, banks can effectively improve their portfolios by: Improving diversification when management expects economic conditions to deteriorate Generally increasing current yields by taking advantage of the tax savings Shifting into taxable securities from municipals when management expects losses

GLOBAL BANKING ACTIVITIES
Bank Management, 5th edition. Timothy W. Koch and S. Scott MacDonald Copyright © 2003 by South-Western, a division of Thomson Learning GLOBAL BANKING ACTIVITIES Chapter 21

Global banking business
One clear trend in the evolution of financial institutions and markets is the expansion of activities across national boundaries. Technology has made it possible to conduct business around the world with relative ease and minimal cost. Producers recognize that export markets are as important as domestic markets, and that the range of competitors includes both domestic and foreign operations.

Global banking activities …involve both traditional commercial banking and investment banking operations. U.S. commercial banks now accept deposits, make loans, provide letters of credit, trade bonds and foreign exchange, and underwrite debt and equity securities in dollars and other currencies. With the globalization of financial markets, all firms compete directly with other major commercial and investment banks throughout the world. Foreign banks offer the same products and services denominated in their domestic currencies and in U.S. dollars. Still, it was not always this way.

U.S. banks were greater in number, but smaller in size.
U.S. banks, although a dominant player in some world markets, have not been considered “large” by international standards Restrictive branching laws, Restrictions on the types of activities U.S. banks could engage in, and Other regulatory factors generally meant that U.S. banks were greater in number, but smaller in size.

U.S. banks, although a dominant player in some world markets, have not been considered “large” by international standards.

By the end of the 20th century, many factors had changed in the U. S
By the end of the 20th century, many factors had changed in the U.S. system. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 effectively eliminated interstate branching restrictions in the U.S. such that: by early 1994, there were 10 U.S. banks with 30 interstate branches. by June 2001, there were 288 U.S. banks with 19,298 interstate branches. U.S. banks were hampered competing internationally by the Glass-Steagall Act, which effectively separated commercial banking from investment banking. As such, U.S. commercial banks essentially provided two products: loans and FDIC-insured deposits. In 1999, the Gramm-Leach-Bliley allowed U.S. banks to fully compete with the largest global diversified financial companies by offering the same broad range of products. The Gramm-Leach-Bliley Act repealed restrictions on banks affiliating with securities firms and modified portions of the Bank Holding Company Act to allow affiliations between banks and insurance underwriters.

By the end of 2000, the largest banking company in the world was Citigroup at just under one-trillion dollars and three of the largest ten banking companies in the world were U.S. banks.

The merger between Citicorp and Travelers created Citigroup, the first diversified financial services company in the U.S. The merger, however, was not completely permissible at the time it was approved under provisions of the Glass-Steagall Act. Gramm-Leach-Bliley Act, made this merger permissible and thereby allowed Citigroup to legally be the world’s largest banking company. Citigroup formed a financial holding company under the provisions of the Gramm-Leach-Bliley Act and became one of the first integrated financial services companies engaged in investment services, asset management, life insurance and property casualty insurance, and consumer lending. Operating companies include Salomon Smith Barney, Salomon Smith Barney Asset Management, Travelers Life & Annuity, Primerica Financial Services, Travelers Property Casualty Corp., and Commercial Credit.

Today, the product offerings of Citigroup are similar to that of Deutsche Bank in Germany
Prior to the merger between Citibank and Travelers, however, Citibank’s product line was more limited. Outside the U.S., Citibank was able to offer a diversified set of products using an Edge Act corporation. Edge Act corporations are domestic subsidiaries of banking organizations chartered by the Federal Reserve. All “Edges” are located in the United States and may be established by U.S. or foreign banks and bank holding companies, but are limited to activities involving foreign customers. They can establish overseas branches and international banking facilities (IBFs) and own foreign subsidiaries.

Foreign banks operating through their American banking offices have also aggressively pursued U.S. business. 50.0% 55.0% 60.0% 65.0% 70.0% 75.0% 80.0% 85.0% 90.0% 95.0% 100.0% 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 Percent of total domestic 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% Percent of total foreign owned Domestic total assets Domestic total deposits Foreign owned total assets Foreign owned total deposits

The growth in market share of U. S
The growth in market share of U.S. offices of foreign banks in total loans and business loans. 50.0% 55.0% 60.0% 65.0% 70.0% 75.0% 80.0% 85.0% 90.0% 95.0% 100.0% 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 Percent of total domestic 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% Percent of total foreign owned Domestic total loans Domestic business loans Foreign owned total loans Foreign owned business loans

The largest U.S. banks with significant international operations.

