Chapter 01 - An Overview of the Changing Financial-Services Sector
CHAPTER 1
AN OVERVIEW OF THE CHANGING FINANCIAL-SERVICES SECTOR
Goal of This Chapter: In this chapter you will learn about the many roles financial service providers play in the economy today. You will examine how and why the banking industry and
the financial services marketplace as a whole is rapidly changing, becoming new and different
as we move forward into the future. You will also learn about new and old services offered to
the public.
Key Topics in This Chapter
•
•
•
•
•
•
Powerful Forces Reshaping the Industry
What Is a Bank?
The Financial System and Competing Financial-Service Institutions
Old and New Services Offered to the Public
Key Trends Affecting All Financial-Service Firms
Appendix: Career Opportunities in Financial Services
Chapter Outline
I.
Introduction: Powerful Forces Reshaping the Industry
II.
What Is a Bank?
A. Defined by the Functions It Serves and the Roles It Play:
B.
Banks and their Principal Competitors
C. Legal Basis of a Bank
D.
III.
Defined by the Government Agency That Insures Its Deposits
The Financial System and Competing Financial-Service Institutions
A.
B.
C.
•
•
•
•
•
Roles of financial system
The competitive challenge for banks
Leading Competitors with banks
Savings Associations
Credit Unions
Money Market Funds
Mutual Funds
Hedge Funds
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Chapter 01 - An Overview of the Changing Financial-Services Sector
IV.
• Security Brokers and Dealers
• Investment Banks
• Finance Companies
• Financial Holding Companies
• Life and Property/Casualty Insurance Companies
Services Banks and Many of Their Closest Competitors Offer the Public
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A.
Services Banks Have Offered for Centuries
1.
Carrying Out Currency Exchanges
2.
Discounting Commercial Notes and Making Business Loans
3.
Offering Savings Deposits
4.
Safekeeping of Valuables and Certification of Value
5.
Supporting Government Activities with Credit
6.
Offering Checking Accounts (Demand Deposits)
7.
Offering Trust Services
B. Services Banks and Many of Their Financial-Service Competitors Began Offering in the
Past Cent ury
1.
Granting Consumer Loans
2.
Financial Advising
3.
Managing Cash
4.
Offering Equipment Leasing
5.
Making Venture Capital Loans
6.
Selling Insurance Policies
7.
Selling and Managing Retirement Plans
C. Dealing in Securities:
Offering Security Brokerage and Investment Banking Services
1. Offering Security Underwriting
2. Offering Mutual Funds, Annuities, and Other Investment Products
3. Offering Merchant Banking Services
4. Offering Risk Management and Hedging Services
D. Convenience: The Sum
Total of All Banking and Financial Services
V.
Key Trends Affecting All Financial-Service Firms
A.
Service Proliferation
B.
Rising Competition
C.
Government Deregulation
D.
An Increasingly Interest-Sensitive Mix of Funds
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Chapter 01 - An Overview of the Changing Financial-Services Sector
E.
Technological Change and Automation
F.
Consolidation and Geographic Expansion
G.
Convergence
H.
Globalization
VI.
The Plan of This Book
VII.
Summary
Concept Checks
1-1.
What is a bank? How does a bank differ from most other financial-service providers?
A bank should be defined by what it does; in this case, banks are generally those financial
institutions offering the widest range of financial services. Other financial service providers
offer some of the financial services offered by a bank, but not all of them within one institution.
1-2.
Under U.S. law what must a corporation do to qualify and be regulated as a commercial
bank?
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Under U.S. law, commercial banks must offer two essential services to qualify as banks for
purposes of regulation and taxation, demand (checkable) deposits and commercial loans. More
recently, Congress defined a bank as any institution that could qualify for deposit insurance
administered by the FDIC.
1-3.
Why are some banks reaching out to become one-stop
conglomerates? Is this a good idea, in your opinion?
financial - service
There are two reasons that banks are increasingly becoming one-stop financial service
conglomerates. The first reason is the increased competition from other types of financial
institutions and the erosion of banks’ traditional service areas. The second reason is the
Financial Services Modernization Act which has allowed banks to expand their role to be full
service providers.
1-4. Which businesses are banking’s closest and toughest competitors? What services do they
offer that compete directly with banks’ services?
Among a bank’s closest competitors are savings associations, credit unions, money market
funds, mutual funds, hedge funds, security brokers and dealers, investment banks, finance
companies, financial holding companies, and life and property-casualty insurance companies.
All of these financial service providers are converging and embracing each other’s innovations.
The Financial Services Modernization Act has allowed many of these financial service providers
to offer the public one-stop shopping for financial services.
1-5.
What is happening to banking’s share of the financial marketplace and why? What kind
of banking and financial system do you foresee for the future if present trends
continue?
The Financial Services Modernization Act of 1999 allowed many of the banks’ closest
competitors to offer a wide array of financial services thereby taking away market share from
“traditional” banks. Banks and their closest competitors are converging into one-stop shopping
for financial services and this trend should continue in the future
1-6.
their
What different kinds of services do banks offer the public today? What services do
closest competitors offer?
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Banks offer the widest range of services of any financial institution. They offer thrift deposits to
encourage saving and checkable (demand) deposits to provide a means of payment for
purchases of goods and services. They also provide credit through direct loans, by discounting
the notes that business customers hold, and by issuing credit guarantees. Additionally, they
make loans to consumers for purchases of durable goods, such as automobiles, and for home
improvements, etc. Banks also manage the property of customers under trust agreements and
manage the cash positions of their business customers. They purchase and lease equipment to
customers as an alternative to direct loans. Many banks also assist their customers with buying
and selling securities through discount brokerage subsidiaries, the acquisition and sale of
foreign currencies, the supplying of venture capital to start new businesses, and the purchase
of annuities to supply future funding at retirement or for other long-term projects such as
supporting a college education. All of these services are also offered by their closest
competitors. Banks and their closest competitors are converging and becoming the financial
department stores of the modern era.
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.
these
What is a financial department store? A universal bank? Why do you think
institutions have become so important in the modern financial system?
Financial department store and universal bank refer to the same concept. A financial
department store is an institution where banking, fiduciary, insurance, and security brokerage
services are unified under one roof. A bank that offers all these services is normally referred to
as a universal bank. These have become important because of convergence and changes in
regulations that have allowed financial service providers to offer all services under one roof
1-8.
Why do banks and other financial intermediaries exist in modern society, according to
the theory of finance?
There are multiple approaches to answering this question. The traditional view of banks as
financial intermediaries sees them as simultaneously fulfilling the financial-service needs of
savers (surplus-spending units) and borrowers (deficit-spending units), providing both a supply
of credit and a supply of liquid assets. A newer view sees banks as delegated monitors who
assess and evaluate borrowers on behalf of their depositors and earn fees for supplying
monitoring services. Banks also have been viewed in recent theory as suppliers of liquidity and
transactions services that reduce costs for their customers and, through diversification, reduce
risk. Banks are also critical in the payment system for goods and services and have played an
increasingly important role as a guarantor and a risk management role for customers.
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1-9. How have banking and the financial services market changed in recent years? What
powerful forces are shaping financial markets and institutions today? Which of these
forces do you think will continue into the future?
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Banking is becoming a more volatile industry due, in part, to deregulation which has opened up
individual banks to the full force of the financial marketplace. At the same time the number and
variety of banking services has increased greatly due to the pressure of intensifying competition
from nonbank financial-service providers and changing public demand for more conveniently
and reliably provided services. Adding to the intensity of competition, foreign banks have
enjoyed success in their efforts to enter countries overseas and attract away profitable
domestic business and household accounts.
1-10
Can you explain why many of the forces you named in the answer to the
previous
question have led to
significant problems for the management of banks and other
financial firms and their stockholders?
The net result of recent changes in banking and the financial services market has been to put
greater pressure upon their earnings, resulting in more volatile returns to stockholders and an
increased bank failure rates. Some experts see banks role and market share shrinking due to
restrictive government regulations and intensifying competition. Institutions have also become
more innovative in their service offerings and in finding new sources of funding, such as offbalance-sheet transactions. The increased risk faced by institutions today, therefore, has
forced managers to more aggressively utilize a wide array of tools and techniques to improve
and stabilize their earnings streams and manage the various risks they face.
1-11
What do you think the financial - services industry will look like 20 years
from now? What are the implications of your projections for its management today?
There appears to be a trend toward continuing consolidation and convergence. There are likely
to be fewer financial service providers in the future and many of these will be very large and
provide a broad range of financial services under one roof. In addition, global expansion will
continue and will be critical to the survival of many financial service providers. Management of
financial service providers will have to be more technologically astute and be able to make a
more diverse set of decisions including decisions about mergers, acquisitions and global
expansion as well as new services to add to the firm.
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Problems and Projects
1.
You recently graduated from college with a business degree and accepted a position
at a major corporation earning more than you could have ever dreamed. You
want to (1) open a checking account for transaction purposes, (2) open a savings
account for emergencies, (3) invest in an equity mutual fund for that far-off
future called retirement, (4) see if you can find more affordable auto insurance, and
(5) borrow funds to buy a condo given your uncle said he was so proud of your
grades that he wanted to give you $20,000 for a down payment. (Is life good or
what?) Make five lists of the financial service firms that could provide you each of
these services.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
(1) Financial service firms that provide checking account services include banks, credit unions
and savings and loan associations. Even securities brokers allow you to open checking accounts.
Recently brokers such as Schwab have become more aggressive in offering interest-bearing
online checkable accounts that often post higher interest rates than many banks are willing to
pay. (2) To open a savings account, one could approach traditional commercial banks, savings
associations, credit unions, or online brokerages and banks with higher yields but less ‘brick and
mortar’ support. (3) For a retirement fund one could choose from a plethora of defined benefit
and defined contribution schemes from private pension funds. Banks, brokerages and insurance
firms offer a variety of retirement investment options including equity mutual funds. (4) For
affordable auto insurance one could use a traditional insurer such as Allstate or State Farm or
approach some of the newer discount insurers including Geico and Progressive. Alternatively,
one could use a reverse auction service such as Esurance to get the best rate. (5) To borrow
funds to buy a condo one could approach a traditional bank, savings associations that specialize
in granting home mortgage loans, or financial companies such as GMAC. A reverse-auction site
such as LendingTree might also be useful in this exercise. The borrower is not limited to a
mortgage loan for financing the purchase of a condo. Other lending mechanisms are available
to finance such purchases. Encourage students to use a search engine to identify top financial
institutions in each of these areas.
2.
Leading money center banks in the United States have accelerated their investment
banking
activities all over the globe in recent years, purchasing corporate debt securities
and stock from their business customers and reselling those
securities to investors in the
open market. Is
this a desirable move by these banking organizations from a profit
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Chapter 01 - An Overview of the Changing Financial-Services Sector
standpoint? From a risk standpoint? From the public
interest point of view? How would
you research their question? If you were managing a corporation that had
placed large
deposits with a bank engaged in such activities, would you be concerned
about the risk to
your company's funds? Why or why not?
In the 1970's and early 1980's investment banking was so profitable that commercial bankers
were lured into the investment banking business largely because of its greater profit potential
than possessed by more traditional commercial banking activities. Later foreign banks,
particularly the British and Japanese banking firms, began to attract away large corporate
customers from U.S. banks, who were restrained by regulation from offering many investment
banking services. Thus, U.S. banks ran into severe difficulty in simply trying to hold onto their
traditional corporate credit and deposit accounts because they could not compete service-wise
in the investment banking field. Today, banks are allowed to underwrite securities through
either a subsidiary or through a holding company structure. This change occurred as part of the
Gramm-Leach-Bliley Act (Financial Services Modernization Act).
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Unfortunately, if investment banking is more profitable than traditional banking product lines,
it is also more risky, consistent with the basic tenet of finance that risk and return are directly
related. That is why the Federal Reserve Board has placed such strict limits on the type of
organization that can offer these services. Currently, the underwriting of most corporate
securities must be done through a subsidiary or as a separate part of the holding company so
that, in theory at least, the bank is not responsible for any losses incurred. For this reason there
may be little reason for depositors (including large corporate depositors) to be concerned
about risk exposure from investment banking. Moreover, the ability to offer such services may
make U.S. banks more viable in the long run which helps their corporate customers who
depend upon them for credit.
On the other hand, opponents of investment banking powers for bank operations inside the
U.S. have some reasonable concerns that must be addressed. There are, for example, possible
conflicts of interest. Information gathered in the investment banking division could be used to
the detriment of customers purchasing other bank services. For example, a customer seeking a
loan may be told that he or she must buy securities from the bank's investment banking
division in order to receive a loan. Moreover, banks could gain effective control over some
nonbank industrial corporations which might subject them to added risk exposure and place
industrial firms not allied with banks at a competitive disadvantage. As a result the GrammLeach-Bliley Act has built in some protections to prevent this from happening.
3.
The term bank has been applied broadly over the years to include
a diverse set of financial-
service institutions, which offer
different financial - service packages. Identify as many of
the different kinds of banks as you can. How do the banks you have identified compare
to the largest banking group
of all – the commercial banks? Why do you think so many
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Chapter 01 - An Overview of the Changing Financial-Services Sector
different financial firms have been called banks? How might this
confusion in terminology
affect financial-service customers?
The general public tends to classify anything as a bank that offers some sort of financial service,
especially deposit and loan services. Other institutions that are often referred to as a bank
without being one are savings associations, credit unions, money market funds, mutual funds,
hedge funds, security brokers and dealers, investment banks, finance companies, financial
holding companies and life and property/casualty insurance companies. All of these
institutions offer some of the services that a commercial bank offers, but generally not the
entire scope of services. Since providers of financial services are normally called banks by the
general public they are able to take away business from traditional banks and it is of utmost
importance for commercial banks to clarify their unique position among financial services
providers.
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4.
What advantages can you see to banks affiliating with insurance companies? How might
such an affiliation benefit a bank? An insurer? Can you identify any possible
disadvantages
to such an affiliation? Can you cite any real - world examples of bank-insurer
affiliations?
How well do they appear to have worked
out in practice?
Before Glass-Steagall banks used to sell insurance services to their customers on a regular basis.
In particular, banks would sell life insurance to loan customers to ensure repayment of the loan
in case of death or disablement. These reasons still exist today and the right to sell insurances
to customers again benefits banks in allowing them to offer their customers complete financial
packages from financing the home or car to insure it, from giving investment advice to selling
life insurance policies and annuities for retirement planning. Generally, a bank customer who is
already purchasing a service from a bank might feel compelled to purchase an insurance
product, as well. On the other hand, insurance companies sometimes have a negative image,
which makes it more difficult to sell certain insurance products. Combining their products with
the trust that people generally have in banks will make it easier for them to sell their products.
The most prominent example of a bank-insurer affiliation is the merger of Citicorp and
Traveler’s Insurance to Citigroup. However, given that Citigroup has sold Traveler’s Insurance
indicates that the anticipated synergy effects did not materialize.
5.
Explain the difference between consolidation and convergence. Are these trends in
banking
and financial services related? Do they influence each other? How?
Consolidation refers to increase in the size of financial institutions. The number of small,
independently owned financial institutions is declining and the average size of individual banks,
as well as securities firms, credit unions, finance companies, and insurance firms, has risen
significantly.
Convergence is the bringing together of firms from different industries to create conglomerate
firms offering multiple services. Clearly, these two trends are related. In their effort to
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compete with each other, banks and their closest competitors have acquired other firms in
their industry as well as across industries to provide multiple financial services in multiple
markets.
6.
What is a financial intermediary? What are its key characteristics? Is a bank a type of
financial intermediary? What other financial-services companies are
financial
intermediaries? What important roles within the financial system do
financial
intermediaries play?
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A financial intermediary is a business that interacts with deficit spending individuals and
institutions and surplus spending individuals and institutions. For that reason any financial
service provider (including banks) is considered a financial intermediary. In their function as
intermediaries they act as a bridge between the deficit and surplus spending units by offering
financial services to the surplus spending individuals and then allocating those funds to the
deficit spending individuals. Financial intermediaries accelerate economic growth by expanding
the available pool of savings, lowering the risk of investments through diversification, and
increasing the productivity of savings and investments.
7. Several main types of financial-service firms—depository institutions, investment
banks, insurance companies,
and finance/credit card companies—are in intense
competition with one another today. Using
Standard & Poor’s Market Insight, Educational
Version, available to users of this McGraw-Hill book, describe the principal
similarities and differences among these different types of companies. You may find
it helpful in answering this question to examine the files on Market Insight devoted
to such financial firms as Bank of America (BAC), American International Group
(AIG), and Capital One Financial Corp (COF).
CHAPTER 2
THE IMPACT OF GOVERNMENT POLICY AND REGULATION ON THE FINANCIALSERVICES INDUSTRY
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Goal of This Chapter: This chapter is devoted to a study of the complex regulatory environment that
governments around the world have created for banks and other financial service firms in an effort to
safeguard the public’s savings, bring stability to the financial system, and prevent abuse of financial
service customers.
Key Topics Presented in This Chapter
•
•
•
•
•
•
•
•
•
The Principal Reasons for Banking and Financial-Services Regulation
Major Financial-Services Regulators and Laws
The Riegle-Neal and Gramm-Leach-Bliley (GLB) Acts
The Check 21, FACT, Patriot, Sarbanes-Oxley, Bankruptcy Abuse, Federal Deposit Insurance
Reform, and Financial-Services Regulatory Relief Acts
Emergency Economic Stabilization Act and the Global Credit Crisis
Some Key Regulatory Issues Left Unresolved
The Central Banking System
Organization and Structure of the Federal Reserve System and Leading Central Banks of Europe
and Asia
Financial-Services Industry Impact of Central Bank Policy Tools
Chapter Outline
I.
Introduction:
II.
Banking Regulation
A.
B.
Nature and Importance of Bank Regulation
Pros and Cons of Strict Rules
1.
To protect the safety of the public's savings
2.
To control the supply of money and credit
3.
To ensure adequate supply of loans and to ensure fairness in the public’s access
to credit & other vital financial services
4.
To maintain confidence in the financial system
5.
To avoid monopoly powers
6.
To provide support for government activities
7.
To support sectors of the economy that have special credit needs
The Impact of Regulation -The Arguments for Strict Rules versus Lenient Rules
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III.
Major Banking Laws-Where and When the Rules Originated
A.
Meet the “Parents”: The Legislation That Created Today’s Bank Regulators
a.
National Currency and Bank Acts (1863-64)
b.
The Federal Reserve Act (1913)
c.
The Banking Act of 1933 (Glass-Steagall)
d.
Establishing the FDIC under Glass-Steagall Act
e.
Criticisms of the FDIC and Responses via New Legislation
The FDIC Improvement Act (1991)
f.
Raising the FDIC Insurance Limit
B.
Instilling Social Graces and Morales-Social Responsibility Laws
C.
Legislation Aimed at Allowing Interstate Banking: Where Can the “Kids” Play?
a.The Riegle-Neal Interstate Banking Law (1994)
b.Branching Efficiency Act (1994)
c.Branch Expansion Abroad
D.
The Gramm-Leach-Bliley Act (1999): What Are Acceptable Activities for
E.
The USA Patriot and Bank Secrecy Acts: Fighting Terrorism
Playtime?
and Money Laundering
F.
The 21st Century Ushers In an Array of New Laws, Regulations, and Regulatory Strategies
IV.
V.
Telling the Truth and Not Stretching It-The Sarbanes-Oxley Accounting Standards Act
(2002)
A.
The FACT Act
B.
Check 21
C.
New Bankruptcy Rules
D.
Federal Deposit Insurance Reform
E.
2008 “Bailout Bill” and proposed New Regulatory Rules
F.
New Regulatory Strategies in a New Century
G.
Using Capital as a Regulator
H.
Market Data as a Regulatory Warning Device
I.
The Role Played by Public Disclosure in Regulating Financial-Service Firms
J.
Unresolved Regulatory Issues
The Regulation of Nonbank Financial-Service Firms Competing with Banks
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Chapter 01 - An Overview of the Changing Financial-Services Sector
A.
B.
C.
Regulating the Thrift (Savings) Industry
1. Credit Unions
2. Savings and Loans and Savings Banks (“Thrifts”)
3. Money Market Funds
Regulating Other Nonbank Financial Firms
1. Life and Property/Casualty Insurance Companies
2. Finance Companies
3. Mutual Funds
4. Security Brokers and Dealers and Investment Banks
5. Hedge Funds
Are Regulations Really Necessary in the Financial-Services Sector?
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VI.
The Central Banking System: It’s Impact on the Decisions and Policies of
Financial Institutions
A.
Organizational Structure of the Federal Reserve System
B.
The Central Bank's Principal Task: Making and Implementing Monetary Policy
1. The Open Market Policy Tool of Central Banking
2. Other Central Bank Policy Tools
3. A Final Note on Central Banking’s Impact on Financial Firms
VII.
Summary of the Chapter
Concept Checks
2-1.
What key areas or functions of a bank or other financial firm are regulated today?
Among the most important areas of banking subject to regulation are the adequacy of a bank's capital,
the quality of its loans and security investments, its liquidity position, fund-raising options, services
offered, and its ability to expand through branching and the formation of holding companies.
2-2.
What are the reasons for regulating each of these key areas or functions?
These areas are regulated, first of all (and primarily), to protect the safety of the depositors' funds so
that the public has some assurance that its savings and transactions balances are secure. Thus, bank
failure is viewed as something to be minimized. There is also a concern for maintaining competition and
for insuring that the public has reasonable and fair access to banking services, especially credit and
deposit services.
Not all of the areas listed above probably should be regulated. Minimizing the risk of bank failure serves
to shelter some poorly managed banks. The public would probably be better served in the long run by
allowing inefficient banks to fail rather than propping them up. Moreover, regulation may serve to
distort the allocation of resources in banking, such as by restricting price competition through legal
interest-rate ceilings and anti-branching laws which leads to overbuilding of physical facilities. The result
is a waste of scarce resources.
2-3.
What is the principal role of the Comptroller of Currency?
The Comptroller of the Currency charters and supervises the activities of national banks through its
policy-setting and examinations.
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2-4.
What is the principal job performed by the FDIC?
The Federal Deposit Insurance Corporation (FDIC) insures the deposits of bank customers, up to a total
of $100,000 per account owner, in banks that qualify for a certificate of federal insurance coverage. The
FDIC is a primary federal regulator (examiner) of state-chartered, non-member banks. It is also
responsible for liquidating the assets of banks declared insolvent by their federal or state chartering
agency.
2-5.
What key roles does the Federal Reserve System perform in the banking and financial system?
The Federal Reserve System supervises and examines the activities of state-chartered banks that choose
to become members of its system and qualify for Federal Reserve membership and regulates the
acquisitions and activities of bank holding companies. However, the Fed's principal responsibility is
monetary policy -- the control of money and credit growth in order to achieve broad economic goals.
2-6
What is the Glass-Steagall Act, and why was it important in banking history?
The Glass-Steagall Act, passed by the U.S. Congress in 1933, was one of the most comprehensive pieces
of banking legislation in American history. It created the Federal Deposit Insurance Corporation to insure
smaller-size bank deposits, imposed interest-rate ceilings on bank deposits, broadened the branching
powers of national banks to include statewide branching if state banks possessed similar powers, and
separated commercial banking from investment banking, thereby removing commercial banks from
underwriting the issue and sale of corporate stocks and bonds in the public market.
There are many people who feel that banks should have some limitations on their investment banking
activities. These analysts focus on two main areas. First, they suggest that this service may cause
problems for customers using other bank services. For example, a bank may require a customer getting
a loan to purchase securities of a company it is underwriting. This potential conflict of interest concerns
some analysts. The second concern deals with whether the bank can gain effective control over an
industrial organization. This could make the bank subject to additional risks or may give unaffiliated
industrial organizations a competitive disadvantage.
Today, banks can underwrite securities as part of the Gramm-Leach Bliley Act (Financial Services
Modernization Act). However, congress built in several protections to make sure that the bank does not
take advantage of customers. In addition, banks are prevented from affiliating with industrial firms
under this law.
2-7.
Why did the federal insurance system run into serious problems in the 1980s and 1990s? Can
the current federal insurance system be improved? In what ways?
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The FDIC, which insures U.S. bank deposits up to $100,000, was not designed to deal with system-wide
failures or massive numbers of failing banks. Yet, the 1980s ushered in more bank closings than in any
period since the Great Depression of the 1930s, bringing the FDIC to the brink of bankruptcy. Also, the
FDIC's policy of charging the same insurance fees to all banks regardless of their risk exposure
encouraged more banks to gamble and accept substantial failure risk. The recent FDIC Improvement Act
legislation has targeted this last area, with movement toward a risk-based insurance schedule and
greater insistence on maintaining adequate long-term bank capital.
2-8.
How did the Equal Credit Opportunity Act and the Community Reinvestment Act address
discrimination?
The Equal Credit Opportunity Act stated that individuals could not be denied a loan because of their age,
sex, race, national origin or religious affiliation or because they were recipients of public welfare. The
Community Reinvestment Act prohibited banks from discriminating against customers based on the
neighborhood in which they lived.
2-9.
How does the FDIC deal with most failures?
Most bank failures are handled by getting another bank to take over the deposits and clean assets of the
failed institution -- a process known as purchase and assumption. Those that are small or in such bad
shape that no suitable bids are received from other banks are closed and the insured depositors are paid
off -- a deposit payoff approach. Larger failures may sometimes be dealt with by open-bank assistance
where the FDIC loans money to the troubled bank and may order a change in management as well.
Large failing money-center banks may also be taken over and operated as "bridge banks" by the FDIC
until disposed of.
2-10.
What changes have occurred in the U.S. banks’ authority to cross state lines?
In 1994 the Riegle-Neal Interstate Banking and Efficiency Act was passed. This law is complicated but
allows bank holding companies with adequate capital to acquire banks or bank holding companies
anywhere in U.S. territory. No bank holding company can control more than 10% of the deposits at the
national level and more than 30% of the deposits at the state level. Bank holding companies are also not
allowed to cross state lines solely for the purpose of collecting deposits. Banks must adequately support
their local communities by providing loans there. Bank holding companies are also allowed to offer a
number of interstate services without necessarily having branches in the state by allowing affiliated
banks to act as agents for the bank holding in other states. This law also allows foreign banks to branch
in the U.S. under the same rules as domestic banks.
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2-11.
How have bank failures influenced recent legislation?
Recent bank failures have caused huge losses to federal insurance reserves and damaged public
confidence in the banking system. Recent legislation has tried to address these issues by providing
regulators with new tools to deal with the failures, such as the bridge bank device, and by granting
banks, through regulation, somewhat broader service powers and more avenues for geographic
expansion through branch offices and holding companies in order to help reduce their risk exposure. In
addition, the increase in bank failures has focused attention on the insurance premiums banks pay and
through the FDIC Improvement Act allowed the FDIC to move towards risk based insurance premiums.
2-12. What changes in regulation did the Gramm-Leach-Bliley (Financial Services Modernization) Act
bring about? Why?
The most important aspect of the law is to allow U.S. bank, insurance companies and securities
companies to affiliate with each other either through a holding company structure or through a bank
subsidiary. The purpose of this law is to allow these companies to diversify their service offerings and
reduce their overall risk. In addition it is thought that this seems to offer customers the convenience of
one stop shopping.
2-13. What new regulatory issues remain to be resolved now that interstate banking is possible and
security and insurance services are allowed to commingle with banking?
There are several key issues that remain to be resolved. One issue is concerned with what we should do
about the governmental safety net. We need to balance risk taking by financial firms with safety for
depositors. Another aspect of this issue is how to protect taxpayers if financial firms are allowed to take
on more risk.
Another issue that needs to be resolved is what to do about financial conglomerates. We need to be
sure that the financial conglomerate does not use the resources of the bank to prop another aspect of
their business. In addition, regulators need to be better trained to adequately regulate the more
complex organizations and functional regulation needs to be reviewed periodically to make sure it is
working.
A third area that needs to be resolved is whether banking and commerce should be mixed. Should a
bank sell cars along with credit cards and other financial services.
2-14 Why must we be concerned about privacy in the sharing and use of financial-service customer’s
information? Can the financial system operate efficiently if the sharing of nonpublic information is
forbidden? How far, in your opinion, should we go in regulating who gets access to private information?
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It is important to be concerned about how private information is shared because it is possible to misuse
the information. For example, if an individual’s medical condition is known to the bank through its
insurance division, the bank may deny a loan based on this confidential information. They can also share
this information with outside parties unless the customer states in writing that this information cannot
be shared.
On the other hand, there could be much duplication of effort if no sharing information is allowed. This
would lead to inefficiencies and higher costs to consumers. In addition, sharing of information would
allow targeting of services to particular customer needs. At this point, no one is quite sure what
information and how it will be shared. It appears that there will eventually be a compromise between
customers’ needs for privacy and the financial-services company’s need for to share that information.
2-15. Why were the Sarbanes-Oxley, Bank Secrecy and USA Patriot Acts enacted in the United States?
What impact are these laws and their supporting regulations likely to have on the financial-services
sector?
The Bank Secrecy Act requires any cash transaction of $10,000 or more be reported to the government
and was passed to prevent money laundering by criminal organizations.
The USA Patriot Act was enacted after the attacks of September 11 and is designed to find and
prosecute terrorists. It was a series of amendments to the Bank Secrecy Act. It requires banks and
financial service providers to establish the identity of any customer opening or changing accounts in the
United States. Many banks are however concerned about the cost of compliance.
The Sarbanes-Oxley Accounting Standards Act came as a response to the disclosure of manipulation of
corporate financial reports and questionable dealings among leading commercial firms, banks and
accounting firms. It prohibits false or misleading information about the financial performance of banks
and other financial service providers and generally tries to enforce higher standards in the accounting
profession.
2-16 Explain how the FACT, Check 21, 2005 Bankruptcy, Financial Services Regulatory Relief, and
Federal Deposit Insurance Reform Acts are likely to affect the revenues and costs of financial firms and
their service to customers.
FACT requires the FTC to make it easier for individuals victimized by identity theft to file a theft report
and requires credit bureaus to help victims resolve the problems. This should make it easier for
customers to handle identity theft problems and may reduce costs to the financial institutions that serve
these customers. Financial institutions should be able to spend less on reimbursing customers for theft
problems and perhaps the instances of identity theft will also be reduced at the same time.
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Check 21 allows financial institutions to send substitute checks to other banks to clear checks rather
than the checks themselves. The substitute checks can be electronic images that can be transferred in
an instant at a much lower cost to other institutions. This should reduce costs to institutions as they do
not have to have an employee physically transfer checks anymore. In addition, financial institutions
should know more quickly whether a check is good and this should reduce fraud and other costs
associated with bad checks.
2005 Bankruptcy Law requires that all higher income borrowers to pay back at least a portion of the
money they have borrowed to the bank. Higher income borrowers will be required to make payment
plans rather than have all of their debts forgiven. This should lower bad debt costs to financial
institutions and may lower borrowing costs for all borrowers.
The Financial Services Regulatory Relief Act of 2006 loosens regulations on depository
institutions, adds selected new service powers to these institutions, and grants the Federal Reserve
authority to pay interest on depository institutions’ legal reserves if deemed necessary.
Federal Deposit Insurance Reform raises the deposit insurance limits for certain retirement accounts
and allows regulators to periodically adjust deposit insurance limits for inflation. This should allow
investors to put more money into insured deposit accounts and may allow banks to have a more stable
and reliable source of funds for loans and other investments. This will probably have the effect of
increasing bank revenues and/or reducing expenses for the bank.
For all of these new laws, the effect should be to make the bank more profitable because of higher
revenues or lower expenses. At the same time these new laws allow financial institutions to better serve
their customers.
2-17.
In what ways is the regulation of nonbank financial institutions different from the regulation of
banks in the United States? How are they similar?
Most nonbank financial institutions are considered “vested with the public interest” and
therefore, face as close supervision from federal and state supervisors as banks do. However,
some institutions are solely regulated at the federal level while others are only regulated at the
state level.
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2-18. Which financial-service firms are regulated primarily at the federal level and which at the state
level? Can you see problems in this type of regulatory structure?
Regulated at the state level
Regulated at the federal level
Mutual Funds
Savings and Loans and Savings Banks
Security Brokers and Dealers and Investment
Banks
Money market funds
Life and property/casualty insurance companies
Credit Unions
Finance companies
Mutual funds
Security brokers and dealers
Security brokers and dealers
Hedge Funds
Financial conglomerates
Some regulators and experts are concerned because they feel that state regulators might not have the
expertise to deal with the new more complex financial firm that exists today. They are also concerned
because the new ‘functional’ regulation is not necessarily coordinated between different regulatory
agencies. Only time will tell if this functional regulatory structure is effective.
2-19.
Can you make a case for having only one regulatory agency for financial service firms?
Yes a case can easily be made for financial service firms. Problems in one area such as security
brokerage services or insurance may eventually lead to problems in the traditional banking area or vice
versa. One regulatory agency might be more likely to find these overlapping problems and prevent them
before they cause the collapse of the entire organization. In addition, one regulatory agency may be
able to better identify and prevent the inherent conflicts of interest that exist when a large financial
conglomerate is formed.
2-20.
What is monetary policy?
Monetary policy consists of regulation and control over the growth of money and credit in an attempt to
pursue broad economic goals such as full employment, avoidance of inflation, and sustainable economic
growth. Its principal tools are open market operations, changes in the discount (lending) rate, and
changes in reserve requirements behind deposits.
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2-21.
What services does the Federal Reserve provide to depository institutions?
Many services needed by banks are provided by the Federal Reserve Banks. Among the most important
services provided by the Fed are checking clearing, the wiring of funds, shipments of currency and coin,
loans from the Reserve banks to qualified depository institutions, and the supplying of information
concerning economic and financial trends and issues. The Fed began charging for its services in order to
help recover the added costs of deregulation which made more institutions eligible for Federal Reserve
services and also to encourage the private marketplace to develop and offer similar services (such as
check clearing and wire transfers).
2-22. How does the Fed affect the banking and financial system through open market operations
(OMO)? Why is OMO the preferred tool for many central banks around the globe?
Open market operations consist of the buying and selling of securities by the central bank in an effort to
influence and shape the course of interest rates and the growth of money and credit. Open-market
operations, therefore, affect bank deposits -- their volume and growth -- as well as the volume of
lending and the interest rates attached to bank borrowings and loans as well as the value of bank stock.
OMO is the preferred tool, because it is also the Central Bank’s most flexible tool. It can be used every
day and any mistakes can be quickly reversed.
2-23
What is a primary dealer and why are they important?
A primary dealer is a dealer in U.S. Treasury Bills and other securities that meets the Federal Reserve
System requirements for trading directly with the Fed’s trading desk inside the New York Federal
Reserve. It is through these trades with primary dealers that the Federal Reserve carries out its
monetary policy objectives and influences the economy including the supply of money and credit and
interest rates. Primary dealers have an integral role to play in the economy of the U.S.
2-24. How can changes in the central bank loan (discount) rate and reserve requirements affect the
operations of depository institutions? What happens to the legal reserves of the banking system when
the Fed grants loans through the discount window? How about when these loans are repaid? What are
the effects of an increase in reserve requirements?
The Discount Window is the department in each Federal Reserve Bank that receives requests to borrow
reserves from banks and other depository institutions which are eligible to obtain credit from the Fed
for short periods of time. The rate charged on such loans is called the discount rate.
Reserve requirements are the amount of vault cash and deposits at the Federal Reserve banks that
depository institutions raising funds from sources of reservable liabilities (such as checking accounts,
business CDs, and borrowings of Eurodollars from abroad) must hold.
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If the Fed grants loans $200 million in reserves from the discount window, total reserves will rise by the
amount of the discount window loan, but then will fall when the loan is repaid.
Increasing reserve requirement means that depository institutions must keep more vault cash and
reserves with the Federal Reserve for each deposit account they hold. This would have the effect of
making less money available for loans. Since this has a multiplicative effect on the economy it can have a
severe effect on the total amount of loans made and on the growth of the money supply that results.
2-25. How did the Federal Reserve change the policy and practice of the discount window recently?
Why was this change made?
The Fed created two new loan types, primary and secondary credit, which replaced the existing
adjustment and extended credit.
Primary credit is extended to sound borrowing institutions at a rate slightly higher than the federal
funds rate.
Secondary credit is extended to institutions that do not qualify for primary credit for temporary funding
needs at a rate slightly above the prime rate.
These changes were implemented to encourage greater use of the discount window and to bring
greater stability the federal funds rate and to the money market as a whole.
2-26. How do the structures of the European Central Bank (ECB), the Bank of Japan , and the People’s
Bank of China appear to be similar to the structure of the Federal Reserve System? How are these
powerful and influential central banks different from one another?
Like the Fed the ECB consists of a governing board and a policy making council and just like the Fed’s
board of governors works with the 12 regional Federal Reserve banks the ECB has a cooperative
arrangement with each EU member nation’s central bank. The policy menu of the ECB however is a lot
simpler than its counterpart at the Fed. The central goal is price stability, which is largely achieved
through open market operations and reserve requirements.
The PBC’s pursuit of monetary policy is supported by an advisory group, the Monetary Policy Committee
(MPC), which meets at least quarterly and includes the PBC’s Governor, the Chair of the China Bank
Regulatory Commission, the Finance Minister, and other members of the Chinese government.
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The BOJ regulates the volume of money and interest rates through open market
operations (using securities issued by the Japanese government and commercial
bills), by providing emergency loans to institutions in trouble and
through the use of moral suasion to convince financial mangers to adhere to the
BOJ’s policies.
However, the Bank of Japan (BOJ),the People’s Bank of China (PBC), and central banks in other parts of
Asia appear to be under close control of their governments, and several of these countries have
experienced higher inflation rates, volatile currency prices, and other significant economic problems in
recent years
Problems
2-1.
For each of the actions described, explain which government agency or agencies a financial
manager must deal with and what banking laws are involved:
A.
Chartering a new bank.
B.
Establishing new bank branch offices.
C.
Forming a bank holding company (BHC) or financial holding company (FHC).
D.
Completing a bank merger.
E.
Making holding company acquisitions of nonbank businesses.
A.
For chartering a new bank in the United States either the state banking commission of the state
where the bank is to be headquartered must be consulted or the Comptroller of the Currency
must be sent an application for a national charter. The National Banking Act governs national
charters while state charters are governed by rules laid down in state banking statutes.
B.
Requests for establishing new branch offices must also be made of the bank's chartering agency
-- either the state banking commission for state-chartered banks or the Comptroller of the
Currency for national banks in the United States.
C.
Requests for holding company formation must be submitted to the Federal Reserve Board or,
for certain routine transactions, to the Federal Reserve Bank in the district. Some states require
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their banking commissions to be notified if a holding company acquires a bank within the state's
borders.
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D.
The Bank Merger Act requires the approval of a bank's principal federal supervisory agency for a
proposed merger even if the bank is state chartered. Mergers involving national banks must be
approved by the Comptroller of the Currency and by the state banking commission if a bank has
a state charter of incorporation. The merger must also be reviewed by other federal agencies
that have supervisory responsibility for a bank, such as the FDIC or the Federal Reserve, and by
the U.S. Department of Justice.
E.
Request for acquisitions of nonbank businesses must be approved by the Federal Reserve Board.
For some more routine transactions, the Federal Reserve Bank in the distract can make the
decision.
2-2. See if you can develop a good case for and against the regulation of financial institutions
in the following areas:
A.
Restrictions on the number of new financial-service institutions allowed to enter the
industry each year.
B.
Restrictions on which depository institutions are eligible for government-sponsored
deposit insurance.
C.
Restrictions on the ability of financial firms to underwrite debt and equity
securities issued by their business customers.
A.
D.
Restrictions on the geographic expansion of banks and other financial firms, such as
limits on branching and holding company acquisitions across county, state, and
international borders.
E.
Regulations on the failure process, defining when banks and other financial firms are to
be allowed to fail and how their assets are to be liquidated.
Restricting entry into the banking industry limits competition and, to some extent, protects
some banks from failure, reducing the risk of depositor loss.
On the other hand, limiting new firms props up some financial-service firms that should be
allowed to fail if the system is to be as efficient as it can be.
B.
Restrictions on which banks can get deposit insurance also limits competition but encourages
some banks to take on more risk because most depositors are protected by the insurance.
Restricting which institutions are eligible for deposit insurance may limit the losses to the
federal agency providing that insurance but may also limit that federal agency’s ability to
monitor and control the money supply and the economy as a result.
C.
Limits on underwriting securities reduce a bank's revenue potential and will probably result in
losing some of the largest corporate customers to foreign banks who face more lenient
regulations.
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On the hand, underwriting securities is inherently risky and limiting this may limit the risk of the
bank. It may also prevent the conflicts of interest that arise when a bank makes loans and
underwrites securities at the same time.
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D.
Limiting a bank's ability to expand geographically exposes it to greater risk of economic
fluctuations within its local market area and makes it more prone to failure.
On the other hand, allowing a bank to expand geographically may concentrate power in the
hands of a few large institutions that make it more likely that service costs will rise for all
customers.
E.
Protecting banks from failure inevitably involves sheltering some inefficient and poorly managed
institutions that waste resources and fail to serve customers effectively. It also tends to make
the average customer less vigilant about the quality and risk of a particular bank's services and
operations because deposits are insured and bank failure seems to most customers to be a
relatively remote possibility.
On the other hand, it makes customers more confident in the system as a whole and makes a
bank run less likely.
2-3. Consider the issue of whether or not the government should provide a system of deposit
insurance. Should it be wholly or partly subsidized by the taxpayers? What portion of the cost
should be borne by depository institutions? by depositors? Should riskier depository institutions
pay higher deposit insurance premiums? Explain how you would determine exactly how big an
insurance premium each depository institutions should pay each year.
If taxpayers subsidize the cost of deposit insurance, depository institutions will be encouraged to take
on added risk. Ideally more risky banks should be compelled to pay more for deposit insurance; some of
this cost would probably be passed on to depositors who would begin to shift their funds to less risky
banks. Eventually banks willing to take on greater risk will find their cost of fund-rising to unacceptably
high levels and will begin to reduce their risk exposure.
It is not clear how high deposit insurance fees should be set to curtail excessive bank risk-taking, though
it seems clear that more risky banks should pay higher insurance fees if we are to move toward a more
efficient deposit insurance system. Since there are several dimensions to bank risk exposure it probably
would not be feasible to tie the size of insurance fees to just one indicator.
Perhaps an index of measures of loan-portfolio risk, interest-rate risk, liquidity risk, etc. would be
preferable with the appropriate measures based upon research evidence from studies of bank failures.
2-4. The Trading Desk at the Federal Reserve Bank of New York elects to sell $100 million in
U.S. government securities to its list of primary dealers. If other factors are held constant, what is
likely to happen to the supply of legal reserves available? To deposits and loans? To interest
rates?
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If the trading desk sold $100 million in U.S. Government securities, the supply of total legal reserves will
decrease by $100 million, some of which will probably be taken from required reserves behind any new
deposits that are created. Deposits and loans will decrease by a multiple of the new reserves and,
initially at least, market interest rates should rise.
2.5.
Suppose the Federal Reserve's discount rate is 4 percent. This afternoon, the Federal Reserve
Board announces that it is approving the request of several of its Reserve Banks to raise their discount
rates to 4.5 percent. What is likely to happen to other interest rates tomorrow morning? Carefully
explain the reasoning behind your answer.
Would the impact of the discount rate change described above be somewhat different if the Fed
simultaneously sold $100 million in securities through its Trading Desk at the New York Fed?
Other interest rates will also rise following a discount rate increase. Of course, if loan demand were
decreasing, market rates could fall despite the upward shift in the discount rate. If the discount rate
were increased when loan demand was rising, market rates would almost surely rise, ceteris paribus.
If the Fed sold $100 million in securities this would reinforce the discount-rate increase. Other interest
rates would almost certainly rise, other factors held constant. However, a Fed purchase would
encourage lower interest rates, offsetting the discount rate effect.
2-6.
Suppose the Fed purchases $500 million in government securities from a primary dealer. What
will happen to the level of legal reserves in the banking system and by how much will they change?
Open market operations consist of the buying and selling of securities by the central
bank in an effort to influence and shape the course of interest rates and the growth of
money and credit. Open-market operations, therefore, affect bank deposits -- their
volume and growth -- as well as the volume of lending and the interest rates attached
to bank borrowings and loans as well as the value of bank stock. If the Fed purchases
$500 million in government securities total bank reserves will increase by $500
million. If the $500 million represents excess reserves, deposits and loans will expand
by a multiplicative factor related to the reserve requirements of the various deposits.
2-7. If the Fed loans depository institutions $200 million in reserves from the discount
windows of the Federal Reserve banks, by how much will legal reserves of the
banking system change? What happens when these loans are repaid by the borrowing
institutions?
The Discount Window is the department in each Federal Reserve Bank that receives requests to borrow
reserves from banks and other depository institutions which are eligible to obtain credit from the Fed
for short periods of time. The rate charged on such loans is called the discount rate.
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Reserve requirements are the amount of vault cash and deposits at the Federal Reserve banks that
depository institutions raising funds from sources of reservable liabilities (such as checking accounts,
business CDs, and borrowings of Eurodollars from abroad) must hold.
If the Fed loans $200 million in reserves from the discount window, total reserves will rise by the
amount of the discount window loan, but then will fall when the loan is repaid. Correspondingly, loans
and deposits should rise by a multiple of the increase in reserves depending on reserve requirements for
deposits and whether the $200 million is excess reserves or not.
CHAPTER 3
THE ORGANIZATION AND STRUCTURE OF BANKING AND THE FINANCIAL-SERVICES INDUSTRY
Goal of This Chapter: The goal of this chapter is to explore the different types of organizations used in
the banking and financial services industry, to see how changing public mobility and changing demand
for financial services, the rise of potent competition, and changing government roles have change the
structure, size and the types of organizations in this industry.
Key Topics in This Chapter
•
•
•
•
•
•
•
•
The Organization and Structure of Banks and the Banking Industry
The Array of Organizational Structures in Banking: Unit, Branch, Holding Company and
Electronic Services
Interstate Banking and the Riegle-Neal Act
The Financial Holding Company (FHC)
Mergers and Acquisitions
Banking Structure and Organization in Europe and Asia
The Changing Organization and Structure of Banking’s Principal Competitors
Economies of Scale and Scope and Expense Preference Behavior
Chapter Outline
I.
Introduction: Organizational Forms and Function in Banking
II.
The Organization and Structure of the Commercial Banking Industry
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III.
A.
Advancing Size and Concentration of Assets
B.
Is a Countertrend Now Under Way?
Internal Organization of the Banking Firm
A.
Community Banks and Other Community-Oriented Financial Firms
B.
Larger Banks-Money Center, Wholesale and Retail
C.
Trends in Organization
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IV.
V.
VI.
The Array of Organizational Structures and Types in the Banking Industry
A.
Unit Banking Organizations
B.
Branching Organizations
1.
Organizational Characteristics
2.
3.
4.
Branching's Expansion
Reasons behind Branching’s Growth
Advantages and Disadvantages of Branch Banking
C.
Electronic Branching-Web Sites and Electronic Networks: An Alternative or a
Supplement to Traditional Bank Branch Offices?
D.
Holding Company Organizations
1.
Organizational Characteristics
2.
Why Holding Companies Have Grown
3.
One-Bank Holding Companies
4.
Multibank Holding Companies
5.
Advantages and Disadvantages of Holding Companies
Interstate Banking Organizations and the Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994
A.
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
B.
Research on Interstate Banking
An Alternative Type of Banking Organization Available as the 21st Century Opened: Financial
Holding Companies (FHCs)
A.
Gramm-Leach-Bliley Act
B.
Financial Holding Companies
C.
Bank Subsidiaries
VII.
Mergers and Acquisitions Reshaping the Structure and Organization of the Financial-Services
Sector
VIII.
The Changing Organization and Structure of Banking’s Principal Competitors
IX.
A.
Consolidation
B.
Convergence
Efficiency and Size: Do Bigger Financial Firms Operate at Lower Cost?
A.
Efficiency in Producing Financial Services
1.
X.
Economies of Scale
2.
Economies of Scope
3.
X-Efficiency
Financial Firm Goals: Their Impact on Operating Cost, Efficiency, and Performance
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XI.
A.
Expense-Preference Behavior
B.
Agency Theory
C.
Corporate Governance
Summary of the Chapter
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Concept Checks
3-1.
How would you describe the size distribution of American banks and the concentration of
industry assets inside the United States? What is happening in general to the size distribution and
concentration of banks in the United States and in other industrialized nations and why?
Although the largest banks in the United States make up only 6.9% of all FDIC insured banks, they
control almost 88.3% of all the industry’s assets. This development is a result of the strong trend
towards consolidation and convergence in the industry not only in the United States, but also globally
and can be explained by the increasing competitive pressures in the industry and the economies of scale
that prevail in banking.
3-2.
Describe the typical organization of a smaller community bank and a larger money-center bank.
What does each major division or administrative unit within the organization do?
Small banks generally have four basic departments or divisions centered on lending (the credit function),
fund-raising, operations, and marketing (and, perhaps, trust services). Daily operations are usually
monitored by a cashier and/or auditor and by the vice presidents in charge of each department and
division. Overall, the small bank's organization chart is simple and uncomplicated. In contrast, the
largest banks usually have many specialized departments and divisions, including separate departments
for different kinds of loans, departments to manage security holdings and borrow in the money market,
a division or department to manage international operations, a marketing division, and a planning unit
along with other divisions.
3-3.
What trends are affecting the way banks and their competitors are organized today?
In general, banks are becoming larger and more complex organizations with more departments and
services and greater specialization. Deregulation and service innovation have accelerated this trend as
intense competition at home and abroad has encouraged banks to become larger organizations, serving
broader and more diversified market areas. Even small banks are reorganizing to meet these challenges
by being more efficient in meeting their broader-based customer needs.
3-4.
What are unit banks?
Unit banks offer their full menu of services from only one office, though they may operate any number
of drive-in windows, automated teller machines that are linked to the bank’s computer system. These
organizations are very common today.
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3-5.
What advantages might a unit bank have over banks of other organizational types? What
disadvantages?
Unit banks have the advantage of being less costly to operate because full-service branch offices are an
expensive way to grow and, because unit banks tend to be relatively small, they seem to be able to offer
personalized services better than larger institutions. One disadvantage is the heavy dependence of most
unit institutions on a single market area, which increases their risk of failure. Some authorities believe,
unit institutions may not be able to afford technologically advanced service delivery systems.
3-6.
What is a branch banking organization?
A branch banking organization sells its full menu of services through several locations, including a head
office and one or more full-service branch offices. Regardless of its number of offices it is one
corporation with one board of directors. However, each office has its own management team with
limited authority to make decisions on customer loan applications and other facts of daily operation.
3-7.
What trend in branch banking has been prominent in the United States in recent years?
Branch banking has become increasingly important with the great majority of states now allowing
statewide branching. Today, more states permit statewide branching and only a minority restrict
branching in some way. There was an increase in the number of branches in the 60’s, 70’s and 80’s as
the population from cities to suburban areas. However, in recent years the growth in full-service
branches has slowed because of the sky-rocketing costs of land and building office facilities. In addition,
ATM’s and electronic networks have taken over much of the routine banking transactions. There is not
as much need for full service branches as before.
3-8.
Do branch banks seem to perform differently than unit banks? In what ways? Can you explain
any differences?
Branch banking has a number of important advantages. With offices spread over different areas branch
banks may achieve more stable earnings and revenue flows. They may be able to grow faster because
the additional offices can bring in more debt capital (principally deposits) with which to grow. However,
research evidence accumulated in recent years suggests that adding new branch offices can subject the
bank to high fixed costs, due to large and rising construction costs, which means the bank must work
harder simply to reach a break-even point. Moreover, branch offices that are poorly situated or that
have the misfortune to be located in an area whose economy is deteriorating may generate higher costs
than revenues and saddle the bank with persistent net losses.
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3-9.
What is a bank holding company?
A bank holding company is a corporation that holds an ownership interest in at least one bank. It is also
allowed to own nonbank businesses as long as they are related to banking.
3-10.
When must a holding company register with the Federal Reserve Board?
If the company owns at least 25 percent of the outstanding stock of at least one bank or otherwise
exerts a controlling influence over at least one bank, it must register with the Federal Reserve Board and
seek the Fed's approval if it wishes to increase its share of ownership in those banks in which it already
has an interest or wishes to acquire additional banks or nonbank businesses.
3-11.
What nonbank businesses are bank holding companies permitted to acquire under the law?
The Bank Holding Company Act (as amended) requires a registered bank holding company to acquire
only those nonbank businesses that are "closely related to banking" and "in the public interest." Among
the most popular of these nonbank businesses that have been approved for holding-company
acquisition include finance companies, mortgage banking firms, leasing companies, insurance agencies,
data processing firms, and several other businesses as well. Increasingly as the 1990s began, bank
holding companies sought approval to acquire failing savings and loan associations which the Federal
Reserve Board granted after a case-by-case review. These S&L acquisitions were sanctioned by the U.S.
Congress when the Financial Institutions Reform, Recovery, and Enforcement Act was passed in 1989
and, with passage of the Federal Deposit Insurance Corporation Improvement Act in 1991, bank holding
companies were granted permission to acquire even healthy savings and loan associations with Federal
Reserve Board approval. Today, the Gramm-Leach-Bliley Act allows financial services companies to be
affiliated with each other. This includes investment-banking activities which allow banks to underwrite
