GESTIÓN BANCARIA Master en Banca y Finanzas Cuantitativas (QF), 2008

GESTIÓN BANCARIA Master en Banca y Finanzas Cuantitativas (QF), 2008
Santiago Carbó Valverde Universidad de Granada

Santiago Carbó Valverde
Universidad de Granada Materiales docentes en:

Esquema de trabajo: Transparencias en inglés
Presentaciones de papers en clase Examen final Referencia básica: - SAUNDERS, A. Y M.M. CORNETT (2000): FINANCIAL INSTITUTIONS MANAGEMENT: A MODERN PERSPECTIVE, 4ª EDICIÓN, MCGRAW HILL, NEW YORK, ESTADOS UNIDOS. - SINKEY, J. (2001): COMMERCIAL BANK FINANCIAL MANAGEMENT, SEXTA EDICIÓN, PRENTICE HALL, NEW YORK, ESTADOS UNIDOS.

(LECTURA DE REFERENCIA: BHATTACHARYA Y THAKOR, 1993)
Tema 1 LA INDUSTRIA DE SERVICIOS FINANCIEROS: LAS ENTIDADES DE DEPÓSITO (LECTURA DE REFERENCIA: BHATTACHARYA Y THAKOR, 1993)

Why study Financial Markets and Institutions?
They are the cornerstones of the overall financial system in which financial managers operate Individuals use both for investing Corporations and governments use both for financing

Overview of Financial Markets
Primary Markets versus Secondary Markets Money Markets versus Capital Markets Foreign Exchange Markets

Primary Markets versus Secondary Markets
markets in which users of funds (e.g. corporations, governments) raise funds by issuing financial instruments (e.g. stocks and bonds) Secondary Markets markets where financial instruments are traded among investors (e.g. Bolsa Madrid, NYSE, NASDAQ)

Money Markets versus Capital Markets
markets that trade debt securities with maturities of one year or less (e.g. Spanish Government bonds, U.S. Treasury bills) Capital Markets markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year

Money Market Instruments Outstanding, 1990-1999 ($Bn)

Capital Market Instruments Outstanding, 1990-1999 ($Bn)

Foreign Exchange Markets
“FX” markets deal in trading one currency for another (e.g. dollar for yen) The “spot” FX transaction involves the immediate exchange of currencies at the current exchange rate The “forward” FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate

Overview of Financial Institutions (FIs)
Institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages of funds (e.g. banks, thrifts, insurance companies, securities firms and investment banks, finance companies, mutual funds, pension funds)

Flow of Funds in a World without FIs: Direct Transfer
Financial Claims (Equity and debt instruments) Suppliers of Funds (Households) Users of Funds (Corporations) Cash Example: A firm sells shares directly to investors without going through a financial institution

Flow of Funds in a world with FIs: Indirect transfer
(Brokers) (Asset transformers) Users of Funds Suppliers of Funds Financial Claims (Equity and debt securities) Financial Claims (Deposits and Insurance policies)

Types of FIs Commercial banks
depository institutions whose major assets are loans and major liabilities are deposits Thrifts and savings banks depository institutions in the form of savings banks, savings and loans, credit unions, credit cooperatives Insurance companies financial institutions that protect individuals and corporations from adverse events (continued)

Securities firms and investment banks
financial institutions that underwrite securities and engage in securities brokerage and trading Finance companies financial institutions that make loans to individuals and businesses Mutual Funds financial institutions that pool financial resources and invest in diversified portfolios Pension Funds financial institutions that offer savings plans for retirement

Services Performed by Financial Intermediaries
Monitoring Costs aggregation of funds provides greater incentive to collect a firm’s information and monitor actions Liquidity and Price Risk provide financial claims to savers with superior liquidity and lower price risk (continued)

Transaction Cost Services
transaction costs are reduced through economies of scale Maturity Intermediation greater ability to bear risk of mismatching maturities of assets and liabilities Denomination Intermediation allow small investors to overcome constraints imposed to buying assets imposed by large minimum denomination size

Services Provided by FIs Benefiting the Overall Economy
Money Supply Transmission Depository institutions are the conduit through which monetary policy actions impact the economy in general Credit Allocation often viewed as the major source of financing for a particular sector of the economy (e.g. farming and real estate) (continued)

Services Provided by FIs Benefiting the Overall Economy
Intergenerational Wealth Transfers life insurance companies and pension funds provide savers with the ability to transfer wealth from one generation to the next Payment Services efficiency with which depository institutions provide payment services directly benefits the economy

Risks Faced by Financial Institutions
Interest Rate Risk Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk Off-Balance-Sheet Risk Technology Risk Operation Risk Country or Sovereign Risk Insolvency Risk

Regulation of Financial Institutions
FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in the public interest In an attempt to prevent their failure and the failure of financial markets overall

Globalization of Financial Markets and Institutions
Financial Markets became more global as the value of stocks traded in foreign markets soared Foreign bond markets have served as a major source of international capital Globalization also evident in the derivative securities market

Factors Leading to Significant Growth in Foreign Markets
The pool of savings from foreign investors has increased International investors have turned to U.S. and other markets to expand their investment opportunities Information on foreign investments and markets is now more accessible (e.g. internet) Some mutual funds allow ability to invest in foreign securities with low transaction costs Deregulation has enhanced globalization of capital flows

(LECTURA DE REFERENCIA: ALLEN Y SANTOMERO (1997)
Tema 2 ¿POR QUÉ SON ESPECIALES LOS INTERMEDIARIOS BANCARIOS? (LECTURA DE REFERENCIA: ALLEN Y SANTOMERO (1997)

Why Are Financial Intermediaries Special?
Objectives: Develop the tools needed to measure and manage the risks of FIs. Explain the special role of FIs in the financial system and the functions they provide. Explain why the various FIs receive special regulatory attention. Discuss what makes some FIs more special than others.

Without FIs Households (net savers) Corporations (net borrowers)
Cash Equity & Debt Corporations (net borrowers)

FIs’ Specialness Without FIs: Low level of fund flows.
Information costs: Economies of scale reduce costs for FIs to screen and monitor borrowers Less liquidity Substantial price risk

Deposits/Insurance Policies
With FIs Cash Households Corporations Equity & Debt FI (Brokers) (Asset Transformers) Deposits/Insurance Policies

Financial Structure Puzzles: a way to explain the role of FIs
stocks are not the most important source of external financing for businesses issuing debt and equity is not the main way that businesses finance operations indirect financing is more important than direct financing banks are the most important source of external funds for businesses financial industry is one of the most heavily regulated industries only large, well-known firms have access to the securities markets collateral is an important part of debt contracts for businesses and households debt contracts are complex and often contain many restrictions for the borrower

Transaction Costs information and other transaction costs in financial system can be substantial How do transaction costs affect investing? How can financial intermediaries reduce transaction costs?

Asymmetric Information
one party to a transaction has better information to make decisions than the other party asymmetric information in financial market causes two main problems adverse selection moral hazard

Adverse Selection asymmetric information problem that occurs prior to a transaction examples of adverse selection result of adverse selection is that lenders may decide not to make loans if they can not distinguish between “good” and “bad” credit risks

Moral Hazard asymmetric information problem that occurs after a transaction risk that borrower will undertake risky activities that will increase the probability of default result of moral hazard is that lenders may decide not to make a loan

Lemons Problem idea presented in article by George Akerlof in terms of lemons in used car market used car buyers are unable to determine quality of car - good car or lemon? What amount is buyer willing to pay for this used car of unknown quality? How can buyer improve information on quality?

Lemons Problem in Stock and Bond Market
asymmetric information prevents investors from identifying good and bad firms What price will these investors pay for stock? Who has better information about the firm? Which firms will “come to the market” for financing under these conditions?

Principal-Agent Problem
define the principal-agent problem Who is the principal and who is the agent? What problem does a separation of ownership and control cause? How could we prevent principal-agent problem?