The largest “foreign owned” banks operating in the U.S.

Universal banking model
Universal banking is the conduct of a variety of financial services such as: trading of financial instruments; foreign exchange activities; underwriting new debt and equity issues; investment management, insurance; as well as extension of credit and deposit gathering Universal banks have long dominated banking in most of continental Europe. Universal banks engage in everything from insurance to investment banking and retail banking— similar to U.S. banks prior to the enactment of the Banking Act of 1933 and Glass-Steagall provisions and now post the passage of the Gramm-Leach-Bliley Act of 1999

Three events changed the historical development of banking in the U.S.
The first was the stock market crash of 1929 and the following Great Depression. Many people blamed the banks and the universal banking activities for the problems although there is no strong evidence to link the speculative activities of banks with the crash. The second was the enactment of the Banking Act of 1933 and the Glass-Steagall provision, which separated commercial banking from investment banking activities. The third was the rising importance of the federal government in financial markets. Prior to these events, the U.S. banking system operated more of less under a universal banking system.

The advantages of universal banking …risk diversification and expanded business opportunities.
A universal bank can spread its costs over a broader base of activities and generate more revenues by offering a bundle of products. Diversification, in turn, reduces risk. insurance companies, investment banks and other suppliers of financial services are moving toward building financial conglomerates The GLB Act repealed Glass-Steagall and allows U.S. banks to operate in the business of commercial banking, investment banking, and insurance. Although there are many restrictions, U.S. banks are allowed to compete with foreign banks on an equal footing for the first time since the passage of the Glass-Steagall Act,

Disadvantages of universal banking …inherent conflict of interest
A universal bank might use pressure tactics to coerce a corporation into using its underwriting services or buy insurance from its subsidiary by threatening to cut off credit facilities. It could force a borrower in financial difficulties to issue risky securities in order to pay off loans. A universal bank could also abuse confidential information supplied by a company issuing securities as well. One area of the new GLB Act that has received significant attention is that of privacy protection

Today, most of Europe uses a unified currency, the Euro.
Formation and development of the European Community (EC) will provide new opportunities for U.S. Banks. By abolishing trade restrictions, the EC exposes European banks to outside competition. In order to increase their competitive advantage, many banks are looking into merging with banks from other countries. Today, most of Europe uses a unified currency, the Euro.

Organizational structures in international markets
Head office International divisions or departments are operated as a part of the head office's organizational structure, with the division managers reporting to senior management (supervisory function). Representative office International office which does not conduct normal banking business but simply represents the corporation, with the purpose of promoting the corporation's name and developing business to be funneled to the home office (exploratory function).

Foreign offices Foreign branch Foreign Subsidiary
A legal part of the home bank which is subject to the laws and regulations of the host nation Shell office Does not conduct business with local individuals; serves as a conduit for Eurodollar activities that originate in the head office Full-service branch Performs all the activities of domestic banks Foreign Subsidiary Foreign banks or non-bank corporations acquired by domestic commercial banks or bank holding companies; distinct from the parent bank and performs the same functions as the domestic banks

Edge act and agreement corporations
Edge Act corporations: Domestic subsidiaries of banks chartered by the Federal Reserve which may be established by U.S. or foreign banks and are limited to activities involving foreign customers. Agreement corporations: State-chartered equivalents of Edge Act Corporations.

International banking facilities
Subparts of banks that are created to conduct international business without the cost and effort of avoiding regulatory requirements through shell units. Exist as a set of accounting entries on the books of the parent company.

Export trading companies
Companies that are acquired by banks and are organized and operated principally for purposes of exporting goods and services produced in the U.S. by unaffiliated persons.

Agencies of foreign banks
Parts of foreign banks that can offer only a limited range of banking services (cannot accept transactions deposits from U.S. residents or issue CDs) with the primary purpose of financing trade originating from firms in their own country.

International financial markets
International markets have evolved to facilitate funds flow in international exchange of goods and services and to reduce the risk of doing business outside the home country.

The Eurocurrency market
A deposit liability in any currency except that of the country in which the bank is located. Eurobank: Bank that issues Eurocurrency claims.

Eurodollars Arise when a Eurobank accepting the deposit receives a dollar claim on the U.S. bank from which the funds were transferred. Eurobanks will redeposit the Eurodollar proceeds in another bank until the funds are given out as a loan by one of the banks. The initial Eurodollar deposit is accepted at the base rate called LIBOR (London Interbank Offer Rate). Each redeposit and the final loan will then be priced at a markup over LIBOR.