securities.
3-12. Are there any significant advantages or disadvantages for holding companies or the public if
these companies acquire banks or nonbank business ventures?
The ability of holding companies to acquire nonbank businesses has given them the capacity to cross
state lines even where state law prohibited entry by out-of-state banking firms. It also allows a holding
company to diversify across many different product lines to help stabilize the company's net earnings.
However, launching nonbank businesses can stretch holding-company management too far and make it
ineffective, resulting in damage to the performance of banks belonging to the same holding company.
The public may gain if holding companies are less subject to failure than other types of financial service
firms and are more efficient to operate. However, the public may lose if the concentration of services in
bank holding companies causes the prices of those services to rise or if resources are drained away from
local communities causing slower growth of those communities.
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3-13.
What did the Riegle-Neal Interstate Banking Act do? Why was it passed into law?
In 1994 the U.S. Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act which
allows bank holding companies to acquire banks throughout the United States
without needing any state’s permission to do so and to establish branch offices across state
lines in every state. The interstate banking law reflects the need & belief for banking firms to diversify
into different geographic markets, demands of the public for financial service providers that can follow
businesses and individuals as they move across the landscape, bring in new capital to revive struggling
local economies, and advances the technology of financial-services delivery.
3-14. Can you see any advantages to allowing interstate banking? What about potential
disadvantages?
As far as problems are concerned, interstate banking threatens to increase the concentration of banking
resources in the U.S., especially among larger banks in various regions of the nation. Increased
concentration possibly could lead to higher prices and less service if the antitrust laws are not fully
enforced. On the other hand, recent studies suggest that interstate mergers generate positive abnormal
returns on bank stock. In addition, these banks are not tied to one local economic area and appear to be
less subject to failure.
3-15. How is the structure of the nonbank financial-services industry changing? How do the
organizational and structural changes occurring today among nonbank financial-service firms parallel
those experienced by the banking industry?
Almost all of banking’s top competitors are experiencing the same changes as banks. For example,
consolidation and convergence are occurring at a rapid pace. Generally, nonbank firms have
experienced the same dynamic structural and organizational revolution as banks and for many of the
same reasons.
3-16. What relationship appears to exist between bank size, efficiency, and operating costs per unit of
service produced and delivered? How about among nonbank financial-service providers?
For banks and nonbank financial service providers alike, economies of scale and scope if achieved can
lead to significant savings in operating costs with increases in service output. Economies of scale mean
that costs per unit decrease as more units of the same service are produced. Economies of scope mean
that as more different services are provided the joint costs of producing those services decrease.
3-17. Why is it so difficult to measure output and economies of scale and scope in the financial
services industry? How could this measurement problem affect any conclusion reached about firm size,
efficiency and expense behavior?
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This is not an easy question to answer. In a financial-service firm, regardless of its size, operating as
efficiently as it possibly can, raises an issue known as x-efficiency. Given the size of a financial firm, it is
operating near to or far away from its lowest possible operating cost.
Research evidence to date is not encouraging, suggesting that most banks, for example, do not operate
at their minimum possible cost. Rather, their degree of x-efficiency tends to be at least 20 to 25 percent
greater in aggregate production costs than it should be under conditions of maximum efficiency.
The financial service business is changing rapidly in form and content and thus one must remain
cautious about cost studies of financial firms. The statistical methodologies available today to carry out
cost studies have serious limitations and tend to focus upon a single point in time rather than
attempting to capture the dynamics of this ever changing industry.
3-18.
What is expense-preference behavior? How could it affect the performance of a financial firm?
Expense preference behavior describes an approach to management in which managers use the
resources of the firm to provide them with personal benefits not needed to produce and sell the
products. This behavior leads to increasing costs of production and declining returns to the firm’s
owners. Such expense-preference behavior may show up in the form of staffs larger than
required to maximize profits or excessively rapid growth, which causes expenses to get out of control.
3-19. Of what benefit is agency theory in helping us understand the consequences of changing control
of a financial services firm? How can control by management as opposed to control by stockholders
affect the behavior and performance of a financial services provider?
Agency theory analyzes the relationship between a firm’s owner (shareholder) and its managers.
It explores whether there is a mechanism to compel managers to act in the best interest and
maximize the welfare of the firm’s owners. Owners do not have access to all the information and
cannot fully evaluate the performance of a manager.
3-20. What is corporate governance, and how might it be improved for the benefit of the
owners and customers of financial firms?
Corporate governance describes the relationships that exist among managers, the board of directors,
the stockholders, and other stakeholders of a corporation. Corporate governance can be improved
through larger boards of directors and a high proportion of outside directors. This will expose managers
to greater monitoring and discipline.
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Problems
3-1.
As a financial journalist, you are writing an article explaining how the U.S. market shares of
small, medium, and large banks have changed over the last 25 years. Utilize Exhibit 3–2 to approximate
the market shares for the years 1985, 1990, 1995, and 2005 for small, medium and large banks. Identify
and discuss the three factors that contributed most to the trends you described.
It can be observed that, smaller banks continue to disappear and the biggest banks are gobbling up
greater industry shares each year. But there are signs that this pattern of change might slow down in
future years. 100 large U.S. banking organizations hold more than three-quarters of industry wide assets
and also their market share has risen recently. The top 100 U.S. banks held only about half of all U.S.
domestic banking assets in 1980, but by 2000 their proportion of the nation’s domestic banking assets
had climbed to more than 70 percent.
Large banks have moved toward the profit-center approach, in which each major department strives to
maximize its contribution to profitability. Also large banks serve many different markets with many
different services, they are better diversified—both geographically and by product line—to withstand
the risks of a fluctuating economy.
The most dramatic changes in the banking industry of the past two decades has been the spread of
interstate banking as state and federal laws paved the way for banking companies to purchase or start
branch offices in different states, making possible nationwide banking for the first time in U.S. history.
This trend reflects the need for banking firms to diversify into different geographic markets and the
demands of the public for financial firms that can follow businesses and individuals as they move across
the landscape.
Another major change in law and regulation was the passage of the Gramm-Leach-Bliley (Financial
Services Modernization) Act in 1999. The GLB law has led to the formation of financial holding
companies (FHCs) entering into product lines (such as security and insurance underwriting services)
previously prohibited or restricted under federal law, paving the way for onestop financial-service
providers.
These are the few sweeping factors contributing to fundamental changes in the banking sector in the
past two decades.
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3-2.
Of the business activities listed below, which activities can be conducted through U.S. regulated
financial-service holding companies today?
a. Data processing companies
b. Office furniture sales
c. Auto and truck leasing companies
d. General life insurance and property-casualty insurance sales
e. Savings and loan associations
f. Mortgage companies
g. General insurance underwriting activities
h. Professional advertising services
i. Underwriting of new common stock issues by nonfinancial corporations
j. Real estate development companies
k. Merchant banks
Banks can perform most of the activities listed. It may be easier to talk about the activities they cannot
do. They cannot sell office furniture. They cannot perform professional advertising services. They can do
just about everything else today.
3-3
You are currently serving as president and chief executive officer of a unit bank that has been
operating out of its present location for five years. Due to the rapid growth of households and
businesses in the market area served by the bank and the challenges posed to your share of this market
by several aggressive competitors, you want to become a branch bank by establishing satellite offices.
Please answer the following questions:
a.
What laws and regulations have a bearing on where you might be able to locate the new
facilities and what services you may offer?
b.
Based on the content of this chapter, what advantages would your branch be likely to have over
the old unit bank? What disadvantages are likely to come with adding branch offices? Any ideas
on how you might minimize these disadvantages?
c.
Would it be a good idea to form a holding company? Based on the material in this chapter, what
advantages could a holding company bring to your bank? Disadvantages?
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In general, the bank would have to seek approval from their chief regulating agency for any major
actions that the bank takes. National banks have get approval from the Comptroller of the Currency.
State member banks have to get approval from the Federal Reserve and state banks with insurance who
are not members of the Federal Reserve would have to seek approval from the FDIC. All other banks
would have to have approval of the state banking commission. However, depending on the services
offered, the Gramm-Leach Bliley Act may apply. The Gramm-Leach-Bliley Act allows banks to offer many
different services either as subsidiaries of the parent bank or under the financial holding company
structure. In this case, the Federal Reserve must approve of the services and the structure of the bank.
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Branch banking has a number of important advantages. With offices spread over different areas branch
banks may achieve more stable earnings and revenue flows. They may be able to grow faster because
the additional offices can bring in more debt capital (principally deposits) with which to grow. However,
research evidence accumulated in recent years suggests that adding new branch offices can subject the
bank to high fixed costs, due to large and rising construction costs, which means the bank must work
harder simply to reach a break-even point. Moreover, branch offices that are poorly situated or that
have the misfortune to be located in an area whose economy is deteriorating may generate higher costs
than revenues and saddle the bank with persistent net losses.
Formation of a holding company has a number of potential advantages. It may help lower the taxes
earned by the whole banking organization and open up the possibility of acquiring nonbank businesses
that help to diversify the bank's operations and reduce the risk to its earnings and long-run viability. The
problem with starting a holding company at the same time as the opening of new branches are the costs
involved (including legal fees, the cost of registering with the Federal Reserve Board, and underwriting
costs as new stock is issued).
3-4.
Suppose you are managing a medium-size branch banking organization (holding about $25
billion in assets) with all of its branch offices located within the same state. The board of directors has
asked you to look into the possibility of the bank offering limited security trading and investment
banking services as well as insurance sales. What laws opens up the possibility of offering the foregoing
services and under what circumstances may they be offered? What do you see as the principal benefits
from and the principal stumbling blocks to successful pursuit of such a project?
The Gramm-Leach-Bliley Act of 1999 allows banks to offer selected nonbank financial services. The bank
could offer these services either as a financial holding company or through bank subsidiaries. The
financial holding company form seems to have the advantage because of limits on how large
subsidiaries can be and because each affiliated firm would have its own capital and its own profits and
losses that are separate from the profits and losses of any other part of the firm. However, fewer than
500 firms have achieved financial holding company status suggesting that this may be an expensive
proposition that would be difficult for medium sized banking firms to undertake.
3-5.
First Security Trust National Bank of Boston is considering making aggressive entry into the
People’s Republic of China, possibly filing the necessary documents with the government in Beijing to
establish future physical and electronic service facilities. What advantages might such a move bring to
the management and shareholders of First Security? What potential drawbacks should be considered by
the management and board of directors of this bank?
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China is a huge market and entering into the Chinese market now may give this bank an advantage over
other banks. They will already have the necessary contacts and understanding of the Chinese system
when it becomes a more open economy in the future. However, there is considerable risk. It could be
years before the economy becomes more open so profit opportunities might be slow to develop. In
addition, the government could change its mind about allowing foreign banks ownership in China and
seize any assets held by foreign banks. Finally, the system is dominated by large government owned
banks and it may be difficult to compete with these banks. The Chinese government could give
preferential treatment to these government banks at the expense of the private sector.
CHAPTER 4
Establishing New Banks,
Branches, ATMs,
Telephone Services,
and Web Sites
Goal of This Chapter: The purpose of this chapter is to learn how new banks are chartered by state and
federal authorities in the United States, to determine what makes a good site for a new branch office, to
recognize how the role of branch offices is changing, and to explore the advantages and disadvantages
of automated banking facilities.
Key Topics in This Chapter
•
•
•
•
•
•
Chartering New Financial-Service Institutions
The Performance of New Banks
Establishing Full-Service Branches and In-Store Branching
Establishing Limited-Service Facilities
ATMs and Telephone Centers
The INTERNET and Online Banking
Chapter Outline
I.
Introduction
A.
The Importance of Convenience and Timely Access to Customers
B.
Service Options Available Today
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II.
III.
1.
Chartering New (De Novo) Financial Institutions
2.
Establishing New Full-Service Branch Offices
3.
Setting Up Limited-Service Facilities
Chartering a New ( De Novo ) Financial-Service Institution
The Bank Chartering Process in the United States
A.
The Chartering Authorities in the U.S.
B.
Benefits of Applying for a Federal (National) Charter
C.
Benefits of Applying for a State Charter
IV.
Questions Regulators Usually Ask the Organizers of a New ( De Novo ) Bank
V.
Factors Weighing on the Decision to Seek a New Charter
A.
External Factors
1.
Level of Economic Activity
2.
Growth of Economic Activity
3.
The Need for a new financial firm.
4.
The Strength and Character of Competition in Supplying Financial Services
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B.
VI.
VII.
VIII.
IX.
X.
Internal Factors
1.
Qualifications and Contacts of the Organizers
2.
Management Quality
3.
Pledging of Capital to Cover the Cost of Filing a Charter Application and Getting
Underway
Volume and Characteristics of New Charters
A.
Numbers of New Charters
B.
Characteristics of New Charter Markets
How Well Do New Charters Perform?
A.
New Bank Financial Performance
B.
Pro-Competitive Effects on Service Offerings and Service Pricing
Establishing Full-Service Branch Offices: Choosing Locations and Designing New Branches
A.
Advantages of Full-Service Branches
B.
Trends in the Design of New Branches
C.
Desirable Sites for New Branches
1.
Expected Rate of Return
2.
Geographic Diversification
D.
Branch Regulation
E.
The Changing Role of Financial-Service Branch Offices
F.
In-Store Branching
Establishing and Monitoring Automated Limited-Service Facilities
A.
Point-of-Sale Terminals
B.
Automated Tellers (ATMs)
1.
History of ATMs
2.
ATM Services
3.
Advantages and Disadvantages of ATMs
4.
The Decision to Install a New ATM
5.
Example of the ATM Capital-Budgeting Decision
Home and Office Banking
A.
Telephone Banking and Call Centers
B.
INTERNET Banking
1.
Services Provided through the INTERNET
2.
Challenges in Providing INTERNET Services
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3.
The Net and Customer Privacy and Security
XI.
Financial-Service Facilities of the Future
XII.
Summary of the Chapter
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Concept Checks
4-1.
Why is the physical presence of a bank still important to many customers despite recent
advances in long-distance communications technology?
Many customers still prefer the personal attention and personal service that contact with bank
employees provide. Moreover, for those services where problems can arise that require detailed
information and explanation-for example, when a customer discovers that his or her account is
overdrawn, or if he or she suspects an account is being victimized by identity theft, or when the
customer’s estimate of an account balance does not agree with the institution that holds that account,
and checks or charges begin to bounce, the presence of a nearby service facility may become important.
4-2.
Why is the creation (chartering) of new banks closely regulated? What about nonbank financial
firms?
The creation of new banks is regulated to insure the safety and soundness of existing banks and to avoid
excessive numbers of bank failures. The same arguments are usually made for non-bank financial firms.
Financial-Service firms hold the public’s savings, are the heart of the payment system and create money.
The failure of these firms could disrupt the economy and too many could mean in excessive growth in
the money supply and inflation.
4-3.
What do you see as the principal benefits and costs of government regulation of the number of
financial service charters issued?
While control over the entry of new banks may reduce the number of failures, it also limits competition,
so that the public may receive a smaller volume or lower quality of services at excessive prices.
4-4.
Who charters new banks in the United States? New thrift institutions?
New banks are chartered by the banking commissions of the individual states or, at the federal level, by
the Comptroller of the Currency. Thrift institutions are chartered by the states or at the federal level by
the Office of Thrift Supervision.
4-5.
What key role does the FDIC play in the chartering process?
The FDIC exercises some control over state bank charter activity as well as federal charters because
most states insist that their new banks qualify for federal deposit insurance before they can open for
business.
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4-6.
What are the advantages of having a national bank charter? A state bank charter?
The benefits of a national charter are:
a.)
b.)
c.)
It brings added prestige due to stricter regulatory standards that may help attract
deposits.
In times of trouble the technical assistance supplied to a struggling institution by
national authorities may be of better quality, giving the troubled bank a better chance
to survive.
Federal rules can pre-empt state laws.
The benefits of a state charter are:
a.)
It may be easier and less costly to secure a state charter and supervisory fees are
usually lower.
b.)
The bank does not have to join the Federal Reserve and therefore avoids buying and
holding low yield stock of the Federal Reserve
c.)
Some states allow a bank to lend a higher percentage of its capital to a single borrower.
d.)
State chartered banks may be able to offer certain services that a national banks may
not be able to offer.
4-7.
What kinds of information must the organizers of new national banks provide the Comptroller of
the Currency in order to get a charter? Why might this required information be important?
The applicants for a national bank charter are required to submit a detailed business plan, which
contains a description of the proposed bank and its marketing, management, and financial plans. The
Comptroller of the Currency asks for information on the number of competing banks and bank-like
institutions in the service area of the proposed bank. More competitive market situations limit the profit
potential and perhaps the growth potential of a new bank. Also requested is information about
shopping centers, retail and wholesale business activity, recent population growth, traffic counts, and
personal income levels - all viewed as indicators of potential demand for banking services in the service
area of the proposed new bank. Applicants must also provide background information on the organizers
and proposed management of a new bank so the Comptroller can decide if these people are qualified,
law-abiding, and trustworthy to manage the public's funds as well as their own.
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4-8.
Why do you think the organizers of a new financial firm are usually expected to put together a
detailed business plan, including marketing, management, and financial components?
This demonstrates to regulators that the organizers of the bank have the expertise, experience and skills
necessary to be successful in managing the new bank. If the organizers of a bank do not know where
they are going, they are unlikely to be successful. In addition, it demonstrates whether the organizers of
the new bank have a realistic picture of the community they are planning on serving and whether the
organizers have a realistic view of the profit potential in the new bank.
4-9.
What are the key factors the organizers of a new financial firm should consider before deciding
to seek a charter?
While a variety of factors are examined by different business people interested in establishing a new
bank, most look at some or all of the following factors.
1.
2.
4-10.
External Factors
a.
The level of local economic activity.
b.
Growth of local economic activity.
c.
The need for a new financial firm.
d.
The strength and character of competition in supplying financial services.
Internal Factors
a.
Qualifications and contacts of the organizers.
b.
Management quality.
c.
Pledging of capital to cover the cost of filing a charter application and begin
operations.
Where are most new banks chartered in the United States?
New charters tend to be concentrated in large urban areas where expected rates of return on the
organizers investments are likely to be the highest. As the population increases relative to the number
of financial firms, the number of new charters increases. The success of local banks already in the area
suggests that new financial firms would also be successful. Places where the concentration ratio for new
banks has increased tend to have fewer new bank charters.
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4-11.
How well do most new banks perform for the public and for their owners?
Most new banks succeed, especially those whose organizers can bring in new deposits and loan
accounts during the first year of the bank's operation. Most are profitable within two to three years of
opening. There is some evidence that newly charted banks are financially ‘fragile’ and more prone to
failure than existing banks. They appear to be more vulnerable to real estate crises than established
banks. New banks tend to under perform their competitors until they have been around for a while and
new banks are more closely supervised than established banks.
4-12. Why is the establishment of new branch offices usually favored over the chartering of new
financial firms as a vehicle for delivering financial services?
The chartering of a new financing corporation is normally a lengthy and expensive process, requiring the
completion of elaborate federal or state application forms, while the branch application process is
normally far simpler and less costly. Moreover, with the increase in the number of failures in recent
years regulatory-imposed capital requirements for new charters have increased substantially, while new
branch offices usually carry significantly lower capital requirements. Moreover, branch offices
themselves are often much less elaborate and costly to build and maintain than are the headquarters'
facility of a new institution where some duplicate facilities can be eliminated (for example, checking
processing, credit analysis, and records departments).
4-13.
What factors are often considered in evaluating possible sites for new branch offices?
Bankers first need to decide the goals and objectives of a new facility. Often this means assessing
whether the proposed new branch is aimed at selling one or more particular services, such as deposits
or loans, and also deciding how closely correlated cash flows and returns from the new branch office
may be with cash flows and returns from the other facilities operated by the bank. If returns or cash
flows through the proposed new institution are negatively correlated or display low positive correlation
with the institution's other facilities, they may be able to lower the variance of its returns or cash flows
by proceeding to establish the new office.
Other considerations revolve around the economic strength of the proposed branch office site-whether
there is adequate traffic volume, large numbers of stores and shops, older or younger age populations
who often require slightly different menus of services, recent area population growth, density and
income, the occupational and residential makeup of the proposed new branch area, a large enough
population to generate enough customers to breakeven and the number and size of facilities operated
by competitors. Generally, for branches designed to attract and hold deposits key factors to consider
usually revolve around individual and family incomes, concentrations of retail stores and shops, olderthan-average residents, and homeowners rather than renters. For branch facilities emphasizing credit
services residential areas with substantial new construction activity, heavy traffic flow, and high
concentrations of stores and shopping centers are typically desirable for consumer and retail loan
demand, while central city office locations are often chosen as locations for commercial loan facilities.
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4-14. What changes are occurring in the design of, and the roles played by, branch offices? Please
explain why these changes are occurring.
Bank branches are increasingly becoming selling platforms in which more and more fee-based services
are attractively and prominently advertised in order to maximize the fee-income generating potential of
each branch. Moreover, branches are becoming increasingly automated to reduce personnel and other
operating costs and improve speed, efficiency, and accuracy in handling a growing service volume.
Branch design has come to reflect these trends with automated facilities placed at easy access points,
along with information booths to speedily direct customers to the service areas they need. Human
tellers may be placed deeper inside branch facilities so that customers must pass by other service
departments and conspicuous advertising in order to encourage customers to become aware of and
avail themselves of other bank services.
4-15. What laws and regulations affect the creation of new bank and thrift branches and the closing of
existing branches? What advantages and what problems can the closing of a branch office create?
The opening of new branch offices must be approved by a bank's or thrift’s principal federal or state
supervisor. Closing a branch office has become much more complicated in recent years as the result of
several new laws and regulations. For example, the FDIC Improvement Act requires 90 days advance
notice of branch closings to both customers and the principal supervisory agency and a posting on the
branch site at least 30 days prior to closing. Banks and thrifts must also make an "affirmative effort" to
reach all segments of their communities without discrimination under the terms of the Community
Reinvestment Act which raises the danger of customer protests against closings if it appears the bank is
under-serving certain groups of customers. Finally, the Community Reinvestment Act can be used as a
vehicle to prevent U.S. banks and thrifts from branching expansion when they have a poor record of
serving all segments of their communities.
Closing selected branch offices can reduce operating costs and divert resources from less profitable to
more profitable uses. However, they risk alienating good customer relationships unless it can serve
those same customers with its remaining facilities.
4-16. What new and innovative sites have been selected for new branch offices in recent years? Why
have these sites been chosen by some financial firms? Do you have any ideas about other sites that you
believe should be considered?
Rapid increases in new branches located in grocery stores, shopping centers, and inside other
businesses and facilities where the public frequently gathers have helped to reduce branch construction
costs and promote cross-selling of goods and financial services. Other branches have been opened in
apartment complexes, senior citizen centers, and other customer-convenient locations as bankers come
to realize they must adjust their service locations and service hours to conform to customer needs in an
intensely competitive financial-services environment.
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4-17.
What are POS terminals, and where are they usually located?
Point-of-sale terminals are set up to accommodate customer purchases of goods and services. These
computer terminals normally are located in supermarkets, gasoline stations, and similar places with a
link to the banks’ own computer records. When a customer of the bank makes a purchase, the amount
of the transaction is deducted from the customer's deposit account and added to the store's account.
Because the customer immediately loses funds many bank customers have been hesitant to use the
service as opposed to paying by check or credit card where payment is delayed for a few days. However,
this depends on whether the POS terminal is an offline or online terminal. An offline terminal
accumulates all transactions until the end of the day when all transactions are subtracted from a
customer’s account. This type of terminal is less costly for the bank to operate. An online terminal
subtracts the transactions immediately from the customer’s account and reduces the chance of an
overdraft occurring but is more expensive for the bank to operate. Consumer reluctance to use POS
terminals appears to be fading and as fees for other services rise this reluctance will continue to
disappear.
4-18. What services do ATMs provide? What are the principal limitations of ATMs as a service
provider? Should ATM carry fees? Why?
The earliest ATMs provided a convenient mechanism for cashing checks, making deposits, and verifying
checking account balances, often at hours when the full-service branch offices were closed. Today,
ATMs frequently provide a wide menu of old and new services, including bill paying, transfer of funds
between accounts, and the purchase of tickets for travel and entertainment. Most authorities expect
ATM usage to grow rapidly as these machines offer more services and as bankers increasingly move to
restrict customer access to more costly human tellers and other bank personnel, often by charging extra
fees for personal service.
ATMs do have some significant limitations that bankers will have to work to overcome. They break down
and need to be replaced, sometimes quite frequently and annoyingly for customers, and as technology
changes often become quickly outdated. Customer activity around ATMs, particularly at night, has
invited criminals to steal money and injure customers, sometimes creating liability for banks. Moreover,
not all customers make use of these facilities due to a preference for personalized service, fear of crime,
or unfamiliarity with how the machines work. Customer education and better service pricing are two
important tools that could help with these problem areas in the future. In addition, ATMs do not rank
high in their ability to sell peripheral services. Some banks have found that there has been a sharp
decline in their ability to sell other services. Finally, ATMs are not necessarily profitable for all banks.
Because they are available 24 hours, some customers may make more frequent and smaller withdrawals
from the machine than they would with a human teller, driving up the costs. In addition, these same
customers will often still demand a human teller to deposit their pay check, making the bank keep both
tellers and ATM machines.
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Whether ATM should carry a fee is rather controversial. Recently, two of the largest ATM networks have
decided to let owners of ATMs charge non-customers a surcharge. Several regional have begun to
charge fees as well. These fees reflect the usage of ATMs. About 85% of all ATM transactions consist of
cash withdrawals and only about 10 percent represent incoming deposits. In addition, in many places,
ATM usage has declined as customers pass over ATMs in favor of credit and debit cards, onsite terminals
and the INTERNET.
4-19. What are self-service terminals and what advantages do they have for financial institutions and
their customers?
Self-service terminals include ATMs and other computer-based limited-service facilities that permit a
customer to call up information about his or her account and recent transactions with the institution or
information about different services that the customer might be interested in purchasing. Many are
accessible 24 hours a day or are easier to get to rather than wait for the help of personnel. They can
save on resources by saving on staff time. Many institutions are adding telephones and video screens so
that customers with problems can dial up an employee day or night with problems. This is also saving
money because they can avoid duplication of staff at each branch.
4-20. Why do many experts regard the telephone as a key instrument in the delivery of financial
services in the future? What advantages does the telephone have over other service-delivery vehicles?
Many different services can be marketed, delivered, and verified at low cost via the phone. It is among
the most popular channels for putting customers in touch with financial-service providers today. Thus
many expert regards the telephone to be the key financial-service delivery device into the future.
Increased call centers to assist customers in obtaining account information and in carrying out
transactions, leads to avoiding walking or driving to a branch office or ATM. The key feature of today’s
telephone is mobility. The biggest advantage of the cell phone is that it is easily transportable and not
tied to any particular location. Phone has revolutionized communications and delivery of services,
lowering dramatically the cost of both. The recent development of bigger and cleaner screens on mobile
phones and the recent implementation of tighter security procedures in accessing accounts have made
cell phones increasingly comparable to personal computers and even more convenient than PCs when
traveling.
4-21. What financial services are currently available on the INTERNET? What problems have been
encountered in trying to offer INTERNET-delivered services?
Customers can make payments, check on account balances, confirm that deposits funds have been
received, checks have cleared, move funds between accounts and get applications for loans, deposits
and other services. In addition banks can advertise on the web. Some of the problems include protecting
customers’ privacy and heading off crime. In addition, the web does not make it easy for a bank to get to
know their customers personally. The cost may also be prohibitive to some customers.
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4-22.
How can financial firms better promote INTERNET service options?
They need to emphasize the safety of their INTERNET services. They need to promote their home page
at every opportunity and update it frequently to keep customers’ interest. They need to do customers
survey about their satisfaction with the services and encourage dialogue via e-mail to resolve problems.
They can also provide programs to download to act as screen savers (and advertisements) and also
information about the institution and the services it provides.
Problems
4-1.
A group of businesspeople from Gwynne Island are considering filing an application with the
state banking commission to charter a new bank. Due to a lack of current banking facilities within a 10mile radius of the community, the organizing group estimates that the initial banking facility would cost
about $2.7 million to build along with another $500,000 in other organizing expenses and would last for
about 20 years. Total revenues are projected to be $410,000 the first year, while total operating
expenses are projected to reach $180,000 in year 1. Revenues are
expected to increase 5 percent annually after the first year, while expenses will grow an estimated 3
percent annually after year 1. If the organizers require a minimum of a 10 percent annual rate of return
on their investment of capital in the proposed new bank, are they likely to proceed with their charter
application given the above estimates?
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Year
Revenues
Op Expense
Net Profit
1
$410,000
$180,000
$230,000
2
$430,500
$185,400
$245,100
3
$452,025
$190,962
$261,063
4
$474,626
$196,691
$277,935
5
$498,358
$202,592
$295,766
6
$523,275
$208,669
$314,606
7
$549,439
$214,929
$334,510
8
$576,911
$221,377
$355,534
9
$605,757
$228,019
$377,738
10
$636,045
$234,859
$401,185
11
$667,847
$241,905
$425,942
12
$701,239
$249,162
$452,077
13
$736,301
$256,637
$479,664
14
$773,116
$264,336
$508,780
15
$811,772
$272,266
$539,506
16
$852,361
$280,434
$571,926
17
$894,979
$288,847
$606,131
18
$939,728
$297,513
$642,215
19
$986,714
$306,438
$680,276
20
$1,036,050
$315,631
$720,418
Initial investment
$3,200,000
Required Rate of Return
Present value of Future Cash
0.10
$3,084,869
Flows
Net Present Value of Investment
($115,131)
Given the above information, the organizers are not likely to proceed given that the net present value of
this investment is negative. The return they are going to earn is less than the 10% they need to earn.
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4-2.
Hampton Savings Bank is considering the establishment of a new branch office at the corner of
Queen Street and Victoria Boulevard. The savings association’s economics department projects annual
operating revenues of $1.6 million from fee income generated by service sales and annual branch
operating expenses of $795,000. The cost of procuring the property is $1.75 million and branch
construction will total an estimated $2.65 million; the facility is expected to last 16 years. If the savings
bank has a minimum acceptable rate of return on its invested capital of 12 percent, will Hampton
savings likely proceed with this branch office project?
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Year
Revenues
Op Expense
Net Profit
1
$1,600,000
$795,000
$805,000
2
$1,600,000
$795,000
$805,000
3
$1,600,000
$795,000
$805,000
4
$1,600,000
$795,000
$805,000
5
$1,600,000
$795,000
$805,000
6
$1,600,000
$795,000
$805,000
7
$1,600,000
$795,000
$805,000
8
$1,600,000
$795,000
$805,000
9
$1,600,000
$795,000
$805,000
10
$1,600,000
$795,000
$805,000
11
$1,600,000
$795,000
$805,000
12
$1,600,000
$795,000
$805,000
13
$1,600,000
$795,000
$805,000
14
$1,600,000
$795,000
$805,000
15
$1,600,000
$795,000
$805,000
16
$1,600,000
$795,000
$805,000
Initial investment
$4,400,000
Required Rate of Return
Present value of Future Cash
0.12
5,614,059
Flows
Net Present Value of Investment
1,214,059
Hampton is likely to proceed with this project because the net present value is positive. This means that
the interest rate that Hampton will earn on this project is higher than the 12% they need to earn.
4-3.
Lifetime Savings Bank estimates that building a new branch office in the newly developed
Washington township will yield an annual expected return of 12 percent with an estimated standard
deviation of 10 percent. The bank’s marketing department estimates that cash flows from the proposed
Washington branch will be mildly positively correlated (with a correlation coefficient of + 0.20) with the
bank’s other sources of cash flow. The expected annual return from the bank’s existing facilities and
other assets is 10 percent with a standard deviation of 3 percent. The branch will represent just 15
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percent of Lifetime’s total assets. Will the proposed branch increase Lifetime’s overall rate of return? Its
overall risk?
The estimated total rate of return would be:
E (R) = 0.15 (12%) + 0.85 (10%) = 10.3%
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The risk attached to this overall return rate would be:
σ2 = (.15)2 (.1)2 + (.85)2 (.03)2 + 2(.15)(.85)(.2)(.1)(0.03)
σ2 = .00102825
Thus   3.21% and the branch will slightly increase the bank's expected return but slightly increase its
overall risk. The bank should proceed with this project.
4-4.
The following statistics and estimates were compiled by Blue Skies Bank regarding a proposed
new branch office and the bank itself:
Branch Office Expected Return
14%
Standard Deviation of Return
=
Bank’s overall expected return =
12%
Standard deviation of bank’s return
=
3%
of Total Bank Assets
=
12%
Correlation of Cash Flows
=
+ 0.56
7%
Branch Asset Value as a Percent
What will happen to the Blue Skies’ total expected return and overall risk if the proposed new branch
project is adopted?
The bank's total expected return is:
E (R) = 0.12 (14%) + 0.88 (12%) =
12.24%
The bank's risk exposure is:
σ2 = (.12)2 (.07)2 + (.88)2 (.03)2 + 2(.12)(.88)(.56)(.07)(.03)
σ2 = .0010159
And thus σ = .03187 or 3.19%
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The proposed project raises the savings banks expected return slightly and but slightly increase its
overall risk. The bank should proceed with this project.
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4-5
Wildflower Financial Services has provided Good Things to Eat Groceries a proposal for in-store
branches in two of its four Livingston locations. Good Things to Eat counterproposed opening one instore branch in one of the two proposed locations as a test case. The locations would be identified as
the Lily Branch or the Daisy Branch. Given the following statistics and forecasts compiled by Wildflower
regarding the two alternatives, which branch should be used as a test case? Base your recommendation
on returns and risk.
In-store branch at Lily location
In-store branch at Daisy
location
Existing facilities
Expected
Return
Standard
Deviation
Correlation
Coefficient with
Other Services
Percentage
of Total
Assets
14.00%
15.00
7.00%
8.50
0.5
0.35
5.00%
5.00
12.00
5.00
95.00
Lily locationThe total expected return is:
E (R) = 0.05 (14%) + 0.95 (12%) =
12.1%
Risk exposure is:
σ2 = (.05)2 (.07)2 + (.95)2 (.05)2 + 2(.05)(.95)(.5)(.07)(.05)
σ2 = .00243475
And thus σ = .04934 or 4.93%
Daisy location-
The total expected return is:
E (R) = 0.05 (15%) + 0.95 (12%) =
12.15%
Risk exposure is:
σ2 = (.05)2 (.09)2 + (.95)2 (.05)2 + 2(.05)(.95)(.35)(.09)(.05)
σ2 = .0024156
And thus σ = .049149 or 4.91%
Based on the statistics and forecasts, the expected return of Daisy location is slightly higher and the risk
is slightly lower compared to Lily location, and thus Daisy location should be used as a test case.
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4-6.
First National Bank of Leesville is considering installing three ATMs in its Westside branch. The
new machines are expected to cost $37,000 apiece. Installation costs will amount to about $12,000 per
machine. Each machine has a projected useful life of 10 years. Due to rapid growth in the Westside
district, these three machines are expected to handle 75,000 cash transactions per year. On average,
each cash transaction is expected to save 50 cents in teller expenses. If First National has a 12 percent
cost of capital, should the bank proceed with this investment project?
Year
Savings
1
$37,500
2
$57,600
3
$57,600
4
$57,600
5
$57,600
6
$57,600
7
$57,600
8
$57,600
9
$57,600
10
$57,600
Initial Investment
Required Rate of Return
(.50*75,000)
147000
(37000*3+12000*3)
0.12
Present Value of Future Cash
Flows
$307,506.42
Net Present Value
$160,506.42
The net present value of this project is positive. First National Bank of Leesville should add the ATM
machines to the Westside.
4-7.
First State Security Bank is planning to set up its own web page to advertise its location and
services on the INTERNET and to offer customers selected service options, such as paying recurring
household bills, verification of account balances, and dispensing deposit account and loan application
forms. What factors should First State take into account as it plans its own web page and INTERNET
service menu? How can the bank effectively differentiate itself from other banks currently present on
the INTERNET? How might the bank be able to involve its own customers in designing its web site and
pricing its INTERNET service package?
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The bank should remember that while the INTERNET is a relatively low cost way of expanding and allows
customers to find the bank rather than the bank having to find customers, there are serious concerns
about privacy. In addition, the INTERNET is not limited by geography and while there are thousands of
potential customers, there are also many financial institutions around the world competing for customer
deposits and loans. The bank needs to be aware that there are many bank web pages out there and that
they will need to invest in employees with the technical expertise to manage the new web site well. One
of the first things the bank needs to do is to take steps to protect its customers and let its customers
know what its privacy and security policies are. Another step the bank can take is to start with a
customer survey to find out what its customers want and need from the bank’s INTERNET services. They
can run this as a contest and give away some small items to the customer with the best ideas for the
web page and INTERNET service. This should help get customers involved in the design and
implementation of the web page and may help the bank start building an online customer base.
CHAPTER 5
THE FINANCIAL STATEMENTS OF BANKS AND THEIR PRINCIPAL COMPETITORS
Goal of This Chapter: The purpose of this chapter is to acquaint the reader with the content, structure
and purpose of bank financial statements and to help managers understand how information from bank
financial statements can be used as tools to reveal how well their banks are performing.
Key Topics in this Chapter
•
•
•
•
•
•
•
•
An Overview of the Balance Sheets and Income Statements of Banks and Other Financial
Firms
The Balance Sheet or Report of Condition
Asset Items
Liability Items
Recent Expansion of Off-Balance Sheet Items
The Problem of Book-Value Accounting and ”Window Dressing”
Components of the Income Statement: Revenues and Expenses
Appendix: Sources of Information on the Financial-Services Industry
Chapter Outline
I. Introduction: The Statements Reviewed in This Chapter
II An Overview of Balance Sheets and Income Statements
III The Balance Sheet (Report of Condition)
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A. The Principal Types of Accounts
B. Assets of the Banking Firm
1. Cash and Due from Depository Institutions
2. Investment Securities: The Liquid Portion
3. Investment Securities: The Income-Generating Portion
4. Trading Account Assets
5. Federal Funds Sold and Reverse Repurchase Agreements
6. Loans and Leases
7. Loan Losses
8. Specific and General Reserves
9. International Loan Reserves
10.Unearned Income
11.Nonperforming (noncurrent) Loans
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12.Bank Premises and Fixed Assets
13.Other Real Estate Owned (OREO)
14.Goodwill and Other Intangible Assets
15.All Other Assets
C. Liabilities of the Banking Firm
1. Deposits
2. Borrowings from Nondeposit Sources
3. Equity Capital for the Banking Firm
a. Preferred Stock
b. Common Equity
D. Comparative Balance Sheet Ratios for Different Size Banks
E. Recent Expansion of Off-Balance-Sheet Items in Banking
F. The Problem of Book-Value Accounting
G. Auditing: Assuring Reliability of Financial Statements
IV. Components of the Income Statement (Report of Income)
A. Financial Flows and Stocks
1. Interest Income
2. Interest Expenses
3. Net Interest Income
4. Loan Loss Expense
5. Noninterest Income
6. Noninterest Expenses
7. Net Operating Income and Net Income
B. Comparative Income Statement Ratios for Different-Size Financial Firms
V. The Financial Statements of Leading Nonbank Financial Firms: A Comparison to Bank Statements
VI. An Overview of Key features of Financial Statements and Their Consequences
VII. Summary of the Chapter
Concept Checks
5-1.
What are the principal accounts that appear on a bank's balance sheet (Report of Condition)?
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The principal asset items on a bank's Report of Condition are loans, investments in marketable
securities, cash, and miscellaneous assets. The principal liability items are deposits and nondeposit
borrowings in the money market. Equity capital supplied by the stockholders rounds out the total
sources of funds for a bank.
5-2.
Which accounts are most important and which are least important on the asset side of a bank's
balance sheet?
The principal bank asset items from most important to least important are::
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Rank Order
Assets
1
Cash
2
Investment Securities
3
Loans
4
Miscellaneous Assets
5-3.
What accounts are most important on the liability side of a balance sheet?
The principal bank liability items from most important to least important are:
Rank Order
Liabilities and Equity Capital
1
Deposits
2
Nondeposit Borrowings
3
Equity Capital
4
Miscellaneous Liabilities
5-4.
What are the essential differences among demand deposits, savings deposits, and time
deposits?
Demand deposits are regular checking accounts against which a customer can write checks or make any
number of personal withdrawals. Regular checking accounts do not bear interest under current U.S. law
and regulation.
Savings deposits bear interest (normally, they carry the lowest rate paid on bank deposits) but may be
withdrawn at will (though a bank usually will reserve the right to require advance notice of a planned
withdrawal).
Time deposits carry a fixed maturity and the bank may impose a penalty if the customer withdraws
funds before the maturity date is reached. The interest rate posted on time deposits is negotiated
between the bank and its deposit customer and may be either fixed or floating.
A NOW account combines features of a savings account and a checking account, while a money market
deposit account encompasses transactional powers similar to a regular checking account (though usually
with limitations on the number of checks or drafts that may be written against the account) but also
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resembles a time deposit with an interest rate fixed for a brief period (such as weekly) but then
becomes changeable over longer periods to reflect current market conditions.
5-5.
What are primary reserves, and secondary reserves and what are they supposed to do?
Primary reserves consist of cash, including a bank's vault cash and checkable deposits held with other
banks or any other funds such as reserves with the Federal Reserve that are accessible immediately to
meet demands for liquidity made against the bank.
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Secondary reserves consist of assets that pay some interest (though usually pay returns that are much
lower than earned on other assets, such as loans) but their principal feature is ready marketability. Most
Secondary reserves are marketable securities such as short term government securities and private
securities such as commercial paper.
Both primary and secondary reserves are held to keep the bank in readiness to meet demands for cash
(liquidity) from whatever source those demands may arise.
5-6.
Suppose that a bank holds cash in its vault of $1.4 million, short-term government securities of
$12.4 million, privately issued money market instruments of $5.2 million, deposits at the Federal
Reserve banks of $20.1 million, cash items in the process of collection of $0.6 million, and deposits
placed with other banks of $16.4 million. How much in primary reserves does this bank hold? In
secondary reserves?
The bank holds primary reserves of:
Vault Cash + Deposits at the Fed + Cash Items in Collection + Deposits With Other Banks
= $1.4 mill. + $20.1 mill. + $0.6 mill. + $16.4 mill.
= $38.5 million
The bank has secondary reserves of:
Short-term Government Securities + Private Money-Market Instruments
= $12.4 mill. + $5.2 mill.
= $17.6 million
5-7.
What are off-balance-sheet items and why are they important to some financial firms?
Off-balance-sheet items are usually transactions that generate fee income for a bank (such as standby
credit guarantees) or help hedge against risk (such as financial futures contracts). They are important as
a supplement to income from loans and to help a bank reduce its exposure to interest-rate and other
types of risk.
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5-8.
Why are bank accounting practices under attack right now? In what ways could financial
institutions improve their accounting methods?
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The traditional practice of banks has been to record the value of assets and liabilities at their value on
the day the accounts were originally created and not change those values over the life of the account.
The SEC and FASB started questioning this practice in the 1980’s because they were concerned that
investors in bank securities would be misled about the true value of the bank. Using this historical value
accounting method may in fact conceal a bank that insolvent in a current market value sense.
The biggest controversy centered on the banks’ investment portfolio which would appear to be easy to
value at its current market price. At a minimum, banks could help themselves by marking their
investment portfolio to market. This would give investors an indication of the true value of the bank’s
investment portfolio. Banks could also consider using the lower of historical or market value for other
accounts on the balance sheet.
5-9.
What accounts make up the Report of Income (income statement of a bank)?
The Report of Income includes all sources of bank revenue (loan income, investment security income,
revenue from deposit service fees, trust fees, and miscellaneous service income) and all bank expenses
(including interest on all borrowed funds, salaries, wages, and employee benefits, overhead costs, loan
loss expense, taxes, and miscellaneous operating costs.) The difference between operating revenues
and expenses (including tax obligations) is referred to as net income.
5-10.
In rank order, what are the most important revenue and expense items on a Report of Income?
By dollar volume in most recent years the rank order of the revenue and expense items on a bank's
Report of Income is:
Rank Order
Revenue Items
Expense Items
1
Loan Income
Deposit Interest
2
Security Income
Interest on Nondeposit Borrowings
3
Service Charges on Deposits
Salaries, Wages, and
and Other Deposit Fees
4
Employee Benefits
Other Operating Revenues
Miscellaneous Expenses
5-11. What is the relationship between the provision for loan losses on a bank's Report of Income and
the allowance for loan losses on its Report of Condition?
Gross loans equal the total of all loans currently outstanding that are recorded on the bank's books. Net
loans are equal to gross loans less any interest income on loans already collected by the bank but not
yet earned and also less the allowance for loan-loss account (or bad-debt reserve).
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The allowance for loan losses is built up gradually over time by an annual noncash expense item that is
charged against the bank's current income, known as the Provision for Loan Losses. The dollar amount
of the annual loan-loss provision plus the amount of recovered funds from any loans previously declared
worthless (charged off) less any loans charged off as worthless in the current period is added to the
allowance-for-loan-losses account.
If current charge-offs of worthless loans exceed the annual loan-loss provision plus any recoveries on
previously charged-off loans the annual net figure becomes negative and is subtracted from the
allowance-for-loan-losses account.
5-12. Suppose a bank has an allowance for loan losses of $1.25 million at the beginning of the year,
charges current income for a $250,000 provision for loan losses, charges off worthless loans of
$150,000, and recovers $50,000 on loans previously charged off. What will be the balance in the
allowance for loan losses at year-end?
The balance in the allowance for loan loss (ALL) account at year end will be:
Beginning ALL
= $1.25 million
Plus: Annual Provision
for Loan Losses
= +0.25
Recoveries on
Loans Previously
= +0.05
Charged Off
Minus: Charge
Offs of Worthless
= -0.15
Loans
Ending ALL
5-13.
= $1.40 million
Who are banking’s chief competitors in the financial services marketplace?
The closest competitors of banks in recent years (at least in terms of the similarity of their financial
statements) are the thrift institutions. These include credit unions and savings associations. If we move a
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little further away from banks both in terms of what they do and the way their financial statements
look, banks also compete with finance companies, life and property casualty insurance companies and
security brokers and dealers.
5-14. How do the financial statements of major nonbank financial firms resemble or differ from bank
financial statements? Why do these differences or similarities exist?
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Banks have very similar financial statements to credit union and savings associations. The only
difference may be in the structure of their loan portfolio. Credit unions probably have more loans to
individuals and savings associations may have more real estate loans as well as loans to individuals.
More differences exist between banks and other major competitors. These differences exist because of
each company’s unique function. Finance companies have loans but on their balance sheet they are
called accounts receivables. In addition, they show heavy reliance on money market borrowings instead
of deposits. Insurance companies are different in that loans they make to businesses show up on the
balance sheet as bonds, stocks, mortgages and other securities. On the liability side, insurance
companies receive the majority of their funds from insurance premiums paid by customers for insurance
protection.
Mutual funds hold primarily corporate stocks, bonds, asset-backed securities and money market
instruments and their liabilities consist primarily of units of the mutual fund sold to the public. Security
brokers and dealers tend to hold a similar range of securities funded by borrowings in the money and
capital markets.
5-15. What major trends are changing the content of the financial statements prepared by financial
firms?
The content of the financial statements of financial firms is changing for several reasons. One trend that
has affected the financial statements of financial firms is the call for those statements to reflect the true
market value of the assets held by the financial firm. More accounts are being listed at the lower of
historical or market value so that investors can get a better understanding of the true value of the firm.
Another trend that is affecting financial firms is the increased use of off-balance sheet items. The
notional amount of these items is sometimes surpassing the value of the items on the balance sheet,
especially for larger financial institutions. This has led regulators to change their reporting requirements
for financial firms and there are likely to be additional requirements in the future.
Another trend that is affecting financial firms is the convergence of the various types of financial firms.
In addition, financial firms are becoming larger and more complex and more financial holding companies
are formed. These are also leading to changes in the content and structure of the financial statements of
financial firms.
5-16. What are the key features or characteristics of the financial statements of banks and similar
financial firms? What are the consequences of these statement features for managers of financialservice providers and for the public?
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The financial statements of financial-service firms exhibit three main characteristics that have important
consequences for managers of these firms and the public.
The first characteristic of these firms is that they have lower operating leverage. They have small
amounts of buildings, equipment and other fixed assets. Operating leverage adds risk to the firm and
firms with large amount of operating leverage can face large fluctuations in net income and earnings per
share for small changes in revenues.
Financial-service firms do not have this problem. However, financial service firms have large amounts of
financial leverage. Financial leverage comes from how the firm finances their assets. If a firm borrows a
lot, they face have larger financial leverage and have a larger amount of risk as a result. Financial service
firms finance approximately 90% of their assets with debt and therefore face significant financial
leverage.
Small changes in revenues can lead to large changes in net income and earnings per share as a result. In
addition, changes in interest rates can have significant effects on the net income and capital position of
financial firms. Finally, most of the liabilities of financial firms are short term. This means that financial
firms can face significant liquidity problems. A sudden demand by depositors for funds can lead to large
problems for financial firms.
Problems
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5-1.
Jasper National Bank has just submitted its Report of Condition to the FDIC. Please fill in the
missing items from its statement shown below (all figures in millions of dollars):
Report of Condition
Total assets
Cash and due from Depository Institutions
Securities
Federal Funds Sold and Reverse Repurch.
Gross Loans and Leases
$2,500
87
233
45
?
Loan Loss Allowance
200
Net Loans and Leases
1700
Trading Account Assets
1,900 * Gross Loans and Leases = Net Loans and Leases+
Loan Loss Allowance
20
*This is the only asset missing and so is total assets
Bank Premises and Fixed Assets
Other Real Estate Owned
?
15
Goodwill and Other Intangibles
200
All Other Assets
175
Total Liabilities and Capital
Total Liabilities
25 less all of the rest of the assets listed here
?
2,500 *Total Liabilities and Capital = Total assets
?
* Total Liabilities = Total Liabilities and Capital-Total
2,260 Equity Capital
*Total Deposits = Total Liabilities Less All of the
Total Deposits
?
Federal Funds Purchased and Repurchase
Agreements.
80
Trading Liabilities
10
Other Borrowed Funds
50
Subordinated Debt
480
All Other Liabilities
40
Total Equity Capital
?
Perpetual Preferred Stock
2
Common Stock
24
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1,600 Other Liabilities
Total Equity Capital = Perpetual Preferred Stock
240 +Common Stock+Surplus+Undivided Profit
Chapter 01 - An Overview of the Changing Financial-Services Sector
Surplus
Undivided Profit
144
70
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5-2.
Along with the Report of Condition submitted above, Jasper has also prepared a Report of
Income for the FDIC. Please fill in the missing items from its statement shown below (all figures in
millions of dollars):
Report of Income
Total Interest Income
Total Interest Expense
Net Interest Income
Provision for Loan and Lease Losses
Total Noninterest Income
$120
?
* Total Interest Expense = Total Interest
80 Income - Net Interest Income
40
?
* Provision for Loan and Lease Losses = Net
Interest Income + Total Noninterest Income Total Noninterest Expense - Pretax Net
4 Operating Income
58
Fiduciary Activities
8
Service Charges on Deposit Accounts
6
* There are four areas of Total Noninterest
Income and only one is missing and the total
Trading Account Gains and Fees
?
Additional Noninterest Income
30
Total Noninterest Expense
14 is given
77
*There are three areas of Total Noninterest
Expense and only one is missing and the total
Salaries and Benefits
?
Premises and Equipment Expense
10
Additional Noninterest Expense
20
Pretax Net Operating Income
47 is given
17
Securities Gains (Losses)
1
Applicable Income Taxes
5
*Pretax Income Plus Security Gains Less
Income Before Extraordinary Income
?
Extraordinary Gains – Net
2
13 Taxes is income before extraordinary income
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Net Income
?
* Net Income = Income Before Extraordinary
15 Income + Extraordinary Gains – Net
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Chapter 01 - An Overview of the Changing Financial-Services Sector
5-3.
If you know the following figures:
Total Interest Income
Total Interest Expenses
$140 Provision for Loan Loss
$5
100 Income Taxes
Total Noninterest Income
15 Increases in bank’s undivided profits
Total Noninterest Expenses
35
5
6
Please calculate these items:
Net Interest Income
Net Noninterest Income
40 *Total Interest Income Less Total Interest Expense
-20 *Total Noninterest Income Less Total Noninterest Expense
Pretax net operating income
15 *Net Interest Income Plus Net Noninterest Income Less PLL
Net Income After Taxes
10 *Pretax net operating income less PLL less Taxes
Total Operating Revenues
155 *Interest Income Plus Noninterest Income
Total Operating Expenses
140 *Interest Expenses Plus Noninterest Expenses Plus PLL
Dividends paid to Common Stockholders
5-4.
4 Net Income After Taxes Less Increases in bank’s undivided profits
If you know the following figures:
Gross Loans
Allowance for Loan Losses
Investment Securities
Common Stock
$275 Trading Account Securities
5 Other Real Estate Owned
36 Goodwill and other Intangibles
$2
4
3
5 Total Liabilities
375
Surplus
19 Preferred Stock
3
Total Equity Capital
39 Nondeposit Borrowings
Cash and Due from Banks
9 Bank Premises and Equipment, Net
Miscellaneous Assets
38
Bank Premises and Equipment, Gross
34
Please calculate these items:
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Total Assets
414 *Total Liabilities Plus Total Equity Capital
Net Loans
270 *Gross Loans Less ALL
Undivided Profit
12 *Total Equity Capital less PS less CS Less Surplus
Fed funds sold
23 *This is the only asset missing so subtract all other
assets from total assets
Depreciation
Total Deposits
* Bank Premises and Equipment, Gross less Bank Premises and
5 Equipment, Net
355 *Total Liabilities less Nondeposit Borrowings
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5-5. The Mountain High Bank has Gross Loans of $750 million with an ALL account of $45 million. Two
years ago the bank made a loan for $10 million to finance the Mountain View Hotel. Two million in
principal was repaid before the borrowers defaulted on the loan. The Loan Committee at Mountain High
Bank believes the hotel will sell at auction for $7 million and they want to charge off the remainder
immediately.
a. The dollar figure for Net Loans before the charge-off is ?
Net Loans = Gross Loans –ALL = $750 - $45 = $705
b. After the charge-off, what are the dollar figures for Gross Loans, ALL and Net Loans assuming
no other transactions.
Gross Loans = $750 - $8 = $742 *assuming the $1 in principal has been recognized on
the balance sheet yet
ALL = $45 - $1 = $44
*The amount of the loan that is bad
Net Loans = $705 -$44 = $661
c. If the Mountain View Hotel sells at auction for $8 million, how with the affect the pertinent
balance sheet accounts?
Gross loans would not change but ALL would be $45 because there would be no bad debt and
net loans would go down by $1 million
5-6.
For each of the following transactions, which items on a bank’s statement of income and
expenses (Report of Income) would be affected?