Solutions to Financing Puzzles
lemons or adverse selection problem tells why marketable securities are not the primary source of financing situation is similar in corporate bond market tells why stocks are not the most important source of external financing

More Solutions to Financial Structure Puzzles
importance of financial intermediaries explains importance of indirect financing explains why banks are most important source of external financing explains why markets are only available to large, well-known firms

Functions of FIs Brokerage function Acting as an agent for investors:
e.g. Merrill Lynch, Charles Schwab Reduce costs through economies of scale Encourages higher rate of savings Asset transformer: Purchase primary securities by selling financial claims to households These secondary securities often more marketable

Role of FIs in Cost Reduction
Information costs: Investors exposed to Agency Costs Role of FI as Delegated Monitor (Diamond, 1984) Shorter term debt contracts easier to monitor than bonds FI likely to have informational advantage

Services Performed by FIs
Monitoring Costs Liquidity and Price Risk Transaction Cost Services Maturity Intermediation Denomination Intermediation

Services Provided by FIs
Money Supply Transmission Credit Allocation Intergenerational Wealth Transfers Payment Services (continued)

Regulation of FIs Regulation is not costless
Net regulatory burden. Safety and soundness regulation Monetary policy regulation Credit allocation regulation Consumer protection regulation Investor protection regulation Entry regulation

Changing Dynamics of Specialness
Trends in the United States Decline in share of depository institutions. Increases in pension funds and investment companies. May be attributable to net regulatory burden imposed on depository FIs. Technological changes affect delivery of financial services and regulatory issues Potential for regulations to be extended to hedge funds Result of Long Term Capital Management disaster

Future Trends Citicorp and Travelers, UBS and Paine Webber
Weakening of public trust and confidence in FIs may encourage disintermediation Increased merger activity within and across sectors Citicorp and Travelers, UBS and Paine Webber More large scale mergers such as J.P. Morgan and Chase, and Bank One and First Chicago Growth in Online Trading Increased competition from foreign FIs at home and abroad Mergers involving world’s largest banks Mergers blending together previously separate financial services sectors

(LECTURA DE REFERENCIA: HUMPHREY ET AL. (2006))
Tema 3 ORGANIZACIÓN INDUSTRIAL DEL SECTOR BANCARIO (LECTURA DE REFERENCIA: HUMPHREY ET AL. (2006))

3. Bank competition 3.1. BANK COMPETITION
THE STRUCTURE-CONDUCT-PERFORMANACE (SCP) PARADIGM: Many empirical studies have considered concentration - mainly the Herfindahl-Hirschman Index (HHI) - as a proxy for bank market power following the Structure-Conduct-Performance (SCP) paradigm (Berger and Hannan, 1989; Hannan and Berger, 1991). However, several contributions to the banking literature during the last two decades have cast doubt on the consistency and robustness of concentration as an indicator of market power (Berger, 1995; Rhoades, 1995; Jackson 1997; Hannan, 1997).

IO theory predicts a correspondence between the Lerner index (L) – as the spread between prices (P) and marginal costs (C’) divided by prices - and the HHI so that , where is a conjecture parameter showing the response of the industry output to changes to a unit output change by the firm, and is the industry price elasticity of demand. If =1 there is a monopoly solution while if =0, then a Bertrand solution holds with L=0. Hence, the correspondence depends upon restrictive assumptions on the conjecture and demand elasticity parameters.

As contestability increases in a market, the reliability of the HHI as a measure of market power is significantly limited. Therefore, changes in the stability of the banking sector as a consequence of industry restructuring or liberalization may cast doubt on the validity of the HHI as a dynamic measure of competition. Instability will also affect conjecture and elasticity parameter so that the relationship between market power and concentration becomes blurred.

Although the SCP hypothesis of a positive relationship between concentration and profits can be derived from oligopoly theory under these assumptions of different solutions to a Cournot model, it is not warranted under alternative models. Some empirical studies have even tested and rejected the hypothesis of Cournot conduct in the banking industry (Roberts, 1984; Berg and Kim, 1994). Econometric developments have permitted the emergence of empirical papers from the so-called New Empirical Industrial Organization (NEIO) perspective, by directly estimating the parameters of a firm's behavioral equation – and, in particular, marginal costs - to directly obtain indicators such as the Lerner Index (Schmalensee, 1989).

Although price to marginal costs indicators are not “new” from a theoretical standpoint, marginal costs have only been econometrically estimated during the last two decades. Applications to the banking industry as in Shaffer (1993), Ribon and Yosha (1999) or Maudos and Fernández de Guevara (2004) have already shown that these price to marginal costs indicators are frequently uncorrelated with concentration ratios.

The definition of the mark-up and the Lerner index can be directly derived from a simplified market structure model (Bresnahan, 1989) where banking firms are supposed to produce a single good. Assuming that banks behave as profit maximizers, the general expression for intermediate oligopolistic market structures with m banks operating in the market is expressed as:

where p is the price of the bank product; C(yj, wj) is a cost function defined for each bank j where yj is the quantity produced by firm j in the industry and wj represents the vector of prices of the factors of bank j. The parameter j expresses the degree of market power from perfectly competitive (j = 0) to monopolist (j = 1). This can be alternatively written as:

where the mark-up of price over marginal cost ([p – C’(yj, wj)]) equals the inverse of the semi-elasticity on bank product demand (1/) times the market structure parameter (j). Therefore, higher values of the mark-up measure will indicate a worsening of bank competition conditions either by a decrease in the semi-elasticity of demand on bank product () or an increase in the market structure parameter (j).

The mark-up is used to compute the Lerner index, which is a relative margin computed as [p – C’(yj, wj)] / p. Higher values of the Lerner index also indicate a worsening of competition conditions.

Introducción Existen, al menos, tres dimensiones en las que se precisan avances para lograr un diagnóstico más preciso de la realidad competitiva de la industria bancaria de la UE y poder arbitrar políticas acordes con los objetivos de integración y la mejora del acceso a los servicios bancarios

(MATERIAL DEL PROFESOR)
Tema 4 GOBIERNO Y ESTRUCTURA ORGANIZATIVA DE LA BANCA (MATERIAL DEL PROFESOR)

“It is the ability to foretell what is going to happen tomorrow, next week, next month, and next year. And to have the ability afterwards to explain why it didn’t happen.” Sir Winston Churchill

What are Financial Intermediaries (FIs)?
Financial Securities: contingent claims on future cash flows – debt, equity, derivatives, hybrids. All firms’ liabilities & net worth are predominately comprised of financial securities. But most firms hold real assets such as inventory, plant & equipment, buildings. FIs’ assets are predominately comprised of financial securities.

Transparent, Transluscent and Opaque FIs

What Services Do FIs Provide?
Information Liquidity Reduced Transaction Costs Transmission of Monetary Policy Credit Allocation Payment Services Intergenerational Wealth Transfer

FIs are the most regulated of all firms
Safety and Soundness Regulation Deposit Insurance Monetary Policy Regulation Reserve Requirements Credit Allocation Regulation (eg., mortgages) Consumer Protection Regulation Community Reinvestment Act, Home Mortgage Disclosure Act, Truth in Lending Protection Investor Protection Regulation Entry Regulation

Types of FIs Depository Institutions Insurance Companies
Securities Firms and Investment Banks Mutual Funds Finance Companies Distinctions blurred by the Gramm-Leach-Bliley Act of that created Financial Holding Companies (FHCs).

Features Common to Most FIs
High Amount of Financial Leverage Low equity/assets ratios. Capital requirements. Off-balance sheet items Contingent claims that under certain circumstances may eventually become balance sheet items (ex. Derivatives, commitments) Revenue: Interest Income & Fees Costs: Interest Expenses and Personnel

Depository Institutions
Commercial Banks: accept deposits and make loans to consumers and businesses. Money Center Banks: Citigroup, Bank of NY, BankOne, Bankers Trust (Deutschebank), JP Morgan Chase and HSBC Bank USA. Savings Associations (S&Ls) Qualified Thrift Lender (QTL) mortgages must exceed 65% of thrift’s assets. Savings Banks Use deposits to fund mortgages & other assets. Credit Unions and Credit cooperatives Nonprofit mutually owned institutions (owned by depositors).

Overview of Depository Institutions
In this segment, we explore the depository FIs: Size, structure and composition Balance sheets and recent trends Regulation of depository institutions Depository institutions performance

Products of FIs Comparing the products of FIs in 1950, to products of FIs in 2003: Much greater distinction between types of FIs in terms of products in 1950 than in 2003 Blurring of product lines and services over time Wider array of services offered by all FI types

Specialness of Depository FIs
Products on both sides of the balance sheet Loans Business and Commercial Deposits

Other outputs of depository FIs
Other products and services 1950: Payment services, Savings products, Fiduciary services By 2003, products and services further expanded to include: Underwriting of debt and equity, Insurance and risk management products

Size of Depository FIs Consolidation has created some very large FIs
Combined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs

Largest Depository Institutions in the US
Total Assets ($Billions) Citigroup $1,208.9 J.P. Morgan Chase* Bank of America** Wells Fargo Wachovia Bank One* Washington Mutual Fleet Boston** U.S. Bancorp SunTrust Banks

Organization of Depository Institutions
Commercial Banks Largest depository institutions are commercial banks. Differences in operating characteristics and profitability across size classes. Notable differences in ROE and ROA as well as the spread Thrifts S&Ls Savings Banks Credit Unions Mix of very large banks with very small banks

Functions & Structural Differences
Functions of depository institutions Regulatory sources of differences across types of depository institutions. Structural changes generally resulted from changes in regulatory policy. Example: changes permitting interstate branching Reigle-Neal Act (1994) in the US In Spain, deregulation in 1989 concerning savings banks operations