The Eurobond market Bonds issued in the international Euromarket, underwritten by an international banking syndicate, not subject to any one country's securities laws, and denominated in any major national currency. Floating-rate Note: Issued in denominations as low as $5,000 with maturities ranging from two to five years, carrying interest rates that vary with LIBOR.

Eurocredits …term loans priced at a premium over LIBOR, with the rate floating every three or six months in most cases, thereby reducing the mismatch between asset and liability maturities Eurocredits are created to overcome interest rate risk.

International lending
International operations generate a considerable portion of earnings for money center banks Citigroup earns about two-thirds of their earnings globally. International lending, however, carries risks not associated with domestic lending Country risk …default risk associated with loans to borrowers outside the home country Foreign exchange risk …the current and potential volatility in earnings and stockholders’ equity due to changes in foreign exchange rates.

Short-term foreign trade financing …international trade and international trade financing are considerably more complex than simply dealing with trading partners within the same country To facilitate trade, someone must enter the transaction and assume the risk that the importer may not pay. Commercial banks fulfill this role through bankers acceptance financing. Trading partners must also have the opportunity to convert one currency into another, which creates a demand for foreign exchange services as well. Bankers acceptance …A time draft that represents a guarantee under which the accepting bank agrees to remit the face value of the draft at maturity. Acceptances are attractive because a bank substitutes its credit rating for that of the importer.

Bankers Acceptance financing of U. S
Bankers Acceptance financing of U.S. Imports …a bankers acceptance is created, discounted, sold, and paid at maturity

Direct international loans …originate from international departments of domestic banks, Edge Act corporations, credit offices of foreign branches and subsidiaries. Credit extended to less-developed countries (LDCs) has exhibited a poor repayment history and many of the banks have chosen to withdraw from lending to these countries after a large number of default incidents that took place in the 1980s. Banks prefer to have foreign exposure in the form of equity investments rather than long-term, constantly renegotiated loans to foreign central banks.

Credit analysis of foreign loans
Credit analysis for international loans follow the same procedures adopted frequently for domestic loans: evaluation of the required loan amount, use of proceeds, source and timing of expected payment, availability of secondary collateral sources.

Foreign exchange activities
Because different countries use different monetary units, traders must be able to convert one unit into another. Foreign exchange markets are where these monetary units are traded. Foreign exchange …currency other than the monetary unit of the home country Exchange rate …the price of one currency in terms of another currency.

Risks unique to international lending:
Foreign exchange risk …the current and potential risk to earnings and stockholders’ equity arising from changes in foreign exchange rates Country risk …default risk associated with loans to borrowers outside the home country Economic risks …quantifiable economic and business risks (mostly examined under regular credit analysis). Political (sovereign) risks …the likelihood that foreign governments will unilaterally alter their debt service payments, regardless of the formal repayment schedule

Foreign Exchange: …currency other than the monetary unit of the home country
Exchange Rate …price of one currency in terms of another currency. Spot Market: …market for exchange of currencies for immediate delivery. Forward Market …market for transactions that represent a commitment to exchange currencies at a specified time in the future at an exchange rate determined at the time the contract is signed.

Foreign exchange risk …current and potential risk to earnings and stockholder’s equity arising from changes in foreign exchange rates Found when changing exchange rates affect a bank’s cash inflows differently than cash outflows associated with positions denominated in different currencies Changes in values of foreign currency positions (buying and selling foreign currencies for their own account) due to changing foreign exchange rates is price risk

Example: Foreign exchange risk
Commerce Bank’s (CB) home country is Poland and home currency is the zloty. current (spot) exchange rate is $1 = 150 zlotys. Commerce Bank: $1,000 in loans $250 in liabilities denominated in U.S. dollars assets are worth 150,000 zlotys liabilities are worth 37,500 zlotys at the prevailing exchange rate. If the exchange rate moved to $1 = 160 zlotys, assets increase in value by 10,000 zlotys, liabilities increase by 2,500 zlotys. the bank’s equity would rise by 7,500 zlotys.

Example (continued): Foreign exchange risk
If the exchange rate moved to $1 = 140 zlotys, assets decrease in value by 10,000 zlotys, liabilities decrease by 2,500 zlotys the bank’s would see stockholders’ equity decrease by 7,500 zlotys These same exposures exist for off-balance sheet commitments and guarantees when counterparties effect the at risk transactions or activities.