a. Office supplies are purchased so the bank will have enough deposit slips and other necessary
forms for customer and employee use next week.
This would be part of Additional noninterest expense and part of Total Noninterest Expense.
b. The bank sets aside funds to be contributed through its monthly payroll to the employee
pension plan in the name of all its eligible employees.
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This would be part of Salaries and Benefits and part of Total Noninterest Expenses.
c. The bank posts the amount of interest earned on the savings account of one of its customers.
This would be part of Total Interest Expenses.
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d. Management expects that among a series of real estate loans recently granted the default
rate will probably be close to 3 percent.
This would be part of PLL to go into reserves for future bad debts.
e. Mr. And Mrs. Harold Jones just purchased a safety deposit box to hold their stock certificates
and wills.
This would be part of Additional Noninterest Income and part of Total Noninterest Income
f. The bank colleges $1 million in interest payments from loans it made earlier this year to Intel
Composition Corp.
This would be part of Total Interest Income
g. Hal Jones’s checking account is charged $30 for two of Hal’s checks that were returned for
insufficient funds.
This would be part of Service Charges on Deposit Accounts and then part of Total Noninterest
Income
h. The bank earns $5 million in interest on government securities it has held since the middle of
last year.
This would be part of Total Interest Income.
i. The bank has to pay its $5,000 monthly utility bill today to the local electric company.
This would be part of Premises and Equipment Expenses and part of Total Noninterest Expenses
j. A sale of government securities has just netted the bank a $290,000 capital gain (net of taxes).
This would be part of Security Gains (Losses)
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5-7.
For each of the transactions described here, which of at least two accounts on a bank’s balance
sheet (Report of Condition) would be affected by each transaction?
a. Sally Mayfield has just opened a time deposit in the amount of $6,000 and these funds are
immediately loaned to Robert Jones to purchase a used car.
Gross Loans +$6,000
Total Deposits +$6,000
b. Arthur Blode deposits his payroll check for $1000 in the bank and the bank invests the funds
in a government security.
Securities + $1,000
Total Deposits +$1,000
c. The bank sells a new issue of common stock for $100,000 to investors living in its community,
and the proceeds of that sale are spent on the installation of new ATMs,
Bank Premises & Equipment, Gross +$100,000
Common Stock /Surplus +$100,000
d. Jane Gavel withdraws her checking account balance of $2,500 from the bank and moves her
deposit to a credit union; the bank employs the funds received from Mr. Alan James, who just
paid off his home equity loan, to provide Ms. Gavel with the funds she withdrew.
Gross Loans -$2,500
Total Deposits -$2,500
e. The bank purchases a bulldozer from Ace Manufacturing Company for $750,000 and leases it
to Cespan Construction Company.
Cash and Due from Bank -$750,000
Gross Loans and Leases +750,000
f. Signet National Bank makes a loan of reserves in the amount of $5 million to Quesan State
Bank and the funds are returned the next day.
On the day the funds are loaned the accounts are affected in the following manner:
Cash and Due from Bank -$5,000,000
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Federal Funds Sold +$5,000,000
and when the finds are returned the next day, the process is reversed.
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g. The bank declares its outstanding loan of $1 million from the Deprina Corp. to be
uncollectible.
Gross Loans -$1,000,000
ALL -$1,000,000
5-8.
The Nitty Gritty Bank is developing a list of off-balance-sheet items for its call report. Please fill
in the missing items from its statement shown below. Using Table 5-5, describe how Nitty Gritty
compares with other banks in the same size category regarding its off-balance sheet activities.
Off-balance-sheet items for Nitty Gritty Bank (in millions of $)
Total unused commitments
$7,000
Standby letters of credit and foreign office
guarantees
$1,350
(Amount conveyed to others)
($50)
Commercial Letters of Credit
$48
Securities Lent
$2,200
Derivatives (total)
$97,000
Notional Amount of Credit Derivatives
$22,000
Interest Rate Contracts
54000
19,800
Foreign Exchange Rate Contracts
?
Contracts on other commodities and equities
Total Derivatives Less All Other
Derivatives
$1,200
All other off - balance -sheet liabilities
$49
Total off-balance-sheet Items
?
Total Assets (on-balance sheet)
The sum of all of the off-balance
$107,597 sheet items
$10,500
Off-balance-sheet assets ÷ on-balance-sheet assets
This looks very similar to other banks of the same size.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
5-9.
See if you can determine the amount of Cardinal State Bank’s current net income after taxes
from the figures below (stated in millions of dollars) and the amount of its retained earnings from
current income that it will be able to reinvest in the bank. (Be sure to arrange all the figures given in
correct sequence to derive the bank’s Report of Income.)
Total Interest Income
Interest on Loans
$86
Int earned on Govt. Bonds and Notes
$9
Total
$95
Total Interest Expense
Interest Paid on Fed Funds Purchased
$5
Interest Paid to Customers Time and Savings
Deposits
$34
Total
$39
Net Interest Income
$56
Provision for Loan Loss
$2
Total Noninterest Income
Service Charges Paid by Depositors
$3
Trust Department Fees
$3
Total
$6
Total Noninterest Expenses
Employee Wages, Salaries and Benefits
$13
Overhead Expenses
$3
Total
$16
Net Noninterest Income
($10)
Pretax Income
$44
Taxes Paid (28%)
$12
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Securities Gains/(Losses)
$(7)
Net Income
$25
Less Dividends
$4
Retained Earnings from Current Income
$21
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5-10. Which of these account items or entries would normally occur on a bank’s balance sheet (Report
of Condition) and which on a bank’s income and expense statement (Report of Income)?
The items which would normally appear on a bank's balance sheet are:
Federal funds sold
Deposits due to Bank
Credit card loans
Leases of Business Equipment
To Customers
Vault cash
Savings Deposit
Allowance for loan losses
Undivided profits
Commercial and Industrial Loans
Mortgage Owed on the Bank’s
Buildings
Repayment of Credit Card Loan
Other Real Estate Owned
Common Stock
Additions to Undivided profits
Federal funds purchased
The items which would normally appear on a bank’s income statement are:
Interest Received on Credit
Card Loans
Depreciation on Plant and Equipment
Interest Paid on Money Market
Deposits
Provision for Loan Losses
Security Gains or Losses
Service Charges on Deposits
Utility Expense
5-11 You were informed that a bank’s latest income and expense statement contained the following
figures (in $ millions):
Net Interest Income
Net Noninterest Income
Pretax net operating income
Security gains
$700
($300)
$372
$10
Increases in bank’s Undivided
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Profit
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Suppose you also were told that the bank’s total interest income is twice as large as its total interest
expense and its noninterest income is three-fourths of its noninterest expense. Imagine that its
provision for loan losses equals 2 percent of its total interest income, while its taxes generally amount to
30 percent of its net income before income taxes. Calculate the following items for this bank’s income
and expense statement:
Total Interest Income (TII) and Total Interest Expense(TIE):
TII = 2TIE and Net Interest Income = TII –TIE = $700 so:
2TIE –TIE = $700 TIE = $700 and TII = 2($700) = $1,400
Total Noninterest Income (TNI) and Total Noninterest Expense(TNE):
TNI = .75TNE and Net Noninterest Income = TNI – TNE = -$300 so:
.75TNE – TNE = -$300 -.25TNE = $300 TNE = $1200 and TNI = .75($1200) = $900
Provision for Loan Losses
PLL = .02*Total Interest Income = .02*($1,400) = $28
Taxes
Net Income Before Taxes = Net Interest Income + Net Noninterest Income –PLL
Net Income Before Taxes = $700 + -$300 - $28 = $372
Taxes = .3* Net Income Before Taxes = .3*372 = $111.60
Dividends
Net Income After Taxes = Net Income Before Taxes - Taxes
Net Income After Taxes = $372 - $111.60 = $260.4
Increase in Undivided Profit = Net Income After Taxes – Dividends
Dividends = Net Income After Taxes – Increase in Undivided Profit
Dividends= $260.4 - $200 = $60.4
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5-12. Why do financial statements issued by banks and by nonbank financial-service providers look
increasingly similar today? Which nonbank financial firms have balance sheets and income statements
that closely resemble those of commercial banks (especially community banks)?
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The resemblance between bank and nonbank financial service providers is caused by the intense
competition between the sectors. Both groups of financial firms are offering more and more similar
services and that development is widely reflected in their respective financial statements. This is
particularly true for nonbank thrift institutions like credit unions and savings associations. Their balance
sheets are dominated by loans, by deposits, and borrowings in the money market. In addition, the
income statements are heavily tilted towards revenues on loans and interest expenses on their deposits
and money market borrowings.
5-13 What principal types of assets and funds sources do nonbank thrifts (including savings banks,
savings and loans, and credit unions) draw upon? Where does the bulk of their revenue come from, and
what are their principal expense items?
The assets of nonbank thrifts are dominated by loans (especially mortgages and consumer installment
loans) and their funding comes primarily from deposits and money market borrowings. As a result, most
of their revenue is generated by their loans and most of their expenses are interest expenses on the
deposits and the money market borrowings.
5-14. How are the balance sheets and income statements of finance companies, insurers, and
securities firms similar to those of banks, and in what ways are they different? What might explain the
differences you observe?
The main similarities between these nonbank competitors can be found on the asset side of their
balance sheets. All of the above rely on loans and securities, although they normally label them
differently. The main difference is the source of funds. None of the aforementioned competitors can
draw upon deposits and has to rely on money market, other borrowings and equity. These differences
are rooted in the nature of their line of business and underlying regulations.
CHAPTER 6
MEASURING AND EVALUATING THE PERFORMANCE OF BANKS AND THEIR
PRINCIPAL COMPETITORS
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Goal of This Chapter: The purpose of this chapter is to discover what analytical tools can be applied to a
bank’s financial statements so that management and the public can identify the most critical problems
inside each bank and develop ways to deal with those problems
Key Topics in this Chapter
•
•
•
•
•
•
Stock Values and Profitability Ratios
Measuring Credit, Liquidity, and Other Risks
Measuring Operating Efficiency
Performance of Competing Financial Firms
Size and Location Effects
Appendix: Using Financial Ratios and Other Analytical Tools to Track Financial Firm
Performance-The UBPR and BHCPR
Chapter Outline
I. Introduction:
II Evaluating Performance
A. Determining Long-Range Objectives
B. Maximizing the Value of the Firm: A Key Objective for Nearly All Financial-Service
Institutions
C. Profitability Ratios: A Surrogate for Stock Values
1. Key Profitability Ratios
2. Interpreting Profitability Ratios
D. Useful Profitability Formulas for Banks and Other Financial-Service Companies
E. Return on Equity and Its Principal Components
F. The Return on Assets and Its Principal Components
G. What a Breakdown of Profitability Measures Can Tell Us
H. Measuring Risk in Banking and Financial Services
1. Credit Risk
2. Liquidity Risk
3. Market Risk
4. Price Risk
5. Interest Rate Risk
6. Foreign Exchange and Sovereign Risk
7. Off-Balance-Sheet Risk
8. Operational (Transactional) Risk
9. Legal and Compliance Risks
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10 Reputation Risk
11. Strategic Risk
12. Capital Risk
I. Other Goals in Banking and Financial-Services Management
III. Performance Indicators among Banking’s Key Competitors
IV.The Impact of Size on Performance
A. Size, Location and Regulatory Bias in Analyzing the Performance of Banks and
Competing Financial Institutions
V. Summary of the Chapter
Appendix to the Chapter - Using Financial Ratios and Other Analytical Tools to Track Financial-Firm
Performance-The UBPR and BHCPR
Concept Checks
6-1. Why should banks and other corporate financial firms be concerned about their level of
profitability and exposure to risk?
Banks in the U.S. and most other countries are private businesses that must attract capital from
the public to fund their operations. If profits are inadequate or if risk is excessive, they will have
greater difficulty in obtaining capital and their funding costs will grow, eroding profitability.
Bank stockholders, depositors, and bank examiners representing the regulatory community are
all interested in the quality of bank performance. The stockholders are primarily concerned with
profitability as a key factor in determining their total return from holding bank stock, while
depositors (especially large corporate depositors) and examiners typically focus on bank risk
exposure.
6-2. What individuals or groups are likely to be interested in these dimensions of performance
for a financial institution?
The individuals or groups likely to be interested in the dimensions i.e., Bank profitability and
Risk are – Other banks lending to a particular bank, borrowers, large depositors, holders of longterm debt capital issued by banks, bank stockholders, and the regulatory community.
6-3.
What factors influence the stock price of a financial-services corporation?
A bank's stock price is affected by all those factors affecting its profitability and risk exposure,
particularly its rate of return on equity capital and risk to shareholder earnings. Research
evidence over the years has found that the stock prices of financial institutions is sensitive to
changes in market interest rates, currency exchange rates, and the strength or weakness of the
economy. A bank can raise its stock price by creating an expectation in the minds of investors of
greater earnings in the future, by lowering the bank's perceived risk exposure, or by a
combination of increases in expected earnings and reduced risk.
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6-4. Suppose that a bank is expected to pay an annual dividend of $4 per share on its stock in
the current period and dividends are expected to grow 5 percent a year every year, and the
minimum required return-to-equity capital based on the bank's perceived level of risk is 10
percent. Can you estimate the current value of the bank's stock?
In this constant dividend growth rate problem the current value of the bank's stock would be:
Po = D1 / (r – g) = $4 / (0.10 – 0.05) = $80.
6-5. What is return on equity capital, and what aspect of performance is it supposed to
measure? Can you see how this performance measure might be useful to the managers of
financial firms?
Return on equity capital is the ratio of Net Income/Total Equity Capital. It represents the rate of
return earned on the funds invested in the bank by its stockholders. Financial firms have
stockholders, who too are interested in the return on the funds that they invested.
6-6
Suppose a bank reports that its net income for the current year is $51 million, its assets total
$1,144 million, and its liabilities amount to $926 million. What is its return on equity capital? Is the ROE
you have calculated good or bad? What information do you need to answer this last question?
The bank's return on equity capital should be:
ROE =
Net Income
Total equity Capital
=
$51 million
= 0.234 or 23.39 percent
$1,144 mill.-$926 mill.
In order to evaluate the performance of the bank, you have to compare the ROE to the ROE of some
major competitors or some industry average.
6-7
What is the return on assets (ROA), and why is it important? Might the ROA measure be
important to banking’s key competitors?
Return on assets is the ratio of Net Income/Total Assets. The rate of return secured on a bank's total
assets indicates the efficiency of its management in generating net income from all of the resources
(assets) committed to the institution. This would be important to banks and their major competitors.
6-8.
A bank estimates that its total revenues will amount to $155 million and its total expenses
(including taxes) will equal $107 million this year. Its liabilities total $4,960 million while its equity capital
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amounts to $52 million. What is the bank's return on assets? Is this ROA high or low? How could you
find out?
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The bank's return on assets would be:
ROA =
Net Income
Total Assets
=
$155 mill. - $107 mill.
= 0.0096 or 0.96 percent
$4,960 mill. + $52 mill.
The size of this bank's ROA should be compared with the ROA's of other banks similar in size and
location to determine if this bank's ROA is high or low.
6-9.
Why do the managers of financial firms often pay close attention today to the net interest
margin and noninterest margin? To the earnings spread?
The net interest margin (NIM) indicates how successful the bank has been in borrowing funds from the
cheapest sources and in maintaining an adequate spread between its returns on loans and security
investments and the cost of its borrowed funds. If the NIM rises, loan and security income must be rising
or the average cost of funds must be falling or both. A declining NIM is undesirable because the bank's
interest spread is being squeezed, usually because of rising interest costs on deposits and other
borrowings and increased competition today.
In contrast, the noninterest margin reflects the banks spread between its noninterest income (such as
service fees on deposits) and its noninterest expenses (especially salaries and wages and overhead
expenses). For most banks the noninterest margin is negative. Management will usually attempt to
expand fee income, while controlling closely the growth of noninterest expenses in order to make a
negative noninterest margin less negative.
The earnings spread measures the effectiveness of the bank's intermediation function of borrowing and
lending money, which, of course, is the bank's primary way of generating earnings. As competition
increases, the spread between the average yields on assets and the average cost of liabilities will be
squeezed, forcing the bank's management to search for alternative sources of income, such as fees from
various services the bank offers.
6-10. Suppose a banker tells you that his bank in the year just completed had total interest expenses
on all borrowings of $12 million and noninterest expense of $5 million, while interest income from
earning assets totaled $16 million and noninterest revenues totaled $2 million. Suppose further that
assets amounted to $480 million, of which earning assets represented 85 percent of that total while
total interest-bearing liabilities amounted to 75 percent of total assets. See if you can determine this
bank's net interest and noninterest margins and its earnings base and earnings spread for the most
recent year.
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The bank's net interest and noninterest margins must be:
Net Interest
=
$16 mill. - $12 mill.
Noninterest
$480 mill.
Margin
Margin
=
$2 mill. - $5 mill.
$480 mill.
= 0.00833
= -0.00625
The bank's earnings spread and earnings base are:
Earnings
=
$16 mill.
Spread
=
Earnings Base
-
$12 mill.
$480 mill * 0.85
$480 mill. * 0.75
= 0.0392
= 0.0333
0.0059
=
$480 mill. – ($480 mill. * 0.15)
=
0.85 or 85 percent
$480 mill.
6-11.
What are the principal components of ROE, and what does each of these components measure?
The principal components of ROE are:
a. The net profit margin or net after-tax income to Total operating revenues which reflects the
effectiveness of a bank's expense control program and service pricing policies;
b. The degree of asset utilization or ratio of Total operating revenues to Total assets which measures the
effectiveness of managing the bank's portfolio management policies, especially the mix and yield on
assets; and,
c. The equity multiplier or ratio of Total assets to Total equity capital which measures a bank's use of
leverage in funding its operations: sources chosen to fund the financial institution (debt or equity).
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6-12. Suppose a bank has an ROA of 0.80 percent and an equity multiplier of 12X. What is its ROE?
Suppose this bank's ROA falls to 0.60 percent. What size equity multiplier must it have to hold its ROE
unchanged?
The bank's ROE is:
ROE = 0.80 percent *12 = 9.60 percent.
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If ROA falls to 0.60 percent, the bank's ROE and equity multiplier can be determined from:
ROE = 9.60% = 0.60 percent * Equity Multiplier
Equity Multiplier = 9.60 percent = 16X.
0.60 percent
6-13. Suppose a bank reports net income of $12, pre-tax net income of $15, operating revenues of
$100, assets of $600, and $50 in equity capital. What is the bank's ROE? Tax-management efficiency
indicator? Expense control efficiency indicator? Asset management efficiency indicator? Funds
management efficiency indicator?
The bank's ROE must be:
ROE =
$12
= 0.24 or 24 percent
$50
Its tax-management, expense control, asset management, and funds management efficiency indicators
are:
Tax Management
=
Efficiency indicator
$12
Expense Control
$15
Efficiency Indicator
= 0.8 or 80 percent
Asset Management
=
Efficiency Indicator
=
$15
$100
= 0.15 or 15 percent
$100
Funds Management
$600
Efficiency Indicator
= 0.1667 or 16.67 percent
=
$600
$50
= 12 x
Alternative Calculation for ROE = 0.8 ×0.15 × 0.1667 ×12
= 0.24 or 24%
6-14. What are the most important components of ROA, and what aspects of a financial institution’s
performance do they reflect?
The principal components of ROA are:
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a. Total Interest Income Less Total Interest Expense divided by Total Assets, measuring a bank's success
at intermediating funds between borrowers and lenders;
b. Provision for Loan Losses divided by Total Assets which measures management's ability to control
loan losses and manage a bank's tax exposure;
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c. Noninterest Income less Noninterest Expenses divided by Total Assets, which indicates the ability of
management to control salaries and wages, other noninterest costs and generate the income;
d. Net Income Before Taxes divided by Total Assets, which measures operating efficiency and expense
control; and
e. Applicable Taxes divided by Total Assets, which is an index of tax management effectiveness.
6-15. If a bank has a net interest margin of 2.50%, a noninterest margin of -1.85%, and a ratio of
provision for loan losses, taxes, security gains, and extraordinary items of -0.47%, what is its
ROA?
The bank's ROA must be:
ROA = Net interest margin + Noninterest margin – Ratio of provision for loan
losses, taxes, security gains, and extraordinary items
ROA = 2.5 percent + (-1.85 percent) – (-.47 percent) = 1.12 percent
6-16. To what different kinds of risk are banks and their financial-service competitors subjected
today?
a. Credit Risk - the probability that the loans and securities the bank holds will not pay out as promised.
b. Liquidity Risk - the probability that the bank will not have sufficient cash on hand in the volume
needed precisely when cash demands arise.
c. Market Risk - the probability that the market value of assets held by the bank will decline due to
falling market prices.
d. Price Risk – the probability or possibility that the value of bond portfolios and stockholders’ equity
may decline due to market prices movement against the financial firm.
e. Interest-Rate Risk - the possibility or probability that the interest rates will change, subjecting the
bank to lower profits or a lower value for the firm’s capital.
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f. Foreign Exchange and Sovereign Risk – the uncertainty that due to fluctuation in currency prices,
assets denominated in foreign currencies may fall, forcing the written down of these assets on its
Balance Sheet.
g. Off-Balance-Sheet Risk – the probability that the volume of off-balance-sheet commitments far
exceeds the volume of conventional assets.
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h. Operational Risk – the uncertainly regarding a financial firm’s earnings due to failures in computer
systems, employee misconduct, floods, lightening strikes and other similar events.
i. Legal and Compliance Risk – the uncertainty regarding a financial firm’s earnings due to actions taken
by our legal system or due to a violation of rules and regulations.
j. Reputation Risk – the uncertainty due to public opinion or the variability in earnings due to positive or
negative publicity about the financial firm.
k. Strategic Risk – the uncertainty in earnings due to adverse business decisions, lack of responsiveness
to industry changes and other poor decisions by management.
k. Capital Risk – the risk that the value of the assets will decline below the value of the liabilities. All of
the other risks listed above can affect earnings and the value of the assets and liabilities and therefore
can have an effect on the capital position of the firm.
6-17. What items on a bank's balance sheet and income statement can be used to measure its risk
exposure? To what other financial institutions do these risk measures seem to apply?
There are several alternative measures of risk in banking and financial service firms. Capital risk is often
measured by bank capital ratios, such as the ratio of total capital to total assets or total capital to risk
assets. Credit risk can be tracked by such ratios as net loan losses to total loans or relative to total
capital. Liquidity risk can be followed by using such ratios as cash assets to total assets or by total loans
to total assets. Interest-rate risk may be indicated by such ratios as interest-sensitive liabilities to
interest-sensitive assets or the ratio of money-market borrowings to money-market assets.
These risk measures also applies to those nonbank financial institutions that are private, profit making
corporations, including stockholder-owned thrift institutions, insurance companies, finance and creditcard companies, security broker and dealer firms, and mutual funds.
6-18. A bank reports that the total amount of its net loans and leases outstanding is $936 million, its
assets total $1,324 million, its equity capital amounts to $110 million, and it holds $1,150 million in
deposits, all expressed in book value. The estimated market values of the bank's total assets and equity
capital are $1,443 million and $130 million, respectively. The bank's stock is currently valued at $60 per
share with annual per-share earnings of $2.50. Uninsured deposits amount to $243 million and money market borrowings total $132 million, while nonperforming loans currently amount to $43 million and
the bank just charged off $21 million in loans. Calculate as many of the risk measures as you can from
the foregoing data.
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Net Loans and Leases
=
Total Assets
$936 mill.
Uninsured Deposits
$1,324 mill.
Total Deposits
= 0.7069 or 70.69 percent
Equity Capital
=
Total Assets
Stock Price
$1,443 mill.
Earnings Per Share
=
$60
$2.50
= 24 X
=
$43 mill.
Net Loans and Leases
Total Loans and Leases
$1,150 mill.
$130 mill.
Nonperforming Assets
=
$243 mill.
= 0.2113 or 21.13 percent
= 0.0901 or 9.01 percent
Charge-offs of loans
=
= 0.0459 or 4.59 percent
$936 mill.
$21
Purchased Funds
$936
Total Liabilities
= 0.0224 or 2.24 percent
=
$243 mill. + $132 mill.
$1,324 mill. - $110 mill.
= 0.3089 or 30.89 percent
Book Value of Assets
Market Value of Assets
=
$1324
= 0.9175 or 91.75 percent
$1443
Problems and Projects
6-1.
An investor holds the stock of Foremost Financials and expects to receive a dividend of $5.75
per share at the end of the year. Stock analysts recently predicted that the bank’s dividends will grow at
approximately 3 percent a year indefinitely into the future. If this is true, and if the appropriate riskadjusted cost of capital (discount rate) for the bank is 12.25 percent, what should be the current price
per share of Foremost Financials’ stock?
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Chapter 01 - An Overview of the Changing Financial-Services Sector
6-2.
Suppose that stockbrokers have projected that Yorktown Savings will pay a dividend of $3 per
share on its common stock at the end of the year; a dividend of $4.50 per share is expected for the next
year, and $ 5.50 per share in the following two year. The risk-adjusted cost of capital for banks in
Yorktown’s risk class is 15 percent. If an investor holding Yorktown’s stock plans to hold that stock for
only four years and hopes to sell it at a price of $60 per share, what should the value of the bank’s stock
be in today’s market?
P0 = $47.08 per share.
6-3
Bluebird Savings Association has a ratio of equity capital to total assets of 9 percent. In contrast,
Cardinal Savings reports an equity-capital-to- asset ratio of 7 percent. What is the value of the equity
multiplier for each of these institutions? Suppose that both institutions have an ROA of 0.85 percent.
What must each institution’s return on equity capital be? What do your calculations tell you about the
benefits of having as little equity capital as regulations or the marketplace will allow?
Bluebird Savings Association has an equity-to-asset ratio of 9 percent which means its equity multiplier
must be:
1/ (Equity Capital / Assets) =
Assets
= 1 / 0.09 = 11.11x
EquityCapital
In contrast, Cardinal Savings has an equity multiplier of:
1/ (Equity Capital / Assets) =
= 14.29x
With an ROA of 0.85 percent Bluebird Savings Association would have an ROE of:
ROE = 0.85 x 11.11x = 9.44 percent.
With an ROA of .85 percent Cardinal Savings would have an ROE of:
ROE = 0.85 x 14.29x = 12.14 percent
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In this case Cardinal Savings is making greater use of financial leverage and is generating a higher return
on equity capital.
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6-4.
The latest report of condition and income and expense statement for Happy Merchants National
Bank are as shown in the following tables:
Happy Merchants National Bank
Income and Expense Statement (Report of Income)
Interest and fees on loans
Interest and dividends on securities
$44
6
Total interest income
50
Interest paid on deposits
32
Interest on nondeposit borrowings
Total interest expense
Net interest income
6
38
12
Provision for loan losses
1
Noninterest income and fees
16
Noninterest expenses:
Salaries and employee benefits
10*
Overhead expenses
5
Other noninterest expenses
2
Total noninterest expenses
17
Net noninterest income
-1
Pretax operating income
16
Securities gains (or losses)
2
Pretax net operating income
Taxes
18
2
Net operating income
16
Net extraordinary income
-1
Net income
15
*Note: the bank currently has 40 FTE employees.
Happy Merchants National Bank
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Report of Condition
Assets
Cash and deposits due from banks
Investment securities
Federal funds sold
Net loans
Liabilities
$100 Demand deposits
$190
150 Savings deposits
180
10 Time deposits
470
670 Federal funds purchased
(Allowance for loan losses = 25)
Total liabilities
(Unearned income on loans = 5)
Equity capital
Plant and equipment
50 Common stock
Surplus
Total assets
Total Earnings Assets
60
900
20
25
980 Retained earnings
35
Total Capital
80
830 Interest-bearing deposits
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Fill in the missing items on the income and expense statement. Using these statements, calculate the
following performance measures:
ROE
Asset utilization
ROA
Equity multiplier
Net interest margin
Tax management efficiency
Net noninterest margin
Expense control efficiency
Net operating margin
Asset management efficiency
Earnings spread
Funds management efficiency
Net profit margin
Operating efficiency ratio
What strengths and weaknesses are you able to detect in Happy Merchants’ performance?
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Expense Control Efficiency =
Pre Tax Net Operating Income $16
=
= .02424 or 24.24%
Total Operating Revenue
$66
Strengths
ROE: Positive value, reflects a high rate of return flowing to shareholders.
Net noninterest margin: Negative value (-.10%), reflects that net noninterest income is inline with noninterest
cost.
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Net profit margin: Positive value reflects effectiveness of management in cost controlling and service pricing
policies.
Asset utilization: Positive value reflects a good portfolio management policies and yield on assets.
Equity multiplier: Positive value reflects efficient financial policies.
Expense control efficiency, asset management efficiency ratio, funds management efficiency ratio, Operating
efficiency ratio also reflects a high operating efficiency and expense control.
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Tax-management efficiency ratio: Positive ratio reflecting the use of security gains or losses and other taxmanagement tools (such as buying tax-exempt bonds) to minimize tax exposure etc.
Weaknesses
ROA: Positive value (1.53%), reflects managerial efficiency and how successful management has been in
converting assets into net earnings. Since the positive value is only 1.53% it acts as a weakness for the Happy
Merchants National Bank.
Net interest margin: Positive value (1.22%), reflects that management is not successful in achieving close
control over earning assets and in utilizing the cheapest sources of funding. Since the positive value is only
1.22% it acts as a weakness for the Happy Merchants National Bank.
Earnings spread: Positive value (.67%), reflects a high competition, forcing management to try and find other
ways to make up for an eroding earnings spread.
6-5.
The following information is for Blue Sky National Bank:
Interest income
$2,200
Interest expense
$1,400
Total assets
$45,000
Securities losses or gains
$21
Earning assets
$40,000
Total liabilities
$38,000
Taxes paid
$16
Shares of Common Stock
outstanding
5,000
Noninterest income
$800
Noninterest expense
$900
Provision for loan losses
$100
Please calculate:
ROE
--------------
ROA
Net interest margin
--------------
Earnings per share
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Net noninterest margin
--------------
Net operating margin
--------------
ROE
=
$605
ROA
$45,000 - $38,000
=
$605
$45,000
= 0.0864or 8.64 percent
= 0. 0134 or 1.34 percent
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Net Interest
=
Margin
=
$40,000
Earnings
=
Per Share
=
Margin
= 0.02 or 2 percent
$40,000
$605
= $.121 per share
$800 - $900
=
$40,000
=
$800
5,000
Net Noninterest
Net Operating
$2,200 - $1400
-$100
$40,000
($2,200 + $800) – ($1,400 + $900 + $100)
Margin
= -0.0025 or -0.25 percent
$45,000
=
$600
= 0.0133 or 1.33 percent
$45,000
Alternative Scenario a:
Suppose interest income, interest expenses, noninterest income, and noninterest expenses each
increase by 5 percent, with all other revenue and expense items shown in the preceding table remain
unchanged. What will happen to Blue Sky’s ROE, ROA, and earnings per share?.
Interest income
$2,310
Interest expense
$1,470
Total assets
Securities losses or gains
$45,000
$21
Earning assets
$40,000
Total liabilities
$38,000
Taxes paid
$16
Shares of Common Stock
outstanding
5,000
Noninterest income
$840
Noninterest expense
$945
Provision for loan losses
$100
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Chapter 01 - An Overview of the Changing Financial-Services Sector
ROE
=
$640
ROA
$45,000- $38,000
=
$640
$45,000
= 0.0914 or 9.14 percent
= 0.0142 or 1.42 percent
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Net Interest
=
Margin
Earnings
=
Per Share
=
=
Margin
$40,000
$40,000
$640
= $.128 per share
$840 - $945
=
$40,000
=
$840
= 0.021 or 2.10 percent
5,000
Net Noninterest
Net Operating
$2310 - $1470
-$105
$40,000
($2310 + $840) – ($1,470 + $945 + $100)
Margin
= -0.00263 or -.26 percent
$45,000
=
$635
= 0.0141 or 1.41 percent
$45,000
Alternative Scenario b:
On the other hand, suppose Blue Sky’s interest income and interest expenses as well as its noninterest
income and expenses decline by 5 percent, again with all other factors held constant. How would the
bank’s ROE, ROA, and per-share earnings change?
Interest income
$2,090
Interest expense
$1,330
Total assets
Securities losses or gains
$45,000
$21
Earning assets
$40,000
Total liabilities
$38,000
Taxes paid
$16
Shares of common stock
outstanding
5,000
Noninterest income
$760
Noninterest expense
$855
Provision for loan losses
$100
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Chapter 01 - An Overview of the Changing Financial-Services Sector
ROE
=
$570
ROA
$45,000 - $38,000
Margin
=
$2090 - $1330
$40,000
$570
$45,000
= 0.0814 or 8.14 percent
Net Interest
=
= 0.012667 or 1.27 percent
=
$760
$40,000
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= 0.019 or 1.90 percent
Chapter 01 - An Overview of the Changing Financial-Services Sector
Earnings Per Share
=
$570
= $.114 per share
5000
Net Noninterest
=
Margin
Net Operating
$760 - $855
=
$40,000
=
-$95
$40,000
($2090 + $760) – ($1,330 + $855 + $100)
Margin
= -0.00238 or -.24 percent
=
$45,000
$565
=0.0126 or 1.26 percent
$45,000
6-6. Washington Group holds total assets of $12 billion and equity capital of $1.2 billion and has just
posted an ROA of 1.10 percent. What is the financial firm’s ROE?
ROE = ROA *
Total Assets
= 0.011 * ($12 / 1.2) = = 0.11 or 11%
Equity Capital
Alternative Scenario a:
Suppose Washington Group finds its ROA climbing by 50 percent, with assets and equity capital
unchanged. What will happen to its ROE? Why?
R0A increases by 50%, with no change in assets or equity capital.
Therefore, the new ROA = 0.011 * 1.5 = 0.0165 or 1.65%.
New ROE = 1.65% * 10 = 16.50%
This represents a 50% increase in ROE. With no changes in assets or equity, the investors' funds are
more effectively utilized, generating additional income and making the bank more profitable.
Alternative Scenario b:
On the other hand, suppose the bank’s ROA drops by 50 percent. If total assets and equity capital hold
their present positions, what change will occur in ROE?
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ROA decreases by 50%, with no change in equity or assets.
Therefore, the new ROA = 0.011 * 0.5 = 0.0055 or 0.55%.
New ROE = 0.55% * 10 = 5.50%
This represents a 50% decrease in ROE. The bank's management has been less efficient, in this case, in
managing their lending and/or investing functions or their operating costs.
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Alternative Scenario c:
If ROA at Washington Group remains fixed at 0.0076 but both total assets and equity double, how does
ROE change? Why?
ROA = .0076 or .76%
Total assets double in size to $24 billion and equity capital doubles in size to $2.4 billion..
Therefore, the equity multiplier (i.e. total assets/equity capital) remains the same (E.M. =
$24/$2.4 = 10). As a result, ROE changes from the original situation (i.e.),
.76% * 10 = 7.6%).
This represents a decrease in ROE. The bank's management has been less efficient, in this case, in
managing their lending and/or investing functions or their operating costs.
Alternative Scenario d:
How would a decline in total assets and equity by half (with ROA still at 0.0076) affect the bank’s ROE?
This, of course, is just the reverse of scenario 3. Since the changes in both assets and equity capital are
the same, the ratio of the two (i.e., the equity multiplier) remains constant. As a result, there is again no
change in ROE.
E.M. = Total Assets/Equity Capital = $6/$0.6 = 10.
Therefore, ROE = .76% * 10 = 7.6%.
6-7. OK State Bank reports total operating revenues of $150 million, with total operating expenses of
$130 million, and owes taxes of $5 million. It has total assets of $1.00 billion and total liabilities of $900
million. What is the bank’s ROE?
Net Income after Taxes = $150 million -$130 million -$5 million = $15 million
Equity Capital = $1.00 billion - $900 million = $100 million
ROE =
Net Income after Taxes
= $15 million / $100 million = 0.15or 15%.
Equity Capital
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Alternative Scenario a: How will the ROE for OK State Bank change if total operating expenses, taxes
and total operating revenues each grow by 10 percent while assets and liabilities stay fixed.
Total revenues = $150 million * 1.10 = $165 million
Total expenses = $130 million * 1.10 = $143million
Tax liability = $5 million * 1.10 = $5.5 million
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Net Income after Taxes = $165 - $143- $5.50 = $16.5 million
ROE = $16.5 million/$100 million = 0.165 or 13.2%
Change in ROE = (16.50%-15%)/15% = 10%
Alternative Scenario b: Suppose OK State’s total assets and total liabilities increase by 10 percent, but
its revenues and expenses (including taxes) are unchanged. How will the bank’s ROE change?
Total assets increase by 10% (Total assets = $ 1.0 * 1.10 = $1.1 billion)
Total liabilities increase by 10% (Total liabilities = $900 million * 1.10 = $990
Revenues and expenses (including taxes) remain unchanged.
Solution: Equity Capital = $1.1 billion - $990 million = $110 million
ROE
=
$15
=
.1364
$110
Therefore change in ROE
=
13.64 percent
13.64 % - 15%
15%
=
-1.36%
= -.0909%
15%
(ROE decreases by 9.09%)
Alternative Scenario c: Can you determine what will happen to ROE if both operating revenues and
expenses (including taxes) decline by 10 percent, with the bank’s total assets and liabilities held
constant?
Total revenues decline by 10% (Total revenues = $150 million * 0.90 = $135million)
Total expenses decline by 10% (Total expenses = $130 million * 0.9 = $117 million)
Tax liability declines by 10% (Tax liability = $5 * 0.9 = $4.5 million)
Assets and liabilities remain unchanged (Therefore, equity remains unchanged)
Solution:
Net Income after Tax = $135 million - 117 million - $4.5 million = $13.5
ROE = $13.5 million = 0.135 = 13.5%
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Chapter 01 - An Overview of the Changing Financial-Services Sector
$100 million
Therefore change in ROE
=
13.5% - 15%
15%
=
-1.5%
= -.10
15%
(ROE decreases by 10%)
Alternative Scenario d: What does ROE become if OK State’s assets and liabilities decrease by 10
percent, while it’s operating revenues, taxes and operating expenses do not change?
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Total assets = $1.0 billion * 0.9 = $900 million
Total liabilities = $900 million * 0.9 =$810 million
Equity capital = $900 million - $810 million = $90 million
ROE
=
$15
=
$90
.1667
16.67 percent
6-8.
Suppose a stockholder-owned thrift institution is projected to achieve a 1.10 percent ROA
during the coming year. What must its ratio of total assets to equity capital be if it is to achieve its target
ROE of 12 percent? If ROA unexpectedly falls to 0.80 percent, what assets-to-capital ratio must it then
have to reach a 12 percent ROE?
ROE = ROA * (Total Assets/Equity Capital)
Total Assets
=
Equity Capital
ROE
=
ROA
12%
= 10.91x
1.10%
If ROA unexpectedly falls to 0.80% and target ROE remains 12%:
12%
=
.80%
*
Total Assets
Equity Capital
Total Assets
=
Equity Capital
12%
=15 x
.80%
6-9.
Watson County National Bank presents us with these figures for the year just concluded. Please
determine the net profit margin, equity multiplier, asset utilization ratio, and ROE.
Net income = $25
Total operating revenues = $135
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Total assets = $1,700
Total equity capital accounts = $160
a.
Net Profit Margin
=
Net Income
=
Total Operating Revenue
b.
Asset Utilization
=
Total Operating Revenues
Total Assets
1-140
$25 mill.
= 0.1852 or 18.52%
$135 mill.
=
$135 mill.
$1700 mill.
= 0.0794 or 7.94%
Chapter 01 - An Overview of the Changing Financial-Services Sector
c.
Equity Multiplier
=
Total Assets
=
$1700 mill.
Total Equity Capital
d.
ROE
=
Net Income
= 10.63 times
$160 mill.
=
$25 mill.
Total Equity Capital
= 0.1563 or 15.63 %
$160 mill.
6-10. Crochett National Bank has experienced the following trends over the past five years (all figures in
millions of dollars):
Year
Net Income
Total Operating
Total
1
$2.7
Revenues
Assets
$26.5
$300
$273
2
3.5
30.1
315
288
3
4.1
39.8
331
301
4
4.8
47.5
347
314
5
5.7
55.9
365
329
Total
Liabilities
Determine the figures for ROE, profit margin, asset utilization, and equity multiplier for this bank. Are
any adverse trends evident? Where would you recommend that management look to deal with the
bank’s emerging problem(s)?
Profit
Asset
Equity
Year
Margin
Utilization
Multiplier
ROA
ROE
1
10.19%
0.0883
11.11x
0.90%
10.0%
2
11.63%
0.0956
11.67x
1.11%
12.96%
3
10.3%
0.1202
11.03x
1.24%
13.67%
4
10.11%
0.1369
10.52x
1.38%
14.55%
5
10.2%
0.1532
10.14x
1.56%
15.83%
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If we look at the entire 5-year period, Crochett's profit margin has remained relatively constant.
However, from year 2 through year 5, there has been a significant decline (from 11.63% to 10.2%). This
can be viewed as troublesome when we note that net income and total operating revenues have more
than doubled during the five-year period. Two potential areas that management should investigate are
(1) the mix of funding sources and (2) non-interest expenses.
Since ROE has grown much more rapidly than ROA, we should be concerned that Crochett is increasing
its liability sources of funding, thereby increasing its leverage to keep its ROE growing. This can cause
serious problems with its income as interest rates rise, driving up its cost of funds.
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With regard to its noninterest expenses, if these are growing faster than the bank's noninterest income,
then there is greater pressure on the bank's net interest margin to offset the increasing negative spread
between noninterest income and noninterest expenses.
Since bank regulators place a great deal of emphasis on capital adequacy, these two areas, leverage and
noninterest margin, could be moving Crochett to a precarious capital adequacy position.
6-11. Paintbrush Hills State Bank has just submitted its Report of Condition and Report of Income to
its principal supervisory agency. The bank reported net income before taxes and securities transactions
of $29 million and taxes $8 million. If its total operating revenues were $650 million, its total assets
$1.75 billion, and its equity capital $170 million, determine the following for Paintbrush Hills:
a. Tax management efficiency ratio.
b. Expense control efficiency ratio.
c. Asset management efficiency ratio.
d. Funds management efficiency ratio.
e. ROE.
a.
Tax Management
=
Net Income
Efficiency Ratio Net Income Before Taxes and Securities Transactions
=
$29 million - $8 million - $21 million
$29 million
b.
Expense Control
$29 million
=
0.724 or 72.4percent.
=
Net Income Before Taxes and Securities Gains
Efficiency Ratio
Total Operating Revenues
=
$ 29 million = 0.045 or 4.5 percent.
$650 million
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c.
Asset Management Efficiency Ratio
=
Total Operating Revenues
(Asset Utilization)
Total Assets
=
$650 million
=
0.371 or 37.1 percent.
=
$ 1,750 million = 10.29 x.
$1,750 million
d.
Funds Management
=
Total Assets
Efficiency Ratio
Equity Capital
$170 million
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e.
ROE
=
Net Income after Taxes
=
Equity Capital
$ 21 million
=
0.124 or 12.4%
$170 million
Alternative Scenario a: Suppose Paintbrush Hills State Bank experienced a 20 percent rise in net beforetax income, with its tax obligation, operating revenues, assets, and equity unchanged. What would
happen to ROE and its components?
ROE
=
ROA
*
Total Assets
=
Net Income
Total Equity
=
[($29 x 1.20) - $8
Total Assets
*
$1,750
$1,750
=
0.0153
*
=
$170
10.3
*
=
$34.8 - $8
$1,750
Total Assets
Total Equity
*
$1,750
$170
0.1576 or 15.76%
This represents a 27% increase in ROE, from 12.4% to 15.76%. Since the equity multiplier did not
change, this increase in ROE is due to the increase in ROA, from 1% to 1.26%.
Alternative Scenario b: If total assets climb by 20 percent, what will happen to Paintbrush’s efficiency
ratio and ROE
Asset Management Efficiency Ratio
=
$650
$650
=
= .31 or 31 percent.
$1750 *1.2 $2100
This represents a decrease of 16.4%.
Funds Management Efficiency Ratio
=
$2100
= 12.35 times
$170
This represents an increase of 20%.
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ROE would not change since the decrease in the asset management efficiency ratio is offset by the
increase in the funds management efficiency ratio.
Alternative Scenario 3: What effect would a 20 percent higher level of equity capital have upon
Paintbrush’s ROE and its components?
Funds Management
Efficiency Ratio
=
Total Assets
Equity Capital
1-146
=
$1,750
$170 x 1.20
=
$1,750
$204
= 8.58 times
Chapter 01 - An Overview of the Changing Financial-Services Sector
ROE = Tax Management Efficiency Ratio * Expense Control Efficiency Ratio * Asset Management
Efficiency Ratio *Funds Management Efficiency Ratio
= 0.724 * 0.045 * 0.371 * 8.58 = 0.1037 or 10.37%
Change in ROE =
10.37% - 12.4% = -0.164 or a 16.4% decrease
12.4%
6-12. Using this information for Dragon International Bank and Trust Company (all figures in millions),
calculate the bank's net interest margin, noninterest margin, and ROA.
Interest income
= $70
Noninterest expense
=8
Interest expense
= 56
Noninterest income
=5
Provision for loan losses
=3
Extraordinary net gains
=1
Security gains (or losses)
=2
Total Assets
= 1000
a.
Net Interest Margin
=
Interest Income – Interest Expenses
Total Assets
=
$70 - $56
=
$1,000
b.
Noninterest Margin
=
$14
=
0.014 or 1.40 %
$1,000
Noninterest Income – Noninterest Expenses
Total Assets
=
$5 - $8
=
$1,000
c.
ROA
=
Net Income
-$3
=
-0.0030 or -.3%
$1,000
=
[($70+$5+$2+$1) – ($56+$8+$3)]
1-147
=
$11
= 0.011 or 1.40%
Chapter 01 - An Overview of the Changing Financial-Services Sector
Total Assets
$1,000
$1,000
6-13. Valley Savings reported these figures (in millions) on its income statement for the past five
years. Calculate this institution’s ROA in each year. Are there any adverse trends? Any favorable trends?
What seems to be happening to this institution?
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Gross interest income
One
Two
Three
Four
Current
Year
Years
Years
Years
Year
Ago
Ago
Ago
Ago
$40
$41
$38
$35
$33
Interest expenses
24
23
20
18
15
Net interest income
16
18
18
17
18
Provision for loan losses
2
1
1
0
0
Net interest income after
14
17
17
17
18
Noninterest income
4
4
3
2
1
Noninterest expense
8
7
7
6
5
Net noninterest income
(4)
(3)
(4)
(4)
(4)
Income before taxes
10
14
13
13
14
Income taxes owed
1
1
0
1
0
Net income after taxes
9
13
13
12
14
(2)
(1)
0
1
2
Net income
7
12
13
13
16
Total assets
385
360
331
319
293
1.82%
3.33%
3.93%
4.08%
5.46%
Loan loss provision
but before gains (losses)
Net securities gains (losses)
ROA
Valley's ROA has gone from an exceptional level, at almost 5.5%, progressively down to a reasonably
good level, at 1.82%, over the last four years.
Growth in interest and noninterest income has been outstripped by the growth in interest and
noninterest expense, as well as the increase in the allowance for loan losses, resulting in a significant
decline in net income from operations. Needless to say, the shift from gains in securities trading to
losses has not been helpful either.
6-14. An analysis of the BHCPR reports on BB&T is presented in this chapter’s appendix. We examined
a wide variety of profitability measures for that bank, including ROA, ROE, net profit margin, net interest
and operating margins, and asset utilization. However, the various measures of earnings risk, credit risk,
liquidity risk, market risk (price and interest rate risk), and capital risk were not discussed in detail.
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Using the data in Tables 6-5 through 6-9, calculate each of these dimensions of risk for BB&T for the
most recent two years and discuss how the bank’s risk exposure appears to be changing over time.
What steps would you recommend to management to deal with any risk exposure problems you
observe?
Note to instructors: The Bank Holding Performance Report (BHCPR) is provided to each bank by the
Federal Financial Institutions Examination Council. The BHCPR is prepared from the call reports of
condition and income that are filed quarterly by all banks. It (the BHCPR) is for the use of regulators and
management to assess how well the bank is performing relative to its internal goals and its peer group.
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The user's guide to the BHCPR is available from the FFIEC for a nominal fee and details the various ratios
and comparative data contained in the BHCPR. The actual BHCPR is much more detailed than the
example provided in the text as Tables 6-5 through 6-9. These exhibits are for illustrative purposes and
do not contain all the information that is necessary to calculate all the risk measures described in the
text. The instructor may find it helpful to use BHCPRs provided by a few local banks in class discussions.
Those actual BHCPRs allow the students to calculate the full range of risk and return measures and
expand discussion of the concepts and ratios considerably.
CHAPTER 7
RISK MANAGEMENT FOR CHANGING INTEREST RATES: ASSET-LIABILITY MANAGEMENT AND
DURATION TECHNIQUES
Goals of This Chapter: The purpose of this chapter is to explore the options bankers have today for
dealing with risk – especially the risk of loss due to changing interest rates – and to see how a bank’s
management can coordinate the management of its assets with the management of its liabilities in
order to achieve the institution’s goals.
Key Topic In This Chapter
•
•
•
•
•
•
Asset, Liability, and Funds Management
Market Rates and Interest Rate Risk
The Goals of Interest Rate Hedging
Interest-Sensitive Gap Management
Duration Gap Management
Limitations of Interest Rate Risk Management Techniques
Chapter Outline
I. Introduction: The Necessity for Coordinating Bank Asset and Liability Management Decisions
II. Asset-Liability Management Strategies
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A. Asset Management Strategy
B. Liability Management Strategy
C. Funds Management Strategy
III. Interest Rate Risk: One of the Greatest Management Challenges
A. Forces Determining Interest Rates
B. The Measurement of Interest Rates
1. Yield to Maturity
2. Bank Discount Rate
C. The Components of Interest Rates
1. Risk Premiums
2. Yield Curves
3. The Maturity Gap and the Yield Curve
D. Responses to Interest Rate Risk
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IV. One of the Goals of Interest-Rate Hedging: Protect the Net Interest Margin
A. The Net Interest Margin
B. Interest-Sensitive Gap Management as a Risk- Management Tool
1. Asset-Sensitive Position
2. Liability-Sensitive Position
3. Dollar Interest-Sensitive Gap
4. Relative Interest Sensitive Gap
5. Interest Sensitivity Ratio
6. Computer-Based Techniques
7. Cumulative Gap
8. Strategies in Gap Management
C. Problems with Interest-Sensitive GAP Management
V. The Concept of Duration as a Risk-Management Tool
A. Definition of Duration
B. Calculation of Duration
C. Net Worth and Duration
D. Price Sensitivity to Changes in Interest Rates and Duration
E. Convexity and Duration
VI. Using Duration to Hedge Against Interest Rate Risk
A. Duration Gap
1. Dollar Weighted Duration of Assets
2. Dollar Weighted Duration of Liabilities
3. Positive Duration Gap
4. Negative Duration Gap
B. Change in the Bank’s Net Worth
VII The Limitations of Duration Gap Management
VIII. Summary of the Chapter
Concept Checks
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7-1.
What do the following terms mean: Asset management? Liability management? Funds
management?
Asset management refers to a banking strategy where management has control over the allocation of
bank assets but believes the bank's sources of funds (principally deposits) are outside its control. The
key decision area for management was not deposits and other borrowings but assets.
Liability management is a strategy of control over bank liabilities by varying interest rates offered on
borrowed funds.
Funds management combines both asset and liability management approaches into a balanced liquidity
management strategy.
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7-2.
What factors have motivated financial institutions to develop funds management techniques in
recent years?
The necessity to find new sources of funds in the 1970s and the risk management problems
encountered with troubled loans and volatile interest rates in the 1970s and 1980s led to the concept of
planning and control over both sides of a bank's balance sheet -- the essence of funds management.
7-3.
What forces cause interest rates to change? What kinds of risk do financial firms face when
interest rates change?
Interest rates are determined, not by individual banks, but by the collective borrowing and lending
decisions of thousands of participants in the money and capital markets. They are also impacted by
changing perceptions of risk by participants in the money and capital markets, especially the risk of
borrower default, liquidity risk, price risk, reinvestment risk, inflation risk, term or maturity risk,
marketability risk, and call risk.
Financial institutions can lose income or value no matter which way interest rates go. Rising interest
rates can lead to losses on security instruments and on fixed-rate loans as the market values of these
instruments fall. Falling interest rates will usually result in capital gains on fixed-rate securities and loans
but an institution will lose income if it has more rate-sensitive assets than liabilities. Rising interest rates
will also cause a loss to income if an institution has more rate-sensitive liabilities than rate-sensitive
assets.
7-4.
What makes it so difficult to correctly forecast interest rate changes?
Interest rates cannot be set by an individual bank or even by a group of banks; they are determined by
thousands of investors trading in the credit markets. Moreover, each market rate of interest has
multiple components--the risk-free interest rate plus various risk premium. A change in any of these rate
components can cause interest rates to change. To consistently forecast market interest rates correctly
would require bankers to correctly anticipate changes in the risk-free interest rate and in all rate
components.
Another important factor is the timing of the changes. To be able to take full advantage of their
predictions, they also need to know when the changes will take place.
7-5.
What is the yield curve, and why is it important to know about its shape or slope?
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The yield curve is the graphic picture of how interest rates vary with different maturities of loans viewed
at a single point in time (and assuming that all other factors, such as credit risk, are held constant).
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The slope of the yield curve determines the spread between long-term and short-term interest rates. In
banking most of the long-term rates apply to loans and securities (i.e., bank assets) and most of the
short-term interest rates are attached to bank deposits and money market borrowings. Thus, the shape
or slope of the yield curve has a profound influence on a bank's net interest margin or spread between
asset revenues and liability costs.
7-6.
What is it that a lending institution’s wishes to protect from adverse movements in interest
rates?
A financial institution wishes to protect both the value of assets and liabilities and the revenues and
costs generated by both assets and liabilities from adverse movements in interest rates.
7-7.
What is the goal of hedging?
The goal of hedging in banking is to freeze the spread between asset returns and liability costs and to
offset declining values on certain assets by profitable transactions so that a target rate of return is
assured.
7-8.
First National Bank of Bannerville has posted interest revenues of $63 million and interest costs
from all of its borrowings of $42 million. If this bank possesses $700 million in total earning assets, what
is First National’s net interest margin? Suppose the bank’s interest revenues and interest costs double,
while its earning assets increase by 50 percent. What will happen to its net interest margin?
Net Interest
Margin
=
$63 mill. - $42 mill.
= 0.03 or 3 percent
$700 mill.
If interest revenues and interest costs double while earning assets grow by 50 percent, the net interest
margin will change as follows:
($63 mill. - $42 mill.) * 2
= 0.04 or 4 percent
$700 mill. * (1.50)
Clearly the net interest margin increases--in this case by one third.
7-9.
Can you explain the concept of gap management?
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Gap management requires the management to perform analysis of the maturities and repricing
opportunities associated with interest-bearing assets and with interest-bearing liabilities. When more
assets are subject to repricing or will reach maturity in a given period than liabilities or vice versa, the
bank has a GAP between assets and liabilities and is exposed to loss from adverse interest-rate
movements based on the gap's size and direction.
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7-10
When is a financial firm asset sensitive? Liability sensitive?
A financial firm is asset sensitive when it has more interest-rate sensitive assets maturing or subject to
repricing during a specific time period than rate-sensitive liabilities. A liability sensitive position, in
contrast, would find the financial institution having more interest-rate sensitive deposits and other
liabilities than rate-sensitive assets for a particular planning period.
7-11. Commerce National Bank reports interest-sensitive assets of $870 million and
Interest-sensitive liabilities of $625 million during the coming month. Is the bank asset sensitive
or liability sensitive? What is likely to happen to the bank’s net interest margin if interest rates
rise? If they fall?
Because interest-sensitive assets are larger than liabilities by $245 million the bank is asset sensitive.
If interest rates rise, the bank's net interest margin should rise as asset revenues increase by more than
the resulting increase in liability costs. On the other hand, if interest rates fall, the bank's net interest
margin will fall as asset revenues decline faster than liability costs.
7-12. Peoples’ Savings Bank, a thrift institution, has a cumulative gap for the coming year of + $135
million and interest rates are expected to fall by two and a half percentage points. Can you calculate the
expected change in net interest income that this thrift institution might experience? What change will
occur in net interest income if interest rates rise by one and a quarter percentage points?
For the decrease in interest rates:
Expected
Change in
= $135 million * (-0.025) = -$3.38 million
Net Interest Income
For the increase in interest rates:
Expected Change
in Net Interest
= $135 million * (+0.0125) = +$1.69 million
Income
7-13 How do you measure the dollar interest-sensitive gap? The relative interest-sensitive gap? What
is the interest-sensitivity ratio?
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The dollar interest-sensitive gap is measured by taking the repriceable (interest-sensitive) assets minus
the repriceable (interest-sensitive) liabilities over some set planning period. Common planning periods
include 3 months, 6 months and 1 year. The relative interest-sensitive gap is the dollar interest-sensitive
gap divided by some measure of bank size (often total assets).
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The interest-sensitivity ratio is just the ratio of interest-sensitive assets to interest sensitive liabilities.
Regardless of which measure you use, the results should be consistent. If you find a positive (negative)
gap for dollar interest-sensitive gap, you should also find a positive (negative) relative interest-sensitive
gap and an interest sensitivity ratio greater (less) than one.
7-14 Suppose Carroll Bank and Trust reports interest-sensitive assets of $570 million and interestsensitive liabilities of $685 million. What is the bank’s dollar interest-sensitive gap? Its relative interestsensitive gap and interest-sensitivity ratio?
Dollar Interest-Sensitive Gap = Interest-Sensitive Assets – Interest Sensitive Liabilities
= $570 - $685 = -$115
Relative Gap
=
$ IS Gap
=
-$115
Bank Size
Interest-Sensitivity
Ratio
=
= -0.2018 or -20.18 percent
$570
Interest-Sensitive Assets
Interest-Sensitive Liabilities
=
$570
= .8321
$685
7-15 Explain the concept of weighted interest-sensitive gap. How can this concept aid management in
measuring a financial institution’s real interest-sensitive gap risk exposure?
Weighted interest-sensitive gap is based on the idea that not all interest rates change at the same
speed. Some are more sensitive than others. Interest rates on bank assets may change more slowly than
interest rates on liabilities and both of these may change at a different speed than those interest rates
determined in the open market.
In the weighted interest-sensitive gap methodology, all interest-sensitive assets and liabilities are given
a weight based on their speed (sensitivity) relative to some market interest rate. Fed Funds loans, for
example, have an interest rate which is determined in the market and which would have a weight of 1.
All other loans, investments and deposits would have a weight based on their speed relative to the Fed
Funds rate. To determine the interest-sensitive gap, the dollar amount of each type of asset or liability
would be multiplied by its weight and added to the rest of the interest-sensitive assets or liabilities.
Once the weighted total of the assets and liabilities is determined, a weighted interest-sensitive gap can
be determined by subtracting the interest-sensitive liabilities from the interest-sensitive assets.
This weighted interest-sensitive gap should be more accurate than the unweighted interest-sensitive
gap. The interest-sensitive gap may change from negative to positive or vice versa and may change
significantly the interest rate strategy pursued by the bank.
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7-16.
What is duration?
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Duration is a value- and time-weighted measure of maturity considers the timing of all cash inflows from
earning assets and all cash outflows associated with liabilities. Duration measures the average time
needed to recover the funds committed to an investment. It is a direct measure of price risk.
7-17.
How is a financial institution’s duration gap determined?
A bank's duration gap is determined by taking the difference between the duration of a bank's assets
and the duration of its liabilities. The duration of the bank’s assets can be determined by taking a
weighted average of the duration of all of the assets in the bank’s portfolio. The weight is the dollar
amount of a particular type of asset out of the total dollar amount of the assets of the bank. The
duration of the liabilities can be determined in a similar manner. The duration of the liabilities is then
adjusted to reflect that the bank has fewer liabilities than assets.
7-18. What are the advantages of using duration as an asset-liability management tool as opposed to
interest-sensitive gap analysis?
Interest-sensitive gap only looks at the impact of changes in interest rates on the bank’s net income. It
does not take into account the effect of interest rate changes on the market value of the bank’s equity
capital position. In addition, duration provides a single number which tells the bank their overall
exposure to interest rate risk.
7-19.
How can you tell you are fully hedged using duration gap analysis?
You are fully hedged when the dollar weighted duration of the assets portfolio of the bank equals the
dollar weighted duration of the liability portfolio. This means that the bank has a zero duration gap
position when it is fully hedged. Of course, because the bank usually has more assets than liabilities the
duration of the liabilities needs to be adjusted by the ratio of total liabilities to total assets to be entirely
correct.
7-20. What are the principal limitations of duration gap analysis? Can you think of some way of
reducing the impact of these limitations?
There are several limitations with duration gap analysis. It is often difficult to find assets and liabilities of
the same duration to fit into the financial-service institution’s portfolio. In addition, some accounts such
as deposits and others don’t have well defined patterns of cash flows which make it difficult to calculate
duration for these accounts.
Duration is also affected by prepayments by customers as well as default. Duration gap models assume
that a linear relationship exists between the market values (prices) of assets and liabilities and interest
rates, which is not strictly true. Finally, duration analysis works best when interest rate changes are
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small and short and long term interest rates change by the same amount. If this is not true, duration
analysis is not as accurate.
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7-21. Suppose that a thrift institution has an average asset duration of 2.5 years and an average
liability duration of 3.0 years. If the thrift holds total assets of $560 million and total liabilities of $467
million, does it have a significant leverage-adjusted duration gap? If interest rates rise, what will happen
to the value of its net worth?
Duration Gap = DA – DL *
Liabilities
= 2.5 yrs. – 3.0 yrs.
Assets
 $467 million