Commercial Banks Primary assets: Inference: Importance of Credit Risk
Real Estate Loans: $2,272.3 billion C&I loans: $870.6 billion Loans to individuals: $770.5 billion Investment security portfolio: $1,789.3 billion Of which, Treasury bonds: $1,005.8 billion Inference: Importance of Credit Risk

Commercial Banks Primary liabilities: Inference:
Deposits: $5,028.9 billion Borrowings: $1,643.3 billion Other liabilities: $238.2 billion Inference: Highly leveraged

Small Banks, US

Large Banks, US

Structure and Composition
Shrinking number of banks: 14,416 commercial banks in 1985 12,744 in 1989 7,769 in 2004 Mostly the result of Mergers and Acquisitions M&A prevented prior to 1980s, 1990s Consolidation has reduced asset share of small banks

Structure & Composition of Commercial Banks
Financial Services Modernization Act 1999 Allowed full authority to enter investment banking (and insurance) Limited powers to underwrite corporate securities have existed only since 1987

Composition of Commercial Banking Sector
Community banks Regional and Super-regional Access to federal funds market to finance their lending activities Money Center banks Bank of New York, Deutsche Bank (Bankers Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USA declining in number

Balance Sheet and Trends
Business loans have declined in importance Offsetting increase in securities and mortgages Increased importance of funding via commercial paper market Securitization of mortgage loans

Some Terminology Transaction accounts
Negotiable Order of Withdrawal (NOW) accounts (“cuenta a la vista”) Money Market Mutual Fund Negotiable CDs (“certificados de depósito”): Fixed-maturity interest bearing deposits with face values over $100,000 that can be resold in the secondary market.

Off-balance Sheet Activities
Heightened importance of off-balance sheet items Large increase in derivatives positions is a major issue Standby letters of credit Loan commitments When-issued securities Loans sold

Trading and Other Risks
Allied Irish / Allfirst Bank $750 million loss (2001) National Australian Bank $450 million loss (2004) Failure of the U.K. investment bank Barings The Bankruptcy of Orange County in California.

Other Fee-generating Activities
Trust services Correspondent banking Check clearing Foreign exchange trading Hedging Participation in large loan and security issuances Payment usually in terms of noninterest bearing deposits

Key Regulatory Agencies
FDIC and the Office of the Comprotroller of the Currency in the US. European Central Bank National central banks National Governments Regional Governments

Web Resources For more detailed information on the regulators, visit:

Banking and Ethics Some cases for the US:
Bank of America and Fleet Boston Financial 2004 J.P. Morgan Chase and Citigroup 2003 role in Enron Riggs National Bank and money laundering concerns 2003

Savings Institutions Comprised of:
Savings and Loans Associations Savings Banks Effects of moral hazard and regulator forbearance. Quite a debate worldwhile.

Savings Institutions: Recent Trends
Industry is smaller overall Intense competition from other FIs mortgages for example Concern for future viability in certain countries.

Credit Unions Nonprofit depository institutions owned by member-depositors with a common bond. Exempt from taxes and Community Reinvestment Act (CRA) in the US. Expansion of services offered in order to compete with other FIs. Very important in certain European countries (Germany, Spain).

Global Issues Near crisis in Japanese Banking
Eight biggest banks reported positive six-month profits China Deterioration, NPLs (nonperforming loans) at 50% levels Opening to foreign banks (WTO entry) German bank problems in early 2000s Implications for future competitiveness

Largest Banks in the World

(LECTURA DE REFERENCIA: ALTUNBAS ET AL.,2007)
Tema 5 La concesión de crédito, el riesgo de crédito y otros riesgos (LECTURA DE REFERENCIA: ALTUNBAS ET AL.,2007)

5.1. THE CONCEPT OF RISK Risks facing all financial institutions can be segmented into three separable types, from a management perspective. These are: (i) risks that can be eliminated or avoided by simple business practices, (ii) risks that can be transferred to other participants, and, (iii) risks that must be actively managed at the firm level.

The management of the banking firm relies on a sequence of steps to implement a risk management system. These can be seen as containing the following four parts: (i) standards and reports, (ii) position limits or rules, (iii) investment guidelines or strategies, (iv) incentive contracts and compensation.

SOURCES OF RISK For the sector as a whole, the risks can be broken into six generic types: systematic or market risk credit risk counterparty risk liquidity risk operational risk legal risk

Systematic risk is the risk of asset value change associated with systematic factors. It is sometimes referred to as market risk, which is in fact a somewhat imprecise term. By its nature, this risk can be hedged, but cannot be diversified completely away. In fact, systematic risk can be thought of as undiversifiable risk.

Credit risk arises from non-performance by a borrower
Credit risk arises from non-performance by a borrower. It may arise from either an inability or an unwillingness to perform in the pre-committed contracted manner. This can affect the lender holding the loan contract, as well as other lenders to the creditor. Therefore, the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to its bank

Counterparty risk comes from non-performance of a trading partner
Counterparty risk comes from non-performance of a trading partner. The non-performance may arise from a counterparty's refusal to perform due to an adverse price movement caused by systematic factors, or from some other political or legal constraint that was not anticipated by the principals. Diversification is the major tool for controlling nonsystematic counterparty risk.

Liquidity risk can best be described as the risk of a funding crisis
Liquidity risk can best be described as the risk of a funding crisis. While some would include the need to plan for growth and unexpected expansion of credit, the risk here is seen more correctly as the potential for a funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis.

Operational risk is associated with the problems of accurately processing, settling, and taking or making delivery on trades in exchange for cash. It also arises in record keeping, processing system failures and compliance with various regulations. As such, individual operating problems are small probability events for well-run organizations but they expose a firm to outcomes that may be quite costly.

Legal risks are endemic in financial contracting and are separate from the legal ramifications of credit, counterparty, and operational risks. New statutes, tax legislation, court opinions and regulations can put formerly well-established transactions into contention even when all parties have previously performed adequately and are fully able to perform in the future.

5.2. REGULATION AND CREDIT RISK: AN EXAMPLE FROM BASEL II
Historically, regulation has limited who can: open or charter new banks and what products and services banks can offer. Imposing barriers to entry and restricting the types of activities banks can engage in clearly enhance safety and soundness, but also hinder competition.

It assumed that the markets for bank products, largely bank loans and deposits, could be protected and that other firms could not encroach upon these markets. Not surprisingly, investment banks, hybrid financial companies, insurance firms, and others found ways to provide the same products as banks across different geographic markets.

However, there is another type of regulation that has concentrated most of the attention in the last three decades, the bank capital regulation. Changes in reserve requirements …directly affect the amount of legal required reserves and thus change the amount of money a bank can lend out. The main recent example is BASEL II.

THE STRATEGIC IMPACT OF BASEL II
Basel 2 is a ‘step change’ in the regulation of capital adequacy. It will alter the industry ‘frame of reference’ for banks in many ways: Regulators are clearly recognizing market realities and seeking a much closer congruence between regulatory and economic capital. The new proposals are more complex and sophisticated than earlier schemes. They will also have to evolve as market conditions, technology and financial management techniques develop.

The calibration exercises that have resulted from the various Quantitative Impact Studies (QIS) are targeted (initially at least) to deliver broadly the same amount of capital as the current Accord. However, the mix of capital charges will change significantly with the wider range of risk weights and greater risk sensitivity of Basel 2. Basel 2 will clearly be much more risk-sensitive in assigning capital charges. Mortgage lending and lending to higher quality borrowers will be incentivised under Basel 2.

It is not clear whether the present or new Basel Accord are a binding constraint on bank’s current credit operations. Jackson et al (2001, Bank of England WP) suggest that banks may employ more conservative capital standards than those imposed under Basel 1 or likely under Basel 2. Compliance costs are likely to increase. Banks will have to evaluate (as a kind of capital investment decision) whether the costs (including compliance costs) of moving to the more advanced Basel 2 systems are worthwhile.

Banks will increasingly target better risk management as a source of competitive advantage. Increasingly, superior risk management will become a ‘key success factor’ for those banks who are able to respond successfully to the new environment. Nevertheless, specialist banks who focus on a smaller number of core products and services should similarly be able to obtain risk management benefits of specialization.

Basel 2 will enhance present securitisation trends in banking
Basel 2 will enhance present securitisation trends in banking. This will help in its turn to emphasise further the strategic importance of investment banking. At the same time, lending bankers will face increasing ‘adverse selection’ trends as the better credits are able to access directly the capital markets. This trend will help to re-emphasise the importance of credit skills in lending banks. It will also put pressure on these banks to widen their margins (in order to achieve the higher risk premia needed to cover their more risky lending).

Governance will be an increasingly important issue in the new regime
Governance will be an increasingly important issue in the new regime. More disclosure is not enough by itself to secure market discipline (the aim of Pillar 3). A wide collection of new and improved governance structures will be needed. These include: a freer market in bank corporate control; good corporate governance in banks; incentive-compatible safety nets; ‘no bail-out’ policies; and proper accounting standards. Banks will be required to disclose more information than ever before to the external market. This will involve additional compliance costs. Strategically, it will reinforce any competitive advantage gained by good risk-management banks.

