1. Saving Institutions

2. 3–2 History of Saving Institution In Europe, savings institution originated in the 19th century. The first English savings bank was established in 1799, The first chartered savings bank in the United States was the Provident Institution for Savings in the Town of Boston, incorporated in December 13, 1816

3. 3–3 Savings institutions are financial intermediaries that raise funds mainly through time and checkable deposits and use the funds to provide loans, principally home mortgages, and to invest in securities. Sometimes referred to as thrift institutions, Definition

4. Components of Saving Institutions The savings institutions sector is made up of: Savings banks Savings banks, are financial intermediaries that acquire funds at periodic intervals on a contractual basis. They tend to invest their funds primarily in long- term securities such as corporate bonds, stocks, and mortgages. Example insurance companies and pension funds. Savings and loan associations “ A cooperative association organized to hold savings of members in the form of dividend-bearing shares and to invest chiefly in home mortgage loans —called also savings and loan“ Known as mutual savings banks, the depositors and borrowers are members with voting rights, and have the ability to direct the financial and managerial goals of the organization

5. 3–5 Ownership mutual (owned by depositors) mutual-to-stock-conversions Allow SIs to obtain additional capital by issuing stock Provide owners with greater potential to benefit from performance Make SIs more susceptible to hostile takeovers

6. 3–6 Ownership in Pakistan State owned Saving institution National saving Bank Mutual owned Saving institution Allied bank Limited (Owned by Ibrahim Group) Bank Alfalah Limited(Owned by Abu Dhabi Group) Abbasi Enterprise(Owned By Mr. Wajid Wasi)

7. 3–7 Difference between saving institution and commercial banks Unlike commercial banks, thrifts have traditionally focused on residential mortgage lending rather than commercial lending Unlike commercial banks, these institutions do not accept demand deposits. Savings banks tend to be smaller and less complex than commercial banks Savings institutions rely on the federal funds market to lend their excess funds or to borrow funds on a short- term basis

8. 3–8 Sources of funds The main sources of funds for SIs are Deposits Borrowed funds Capital They obtain most of their funds from variety of savings and time deposits, including Passbook saving, Retail certificates of deposit(CDs) Money market deposit accounts(MMDAs) Before 1978 SIs focused primarily on pass-book saving accounts Since 1978, SIs are allowed to offer retail CDs with rates tied to Treasury bills Since 1981, SIs are allowed to offer NOW accounts as a result of DIDMCA Since 1986, all deposits were free from ceiling rates. Firstly, they can borrow from other depository institutions that have excess funds in the federal funds market Second, SIs can borrow through repurchase agreement(repo). With the repo an institution sell securities, shortly thereafter. Third, SIs can borrow at the Federal Reserve, but this is not as common as the other alternative The capital(or net worth) of an SI is primarily composed of retained earnings funds obtained from issuing stock. During period when SIs are performing well, capital is boosted by additional retained earnings.

9. 3–9 Uses of Funds The main uses of funds in saving institutions are: Cash Mortgages Mortgage backed securities Other securities Consumer and commercial loans Other users They maintain cash to satisfy reserve requirement They are enforced by federal reserve system to maintain reserve They hold reserve in other institutions in return of various services Primary assets of saving institution Have long term maturities and are usually be prepaid by borrowers 90% mortgages originated are homes purpose 10%work for commercial properties Mortgages can be sold in secondary market and market value change in response to interest rate movement There is interest rate risk as well as credit(default)risk To protect against interest rate risk saving institution use variety of techniques To protect against credit rate risk mortgages serve as collateral To obtain funds SIS commonly issued securities backed by mortgages SIS use available funds to purchase these securities The seller may continue to service the mortgages It passes on the periodic payments to the purchaser It retains a small amount as service fee All SIS invested in two types of bonds Treasury bonds Corporate bonds SIS have also invested in Junk bonds THE proportion of funds invested in junk bonds varied substantially among SIS some stated imposed limits on this type of investments.

10. 3–10 Many SIS are attempting to increase their consumer loans and commercial loans Both type of chartered include Federally chartered State chartered State chartered SIS were also granted more lending by their respective states Federally chartered SIS are allowed to invest up to 30%of their assets in non mortgages loans and securities A maximum 10 % of assets can be used to provide non- real estate commercial loans Some saving institutions taken advantage of the de-regulatory acts by providing corporate and consumer loans, The maturities range between 1 to 4 years The loss rate on mortgages loans has been significant lowers than the loss rate on credit card loans Consumer and commercial loans Saving banks provide temporary financing to other institutions through the use of repurchase agreements They can lend funds on short term basis in federal fund market Other uses of funds

11. 3–11 Regulations of Saving institutions Saving institute are regulated at both state level federal level Supervision can be vary according to whether SI is manual stock owned In Pakistan Saving institutions are regulated by State Bank of Pakistan

12. 3–12 Regulatory assessment of Savings Institutions Regulators conduct periodic onsite examination. They ensure minimum level of capital required and maintain their exposure to risk within a tolerable range. SIs are monitored similar to commercial banks. They are assessed according to their capital adequacy, asset quality, management, and sensitivity to market conditions