 $560 million
= 2.5 years – 2.5018 years
= -0.0018 years
This bank has a very slight negative duration gap; so small in fact that we could consider it insignificant.
If interest rates rise, the bank's liabilities will fall slightly more in value than its assets, resulting in a small
increase in net worth.
7-22. Stilwater Bank and Trust Company has an average asset duration of 3.25 years and an average
liability duration of 1.75 years. Its liabilities amount to $485 million, while its assets total $512 million.
Suppose that interest rates were 7 percent and then rise to 8 percent. What will happen to the value of
the Stilwater bank's net worth as a result of a decline in interest rates?
First, we need an estimate of Stilwater's duration gap. This is:
Duration Gap = 3.25 yrs. – 1.75 yrs *
$485 mill.
= + 1.5923 years
$512 mill.
Then, the change in net worth if interest rates rise from 7 percent to 8 percent will be:

Change in NW = - 3.25 yrs.x

+ .01
x $512 mill
(1 + .07)
 

+ .01
x$485 mill. 
 - - 1.75 yrs.x
(1 + .07)
 

= -$7.62 million.
Problems
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Chapter 01 - An Overview of the Changing Financial-Services Sector
7-1.
A government bond is currently selling for $1,150 and pays $75 per year in interest for 14 years
when it matures. If the redemption value of this bond is $1,000, what is its yield to maturity if purchased
today for $1,150?
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The yield to maturity equation for this bond would be:
$1150 =
$75
$75
$75
$75
$75
$75
$75
$75
$75
$75
$75
$75
$75
$10
+
+
+
+
+
+
+
+
+
+
+
+
+
1
2
3
4
5
6
7
8
9
10
11
12
13
(1 + ?) (1 + ?) (1 + ?) (1 + ?) (1 + ?) (1 + ?) (1 + ?) (1 + ?) (1 + ?) (1 + ?)
(1 + ?)
(1 + ?)
(1 + ?)
(1 +
Using a financial calculator the YTM =5.9%
7-2.
Suppose the government bond described in problem 1 above is held for five years and then the
savings institution acquiring the bond decides to sell it at a price of $975. Can you figure out the average
annual yield the savings institution will have earned for its five-year investment in the bond?
$1,150 =
$75
$975
$75
$75
$75
$75
+
+
+
+
+
5
3
2
1
4
(1 + HPY) (1 + HPY) (1 + HPY) 5
(1 + HPY)
(1 + HPY)
(1 + HPY)
Using a financial calculator, the HPY is 3.7%
7-3.
U.S. Treasury bills are available for purchase this week at the following prices (based upon $100
par value) and with the indicated maturities:
a.
$98.50, 182 days.
b.
$97.50, 270 days.
c.
$99.25, 91 days.
Calculate the bank discount rate (DR) on each bill if it is held to maturity. What is the equivalent yield to
maturity (sometimes called the bond-equivalent or coupon equivalent yield) on each of these Treasury
Bills?
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The discount rates and equivalent yields to maturity (bond-equivalent or coupon-equivalent yields) on
each of these Treasury bills are:
Discount Rates
Equivalent Yields to Maturity
a.
100 − 98.50 360
*
= 2.97%
100
182
100 − 98.5 365
*
= 3.05%
98.50
182
b.
$100 − 97.50 360
*
= 3.33%
100
270
100 − 97.5 365
*
= 3.47%
97.50
270
c.
100 − 99.25 360
*
= 2.97%
100
91
100 − 99.25 365
*
= 3.03%
99.25
91
7-4.
Clarksville Financial reports a net interest margin of 2.75 percent in its most recent financial
report with total interest revenues of $95 million and total interest costs of $82 million. What volume of
earning assets must the bank hold? Suppose the bank’s interest revenues rises by 5 percent and its
interest costs and earnings assets increase by 9 percent. What will happen to Clarksville’s net interest
margin?
The relevant formula is:
Net Interest Margin = .0275 =
$95 mill.− $82 mil.
Earning Assets
Then Earning Assets = $473 million.
If revenues rise by 5 percent and costs and earnings assets rise by 9 percent net interest margin is:
Net Interest Margin =
$95(1 + .05) − $82(1 + .09)
473(1 + .09)
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=
99.75 − 89.38
515.57
= 0.0201 or 2.01 percent.
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7-5.
If a credit union’s net interest margin, which was 2.50 percent, increases 15 percent and its total
assets, which stood originally at $625 million, rise by 20 percent, what change will occur in the bank's
net interest income?
The correct formula is:
.025 * (1+.15) =
Net Interest Income
$625 million * (1 + .2)
Net Interest Income = 0.02875 * $750 million
= $21.5625 million.
7-6.
The cumulative interest-rate gap of Jamestown Savings Bank increases 75 percent from an initial
figure of $22 million. If market interest rates rise by 25 percent from an initial level of 4.5 percent, what
change will occur in this thrift’s net interest income?
The key formula here is:
Change in the = Change in interest rates (in percentage points) * cumulative gap
Net Interest
Income
= (0.045 * .25) x ($22 mill.) * (1+.75)
= .43
Thus, the bank's net interest income will drop by 57 percent.
7-7.
Old Settlers State Bank has recorded the following financial data for the past three years (dollars
in millions):
Current Year
Previous Year
Two Years Ago
Interest revenues
$80
$82
$84
Interest expenses
66
68
70
Loans (Excluding nonperforming)
400
405
400
Investments
200
195
200
Total deposits
450
425
475
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Money market borrowings
100
125
75
What has been happening to the bank’s net interest margin? What do you think caused the changes you
have observed? Do you have any recommendations for Old Settlers management team?
Net interest margin (NIM) = Net Interest Income/Earning Assets, where
Net Interest Income = Net Interest Revenues - Net Interest Expenses
Earning Assets = Loans + Investments
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NIM (Current) = ($80-66)/ (400 + 200) = 14/600 = 0.0233 or 2.33%
NIM (previous) = ($82-68)/ (405 + 195) = 14/600 = 0.0233 or 2.33%
NIM (Two years ago) = ($84-70)/ (400 + 200) = 14/600 = 0.0233 or 2.33%
The net interest margin is steady in all the three years As interest revenues and expenses are varying
simultaneously.There is no fluctuation in the net interest margin.
7-8
The First National Bank of Spotsburg finds that its asset and liability portfolio contains the
following distribution of maturities and repricing opportunities:
Loans
Coming
Next
Next
More Than
Week
30 Days
31-90 Days
90 Days
$210
$300
$475
$525
+21
+26
40
70
Total IS Assets
$231
$326
$515
$595
Transaction Dep.
$350
$ ---
$ ---
$ ---
Time Accts.
100
276
196
100
Money Mkt. Borr.
136
140
100
50
$586
$416
$296
$150
GAP
- $355
- $90
$219
+ $445
Cumulative GAP
- $355
- $445
- $226
$219
Securities
Total IS Liab.
First National has a negative gap in the nearest period and therefore would benefit if interest rates fell.
In the next period it has a slightly negative gap and would therefore benefit of interest rate rose.
However, its cumulative gap is still negative. The third period is positive gap and hence the bank would
benefit if interest rates rises. In the final period the gap is positive and the bank would benefit if interest
rates rose. Its cumulative gap is slightly positive and also shows that rising interest rates would be
beneficial to the bank overall.
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7-9
Fluffy Cloud Savings Bank currently has the following interest-sensitive assets and liabilities on
its balance sheet with the interest-rate sensitivity weights noted.
Interest-Sensitive Assets
Index
Federal fund loans $50
1.00
Security holdings $50
Loans and leases $310.8
Interest-Sensitive Liabilities
Index
1.20
Interest-bearing deposits $250
.75
1.45
Money-market borrowings $85
.95
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What is the bank’s current interest-sensitive gap? Adjusting for these various interest-rate sensitivity
weights what is the bank’s weighted interest-sensitive gap? Suppose the federal funds interest rate
increases or decreases one percentage point. How will the bank’s net interest income be affected (a)
given its current balance sheet makeup and (b) reflecting its weighted balance sheet adjusted for the
foregoing rate-sensitive indexes?
Solution:
Dollar IS Gap
Weighted IS Gap
a.)
=
ISA - ISL
=
=
($50 + $50 + $310.8) - ($250 + $85)
[(1)($50) + (1.20)(50) + (1.45) (310.8)]
= $410.8 - $335
-
[(.75)($250) + (.95)($85)]
=
$50 + $60 + $450.66
-
$187.5 + $80.75
=
$560.66
-
$268.25
=
$292.41
Change in Bank’s Income = IS Gap * Change in interest rates
= ($75.8) (.01) = $.76 million
Using the regular IS Gap; net income will change by plus or minus $760,000
b.)
Change in Bank’s Income = Weighted IS Gap * Change in interest rates
= ($292.41) (.01) = $2.9241
Using the weighted IS Gap; net income will change by plus or minus $2,924,100
7-10 Twinkle Savings Association has interest-sensitive assets of $325 million, interest-sensitive
liabilities of $325 million, and total assets of $500 million. What is the bank’s dollar interest-sensitive
gap? What is Twinkle’s relative interest-sensitive gap? What is the value of its interest-sensitivity ratio?
Is it asset sensitive or liability sensitive? Under what scenario for market interest rates will Twinkle
experience a gain in net interest income? A loss in net interest income?
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Dollar Interest-Sensitive Gap = ISA – ISL = $325 - $325 = $0
Relative Interest-Sensitive Gap
=
ISA – ISL
Bank Size
Interest-Sensitivity Ratio
=
ISA
ISL
1-175
=
$325
$325
=
$0
$500
=1
=0
Chapter 01 - An Overview of the Changing Financial-Services Sector
Here the interest sensitivity Gap is zero as the interest sensitive assets are equal to interest sensitive
liabilities. Twinkle Savings Association is relatively insulated from interest rate risk. interest revenues
from assets and funding costs will change at the same rate. The interest-sensitive gap is zero, and the
net interest margin is protected regardless of which way interest rates go.
7-11 Richman Bank,, N.A., has a portfolio of loans and securities expected to generate cash inflows
for the bank as follows:
Expected Cash Inflows of
Principal & Interest Payments
$1,500,675
Annual Period in Which Cash Receipts Are
Expected
Current year
746,872
Two years from today
341,555
Three years from today
62,482
Four years from today
9,871
Five years from today
Deposits and money market borrowings are expected to require the following cash outflows:
Expected Cash Outflows of
Principal $ Interest Payments
$1,595,786
Annual Period during Which Payments must
be Made
Current year
831,454
Two years from today
123,897
Three years from today
1,005
Four years from today
-----
Five years from today
If the discount rate applicable to the previous cash flows is 5 percent, what is the duration of the
Richman’s portfolio of earning assets and of its deposits and money market borrowings? What will
happen to the bank's total returns, assuming all other factors are held constant, if interest rates rise? If
interest rates fall? Given the size of the duration gap you have calculated, in what type of hedging
should Richman engage? Please be specific about the hedging transactions that are needed and their
expected effects.
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Richman has asset duration of:
$1,500,675*1 + $746,872 * 2 + $341,555 * 3 + $62,482 * 4 + $9,871 * 5
(1 + 0.05)1
DA =
(1 + 0.05)2
(1 + 0.05)3
$1,500,675 + $746,872 + $341,555 + $62,482
(1 + 0.05)1 (1 + 0.05)2
(1 + 0.05)4
+ $9,871
(1 + 0.05)3 (1 + 0.05)4 (1 + 0.05)5
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Chapter 01 - An Overview of the Changing Financial-Services Sector
=
$3, 913,515.60 / $2,460,835.54 = 1.5903 years
Richman has a liability duration of:
$1,595786 * 1 + $831,454 * 2 + $123,897 * 3 + $1,005 * 4
(1 + 0.05)1
(1 + 0.05)2
(1 + 0.05)3
(1 + 0.05)4
DL=
$1,595,786+ $831,454 + $123,897 +
(1 + 0.05)1
$1,005
(1 + 0.05)2 (1 + 0.05)3 (1 + 0.05)4
= $3,352,490.69 / $2,381,803.18 = 1.4075 years
Richman's Duration Gap = Asset Duration - Liability Duration = 1.5903 - 1.4075 = 0.1828 years.
Because Richman's Asset Duration is greater than its Liability Duration, the bank has a positive duration
gap, which means that the bank's total returns will decrease if interest rates rise because the value of
the liabilities will decline by less than the value of the assets. On the other hand, if interest rates were
to fall, this positive duration gap will result in the bank's total returns increasing. In this case, the value
of the assets will rise by a greater amount than the value of the liabilities.
Given the magnitude of the duration gap, the management of Richman Bank, needs to do a combination
of things to close its duration gap between assets and liabilities. It probably needs to try to shorten
asset duration, lengthen liability duration, and use financial futures or options to deal with whatever
asset-liability gap exists at the moment. The bank may want to consider securitization or selling some of
its assets, reinvesting the cash flows in maturities that will more closely match its liabilities' maturities.
The bank may also consider negotiating some interest-rate swaps to change the cash flow patterns of its
liabilities to more closely match its asset maturities.
7-12. Given the cash inflow and outflow figures in Problem 11 for Richman Bank, N.A., suppose that
interest rates began at a level of 5 percent and then suddenly rise to 5.75 percent. If the bank has total
assets of $5 billion and total liabilities of $4.5 billion, by how much would the value of Richman’s net
worth change as a result of this movement in interest rates? Suppose, on the other hand, that interest
rates decline from 5 percent to 4.5 percent. What happens to the value of Richman’s net worth in this
case and by how much in dollars does it change? What is the size of its duration gap?
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From Problem #11 we find that Richman's average asset duration is 1.5903 years and average liability
duration is 1.4075 years. If total assets are $5 billion and total liabilities are $4.5 billion, then Richman
has a duration gap of:
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Duration Gap =
1.5903 – 1.4075 *
=
1.5903 – 1.26675
=
0.3236
$4.5 bill.
$5 bill.
The change in Casio's net worth would be:
Change in Value of Net Worth = [-DA *
r
r
* A] – [- DL *
* L]
(1 + r)
(1 + r)
If interest rates fall from 5 percent to 4.5 percent,

Change in NW = - 1.5903 x

 

(-.05)
(-.05)
x $5 bill  − - 1.4075 x
x $4.5 bill.
(1 + .05)
(1 + .05)
 

=
+ 0.3786 – 0.3016
=
+ 0.0770 billion.
7-13. Watson Thrift Association reports an average asset duration of 7 years, an average liability
duration of 3.25 years. In its latest financial report, the association recorded total assets of $1.8 billion
and total liabilities of $1.5 billion. If interest rates began at 6 percent and then suddenly climbed to 7.5
percent, what change (in percentage terms) wills this bond’s price experience if market interest rates
change as anticipated?
The key formula is:
Change in net worth = [-DA *
Dr
r
* A] - [- DL *
* L]
(1 + r)
(1 + r)
For the change in interest rates from 6 to 7.5 percent, Watson's net worth will change to:
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Change in Net Worth
=

 

(+.015)
(+.015)
- 7 years x (1 + .06) x$1800 bill. - - $3.25 years x (1 + .06) x $1500 bill.

 

= -$178.30 million + $68.99 million
= -$109.31 million
On the other hand, if interest rates decline from 6 to 5 percent we have:
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Change in Net Worth =

 

(-.01)
(-.01)
- 7 yrs x (1 + .06) x$1800 mill.  - - 3.25 yrs x (1 + .06) x$1500 mill. 

 