Under Pillar 3 and with likely changes in bank governance arrangements, the prospects of take-overs (and no bail-outs) for individual banks who are ‘inefficient’ are likely to increase. This ‘new world’ is a likely further threat to concepts like mutuality and subsidised (or at least protected from competition) regional banking. Insofar as the new capital regime allows non-bank financial companies a competitive advantage (via lesser capital backing), banks will attempt to alter the balance of competitive advantage through regulatory arbitrage

More work is needed on stress testing under Basel 2 and banks can expect further, more detailed efforts from regulators in this area. Already, stress testing appears to be a standard management technique for many banks and most banks that stress test do so at a high frequency (daily or weekly): see Fender and Gibson (Risk, 2001).

Perhaps the most fundamental strategic impact of Basel 2 is that it will enhance the SWM (Shareholder Wealth Maximisation) model as the major strategic and managerial model for banks. The essence of this model is its focus on risk and return and the impact of this tradeoff on bank value; the model also emphasises the need for greater risk sensitivity in risk assessments and pricing. Within this model, better risk management is rewarded.

5.3. THE SPANISH SAVINGS BANKS AND THE NEW REGULATORY FRAMEWORK
Although most of the strategic implications mentioned earlier for retail banks apply also to Spanish savings banks, there are some specific features of the Spanish savings banks that may modify some of these conclusions. These specific features are explored in this section (and summarised in Diagram 1): There have been some recent regulatory actions regarding risk and capital in the Spanish banking system that should be taken into account when defining the threats and opportunities of the new framework for savings banks. The development of a Default Hedging Statistical Fund (the so-called FECI) by the Bank of Spain are two of the recent developments in the regulatory field that impact on the current solvency risk of Spanish savings banks

1. SPANISH SAVINGS BANKS AND THE NEW REGULATORY
DIAGRAM 1. SPANISH SAVINGS BANKS AND THE NEW REGULATORY CAPITAL FRAMEWORK. KEY FEATURES SPANISH SAVINGS BANKS AND THE NEW REGULATORY CAPITAL FRAMEWORK REGULATION: MARKET DEVELOPMENTS – B ASEL 2 CAPITAL REGULATION AND OWNERSHIP STRATEGIC IMPLICATIONS SECTORAL PROJECT FOR THE GLOBAL CONTROL OF RISK

The establishment of so-called statistical, pro-cyclical or dynamic provisions:
Requiring banks to increase these provisions when the business cycle is positive and reducing them during downturns in order to favor intertemporal risk smoothing and loan supply. Basel 2 does not appear to change the view of banking as a pro-cyclical business. Basel 2 could even exacerbate cyclical effects. It is this contingency that has led the Bank of Spain to establish the so-called pro-cyclical or dynamic provisions. The recent lending patterns of the Spanish savings banks are known to reduce these pro-cyclical effects since they have increased credit supply almost linearly over the business cycle.

The lending behavior of savings banks has not resulted in higher defaults. On the contrary, default risk management at savings banks has apparently been more efficient than for commercial banks, a fact that may be largely explained by the intertemporal risk smoothing advantages achieved via a close contractual relationship with their customers.

There are three main types of “savings-bank” specific effects:
(1) those concerning the aim of Basel 2 and the differences between economic and regulatory capital; (2) those that refer to specialization, size and lending diversification; (3) those related to the implementation of the new capital adequacy requirements, including the sectoral project of Spanish savings banks for the global control of risk.

(i) Aim of Basel 2 and Economic and Regulatory Capital Differences
While the objective of Stakeholder Wealth Maximization (STWM) may match more closely the nature of Spanish savings banks, SWM should not be a problem for savings institutions since they have to compete with commercial banks. Nevertheless, the SWM model will be reinforced by Basel 2 and Spanish savings banks may benefit from recent regulatory changes that stress their ownership status as private and non-subsidised.

(ii) Size, specialisation and lending diversification
Specialist banks (like savings banks) focusing on a smaller number of core products may also be able to obtain the risk management benefits of specialisation. Continuous calibration and capital treatment may reduce the potential loss of competitiveness in retail banking. Servicing, relationship banking and dynamic lending will also be valued positively.

(iii) Final implementation of Basel 2 on Spanish savings banks: the sectoral project for the global control of risk The Spanish Confederation of Savings Banks (CECA) has led an ambitious initiative to undertake a sectoral project for the global control of risk. Since this project is oriented to the whole savings bank sector, it has to deal with various problems, like the rigidities of employing a single model for all institutions. However, the project is targetted to provide savings banks with adequate and centralised human and technological resources in order to implement their own model with a high standard of quality.

The model for each line of business incorporates risk measurement, control and management operating with three different working groups: information management; organization and procedures; quantitative tools.

5.4. COMPARATIVE DESCRIPTIVE STATISTICS
The credit risk of Spanish depository institutions does not seem to be a concern in the short-run. The ratios “doubtful assets/total exposures” and “doubtful loans of other resident sectors/total exposures of resident sectors” have decreased in recent years and are lower than 1% (Table 1). “Statistical” provisions have increased over time as a percentage of total provisions (Table 1).

TABLE 1. Source: Bank of Spain (Memory of Bank Supervision 2004)

Savings banks and credit co-operatives have enjoyed higher margins compared to commercial banks (Table 2). The margins are in line with the European standards. However, competitive presures have resulted in a decrease of margins over time during the last years.

As shown in Table 3, Spanish banks have progressively changed their financial structure to fulfill the requirements of Basel 2. Both Tier 1 and Tier 2 capital have increased significantly in recent years. Banks have increased both the average weight of credit risk exposure and off-balance sheet exposure.

Changes in capitalization structure have led to an anticipated fulfillment of Basel 2 requirements (Figure 1a). Tier 1 capital has largely contributed to a reduction in capital requirements, in a context of a significant increase in risk-weighted assets (rise in overall business and Santander’s purchase of Abbey National) (Figure 1b). However, Tier 1 capital has contributed to the growth rate of capital (Figure 1c). Reserves have contributed largely to the growth of Tier 1 capital while the contribution of intangible assets has been negative (Figure 1d).

FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS BANKS IN SPAIN (1)
Source: Bank of Spain (Financial Stability Report, n.8, 2005, May)

Measurement of credit risk

Types of Loans: C&I (commercial and industrial) loans: secured and unsecured Syndication Spot loans, Loan commitments Decline in C&I loans originated by commercial banks and growth in commercial paper market. Downgrades of Ford, General Motors and Tyco RE (real state) loans: primarily mortgages Fixed-rate, variable rates Mortgages can be subject to default risk when loan-to-value declines.

*CreditMetrics (sistema patentado)
“If next year is a bad year, how much will I lose on my loans and loan portfolio?” VAR = P × 1.65 × s Neither P, nor s observed. Calculated using: (i)Data on borrower’s credit rating; (ii) Rating transition matrix; (iii) Recovery rates on defaulted loans; (iv) Yield spreads.

* Credit Risk+ (sistema patentado)
Developed by Credit Suisse Financial Products. Based on insurance literature: Losses reflect frequency of event and severity of loss. Loan default is random. Loan default probabilities are independent. Appropriate for large portfolios of small loans. Modeled by a Poisson distribution.

Credit risk measurement has evolved dramatically over the last 20 years.
The five forces made credit risk measurement become more important than ever before: A worldwide structural increase in the number of bankruptcies. A trend towards disintermediation by the highest quality and largest borrowers.

(iii) More competitive margins on loans.
(iv) A declining value of real assets in many markets. (v) A dramatic growth of off-balance sheet instrument with inherent default risk exposure, including credit risk derivatives.