Managing foreign exchange rate risk
A bank’s risk managers analyze aggregate foreign exchange risk by currency. A bank’s net balance sheet exposure in currency j (NEXPj) is the amount of assets minus the amount of liabilities denominated in currency j: NEXPj = Aj – Lj where Aj = assets denominated in currency j, Lj = liabilities denominated in currency j. If NEXPj > 0, the bank is long on currency j and if NEXPj < 0, the bank is short currency j.

Gain/Loss in a position
The bank will lose if: it is long a currency (NEXPj > 0) and the currency depreciates in value (the currency buys less of another currency). if it is short a currency (NEXPj < 0) and the currency appreciates in value (the currency buys more of another currency). The gain/loss in a position with a currency is indicated by: Gain/Loss in a Position With Currency j = NEXPj x [spot exchange rate at time t – spot exchange rate at time t-1]

Example: gain/loss in a position
Current (spot) exchange rate is $1 = 150 zlotys. Commerce Bank’s (CB) would lose if long U.S. dollars the dollar depreciates as indicated by a movement in the exchange rate to $1 = 140 zlotys. Loss = [1, ] x [ ] = -7,500 zlotys CB would gain if the dollar appreciates as indicated by a exchange rate change to $1 = 160 zlotys.

Example: forward markets
A bank commits to buy 1 million yen, 90 days forward for $9804. This means that after 90 days, the bank pays $9804 and receives 1 million yen, regardless of movements in exchange rates during the 90-day period.

Forward markets: forward premium.
Forward premium …the forward price of a currency is higher than its spot price, the foreign currency is priced at a premium. Example: a bank agrees to buy 1 million yen 90 days forward for 102 yens per dollar. If the spot rate is 105 yens per dollar, the yen is priced at a forward premium against the dollar.

Forward markets: forward discount.
Forward discount …the forward price of a currency is lower than its spot price, the foreign currency is priced at a discount. Example: a bank agrees to buy 1 million yen 90 days forward for 102 yens per dollar. if the spot rate is 100 yens per dollar, the yen is priced at a forward discount against the dollar.

Relationship between foreign exchange rates and interest rates.
Arbitrage transactions between countries guarantee that interest rate changes produce changes in foreign exchange rates, and vice versa. If the interest rate differential between securities in two countries falls out of line with the spot-to-forward exchange rate differential, a covered interest arbitrage will take place and investors will make net profits from the series of transactions.

Continuing arbitrage will go on until prices move back into line to eliminate the riskless return from covered interest arbitrage. Covered interest arbitrage 2. Convert dollars to francs at $1 = 1.7 francs 3. Invest in Swiss securities yielding 10% 000 , 1 $ 0.09 $1,009,000 francs million 1.7 (1.7) $1,090,000 = + ú û ù ê ë é $1,121,776 (1.667) ) (1.7)(1.10 1.87 1. Borrow dollars at 9% 4. Sell francs for doll ars 1 year forward at $1 = francs Sample Transaction: Borrow $1,000,000 1. Borrow $1,000,000 at 9%; agree to repay $1,090,000 in one year. 2. Convert $1,000,000 to 1.7 million francs in spot market at $1 = 1.7 francs. 3. Invest 1.7 m illion francs in 1 - year security yielding 10%; will receive 1.87 million francs after 1 year. 4. Sell 1.87 million francs 1 year forward for $1,121,776 at $1 = francs. Net profit = $1,121,776 $1,090,000 = $ 31,776

Foreign exchange rates and interest rates
Covered interest arbitrage …exists when the interest rate differential between securities in two countries is out of line with the spot-to-forward exchange rate differential. Interest rate parity …exist when covered interest arbitrage profit potential is eliminated.

Interest rate parity implies:
Where i1: Annual interest rate in Country 1. i2: Annual interest rate in Country 2. s1,2: Spot exchange rate equal to the number of units of Country 2's currency for one unit of Country 1's currency. f1,2: One-year forward exchange rate equal to the number of units of Country 2's currency for one unit of Country 1's currency.

The interest rate parity equilibrium condition suggests that:
The forward exchange rate differential, as a fraction of the spot rate, should equal the interest rate differential relative to 1 plus an interest factor to eliminate arbitrage profits. Example: i1 is 9%, i2 is 10%, and s1,2 is 1.7 as in the previous example, then f1,2 should be equal to :

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