= + $118.87 mill. - $45.99 mill.
= + $72.88 million
7-14. A financial firm holds a bond in its investment portfolio whose duration is 13.5 years. Its current
market price is $950. While market interest rates are currently at 7 percent for comparable quality
securities, a decrease in interest rates to 6.75 percent is expected in the coming weeks. What changes
(in percentage terms) will this bond’s price experience if market interest rates change as anticipated?
Solution:
P
i
(−.0025)
 − Dx
= −13.5 x
= +.03154 or 3.15 percent
P
(1 + i)
(1.07)
This bond’s price will increased by 3.15 percent or its price will rise to $971.965.
7-15. A savings bank’s weighted average asset duration is 10 years. Its total liabilities amount to
$925 million, while its assets total 1 billion dollars. What is the dollar-weighted duration of the bank’s
liability portfolio if it has a zero leverage – adjusted duration gap ?
Given the bank has a duration gap equal to zero:
Duration Gap = DA - DL x
Total Liabilitie s
Total Assets
DL = (DA - Duration Gap) x
Total Assets
$1000
= (10 - 0) x
= 10.81years
Total Liabilitie s
$925
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7-16 Blue Moon National Bank holds assets and liabilities whose average durations and dollar
amounts are as shown in this table:
Asset and Liability Items
Investment Grade Bonds
Avg.Duration(yrs)
$ Amount
12.00
$65.00
Commercial Loans
4.00
$400.00
Consumer Loans
8.00
$250.00
Deposits
1.10
$600.00
Nondeposit Borrowings
0.25
$50.00
What is the weighted average duration of New Phase’s asset portfolio and liability portfolio? What is
the leverage-adjusted duration gap?
D A =  Wi * D i =
65
400
250
*12 +
*4 +
* 8 = 1.0909 +2.2378 + 2.7972 = 6.13 years
715
715
715
D L =  Wi * D i =
600
50
*1.1 +
* 0.25 = 1.0154 + 1.0154 = 2.03 years
650
650
Duration Gap = D A − D L *
TL
650
= 6.13 − 2.03 *
= 3.7273
TA
715
7-17 A government bond currently carries a yield to maturity of 7 percent and a market price of
$1161.68. If the bond promises to pay $100 in interest annually for five years, what is its current
duration?
1*
D=
$100
$100
$100
$100
$1100
+ 2*
+ 3*
+ 4*
+ 5*
1
2
3
4
(1 + .07)
(1 + .07)
(1 + .07)
(1 + .07)
(1 + .07) 5
= 4.22 years
$100
$100
$100
$100
$1100
+
+
+
+
(1 + .07)1 (1 + .07) 2 (1 + .07) 3 (1 + .07) 4 (1 + .07) 5
7-18 Clinton National Bank holds $15 million in government bonds having a duration of 7 years. If
interest rates suddenly rise from 6 percent to 7 percent, what percentage change should occur in the
bonds’ market price?
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P
r
.01
= −D *
= -7 *
= −.066 Or 6.6 percent
P
(1 + r)
(1 + .06)
CHAPTER 8
RISK MANAGEMENT: FINANCIAL FUTURES, OPTIONS, SWAPS, AND OTHER HEDGING TOOLS
Goal of This Chapter: The purpose of this chapter is to examine how financial futures, option, and swap
contracts, as well as selected other asset-liability management techniques can be employed to help
reduce a banks/firms potential exposure to loss as market conditions change. We will also discover how
swap contracts and other hedging tools can generate additional revenues for banks by providing riskhedging services to their customers.
Key Topics in this Chapter
•
•
•
•
•
•
•
The Use of Derivatives
Financial Futures Contracts: Purpose and Mechanics
Short and Long Hedges
Interest-Rate Options: Types of Contracts and Mechanics
Interest-Rate Swaps
Regulations and Accounting Rules
Caps, Floor, and Collars
Chapter Outline
I. Introduction: Several of the Most Widely Used Tools to Manage Risk Exposure
II. Use of Derivative Contracts
III. Financial Futures Contracts: Promises of Future Security Trades at a Set Price
A. Background on Financial Futures
B. Purpose of Financial Futures Trading
C. The Short Hedge in Futures
D. The Long Hedge in Futures
1. Using Long and Short Hedges to Protect Income and Value
2. Basis Risk
3. Basis Risk with a Short Hedge
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4. Basis Risk with a Long Hedge
5. Number of Futures Contracts Needed
IV. Interest-Rate Options
V. Regulations and Accounting Rules for Bank Futures and Options Trading
VI. Interest Rate Swaps
VII. Caps, Floors, and Collars
A. Interest-Rate Caps
B. Interest-Rate Floors
C. Interest-Rate Collars
VIII. Summary of the Chapter
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Concept Checks
8-1.
What are financial futures contracts? Which financial institutions use futures and other
derivatives for risk management?
Financial futures contracts is an agreement calling for the delivery of specific types of securities at a set
price on a specific future date. Financial futures contract help to hedge interest rate risk and are thus,
used by any bank or financial institution that is subject to interest rate risk.
8-2.
How can financial futures help financial service firms deal with interest rate risk?
Financial futures allow banks and other financial institutions to deal with interest rate risk by reducing
risk exposure from unexpected price changes. The financial futures markets are designed to shift the risk
of interest rate fluctuations from risk-averse investors to speculators willing to accept and possibly profit
from such risks.
8-3.
What is a long hedge in financial futures? A short hedge?
A long hedger offsets risk by buying financial futures contracts around the time new deposits are
expected, when a loan is to be made, or when securities are added to the bank's portfolio. Later, as
deposits and loans approach maturity or securities are sold, a like amount of futures contracts is sold. A
short hedger offsets risk by selling futures contracts when the bank is expecting a large cash inflow in
the near future. Later, as deposits come flowing in, a like amount of futures contracts is purchased.
In concise manner - The long hedge, or buying, hedge to protect against falling interest rates
and the short hedge, or selling, hedge to protect against rising interest rates
8-4.
What futures transactions would most likely be used in a period of rising interest rates? Falling
interest rates?
Rising interest rates generally call for a short hedge, while falling interest rates usually call for some
form of long hedge.
8-5.
How do you interpret the quotes for financial futures in The Wall Street Journal?
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The first column gives you the opening price, the second and third the daily high and low price,
respectively. The fourth column shows the settlement price followed by the change in the settlement
price from the previous day. The next two columns show the historic high and low price and the last
column points out the open interest in the contract.
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8-6.
A futures contract on Eurodollar deposit is currently selling at an interest yield of 4 percent,
while yields on 3-month Eurodollar deposits currently stand at 4.60 percent. What is the basis for the
Eurodollar futures contracts?
The basis for the Eurodollar future contracts is currently 4.60% – 4% or 60 basis points.
8-7.
Suppose a bank wishes to sell $150 million in new deposits next month. Interest rates today on
comparable deposits stand at 8 percent, but are expected to rise to 8.25 percent next month.
Concerned about the possible rise in borrowing costs, management wishes to use a futures contract.
What type of contract would you recommend? If the bank does not cover the interest rate risk involved,
how much in lost potential profits could the bank experience?
At an interest rate of 8 percent:
$150 million x 0.08 x
30
= $1 million
360
At an interest rate of 8.25 percent:
$150 million x 0.0825 x
30
= $1.0313 million
360
The potential loss in profit without using futures is $0.0313 million or $31.3 thousand. In this case the
bank should use a short hedge.
8-8.
What kind of futures hedge would be appropriate in each of the following situations?
a. A financial firm fears that rising deposit interest rates will result in losses on fixed-rate loans?
b. A financial firm holds a large block of floating-rate loans and market interest rates are falling?
c. A projected rise in market rates of interest threatens the value of a firm’s bond portfolio?
a. The rising deposit interest rates could be offset with a short hedge in futures contracts (for example,
using Eurodollar deposit futures).
b. Falling interest yields on floating-rate loans could be at least partially offset by a long hedge in
Treasury bonds.
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c. The firm’s bond portfolio could be protected through appropriate short hedges using Treasury bond
and note futures contracts.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
8-9.
Explain what is involved in a put option?
A put option allows its holder to sell securities to the option writer at a specified price. The buyer of a
put option expects market prices to decline in the future or market interest rates to increase. The writer
of the contract expects market prices to stay the same or rise in the future.
Buyer receives from an option writer the right to sell and deliver securities, loans, or futures contracts to
the writer at an agreed-upon strike price up to a specified date in return for paying a fee (premium) to
the option writer. If interest rates rise the market value of the optioned securities, loans, or futures
contracts will fall. Exercising put option results in a gain for the buyer.
8-10.
What is a call option?
A call option permits the option holder to purchase specific securities at a guaranteed price from the
writer of the option contract. The buyer of the call option expects market prices to rise in the future or
expects interest rates to fall in the future. The writer of the contract expects market prices to stay the
same or fall in the future.
8-11.
What is an option on a futures contract?
An option on a futures contract does not differ from any other kind of option except that the underlying
asset is not a security, but a futures contract.
8-12.
What information do T-bond and Eurodollar futures option quotes contain?
The quotes contain information about the strike prices and the call and put prices at each different
strike price for given months.
8-13. Suppose market interest rates were expected to rise? What type of option would normally be
used?
If interest rates were expected to rise, a put option would normally be used. A put option allows the
option holder to deliver securities to the option writer at a price which is now above market and make a
profit.
8-14. If market interest rates were expected to fall, what type of option would a financial institution’s
manager be likely to employ?
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If interest rates were expected to fall, a call option would likely be employed. When interest rates fall,
the market value of a security increases. The security can then be purchased at the option price and sold
at a profit at the higher market price.
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8-15. What rules and regulations have recently been imposed on the use of futures, options, and
other derivatives? What does the Financial Accounting Standards Board (FASB) require publicly traded
firms to do in accounting for derivative transactions?
Each bank has to implement a proper risk management system comprised of (1) policies and procedures
to control financial risk taking, (2) risk measurement and reporting systems and (3) independent
oversight and control processes. In addition, FASB introduced statement 133 which requires that all
derivatives are recorded on the balance sheet as assets or liabilities at their fair value. Furthermore, the
change in the fair value of a derivative and a fair value hedge must be reflected on the income
statement.
8-16.
What is the purpose of an interest rate swap?
The purpose of an interest rate swap is to change an institution's exposure to interest rate fluctuations
and achieve lower borrowing costs.
8-17.
What are the principal advantages and disadvantages of interest-rate swaps?
The principal advantage of an interest-rate swap is the reduction of interest-rate risk of both parties to
the swap by allowing each party to better balance asset and liability maturities and cash-flow patterns.
Another advantage of swaps is that they usually reduce interest costs for one or both parties to the
swap. The principal disadvantage of swaps is they may carry substantial brokerage fees, credit risk and
some basis risk.
8-18.
How can a financial institution get itself out of an interest-rate swap agreement?
The usual way to offset an existing interest-rate swap is to undertake another interest-rate swap
agreement with opposite characteristics.
8-19. How can financial-service providers make use of interest rate caps, floors, and collars to
generate revenue and help manage interest rate risk?
Banks and other financial institutions can generate revenue by charging up-front fees for interest rate
caps on loans and interest rate floors on securities. In addition, a positive net premium on interest rate
collars will add to a bank's fee income. Caps, floors, and collars help manage interest rate risk by setting
maximum and minimum interest rates on loans and securities. They allow the lender and borrower to
share interest rate risk.
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8-20. Suppose a bank enters into an agreement to make a $10 million, three-year floating-rate loan to
one of its best corporate customers at an initial rate of 8 percent. The bank and its customer agree to a
cap and a floor arrangement in which the customer reimburses the bank if the floating loan rate drops
below 6 percent and the bank reimburses the customers if the floating loan rate rises above 10 percent.
Suppose that, at the beginning of the loan's second year, the floating loan rate drops to 5 percent for a
year and then, at the beginning of the third year, the loan rate increases to 12 percent for the year.
What rebates must be paid by each party to the agreement pay?
The rebate owed by the bank for the third year must be:
(12%-10%) x $10 million = $200,000.
The rebate that must be forwarded to the bank for the second year must be:
(6%-5%) x $10 million = $100,000.
Problems
8-1.
You hedged your bank’s exposure to declining interest rates by buying one June Treasury bond
futures contract at the opening price on April 10, 2008 (see exhibit 8-2). It is now Tuesday, June 10, and
you discover that on Monday, June 9, June T-bond futures opened at 115-165 and settled at 114-300.
a. What is the profit or loss on your long position as of settlement on June?
Buy at 119-075 or 119,07/32, ½ of 1/32 per contract = 119,234.38
Value at settlement on June, 114-300 or 114 30/32 = 114,937.50
Loss = 114,937.5 – 119,234.38 = -$4,296.88
b. If you deposited the required initial margin on April 10 and have not touched the equity
account since making that cash deposit, what is your equity account balance?
The equity account balance will decrease by the loss in the position,
thus $1,800 + ($4296) = ($2496.88).
8-2
Use the quotes of Eurodollar futures contracts traded on the Chicago Mercantile Exchange as
shown below to answer the following questions:
a. What is the annualized discount yield based on the “low” index price for the nearest
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Chapter 01 - An Overview of the Changing Financial-Services Sector
March contract?
The annualized discount yield is 100 – 96.40 = 3.60percent
b. If your financial firm took a short position at the high price for the day for 15 contracts,
what would be the dollar gain or loss at settlement on June 9, 2008?
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Sell at high price: (1,000,000x[1-((3.60/100)x90/360)]x15 = 14,865,000.00
Value at settlement: (1,000,000x[1-((3.545/100)x90/360)]x15 = 14,867,062.50
Loss: 14,865,000.00 – 14,867,062.50 = $2,062.50
c. If you deposited the initial required hedging margin in your equity account upon taking
the position described in b, what would be the marked-to-market value of your equity
account at settlement?
Initial margin = $750x15 = $11,250
You realize a $2,062.50 Loss for this transaction.
Thus your equity position is: $11,250 - $2,062.50 = $9,187.50
8-3.
What kind of futures or options hedges would be called for in the following situations?
a. Market interest rates are expected to increase and your financial firm’s asset-liability
managers expect to liquidate a portion of their bond portfolio to meet customers’ demands for
funds in the upcoming quarter.
Financial firm can expect a lower price when they sell their bond portfolio unless it uses short futures
hedges in which contracts for government securities are first sold and then purchased at a profit as
security prices fall provided interest rate really do rise as expected. A similar gain could be made using
put options on government securities or on financial futures contracts.
b. Your financial firm has interest-sensitive assets of $79 million and interest-sensitive liabilities
of $88 million over the next 30 days and market interest rates are expected to rise.
Financial firm interest-sensitive liabilities exceed its interest-sensitive assets by $9 million which means
the firm will be open to losses if interest rates rise. The firm could sell financial futures contracts or use a
put option on government securities or financial futures contracts approximately equal in dollar volume
to the $9 million interest-sensitive gap to hedge their risk.
c. A survey of Tuskee Bank’s corporate loan customers this month (January) indicates that, on
balance, this group of firms will need to draw $165 million from their credit lines in February
and March, which is $65 million more than the bank’s management has forecasted and
prepared for. The bank’s economist has predicted a significant increase in money market
interest rates over the next 60 days.
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The forecast of higher interest rates means the bank must borrow at a higher interest cost which, other
things held equal, will lower its net interest margin. To offset the expected higher borrowing costs the
bank's management should consider a short sale of financial futures contracts or a put option
approximately equal in volume to the additional loan demand. Either government securities or EuroCDs
would be good instruments to consider using in the futures market or in the option market.
d. Monarch National Bank has interest-sensitive assets greater than interest sensitive liabilities
by $24 million. If interest rates fall (as suggested by data from the Federal Reserve Board) the
bank’s net interest margin may be squeezed due to the decrease in loan and security revenue.
Monarch National Bank has interest-sensitive assets greater than interest-sensitive liabilities by $24
million. If interest rates fall, the bank's net interest margin will likely be squeezed due to the faster fall in
interest income. Purchases of financial futures contracts followed by a subsequent sale or call options
would probably help here.
e. Caufield Thrift Association finds that its assets have an average duration of 1.5 years and its
liabilities have an average duration of 1.1 years. The ratio of liabilities to assets is .90. Interest
rates are expected to increase by 50 basis points during the next six months.
Caufield Bank and Trust Company has asset duration of 1.5 years and liabilities duration of 1.1. A 50basis point rise in money-market rates would reduce asset values relative to liabilities which mean its
net worth would decline. The bank should consider short sales of government futures contracts or put
options on these securities or on their related futures contracts.
8-4.
Your financial firm needs to borrow $500 million by selling time deposits with 180-day
maturities. If interest rates on comparable deposits are currently at 4 percent, what is the cost of issuing
these deposits? Suppose interest rates rise to 5 percent. What then will be the cost of these deposits?
What position and types of futures contract could be used to deal with this cost increase?
At a rate of 4 percent the interest cost is:
$500 million x 0.04 x
180
= $10,000,000
360
At a rate of 5 percent the interest cost would be:
$500 million x 0.05 x
180
= $12,500,000
360
A short hedge could be used based upon Eurodollar time deposits.
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8-5.
In response to the above scenario, management sells 500, 90-day Eurodollar time deposits
futures contracts trading at an index price of 98. Interest rates rise as anticipated and your financial firm
offsets its position by buying 500 contracts at an index price of 96.98. What type of hedge is this? What
before-tax profit or loss is realized from the futures position?
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Firm sells Eurodollar futures at (1,000,000*[1-((2/100)*90/360)]
$995,000 (per contract)
Firm buys Eurodollar futures at (1,000,000*[(1-(3.02/100)*90/360]$992,450 (per contract)
Expected Before-tax Profit
$ 2,550 (per contract)
And Total Profit would be 500*$2550 = $1,275,000
In this case the firm has employed a short hedge which partially offsets the higher borrowing costs
outlined above.
8-6.
It is March and Cavalier Financial Services Corporation is concerned about what an increase in
interest rates will do to the value of its bond portfolio. The portfolio currently has a market value of
$101.1, million and Cavalier’s management intends to liquidate $1.1 million in bonds in June to fund
additional corporate loans. If interest rates increase to 6 percent, the bond will sell for $1 million with a
loss of $100,000. Cavalier’s management sells 10 June Treasury bond contracts at 109-050 in March.
Interest rates do increase, and in June Cavalier’s management offsets its position by buying 10 June
Treasury bond contracts at 100-030.
a. What is the dollar gain/loss to Cavalier from the combined cash and futures market
operations described above?
Loss on cash transaction: $100,000
Gain on futures transaction: $110,562,50 – $100,937.50 = $9,625.00 (per contract)
Loss: 9,625.00(10) – 100,000 = -$3,750
b. What is the basis at the initiation of the hedge?
110,000 – 110,562.50 = -562.50
c. What is the basis at the termination of the hedge?
100,000 – 100,937.50 = -937.50
d. Illustrate how the dollar return is related to the change in the basis from initiation to
termination?
Dollar return = -937.50 + 562.50 = -375 per contract or –375(10) = -$3,750
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8-7.
By what amount will the market value of a Treasury bond futures contract change if interest
rates rise from 5 to 5.75 percent? The underlying Treasury bond has a duration of 10.48 years and the
Treasury bond futures contract is currently quoted at 113-06 (Remember that Treasury bonds are
quoted in 32nds)
Change in value = -10.48 x $113,179.69 x.0075/ (1+.05) = -$8,472.31
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8-8.
Lazy Days National Bank reports that its assets have a duration of 7 years and its liabilities
average 2.75 years in duration. To hedge this duration gap, management plans to employ Treasury bond
futures, which are currently quoted at 112-170 and have a duration of 10.36 years. Lazy Days’ latest
financial report shows total assets of $100 million and liabilities of $90 million. Approximately how many
futures contracts will the bank need to cover its overall exposure?
[7 −
Number of Futures Contracts Needed =
90
* 2.75] *100,000,000
100
= 372.32
10.36 *117,312.50
8-9
You hedged your financial firm’s exposure to declining interest rates by buying one September
call on Treasury bond futures at the premium quoted on April 15, 2008
(see exhibit 8-4).
a. How much did you pay for the call in dollars if you chose the strike price of 11000?
(Remember that option premiums are quoted in 64ths.)
Price per call = 7.96875 x 100,000 = $796,875.00
b. Using the following information for trades on June 10, 2008, if you sold the call on
June 10, 2008 due to a change in circumstances would you have reaped a profit or loss?
Determine the amount of the profit/loss.
Sell call at: 4.484375 x 100,000 = $448,438.50
Loss = 448,438 – 796,875 = -$348,437.50
8-10 Refer to the information given for problem 9. You hedged your financial firm’s exposure to
increasing interest rates by buying one September put on Treasury bond futures at the premium quoted
on April 15, 2008 (see exhibit 8-4).
a. How much did you pay for the put in dollars if you chose the strike price of 11,000?
(Remember that premiums are quoted in 64ths.)
Price per put = .765625 x 100,000 = $76,562.5
b. Using the above information for trades on June 10, 2008, if you sold the put on June
10, 2008 due to a change in circumstances would you have reaped a profit or loss?
Determine the amount of the profit or loss.
Sell put at: 1.15625 x 100,000 = $115,625
Loss = -$115,625 + 76,562.5 = -$39,063
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8-11. You hedged your thrift institution’s exposure to declining interest rates by buying one December
call on Eurodollar deposits futures at the premium quoted on June 10, 2008 (see exhibit 8-4).
a. How much did you pay for the call in dollars if you chose the strike price of 972,500?
Value of the call: 43.25 x $25 = $1,081.25
b. If December arrives and Eurodollar Deposit Futures have a settlement index at expiration of
96.50, what is your profit or loss? (Remember to include the premium paid for the call option).
Payout from settlement: is 0 (since the option is out of the money)
Net loss: $0 –$1,081.25 = $1,081.25
8-12. You hedged your financial firm’s exposure to increasing interest rates by buying one December
put on Eurodollar deposit futures at the premium quoted on April 15, 2008 (see exhibit 8-4).
a. How much did you pay for the put in dollars if you chose the strike price of 977,500?
Value of the put: 19.25 x $25 = $481.25
b. If December arrives and Eurodollar Deposit Futures have a settlement index at expiration of
96.50, what is your profit or loss? (Remember to include the premium paid for the put option).
Payout from settlement: (977,500-965,000) = 12,500 basis point x $25 = $ 312,500
Net Gain: $312,500 - $481.25 = $312,018.75
8-13. A bank is considering the use of options to deal with a serious funding cost problem. Deposit
interest rates have been rising for six months, currently averaging 5 percent, and are expected to climb
as high as 6.75 percent over the next 90 days. The bank plans to issue $60 million in new money market
deposits in about 90 days. It can buy put or call options on 90 day Eurodollar time deposit futures
contracts for a quoted premium of 31.00 or $775.00 for each million-dollar contract. The strike price is
quoted as 950,000. We expect the futures to trade at an index of 935,000 within 90 days. What kind of
option should the bank buy? What before tax profit could the bank earn for each option under the
terms described?
You are trying to protect the bank against rising interest rates, thus you want to buy a put option.
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Profit on put:
payout from settlement = (950,000-935,000) 15,000 basis points x $25 = $375,000
Net profit: $375,000 - $775 = $374,225
If the bank bought the call option, the value at settlement would be $0 and the bank would loose the
call premium of $775.
8-14. Hokie Savings wants to purchase a portfolio of home mortgage loans with an expected average
return of 6.5 percent. The management is concerned that interest rates will drop and the cost of the
portfolio will increase from the current price of $50 million. In six months when the funds become
available to purchase the loan portfolio, market interest rates are expected to be in the 5.5 percent
range. Treasury bond options are available today at a quoted price of 10,900 (i.e., $109,000 per
$100,000 contract), upon payment of a $700 premium, and are forecast to drop to a market value of
$99,000 per contract. Should Hokie buy puts or calls? What before-tax profits could the Hokie earn per
contract on this transaction? How many options should Hokie buy?
Profit per contract: $109,000 - $99,000 - $700 = $9,300
Hokie should buy enough put options to offset the decrease in the price of the loan portfolio. Thus,
figure out the price decrease and divide that number by 9,300 to get the number of put options needed.
8-15. A savings and loan’s credit rating has just slipped, and half of its assets are long term mortgages.
It offers to swap interest payments with a money center bank in a $100 million deal. The bank can
borrow short term at LIBOR (3 percent) and long term at 3.95 percent. The S&L must pay LIBOR plus 1.5
percent on short term debt and 7 percent on long term debt. Show how these parties could put
together a swap deal that benefits both of them.
This SWAP agreement would have the form:
S&L
Fixed Rate the
Floating Rate
Potential
Borrower Pays
the Borrower
Interest-Rate
if They Issue
Pays on Short-
Savings of Each
Long-Term Bonds
Term Loans
Borrower
LIBOR + 1.50%
2.50%
7.00%
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Money- Center Bank
3.95%
Difference in Rates
3.05%
LIBOR (3%)
0.95%
1.50%
1.55%
Due to Differences in Credit Ratings
If the money-center bank borrows long-term at 3.95 percent and the S&L at LIBOR + 1.50 percent (which
is currently 3.00 + 1.50 or 4.50 percent) and they exchange interest payments, both would save if the
S&L agreed to pay a portion of the bank’s basic borrowing rate. For example, the S&L could pay 260
basis points to the bank which would more than cover the difference. After the exchange in payments
and basis points the S&L would pay 3.95% +2.6% or 6.55% which is lower than the S&L’s long term rate
and the bank would pay 5.45%-2.6% or 2.85% which is less than the bank’s short term rate and each
party would get the type of payment they want.
8-16. A financial firm plans to borrow $75 million in the money market at a current interest rate of 4.5
percent. However, the borrowing rate will float with market conditions. To protect itself the firm has
purchased an interest-rate cap of 5 percent to cover this borrowing. If money market interest rates on
these funds suddenly climb to 5.5 percent as the borrowing begins, how much in total interest will the
firm owe and how much of an interest rebate will it receive assuming the borrowing is only for one
month?
Total
Interest Owed
Amount
=
Borrowed
= $75 million x 0.055 x
Interest
*
Rate Charged
Number of Months
*
12
1
12
= $0.34375 million or $343,750.
How much of an interest rebate will the bank receive for its one-month borrowing?
Interest Rebate = Market Interest Rate - Cap Rate x Amt. Borrowed x
= (.055 - .05) x $75 million x
1
12
= $31,250.
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8-17. Suppose that Islander Savings Association has recently granted a loan of $2.25 million to Oyster
Farms at prime plus 0.5 percent for six months. In return for granting Oyster Farms an interest cap of 7.5
percent on its loan, this thrift has received from this customer a floor rate on the loan of 5 percent.
Suppose that, as the loan is about to start the prime rate declines to 4.25 percent and remains there for
the duration of the loan. How much (in dollars) will Oyster Farms have to pay in total interest on this six
month loan? How much in interest rebates will Oyster Farms have to pay due to the fall in the prime
rate?
Total
Interest Owed
=
Amount
*
Borrowed
Interest
*
Number of Months
Rate Charged
= $2.25 million x (.0425 + .0050) x
12
6
12
= $0.104063 million or $104,062.50
Oyster will have to pay an interest rebate to Exeter National Bank of:
Interest Rebate = Floor Rebate - Current Interest Rate x Amt. Borrowed x
= (.050 - .0475) x $2.25 million x
Number of Months
12
6
12
= $0.011250 million or $11,250
CHAPTER 9
RISK MANAGEMENT: ASSET-BACKED SECURITIES, LOAN SALES, CREDIT STANDBYS, AND CREDIT
DERIVATIVES
Goal of This Chapter: The purpose of this chapter is to learn about some of the newer financial
instruments that financial institutions have used in recent years to help reduce the risk exposure of their
institutions and, in some cases, to aid in generating new sources of fee income and in raising new funds
to make loans and investments.
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Key Topics in This Chapter
•
•
•
•
•
The Securitization Process
Securitization’s Impact and Risks
Sales of Loans: Nature and Risks
Standby Credits: Pricing and Risks
Credit Derivatives and CDOs - Benefits and Risks
Chapter Outline
I. Introduction
II. Securitizing Loans and Other Assets
A. Nature of Securitization
B. The Securitization Process
C. Advantages of Securitization
D. The Beginnings of Securitization – The Home Mortgage Market
1. Collateralized Mortgage Obligations – CMOs
2. Home Equity Loans
3. Loan-Backed Bonds
E. Examples of Other Assets That Have Been Securitized
F. The Impact of Securitization upon Lending Institutions
G. Regulators’ Concerns about Securitization
Ill. Sales of Loans to Raise Funds and Reduce Risk
A. Nature of Loan Sales
B. Participation loan, Assignment loan and Loan Strip
C. Reasons behind Loan Sales
D. The Risks in Loan Sales
IV. Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance
A. The nature of standby letter of Credit (Contingent Obligations)
B. Types of Standby Credit Letters
C. Advantages of Standbys
D. Reasons for Rapid Growth of Standbys
E. The Structure of SLCs
F. The Value and Pricing of Standby Letters
G. Sources of Risk with Standbys
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H. Regulatory Concerns about SLCs
I. Research Studies on Standbys, Loan Sales, and Securitizations
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V. Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet
A. An Alternative to Securitization
B. Credit Swaps
C. Credit Options
D. Credit Default Swaps (CDSs)
E. Credit-Linked Notes
F. Collateralized Debt Obligations (CDOs)
G. Risks Associated with Credit Derivatives
VI. Summary of the Chapter
Concept Checks
9-1.
What does securitization of assets mean?
Securitization involves the pooling of groups of earning assets, removing those pooled assets from the
bank’s balance sheet, and issuing securities against the pool. As the pooled assets generate interest
income and repayments of principal the cash generated by the pooled earning assets flows through to
investors who purchased those securities.
9-2.
What kinds of assets are most amenable to the securitization process?
The best types of assets to pool are high quality, fairly uniform loans, such as home mortgages or credit
card loans.
9-3.
What advantages does securitization offer lending institutions?
Securitization gives lending institutions the opportunity to use their assets as sources of funds and, in
particular, to remove lower-yielding assets from the balance sheet to be replaced with higher-yielding
assets.
9-4.
What risks of securitization should the managers of lending institutions be aware of?
Lending institutions often have to use the highest-quality assets in the securitization process which
means the remainder of the portfolio may become more risky, on average, increasing the bank’s capital
requirements.
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9-5.
Suppose that a bank securitizes a package of its loans that bears a gross annual interest yield of
13 percent. The securities issued against the loan package promise interested investors an annualized
yield of 8.25 percent. The expected default rate on the packaged loans is 3.5 percent. The bank agrees
to pay an annual fee of 0.35 percent to a security dealer to cover the cost of underwriting and advisory
services and a fee of 0.25 percent to Arunson Mortgage Servicing Corporation to process the expected
payments generated by the packaged loans. If the above items represent all the costs associated with
this securitization can you calculate the percentage amount of residual income the bank expects to earn
from this particular transaction?
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The bank’s estimated residual income should be about:
Gross Loan
Yield
Security
-
Interest Rate
13%
-
Expected Default On
-
Packaged Loans
8.25%
3.5%
Servicing
Expected
Fee
=
-
and Advisory Fee
.35%
Residual Income
.25%
9-6.
Underwriting
.65%
What advantages do sales of loans have for lending institutions trying to raise funds?
Loan sales permit a lending institution to get rid of less desirable or lower-yielding loans and allow them
to raise additional funds. In addition, replacing loans that are sold with marketable securities can
increase the liquidity of the lending institution.
9-7.
Are there any disadvantages to using loan sales as a significant source of funding for banks and
other financial institutions?
The lender may find themselves selling off their highest quality loans, leaving their loan portfolio
stocked with poor-quality loans which can trigger the attention of regulators who might require higher
capital requirements for the lender.
9-8.
What is loan servicing?
Loan servicing involves monitoring borrower compliance with a loan’s terms, collecting and recording
loan payments, and reporting to the current holder of the loan.
9-9.
How can loan servicing be used to increase income?
Many banks have retained servicing rights on the loans they have sold, earning fees from the current
owners of those loans. They generate fee income by collecting interest and principal payments from
borrowers and passing the proceeds along to loan buyers.
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9-10.
What are standby credit letters? Why have they grown so rapidly in recent years?
Standby credit letters are promises of a lender to pay off an obligation of one of its customers in case
that customer cannot pay. It can also be a guarantee that a project of customer is completed on time.
There are several reasons that standby credit agreements have grown. There has been a tremendous
growth in direct financing by companies (issuance of commercial paper) and with growing concerns
about default risk on these direct obligations banks have been asked to provide a credit guarantee.
Another reason for their growth is the ability of the bank to use their skills to add fee income to the
bank. Another reason is that these have a relatively low cost for the bank. Finally banks and customers
perceive that there has been an increase in economic fluctuations and there has been increased
demand for risk reducing devices.
9-11.
Who are the principal parties to a standby credit agreement?
The principal parties to a standby credit agreement are the issuing bank or other institution, the account
party who requested the letter, and the beneficiary who will receive payment from the issuing
institution if the account party cannot meet its obligation.
9-12.
What risks accompany a standby credit letter for (a) the issuer and (b) the beneficiary?
Standbys present the issuer with the danger that the customer whose credit the issuer has backstopped
with the letter will need a loan. That is, the issuer’s contingent obligation will become an actual liability,
due and payable. This may cause a liquidity squeeze for the issuer. The beneficiary that has to collect on
the letter must be sure it meets all the conditions required for presentation of the letter or it will not be
able to recover its funds.
9-13
How can a lending institution mitigate the risks inherent in issuing standby credit letters?
They can use various devices to reduce risk exposure from the standby credit letters they have issued,
such as:
1. Frequently renegotiating the terms of any loans extended to customers who have SLCs so that
loan terms are continually adjusted to the customer’s changing circumstances and there is less
need for beneficiaries to press for collection.
2. Diversifying SLCs issued by region and by industry to avoid concentration of risk exposure.
3. Selling participations in standbys in order to share risk with other lending institutions.
9-14. Why were credit derivatives developed? What advantages do they have over loan sales and
securitizations, if any?
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Credit derivatives were developed because not all loans can be pooled. In order to be pooled, the group
of loans has to have common features such as maturities and cash flow patterns and many business
loans do not have those common features. Credit derivatives can offer the beneficiary protection in the
case of loan default and may help the bank reduce its credit risk and possibly its interest rate risk as
well.
9-15.
What is a credit swap? For what kinds of situations was it developed?
A credit swap is where two lenders agree to swap portions of their customer’s loan repayments. It was
developed so that banks do not have to rely on one narrow market area. They can spread out the risk in
the portfolio over a larger market area.
9-16.
What is a total return swap? What advantages does it offer the swap beneficiary institution?
A total return swap is a type of credit swap where the dealer guarantees the swap parties a specific rate
of return on their credit assets. A total return swap can allow a bank to earn a more stable rate of return
than it could earn on its loans. This type of arrangement can also shift the credit risk and the interest
rate risk from one bank to another.
9-17.
How do credit options work? What circumstances result in the option contract paying off?
A credit option helps guard against losses in the value of a credit asset or helps offset higher borrowing
costs. A bank which purchases a credit option contract will exercise their option if the asset declines
significantly in value or loses its value completely. If the assets are paid off as expected then the option
will not be exercised and the bank will lose the premium they paid for the option. A bank can also
purchase a credit option which will be exercised if their borrowing costs rise above a specified spread
between their cost and a riskless asset.
9-18.
When is a credit default swap useful? Why?
A credit default swap is a credit option written on a portfolio of assets or a credit swap on a particular
loan where the other bank in the swap agrees to pay the first bank a certain fee if the loan defaults. This
type of arrangement is designed for banks that can handle relatively small losses but want to protect
themselves from serious losses.
9-19.
Of what use are credit-linked notes?
A credit-linked note allows the issuer of a note to lower the coupon payments if some significant fact
changes. For example, if more loans on which the notes are based default than expected, the coupon
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payments on the notes can be lowered. The lender has taken on credit-related insurance from the
investors who have purchased the note.
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9-20.
What are CDOs? How do they differ from other credit derivatives?
A CDO is very similar to loan securitization, where the pool of assets can include high yield corporate
bonds, stock, commercial mortgages, or other financial instruments, which are generally of higher risk
than in the traditional loan securitization. Some CDO pools contain debt and other financial instruments
from dozens of companies in order to boost potential returns and diversify away much of the risk.
9-21. What risks do credit derivatives pose for financial institutions using them? In your opinion what
should regulators do about the recent rapid growth of this market, if anything?
There are several risks associated with these instruments. One risk is that the other party in the swap or
option may fail to meet their obligation. Courts may rule that these instruments are illegal or improperly
drawn. These types of instruments are relatively new and the markets for these instruments are
relatively thin. If a bank needs to resell one of these contracts they may have difficulty finding a buyer or
they may not be able to sell it at a reasonable price. Regulators need to understand clearly the benefits
and risks of these types of credit instruments and act to ensure the safety of the banks.
Problems
9-1.
GoodTimes National Bank placed a group of 10,000 consumer loans bearing an average
expected gross annual yield of 7.5 percent in a package to be securitized. The investment bank advising
GoodTimes estimates that the securities will sell at a slight discount from par that results in a net
interest cost to the issuer of 8 percent. Based on recent experience with similar types of loans, the bank
expects 3 percent of the packaged loans to default without any recovery for the lender and has agreed
to set aside a cash reserve to cover this anticipated loss. Underwriting and advisory services provided by
the investment banking firm will cost 0.5 percent. GoodTimes will also seek a liquidity facility, costing
0.5 percent and a credit guarantee if actual loans defaults should exceed the expected loan default rate,
costing 0.6 percent. Please calculate the residual income for GoodTimes from this loan securitization.
The estimated residual income for GoodTimes National Bank is:
Gross Loan
Yield
Security
-
Interest Rate
Expected Default On
-
Packaged Loans
7.5%
8%
3%
Liquidity
Credit
Expected
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-
And Advisory Fee
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Facility
-
Fee
0.5%
Enhancement
-
Fee
=
0.6%
Residual Income
-5.1%
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9-2.
Colburn Corporation is requesting a loan for repair of some assembly-line equipment in the
amount of $9.5 million. The nine-month loan is priced by Farmers Financial Corporation at a 7.5 percent
rate of interest. However, the finance company tells Colburn that if it obtains a suitable credit guarantee
the loan will be priced at 7 percent. Lifetime Bank agrees to sell Colburn a standby credit guarantee for
$10,000. Is Colburn likely to buy the standby credit guarantee Lifetime has offered? Please explain.
The interest savings from having the credit guarantee would be:
[$9.5 mill. * 0.075 * ¾] - [$9.5 mill. x 0.07 * ¾] =
$534,375 - $498,750 = $35,625
Clearly, the $10,000 guarantee is priced correctly and will be purchased. Colburn would only
have to pay a 7 percent coupon rate for the loan instead of 7.5 percent.
9-3.
The Lake View Bank Corp. has placed $100 million of GNMA-guaranteed securities in a trust
account off the balance sheet. A CMO with four tranches has just been issued by Lake View using the
GNMAs as collateral. Each tranche has a face value of $25 million and makes monthly payments. The
annual coupon rates are 4.5 percent for Tranche A, 5 percent for Tranche B, 5.5 percent for Tranche C,
and 6.5 percent for Tranche D.
a. Which tranche has the shortest maturity, and which tranche has the most prepayment
protection?
Tranche A has the shortest maturity and tranche D has the most prepayment protection.
b. Every month principal and interest is paid on the outstanding mortgages, and some mortgages
are paid in full. These payments are passed through to Lake View, and the trustee uses the funds
to pay coupons to CMO bondholders. What are the coupon payments owed for each tranche for
the first month?
Tranche A: 25 million x (.045/12) = $93,750
Tranche B: 25 million x (.050/12) = $104,167
Tranche C: 25 million x (.055/12) = $114,583
Tranche D: 25 million x (.065/12) = $135,417
c. If scheduled mortgage payments and early prepayments bring in $5 million, how much will be
used to retire the principal of CMO bondholders and which tranche will be affected?
Total interest to be paid: $93,750 + $104,167 + $114,583 + $135,417 = $447,917
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Amount applied to principal: $5,000,000 - $447,917 = $4,552,083
Tranche A will be affected by the reduction in principal.
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d. Why does Tranche D have a higher expected return?
Tranche D has the longest maturity and the highest reinvestment risk and thus, should have the
highest expected return. In addition, since prepayments are first applied to the other tranches,
tranche D also carries the highest amount of default risk.
9-4. First Security National Bank has been approached by a long-standing customer, United
Safeco Industries, for a $30 million term loan for five years to purchase new stamping machines
that would further automate the company’s assembly line in the manufacture of metal toys and
containers. The company also plans to use at least half the loan proceeds to facilitate its buyout
of Calem Corp., which imports and partially assembles video recorders and cameras. Additional
funds for the buyout will come from a corporate bond issue that will be underwritten by an
investment banking firm not affiliated with First Security.
The problem the bank’s commercial credit division faces in assessing this customer’s
loan request is a management decision reached several weeks ago that the bank should gradually
work down its leverage buyout loan portfolio due to a significant rise in nonperforming credits.
Moreover, the prospect of sharply higher interest rates has caused the bank to revamp its loan
policy toward more short term loans (under one year) and fewer term (over one year) loans.
Senior management has indicated it will no longer approve loans that require a commitment of
the bank’s resources beyond a term of three years, except in special cases.
Does First Security have any service option in the form of off-balance-sheet instruments
that could help this customer while avoiding committing $30 million in reserves for a five-year
loan? What would you recommend that management do to keep United Safeco happy with its
current banking relationship? Could First Security earn any fee income if it pursued your idea?
Suppose the current interest rate on Eurodollar deposits (three-month maturities) in
London is 3.40 percent, while Federal funds and six-month CDs are trading in the United States
at 3.57 percent and 3.19 percent, respectively. Term loans to comparable quality corporate
borrowers are trading at one-eighth to one-quarter percentage point above the three-month
Eurodollar rate or one-quarter to one-half point over the secondary-market CD rate. Is there a
way First Security could earn at least as much fee income by providing United Safeco with
support services as it could from making the loan the company has asked for (after all loan costs
are taken into account)? Please explain how the customer could benefit even if the bank does not
make the loan requested.
In view of these reasonable objectives on the part of First Security National Bank’s management, the
bank should consider recommending that the leveraged buy-out portion of the request be handled by
an offering of bonds or, perhaps, 5-year notes, with the bank issuing a standby letter of credit for a
portion (though probably not all) of the bond or note issue. Armed with First Security’s standby credit
agreement, United Safeco should be able to borrow through a security issue at a substantially lower
interest rate. First Security could sell participations in the standby credit to share its risk exposure.
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For the portion of the loan that calls for the purchase of new assembly-line equipment, management
might seriously consider proposing a shorter-term loan for about one-third to one-half the total amount
requested by Safeco. This loan would be secured by a pledge of the new equipment plus sufficient
covenants to insure the maintenance of adequate liquidity and require bank approval before significant
amounts of other forms of debt are undertaken.
First Security could generate fee income from this relationship by assessing a fee for issuing the standby
letter of credit. The fee for a standby letter of credit typically ranges from ½ percent to 1 percent of the
amount of the standby guarantee, depending upon the bank’s assessment of the degree of risk
exposure in the guarantee.
If First Security issues a standby letter of credit on behalf of United Safeco as described above, both
parties should benefit. First Security, by issuing the standby credit agreement, does not have to tie up
$30 million in reserves for an extended period of time as it would if it made the requested loan,
particularly in a projected rising interest rate environment. The ½ percent to 1 percent fee would
compare favorably in amount to the 1/8 to ¼ percent spread over the Eurodollar rate or the ¼ to ½
percent spread over the federal funds or CD rate that currently prevails in the market. Under the riskbased capital standards now in effect, the standby letter of credit will require the bank to hold capital in
an amount equal to the capital requirement for the loan. Therefore, United Security National will have
the same capital requirement for either transaction, the loan or the standby letter of credit.
Also, as stated above, United Safeco should be able to issue bonds or notes at a more favorable rate
with United Security National’s standby letter of credit behind them.
9-5.
What type of credit derivatives contract would you recommend for each of the following
situations:
a. A bank plans to issue a group of bonds backed by a pool of credit card loans but fears that the
default rate on these credit card loans will rise well above 6 percent of the portfolio – the
default rate it has projected. The bank wants to lower the interest costs on the bonds in case
the loan default rate rises too high.
The best solution to this problem is to use credit linked notes. The interest payments on these
notes will change if significant factors change.
b. A commercial finance company is about to make a $50 million project loan to develop a new
gas field and is concerned about the risks involved if petroleum geologists’ estimates of the
field’s potential yield turn out to be much too high and the field developer cannot repay.
One possibility for solving this problem is to use a credit option. If the developer cannot repay
the loan then the option would pay off. They would lose their premium if the developer can
repay the loan but they are protected against significant loss.
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c. A bank holding company plans to offer new bonds in the open market next month, but knows
that the company’s credit rating is being reevaluated by credit-rating agencies. The holding
company wants to avoid paying sharply higher credit costs if its rating is lowered by the
investigating agencies.
A credit risk option would be a good solution to this problem because it protects the bank from
higher borrowing costs in the future. If the borrowing costs rise above the spread specified in
the option contract, the contract would pay off.
d. A mortgage company is concerned about possible excess volatility in its cash flow off a group
of commercial real estate loans supporting the building of several apartment complexes.
Moreover, many of these loans were made at fixed interest rates, and the company’s economics
department has forecast a substantial rise in capital market interest rates. The company’s
management would prefer a more stable cash flow emerging from this group of loans if it could
find a way to achieve it.
One possibility to solve this problem would be to enter into a total return swap with another
bank. The other bank would receive total payments of interest and principal on this loan as well
as the price appreciation on this loan. The original bank would receive LIBOR plus some spread
in return as well as compensation for any depreciation in value of the loan.
e. First National Bank of Ashton serves a relatively limited geographic area centered upon a
moderate-sized metropolitan area. It would like to diversify its loan income but does not wish to
make loans in other market areas due to its lack of familiarity with loan markets outside the
region it has served for many years. Is there a derivative contract that could help the bank
achieve the loan portfolio diversification it seeks?
This bank could enter into a credit swap with another bank. This swap agreement means that
the two banks simply exchange a portion of their customers’ loan repayments. The purpose of
this type of swap agreement is to help the two banks diversify their market area with having to
make loans in an unfamiliar area.
CHAPTER 10
THE INVESTMENT FUNCTION IN FINANCIAL-SERVICES MANAGEMENT
Goal of This Chapter: The purpose of this chapter is to discover the types of securities that financial
institutions acquire for their investment portfolio and to explore the factors that a manager should
consider in determining what securities a financial institution should buy or sell.
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Key Topics in This Chapter
•
•
•
•
•
•
•
Nature and Functions of Investments
Investment Securities Available: Advantages and Disadvantages
Measuring Expected Returns
Taxes, Credit, and Interest Rate Risks
Liquidity, Prepayment, and Other Risks
Investment Maturity Strategies
Maturity Management Tools
Chapter Outline
I. Introduction: The Roles Performed by Investment Securities in Bank Portfolios
II. Investment Instruments Available to Banks and Other Financial Firms
III. Popular Money-Market Instruments
A. Treasury Bills
B. Short-Term Treasury Notes and Bonds
C. Federal Agency Securities
D. Certificates of Deposit
E. International Eurocurrency Deposits
F. Bankers' Acceptances
G. Commercial Paper
H. Short-Term Municipal Obligations
IV. Popular Capital Market Instruments
A. Treasury Notes and Bonds
B. Municipal Notes and Bonds
C. Corporate Notes and Bonds
V. Investment Instruments Developed More Recently
A. Structured Notes
B. Securitized Assets
C. Stripped Securities
VI. Investment Securities Actually Held by Banks
VII. Factors Affecting Choice of Investment Securities
A. Expected Rate of Return
B. Tax Exposure
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1. The Tax Status of State and Local Government Bonds
2. The Impact of Changes in Tax Laws
3. Bank Qualified Bonds
4. Tax Swapping Tool
5. The Portfolio Shifting Tool
C. Interest-Rate Risk
D. Credit or Default Risk
E. Business Risk
F. Liquidity Risk
G. Call Risk
H. Prepayment Risk
I. Inflation Risk
J. Pledging Requirements
VIII. Investment Maturity Strategies
A. The Ladder or Spaced-Maturity, Policy
B. The Front-End Load Maturity Policy
C. The Back-End Load Maturity Policy
D. The Barbell Strategy
E. The Rate Expectations Approach
IX. Maturity Management Tools
A. The Yield Curve
1. Forecasting Interest Rates and the Economy
2. Risk-Return Trade-Offs
3. Pursuing the Carry Trade
4. Riding the Yield Curve
B. Duration
1. Immunization
X. Summary of the Chapter
Concept Checks
10-1. Why do banks and other institutions choose to devote a significant portion of their assets to
investment securities?
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Investments perform many different roles that act as a necessary complement to the advantages loans
provide. Investments generally have less credit risk than loans, allow the bank or thrift institution to
diversify into different localities than most of its loans permit, provide additional liquid reserves in case
more cash is needed, provide collateral as called for by law and regulation to back government deposits,
help to stabilize bank income over the business cycle, aid banks in reducing their exposure to taxes, and
also act as hedge against losses due to changing interest rates.
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10-2.
What key roles do investments play in the management of a depository institution?
See answer to 10-1
10-3. What are the principal money market and capital market instruments available to institutions
today? What are their most important characteristics?
Banks purchase a wide range of investment securities. The principal money market instruments
available to banks today are Treasury bills, federal agency securities, CD's issued by other depository
institutions, Eurodollar deposits, bankers' acceptances, commercial paper, and short-term municipal
obligations. The common characteristics of most these instruments is their safety and high
marketability. Capital market instruments available to banks include Treasury notes and bonds,
municipal notes and bonds, and corporate notes and bonds. The characteristics of these securities is
their long run income potential.
10-4.
What types of investment securities do banks seem to prefer the most? Can you explain why?
Commercial banks clearly prefer these major types of investment securities: United States Treasury
securities, federal agency securities, and state and local government (municipal) bonds and notes. They
hold small amounts of equities and other debt securities (mainly corporate notes and bonds). They pick
these types because they are best suited to meet the objectives of a banks investment portfolio, such as
tax sheltering, reducing overall risk exposure, a source of liquidity and naturally generating income as
well as diversifying their assets.
10-5.
What are securitized assets? Why have they grown so rapidly in recent years?
Securitized assets are loans that are placed in a pool and, as the loans generate interest and principal
income, that income is passed on to the holders of securities representing an interest in the loan pool.
These loan-backed securities are attractive to many banks because of their higher yields and frequent
federal guarantees (in the case, for example, of most home-mortgage-backed securities) as well as their
relatively high liquidity and marketability
10-6.
What special risks do securitized assets present to institutions investing in them?
Securitized assets often carry substantial interest-rate risk and prepayment risk, which arises when
certain loans in the securitized-asset pool are paid off early by the borrowers (usually because interest
rates have fallen and new loans can be substituted for the old loans at cheaper loan rates) or are
defaulted. Prepayment risk can significantly decrease the values of securities backed by loans and
change their effective maturities. Also, the substantial weaknesses among these investments, including
sharp deterioration in their market values as the underlying assets (loans) experienced a significant rise
in default rates.
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10-7.
What are structured notes and stripped securities? What unusual features do they contain?
Structured notes usually are packaged investments assembled by security dealers that offer customers
flexible yields in order to protect their customers' investments against losses due to inflation and
changing interest rates. Most structured notes are based upon government or federal agency securities.
Stripped securities consist of either principal payments or interest payments from a debt security. The
expected cash flow from a Treasury bond or mortgage-backed security is separated into a stream of
principal payments and a stream of interest payments, each of which may be sold as a separate security
maturing on the day the payment is due. Some of these stripped payments are highly sensitive to
changes in interest rates. In particular, stripped securities offer interest-rate hedging possibilities to help
protect an investment portfolio against loss from interest-rate changes.
10-8.
How is the expected yield on most bonds determined?
For most bonds, this requires the calculation of the yield to maturity (YTM) if the bond is to be held to
maturity or the planned holding period yield (HPY) between point of purchase and point of sale. YTM is
the expected rate of return on a bond held until its maturity date is reached, based on the bond's
purchase price, promised interest payments, and redemption value at maturity. HPY is a rate of discount
bringing the current price of a bond in line with its stream of expected cash inflows and its expected sale
price at the end of the bank's holding period.
10-9. If a government bond is expected to mature in two years and has a current price of $950, what
is the bond's YTM if it has a par value of $1,000 and a promised coupon rate of 10 percent? Suppose this
bond is sold one year after purchase for a price of $970. What would this investor's holding period yield
be?
The relevant formula is:
$950 =
$100
$100
$1000
+
+
1
2
(1 + YTM) (1 + YTM)
(1 + YTM)2
Using a financial calculator we get:
YTM = 12.99%
If the bond is sold after one year, the formula entries change to:
$950 =
$100
$970
+
1
(1 + HPY)
(1 + HPY)1
and the HPY is:
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HPY = 12.63%
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10-10. What forms of risk affect investments?
The following forms of risk affect investments: interest-rate risk, credit risk, business risk, liquidity risk,
prepayment risk, call risk, and inflation risk. Interest-rate risk captures the sensitivity of the value of
investments to interest-rate movements, while credit risk reflects the risk of default on either interest or
principal payments. Business risk refers to the impact of credit conditions and the economy, while
liquidity risk focuses on the price stability and marketability of investments. Prepayment risk is specific
to certain types of investments and focuses on the fact that some loans which the securities are based
on can be paid off early. Call risk refers to the early retirement of securities and inflation risk refers to
their possible loss of purchasing power.
10-11. How has the tax exposure of various U.S. bank security investments changed in recent years?
In recent years, the government has treated interest income and capital gains from most bank
investments as ordinary income for tax purposes. In the past, only interest was treated as ordinary
income and capital gains were taxed at a lower rate. Tax reform in the United States has also had a
major impact on the relative attractiveness of state and local government bonds as bank investments,
limiting bankers’ ability to deduct borrowing costs for tax purposes when borrowing money to buy
municipal securities.
10-12. Suppose a corporate bond an investment officer would like to purchase for her bank has a
before-tax yield of 8.98 percent and the bank is in the 35 percent federal income tax bracket. What is
the bond's after-tax gross yield? What after tax rate of return must a prospective loan generate to be
competitive with the corporate bond? Does a loan have some advantages for a lending institution that a
corporate bond would not have?
After-tax Gross Yield on Corporate Bond = 8.98 %( 1 - 0.35) = 5.84%.
A prospective loan must generate a comparable yield to that of the bond to be competitive. However,
granting a loan to a corporation may have the added advantage of bringing in additional service
business for the bank that merely purchasing a corporate bond would not do. In this case the bank
would accept a somewhat lower yield on the loan compared to the bond in anticipation of getting more
total revenue from the loan relationship due to the sale of other bank services.
10-13. What is the net after-tax return on a qualified municipal security whose nominal gross return is
6 percent, the cost of borrowed funds is 5 percent, and the financial firm holding the bond is in the 35
percent tax bracket? What is the tax-equivalent gross yield (TEY) on this tax-exempt security?
Net After-Tax Return = (.06 - .05) + (0.35 x 0.80 x .05) = 0.024 or 2.4%
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The security's tax-equivalent yield in gross terms is 6 %/( 1-0.35) or 9.23%.
10-14. Spiro Savings Bank currently holds a government bond valued on the day of its purchase at $5
million, with a promised interest yield of 6-percent, whose current market value is $3.9 million.
Comparable quality bonds are available today for a promised yield of 8 percent. What are the
advantages to Spiro Savings from selling the government bond bearing a 6 percent promised yield and
buying some 8 percent bonds?
In this instance the bank could sell the 6-percent bonds, buy the 8 percent bonds, and experience an
extra 2 percent in yield. The bank would experience a capital loss of $1.1 million from the bond's book
value, but the after-tax loss would be only $1.1 million * (1-0.35) or $0.715 million.
10-15. What is tax swapping? What is portfolio shifting? Give an example of each?
A tax swap involves exchanging one type of investment security for another when it is advantageous to
do so in reducing the bank's current or future tax exposure. For example, the bank may sell loweryielding securities at a loss in order to reduce its current taxable income, while simultaneously
purchasing new higher-yielding securities in order to boost future returns on its investment portfolio or
to replace taxable securities with tax-exempt securities. Portfolio switching which involves selling certain
securities out of a bank's portfolio, often at a loss, and replacing them with other securities, is usually
carried out to gain additional current income, add to future income, or to minimize a bank's current or
future tax liability. For example, the bank may shift its holdings of investment securities by selling off
selected lower-yielding securities at a loss, and substituting higher-yielding securities in order to offset
large amounts of loan income.
10-16. Why do depository institutions face pledging requirements when they accept government
deposits?
Pledging requirements are in place to safeguard the deposit of public funds. The first $100,000 of public
deposits is covered by federal deposit insurance; the rest must be backed up by bank holdings of U.S.
Treasury and federal agency securities valued at their par values.
10-17. What types of securities are used to meet collateralization requirements?
When a bank borrows from the discount window of its district Federal Reserve bank, it must pledge
either federal government securities or other collateral acceptable to the Fed. Typically, banks will use
U.S. Treasury securities to meet these collateral requirements. If the bank raises funds through
repurchase agreements (RPs), banks must pledge securities, typically U.S. Treasury and federal agency
issues, as collateral in order to borrow at the low RP interest rate.
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10-18. What factors affect a financial-service institution’s decision regarding the different maturities of
securities it should hold?
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In choosing among various maturities of short-term and long-term securities to hold, the financial
institution needs to carefully consider the use of two key maturity management tools - the yield curve
and duration. These two tools help management understand more fully the consequences and potential
impact on earnings and risk of any particular maturity mix of securities they choose.
10-19. What maturity strategies do financial firms employ in managing their portfolios?
In choosing the maturity distribution of securities to be held in the financial firm’s investment portfolio
one of the following strategies typically is chosen by most institutions:
a. The Ladder or Spread-Maturity Strategy
b. The Front-End Load Maturity Strategy
c. The Back-End Load Maturity Strategy
d. The Barbell Strategy
e. The Rate Expectation Approach
The ladder or spaced-maturity strategy involves equally spacing out a bank's security holdings over its
preferred maturity range to stabilize investment earnings. The front-end load maturity strategy implies
that a bank will pile up its security holdings into the shortest maturities to have maximum liquidity and
minimize the risk of loss due to rising interest rates. The back-end loaded maturity policy calls for placing
all security holdings at the long-term end of the maturity spectrum to maximize potential gains if
interest rates fall and to earn the highest average yields. In contrast, the bar-bell strategy places a
portion of the bank's security holdings at the short-end of the maturity spectrum and the rest at the
longest maturities, thus providing both liquidity and maximum income potential. Finally, the rate
expectations approach calls for shifting maturities toward the short end if rates are expected to rise and
toward the long-end of the maturity scale if interest rates are expected to fall.
10-20. Bacone National Bank has structured its investment portfolio, which extends out to four-year
maturities, so that it holds about $11 million each in one-year, two-year, three-year and four-year
securities. In contrast, Dunham National Bank and Trust holds $36 million on one- and two-year
securities and about $30 million in 8- to 10-year maturities. What maturity strategy is each bank
following? Why do you believe that each of these banks has adopted the particular strategy it has as
reflected in the maturity structure of its portfolio?
Bacone National Bank has structured its investment portfolio to include $11 million equally in each of