Responses of academics and practitioners:
Developing new and more sophisticated credit-scoring/early-warning systems Moved away from only analyzing the credit risk of individual loans and securities towards developing measures of credit concentration risk Developing new models to price credit risk (e.g. RAROC) Developing models to measure better the credit risk of off-balance sheet instruments

Credit Risk Management
An FI’s ability to evaluate information and control and monitor borrowers allows them to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments An FI accepts credit risk in exchange for a fair return sufficient to cover the cost of funding (e.g., covering the cost of borrowing, or issuing deposits)

Credit Scoring Power of sale Credit scoring system
a mathematical model that uses observed loan applicant’s characteristics to calculate a score that represents the applicant’s probability of default Perfecting collateral ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default Foreclosure taking possession of the mortgaged property to satisfy a defaulting borrower’s indebtedness Power of sale taking the proceedings of the forced sale of property to satisfy the indebtedness

Credit Scoring Consumer (individual) and Small-business lending
techniques for scoring consumer loans very similar to mortgage loan credit analysis but more emphasis placed on personal characteristics such as annual gross income and the TDS score small-business loans more complicated and has required FIs to build more sophisticated scoring models combining computer-based financial analysis of borrower financial statements with behavioral analysis of the owner

Ratio Analysis Historical audited financial statements and projections of future needs Calculation of financial ratios in financial statement analysis Relative ratios offer information about how a business is changing over time Particularly informative when they differ either from an industry average or from the applicant’s own past history

Common Size Analysis and After the Loan
Analyst can divide all income statement amounts by total sales revenue and all balance sheet amounts by total assets Year to year growth rates give useful ratios for identifying trends Loan covenants reduce risk to lender Conditions precedent those conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted

Large Commercial and Industrial Lending
Very attractive to FIs because transactions are often large enough make them very profitable even though spreads and fees are small in percentage FIs act as broker, dealer, and adviser in credit management The standard methods of analysis used for mid-market corporates applied to large corporate clients but with additional complications Financial ratios such as the debt-equity ratio are usually key factors for corporate debt

The KMV Model Banks can use the theory of option pricing to assess the credit risk of a corporate borrower The probability of default is positively related to: the volatility of the firm’s stock the firm’s leverage A model developed by KMV corporation is being widely used by banks for this purpose

Calculating the Return on a Loan
A number of factors impact the promised return that an FI achieves on any given dollar loan the interest rate on the loan any fees relating to the loan the credit risk premium on the loan the collateral backing the loan other nonprice terms (such as compensating balances and reserve requirements)

Return on Assets (ROA) 1 + k = 1 + f + (L + m) 1 - (b(1 - R)) where
k = the contractually promised gross return on the loan f = direct fees, such as loan origination fee L = base lending rate m = risk premium b = compensating balances R = reserve requirement charge

Risk-Adjusted Return on Capital (RAROC)
Rather than evaluating the actual or promised annual cash flow on a loan as a percentage of the amount lent (ROA), the lending officer balances the loan’s expected income against the loan’s expected risk RAROC = One-year income on a loan/Loan (asset risk or capital at risk

APPENDIX: Bank regulation and credit risk: an example from Basel II and savings banks
Historically, regulation has limited who can: open or charter new banks and what products and services banks can offer. Imposing barriers to entry and restricting the types of activities banks can engage in clearly enhance safety and soundness, but also hinder competition.

It assumed that the markets for bank products, largely bank loans and deposits, could be protected and that other firms could not encroach upon these markets. Not surprisingly, investment banks, hybrid financial companies, insurance firms, and others found ways to provide the same products as banks across different geographic markets.

However, there is another type of regulation that has concentrated most of the attention in the last three decades, the bank capital regulation. Changes in reserve requirements …directly affect the amount of legal required reserves and thus change the amount of money a bank can lend out. The main recent example is BASEL II.

Basel 2 is a ‘step change’ in the regulation of capital adequacy
Basel 2 is a ‘step change’ in the regulation of capital adequacy. It will alter the industry ‘frame of reference’ for banks in many ways: Regulators are clearly recognizing market realities and seeking a much closer congruence between regulatory and economic capital. The new proposals are more complex and sophisticated than earlier schemes. They will also have to evolve as market conditions, technology and financial management techniques develop.

The calibration exercises that have resulted from the various Quantitative Impact Studies (QIS) are targeted (initially at least) to deliver broadly the same amount of capital as the current Accord. However, the mix of capital charges will change significantly with the wider range of risk weights and greater risk sensitivity of Basel 2. Basel 2 will clearly be much more risk-sensitive in assigning capital charges. Mortgage lending and lending to higher quality borrowers will be incentivied under Basel 2.

It is not clear whether the present or new Basel Accord are a binding constraint on bank’s current credit operations. Jackson et al (2001, Bank of England WP) suggest that banks may employ more conservative capital standards than those imposed under Basel 1 or likely under Basel 2. Compliance costs are likely to increase. Banks will have to evaluate (as a kind of capital investment decision) whether the costs (including compliance costs) of moving to the more advanced Basel 2 systems are worthwhile.

Banks will increasingly target better risk management as a source of competitive advantage. Increasingly, superior risk management will become a ‘key success factor’ for those banks who are able to respond successfully to the new environment. Nevertheless, specialist banks who focus on a smaller number of core products and services should similarly be able to obtain risk management benefits of specialization.

Basel 2 will enhance present securitisation trends in banking
Basel 2 will enhance present securitisation trends in banking. This will help in its turn to emphasise further the strategic importance of investment banking. At the same time, lending bankers will face increasing ‘adverse selection’ trends as the better credits are able to access directly the capital markets. This trend will help to re-emphasise the importance of credit skills in lending banks. It will also put pressure on these banks to widen their margins (in order to achieve the higher risk premia needed to cover their more risky lending).

Governance will be an increasingly important issue in the new regime
Governance will be an increasingly important issue in the new regime. More disclosure is not enough by itself to secure market discipline (the aim of Pillar 3). A wide collection of new and improved governance structures will be needed. These include: a freer market in bank corporate control; good corporate governance in banks; incentive-compatible safety nets; ‘no bail-out’ policies; and proper accounting standards. Banks will be required to disclose more information than ever before to the external market. This will involve additional compliance costs. Strategically, it will reinforce any competitive advantage gained by good risk-management banks.

Under Pillar 3 and with likely changes in bank governance arrangements, the prospects of take-overs (and no bail-outs) for individual banks who are ‘inefficient’ are likely to increase. This ‘new world’ is a likely further threat to concepts like mutuality and subsidised (or at least protected from competition) regional banking. Insofar as the new capital regime allows non-bank financial companies a competitive advantage (via lesser capital backing), banks will attempt to alter the balance of competitive advantage through regulatory arbitrage

More work is needed on stress testing under Basel 2 and banks can expect further, more detailed efforts from regulators in this area. Already, stress testing appears to be a standard management technique for many banks and most banks that stress test do so at a high frequency (daily or weekly): see Fender and Gibson (Risk, 2001).

Perhaps the most fundamental strategic impact of Basel 2 is that it will enhance the SWM (Shareholder Wealth Maximisation) model as the major strategic and managerial model for banks. The essence of this model is its focus on risk and return and the impact of this tradeoff on bank value; the model also emphasises the need for greater risk sensitivity in risk assessments and pricing. Within this model, better risk management is rewarded.

Although most of the strategic implications mentioned earlier for retail banks apply also to Spanish savings banks, there are some specific features of the Spanish savings banks that may modify some of these conclusions. These specific features are explored in this section (and summarised in Diagram 1): There have been some recent regulatory actions regarding risk and capital in the Spanish banking system that should be taken into account when defining the threats and opportunities of the new framework for savings banks. The development of a Default Hedging Statistical Fund (the so-called FECI) by the Bank of Spain are two of the recent developments in the regulatory field that impact on the current solvency risk of Spanish savings banks

1. SPANISH SAVINGS BANKS AND THE NEW REGULATORY
DIAGRAM 1. SPANISH SAVINGS BANKS AND THE NEW REGULATORY CAPITAL FRAMEWORK. KEY FEATURES SPANISH SAVINGS BANKS AND THE NEW REGULATORY CAPITAL FRAMEWORK REGULATION: MARKET DEVELOPMENTS – B ASEL 2 CAPITAL REGULATION AND OWNERSHIP STRATEGIC IMPLICATIONS SECTORAL PROJECT FOR THE GLOBAL CONTROL OF RISK

The establishment of so-called statistical, pro-cyclical or dynamic provisions:
Requiring banks to increase these provisions when the business cycle is positive and reducing them during downturns in order to favor intertemporal risk smoothing and loan supply. Basel 2 does not appear to change the view of banking as a pro-cyclical business. Basel 2 could even exacerbate cyclical effects. It is this contingency that has led the Bank of Spain to establish the so-called pro-cyclical or dynamic provisions. The recent lending patterns of the Spanish savings banks are known to reduce these pro-cyclical effects since they have increased credit supply almost linearly over the business cycle.

The lending behavior of savings banks has not resulted in higher defaults. On the contrary, default risk management at savings banks has apparently been more efficient than for commercial banks, a fact that may be largely explained by the intertemporal risk smoothing advantages achieved via a close contractual relationship with their customers.

There are three main types of “savings-bank” specific effects:
(1) those concerning the aim of Basel 2 and the differences between economic and regulatory capital; (2) those that refer to specialisation, size and lending diversification; (3) those related to the implementation of the new capital adequacy requirements, including the sectoral project of Spanish savings banks for the global control of risk.

(i) Aim of Basel 2 and Economic and Regulatory Capital Differences
While the objective of Stakeholder Wealth Maximisation (STWM) may match more closely the nature of Spanish savings banks, SWM should not be a problem for savings institutions since they have to compete with commercial banks. Nevertheless, the SWM model will be reinforced by Basel 2 and Spanish savings banks may benefit from recent regulatory changes that stress their ownership status as private and non-subsidised.