13. 3–13 Exposure to risk SIs are exposed to Liquidity risk Credit risk Interest rate risk Their sources and uses of funds differ from other banks so their exposure to risk varies as well. SIs commonly use short-term liabilities to finance long- term assets. They depend on additional deposits to accommodate withdrawal requests. If new deposits are not sufficient to cover withdrawal request, SIs can experience liquidity problems. This problem can be solved by obtaining funds through repurchase agreements or borrowing funds in the federal funds market. An alternative method for resolving this problem is, to sell assets in exchange for cash. They can sell their treasury securities or even some of their mortgages in the secondary market.. Liquidity risk The main reason for credit risk at SIs is mortgages. Federal Housing Authority(FHA) mortgages originated by SIs insured against credit risk. Conventional mortgages are not insured against credit risk. Private insurance can be obtained from conventional mortgages, but SIs incur the risk themselves rather than pay for the insurance. SIs exposure to credit risk increased because they rely on households for most of their income. Credit risk The exposure of SIs to interest rate risk is high They have a heavy concentration of fixed rate mortgages The spread between their interest revenue and interest expenses narrowed when interest rate increased. The spread even becomes negative because rates on deposits increased beyond the fixed interest rates charged on mortgages Interest rate risk

14. 3–14 Interaction with other Financial Institution SIs interacts with various types of financial institutions. Saving institutions compete with commercial banks and money market mutual funds to obtain funds as well as with finance companies in lending funds. Types of financial institutionsInteraction with saving institutions Commercial banksCompete with SIs in attracting deposits providing commercial loans Finance companiesCompete with SIs in providing consumers and commercial loans Money market mutual funds Compete with SIs in attracting short term investment from investors Insurance companiesPurchase mortgages from SIs in the secondary market

15. 3–15 Participation in Financial Market As SIs interact with other financial institutions, they rely on various financial markets, as summarized in this Exhibit; Financial MarketsHow saving institution participate in this market Money Markets Compete with other depository institutions for short term deposits issuing by commercial papers Mortgage Markets Sell mortgage in secondary market and issue mortgage backed securities Bond Markets Purchase bonds from their portfolio investment Future Markets Hedge against interest rate movements by taking position in interest rate future Option Markets Hedge against interest rate movement by purchasing a put option on interest rate futures. Swap Markets Hedge against interest rate movement by engaging in interest rate swap

16. 3–16 Management of Interest Rate Risk Savings institution can use following methods to manage their interest risk Adjustable rate mortgage (ARMs) The interest rate on adjustable rate mortgages is tied to market-determined rates. It enables Sis to maintain a more stable spread between interest revenue and interest expenses. ARMs reduces the adverse impact of rising interest rates, they also reduce the favorable impact of declining interest rate. While ARMs reduce the risks of SIs, they expose consumers to interest rate risk. Interest Rate Future Contracts This contract allows for the purchase of a specific amount of a particular debt security for a specified price at a future point in time. Sellers of future contract are obligated to sell the securities for the contract price at the stated future point in time. If interest rate rises, the market value of the securities represented by the future contract will decrease. The SIs will benefit from the difference between the market value at which they can purchase these securities in the future and the future price at which they will sell the securities. Interest Rate Swaps Interest rate swap allows an SI to swap fixed-rate payment (an outflow) for variable-rate payments (an inflow). The fixed-rate outflow payments can be matched against the fixed-rate mortgages held so that a certain spread can be achieved. In a rising rate environment, the institution’s fixed- rate outflow payment from the swap agreement remains fixed, while the variable-rate inflow payment due to the swap increases.

17. 3–17 Valuation of Saving Institutes Valued by: Managers to monitor progress Financial institutions to take acquisition Value is based on present value of its future cash flows Value changes in response to changes in expected cash flows ΔV = f[ΔE(CF), Δk] + -

18. 3–18 Factors that affect required rate of return It can be modeled as: R, RP) Δk = f(ΔR, ΔRP) + + + + Risk free Rate: An increase in the risk free results in a higher return required by investors which decreases the firm value. Risk Premium: If the risk premium on SI rises, so will the required rate of return by investors who invest in SI. So increase in risk premium decrease its cash flows.

19. 3–19 Factors that affect Cash Flows Economic growth Risk-free interest rate Industry conditions Management abilities Enhance cash flows by increasing household demand for consumer loan or mortgage loan Reduce the loan default Increase the demand for other financial services(real estate and insurance services) because households have high disposable income Cash flow is inversely related to interest rate movements When interest rate decreases other market rates also decrease and demand for SI’ s loans increases which increases cash flows Increase in interest rates reduce SI.s expected cash flows because the interest paid on deposits may increase more than interest earned on loans Industry conditions like regulatory constraints, technology and competition also affect cash flows If regulatory constraints are reduced the expected cash flows of some SI,s increase Reduced regulatory constraints may cause les efficient SI,s to lose market share and result is reduction in cash flows Efficient management abilities increase cash flows Use technology that reduces expense Capitalize on regulatory changes by offering diversified customer services Use derivatives securities to alter positional return and increase cash flows