four one-year maturity intervals. This is clearly a spaced maturity or ladder policy. In contrast, Dunham
National Bank holds $36 million in one and two-year securities and about $30 million in 8 and 10-year
maturities, which is clearly a barbell strategy. Dunham National Bank pursues its strategy to provide
both liquidity (from the short maturities) and high income (from the long maturities), while Bacone
National is a small bank that needs a simple-to-execute strategy.
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10-21. How can the yield curve and duration help an investment officer choose which securities to
acquire or sell?
Yield curves possibly provide a forecast of the future course of short-term rates, telling us what the
current average expectation is in the market. The yield curve also provides an indication of equilibrium
yields at varying maturities and, therefore, gives an indication if there are any significantly underpriced
or overpriced securities. Finally, the yield curve's shape gives the bank's investment officer a measure of
the yield trade-off - that is, how much yield will change, on average, if a security portfolio is shortened
or lengthened in maturity.
Duration tells a bank about the price volatility of its earning assets and liabilities due to changes in
interest rates. Higher values of duration imply greater risk to the value of assets and liabilities held by a
bank. For example, a loan or security with a duration of 4 years stands to lose twice as much in terms of
value for the same change in interest rates as a loan or security with a duration of 2 years.
10-22. A bond currently sells for $950 based on a par value of $1,000 and promises $100 in interest for
three years before being retired. Yields to maturity on comparable-quality securities are currently at 12
percent. What is the bond’s duration? Suppose interest rates in the market fall to 10 percent. What will
be the approximate percent change in the bond’s price?
Present
Present
Value
Value of
Weight
Cash
Factor
Cash
Of Each
Duration
Flow
at 12%
Flow
Cash Flow
Components
1
$100
0.893
$89.30
(89.30/950) = 0.0940
0.0940
2
100
0.797
79.70
(79.70/950) = 0.0839
0.1678
3
1100
0.712
783.20
(783.20/950) = 0.8244
2.4733
Year
2.7351 years
Clearly the bond's duration is 2.7351 years. If interest in the market fall to 10 percent, the approximate
percentage change in the bond's price will be:
Percentage Change in Price = − D x
i
x 100%
(1 + i)
= - 2.7351 x
- .02
x 100% = 4.884 percent
(1 + .12)
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Problems
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Chapter 01 - An Overview of the Changing Financial-Services Sector
10-1. A 10-year U.S. Treasury bond with a par value of $1000 is currently for $1015 from various
security dealers. The bond carries a 7.5-percent coupon rate with payments made annually. If purchased
today and held to maturity, what is its expected yield to maturity?
(Hint - the following relationships can help in solving for the yield:
If price < par value, then yield > coupon rate;
If price = par value, then yield = coupon rate;
If price > par value, then yield < coupon rate.)
Since the bond is selling at a premium, that is, price > par value, the yield will be less than the coupon
rate, or a yield < 7.5%.
The relevant formula is:
$1015 =
$75
$75
$75
$1000
+
+ ... +
+
1
2
10
(1 + YTM) (1 + YTM)
(1 + YTM)
(1 + YTM)10
YTM = 7.29% (using a financial calculator)
10-2. A municipal bond has a $1,000 face (par) value. Its yield to maturity is 6 percent, and the bond
promises its holders $75 per year in interest (paid annually) for the next 10 years before it matures.
What is the bond’s duration?
Annual
PV of
Time
Time
Interest
PV
Annual
Period
Weighted
Year
Income
@ 6%
Interest
Recorded
PV
1
$75
0.943
70.75
x
1
=
$70.75
2
$75
0.890
66.75
x
2
=
$133.50
3
$75
0.840
62.97
x
3
=
$188.91
4
$75
0.792
59.41
x
4
=
$237.64
5
$75
0.747
56.04
x
5
=
$280.20
6
$75
0.705
52.87
x
6
=
$317.22
7
$75
0.665
49.88
x
7
=
$349.16
8
$75
0.627
47.06
x
8
=
$376.48
9
$75
0.592
44.39
x
9
=
$399.51
10
$75
0.558
41.88
x
10
=
$418.80
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10
$1,000
0.558
558.39
x
1110.39
10
=
$5,583.90
$8,356.07
Then duration = $ 8,356.07 / $1,110.39 = 7.525years
10-3. Calculate the yield to maturity of a 20-year U.S. government bond that is selling for $1,050 in
today’s market and carries a 7 percent coupon rate with interest paid semiannually.
$1050 =
$35
$35
$35
$1000
+
+ ... +
+
1
2
40
(1 + YTM/2) (1 + YTM/2)
(1 + YTM/2)
(1 + YTM/2)40
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YTM/2 = 3.274%, YTM = 6.55% (using a financial calculator)
10-4. A corporate bond being seriously considered for purchase by First Security Savings Bank will
mature 20 years from today and promises a 12 percent interest payment once a year. Recent inflation in
the economy has driven the yield to maturity on this bond to 15 percent, and it carries a face value of
$1000. Calculate this bond’s duration.
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
20
Interest
Income
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$1,000
PV at
10%
0.9090
0.8260
0.7510
0.6830
0.6210
0.5640
0.5130
0.4670
0.4240
0.3860
0.3500
0.3190
0.2900
0.2630
0.2390
0.2180
0.1980
0.1800
0.1640
0.1490
0.1490
PV of
Annual
Interest
54.54
49.56
45.06
40.98
37.26
33.84
30.78
28.02
25.44
23.16
21.00
19.14
17.40
15.78
14.34
13.08
11.88
10.80
9.84
8.94
149.00
659.84
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
Time
Period
Recorded
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
20
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
Time
Weighted
PV
$54.54
$99.12
$135.18
$163.92
$186.30
$203.04
$215.46
$224.16
$228.96
$231.60
$231.00
$229.68
$226.20
$220.92
$215.10
$209.28
$201.96
$194.40
$186.96
$178.80
$2,980.00
$6,816.58
Therefore, the bond's duration is: $6,816.58/$659.84 = 10.33 years.
10-5. Lifelong Savings Bank regularly purchases municipal bonds issued by small rural school districts
in its region of the state. At the moment, the bank is considering purchasing an $8 million general
obligation issue from the York school district, the only bond issue that district plans this year. The bonds,
which mature in 15 years, carry a nominal annual rate of return of 6.75 percent. Lifelong Savings, which
is in the top corporate tax bracket of 35 percent, must pay an average interest rate of 5.5 percent to
borrow the funds needed to purchase the municipals. Would you recommend purchasing these bonds?
Calculate the net after-tax return on this bank-qualified municipal security. What is the tax advantage
for being a qualified bond?
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Because these bonds were issued by a small governmental unit issuing less than $10 million in securities
annually, the interest cost the bank has to pay to acquire the funds needed to buy these bonds is tax
deductible. Therefore, their net after-tax return is:
Net A.T.R
= (6.75% - 5.5%) + (0.80 x 0.35 x 5.5%)
= 6.75% -5.5% + 1.54%
= 2.79%
This net yield figure should be compared with other investments of comparable risk on an after-tax
basis. However, the tax-exempt status of the income coupled with the tax-deductibility of the interest
expense make these bonds a very attractive alternative.
10-6. Lifelong Savings Bank also purchases municipal bonds issued by the city of Richmond. Currently
the bank is considering a nonqualified general obligation municipal issue. The bonds, which mature in 15
years, provide a nominal annual rate of return of 10.25 percent. Lifelong Savings Bank has the same cost
of funds and tax rate as stated in the previous problem.
a. Calculate the net after tax return on this nonqualified municipal security
Net A.T.R. = 10.25 – 5.5 = 4.75 percent
b. What is the difference in the net after-tax return for this qualified security (problem 6) versus
the nonqualified municipal security?
Net A.T.R (qualified security) – Net A.T.R (nonqualified municipal security)
= 2.79% - 4.75%
= 1.96%
Therefore, the net A.T.R for qualified security is 1.96% less than the nonqualified municipal security.
c. Discuss the pros and cons of purchasing the nonqualified rather than the bank qualified
municipal described in the previous problem.
Clearly, the net after tax return for the nonqualified bond is higher than for the qualified bond. On the
other hand, nonqualified bonds are less liquid and thus, carry a higher liquidity risk (they also tend to
have a higher default risk, but that should already be priced into the yield of the bond.
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10-7. Lakeway Thrift savings and Trust is interested in doing some investment portfolio shifting. This
institution has had a good year thus far with strong loan demand; its loan revenue has increased by 16
percent over last year’s level. Lakeway is subject to the 35 percent corporate income tax rate. The
investments officer has several options in the form of bonds that have been held for some time in its
portfolio:
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a. Selling $4 million in 12-year City of Dallas bonds with a coupon rate of 7.5 percent and
purchasing $4 million in bonds from Bexar County (also with 12-year maturities) with a coupon
rate of 8% and issued at par. The Dallas bonds have a current market value of $3,750,000 but
are listed at par on the thrift institution’s books
b. Selling $4 million in 12-year U.S. Treasury bonds that carry a coupon rate of 12% and are
recorded at par, which was the price when the bank purchased them. The market value of these
bonds has risen to $4,330,000.
Which of these two portfolio shifts would you recommend? Is there a good reason for not selling the
Treasury bonds? What other information is needed to make the best decision? Please explain.
Under Option A Lakeway will take an immediate $4 million - $3.75 million, or $250,000, loss before taxes
(or a loss of $162,500 after taxes) which can be used to help offset the high taxable loan income earned
this year. Moreover, the thrift will be able to earn 8% on an investment of $4 million, or $320,000, in
annual interest income compared to only $300,000 with the bonds currently held or a gain in taxexempt income of $20,000 per year. (Of course, if the thrift can only afford to buy $3,750,000 in new
municipals - the sale price of the old bonds - it will generate about $300,000 in after-tax interest and
have no net gain in tax-exempt interest income, but will still have a tax-deductible loss on the sale of the
old bonds.)
Under Option B the U.S. Treasury bonds must be sold for a gain of $330,000 which is taxable income.
Because Lakeway does not need additional taxable income, Option B is less desirable than Option A.
Besides, the Treasury bonds are selling at a premium above par which indicates their coupon rate is
higher than current interest rates on investments of comparable risk, suggesting the wisdom of
retaining these bonds in the bank's portfolio either until loan revenues decline and the bank needs
additional taxable income or until interest rates rise well above current levels and new securities appear
that promise significantly higher interest yields.
10-8.
Current market yields on U.S. government securities are distributed by maturity as follows:
3-month Treasury bills
6-month Treasury bills
1-year Treasury notes
2-year Treasury notes
3-year Treasury notes
5-year Treasury notes
7-year Treasury notes
10-year Treasury bonds
20-year Treasury bonds
30-year Treasury bonds
=
=
=
=
=
=
=
=
=
=
1.85
1.99
2.17
2.51
2.82
3.28
3.56
3.98
4.69
4.68
percent
percent
percent
percent
percent
percent
percent
percent
percent
percent
Draw a yield curve for the above securities. What shape does the curve have? What significance might
this yield curve have for an investing institution with 75 percent of its investment portfolio in 7-year to
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30-year Treasury bonds and 25 percent in U.S. government bills and notes under one year? What would
you recommend to management?
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The yield curve for U.S. Treasury bonds clearly slopes upward and declines for 30-year maturities. Like
most yield curves this curve does not become flat at longer maturities, but declines slightly at 30-year
maturity segment. A financial institution with 75 percent of its portfolio in this 7- to 30-year range gains
very little yield advantage over those institutions holding shorter maturities in the form of 3-month bills
to 5-year notes. Yet, the longer-term bonds are less liquid so that a bank holding 7+-year maturities
faces substantially greater liquidity risk. This bank would probably be better off to do some portfolio
shifting into medium-term maturities.
10-9. A bond possesses a duration of 7.68 years. Suppose that market interest rates on comparable
bonds were 7 percent this morning, but have now shifted upward to 7.25 percent. What percentage
change in the bond’s value occurred when interest rates increased by 25 basis points?
Percent Change in Value =
 + .0025  − 1.92
= −.0179 or 1.79%
=
 1 + .07  1.07
7.68 
10-10. The investment officer for Sillistine Savings is concerned about interest-rate risk lowering the
value of the institution’s bonds. A check of the bond portfolio reveals an average duration of 4.5 years.
How could this bond portfolio be altered in order to minimize interest rate risk within the next year?
Sillistine’s bond portfolio has an average duration of 4.5 years. This is relatively long, subjecting them to
substantial interest-rate risk. Shortening the duration of the portfolio or the use of hedging tools (such
as futures and options) is recommended.
10-11. A bank’s economic department has just forecast accelerated growth in the economy with GDP
expected to grow at a 4.5 percent annual growth rate for at least the next two years. What are the
implications of this economic forecast for an investment officer? What types of securities should the
officer think most seriously about adding to the investment portfolio? Why? Suppose the bank holds a
security portfolio similar to that described in Table 10-3 for all insured U.S. banks. Which type of
securities might the investments officer want to think seriously about selling if the projected economic
expansion takes place? What losses might occur and how could these losses be minimized?
This economic forecast suggests that the current yield curve should be upward sloping and that interest
rates will rise over the next two years. In addition, loan demand should increase as the economy
expands suggesting that the bank may have to sell some of its investment portfolio in the future to meet
that demand. The investment officer would probably shorten the maturities of the investment portfolio.
An exception to this might be if the investment officer wants to ride the yield curve by selling shorter
term securities at a premium today and replacing them with longer maturity securities with higher
coupon rates. However, the investment manager must take into account the risk of capital losses for the
future with this strategy. The investment manager can reduce his risks with the appropriate hedging
tools as discussed in previous chapters.
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10-12. Contrary to the exuberant economic forecast described in problem 11, suppose a bank’s
economic department is forecasting a significant recession in economic activity. Output and
employment are projected to decline significantly over the next 18 months. What are the implications of
this forecast for an investment portfolio manager? What is the outlook for interest rates and inflation
under the foregoing assumption? What types of investment securities would you recommend as good
additions to the portfolio during the period covered by the recession forecast and why? What other
kinds of information would you like to have about the bank’s current balance sheet and earnings report
in order to help you make the best quality decisions regarding the investment portfolio?
This economic forecast suggests that the current yield curve should be flat or downward sloping and
interest rates and inflation should fall over the next 18 months. In addition, loan demand should decline
in the future as output and employment decline. The portfolio manager should lengthen the maturities
of the investment portfolio and lock in higher rates now. However, the investment manager should look
at the bank’s current interest-sensitive gap and duration gap position as well as their current earnings
and tax status and consider these aspects of the bank’s balance sheet before making any decisions.
10-13. Arrington Hills Savings Bank, a $3.5 billion asset institution, holds the investment portfolio
outlined in the following table. The savings bank serves a rapidly growing money center into which
substantial numbers of businesses are relocating their corporate headquarters. Suburban areas around
the city are also growing rapidly as large numbers of business owners and managers along with retired
professionals are purchasing new homes. Would you recommend any change in the makeup of this
investment portfolio? Please explain why.
Types of Securities Held
U.S. Treasury securities
Percent
of Total
Portfolio Types of Securities Held
38.70% Securities available for sale
Percent
of Total
Portfolio
45.60%
Securities with Maturities:
Federal agency securities
35.20% Under one year
11.30%
State and local government
obligations
15.50% One to five years
37.90%
Domestic debt securities
5.10% Over five years
50.80%
Foreign debt securities
4.90%
Equities
0.60%
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This bank is going to experience increasing loan demand in the future. This may mean increased taxes in
the future, increased liquidity risk and increased credit risk from its loan portfolio. To help with the
liquidity risk, the bank may want to consider shifting some of its portfolio from securities with more than
five years to maturity to shorter term securities. In terms of the increased taxes and credit risk, it
depends on which one of these is more important. The proportion of the municipal bonds in this bank’s
portfolio is already higher than the average bank of its size. The bank may want to reduce its credit risk
by reducing its municipal bond portfolio. However, this bank does have other ways of reducing its credit
risk and it may want to decrease its taxability by increasing its investment in municipal bonds.
CHAPTER 11
LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES AND POLICIES
Goal of This Chapter: The purpose of this chapter is to explore the reasons why financial institutions
often face heavy demands for immediately spendable funds (liquidity) and learn about the methods
they can use to prepare for meeting their cash needs.
Key Topics in This Chapter
•
•
•
•
•
•
Sources of Demand for and Supply of Liquidity
Why Financial Firms Have Liquidity Problems
Liquidity Management Strategies
Estimating Liquidity Needs
The Impact of Market Discipline
Legal Reserves and Money Management
Chapter Outline
I. Introduction: Meaning of Liquidity
II. The Demand for and Supply of Liquidity
A. Sources of Liquidity Demands
B. Sources of Liquidity Supplies
C. Net Liquidity Position and Liquidity Surpluses and Deficits
III. Why Financial Firms Often Face Significant Liquidity Problems
A. Maturity Mismatches
B. Sensitivity to Changes in Market Interest Rates
C. Meeting Demand for Liquidity and Public Confidence
IV. Strategies for Liquidity Managers
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A. Asset Liquidity Management (or Asset Conversion) Strategies
B. Borrowed Liquidity (Liability) Management Strategies
C. Balanced Liquidity Management Strategies
D. Guidelines for Liquidity Managers
V. Estimating Liquidity Needs
A. The Sources and Uses of Funds Approach
B. The Structure of Funds Approach
C. Liquidity Indicator Approach
D. The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace
1. Public confidence
2. Stock price behavior
3. Risk premiums on CDs and other borrowings
4. Loss sales of assets
5. Meeting commitments to credit customers
6. Borrowings from the central bank
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VI. Legal Reserves and Money Position Management
A. The Money Position Manager
B. Legal Reserves
C. Regulations on Calculating Legal Reserve Requirements
1. Reserve Computation
2. Reserve Maintenance
3. Reserve Requirements
4. Calculating Required Reserves
5. Penalty for a Reserve Deficit
6. Clearing Balances
D. Factors Influencing the Money Position
1. Controllable Factors
2. Noncontrollable Factors
3. An Example
4. Use of the Federal Funds Market
5. Other Options besides Fed Funds
6. Bank Size and Borrowing and Lending Reserves for the Money Position
7. Overdraft Penalties
VII. Factors in Choosing among the Different Sources of Reserves
A. Immediacy of need
B. Duration of need
C. Access to the market for liquid funds
D. Relative costs and risks of alternative sources of funds
E. The interest rate outlook
F. Outlook for central bank monetary policy
G. Rules and regulations applicable to a liquidity source
VIII. Central Bank Reserve Requirements around the Globe
IX. Summary of the Chapter
Concept Checks
11-1.
What are the principal sources of liquidity demand for a financial firm?
The most pressing demands for liquidity arise principally from customers withdrawing money from their
deposits and from credit requests. However, demands for liquidity can also come from paying off
previous borrowings, operating expenses and taxes incurred during operations and from payment of a
cash dividend to stockholders.
11-2.
What are the principal sources from which the supply of liquidity comes?
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Supplies of funds stem principally from incoming deposits, sales of assets, particularly marketable
securities and repayments of outstanding loans. Liquidity also comes from the sale of nondeposit
services and borrowings from the money market.
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11-3. Suppose that a bank faces the following cash inflows and outflows during the coming week: (a)
deposit withdrawals are expected to total $33 million, (b) customer loan repayments are expected to
amount to $108 million, (c) operating expenses demanding cash payment will probably approach $51
million, (d) acceptable new loan requests should reach $294 million, (e) sales of bank assets Concept
Check are projected to be $18 million, (f) new deposits should total $670 million, (g) borrowings from
the money market are expected to be about $43 million, (h) nondeposit service fees should amount to
$27 million, (i) previous bank borrowings totaling $23 million are scheduled to be repaid, and (j) a
dividend payment to bank stockholders of $140 million is scheduled. What is this bank’s projected net
liquidity position for the coming week?
(In millions of dollars)
Cash Inflows
Customer Loan Repayments
Cash Outflows
$108
Sales of Bank Assets
New Deposits
Deposit Withdrawals
$33
18
Operating Expenses
51
670
New Loan Requests
294
Money-Market Borrowings
43
Repayment of Previous Borrowings
Nondeposit Service Fees
27
Dividend to Stockholders
Total Cash Inflows
$866
Total Cash Outflows
23
140
$541
Net Liquidity
Position
Total Cash
Total Cash
Projected for
= Inflows
- Outflows
the Coming Week
= $866 million - $541 million
= + $325 million
11-4.
When is a financial institution adequately liquid?
A financial institution is adequately liquid if it has adequate cash available precisely when cash is needed
at a reasonable cost. Management can monitor the cash position over time, and also monitor what is
happening to its cost of funds. One indicator of the adequacy of the liquidity position is its cost - a rising
interest cost may reflect greater perceived risk for the borrowing bank as viewed by capital-market
investors.
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11-5.
Why do financial firms face significant liquidity management problems?
Financial institutions are prone to liquidity management problems due to:
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(1) A maturity mismatch situation in which most depository institutions hold an unusually high
proportion of liabilities subject to immediate payment, especially demand (checkable) deposits and
money market borrowings;
(2) The sensitivity of changes to their assets and liabilities values towards market interest-rate
movements; and
(3) Their central role in the payments process.
11-6. What are the principal differences among asset liquidity management, liability management,
and balanced liquidity management?
Asset management is a strategy for meeting liquidity needs, used mainly by smaller banks, in which
liquid funds are stored in readily marketable assets that can be quickly converted into cash as needed.
Liability management involves borrowing enough immediately spendable funds to cover demands for
liquidity made against a bank. Balanced liquidity management calls for using both asset management
and liability management to cover a bank's liquidity needs.
11-7. What guidelines should management keep in mind when it manages a financial firm’s liquidity
position?
It is important for a liquidity manager to: (a) keep track of the activities of other departments within the
bank; (b) know in advance the planned activities of the bank's largest credit and deposit customers; (c)
set clear priorities and objectives in liquidity management; and (d) react quickly to liquidity deficits and
liquidity surpluses.
Liquidity managers must know what other departments within the institution are doing because their
activities affect the liquidity position and liquidity management decisions. The liquidity manager can
make better decisions to profitably invest surplus liquid funds or avoid costly, last-minute borrowings if
he or she knows what the bank's principal depositors and creditors will do in advance. By setting clear
priorities and objectives the liquidity manager has a better chance to make sound decisions plus an
ability to act quickly to invest surpluses in order to gain maximum income or avoid costly deficits and
prolonged borrowings.
11-8. How does the sources and uses of funds approach help a manager estimate a financial
institution’s need for liquidity?
The sources and uses of funds approach estimates future deposit inflows and estimated outflows of
funds associated with expected loan demand and calculates the net difference between these items in
each planning period.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
When sources and uses of liquidity do not match, there is a liquidity gap, measured by the size of the
difference between sources and uses of funds. When sources of liquidity (e.g., increasing deposits or
decreasing loans) exceed uses of liquidity (e.g., decreasing deposits or increasing loans) then the
financial firm will have a positive liquidity gap (surplus). Its surplus liquid funds must be quickly invested
in earning assets until they are needed to cover future cash needs. On the other hand, when uses
exceed sources, a financial institution faces a negative liquidity gap (deficit). It now must raise funds
from the cheapest and most timely sources available.
11-9. Suppose that a bank estimates its total deposits for the next six months in millions of dollars to
be, respectively, $112, $132, $121, $147, $151 and $139, while its loans (also in millions of dollars) will
total an estimated $87, $95, $102, $113, $101 and $124, respectively, over the same six months. Under
the sources and uses of funds approach, when does this bank face liquidity deficits, if any?
Estimated Total Deposits
Estimated Total Loans
$112
$87
132
95
121
102
147
113
151
101
139
124
Estimated Liquidity
Change in Deposits
Change in Loans
Deficit or Surplus
$ ---
$ ---
$ ---
+20
+8
+12
-11
+7
-18
+26
+11
+15
+4
-12
+16
-12
+23
-35
Clearly, the bank has projected liquidity surpluses (which should be profitably invested) in three out of
six months, but a deficit is estimated for the third and last month which will have to be covered through
borrowings and possibly through the sale of liquid assets.
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11-10. What steps are needed to carry out the structure of funds approach to liquidity management?
In the first step, the institution's deposits and other funds sources are divided into categories based
upon their estimated probability of being withdrawn and, therefore, lost to the financial firm. Second,
the liquidity manager must set aside liquid funds according to some desired operating rules for those
categories. Categories can include "hot money" liabilities, vulnerable funds, and stable funds.
11-11. Suppose that a thrift institution’s liquidity division estimates that it holds $19 million in hot
money deposits and other IOUs against which it will hold an 80 percent liquidity reserve, $54 million in
vulnerable funds against which it plans to hold a 25 percent reserve, and $112 million in stable or core
funds against which it will hold a 5 percent liquidity reserve. The thrift expects its loans to grow 8
percent annually; its loans currently stand at $117 million, but have recently reached $132 million. If
reserve requirements on liabilities currently stand at 3 percent, what is this depository institution’s total
liquidity requirement?
Total Liquidity Requirement
= 0.80 ($19 million - 0.03 x $19 million)
+ 0.25 ($54 million - 0.03 x $54 million)
+ 0.05 ($112 million - 0.03 x $112 million)
+ ($132 million +O.08 x $132 million - $117 million)
= $58.831 million
11-12. What is the liquidity indicator approach to liquidity management?
The liquidity indicator approach uses tell-tale financial ratios (e.g., total loans/total assets or cash
assets/total assets) whose changes over time may reflect the changing liquidity position of the financial
institution. The ratios are used to estimate liquidity needs and to monitor changes in the liquidity
position.
11-13. First National Bank posts the following balance sheet entries on today’s date: Net loans and
leases, $3,502 million; cash and deposits held at other banks, $633 million; Federal funds sold $48
million; U.S. government securities, $185 million; Federal funds purchased, $62 million; demand
deposits, $988 million; time deposits, $2,627 million; and total assets, $4,446 million. How many
liquidity indicators can be calculated from these figures?
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(In millions of dollars)
Liabilities
Assets
Cash Deposits held at
Federal Fund Purchased
$
62
other Banks
$ 633
U.S. Government securities
$ 185
Demand Deposits
$ 988
Net Loans and Losses
$3,502
Time Deposits
$2,627
Federal Funds Sold
$
Total Assets
$4,446
48
The liquidity indicators that we can construct from the foregoing figures include:
Cash Position Indicator:
Cash and Deposits Due from Other Banks
=
Total Assets
$633
=
14.24 percent
$4446
Net Federal Funds Position:
(Federal Funds Sold – Federal Funds Purchased)
=
($48 - $62)
Total Assets
$4446
Capacity Ratio:
Net Loans and Leases
Total Assets
=
$3,502
$4446
Deposit Composition Ratio:
1-258
=
77.77 percent
=
- 0.31 percent
Chapter 01 - An Overview of the Changing Financial-Services Sector
Demand Deposits
=
Time Deposits
$988
=
37.61 percent
$2,627
Liquid Securities Indicator:
U.S. Government Securities
=
Total Assets
$185
=
4.16 percent
$4446
11-14. How can the discipline of the marketplace be used as a guide for making liquidity management
decisions?
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No financial institution can tell for sure if it has sufficient liquidity until it has passed the market's test.
Specifically, management should look at these signals: public confidence, stock price behavior, risk
premiums on CDs and other borrowings, loss sales of assets, meeting commitments to credit customers
and borrowings from the Federal Reserve banks. If problems exist in any of these areas, management
needs to take a close look at its liquidity management practices to determine whether changes are in
order.
11-15. What is money position management?
Money position management is the management of a financial institution’s liquidity position that
requires quick decisions which may have long-run consequences on profitability. Most large depository
institutions have designated an officer of the firm as money position manager. A money position
manager is responsible for ensuring that the institution maintains an adequate level of legal reserves.
Legal reserve requirements apply to all qualified depository institutions, including commercial and
savings banks, savings and loan associations, credit unions, and agencies and branches of foreign banks
that offer transaction deposits or nonpersonal (business) time deposits or borrow through Eurocurrency
liabilities.
11-16. What is the principal goal of money position management?
The money-position management’s goal is to ensure that the bank has sufficient legal reserves to meet
its reserve requirements as imposed by the central bank. Also make sure that it holds not more than the
minimum legal requirement because excess legal reserves yield no income for the bank.
11-17. Exactly how is a depository institution’s legal reserve requirement determined?
Each reservable liability item is multiplied by the stipulated reserve requirement percentage set by the
Federal Reserve Board to derive the bank's total legal reserve requirements. Thus, total required legal
reserves equal the reserve requirement on transaction deposits times the daily average amount of net
transaction deposits over a designated period plus the reserve requirement on nontransaction
reservable liabilities times the daily average amount of nontransaction reservable liabilities. Currently
nontransaction liabilities have a reserve requirement of zero.
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11-18. First National Bank finds that its net transactions deposits average $140 million over the latest
reserve computation period. Using the reserve requirement ratios imposed by the Federal Reserve as
given in the textbook, what is the bank's total required legal reserve?
Total Required Legal Reserves
= 0.03 * [First $43.9-$9.3 million of Transaction Deposits] +
.10*[Amount of Transaction Deposits in Excess of $43.9 million]
= .03 * $34.6 + .10 * ($140 - $43.9)
= $1.038 million + $9.61 million
= $10.648 million
11-19. A U.S. savings bank has a daily average reserve balance at the Federal Reserve bank in its district
of $25 million during the latest reserve maintenance period. Its vault cash holdings averaged $1 million
and the savings bank's total transaction deposits (net of interbank deposits and cash items in collection)
averaged $200 million daily over the latest reserve maintenance period. Does this depository institution
have a legal reserve deficiency? How would you recommend that its management responds to the
current situation?
The bank's total required legal reserves must be:
Required Legal Reserves = 0.03 x [First $43.9 – $9.3 million of Transactions Deposits] +
0.10 x [Transactions Deposits Over $43.9 million]
= .03*$34.6 + .10*($200 - $43.9)
= $1.038 million + $15.61 million = $16.648 million
The average vault cash of $1 million plus the $25 million at the district Reserve Bank indicates total
maintained reserves of $26 million, meaning the bank is over required reserves by $9,352,000.
Management will have to plan how to invest this excess reserve taking into account any anticipated
drain on funds in the near future and taking into account any reserve deficit in the previous period.
11-20. What factors should a money position manager consider in meeting a deficit in a depository
institution’s legal reserve account?
Several factors must be taken into account by the money position manager, including current and
expected future levels of interest rates, projected changes in monetary policy, the bank's borrowing
capacity and current holdings of liquid assets, the bank's forecast of future deposit growth and loan
demand, the expected size and duration of any liquidity deficits or surpluses, and his or her knowledge
of the future plans of the bank's largest depositors and borrowers with credit lines.
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11-21. What are clearing balances? Of what benefit can clearing balances be to a depository that uses
the Federal Reserve System’s check-clearing network?
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Any financial institution using the Federal Reserve check clearing system has to maintain a minimum
balance with the Federal Reserve. The amount is determined by its estimated check clearing needs and
its recent record of overdrafts. The clearing balance can be a benefit because the institution earns
credits from holding this balance with the Fed and this credit can be used to pay the fees the Fed
charges for services.
11-22. Suppose a bank maintains an average clearing balance of $5 million during a period in which the
Federal funds rate averages 6 percent. How much would this bank have available in credits at the
Federal Reserve Bank in its district to help offset the charges assessed against the bank for using Federal
Reserve services?
Reserve Credit = Avg. Clearing Balance x Annualized Fed Funds Rate x 14 days/360 days
= $5,000,000 x .06 x 14/360 = $11,666.67
11-23. What are sweeps accounts? Why have they led to a significant decline in the total legal reserves
held at the Federal Reserve banks by depository institutions operating in the United States?
A sweeps account is a service provided by banks where they sweep money out of accounts that carry
reserve requirements (such as demand deposits and other checking accounts) into savings accounts
which do not carry reserve requirements overnight. This service lowers the bank’s overall cost of funds
while still allowing the customer access to their deposits for payments. These sweep arrangements
account for nearly $200 billion in deposit balances today and therefore have significantly reduced the
total reserve requirements of banks.
Problems
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11-1. Pretty Lake Hills State Bank estimates that over the next 24 hours the following cash inflow and
outflows will occur (all figures in millions of dollars):
Deposit withdrawals
$98 Sales of bank assets
40
Deposit inflows
87 Stockholder dividend payments
150
Scheduled loan repayments
89 Revenues from sale of nondeposit services
95
Acceptable loan requests
56 Repayments of bank borrowings
60
Borrowings from the money market
75 Operating expenses
45
What is this bank’s projected net liquidity position in the next 24 hours? From what sources can the
bank cover its liquidity needs?
Deposit withdrawals
$98
-
Deposit inflows
$87
+
Scheduled loan repayments
$89
+
Acceptable loan requests
$56
-
Borrowings from the money market
$75
+
Sales of bank assets
$40
+
$150
-
Revenues from sale of nondeposit
services
$95
+
Repayment of bank borrowings
$60
-
Operating expenses
$45
-
Stockholder dividend payments
= + [$87+ $89+ $75+ $40+ $95] - [$98+ $56+ $150+ $60+ $45]
= - $23 million.
Faced with an expected liquidity deficit Pretty Lake Hills State Bank could arrange to increase its money
market borrowings from other institutions or sell some of its assets or do some of both.
11-2. Mountain Top Savings is projecting a net liquidity deficit of $5 million next week partially as a
result of expected quality loan demand of $24 million, necessary repayments of previous borrowings of
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$15 million, disbursements to cover operating expenses of $18 million, planned stockholder dividend
payments of $5 million, expected deposit inflows of $26 million, revenues from nondeposit service sales
of $18 million, scheduled repayment of previously made customer loans of $23 million, asset sales of
$10 million, and money market borrowings of $15 million. How much must Mountain Top’s expected
deposit withdrawals be for the coming week?
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Supplies of Liquidity Flowing into the Mountain Top Savings
Expected deposit inflows
Revenues from nondeposit service
sales
$26 million
18 million
Scheduled repayments of prev.
made customer loans
23 million
Asset sales
10 million
Money market borrowings
15 million
Total Source of Liquidity
$92 million
Demands on the Mountain Top Savings for
Liquidity
Expected quality loan demand
$24 million
Necessary repayments of
previous borrowings
15 million
Disbursements to cover
operating expenses
18 million
Stockholder dividend payments
5 million
Total Uses of Liquidity Excluding
Deposit Withdrawals
Then Net Liquidity Deficit
$62 million
= Liquidity Supplies - Liquidity Demands - Deposit Withdrawals
- $5 million = $88 million - $62 million - Deposit Withdrawals
Therefore, expected deposit withdrawals must equal $31 million for the next week.
11-3. First National Bank of Lawrenceville has forecast its checkable deposits, time and savings
deposits, and commercial and household loans over the next eight months. The resulting estimates (in
millions) are shown in below. Use the sources and uses of funds approach to indicate which months are
likely to result in liquidity deficits and which in liquidity surpluses if these forecasts turn out to be true.
Explain carefully what you would do to deal with each month’s projected liquidity position.
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Checkable
Time and Savings
Commercial
Consumer
Deposits
Deposits
Loans
Loans
January
120
550
650
140
February
115
500
650
200
March
100
500
700
200
April
90
485
700
150
May
105
465
710
150
June
80
490
700
175
July
90
525
700
175
August
100
515
675
175
Month
Solution:
Change
Change
Total
from Previous
Total
from Previous
Deposits
Month
Loans
Month
January
670
----
790
----
February
615
-55
850
March
600
-15
April
575
May
Month
Source
Use
Net
+60
0
115
-115
900
+50
0
65
-65
-25
850
-50
50
25
+25
570
- 5
860
+10
0
19
-15
June
570
0
875
+15
0
15
-15
July
615
+45
875
0
45
15
+45
August
615
+ 0
850
-25
25
0
+25
January-February, February-March, April-May and May-June will all have liquidity deficits as a result of
decreasing deposits, increasing assets, or both. March-April, June-July, and July-August will all have
liquidity surpluses as a result of increasing deposits, decreasing loans, or both.
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First National has several options available:
January-February, February-March, April-May and May-June the bank faces deficits ranging from $15 to
$115 million. These deficits can be met by:
1. aggressive advertising to attract NOW deposits,
2. issuing negotiable CDs in the money market,
3. if they have a holding company, the holding company could sell commercial paper and pass the
proceeds through to the bank subsidiary,
4. borrowing Federal funds,
5. borrowing from the Federal Reserve district bank (although this is not a likely alternative for
most banks),
6. selling securities under agreements to repurchase,
7. selling some of their loans,
8. selling some of their securities, or
9. a combination of a number of these alternatives.
March-April, June-July, and July-August the bank faces anticipated surpluses ranging from $25 to $45
million. These surpluses afford the bank the opportunity to:
1. aggressively pursue new loans,
2. invest in various money market instruments, such as Treasury securities, or,
3. a combination of these alternatives.
Since both periods are relatively short lived, the bank should opt for more temporary measures, that is,
use of the money market. However, if their longer-term forecasts hold promise for continued growth,
they may well want to develop strategies for attracting more deposits and loans, as well.
11-4. King Savings is attempting to determine its liquidity requirements today (the last day of August)
for the month of September. September is usually a month of heavy loan demand due to the beginning
of the school term and the buildup of business inventories of goods and services for the fall season and
winter. This thrift institution has analyzed its deposit accounts thoroughly and classified them as
explained below.
Management has elected to hold a 75 percent reserve in liquid assets or borrowing capacity for
each dollar of hot money deposits, a 20 percent reserve behind vulnerable deposits and a 5 percent
reserve for its holdings of core funds. Assume time and savings deposits carry a zero percent reserve
requirement and all checkable deposits carry a 3 percent reserve requirement. King currently has total
loans outstanding of $2,389 million, which two weeks ago were as high as $2,567 million. Its loans’
mean annual growth over the past three years has been about 8 percent. Carefully prepare low and high
estimates for King’s total liquidity requirement for September.
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Checkable Deposits
Savings Deposits
Time
Deposits
Hot money funds
$10
$____
$782
Vulnerable funds
22
152
540
Stable (core) funds
30
285
172
Millions of Dollars
Checkable
Savings
Nonpersonal
deposits
deposits
time deposits
Hot money funds
$10
----
782
792
Vulnerable funds
22
152
540
714
Stable (core) funds
$30
285
172
487
62
437
1,494
1,993
Source
Totals
Totals
Deposit Liquidity Requirement = 0.75 [Net "Hot Money" Funds] + 0.20 [Net Vulnerable Funds]
+ 0.05 [Net "Core" Funds]
a) Net Hot Money Funds = [$10 million - ($10 million * 0.03)] + [$0 million] + [$782 million]
= $9.7 + $0 + $782 = $791.7 million
(b) Net Vulnerable Funds = [$22 million - ($22 million * 0.03)] + [$152 million] + [$540
= $21.34 + $152 + $540 = $713.34 million
million]
(c) Net Core Funds = [$30 million - ($30 million * 0.03)] + [$285 million] + [$172 million]
= $29.1 + $285 + $172 = $486.1 million
Therefore, deposit liquidity requirement = 0.75 [$791.7] + 0.20 [$713.34] + 0.05 [$486.1]
= $593.775 + $142.668 + $24.305
= $760.748 million OR $761 million
Total liquidity requirement = additional loan demand + deposit liquidity requirement
Recent experience: Currently, loans total $2,389 million, but recently have been as high as $2,567
million, or an additional $178 million.
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Historically (based on past three years), loan growth has averaged 8 percent annually.
Anticipated additional loan demand (low estimate) = $2,389 * 1.08 = $2,580
Anticipated additional loan demand (high estimate) = $2,567 * 1.08 = $2,772
Therefore, additional loan demand could range from $191 million to as much as $383(2772-2389)
million.
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Total liquidity requirement (low estimate) = $761 + $191 = $952 million.
Total liquidity requirement (high estimate) = $761 + $383 = $1,144 million.
11-5 Using the financial information for Watson National Bank, calculates as many of the liquidity
indicators discussed in this chapter for Watson as you can. Do you detect any significant liquidity
trends? Which trends should management investigate?
Most recent year
Previous year
Assets:
Cash and due from depository
institutions
$345000
$358,000
U.S. Treasury securities
$176,000
$178,000
Other securities
$339,000
$343,000
Pledged securities
$287,000
$223,000
Federal funds sold and reverse
repurchase agreements
$175,000
$131,000
$2,148,000
$1,948,000
$3,200,000
$3,001,000
Demand deposits
$500,000
$456,000
Savings deposits
$730,000
$721,000
$1,100,000
$853,000
$2,430,000
$2,130,000
$850,000
$644,000
$58,000
$37,000
$217,000
$237,000
$25,000
$16,000
Loans and leases net
Total Assets
Liabilities:
Time deposits
Total deposits
Core deposits
Brokered deposits
Federal funds purchased and
repurchase agreements
Other money market borrowings
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Cash and due from depository
institutions
$345,000
$358,000
U.S. Treasury securities
$176,000
$178,000
Other securities
$339,000
$343,000
Pledged securities
$287,000
$223,000
Federal funds sold and reverse
repurchase agreements
$175,000
$131,000
Loans and leases Net
$2,148,000 $1,948,000
Total Assets
$3,200,000 $3,001,000
Liabilities:
Demand deposits
$500,000
$456,000
Savings deposits
$730,000
$721,000
$1,100,000
$853,000
Time deposits
Total deposits
$2,430,000 $2,130,000
Core deposits
Brokered deposits
Federal funds purchased and
repurchase agreements
Other money market borrowings
$850,000
$644,000
$58,000
$37,000
$217,000
$237,000
$25,000
$16,000
Most Recent Year
Cash position indicator:
345,000/3,200,000
Cash and due from banks/Total assets
Previous Year
358,000/3,001,000
= .1078
= .1193
Liquid securities indicator:
176,000/3,200,000
178,000/3,001,000
U.S. Govt. sec. / Total assets
=.055
=.0593
Net federal funds position:
(175,000-217,000)/3,200,000
(Fed funds sold-Fed funds purchased)
=-.0131
(131,000-237,000)/3,001,000
=-.0353
/Total Assets
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Capacity ratio:
2,148,000/3,200,000
Net loans and leases/Total assets
Pledged security ratio:
=.6713
287,000/515,000
Pledged securities/Total securities
Hot Money Ratio:
1,948,000/3,001,000
=.6491
223,000/521,000
=.557
345,000+176,000+175,000
=.428
358,000+178,000+131,000
Money mkt assets*/Volatile liabilities
217,000 + 25,000
237,000 + 16,000
Cash, U.S. Govt Sec., Fed Funds Sold
=2.88 X
=2.64 X
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Deposit brokerage index
58,000/2,430,000
37,000/2,130,000
Brokered deposits/Total deposits
=.0239
=.0174
Deposit Composition Ratio
500,000/1,100,000
456,000/853,000
Demand deposits/Time deposits
=.4545
=.5346
Core deposit ratio
850,000/3,200,000
644,000/3,001,000
Core deposits/Total assets
=.2656
=.2146
Watson appears to have mixed liquidity trends, though most indicators reflect declining liquidity. Cash
assets are falling relative to total assets, though holdings of U.S. Government securities are rising
relative to total assets. Net loans are rising, squeezing out some liquid assets from total assets and
more of the government securities the bank holds are now pledged to back government deposits and,
therefore, are not available for liquidity needs. Another area of concern that needs management's
attention is the near tripling in the proportion of deposits coming from security brokers. A comforting
offsetting trend, however, is the decline in volatile demand deposits relative to more stable time
deposits.
11-6. The Bank of Your Dreams has a simple balance sheet. The figures are in millions of dollars as
follows:
Assets
Liabilities and Equity
Cash
$100 Deposits
$4000
Securities
1,000 Other liabilities
500
Loans
4,000 Equity
600
Total assets
Total Liabilities and
5,100 equity
5100
Although the balance sheet is simple, the bank’s manager encounters a liquidity challenge when
depositors withdraw $500 million.
a. If asset conversion method is used and securities are sold to cover the deposit drain, what
happens to the size of Bank of Your Dreams?
b. If liability management is used to cover the deposit drain what happens to the size of Bank of
Your Dreams?
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a. In this case, the bank would shrink by the amount of deposit withdrawals. Thus total assets
would decrease to $5,100 – 500 = $4,600.
b. There would be no change in the size of the bank.
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11-7. The liquidity manager for the Bank of Your Dreams needs cash to meet some unanticipated loan
demand. The loan officer has $600 million in loans that he wants to make. Use the simplified balance
sheet provided in the previous problem to answer the following questions:
a. If asset conversion is used and securities are sold to provide money for the loans, what
happens to the size of the Bank of Your Dreams?
b. If liability management is used to provide funds for the loans, what happens to the size of the
Bank of Your Dreams?
a. Since securities are simply replaced by loans there will be no change in size
b. In this case, the size of the bank would increase by the amount of total new loans.
Thus, Total assets would increase to $5,100 + 600 = $5,700
11-8. Suppose Victoria Savings Bank's liquidity manager estimates that the bank will experience a
$375 million liquidity deficit next month with a probability of 10 percent, a $200 million liquidity deficit
with a probability of 40 percent, a $100 million liquidity surplus with a probability of 30 percent, and a
$250 million liquidity surplus bearing a probability of 20 percent. What is this savings bank’s expected
liquidity requirement? What should management do?
Liquidity Deficits or
Associated
Surpluses
Probabilities
-$375 million
10%
-$200 million
40
+$100 million
30
+$250 million
20
100%
The bank's expected liquidity requirement is:
Expected Liquidity Requirement = 0.10 *(-$375 million) + 0.40 * (-$200 million) +
0.30* (+$100 million) + 0.20 * (+$250 million)
= -$37.5 million - $80 million + $30 million + $50 million
= -$37.5 million
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Faced with a expected liquidity deficit the bank's liquidity manager must still begin preparing for
meeting the institution's cash needs through arranging for credit lines or deposits from other banks and
actual or potential deposit customers and strengthening the bank's liquid asset position.
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11-9. First Savings of Rainbow, Iowa, reported transactions deposits of $75 million (the daily average
for the latest two-week reserve computation period). Its nonpersonal time deposits over the most
recent reserve computation period averaged $37 million daily, while vault cash averaged $0.95 million
over the vault-cash computation period. Assuming that reserve requirements on transaction deposits
are 3 percent for deposits over $9.3 million and up to $43.9 million and 10 percent for all transaction
deposits over $43.9 million while time deposits carry a 3 percent required reserve, calculate this savings
institution’s required daily average reserve at the Federal Reserve Bank in the district.
Daily required reserves at Fed= [($43.9-9.3)*0.03] + [($75 – $43.9)*.10] + [$37 * 0.03] -$0.95
= $1.038 + $3.11 + $1.11 - $0.95 = $5.258- $0.95 = $4.308 million
11-10. Elton Harbor Bank has a cumulative legal reserve deficit of $44 million at the Federal Reserve
bank in the district as of the close of business this Tuesday. The bank must cover this deficit by the close
of business tomorrow (Wednesday).
Charles Tilby, the bank's money desk supervisor, examines the current distribution of money market and
long-term interest rates and discovers the following:
Money Market Instrument
Current Market Yield
Federal funds
1.98%
Borrowing from the central bank’s discount window
2.25
Commercial paper (one-month maturity)
2.33
Banker's acceptances (three-month maturity)
2.30
Certificates of deposit (one-month maturity)
2.52
Eurodollar deposits (three-month maturity)
3.00
U.S. Treasury bills (three-month maturity)
1.85
U.S. Treasury notes and bonds (1-year maturity)
2.57
U.S. Treasury notes and bonds (5-year maturity)
3.65
U.S. Treasury notes and bonds (10-year maturity)
4.19
One week ago, the bank borrowed $20 million from the Federal Reserve's discount window, which it
paid back yesterday. The bank had a $5 million reserve deficit during the previous reserve maintenance
period. From the bank's standpoint, which sources of reserves appear to be the most promising? Which
source would you recommend to cover the bank's reserve deficit? Why?
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The array of interest rates given in this problem suggests a number of ways Elton Harbor Bank could
meet its reserve requirements. Federal funds borrowing currently is relatively cheaper than most other
short-term sources of funds at an annual rate of 1.98 percent. The bank only has to borrow for 24 hours
and can return the borrowed funds on Thursday, thus incurring only one day's interest cost. Elton may
also be able to borrow at the Federal Reserve's discount window at the relatively cheap interest cost
compare to other source at 2.25 percent, except that it has just repaid a Fed loan and may have
borrowed recently. It would be good if a CD customer or a Treasury bills (three-month maturity) could
be found to supply a total of $40+ million. The Federal funds market appears to be the best near term
source of reserves in case no CD customer or Treasury bills holder found.
11-11. Gwynn’s Island Building and Loan Association estimates the following information regarding this
institution’s reserve position at the Federal Reserve for the reserve maintenance period that begins
today (Thursday):
Calculated required daily average balance at the Federal Reserve Bank = $760 million
A loan received by the Fed's discount window a week ago that comes
due on Friday (day 9)
= $ 70 million
Planned purchases of U.S. Treasury securities on behalf
of the association and its customers:
Tomorrow (Friday)
= $ 80 million
Next Wednesday (day 7)
= $ 35 million
Next Friday (day 9)
= $ 18 million
Gwynn’s Island also had a closing reserve deficit in the preceding reserve maintenance period of $5
million. What problems are likely to emerge as this savings association tries to manage its reserve
position over the next two weeks? Relying on the Federal funds market and loans from the Federal
Reserve’s discount window as tools to manage its reserve position, carefully construct a pro forma daily
worksheet for this association’s money position over the next two weeks. Insert your planned
adjustments in discount window borrowing and Federal funds purchases and sales over the period to
show how you plan to manage Gwynn’s Island’s reserve position and hit your desired reserve target.
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Check clearing estimates over the next 14 days are as follows:
Credit Balance
Debit Balance
Day
in Millions (+)
in Millions (-)
1
+10
2
-60
3
Closed
4
Closed
5
-40
6
-25
7
+30
8
-45
9
-5
10
Closed
11
Closed
12
+20
13
-70
14
Est.
Daily
Avg
Day
Res.
Bal.
+10
Federal
Federal
Funds
Discount
Treas.
Clear- Trans.
ings
Window
Sec.
Purchases
(+)
Borrow
(+)
Red. (+)
Sales ((-)
Repay(-)
Check
Req
Purch (-)
Closing
Excess
or
Daily
Deficit
Avg.
in Legal
Bal.
Cum.
Cum.
Exc.
Closing
or
Res.
Def.
Res.
Bal.
at Fed.
Deficit from Previous Period - $5 mill
1 (Thurs)
$760
+10
2 (Fri)
$760
-60
3 (Sat)
$760
+205
-80
1-280
$765
+5
+5
765
830
70
75
1595
830
70
145
2425
Chapter 01 - An Overview of the Changing Financial-Services Sector
4 (Sun)
$760
830
70
215
3255
5 (Mon)
$760
-40
585
-175
40
3840
6 (Tues)
$760
-25
560
-200
-160
4400
7 (Weds)
$760
+30
555
-205
-365
4955
8 (Thurs)
$760
-45
510
-250
-615
5465
9 (Fri)
$760
-5
1017
+257
-358
6482
10 (Sat)
$760
1017
+257
-101
7499
11 (Sun)
$760
1017
+257
+156
8516
12 (Mon)
$760
+20
737
-23
+133
9253
13 (Tues)
$760
-70
667
-93
+40
9920
14 (Wed)
$760
+10
720
-40
0
10,640
-205
-35
+300
+230
-300
+43
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Chapter 01 - An Overview of the Changing Financial-Services Sector
In this case the bank's money desk manager tried to avoid deepening deficits by periodically particularly
on Fridays - borrowing heavily in the Federal funds market and at the Federal Reserve bank. And
fortunately, however, by the beginning of the last day (Wednesday) of the reserve settlement period the
bank has a cumulative deficit of $0 million. The planned borrowing in Federal funds will be enough to
prevent any deficit position. It will have a cumulative reserve balance of $10,640 million as of the final
Wednesday in the settlement period and under the law must have a cumulative reserve balance slightly
in excess of $760 million * 14 or $10,640 million. Clearly this institution has managed its reserve position
well.
11-12. Lathrop Bank and Trust Co. has calculated its daily average deposits and vault cash holdings for
the most recent two-week computation period as follows:
Net transaction deposits
= $ 87,457,350
Nonpersonal time deposits under
18 months to maturity
Eurocurrency liabilities
= $168,943,580
= $ 7,340,210
Daily average balance in vault cash
= $ 1,500,075.
Suppose the reserve requirements posted by the Board of Governors of the Federal Reserve System are
as follows:
Net transaction accounts:
$9.3 to $43.9 million
3%
More than $43.9 million
10%
Nonpersonal time deposits:
Less than 18 months
3%
18 months or more
0%
Eurocurrency liabilities-all types
3%
What is this savings bank's total required level of legal reserves? How much must the bank hold on a
daily average basis with the Federal Reserve bank in its district?
Solution:
[($43.9 million-9.3 million) * 0.03] + [($87,457,350 - $43.9 million) * 0.10]
+ [($168,943,580 + $7,340,210) * 0.03]
= $1,038,000 + $4,355,735 + $5,288,514 = $10,682,249
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Daily average reserve holdings: $10,682,249 - $1,500,075 = $9,182,174
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11-13. Frost Street National Bank currently holds $750 million in transaction deposits subject to reserve
requirements but has managed to enter into sweep account arrangements with its transaction deposit
customers affecting $150 million of their deposits. Given the current legal reserve requirements
applying to transaction deposits (as mentioned in this chapter), by how much would Frost Street’s total
legal reserves decrease as a result of these new sweep account arrangements, which stipulate that
transaction deposit balances covered by the sweep agreements will be moved overnight into savings
deposits?
Legal Reserve Would Decrease = 0.03 * ($43.9 - $9.3) + 0.10 * ($150 – $43.9)
= $1.038 + $10.61
= $11.648 million
11-14 Sweetbriar Savings Association maintains a clearing account at the Federal Reserve Bank and
agrees to keep a minimum balance of $30 million in its clearing account. Over the two-week reserve
maintenance period ending today Sweetbriar managed to keep an average clearing account balance of
$33 million. If the Federal funds interest rate has averaged 2.25 percent over this particular
maintenance period, what maximum amount would Sweetbriar have available in the form of Federal
Reserve credit to help offset any fees the Federal Reserve might charge this association for using Federal
Reserve services?
Reserve Credit = Avg. Clearing Balance *Annualized Fed Funds Rate * 14 days/360 days
= $33,000,000 * 0.0225 * 14 days/360 days
= $28,875
CHAPTER 12
MANAGING AND PRICING DEPOSIT SERVICES
Goal of This Chapter: This chapter has multiple goals. One of the most important is to learn about the
different types of deposits financial institutions offer and, from the perspective of a manager, to
discover which types of deposits are among the most profitable to offer their customers. We also want
to explore how an institution’s cost of funding can be determined and examine the different methods
open to institutions to price the deposits and deposit-related services they sell to the public.
Key Topics in This Chapter
•
•
•
Types of Deposit Accounts Offered
The Changing Mix of Deposits and Deposit Costs
Pricing Deposit Services
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•
•
•
•
Conditional Deposit Pricing
Rules for Deposit Insurance Coverage
Disclosure of Deposit Terms
Lifeline Banking
Chapter Outline
I. Introduction: The Importance of Deposits and the Challenge of Managing Deposits
II.Types of Deposits Offered by Banks and Other Depository Institutions
A. Transaction (Payments or Demand) Deposits
1. Noninterest-Bearing Transaction Deposits
2. Interest-Bearing Transaction Deposits
a. NOW Accounts
b. Money Market Deposit Accounts (MMDAs)
c. Super NOWs
B. Nontransaction (Savings or Thrift) Deposits
1. Passbook Savings Deposits
2. Statement Savings Deposits
3. Time Deposits
C. Retirement Savings Deposits
1. Individual Retirement Accounts (IRAs)
2. Keogh Plans
3. Roth IRAs
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III. Interest Rates Offered on Different Types of Deposits
A. The Composition of Deposits
1. Trend toward Interest-Bearing and Nontransaction Deposits
2. The Importance of Core Deposits
3. Changes in the Relative Importance of Other Types of Deposits
B. The Ownership of Deposits
C. Cost of Different Deposit Accounts
IV. Pricing Deposit-Related Services
V. Pricing Deposits at Cost Plus Profit Margin
A. Estimating Deposit Service Costs
B. An Example of Pooled Funds Costing
VI. Using Marginal Cost to Set Interest Rates on Deposits
A. Conditional Pricing
VII. Pricing Based on the Total Customer Relationship and Choosing a Depository
A. The Role That Pricing and Other Factors Play When Customers Choose a Depository
Institution to Hold Their Accounts
VIII. Basic (Lifeline) Banking: Key Services for Low-Income Customers
IX. Summary of the Chapter
Concept Checks
12-1.
What are the major types of deposit plans that depository institutions offer today?
Deposit plans can be divided broadly into transaction deposits, thrift or nontransaction deposits, and
hybrid deposits. The primary function of transaction deposits is to make payments and these deposits
include regular checking accounts and NOW accounts. The principal function of thrift deposits is to serve
as accumulated savings and include passbook and statement savings accounts, CDs, and other time
deposit accounts. Hybrid deposits combine transactions and thrift features and include money-market
deposit accounts and Super NOWs.
12-2.
What are core deposits, and why are they so important today?
Core deposits are the most stable components of a depositary institution’s funding base and usually
include smaller-denomination savings and third-party payments accounts. They are characterized by
relatively low interest-rate elasticity. Holding a substantial proportion of core deposits has an advantage in
having access to a stable and cheaper source of funding with relatively low interest-rate risk.
12-3.
How has the composition of deposits changed in recent years?
There has been a shift in the public’s holdings of deposits toward greater relative proportions of the
highest-yielding time deposits and toward hybrid accounts that maximize depositor returns, while still
giving them access to deposited funds to make payments.
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12-4. What are the consequences for the management and performance of depository institutions
resulting from recent changes in deposit composition?
While depository institutions would prefer to sell only the cheapest deposits to the public, it is
predominately public preference that determines which types of deposits will be created. Institutions that
do not wish to conform to customer preferences will simply be outbid for deposits by those who do.
Managers who fail to stay abreast of changes in their competitors’ deposit pricing and marketing
programs stand to lose both customers and profits.
12-5.
Which deposits are the least costly for depository institutions? The most costly?
Commercial checkable deposits, particularly regular noninterest bearing demand deposits, are usually the
least costly. The most costly deposits are passbook savings accounts having substantial deposit and
withdrawal activity and higher interest-rate time deposits.
12-6. Describe the essential differences between the following deposit pricing methods in use today:
cost-plus pricing, conditional pricing, and relationship pricing.
Cost-plus deposit pricing encourages banks to determine what costs they are incurring in labor and
management time, materials, etc., in offering each deposit service. Cost-plus pricing generally calls for a
bank to charge deposit service fees adequate to cover all the costs of offering the service plus a small
margin for profit. Conditional pricing is used today as a tool by banks to attract the kinds of depositors
they want to have as customers. With this pricing technique a bank will post a schedule of offered
interest rates or fees assessed for deposits of varying sizes and based on account activity. Generally
larger volume deposits carry higher interest returns to the depositor or are assessed lower service
charges, encouraging customers to hold a high average deposit balance which gives the bank more
funds to invest in earning assets. Finally, relationship pricing involves basing fees charged a customer on
the number of services and the intensity of use of services the customer purchases from a bank.
12-7. A bank determines from an analysis of its cost-accounting figures that for each $500 minimumbalance checking account it sells account processing and other operating costs will average $4.87 per
month and overhead expenses will run an average of $1.21 per month. The bank hopes to achieve a
profit margin over these particular costs of 10 percent of total monthly costs. What monthly fee should
it charge a customer who opens one of these checking accounts?
The relevant formula is:
Unit Price
Charged
per Month
Operating
= Expense
Per Unit
Overhead
+
Expense
Per Unit
In this case:
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+ Profit Margin
Per Unit
Chapter 01 - An Overview of the Changing Financial-Services Sector
Unit Price Charged Per Month = $4.87 + $1.21 + 0.10 x ($4.87 + $1.21) = $6.69
12-8. To price deposits successfully, service providers must know their costs. How are these costs
determined using the historical average cost approach? The marginal cost of funds approach? What are
the advantages and disadvantages of each approach?
The historical average cost approach looks at the past. It asks the following question:
What funds has the bank raised to date and what did they cost? The marginal cost deposit-pricing
method focuses upon the weighted average cost of new funds raised from all of the different sources of
funds the bank draws upon or plans to draw upon in the current period.
Marginal cost is preferred over historical average cost as frequent changes in interest rates will make
historical average cost a treacherous standard for pricing.
12-9. How can the historical average cost and marginal cost of funds approaches be used to help
select assets (such as loans) that a depository institution might wish to acquire?
The historical average cost rate is called break-even because the institution must earn at least this rate
on its earning assets (primarily loans and securities) just to meet the total operating costs of raising
borrowed funds and the stockholders' required rate of return. Therefore, the institution will know the
lowest rate of return that it can afford to earn on assets it might wish to acquire. The marginal cost of
funds approach can be used as a guide to select loans and other assets because the institution
interested in profit maximizing would want to be sure to cover its fund-raising costs.
12-10. What factors do household depositors rank most highly in choosing a financial firm for their
checking account? Their savings account? What about business firms?
Studies cited in this chapter indicate that households (individuals and families) appear to consider, in
rank order, the following factors in choosing an institution to hold their checking account: convenient
location, availability of other services, safety, low fees and low minimum balances, and high deposit
interest rates. In selecting an institution to hold their savings account households appear to consider, in
rank order: familiarity, interest rate paid, transactional convenience, location, availability of payroll
deduction, and any fees charged. Business firms, on the other hand, seem to consider such factors as
the financial health of the lending institution, whether the institution will be a reliable source of credit in
the future, the quality of managers, whether loans are competitively priced, the quality of financial
advice given, and whether cash management and operations services are provided.
12-11. What does the 1991 Truth in Savings Act require financial firms selling deposits inside the United
States to tell their customers?
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The Truth in Savings Act requires financial firms to fully inform their deposit customers on the terms
offered to each depositor. The customer must be told when a new account is opened or if a deposit is
renewed, what annual percentage yield (APY) is being offered and what minimum balance is required to
receive that yield. Moreover, the depositor must be informed about any penalties or service fees which
could reduce his or her expected yield. If the terms of a deposit are changed in a way that would reduce
the depositor's return advance notice must be given to the account holder.
12-12. Use the APY formula required by the Truth in Savings Act for the following calculation. Suppose
that a customer holds a savings deposit in a savings bank for a year. The balance in the account stood at
$2,000 for 180 days and $100 for the remaining days in the year. If the Savings bank paid this depositor
$8.50 in interest earnings for the year, what APY did this customer receive?
The correct formula is:
365