(ii) Size, specialisation and lending diversification
Specialist banks (like savings banks) focusing on a smaller number of core products may also be able to obtain the risk management benefits of specialisation. Continuous calibration and capital treatment may reduce the potential loss of competitiveness in retail banking. Servicing, relationship banking and dynamic lending will also be valued positively.

(iii) Final implementation of Basel 2 on Spanish savings banks: the sectoral project for the global control of risk The Spanish Confederation of Savings Banks (CECA) has led an ambitious initiative to undertake a sectoral project for the global control of risk. Since this project is oriented to the whole savings bank sector, it has to deal with various problems, like the rigidities of employing a single model for all institutions. However, the project is targetted to provide savings banks with adequate and centralised human and technological resources in order to implement their own model with a high standard of quality.

The model for each line of business incorporates risk measurement, control and management operating with three different working groups: information management; organization and procedures; quantitative tools.

COMPARATIVE DESCRIPTIVE STATISTICS
The credit risk of Spanish depository institutions does not seem to be a concern in the short-run. The ratios “doubtful assets/total exposures” and “doubtful loans of other resident sectors/total exposures of resident sectors” have decreased in recent years and are lower than 1% (Table 1). “Statistical” provisions have increased over time as a percentage of total provisions (Table 1).

Savings banks and credit co-operatives have enjoyed higher margins compared to commercial banks (Table 2). The margins are in line with the European standards. However, competitive presures have resulted in a decrease of margins over time during the last years.

As shown in Table 3, Spanish banks have progressively changed their financial structure to fulfill the requirements of Basel 2. Both Tier 1 and Tier 2 capital have increased significantly in recent years. Banks have increased both the average weight of credit risk exposure and off-balance sheet exposure.

Changes in capitalization structure have led to an anticipated fulfillment of Basel 2 requirements (Figure 1a). Tier 1 capital has largely contributed to a reduction in capital requirements, in a context of a significant increase in risk-weighted assets (rise in overall business and Santander’s purchase of Abbey National) (Figure 1b). However, Tier 1 capital has contributed to the growth rate of capital (Figure 1c). Reserves have contributed largely to the growth of Tier 1 capital while the contribution of intangible assets has been negative (Figure 1d).

Other Risks Faced by Financial Intermediaries

Risks Faced by Financial Intermediaries
Liquidity Risk Interest Rate Risk Market Risk Off-Balance-Sheet Risk Foreign Exchange Risk Country or Sovereign Risk Technology Risk Operational Risk Insolvency Risk

Market Risk Incurred in trading of assets and liabilities (and derivatives). Examples: Barings & decline in ruble. DJIA dropped 12.5 percent in two-week period July, 2002. Heavier focus on trading income over traditional activities increases market exposure. Trading activities introduce other perils as was discovered by Allied Irish Bank’s U.S. subsidiary, AllFirst Bank when a rogue trader successfully masked large trading losses and fraudulent activities involving foreign exchange positions

Off-Balance-Sheet Risk
Striking growth of off-balance-sheet activities Letters of credit Loan commitments Derivative positions Speculative activities using off-balance-sheet items create considerable risk

Technology and Operational Risk
Risk that technology investment fails to produce anticipated cost savings. Risk that technology may break down. CitiBank’s ATM network, debit card system and on-line banking out for two days Wells Fargo Bank of New York: Computer system failed to recognize incoming payment messages sent via Fedwire although outgoing payments succeeded

Technology and Operational Risk
Operational risk not exclusively technological Employee fraud and errors Losses magnified since they affect reputation and future potential Merrill Lynch $100 million penalty

Country or Sovereign Risk
Result of exposure to foreign government which may impose restrictions on repayments to foreigners. Often lack usual recourse via court system. Examples: Argentina Russia South Korea Indonesia Malaysia Thailand.

Country or Sovereign Risk
In the event of restrictions, reschedulings, or outright prohibition of repayments, FIs’ remaining bargaining chip is future supply of loans Weak position if currency collapsing or government failing Role of IMF Extends aid to troubled banks Increased moral hazard problem if IMF bailout expected

Liquidity Risk Risk of being forced to borrow, or sell assets in a very short period of time. Low prices result. May generate runs. Runs may turn liquidity problem into solvency problem. Risk of systematic bank panics. Example: 1985, Ohio savings institutions insured by Ohio Deposit Guarantee Fund Interaction of credit risk and liability risk Role of FDIC (see Chapter 19)

Insolvency Risk Risk of insufficient capital to offset sudden decline in value of assets to liabilities. Continental Illinois National Bank and Trust Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.

Insolvency Risk Management
Net worth a measure of an FI’s capital that is equal to the difference between the market value o its assets and the market value of its liabilities Book Value value of assets and liabilities based on their historical costs Market value or mark-to-market value basis balance sheet values that reflect current rather than historical prices

Central Bank & Interest Rate Risk
Federal Reserve Bank: U.S. central bank Open market operations influence money supply, inflation, and interest rates Oct-1979 to Oct-1982, nonborrowed reserves target regime – did not work Implications of reserves target policy: Increases importance of measuring and managing interest rate risk. Effects of interest rate targeting. Lessens interest rate risk Greenspan view: Risk Management Focus on Federal Funds Rate Simple announcement of Fed Funds increase, decrease, or no change.

Implications Emphasizes importance of: Measurement of exposure
Control mechanisms for direct market risk—and employee created risks Hedging mechanisms

Market Risk Market risk is the uncertainty resulting from changes in market prices . Affected by other risks such as interest rate risk and FX (foreign exchange) risk It can be measured over periods as short as one day. Usually measured in terms of dollar exposure amount or as a relative amount against some benchmark.

Market Risk Measurement
Important in terms of: Management information Setting limits Resource allocation (risk/return tradeoff) Performance evaluation Regulation BIS and Fed regulate market risk via capital requirements leading to potential for overpricing of risks Allowances for use of internal models to calculate capital requirements

(MATERIAL DEL PROFESOR)
Tema 6 ANATOMÍA DE LAS CRISIS BANCARIAS: LA CRISIS CREDITICIA DE 2007 Y 2008 (MATERIAL DEL PROFESOR)

Asymmetric information and its implications
Banking crises Definition of a banking crisis. Recent evidence and why we should care. Sources of banking crises. Regulatory responses Strengthening regulation and supervision. Reforming the financial safety net (deposit insurance and lender of last resort).

Asymmetric Information and its Implications

Definition Information is asymmetric when one party to an economic relationship or transaction has less information about it than the other party or parties. Pervasive role in financial markets. Lenders often do not know the riskiness of the borrower applying for a loan; Lenders may not be able to observe whether the borrower will invest in a safe or risky project.

The very existence of financial institutions can be explained on asymmetric-information grounds.
Reason: financial intermediaries specialize in gathering and analyzing infor-mation about borrowers and their investment projects. They thereby attenuate the incidence of information asymmetries. From this perspective, they act as delegated monitors.

General Implications Adverse selection. If the price of insurance against a particular contingency is fixed independently of the characteristics of the behavior of the insured, individuals at greater risk will choose to insure. Moral hazard. After a contract comes into effect, insured agents have an incentive to change their behavior in ways that adversely affect the interests of the insurer.

Free-rider problems. An agent that collects infor-mation about a particular risk may be unable to prevent other agents from using that information (e.g. deposit insurance institution that is unable to price risk accurately). Rational herding. Agents may choose to disregard their own information and instead react to information on the decisions taken by other agents (information externalities).

Principal-agent and monitoring problems
Principal-agent and monitoring problems. A principal may be unable to observe perfectly the actions of the agent to whom a certain activity or responsibility is delegated. Examples: Bank shareholders may not perfectly observe investment decisions taken by managers; regulators may not be able to determine the exact degree of riskiness of loans made by banks.

Implications for the credit market
Adverse selection ensures that a disproportionate number of “bad” projects are presented for financing. Borrowers are induced to choose projects for which the probability of default is higher, because riskier projects are associated with higher expected returns. May lead to credit rationing; see Stiglitz and Weiss (1981). Banks may be tempted to engage in overly risky lending activities in the presence of deposit insurance.

Banking Crises

Definition of a Banking Crisis
Problematic, no standard definition: Example: (Detragiache, Demirguc-Kunt (1998a)). A distress episode is a crisis when Ratio of nonperforming loans to total bank loans exceeded 10%. Cost of the rescue operation (or bailout) was at least 2% of GDP.

Episode involved a large-scale nationalization of banks (and possibly other institutions).
Extensive bank runs took place or emergency measures (deposit freezes, prolonged bank holidays, or generalized deposit guarantees) were enacted by the government.

Problems Information on nonperforming loans: often not reliable and timely. Evergreening problem. Cost of rescue operations is often difficult to measure due to the importance of quasi-fiscal costs, contingent liabilities, and restructuring costs. Liquidity provided at below-market interest rates (quasi-fiscal effect). Promise to bail out ailing banks provides an implicit subsidy.

Estimating the net costs of banking sector restructuring is difficult; requires assumptions about
amount of liquidity support; present and future incidence of nonperforming loans and their recovery rate. Estimates are often calculated on a gross basis; leads to overestimation by excluding (Hawkins and Turner (1999)) future proceeds from reprivatization; loan recovery; repayment of the liquidity assistance provided by the government.

“Run” or “event” criterion: A crisis can indeed, in some cases, be dated that way.
Problems Runs are often short lived. Dramatic “events” rarely represent either the beginning, or the end, of the crisis. In most cases insolvency problems were already present and worsening; event itself is merely the point at which underlying problems are revealed (either to the regulator or the public).

Subprime Mortgage Crisis

Background Introduction
What is Subprime lending? the practice of making loans to borrowers who do not qualify for the best market interest rate because of their deficient credit history or inability to prove they could for the loans they are applying. Subprime loan involves high risks. --housing market --a combination of high interest rates, bad credit history and murky financial situations associated with the applicants.

Causes of the Crisis Many factors created the crisis, but the most immediate causes were a rising interest rate environment which caused people with adjustable rate mortgages (ARM) to see significant increases in their mortgage payments, and declining property values as the national real estate market finally began making corrections (Housing bubble bursts).

Role of Mortgage lenders
--Incomplete lending procedure. For example, Many of the sub-prime loans did not even require that borrowers document the income listed on their loan application with a pay stub. some of the lending probably involved actual fraudulence where people misstated their income and qualifications. --adjustable-rate mortgages (ARM); interest-only adjustable-rate mortgages

--Difficult to refinance due to declining property values.
Role of Subprime borrowers—homeowners --With the assumption that housing prices would continue to increase, many subprime borrowers are encouraged to obtain ARM. --Difficult to refinance due to declining property values. Role of Regulators --In response to a concern that lending environment was too easy or say, not properly regulated, the House and Senate are both considering making some new bills to regulate lending practices.

Part III- The countrywide influence and the corresponding reactions
Drastic fluctuation in stock market--investors began to worry about whether the Subprime crisis will turn into a global economic one. Many investment banks, mortgage lenders, real estate investment trusts and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation. --New Century Finance; American Home Mortgage --Merrill Lynch;Citigroup

The recession of housing market and the continually increased oil prices will slow down the step of economic growth rate of the U.S.

Subprime Mortgage Crisis
Sharp rise in home foreclosures in late 2006 Only 9% in 1996, 13% in 1999, 20% in 2006 $1.3 Trillion subprime mortgage as of March 2007 The delinquency rate had risen to 21% by 2008 Subprime Borrowers For poor credit history Limited income Subprime Lenders Greater risks High returns

New Model of Mortgage Lending
Source: BBC News

Causes of the Crisis The Housing Downturn Borrowers
Excess supply of home inventory Sales volume of new homes dropped Reduced market prices (10.4% 12/06-12/07) Increasing foreclosure rates Borrowers Difficulties in re-financing Begin to default on loans Walk away from properties Fraudulent misrepresentations

Causes of the Crisis Financial Institutions Securitization
Attraction from high returns Offered high-risk loan and incentives Believes that will pass on the risk to others Securitization Mortgage backed securities Risk readily transferred to other investors From 54% in 2001 to 75% in 2006

Causes of the Crisis Government and Regulators Central banks
Community Reinvestment Act, encourages the development of the subprime debacle Glass-Steagall Act contributes to the subprime crisis (FDIC back up) Central banks Less concerned with avoiding asset bubbles React after bubbles burst to minimize the impact No determination on monetary policy Institutions risk more because of Fed’s rescue

Direct Impacts of the Crisis
Stock Market 08/15/07 Dow Jones had dropped below 13,000 from July’s 14000 First 3 weeks of 08, the Dow Jones Industrial Average fell 9% 1/18/08 Dow Jones/0.5%, S&P 500/0.6%, and NASDAQ/0.3% 01/21/08 (black Monday) the world’s biggest falls since Sept. 11, 2001

Financial Institutions – Bankruptcy New Century Financial (USA)– Apr. 2, 2007 American Home Mortgage (USA) – Aug. 6, 2007 Sentinel management Group (USA) – Aug. 17, 2007 Ameriquest (USA) – Aug. 31, 2007 NetBank (USA) – Sept. 30, 2007 Terra Securities (Norway) – Nov. 28, 2007 American Freedom Mortgage Inc. (USA) – Jan. 30, 2007

Financial Institutions – Write-Downs Citigroup (USA) - $24.1 bln Merrill Lynch (USA) - $22.5 bln UBS AG (Switzerland) - $16.7 bln Morgan Stanley (USA) - $10.3 Credit Agricole (France) - $4.8 bln HSBC (United Kingdom) - $3.4 bln Bank of America (USA) - $5.28 bln CIBC (Canada) – 3.2 bln Deutsche Bank (Germany) - $3.1 bln By 02/19/08 losses or write-downs > U.S. $150 bln Be expected exceeding $200 - $400 bln

Domestic Impacts of the Crisis
Home Owners Housing prices down 10.4% in Dec. 07 vs. year-ago Sales of new homes dropped by 26.4% in 07 vs. 06 By Jan. 2008, the inventory of unsold new homes stood at 9.8 months, the highest level since 1981. Two million families will be evicted from their homes Minorities Disproportionate level of foreclosures in minority 46% Hispanics, 55% blacks got higher cost loans

Domestic Impacts of the Crisis
Economy Condition Recession Low GDP growth rate Business close out or lose money (banks, builders etc.) Weak financial market Low consumer spending Lose jobs Other credit markets Credit card Car loan

Global Impacts of the Crisis
Investors will be very cautious to act Lack confidence in stock/bound market Consumer spending will slowdown Lack of cash or unwilling to spend World economy may slip into recession U.S. economy condition will affect global economy GDP growth will be low Lose businesses Lose jobs Economy slow down

Global Impacts of the Crisis
Financial market May take long time to recover Unemployment rate may be high Slow economy increase unemployment rate Exports will decrease in China, Korea, Taiwan GDP growth heavily depends on export

Government and Central Banks’ Actions
08/2007, President Bush announced – Hope New Alliance 02/13/08, President signed a tax rebates of $168 bln 09/18/07, the Fed dropped rate ½ point 10/31/07, ¼ point cut by Fed 12/11/07, ¼ point cut by Fed 01/22/08 the Fed slashed the rate by 3/4 points to 3.5% 01/30/08 another cut of 1/2 points to 3% Central Banks have pumped billions of dollars to banks Central Banks of the world have done the same thing

LECTURA DE REFERENCIA: CARBÓ ET AL. 2008. EN PRENSA
Tema 7 LAS REDES DE SEGURIDAD, LOS SEGUROS DE DEPÓSITOS Y LOS INCENTIVOS DE LA BANCA INTERNACIONAL LECTURA DE REFERENCIA: CARBÓ ET AL EN PRENSA

Banking Crises: Regulatory Responses
Information disclosure. Strengthening regulation and supervision. Reforming the financial safety net (deposit insurance and lender of last resort).

Information disclosure
Transparency (e.g. improvements in standards for data dissemination): viewed as important to crisis prevention. Can help markets to improve their pricing of risk, prevent the buildup of imbalances, and force policymakers to take timely action to address vulnerabilities. However: information disclosure is not a “cure-all.” Information is noisy and can be misinterpreted; perverse effect: bank runs.

Strengthening regulation and supervision
Current consensus: bank supervision needs to be strengthened before financial liberalization. Objectives: ensure adequate internal controls and procedures, avoid concentrated patterns of credit or market risk exposure... …enforce accounting principles and disclosure requirements... …impose stricter asset classification and provisioning practices that reduce the scope for delay in recognizing bad loans, and encourage banks to make adequate provisions against loan losses.

Also: improve incentives for supervisors
Also: improve incentives for supervisors. Risks of forbearance (leaving insolvent banks in operation) and regulatory capture: create moral hazard, regulation becomes ineffective. October 1997: Basle Committee on Banking Supervision released 25 core principles for effective banking supervision that cover licensing structure, prudential regulations and requirements, methods for on-site and off-site banking supervision, information requirements, prerogatives of supervisors.

Prudential regulations aimed at containing risks associated with capital flows:
Limits on banks’ open net foreign currency positions (difference between unhedged foreign-currency assets and liabilities). Limits on exposure to volatility in equity and real-estate markets… …would help to insulate the banking system from bubbles associated with large capital inflows… …and help to avoid excessive concentration of credit risk.

Discourage excessive exposures of domestic firms and (indirectly banks) by taxing short-term capital inflows (e.g. Chile). Impose marginal reserve requirements on deposits (higher as the maturity of deposits shortens); help to insulate the banking system from exposure to the risks of abrupt reversals in capital flows; prevent a credit boom driven by a surge in bank deposits (ensures a gradual expansion of banks' loan portfolios). Attractive goal when capital inflows take mostly the form of short-term bank deposits.