Interest Earned
APY = 100 (1 +
) Days in Period - 1
Average Account Balance


In this instance,
$8.50 365365 

APY = 100 (1 +
)
- 1
$1036.99


Or
APY = 0.82 percent,
Where the average account balance is:
$2000 x 180 days + $100 x 185 days
= $1036.99
365 days
12-13. What is lifeline banking? What pressures does it impose on the managers of banks and other
financial institutions?
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Lifeline banking consists of basic service packages offered by banks to customers not generally able to
afford conventional bank service offerings. The essence of these services is that they carry low service
fees and usually do not offer all of the features of banking services carrying full service fees. The
pressure on managers to offer basic or lifeline services has aroused a big controversy. From a profit
motive point of view banks should not offer unprofitable services. On the other hand, financial institutions
are partially subsidized by government in the form of low-interest loans and deposit insurance and,
therefore, have some public-service responsibilities which may include providing certain basic services to
all potential customers, regardless of their income or social status.
12-14. Should lifeline banking be offered to low-income customers? Why or why not?
This is not an easy question to answer. One of the most serious problems individuals outside the financial
mainstream face is lack of access to a deposit account. Lifeline banking is providing basic banking
services to these individuals. Most financial-service providers are privately owned corporations
responsible to their stockholders to earn competitive returns on invested capital. Providing financial
services at prices so low, they do not cover production costs interferes with that important goal. Thus,
from a profit motive point of view banks should not offer unprofitable services. However, it should be
considered that depository institutions receive important aid from the government that grants them a
competitive advantage over other financial institutions like deposit insurance. Therefore, they have some
public-service responsibilities which may include providing certain basic services to all potential
customers.
Problems
12-1.
Rhinestone National Bank reports the following figures in its current Report of Condition:
Cash and Interbank Dep
50
Core Deposits
50
S.T. Securities
15
Large Negotiable CDs
150
Total Loans, gross
400
Brokered Deposits
65
L.T. Securities
150
Other Deposits
45
Other Assets
10
Money Mkt. Liabilities
195
Total Assets
625
Other Liabilities
65
Equity Capital
55
Total Liab. & Eq.
625
[NOTE: The balance sheet in the Text/PDF does not tally. The error in the value of “Other
Liabilities” has been corrected in the IM.]
a. Evaluate the funding mix of deposits and nondeposit sources of funds employed by Rhinestone. Given
the mix of its assets, do you see any potential problems? What changes would you like to see
management of this bank make? Why?
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Core deposits/Assets
=
8.00%
Large Negotiable CDs/Assets
=
24.00%
Brokered Deposits/Assets
=
10.40%
Other Deposits/Assets
=
7.2%
Money Market Liabilities/Assets
=
31.2%
Other Liabilities/Assets
10.40%
=
Equity Capital/Assets
=
8.80%
The proportion of core deposits at Rhinestone is exceptionally low, while large CDs and other
money-market borrowings make up more than 54 percent of the bank’s total funding sources.
This funding mix tends to subject the bank to excessive vulnerability to quick withdrawal of
funds and high interest-rate risk exposure. Rhinestone also appears to be excessively dependent
on brokered deposits which are highly volatile and interest-sensitive. Adding in these brokered
deposits, more than half of Rhinestone’s assets are funded with highly interest-sensitive deposits
and money-market borrowings. Management needs to expand the bank’s core deposits and other
more stable funds sources.
b. Suppose market interest rates are projected to rise significantly. Does Rhinestone appear to
face significant losses due to liquidity risk? Due to interest rate risk? Please be as specific as
possible.
If interest rates rise, Rhinestone will experience higher interest costs immediately or within hours
or a few days on at least 50 percent of its funding sources. Unfortunately all but $65 million of
its $625 million in total assets are longer-term, inflexible assets whose interest yields cannot be
adjusted as rapidly as the interest rates to be paid out on the bank’s liabilities. Other factors held
equal, the bank’s earnings will be squeezed. Management needs to do some serious restructuring
work on both sides of the bank’s balance sheet in moving toward more flexible-return assets and
more flexible-cost liabilities, and to move toward greater use of interest-rate hedging techniques.
12-2. Kalewood Savings Bank has experienced recent changes in the composition of its deposit
(see the following table; all figures in millions of dollars). What changes have recently occurred
in Kalewood’s deposit mix? Do these changes suggest possible problems for management in
trying to increase profitability and stabilize earnings?
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Types of Deposits Held
Regular and special checking accounts
This
Year
One
Year
Ago
Two Three
Years Years
Ago
Ago
$235
$294
$337
$378
Interest-bearing checking accounts
392
358
329
287
Regular (passbook) savings deposits
501
596
646
709
Money market deposit accounts
863
812
749
725
Retirement deposits
650
603
542
498
CDs under $100,000
327
298
261
244
CDs $100,000 and over
606
587
522
495
Regular and special checking accounts have declined sharply from $378 million to $235 million,
while interest-bearing checking accounts rose from $287 million to $392 million. Passbook
savings deposits have fallen by more than $200 million while money-market deposit accounts,
retirement accounts, and both small and large ($100,000 +) CDs have all risen substantially.
Management has several reasons to be concerned about these developments because the bank’s
funds are shifting into accounts bearing significantly higher interest costs, while the bank is
suffering substantial erosion in its core deposits represented by regular (passbook) savings
deposits and small checking accounts. Thus, more interest-sensitive funds are supplanting
deposits that are more loyal and less interest-elastic. The bank may find its profits are likely to be
squeezed by higher interest costs and its earnings may become more volatile if market interest
rates experience significant changes in the period ahead because a greater portion of the bank’s
funding is coming from more interest-sensitive deposits. A possible offsetting advantage is the
shift away from deposits that can be withdrawn without notice (i.e., regular and special checking
accounts and passbook savings deposits) toward longer-term deposit instruments with fixed
maturities, giving the bank a somewhat longer term and, perhaps, somewhat more predictable
funding base.
12-3. First Metrocentre Bank posts the following schedule of fees for its household and smallbusiness transaction accounts:
•
For average monthly account balances over $1,500 there is no monthly maintenance fee and no
charge per check or other draft.
• For average monthly account balances of $1,000 to $1,500, a $2 monthly maintenance fee is
assessed and there is a 10¢ charge per check or charge cleared.
• For average monthly account balances of less than $1,000, a $4 monthly maintenance fee is
assessed and there is a 15¢ per check or per charge fee.
What form of deposit pricing is this? What is First Metrocentre trying to accomplish with its pricing
schedule? Can you foresee any problems with this pricing plan?
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First Metrocentre Bank has posted a schedule of deposit fees that allows the customer service-charge
free checking for average monthly account balances over $1,500. Lower balances are assessed an
inverse monthly maintenance fee plus an increased per-check charge as the average monthly account
balance falls. This is conditional deposit pricing designed to encourage more stable, larger-denomination
accounts which would give the bank more money to use and, perhaps, a more stable funding base. The
fees on under-$1,000 accounts are stiff which may drive away many small depositors to other banks.
12-4.
Gold Mine Pit Savings Association finds that it can attract the following amounts of deposits if it
offers new depositors and those rolling over their maturing CDs the interest rates indicated
below:
Expected Volume
Rate of Interest
of New Deposits
Offered Depositors
$10 million
3.00%
15 million
3.25
20 million
3.50
26 million
3.75
28 million
4.00
Management anticipates being able to invest any new deposits raised in loans yielding 6.25 percent.
How far should this thrift institution go in raising its deposit interest rate in order to maximize total
profits (excluding interest costs)?
Expected
Inflows
Rate
Offered on
New
Funds
Total
Interest
Cost
Marginal
Interest
Cost
Marginal
Cost Rate
Marginal
Revenue
Rate
Exp. Diff. In
Marg. Rev
and Cost
Total
Profits
Earned
$10
3.0%
0.3000
0.3000
3.000%
6.25%
+3.250%
$0.3250
15
3.25
0.4875
0.1875
3.750
6.25
+2.500
$0.4500
20
3.50
0.7
0.2125
4.250
6.25
+2.00
$0.5500
26
3.75
0.975
0.275
4.583
6.25
+1.667
$0.6500
28
4.00
1.12
0.145
7.250
6.25
-1.00
$0.6300
Gold Mine Pit Savings Association should raise its deposit rate to 3.75%, attracting $26 million in new
deposits; because up to that point the marginal revenue rate is greater than the marginal cost rate and
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total profits are also rising. At 4.0%, the marginal cost rate is greater than the marginal revenue rate and
total profits have fallen from a high of $0.65 million back down to $0.63 million.
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12-5. Red Brick Bank plans to launch a new deposit campaign next week in hopes of bringing in from
$100 million to $600 million in new deposit money, which it expects to invest at a 5.5 percent yield.
Management believes that an offer rate on new deposits of 2.75 percent would attract $100 million in
new deposits and rollover funds. To attract $200 million, the bank would probably be forced to offer
3.25 percent. Red Brick’s forecast suggests that $300 million might be available at 3.75 percent, $400
million at 4.00 percent, $500 million at 4.25 percent, and $600 million at 4.5 percent. What volume of
deposits should the institution try to attract to ensure that marginal cost does not exceed marginal
revenue?
Expected
Inflows
Rate
Offered on
New
Funds
Total
Interest
Cost
Marginal
Interest
Cost
Marginal
Cost Rate
Marginal
Revenue
Rate
Exp. Diff. In
Marg. Rev
and Costs
Total
Profits
Earned
$100
2.75%
2.75
2.75
2.75%
5.50%
+2.75%
$2.75
$200
3.25%
6.50
3.75
3.75%
5.50%
+1.75%
$4.50
$300
3.75%
11.25
4.75
4.75%
5.50%
+0.75%
$5.25
$400
4%
16.00
4.75
4.75%
5.50%
+0.75%
$6.00
$500
4.25%
21.25
5.25
5.25%
5.50%
+0.25%
$6.25
$600
4.5%
27.00
5.75
5.75%
5.50%
-0.25%
$6.00
The marginal revenue rate is greater than the marginal cost rate up to $500 million in new deposits. At
$600 million, the marginal cost rate of 5.75% is greater than the marginal revenue rate of 5.50%.
Therefore, Red Brick Bank should try and attract $500 million in new deposits.
12-6. Richman Savings Bank finds that its basic transaction account, which requires a $400 minimum
balance, costs this savings bank an average of $2.65 per month in servicing costs (including labor and
computer time) and $1.18 per month in overhead expenses. The savings bank also tries to build in a
$0.50 per month profit margin on these accounts. What monthly fee should the bank charge each
customer?
Following the cost-plus-profit approach, the monthly fee should be:
Monthly fee
= $2.65 + $1.18 + $0.50 = $4.33 per month.
Further analysis of customer accounts reveals that for each $100 above the $500 minimum in average
balance maintained in its transaction accounts, Richman Savings saves about 5 percent in operating
expenses with each account. (Note: If the bank saves about 5 percent in operating expenses for each
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$100 held in balances above the $500 minimum, then a customer maintaining an average monthly
balance of $1,000 should save the bank 25 percent in operating costs.) For a customer who consistently
maintains an average balance of $1,000 per month, how much should the bank charge in order to
protect its profit margin?
The appropriate fee for this customer would be:
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[$2.65 -0.25 ($2.65)] + $1.18 + $0.50 = $1.9875 + $1.18 + $0.50 = $3.6675 per month.
12-7. Monica Lane maintains a savings deposit with Monarch Credit Union. This past year Monica
received $10.75 in interest earnings from her savings account. Her savings deposit had the following
average balance each month:
January
$400
July
$350
February
250
August
425
March
300
September
550
April
150
October
600
May
225
November
625
June
300
December
300
What was the annual percentage yield (APY) earned on Monica’s savings account?
Monica’s account had an average balance this year of:
[$400 x 31 days + $250 x 28 days + $300 x 31 days + $150 x 30 days
+ $225 x 31 days + $300 x 30 days + $350 x 31 days + $425 x 31 days +
$550 x 30 days + $600 x 31 days + $625 x 30 days + $300 x 31 days]
365 days
= $373.56
Then the APY must be:


APY = 100 (1 +
$10.75 365/365 
)
− 1 = 2.88 percent
$373.56

12-8. The National Bank of Mayville quotes an APY of 3.5 percent on a one-year money market CD
sold to one of the small businesses in town. The firm posted a balance of $2,500 for the first 90 days of
the year, $3,000 over the next 180 days, and $4,500 for the remainder of the year. How much in total
interest earnings did this small business customer receive for the year?
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Using the APY formula we can fill in the variables whose values are known and find the unknown
interest earnings. Thus:

APY = 100 (1 +



Interest Earnings 365/365 
)
− 1
Average Balance

3.5% = 100 (1 +
Interest Earnings 365/365 
)
− 1
$3267.12

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Where the account's average balance is found from:
Average Balance =
$2500 x 90 days + $3000 x 180 days + $4500 x 95 days
365 days
= $3267.12
Then:
 Interest Earnings 
 = 0.030608 x Interest Earnings
$3267.12