Problems measures could result in some degree of disintermediation of capital inflows; they do not discriminate between “weak” (or undercapitalized) banks and “strong’” banks, whose behavior is less risky and credit assessment capacity is strong. Inadequate supervision: second-best argument for maintaining restrictions on capital flows, imposing limits on lending growth, or to proceed more gradually with financial liberalization.

Deposit insurance and lender of last resort.
Financial safety nets Deposit insurance and lender of last resort. As with any form of insurance, they both tend to exacerbate the problem of moral hazard: If banks know (or believe) that they will be rescued in case of liquidity problems, they will have fewer incentives to manage their portfolios prudently. If depositors are insured against loss, they will have limited incentives to monitor the soundness of the institutions with which they place their funds.

Financial safety nets--Deposit insurance
Benefits If depositors' funds are guaranteed, borrowers need not worry about bank soundness. May eliminate costly runs (Diamond-Dybvig). Pitfalls If deposits are guaranteed, depositors will not monitor bank quality. Insolvent banks will continue to operate as long as government guarantees are credible. Because they are not liable for doing poorly, banks may take on riskier loans.

Deposit insurance cannot prevent bank runs resulting from a loss of confidence in the currency, because it generally does not guarantee the foreign-currency value of deposits. Mitigating Moral Hazard Reduce risk to the system by closely monitoring banks' activities and supervising compliance with regulations. Limit explicit deposit insurance (coinsurance). Both insured and insurer are responsible for some loss. Depositors may lose a certain % of the covered amount (UK) or bear a specified fraction of the loss at different levels of coverage (Italy).

Limitations Partial deposit insurance may not strengthen discipline; de facto treatment of depositors after bank failures is often more generous than de jure arrangements. Small depositors may be too dispersed or too unsophisticated to exert much pressure (through deposit withdrawals) on weak banks.

Adjust premiums for risk to induce greater monitoring by depositors and enhance cautious lending practices. In practice, however: differences in premium rates across banks are small. Evidence Garcia (1999): survey of the characteristics of explicit deposit insurance system (DIS) in 68 industrial and developing countries. DIS: often introduced in the context of a crisis. Example: Asia: full guarantee of deposits put in place during the crisis (Korea, Malaysia).

Coverage levels: vary across countries.
IMF: uses twice per capita income as a rule of thumb to evaluate coverage levels (other factors: distribution of deposits by size). Significant negative relation between per capita income and DIS coverage ratio. Interpretation: moral hazard is stronger in developing countries. Almost one-third of the total use risk-adjusted premiums. Co-insurance features: more limited.

Shift away from voluntary DIS to compulsory schemes (more than 80% now; 55 out of 68); reduces adverse selection problems. DIS now tend to be funded by member institutions, with access to emergency financing from the government. Trend toward excluding foreign-currency deposits from coverage; in Garcia’s sample, 40% do so. Many countries that cover foreign-currency deposits pay out in domestic currency to protect the DIS from exposure to foreign exchange risk.

Ratio of Deposit Coverage to per capita GDP, 1999
Average ratios for: the World - 3.0 Africa - 6.2 Asia - 4.0 Europe - 1.6 Middle East - 3.4 Western Hemisphere - 3.2 Source: Garcia (2000).

Impact on banking stability
Limited evidence. Demirguc-Kunt and Detragiache (1999): sample of 61 countries for Explicit DIS is detrimental to bank stability, when bank interest rates are deregulated and institutional environment is weak. Adverse impact tends to be stronger the larger the coverage, when the scheme is funded, and where it is run by the government rather than the private sector. Interpretation: unless other safeguards are in place, DIS induces more risk-taking.

Financial safety nets--Lender of last resort
Benefits Informational asymmetries: make solvent banks vulnerable to deposit runs and/or inadequate access to interbank lending in times of crisis. Domino effect or too big to fail problem (insolvent bank): potential risk to stability of the financial system as a whole following the failure of a solvent bank. Bail out is rational to avoid threats to the entire system. Absence of a LOLR facility can drive illiquid banks into insolvency by forcing them to liquidate their assets at “fire sale” prices.

Pitfalls Direct financial cost involved in the explicit provision of funds to insolvent institutions; potential losses. By insuring banks against the costs of liquidity or solvency problems, the provision of liquidity may increase moral hazard. Government guarantees may thus lead to greater incentives to take on risky loans. The existence of a LOLR with the ability to print money can allow inflationary beliefs to become self-fulfilling (Antinolfi, Huybens, and Keister (2001)).

Implications Central bank needs to weigh the cost of providing capital to a possibly insolvent bank against the cost of the instability generated by not doing so. In practice: difficult. Constructive ambiguity: may limit moral hazard by introducing an element of uncertainty into the provision of LOLR assistance (Enoch, Stella, and Khamis (1997)). Difficult notion to pin down; encompasses, besides uncertainty as to whether intervention will occur at all, uncertainty regarding both its exact timing and the terms and penalties attached to it.

LECTURA DE REFERENCIA: ROCHET Y TIROLE, 2003
Tema 8 MEDIOS DE PAGO: TARJETAS BANCARIAS Y MERCADOS BILATERALES LECTURA DE REFERENCIA: ROCHET Y TIROLE, 2003

(Systems, processing, hardware, firmware, Issuing)
An Overview The Players Cardholder Banks Issuing and Acquiring Corporate Sponsor Merchant / POI Processor The Programs Specifics Access Device (Card, Transponder, Terminals ….) Rewards (Points, coupons…) Program (Loyalty supplier, database, rules) Collateral (setup, statements, printed materials) The How! Technology (Systems, processing, hardware, firmware, Issuing)

Electronic Payment Systems
Electronic commerce involves the exchange of some form of money for goods and services. Implementation of electronic payment systems is in its infancy and still evolving. Electronic payments are far cheaper than the traditional method of mailing out paper invoices and then processing payments received.

Estimates of the cost of billing one person vary between $1 and $1.50. Sending bills and receiving payments over the Internet promises to drop the transaction cost to an average of 50 cents per bill. Today, four basic ways to pay for purchases dominate business-to-consumer commerce.

Electronic cash distribution and payment can be handled by wallets, smart cards, or proprietary, limited-use scrip. Scrip is digital cash minted by a company instead of by a government. Companies like Payment Online sell packages of payment processing services to Web merchants that accept several types of payments.

Payment Cards Payment cards are all types of plastic cards that consumers use to make purchases: Credit cards such as a Visa or a MasterCard, has a preset spending limit based on the user’s credit limit. Debit cards removes the amount of the charge from the cardholder’s account and transfers it to the seller’s bank. Charge cards such as one from American Express, carries no preset spending limit.

Advantages and Disadvantages of Payment Cards
Payment cards provide fraud protection. They have worldwide acceptance. They are good for online transactions. Disadvantages: Payment card service companies charge merchants per-transaction fees and monthly processing fees.

Payment Acceptance and Processing
Open and closed loop systems will accept and process payment cards. A merchant bank or acquiring bank is a bank that does business with merchants who want to accept payment cards. Software packaged with your electronic commerce software can handle payment card processing automatically.

Payment Acceptance and Processing

PAYMENT SYSTEMS ARE TWO-SIDED MARKETS
-Card payment systems provide joint services to two users: the cardholder and the merchant. -Even if surcharging is allowed, merchants are reluctant to do it. -Thus it is important to send the correct price signal to the cardholder, who has the last word about the means of payment. -We have a Two-Sided Market because the price structure matters.

OTHER TWO-SIDED MARKETS
Platform Buyers Sellers readers/viewers players computer users consumers newspapers, TV operators video consoles operating systems shopping malls advertisers game developers Software developers shops For all these platforms, finding the appropriate business model (price structure) is vital.

OTHER TWO-SIDED MARKETS
Price structure is often skewed in two-sided markets: Video consoles are subsidized by platforms (extract revenue from developers) Some TV channels and newspapers are free for readers (only advertisers pay) Most shopping malls subsidize buyers (free parking) This does not mean that prices should be regulated. Also, traditional competition policy analysis (excessive prices, predation) does not apply.

THE ROLE OF INTERCHANGE FEES
- In proprietary systems (AMEX, Diners Club) the price structure is chosen by the network. - In four-party systems, payment services are provided jointly by two providers: the issuer and the acquirer. - The interchange fee is a transfer between the two providers that sets the rule for allocating the total cost of the card payment between these two providers.

THE ROLE OF INTERCHANGE FEES
Prices and costs in a four-party system (system fees and costs neglected) Thus decreasing a implies : cost decrease for acquirers and revenue decrease (cost increase) for issuers

GESTIÓN BANCARIA Master en Banca y Finanzas Cuantitativas (QF), 2008

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