3.5% = 100 
or Interest Earnings = $114.35
CHAPTER 13
MANAGING NONDEPOSIT LIABILITIES
Goal of This Chapter: The purpose of this chapter is to learn about the principal nondeposit sources of
funds that financial institutions can borrow to help finance their activities and to see how managers
choose among the various nondeposit funds sources currently available to them.
•
•
•
•
•
•
Key Topics in this Chapter
Liability Management
Customer Relationship Doctrine
Alternative Nondeposit Funds Sources
Measuring the Funds Gap
Choosing Among Different Funds Sources
Determining the Overall Cost of Funds
Chapter Outline
I. Introduction
II. Liability Management and the Customer Relationship Doctrine
A. Customer Relationship Doctrine
B. Liability Management
Ill. Alternative Nondeposit Sources of Funds
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Chapter 01 - An Overview of the Changing Financial-Services Sector
A. Federal Funds Market (“Fed Funds”)
B. Repurchase Agreements as a Source of Funds
C. Borrowing from Federal Reserve Banks
1. Primary Credit
2. Secondary Credit
3. Seasonal Credit
D. Advances from Federal Home Loan Banks
E. Development and Sale of Large Negotiable CDs
F. Eurocurrency Deposit Market
G. Commercial Paper Market
E. Long-Term Nondeposit Funds Sources
IV. Choosing Among Alternative Nondeposit Sources
A. Measuring a Financial Firm’s Total Need for Nondeposit Funds: The Available Funds Gap
B. Nondeposit Funding Sources: Factors to Consider
1. Relative Costs
2. The Risk Factor
3. The Length of Time Funds Are Needed
4. The Size of the Borrowing Institution
5. Regulations
V. Summary of the Chapter
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Concept Checks
13-1.
What is liability management?
Liability management involves the conscious control of the funding sources of a financial institution,
using the interest rates (yields) offered on deposits and other borrowings to regulate the inflow of funds
to match the bank's immediate funding needs.
13-2. What advantages and risks does the pursuit of liability management bring to a borrowing
institution?
Improved control over funding sources enables a borrowing institution to plan its growth more
completely, but liability management opens up certain risks, particularly of the interest-rate risk and
solvency (default or failure) risk variety, because it tends to be more sensitive to changes in market
interest rates.
13-3. What is the customer relationship doctrine, and what are its implications for fundraising by
lending institutions?
The customer relationship doctrine places lending to customers at the top of the priority list, which
proclaims that the first priority of a lending institution is to make loans to all those customers from
whom the lender expects to receive positive net earnings. It argues that a lending institution should
make all good loans that is, all loans that meet the institution's quality and profitability standards and
then find the funds needed to fund those loans they decide to make. Funds uses thus become a higher
immediate priority item than funds sources.
13-4.
For what kinds of funding situations are Federal funds best suited?
Federal funds are best suited for institutions short of reserves to meet their legal reserve requirements
or to satisfy customer loan demand. It satisfies this demand by tapping immediately usable funds.
13-5.
Chequers State Bank loans $50 million from its reserve account at the Federal Reserve
Bank of Philadelphia to First National Bank of Smithville, located in the New York Federal Reserve Bank's
district, for 24 hours with the funds returned the next day. Can you show the correct accounting entries
for making this loan and for the return of the loaned funds?
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Step 1 - Lending the $50 million
Chequers State Bank
Assets
Liabilities
Federal funds
sold
+ $50 mill.
Reserves
at Fed
- $50 mill.
Step 2 - Using the borrowed funds can also be shown, though it is not mentioned in the problem. You
could show First National Bank of Smithville making a loan for $50 million under Assets, giving up $50
million from its reserve account.
First National Bank of
Smithville
Assets
Liabilities
Reserves
At Fed
Federal Funds
+ $50 mill.
Purchased
+$50 mill.
Step 3 - Repaying the Loan of Federal Funds
Chequers State Bank
Assets
Liabilities
Reserves
at Fed
+ $50 mill.
Federal
funds sold
- $50 mill.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
First National Bank of Smithville
Assets
Reserves
at Fed
Liabilities
Federal funds
- $50 mill.
purchased
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- $50 mill.
Chapter 01 - An Overview of the Changing Financial-Services Sector
13-6. Hillside Savings Association has an excess balance of $35 million in a deposit at its principal
correspondent, Sterling City Bank, and instructs the latter institution to loan the funds today to another
bank or thrift institution, returning them to its correspondent deposit the next business day. Sterling
loans the $35 million to Imperial Security National Bank for 24 hours. Can you show the proper
accounting entries for the extension of this loan and the recovery of the loaned funds by Hillside
Savings?
Step 1 - Lending Federal Funds to a Correspondent
Hillside Security Bank
Assets
Liabilities
Deposit with
Correspondent
-$35 mill.
Federal Funds
loaned
+$35 mill.
Sterling City Bank
Assets
Liabilities
Federal funds
purchased
+$35 mill.
Respondent
Bank's deposit -$35 mill.
Step 2 - The Correspondent Bank Loans Funds to another Bank
Sterling City Bank
Assets
Reserves
Liabilities
-$35 mill.
Federal funds
loaned
+$35 mill.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Imperial Security National Bank
Assets
Reserves
+ $35 mill.
Liabilities
Federal funds
purchased
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$35 mill.
Chapter 01 - An Overview of the Changing Financial-Services Sector
Step 3 - Repaying the Loan to the Respondent Bank
Hillside Security Bank
Assets
Liabilities
Deposit with
Correspondent
+$35 mill.
Federal funds
loaned
-$35 mill.
Sterling City Bank
Assets
Liabilities
Federal funds
purchased
-$35 mill.
Bank's
deposit
13-7.
+$35 mill.
Compare and contrast Fed funds transactions with RPs?
Less popular than Fed funds and more complex are repurchase agreements (RPs). RPs are agreements
to sell securities temporarily by a borrower of funds to a lender of funds with the borrower agreeing to
buy back the securities at a guaranteed price at a set time in the future. Both are instruments available
for short term borrowing. However, RP agreements are collateralized loans and thus, the lender is not
exposed to credit risk as they are with Federal funds transactions. Most RPs are transacted across the
Fed Wire system, just as are Fed funds transactions. RPs may take a bit longer to transact then a Fed
funds loan because the seller of funds (the lender) must be satisfied with the quality and quantity of
securities provided as collateral.
13-8.
What are the principal advantages to the borrower of funds under an RP agreement?
RPs are a low-cost and low-risk way of borrowing loanable funds for short periods of time (usually 3 or 4
days). They are low risk because they are essentially a collateralized loan. The securities that are sold as
part of the agreement act as collateral.
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13-9. What are the advantages of borrowing from the Federal Reserve banks or other central bank?
Are there any disadvantages? What is the difference between primary, secondary, and seasonal credit?
What is the Lombard rate and why might such a rate be useful in achieving monetary policy goals?
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Borrowing from the Federal Reserve banks is a viable alternative to the Federal funds market. These
loans are made for a short term (usually two weeks). Primary credits are short term loans available to
sound depositary institutions. Secondary credits are short term loans available to institutions that do
not qualify for primary credit. Seasonal credit refers to loans given to small and medium sized
institutions to cover seasonal swings in their deposits and loans.
The Lombard rate is the Feds discount rate which is set above the Federal funds rate. If borrowing from
the discount window is more expensive than the Fed funds market, banks will use the discount window
less frequently and central banks do not have to restrict access to the discount window and do not have
to worry about banks borrowing at the discount window and lending these funds at the Federal funds
rate. Thus, the “Lombard” rate effectively acts as a ceiling on overnight borrowing rates.
13-10. How is a discount window loan from the Federal Reserve secured? Is collateral really necessary
for these kinds of loans?
A discount window loan must be secured by collateral acceptable to a Federal Reserve bank (usually U.S.
government securities). Most banks keep government securities in the vaults of the Federal Reserve for
this purpose. The Federal Reserve bank will also accept some government agency securities and highgrade commercial paper as collateral.
Each type of discount window loan carries its own loan rate, with secondary credit generally posting the
highest interest rate and seasonal credit the lowest. For example, in March 2008 the Federal Reserve’s
discount window loan rates were 2.50 percent for primary credit, 3.00 percent for secondary credit, and
2.95 percent for seasonal credit.
13-11. Posner State Bank borrows $10 million in primary credit from the Federal Reserve Bank of
Cleveland. Can you show the correct entries for granting and repaying this loan?
The proper entries are:
Step 1 - Securing a Loan from the Fed.
Posner State Bank
Assets
Reserves on deposit
Liabilities
Notes
at the Federal
payable
Reserve Bank + $10 mill
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+$10 mill.
Chapter 01 - An Overview of the Changing Financial-Services Sector
Federal Reserve Bank of Cleveland
Assets
Loans and
advances
Liabilities
Bank reserve
+$10 mill.
accounts
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$10 mill.
Chapter 01 - An Overview of the Changing Financial-Services Sector
Step 2 - Repaying the Loan to the Fed.
Posner State Bank
Assets
Reserves on deposit
Liabilities
Notes
at the Federal
Reserve Bank
Payable
-$10 mill.
-$10 mill
Federal Reserve Bank of Cleveland
Assets
Loans and
advances
Liabilities
Bank reserve
-$10 mill.
accounts
-$10 mill.
13-12. Which institutions are allowed to borrow from the Federal Home Loans Banks? Why is this
source so popular for many institutions?
Federal Home Loan Banks lend to institutions that grant mortgage loans and uses those as collateral.
These loans are very popular because they represent a stable source of funds at below market lending
rates.
13-13. Why were negotiable CDs developed?
Negotiable CDs were developed to attract large corporate deposits and savings from wealthy
individuals. Because these were not insured they paid a higher interest rate than traditional deposits.
The concept of liability management and short-term borrowing to supplement deposit
growth was given a significant boost early in the 1960s with the development of negotiable CD.
13-14 What are the advantages and disadvantages of CDs as a funding source?
Negotiable CDs offer a way to attract large amounts of funds quickly and for a known time period.
However, these funds are highly interest sensitive and often are withdrawn as soon as the maturity date
arrives unless management aggressively bids in terms of yield to keep the CD.
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13-15. Suppose a customer purchases a $1 million, 90-day CD, carrying a promised 6 percent
annualized yield. How much in interest income will the customer earn when this 90-day instrument
matures? What total volume of funds will be available to the depositor at the end of 90 days?
Interest Income
=
Principal
*
Days to Maturity
To Customer
360 days
= $1,000,000 
90
 .06
360
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*
Annual Rate
Of Interest
Chapter 01 - An Overview of the Changing Financial-Services Sector
= $15,000
Total amount
=
Principal
+
Interest
due Customer
=
$1,000,000
+
$15,000
=
$1,015,000
13-16. Where do Eurodollars come from?
Eurodollars arise from dollar deposits made in financial institutions and at branch offices outside U.S.
territory. Many Eurodollar deposits arise from U.S. balance-of-payments deficits that give foreigners
claims on U.S. assets and from the need to pay in dollars for some international commodities (such as
oil) that are denominated principally in U.S. dollars.
13-17. How does a bank gain access to funds from the Eurocurrency markets?
Access to these funds is obtained by contacting correspondent banks by telephone, wire, or cable.
13-18. Suppose that JP Morgan Chase Bank in New York elects to borrow $250 million from Barclay’s
Bank of London, loans the borrowed funds for a week to a security dealer, and then returns the
borrowed funds. Can you trace through the resulting accounting entries?
If, Chase borrows from Barclay’s Bank of London, the entries would appear as follows:
JP Morgan-Chase
Assets
Liabilities
Deposits held at
Deposits due to
other banks +$250 mill.
foreign banks
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+$250 mill.
Chapter 01 - An Overview of the Changing Financial-Services Sector
U.S. Bank Serving as Correspondent to Barclay’s
Assets
Liabilities
Deposits due
foreign bank
-$250 mill.
Deposits of
JP Morgan-Chase +$250 mill.
Barclay’s Lending to JP Morgan-Chase Bank
Assets
Liabilities
Deposit at U.S.
Correspondent
Bank
+$250 mill.
Eurodollar loan to
JP-Morgan Chase
Bank
-$250 mill.
JP-Morgan Chase lending the funds to a security Dealer
JP Morgan Chase
Loan to Security
Dealer +$250
Deposit Held at Other Bank $250
When JP Morgan-Chase repays its loans we have:
JP Morgan-Chase Bank
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Assets
Deposits held at
Liabilities
Deposits due to
other banks -$250 mill.
foreign banks -$250 mill.
U.S. Bank Serving as Correspondent to Foreign Bank
Assets
Liabilities
Deposits due to
foreign banks +$250 mill.
Deposits of JP Morgan-Chase
Bank -$250 mill.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Foreign Bank Lending Eurodollars
Assets
Liabilities
Deposit at U.S.
Correspondent
Bank
+$250 mill.
Eurodollar loan to
JP Morgan-Chase
Bank
-$250 mill.
13-19. What is commercial paper? What types of organizations issue such paper?
Commercial paper consists of short-term notes, with maturities ranging from three or four days to nine
months, issued by well-known companies to raise working capital. The notes are generally sold at a
discount from their face value through security dealers or through direct contact between the issuing
company and interested investors.
Commercial paper is a high-quality, short-term debt obligation with an excellent credit rating to provide
for short-term cash needs. There are two types of commercial paper. The first type is industrial paper
generally issued by industrial companies to purchase inventories of goods or raw materials. The second
type if finance paper is issued mainly by finance companies or financial holding companies to purchase
loans of the books of other financial firms in the same organization so that more loans can be made.
13-20. Suppose that the finance company affiliate of Citigroup issues $325 million in 90 day commercial
paper to interested investors and uses the proceeds to purchase loans from Citibank. What accounting
entries should be made on the balance sheets of Citibank and Citigroup’s finance company affiliates?
The appropriate entries for the above transaction are:
Step 1 - Commercial Paper is Sold by the Affiliated Finance Company
Citibank
Assets
Liabilities
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Finance Affiliate
Assets
Cash
Account
Liabilities
Commercial
+$325 mill.
Paper
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+$325 mill.
Chapter 01 - An Overview of the Changing Financial-Services Sector
Step 2 - The Affiliated Finance Company Purchases Loans from Citibank
Citibank
Assets
Liabilities
Loans
-$325 mill.
Reserves
+$325 mill.
Finance Affiliate
Assets
Liabilities
Cash Account -$325 mill.
Loans Purchased
from Citibank +$325 mill.
13-21. What long-term nondeposit funds sources do banks and some of their closest competitors draw
upon today? How do these interest costs differ from those costs associated with most money market
borrowings?
Long-term nondeposit funds include mortgages, capital notes, and debentures. Generally, the interest
costs on these funds sources are substantially higher than money market loans but are more stable
usually.
13-22. What is the available funds gap?
The funds gap is the difference between current and projected credit and deposit flows that creates a
need for raising additional reserves or for profitably investing any excess reserves that may arise. The
difference between current and projected outflows and inflows of funds yields an
estimate of each institution’s available funds gap.
13-23. Suppose J.P. Morgan Chase Bank of New York discovers that projected new loan demand next
week should total $325 million and customers holding confirmed credit lines plan to draw down $510
million in funds to cover their cash needs next week, while new deposits next week are projected to
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Chapter 01 - An Overview of the Changing Financial-Services Sector
equal $680 million. The bank also plans to acquire $420 million in corporate and government bonds
next week. What is the bank's projected available funds gap?
The expected funds gap (with all figures in millions of dollars) would be:
Projected
= $325 + $510 + $420 - $680 = $575.
Funds Gap
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Chapter 01 - An Overview of the Changing Financial-Services Sector
13-24. What factors must the manager of a financial institution weigh in choosing among the various
nondeposit sources of funding available today?
A manager must weigh factors such as relative costs, risk, length of time funds are needed, size of the
institution and its funding need, and regulations in choosing what nondeposit funds sources to use.
Other factors held constant, management will seek out the lowest cost nondeposit funding sources
available subject to the risk of availability problems and the danger of interest-rate volatility. When
funds are needed for longer periods, negotiable CDs and Eurodollars are usually the preferred sources
whereas very short-term cash needs usually will be met by Federal funds and RPs or by borrowing from
the Federal Reserve banks. However, regulations impose reserve requirements on some funding
sources (e.g., CDs) which increases their cost and these rules limit access to some sources (e.g.,
borrowings from the Fed's Discount Window).
Problems
13-1. Robertson State Bank decides to loan a portion of its reserves in the amount of $70 million held
at the Federal Reserve Bank to Tenison National Security Bank for 24 hours. For its part, Tenison plans to
make a 24-hour loan to a security dealer before it must return the funds to Robertson State Bank. Please
show the proper accounting entries for these transactions.
Step 1 - Lending the $70 million
Robertson State Bank
Assets
Liabilities
Federal Funds
Sold
+$70 mill.
Reserves at
Fed.
-$70 mill.
Tenison National Security Bank
Assets
Reserves
at Fed.
Liabilities
Federal funds
+$70 mill.
purchased
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+$70 mill.
Chapter 01 - An Overview of the Changing Financial-Services Sector
Step 2 - Loaning the Borrowed Funds
Tenison National Security Bank
Assets
Liabilities
Reserves at
Fed.
-$70 mill.
Loans
+$70 mill.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Step 3 - Repaying the Loan of Federal Funds
Robertson State Bank
Assets
Liabilities
Reserves
at Fed.
+$70 mill.
Federal
Funds Sold -$70 mill.
Tenison National Security Bank
Assets
Reserves at
Liabilities
+$70 mill.
Fed
Loans
- $70 mill
Reserves
Federal funds
at Fed.
-$70 mill.
purchased
-$70 mill.
13-2. Masoner Savings, headquartered in a small community, holds most of its correspondent
deposits with Flagg Metrocenter Bank, a money center institution. When Masoner has a cash surplus in
its correspondent deposit, Flagg automatically invests the surplus in Fed funds loans to other money
center banks. A check of Masoner’s records this morning reveals a temporary surplus of $11 million for
48 hours. Flagg will loan this surplus for two business days to Secoro Central City Bank, which is in need
of additional reserves. Please, show the correct balance sheet entries to carry out this loan and to pay
off the loan when its term ends.
Step 1 - Lending Federal Funds to a Correspondent
Masoner Savings
Assets
Liabilities
Deposit with
Correspondent -$11 mill.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Federal funds
loaned
+11 mill.
Flagg Metrocenter Bank
Assets
Liabilities
Federal funds
purchased
+$11 mill.
Respondent
Bank's deposit
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-$11 mill.
Chapter 01 - An Overview of the Changing Financial-Services Sector
Step 2 - The Correspondent Bank Loans Funds to Another Bank
Flagg Metrocenter Bank
Assets
Reserves
Liabilities
-$11 mill.
Federal funds
loaned
+$11 mill.
Secoro Central City Bank
Assets
Reserves
Liabilities
+$11 mill.
Federal funds
purchased
+$11 mill.
Step 3 - Repaying the Loan to the Respondent Bank
Masoner Savings
Assets
Liabilities
Deposit with
Correspondent +$11 mill.
Federal funds
loaned
-$11 mill.
Flagg Metrocenter Bank
Assets
Liabilities
Federal funds
purchased
-$11 mill.
Respondent Bank's
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Chapter 01 - An Overview of the Changing Financial-Services Sector
deposit
+$11 mill.
13-3. Relgade National Bank secures primary credit from the Federal Reserve Bank of San Francisco in
the amount of $32 million for a term of seven days. Please show the proper entries for granting this loan
and then paying off the loan.
The correct entries are:
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Step 1 - Receiving a Loan from the Fed
Relgade National Bank
Assets
Liabilities
Reserves on deposit at
Notes payable
+$32 mill.
the Federal Reserve Bank
+$32 mill.
Federal Reserve Bank of San Francisco
Assets
Liabilities
Loans and
Bank reserve
advances
+$32 mill.
accounts
+$32 mill.
Step 2 - Repaying the Loan to the Fed.
Relgade National Bank
Assets
Reserves on Deposit
Liabilities
Notes payable
-$32 mill.
at the Federal Reserve
Bank.
-$32 mill.
Federal Reserve Bank of San Francisco
Assets
Loans and
advances
Liabilities
Bank reserve
-$32 mill.
accounts
-$32 mill.
13-4. Rockfish Corporation purchases a 60-day negotiable CD with a $5 million denomination from
Bait Bank and Trust, bearing a 3.75 percent annual yield. How much in interest will the bank have to pay
when this CD matures? What amount in total will the bank have to pay back to Rockfish at the end of 60
days?
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Interest Owed
To Rockfish
Corp.
60
=
$5,000,000
*
360
*
By Bank
= $31,250.00
Total amount
owed Rockfish
in 45 days
= $5,000,000
in principle
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+ $31,250.00
in interest
0.0375
Chapter 01 - An Overview of the Changing Financial-Services Sector
= $5,031,250.00
13-5. Lost Valley Bank borrows $125 million overnight through a repurchase agreement (RP)
collateralized by Treasury bills. The current RP rate is 2.75 percent. How much will the bank pay in
interest cost due to this borrowing?
Interest cost of RP
13-6.
= $125,000,000 x 0.0275 x
1
= $9,548.61
360
Rosemary Bank of New York expects new deposit inflows next month of $375
million and deposit withdrawals of $500 million. The bank's economics department has projected that
new loan demand will reach $460 million and customers with approved credit lines will need $175
million in cash. The bank will sell $480 million in securities, but plans to add $85 million in new
securities to its portfolio. What is the projected available funds gap?
The estimated available funds gap (with all figures in millions of dollars) is:
Projected funds gap = $460 + $175 + [$85 - $480] - [$375 - $500]
= $365 million
13-7. Wells Fargo Bank borrowed $150 million in Fed funds from J.P. Morgan Chase Bank in New York
City for 24 hours to fund a 30 day loan. The prevailing Fed funds rate on loans of this maturity stood at
2.25 percent when these two institutions agreed on the loan. The funds loaned by Morgan were in the
reserve deposit that bank keeps at the Federal Reserve Bank of New York. When the loan to Wells
Fargo Bank was repaid the next day, J.P. Morgan used $50 million of the returned funds to cover its own
reserve needs and loaned $100 million in Fed funds to Bank of America, Charlotte, for a two day period
at the prevailing funds rate of 2.40 percent. With respect to these transactions,
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Chapter 01 - An Overview of the Changing Financial-Services Sector
(a) Construct T-account entries similar to those you encountered in this chapter, showing the original
Fed funds loan and its repayment on the books of J.P. Morgan, Wells Fargo, and Bank of America
Savings.
JP Morgan Chase Bank
Loan of Reserves
is made to Wells Fargo
Bank
Wells Fargo Bank
Assets
Bank of America
Assets
Reserves at Fed
Reserves at Fed.
-150
+150
Federal Funds
Liabilities
Fed Funds Purchased
Loaned +150
+150
Loan of reserves is
repaid to JP Morgan
Chase Bank
Assets
Assets
Reserves at Fed.
Reserves at Fed.
+150
-150
Federal Funds Loaned
Liabilities
Fed. Funds Purchased
-150
-150
Loan of reserves by
JP Morgan-Chase is
extended to Bank of
America Savings
Assets
Assets
Reserves at Fed.
Reserves at Fed.
-100
+100
Federal Funds Loaned
Liabilities
Fed. Funds Purchased
+100
+100
Loan is repaid by Bank of
America Savings
Assets
Assets
Reserves at Fed.
Reserves at Fed.
+100
-100
Federal Funds Loaned
-100
Liabilities
Fed. Funds Purchases
-100
(b) Calculate the total interest earned by Morgan on both Fed funds loans.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
1. Wells Fargo Bank Loan: 0.0225 X $150 Million X 1/360 = $9,375
2. Bank of America Savings: 0.024 X $100 Million X 2/360 = $13,333
13-8. Clear Skies Bank of Florida issues a 3-month (90-day) negotiable CD in the amount of $25 million
to ABC Insurance Company at a negotiated annual interest rate of 3.25 percent (360 day basis).
Calculate the value of this CD account on the day it matures and the amount of interest income ABC will
earn. What interest return will ABC Insurance earn in a 365 day year?
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Chapter 01 - An Overview of the Changing Financial-Services Sector
= Principal + (Principal * Days to Maturity / 360 * Annual Interest Rate)
= $25 million + ($25 million * 90 / 360 * 0.0325) = $25,203,125
The amount of interest income Travelers will earn is:
$25 million *90 / 360 * 0.0325 = $203,125.
On the basis of a 365-day year Travelers' will earn
365/360 * 0.0325 = 0.03295 or 3.30%
13-9. Banks and other lending affiliates within the holding company of Goodtimes Financial are
reporting heavy loan demand this week from companies in the southeastern United States that are
planning a significant expansion of inventories and facilities before the beginning of the fall season. The
holding company plans to raise $850 million in short-term funds this week, of which about $835 million
will be used to meet these new loan requests. Fed funds are currently trading at 2.25 percent,
negotiable CDs are trading in New York at 2.40 percent, and Eurodollar borrowings are available in
London at all maturities under one year at 2.30 percent. One-month maturities of directly placed
commercial paper carry market rates of 2.35 percent, while the primary credit discount rate of the
Federal Reserve Bank of Richmond is currently set at 3.25 percent a source that Interstate has used in
each of the past two weeks. Noninterest costs are estimated at 0.25 percent for Fed funds, discount
window borrowings, and CDs; 0.35 percent for Eurodollar borrowings; and 0.50 percent for commercial
paper. Calculate the effective cost rate of each of these sources of funds for Interstate and make a
management decision on what sources to use. Be prepared to defend your decision.
Effective Federal Funds Cost Rate =
0.0225 x $850 Million + 0.0025 x $850 Million
$835 Million
=
$19.13 million + $2.125 million
$835 million
= 2.54%
Effective CD Cost Rate =
0.024 * $850 million + 0.0025 * $850 million
$835 million
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Chapter 01 - An Overview of the Changing Financial-Services Sector
=
$20.40 million + $2.125 million
$835 million
= 2.70%
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Effective Eurodollar Cost Rate =
0.023 * $850 million + 0.0035 * $850 million
$835 million
=
$19.55 million + $2.975 million
$835 million
= 2.70%
Effective Commercial Paper Cost Rate =
0.0235 * $850 million + 0.0050 * $850 million
$835 million
=
$19.98 million + $4.25 million
$835 million
= 2.90%
Effective Cost of Borrowing from the Fed =
0.0325 * $850 million + 0.0025 * $850 million
$835 million
=
$27.63 million + $2.125 million
$835 million
= 3.56%
The cheapest source of all would be borrowing from the Fed Funds Market.
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Chapter 01 - An Overview of the Changing Financial-Services Sector
13-10. Surfs-Up Security Savings is considering the problem of trying to raise $80 million in money
market funds to cover a loan request from one of its largest corporate customers, which needs a 6-week
loan. However, current forecasts call for a rise in money market interest rates over the next six weeks.
Current money market interest rates are currently at the levels indicated below:
Federal funds, average for week just concluded
Discount window of the Federal Reserve bank
CDs (prime rated, secondary market):
One month
Three months
Six months
Eurodollar deposits (three months)
Commercial paper (directly placed):
One month
Three months
1.98%
2.25
2.52
2.8
3.18
3
2.33
2.7
Unfortunately, Surfs-Up’s economics department is forecasting a substantial rise in money market
interest rates over the next six weeks. What would you recommend to its funds management
department regarding how and where to raise the money needed? Be sure to consider such cost factors
as legal reserve requirements, regulations, and what happens to the relative attractiveness of each
funding source if interest rates rise continually over the period of the proposed loan.
Federal funds could be used to fund this loan, but not only do they happen to be the most expensive
source in terms of interest cost right now, but also the Fed funds rate is very sensitive to market
pressures and, therefore, will rise along with other market interest rates if the bank's forecast turns out
to be correct. Either 3-month CDs or 3-month commercial paper appear to represent good alternatives
because the bank, presumably, can lock in the interest cost to fund this loan for the entire life of the
loan. Assuming that the money market shares the expectations of the bank that interest rates will rise
over the next six weeks, the bank will very likely have to pay a premium over the current rates on either
the CDs or commercial paper. However, locking in these rates would still represent the better
alternative.
Alternative Scenario:
What if Surf’s-Up's economists are wrong and money market rates decline significantly over the next six
weeks? How would your recommendations to funds management department change on how and
where to raise the funds needed?
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Significantly declining interest rates would make shorter-term sources much more attractive to the
bank. Federal funds, for example, although currently the one of the most expensive sources may well
be a good alternative, since the federal funds rate is very sensitive to interest rate changes. One-month
CDs would also be a good alternative, as would one-month commercial paper. With the shorter
maturities, the bank could readjust its costs downward as the interest rates continue to fall, maintaining
the spread between the rate the bank is charging the borrower, which will be declining as rates fall, and
the rate it is paying for its funds.
13-11. Firefly Bank and Trust has received $800 million in total funding, consisting of $200 million in
checkable deposit accounts, $400 million in time and savings deposits, $100 million in money market
borrowings, and $100 million in stockholders’ equity. Interest costs on time and savings deposits are
2.50 percent, on average, while noninterest costs of raising these particular deposits equal
approximately 0.50 percent of their dollar volume. Interest costs on checkable deposits average only
0.75 percent because many of these deposits pay no interest, but noninterest costs of raising checkable
accounts are about 2 percent of their dollar total. Money market borrowings cost Firefly an average of
3.25 percent in interest costs and 0.25 percent in noninterest costs. Management estimates the cost of
stockholders’ equity capital at 13 percent before taxes. (The bank is currently in the 35-percent
corporate tax bracket.) When reserve requirements are added in, along with uncollected dollar
balances, these factors are estimated to contribute another 0.75 percent to the cost of securing
checkable deposits and 0.50 percent to the cost of acquiring time and savings deposits. Reserve
requirements (on Eurodeposits only) and collection delays add an estimated 0.25 percent to the cost of
the money market borrowings.
(a) Calculate Firefly’s weighted average interest cost on total volume funds raised, figured on a before-tax
basis?
(b) If the bank's earning assets total $700 million, what is its break-even cost rate?
(c) What is Firefly 's overall historical weighted average cost of capital?
Funding Source
Checkable Deposits
Time & Savings Deposits
Money-Market Borrowings
Stockholders' Equity
Totals
Amount
($ millions)
200
400
100
100
800
Interest Costs
Noninterest Costs
Total Funding Costs
1.5
10
3.25
13
14.75
5.5
4
0.5
0
10
7
14
3.75
13
24.75
a) Weighted Average Interest Cost = (Total dollar interest) / (Total deposits and borrowing)
= $14.75 million / $700 million = 0.0211 or 2.11%
b) Break-even cost rate = (Total funding costs) / (earning assets)
= $24.75/$700 = 0.0354 or 3.54%
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c) Firefly's historical weighted-average cost of capital (Before-tax)
= (Breakeven cost rate * proportion of borrowed funds)
+ (before-tax cost of stockholders' equity * proportion of stockholders' equity)
= [(3.54%) * (700/800) + (13%) * (100/800)]
= 3.10% + 1.63% = 4.72%
13-12. Aspiration Savings Association is considering funding a package of new loans in the amount of
$400 million. Aspiration has projected that it must raise $450 million in order to have $400
million available to make the new loans. It expects to raise $325 million of the total by selling
time deposits at an average interest rate of 2.25 percent. Noninterest costs from selling time
deposits will add an estimated 0.45 percent in operating expenses. Aspiration expects another
$125 million to come from noninterest-bearing transaction deposits, whose noninterest costs
are expected to be 3.25 percent of the total amount of these deposits. What is the Association’s
projected pooled-funds marginal cost? What hurdle rate must it achieve on its earning assets?
Source of Funds
Time Deposits
Transaction Deposits
Dollar Amount
Noninterest
($ millions) Interest Rate Cost Rate
325
125
450
2.25%
-
0.45%
3.25%
Total
Interest
Expenses
$7.31
0
$7.31
Total
Noninterest
Expenses
$
$
$
The bank's pooled marginal funds cost must be:
7.31 million + 5.5250 million = 2.85%
$450 million
With only a net $400 million in funds the bank can invest, the bank's hurdle rate over total earning
assets must be:
$12.8375 Million
$400 Million
= 3.21%
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4.0625
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CHAPTER 14
INVESTMENT BANKING, INSURANCE, AND OTHER SOURCES OF FEE INCOME
Goal of This Chapter: This chapter is designed to explore several of the most important non-deposit
financial services banks have offered to the public in recent years, including investment banking, trust
services, investments in stocks, bonds and mutual funds, insurance policies, and annuities and examine
their possible benefits.
Key Topics in This Chapter
•
•
•
•
•
•
•
The Ongoing Search for Fee Income
Investment Banking Services
Mutual Funds and Other Investment Products
Trust Services and Insurance Products
Benefits of Product-Line Diversification
Economies of Scope and Scale
Information Flows and Customer Privacy
Chapter Outline
I. Introduction
II. Sales of Investment Banking Services
A. Key Investment Banking Services
B. Linkages between Commercial and Investment Banking
C. Possible Advantages and Disadvantages of Linking Commercial and Investment
Banking
D. Key Issues for Investment Banks of the Future
III. Selling Investment Products to Consumers
A. Mutual Fund Investment Products
B. Annuity Investment Products
C. The Track Record for Sales of Investment Products
D. Risks and Rules for Selling Investment Products
IV. Trust Services as a Source of Fee Income
A. History Trust Services
B. Roles of Trust Departments
C. Types of Trusts
V. Sales of Insurance-Related Products
A. Types of Insurance Products Sold Today
1. Life Insurance Policies
2. Life Insurance Underwriters
3. Property/Casualty Insurance Policies
4. Property/Casualty Insurance Underwriters
B. Rules Covering Insurance sales by Federally Insured Depository Institutions
VI. The Alleged Benefits of Financial-Services Diversification
A. An Example of the Product-Line Diversification Effect Reducing Risk
B. Potential Economies of Scale and Scope
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VII. Information Flows within the Financial Firm
VIII. Summary of the Chapter
Concept Checks
14-1.
What services are provided by investment banks (IBs)? Who are their principal clients?
The primary role of investment bankers is to serve as financial advisers to corporations, governments,
and other large institutions. Investment bank help underwrite a number of securities for corporations
including common and preferred stock, corporate bonds, government and federal agency securities and
others. In addition, they can provide a number of services including advising clients regarding
acquisitions and mergers, creating and trading in derivatives, brokering loan sales, setting up special
purpose entities, stock and bond trading, currency and commodity trading, issuing credit and liquidity
enhancements and developing business plans so companies can expand into new markets.
14-2. Why were U.S. commercial banks forbidden to offer investment banking services for several
decades? How did this affect the ability of U.S. banks to compete for underwriting business?
The Glass-Steagall Act prohibited commercial banks from offering investment bank services for primary
two reasons. One, the bank could force a customer seeking a loan to buy the securities that they were
trying to sell as a condition for getting a loan, and second, the bank would be exposed to increased risk
due to the volatile and cyclical behavior of IB activity. U.S banks were not able to compete for
underwriting business with foreign banking firms who in turn captured U.S. customers.
14-3. What advantages do commercial banks with investment banking affiliates appear to have over
competitors that do not offer investment banking services? Possible disadvantages?
IB services complement traditional lending services allowing commercial banking firms to offer both
conventional loans and security underwriting to customers who seek to raise new funds. In addition,
there are economies in information gathering about clients. On the other had, IB services are highly
sensitive to fluctuations in the economy and would increase the risk exposure of the commercial bank.
14-4. What are investment products? What advantages might they bring to an institution choosing to
offer these services?
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Investment products include stocks, bonds, mutual funds and other nondeposit services. The two most
popular investment products offered include mutual funds and annuities. The potential advantages
include generating considerable fee income which may be less sensitive to interest rate movements
than traditional services such as loans and deposits. In addition, it is possible that it might add prestige
and may help position the institution well for the future as more and more individuals start planning for
retirement.
14-5. What risks do investment products pose for the institutions that sell them? How might these
risks be minimized?
There are several risks involved in the sale of these products. The value of these products is market
driven and customers may blame the bank when they do not reach their earnings goals. Because of
their reputation, customers may hold depository institutions to a higher standard than securities
brokers. As a result, they may end up involved in costly litigation with customers who are disappointed
or who claim that the risks involved were not adequately explained. In addition, they may have
compliance problems if they do not properly register their investment products or fail to follow the rules
for the sale of these products.
Regulators already require these products to be sold in a separate area from where deposits are taken
and banks are required to prominently display that these products are not covered by deposit insurance.
In addition, customers must be told that these products are subject to risks including potential loss of
principal. Customers must sign a document stating they were informed of these risks. In addition, they
must make sure that the names of these products cannot be confused with their regular products.
Finally, they must demonstrate that they are regularly monitoring themselves to ensure that their sales
personnel are complying with the regulatory requirements and banks are also supposed to be sure that
the products they sell meet the needs of each particular customer and situation. Compliance with these
regulations should help minimize the risks inherent in these products.
14-6.
What exactly are trust services?
Trust departments manage the property of customers including their securities, land, buildings and
other investments. This is one of the oldest services provided by banks. Trust departments should
safeguard and prudently manage a customer’s assets to generate earnings.
14-7. How do trust services generate fee income and often deposits as well for banks and other
financial institutions offering this service?
Trust departments manage the assets of their customers. These assets include deposits and in some
cases these deposits can be substantial. Trusts can be formed for individuals as well as businesses and
charitable groups and they can have large deposits associated with them. The financial institution
charges their customers a fee for providing these services.
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14-8. What types of insurance products do banks and a number of their competitors sell today? What
advantages could these products offer depository institutions choosing to sell insurance services? Can
you see any possible disadvantages?
Financial institutions are starting to offer several insurance products. One product that they offer today
is life insurance in which the bank promises to pay a beneficiary a specific cash payment in the event of
the death of the policyholder. Another insurance product they are interested in is acting as a life
insurance underwriter. Here, the institution would manage risks associated with paying life insurance
claims. They want to profit from managing insurable risks and collect more in life insurance premiums
than they pay in claims. Financial institutions are also getting involved in selling insurance policies for
protection from loss due to personal injury, property damage and other losses associated with property
and casualty insurance products. In addition, they want to underwrite property-casualty insurance risks.
Again, they want to collect more in premiums than they have to pay in claims on these contracts.
There are two potential advantages to offering these services. One of these is the product line
diversification effect which means that because these products are not highly correlated with their
other services that it can reduce the variability of the overall cash flows generated from the institution.
In addition, there may be potential economies of scope from offering these products. Potential cost
savings may exist because the same personnel can offer both traditional services as well as the newer
nontraditional services such as insurance products. On the other hand, selling insurance services
requires financial institutions to adhere to strict consumer protection rules.
14-9. What is convergence? Product-line diversification? Economies of scale and scope? Why might
they be of considerable importance for banks and other financial-service firms?
Convergence is the bringing together of firms from different industries in order to create large
conglomerates offering multiple services in one place. Product-line-diversification suggests that offering
services that are not perfectly correlated with each other has the potential to reduce the risk (variability)
of the cash flows of the overall company. Economies of scale mean that there might be cost savings
from being able to produce a larger number of units of the same product. Economies of scope mean
that there are potential costs savings resulting from (for example) the same employee may be able to
offer both traditional and nontraditional services. These things mean that banks and other financial
institutions may be more efficient and productive in delivering services to customers either resulting in
higher profit margins for companies or cost savings for consumers.
14-10. How can financial-service customers limit the sharing of their private data by different financialservice firms? In what way could customer information sharing be useful for financial institutions and
for their customers? What possible dangers does information sharing present?
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Financial-services firms must inform customers of their policy regarding the sharing of information with
other parties. Financial-services firms must also inform customers about how the customer can opt out
of having their information shared with other parties. Generally, the customer must inform the
company within 30 days of being notified that they do not want their information shared. There is some
information that customers cannot protect from being shared.
This information can be extremely useful to financial institutions because they can use the information
to offer more than one service to the customer. They have already gathered the relevant information
and can target products and services that are particularly a good fit for that customer. This can benefit
them by increasing profits and cash flows and can benefit the customer by allowing them to get all of
their financial services needs taken care of in one place.
However, there are some real dangers that this information can be misused in some cases. For
example, if there is some adverse private information about a particular customer (for example they
have a very serious medical condition) that information might be used to deny them several financial
services (such as getting a new mortgage). This customer essentially becomes blacklisted by many
financial-services companies.
Problems and Projects
14-1. Suppose the management of the First National Bank of New York decides that it needs to
expand its fee-income generating services. Among the services the bank is considering adding to
its service menu are investment banking, the brokerage of mutual funds, stocks, bonds and
annuities, sales of life and casualty insurance policies, and offering personal and commercial
trust services.
a. Based on what you read in this chapter, list as many potential advantages as you can that might come
to First National as a result of adding these services to its menu?
First National may be able to supplement traditional sources of income with the new fee income
that they generate. In addition, they may be able to reduce the risk of the overall institution by
adding services that are not very correlated with their traditional services. They may find that
some of these services are less interest rate sensitive than traditional services. They may be able
to generate economies of scale and scope from offering these services. The production cost per
unit tends to drop as the firm gets larger. It may also be cheaper to jointly produce two or more
services than having to produce each service separately.
b. What potential disadvantages might the bank encounter from selling these fee-generating
services?
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There are many potential disadvantages. Investment banking activities tend to be much more
volatile than commercial banking activities and there is not much job security in this area. In
selling investment products and because of their reputation, customers may hold First National to
a higher standard than a securities broker. First National could also get involved in costly
lawsuits filed by disappointed investors. In addition, First National needs to be sure to comply
with all regulations concerning selling investments products. Customers could confuse First
National’s traditional products with their investment products if First National does not disclose
the differences between their traditional products and the newer services they are offering. The
same things are true if they offer insurance products. First National must be clear about the
difference between the insurance products they offer and the other services they offer.
c. Are there risks to the bank from developing and offering services such as these? If so, can you
think of ways to lower the bank’s risk exposure from offering these new services?
First National faces the risk of a customer becoming angry because the return they receive is not
as good as they expected. They also face the risk these customers may feel they have been
misled about these products and sue the bank. First National must also be careful to be in full
compliance with all regulations. The bank can prevent some of this by counseling each customer
as to the risks involved in these products and have them sign a form stating that they understand
the risks involved in these products.
d. What might happen to the size and volatility of revenues, expenses and profitability from
selling fee-based services like those mentioned above?
It is possible that the revenues will rise and expenses will fall, increasing the return to the bank.
In addition, it is possible that the volatility of the bank’s earnings will decrease. It depends, in
part, on how correlated the new services are with the old services. If they are not correlated
returns can actually rise and volatility decease from adding the new services.
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14-2. A commercial bank decides to expand its service menu to include the underwriting of
new security offerings (i.e. investment banking) as well as offering traditional lending and
deposit services. It discovers that the expected return and risk associated with these two sets of
service offerings are as follows:
Expected return - traditional services
Expected return - security underwriting
Standard deviation - traditional services
Standard deviation - security underwriting
Correlation of returns between two services
Proportion of revenue - traditional services
Proportion of revenue - security underwriting
3.5%
12%
2.5%
6%
+.25
65%
35%
Please calculate the effects of the new service on the banking company’s overall return and risk
as captured by the bank’s standard deviation of returns.
E(R) = WT R T + WSR S = .85(10%) + .15(15) = 10.75%
S.D. = WT2 *  T2 + WS2 *  S2 + 2 * rTS * WT * WS *  T *  S
= .652 * 2.52 + .352 * 6 2 + 2 *.25 *.65 *.35 * 2.5 * 6
=2.96%
14-3 Based on what you learned from reading this chapter and from studies you uncovered on
the Web which of the financial firms listed below are most likely to benefit from economies of
scale or scope and which will probably not benefit significantly from these economies based on
the information given?
a. A new bank offering traditional banking services (principally deposits and loans) was
chartered earlier this year, gaining $50 million in assets within the first six months.
This bank should benefit from the increase in size as economies of scale take effect. This firm
should continue to enjoy economies of scale as it grows in the next several years. However,
these economies of scale will not continue indefinitely and there is some evidence that
economies of scale are exhausted fairly quickly in banking firms.
b. A community bank with about $250 million in assets provides traditional banking services but
also operates a small trust department for the convenience of families and small business.
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This bank probably does not benefit much from economies of scope. The trust business is small
and if it is mostly a convenience for families and small businesses it does not seem it would be
much less costly to jointly produce these services.
c. A financial holding company (FHC) with about $2 billion in assets offers a full range of
banking and investment services, giving customers access to a family of mutual funds.
Economies of scale start to disappear in about this range although there may be some small
economies of scale that still exist up until the size of about 10 billion. There does not appear to
be much evidence that exists to support the idea of economies of scope. No economies of scope
can be documented
d. A bank holding company with just over $10 billion in assets also operates a security brokerage
subsidiary, trading in stocks and bonds for its customers.
This firm appears to be outside of the range where any economies of scale exist. The evidence
for economies of scope is not clear and there does not appear to be much support for any large
economies of scope.
e. A financial holding company (FHC) with $750 billion in assets controls a commercial bank,
investment banking house, chain of insurance agency offices, and finance company and supplies
commercial and consumer trust services through its recently expanded trust department.
This firm appears to be much larger than necessary to generate any economies of scale and the
evidence for economies of scope suggest that there is not much economies of scope in this
industry.
CHAPTER 15
THE MANAGEMENT OF CAPITAL
Goal of This Chapter: The purpose of this chapter is to discover why capital – particularly equity capital –
is so important for financial institutions, to learn how managers and regulators assess the adequacy of
an institution’s capital position, and to explain the ways that management can raise new capital.
Key Topics in This Chapter
•
•
•
•
•
•
The Many Tasks of Capital
Capital and Risk Exposures
Types of Capital In Use
Capital as the Centerpiece of Regulation
Basel I and Basel II
Planning to Meet Capital Needs
Chapter Outline
I. Introduction: What Is Capital?
II. The Many Tasks Capital Performs
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A. Cushion Against Risk of Failure
B. Provides Funds Needed to Begin Operations
C. Promotes Public Confidence
D. Provides Funds for Future Growth and New Services
E. Regulator of Growth
F. Capital Plays a Role in Mergers
G. Limits How Much Risk Exposure Banks and Competing Firms Can Accept
H. Protects the Government’s Deposit Insurance System
III. Capital and Risk
A. Key Risks in Banking and Financial Institutions’ Management
1. Credit Risk
2. Liquidity Risk
3. Interest Rate Risk
4. Operating Risk
5. Exchange Risk
6. Crime Risk
B. Defenses against Risk
1. Quality Management
2. Diversification
a. Portfolio
b. Geographic
3. Deposit Insurance
4. Owners' Capital
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IV. Types of Capital in Use
A. Common stock
B. Preferred stock
C. Surplus
D. Undivided profits
E. Equity reserves
F. Subordinated debentures
G. Minority interest in consolidated subsidiaries
H. Equity commitment notes
Relative Importance of the Different Sources of Capital
V. One of the Great Issues in the History of Banking: How Much Capital Is Really Needed?
A. Regulatory Approach to Evaluating Capital Needs
1. Reasons for Capital Regulation
2. Research Evidence
VI. The Basle Agreement on International Capital Standards: An Historic Contract among Leading Nations
A. Basel I
1. Tier 1 (core) Capital
2. Tier 2 (supplemental) Capital
3. Calculating Risk-Weighted Assets under Basel I
4. Calculating the Capital-to-Risk-Weighted Assets Ratio Under Basel I
B. Capital Requirements Attached to Derivatives
1. Bank Capital Standards and Market Risk
2. Value at Risk (VaR) Models Responding to Market Risk
3. Limitations and Challenges of VaR and Internal Modeling
C. Basel II: A New Capital Accord Unfolding
1. Why Basel II Appears to Be Needed
2. Pillars of Basel II
3. Internal Risk Assessment
4. Operational Risk
5. Basel II and Credit Risk Models
6. A Dual (Large-Bank, Small-Bank) Set of Rules
7. Problems Accompanying the Implementation of Basel II
VII. Changing Capital Standards Inside the United States
A. FDIC Improvement Act
B. Prompt Corrective Action
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1. Well capitalized
2. Adequately capitalized
3. Undercapitalized
4. Significantly undercapitalized
5. Critically undercapitalized
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VIII. Planning to Meet Capital Needs
A. Raising Capital Internally
1. Dividend Policy
2. How Fast Must Internally Generated Funds Grow?
B. Raising Capital Externally
1. Selling Common Stock
2. Selling Preferred Stock
3. Issuing Debt Capital
4. Selling Assets and Leasing Facilities
5. Swapping Stock for Debt Securities
6. Choosing the Best Alternative for Raising Outside Capital
IX. Summary of the Chapter
Concept Checks
15-1.
What does the term capital mean as it applies to financial institutions?
Funds contributed to a financial institution primarily by its owners, consisting mainly of stock, reserves,
and retained earnings, plus any long-term debt issued that qualifies under regulations.
15-2.
What crucial roles does capital play in the management and viability of financial firm?
Capital provides the long-term, permanent funding that is needed to construct facilities and provide a
base for the future expansion of assets. Capital also absorbs operating losses until management has a
chance to correct the institution's problems. From a regulatory perspective capital limits the growth of
risky assets.
15-3.
What are the links between capital and risk exposure among financial-service providers?
Capital functions as a cushion to absorb losses until management can correct the problems generating
those losses. Institutions face many different kinds of risk: (1) crime risk, (2) interest-rate risk, (3) credit
risk, (4) liquidity risk, (5) exchange risk and (6) operational risk. Capital represents the ultimate line of
defense against these risks when all other defenses fail.
15-4. What forms of capital are in use today? What are the key differences between the different
types of capital?
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The principal forms of bank capital include common and preferred stock, surplus, undivided profits,
equity reserves, subordinated notes and debentures, minority interest in consolidated subsidiaries, and
equity commitment notes. Common stock represents the par value paid by owners, while surplus is the
amount paid over par value for the stock when it is first sold. Preferred stock is a special type of
ownership where dividends are fixed and stockholders generally do not have a vote on major activities
undertaken by the firm. Retained earnings or undivided profits are the accumulated earnings of the
firm kept to reinvest back in the company. Subordinated notes and debentures are long term debt
instruments that don not represent ownership claims. Equity reserves represents the funds set aside for
contingencies, such as legal action against the institution, reserve for dividend expected to be paid but
not yet declared or shrinking fund to retire stock or debt in the future. Minority interests in consolidated
subsidiaries are one in which financial firms holds ownership shares in other businesses. Equity
commitment notes are one in which debt securities are repaid from the sale of stock.
15-5. Measured by volume and percentage of total capital, what are the most important and least
important forms of capital held by U.S.-insured banks? Why do you think this is so?
The most important form of capital is surplus, followed by retained earnings, subordinated notes and
debentures, and common and preferred stock. Common stock represents what owners contribute
originally when they buy the stock to begin with. Retained earnings represent the growth in earnings
that accumulate in the firm over time. What the owners contribute to the firm and the wealth that
accumulates over time are the true cushion against loss that capital represents.
15-6. How do small banks differ from large banks in the composition of their capital accounts and in
the total volume of capital they hold relative to their assets? Why do you think these differences exist?
Small banks rely mainly on surplus value of their stock and retained earnings (undivided profits) and
very little on long-term debt (subordinated notes and debentures), whereas large banks rely on surplus
value of stock, retained earnings and long term debt. Small banks have a difficult time to place their
equity and debt securities in the market and thus, rely more heavily on internal capital (i.e. retained
earnings). Nevertheless, it is generally the smallest banks that maintain the thickest cushion of capital
relative to their asset size.
15-7 What is the rationale for having the government set capital standards for financial institutions as
opposed to letting the private marketplace set those standards?
The government's interest in capital stems from its efforts to stabilize the financial system and avoid
drains on the federal insurance system. Capital requirements have long been subject to government
regulation, though bankers frequently argue that the market, rather than regulators, should determine
how much capital a financial institution should hold. The fear among regulators, however, is that
financial institutions would hold too little capital to avoid excessive numbers of failures and that the
private market cannot adequately assess their need for capital.
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15-8. What evidence does recent research provide on the role of the private marketplace in
determining capital standards?
The results of recent studies are varied, but most find that the private marketplace is more important
than government regulation in determining the amount and type of capital financial institutions must
hold. However, Recently government regulation appears to have become nearly as important as the
private marketplace by tightening capital regulations and imposing minimum capital requirements,
especially in the wake of the great credit crisis of 2008.
15-9.
According to recent research, does capital prevent a financial institution from failing?
If capital is large enough to absorb operating losses it can prevent failure for a time, at least until the
capital is all used up. However, there is no solid, undisputed evidence of a significant relationship
between the size of the capital-to-asset ratio and the incidence of failure.
15-10. What are the most popular financial ratios regulators use to assess the adequacy of bank capital
today?
The prime capital-adequacy ratios are total capital to assets, equity capital to assets, total capital to risk
assets, and primary or core capital and supplementary or secondary capital to total assets and to riskadjusted assets.
15-11. What is the difference between core (or tier 1) capital and supplemental (or tier 2) capital?
Core capital is the permanent capital of a bank, consisting mainly of common stock, surplus, undivided
profits (retained earnings), qualifying noncumulative perpetual preferred stock, minority interest in the
equity accounts of consolidated subsidiaries, and selected identifiable intangible assets less goodwill,
equity reserves and other intangible assets. Supplemental capital is secondary forms of bank capital,
which includes the allowance (reserves) for loan and lease losses, subordinated debt capital
instruments, mandatory convertible debt, intermediate-term preferred stock, cumulative perpetual
preferred stock with unpaid dividends, and equity notes and other long-term capital instruments that
combine both debt and equity features.
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15-12. A bank reports the following items on its latest balance sheet: allowance for loan and lease
losses, $42 million; undivided profits, $81 million; subordinated debt capital, $3 million; common stock
and surplus, $27 million; equity notes, $2 million; minority interest in subsidiaries, $4 million; mandatory
convertible debt, $5 million; identifiable intangible assets, $3 million; and noncumulative perpetual
preferred stock, $5 million. How much does the bank hold in Tier 1 capital? In Tier 2 capital? Does the
bank have too much Tier 2 capital?
The Tier 1 capital items include:
Common stock and surplus
$27 mill.
The Tier 2 capital items include:
Allowance for loan and
$42 mill.
lease losses
Undivided profits
81
Noncumulative perpetual
preferred stock
5
Identifiable intangible assets
3
Subordinated debt capital
3
Mandatory convertible debt
5
Equity notes
2
Minority interest in
subsidiaries
Total Tier 1 capital
4
$120 mill.
Total Tier 2 capital
$52 mill.
The bank does not have too much Tier 2 capital. Tier 2 capital can be up to 100 percent of the amount of
Tier 1 capital and still count toward meeting capital requirements.
15-13. What changes in the regulation of bank capital were brought into being by the Basel
Agreement? What is Basel I? Basel II?
U.S. banks, along with international banks from other industrialized nations, must hold a ratio of core
capital or Tier 1 (permanent) capital to risk-weighted assets of 4 percent and an additional 4 percent in
supplementary or secondary capital, under the terms of the Basel Agreement on international capital
standards. Basel I refers to the capital standards that are in effect today. Basel II is a new capital
requirement accord that is supposed to address the weaknesses of Basel I. It is scheduled to be phased
in starting in 2008.
15-14. First National Bank reports the following items on its balance sheet: cash, $200 million; U.S.
government securities, $150 million; residential real-estate loans, $300 million; and corporate loans,
$350 million. Its off-balance-sheet items include standby credit letters, $20 million and long-term credit
commitments to corporations, $160 million. What are First National's total risk-weighted assets? If the
bank reports Tier I capital of $30 million and Tier 2 capital of $20 million, does it have a capital
deficiency?
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We first convert the off-balance-sheet items to their credit-equivalent amounts:
Off-Balance-Sheet Items:
Standby credit letters $20 mill. * 1.00 = $20 mill.
Long-term commitments to corporations $160 mill. * 0.50 = 80 mill.
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Then we risk-weight all assets:
Risk-Weighted Assets
Cash
$200 mill. * 0 =
$0 mill.
U.S. Government Securities:
$150 mill. * 0 =
0
Standby Credit Letters:
$20 mill. * 0.20 =
4
Residential Real Estate Loans:
$300 * 0.50 =
150
Corporate Loans:
$350 * 1.00 =
350
Long-Term Credit Commitments:
$80 * 1.00 =
80
Total Risk-Weighted Assets =
$584
The bank has total capital of:
Tier 1 capital = $30 mill.
Tier 2 capital = $20 mill.
$50 mill.
The bank's capital to risk-weighted asset ratio is:
$50 mill. = 0.086 or 8.6%
$584 mill.
which exceeds the minimum requirement of 8 percent. Moreover, more than 4 percent of the 8.6
percent in capital is Tier 1 capital, so the bank satisfies the capital requirements.
15-15. How is the Basel Agreement likely to affect a bank's choices among assets it would like to
acquire?
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Under the capital standards brought into being by the Basel Agreement, differing risk weights will apply
to different kinds of bank assets. Each dollar of high-risk assets, such as corporate loans and home
mortgages, requires a greater proportion of bank capital pledged behind it than a dollar of low-risk
assets, such as government securities. Banks desiring to keep their capital costs as low as possible will
move toward government securities and away from corporate loans and home mortgage loans. They
will also change the types of off-balance sheet items they hold for the same reason.
15-16. What are the most significant differences between Basel I and Basel II? Explain the importance
of the concepts of internal risk assessment, VaR, and market discipline
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Basel I used a one size fits all approach to determine a bank’s capital requirements. Basel II recognizes
that different banks have different risk exposures and should be subject to different capital
requirements. It also broadens the types of risk considered for determining capital requirements,
including credit, market and operational risk. Internal risk assessment refers to an innovation in Basel II
which allows banks to measure their own risk exposure. These measurements are subject to review by
the regulators to ensure that they are reasonable. The VaR model is one of the models used to
determine a bank’s risk exposure. It measures the price or market risk of a portfolio of assets whose
value may decline due to adverse movements in the financial markets or interest rates. Market
discipline refers to the market determining the bank’s risk exposure. In order to achieve that a bank
would be required to issue subordinated debt. Since this debt is not guaranteed the buyers of these
notes would be very vigilant about the issuing bank’s financial condition.
15-17. What steps should be part of any plan for meeting a long-range need for capital?
The four key phases of planning to meet a bank's capital needs are as follows:
1. Develop an overall financial plan.
2. Determine the amount of capital that is appropriate given the goals, planned service offerings,
acceptable risk exposure, and state and federal regulations.
3. Determine how much capital can be generated internally through profits retained in the
business.
4. Evaluate and choose that source of external capital best suited to the institution’s needs and goals.
15-18. How does dividend policy affect the need for capital?
The retention ratio is of great importance to management. A retention ratio set too low results in slower
growth of internal capital, which may increase the failure risk and retard the expansion of earning
assets. A retention ratio set too high can result in a cut in stockholders’ dividend income. Other factors
held constant, such a cut would reduce the market value of stock issued by a financial institution. The
optimal dividend policy is one that maximizes the value of the stockholders’ investment.
15-19. What is the ICGR, and why is it important to the management of a financial firm?
The ICGR indicates how fast a firm can allow its assets to grow and still keep its capital-to-asset ratio
fixed. The ICGR indicates how fast earnings must grow and what proportion must be retained in the
business to insure a constant capital-to-asset ratio.
15-20. Suppose that a bank has a rate of return on equity capital of 12 percent and its retention ratio is
35 percent. How fast can this bank's assets grow without reducing its current ratio of capital to assets?
Suppose that the bank's earnings (measured by ROE) drop unexpectedly to only two-thirds of the
expected 12 percent figure. What would happen to the bank's ICGR?
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The relevant formula is:
ICGR
= ROE x Retention Ratio
= 0.12 * 0.35
= 0.042 or 4.2 percent
If ROE unexpectedly drops to only two-thirds of the expected 12 percent figure, the ICGR becomes:
ICGR
= [0.12 * 0.66] * 0.35
= 0.028 or 2.8 percent.
15-21. What are the principal sources of external capital for a financial institution?
The principal sources of external capital are: selling common stock, selling preferred stock, issuing debt
capital, selling assets, leasing certain fixed assets or swapping stock for debt securities.
15-22. What factors should management consider in choosing among the various sources of external
capital?
The choice of alternative that management should choose will depend primarily on the impact each
source would have on returns to stockholders, usually measured by earnings per share (EPS). Other key
factors to consider are the institution’s risk exposure, the impact on control by existing stockholders, the
state of the market for the assets or securities being sold, and regulations.
Drawing upon common and preferred stock increases the borrowing capacity and provides permanent
capital, but it can result in ownership and earnings dilution. Debt capital is generally cheaper to issue
due to the leveraging effect, but creates greater risk of variability in shareholder returns and increased
risk failure. Selling assets and leasing capital usually creates a substantial inflow of cash. Swapping Stock
for Debt Securities strengthens its capital and saved the cost of future interest payments on the notes.
Problems and Projects
15-1. The management at Thyme National Bank located in Key West, Florida, is calculating the key
capital adequacy ratios for its third-quarter reports. At quarter-end the bank’s total assets are $92
million and its total risk-weighted assets including off-balance-sheet items are $85.5 million. Tier 1
capital items sum to $4.75 million, while Tier 2 capital items total $2.5 million. Calculate Thyme
National’s leverage ratio, total capital-to-total assets, core capital-to-total risk-weighted assets, and total
capital- to-total risk-weighted assets. Does Thyme National meet the Basel I requirement stipulated for a
bank to qualify as adequately capitalized? In which of the five capital adequacy categories created by
U.S. federal regulators for PCA purposes does Thyme National fall? Is Thyme National subject to any
regulatory restrictions given its capital adequacy category?
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Total assets
$92
million
Risk weighted assets including off-balancesheet items
$85.5
million
Tier 1 capital
$4.75
million
Tier 2 capital
$2.5
million
Leverage ratio:
Tier 1 capital/Total asset
= $4.75 million/$92 million = 0.0516 or 5.16 percent
Total capital-to-total assets ratio:
(Tier 1 capital + Tier 2 capital)/Total assets
= ($4.75 million + $2.5 million)/$92 million
= $7.25 million/$92 million = 0.0788 or 7.88 percent
Core capital-to-total risk-weighted assets:
= Tier 1 capital/ Risk weighted assets including off-balance-sheet items
= $4.75 million/$85.5 million = 0.0555 or 5.56 percent
Total capital-to-total risk-weighted assets:
= (Tier 1 capital + Tier 2 capital)/ Risk weighted assets including off-balance-sheet items
= ($4.75 million + $2.5 million)/$85.5 million = 0.0848 or 8.48 percent
Yes, Thyme National Bank meet the Basel I requirement of having a minimum ratio of capital to risk
weighted assets of at least 8 percent, a ratio of Tier 1 capital to risk-weighted assets of at least 4
percent, and a leverage ratio of at least 4 percent stipulated for a bank to qualify as adequately
capitalized. Thyme National Bank falls in “adequately capitalized” category among the five capital
adequacy categories created by U.S. federal regulators for PCA purpose. Thyme National Bank is subject
to a regulatory restriction of not accepting broker-placed deposits without regulatory approval.
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15-2. Please indicate which items appearing on the following financial statements would be classified
under the terms of the Basel Agreement as ( a ) Tier 1 capital or ( b ) Tier 2 capital.
Allowance for loan
and lease losses
Subordinated debt under
two years to maturity
Intermediate-term
preferred stock
Qualifying noncumulative
perpetual preferred stock
Cumulative perpetual preferred
stock with unpaid dividends
Tier 1
Subordinated debt capital
instruments with an original average
maturity of at least fi ve years
Common stock
Equity notes
Undivided profits
Mandatory convertible debt
Minority interest in the equity
accounts of consolidated
subsidiaries
Qualifying noncumulative
Preferred stock
Tier 2
Allowance for loan and lease
losses
Common stock
Intermediate term preferred stock
Undivided profits
Cumulative perpetual preferred Stock
with unpaid dividends
Minority interest in the equity
Accounts of consolidated
subsidiaries
Subordinated debt capital Instrument
with an original Maturity of at least 5
Years
Equity notes
Mandatory convertible debt
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15-3. Under the terms of the Basel I Agreement, what risk weights apply to the following on-balancesheet and off-balance-sheet items?
Residential real estate loans
Cash
Commercial loans
U.S. Treasury securities
Deposits held at other banks
GNMA mortgage-backed
securities
Standby credit letters for
commercial paper
Federal agency securities
Munici pal general obligation bonds
Investments in subsidiaries
FNMA or FHLMC issued
or guaranteed securi ties
Credi t card loans
Standby letters of credit for municipal
bonds
Long-term unused commitments to
make corporate loans
Currency derivative contracts
Interest-rate derivative contracts
Short-term (under one year) loan
commitments
Bank real property
Bankers’ acceptances
Municipal revenue bonds
Reserves on deposit at the Federal
Reserve banks
The items which would appear in the 0%, 20%, 50% and 100% risk weight categories are the following:
0%
20 %
50 %
100 %
Cash
Deposits held at other
banks
Residential real estate
loans
Commercial loans
U.S. Treasury securities
Federal agency
securities
Long term
commitments to make
corporate loans
Standby credit letters
for commercial paper
GNMA mortgage backed securities
Municipal general
obligation bonds
Currency derivative
contracts
Investments in
subsidiaries
Short term loan
commitments
FNMA or FHLMC issued Interest-rate derivative
or guaranteed securities contracts
Credit card loans
Reserves on deposit at
the Federal Reserve
banks
Standby letters of credit
for municipal bonds
Bank real estate
Municipal revenue
bonds
Bankers’ acceptances
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15-4. Using the following information for Bright Star National Bank, calculate that bank’s ratios of Tier
1-capital-to-risk-weighted assets and total-capital-to-risk-weighted assets under the terms of the Basel I
Agreement. Does the bank have sufficient capital?
On-Balance-Sheet Items (Assets)
Off-Balance-Sheet Items
$ 4.5 million
Standby letters of credit
backing repayment of
commercial paper
$ 17.5 million
U.S Treasury securities
25.6
Long term unused loan
commitments to
corporate customers
30.5
Deposit balances due
from other banks
4.0
Total off-balance-sheet
items
$ 48 million
Loans secured by first
lines on residential
property (1- to-4- family
dwellings)
50.8
Tier 1 capital
$7.5 million
Loans to corporations
105.3
Tier 2 capital
$5.8 million
Cash
Total assets
$190.2 million
Bright Star National Bank's required level of capital under the new international capital standards would
be determined from:
Standby credit letter: $17.5 million * 1.00 = $17.5 million
Long-term credit commitments: $30.5 million * 0.50 = 15.25 million
0% Risk-Weighting Category:
Cash
U.S. Treasury securities
$ 4.5 million
25.6 million
$ 30.1 * 0 = $0 million
20% Risk Weighting Category:
Balances due from other Banks
$ 4.0 million
Credit equivalent Amounts of
Standby credits
17.5 million
$ 21.5 million * 0.20 = $4.3 million
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50% Risk Weighting Category:
Residential real estate loans
$ 50.8 million x 0.50 = $25.4 million
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Chapter 01 - An Overview of the Changing Financial-Services Sector
100% Risk Weighting Category:
Loans to corporations
$105.3 million
Credit equivalents of
long-term commitments
$15.25 million
$120.55 million * 1.0 = $120.55 million
Total Risk-Weighted Assets
$150.25 million
The bank's capital ratio is:
Tier 1 capital/Risk-Weighted Assets = $ 7.5 million
= 4.99%
$ 150.25 million
Total capital/Risk-Weighted Assets = $ 13.3 million
= 8.85%
$ 150.25 million
It is just above the minimum Tier 1 capital requirement of 4 percent and total capital (Tier One + Tier
Two) requirement of 8 percent.
15-5. Please calculate New River National Bank’s total risk weighted assets, based on the following
items that the bank reported on its latest balance sheet. Does the bank appear to have a capital
deficiency?
Cash
Domestic interbank deposi ts
U.S. government securities
Residential real estate loans
Commercial loans
Total assets
Total liabilities
Total capi tal
$115 million
130 million
250 million
450 million
520 million
$1,465 million
$1,350 million
$115 million
Off-balance-sheet items include
Standby credi t letters that back munici pal
general obligation bonds
Long-term unused loan commitments to
private companies
$ 87 million
145 million
The risk-weighted assets of New River National Bank would be calculated as follows:
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Off-Balance-Sheet Items:
Standby credit letters = $87 mill. * 1.00 = $87 million
Long-term corporate credit commitments = $145 mill. * 0.50 = $72.5 mill.
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On-Balance-Sheet Items and Credit-Equivalent Off-Balance Sheet Items:
Asset Items
Risk-Weight
Cash
$115 miIl. * 0
=
0
U.S. government securities
$250 mill. * 0
=
0
Domestic interbank deposits
$130 mill. * 0.20
=
26 mill.
Standby credit letters
$87 mill. * 0.20
=
17.4 mill.
Residential real estate loans
$450 mill. * 0.50
=
225 mill.
Commercial loans
$520 mill. * 1.00
=
520 mill.
$72.5 mill. * 1.00
=
72.5 mill.
=
$860.9 mill.
Long-Term corporate credit
commitments
Total Risk-Weighted Assets
New River's overall capital-to-assets ratio is:
Total Capital
Total Risk-Weighted Assets
=
$115 million
=
0.1336 or 13.36 percent
$860.9 million
Overall, it does not appear from the information given above that New River has a capital deficiency.
15.6 Suppose that New River National Bank, whose balance sheet is given in problem 5, reports the
forms of capital shown in the following table as of the date of its latest financial statement. What is the
total dollar volume of Tier 1 capital? Tier 2 capital? Calculate the Tier 1 capital-to-risk-weighted-assets
ratio, total capital-to-risk-weighted-asset ratio, and the leverage ratio. According to the data given in
problems 5 and 6, does New River have a capital deficiency? What is its PCA capital adequacy category?
Common stock (par value)
Surplus
Undivided profi ts
Allowance for loan losses
Subordinated debt capital
Intermediate-term preferred stock
$ 10 million
15 million
45 million
25 million
15 million
5 million
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New River National Bank has the following Tier 1 and Tier 2 Capital items and totals:
Tier 1 Capital
Tier 2 Capital
Common stock (par)
$10 million
Allowance for loan loss
$25 million
Surplus
$15 million
Subordinated debt capital
$15 million
Undivided profit
$45 million
Intermediate term preferred stock
$5 million
Total Tier 1 capital
$70 million
Tier 1 Capital
=
Total Risk-Weighted Assets
Total Capital
Total Tier 2 capital
$70 million
=
0.0813 or 8.13 percent
=
0.1336 or 13.36 percent
=
$70 million/$771 million
$45 million
$860.9 million
=
Total Risk-Weighted Assets
$70 + $45 million
$860.9 million
Leverage ratio:
Tier 1 Capital
=
Total average Assets
$70 million
$860.9 - $17.4 $72.5 million
0.0908 or 9.08 percent
This bank has sufficient Tier 1 capital and since its Tier 2 capital amount is less than its Tier 1 capital
amount it satisfies the requirements of Basel I. Also its PCA capital adequacy category is Well capitalized
(it has a ratio of capital to risk-weighted assets of at least 10 percent, a ratio of Tier 1 (or core) capital to
risk-weighted assets of at least 6 percent, and a leverage ratio (Tier 1 capital to average total assets) of
at least 5 percent).
15-7. Colburn Savings Association has forecast the following performance ratios for the year
ahead. How fast can Colburn allow its assets to grow without reducing its ratio of equity
capital to
total assets, assuming its performance holds reasonably steady over it planning
period?
Profit margin of net income
over operating revenue
17.75%
Asset utilization (operating
revenue/assets)
8.25%
Equity multiplier
9.5x
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Net earnings retention Ratio
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45.00%
Chapter 01 - An Overview of the Changing Financial-Services Sector
Internal Capital Growth Rate = Profit Margin * Asset Utilization * Equity Multiplier * Retention
Ratio
= 0.1775 * 0.0825 * 9.5 * 0.450
= 0.0626 or 6.26%
Its assets cannot grow any faster than 6.26 percent in order to avoid reducing its ratio of equity capital
to total assets.
15-8. Using the formulas developed in this chapter and in Chapter 6 and the information that follows,
calculate the ratios of total capital to total assets for the banking firm listed below. What relationship
among these banks’ return on assets, return on equity capital, and capital-to- assets ratios did you
observe? What implications or recommendations would you draw for the management of each of these
institutions?
Net Income/Total Assets
Name of Bank
Net Income/Total Equity Capital
(or ROE)
(or ROA)
First National Bank of Hopkins
1.4%
15%
Safety National Bank
1.2%
13%
Ilsher State Bank
0.9%
11%
Mercantile Bank and Trust
Company
0.5%
6%
Lakeside National Trust
-0.5%
-7%
The basic relationship needed in this problem is
ROE
=
Net Income After Taxes
=
Net Income After Taxes
Equity Capital
*
Total Assets
Total Assets
=
ROA
Equity Capital
*
Total Assets
Equity Capital
In which case:
Total Assets
Equity Capital
=
ROE
and
ROA
Equity Capital
Total Assets
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ROA
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Chapter 01 - An Overview of the Changing Financial-Services Sector
Therefore the ratio of total capital to total assets for the banks named in the problem must be:
First National Bank of Hopkins = 0.014/0.15 = 0.0933 or 9.33%.
Safety National Bank = 0.012/0.13 = 0.0923 or 9.23%
Ilsher State Bank = 0.009/0.11 = 0.0818 or 8.18%
Mercantile Bank and Trust Company = 0.005/0.06 = 0.0833 or 8.33%
Lakeside National Bank = -0.005/-0.07 = 0.0714 = 7.14%
None of the banks appear to have a serious capital deficiency problem. However, the bank with the
lowest capital to total assets ratio is also the one with a negative return on assets and return on equity.
The negative earnings may be eroding the capital position of this bank.
15-9. Over the Hill Savings has been told by examiners that it needs to raise an additional $8 million in
long-term capital. Its outstanding common equity shares total 5.4 million, each bearing a par value of
$1. This thrift institution currently holds assets of nearly $2 billion, with $135 million in equity. During
the coming year, the thrift’s economist has forecast operating revenues of $180 million, of which
operating expenses are $25 million plus 70% of operating revenues.
Among the options for raising capital considered by management are (a) selling $8 million in
common stock, or 320,000 shares at $25 per share; (b) selling $8 million in preferred stock bearing a 9
percent annual dividend yield at $12 per share; or (c) selling $8 million in 10-year capital notes with a 10
percent coupon rate. Which option would be of most benefit to the stockholders? (Assume a 34% tax
rate) What happens if operating revenue more than expected ($225 million rather than $180 million)?
What happens if there is a slower-than-expected volume of revenues (only $110 million instead of $180
million)? Please explain.
(a)
(b)
(c)
Sale of
Sale of 9%
Common Stock
Preferred Stock
Sale of 10%
at $25 per share
at $12 per share
Capital Notes
Operating revenues
$180,000,000
$180,000,000
$180,000,000
Operating expenses
151,000,000
151,000,000
151,000,000
Net revenues
$ 29,000,000
$ 29,000,000
$ 29,000,000
Interest on capital notes
-------------------
-------------------
800,000
$29,000,000
$29,000,000
$28,200,000
Before-tax income
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Estimated income taxes
After-tax income
9,860,000
9,860,000
9,588,000
$ 19,140,000
$ 19,140,000
$ 18,612,000
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Preferred stock dividends
Net income for common
----------------------
$
720,000
---------------------
19,140,000
$ 18,420,000
$ 18,612,000
5,720,000
5,400,000
5,400,000
$ 3.35
$3.41
$3.45
stockholders
Shares of common stock
outstanding
Earnings per share of
common stock
In this case sale of the debt would yield the highest EPS for the bank's shareholders
Because of the dilution effect of issuing stock.
If operating revenue rose to $225 million the situation would be the following:
(a)
(b)
(c)
Sale of
Sale of 9%
Common Stock
Preferred Stock
Sale of 10%
at $25 per share
at $12 per share
Capital Notes
Operating revenues
$225,000,000
$225,000,000
$225,000,000
Operating expenses
182,500,000
182,500,000
182,500,000
Net revenues
$ 42,500,000
$ 42,5000,000
$ 42,500,000
Interest on capital notes
-------------------
-------------------
800,000
$42,500,000
$42,500,000
$41,700,000
14,450,000
14,450,000
14,178,000
$ 28,050,000
$ 28,050,000
$ 27,522,000
Before-tax income
Estimated income taxes
After-tax income
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Preferred stock dividends
Net income for common
----------------------
$
720,000
---------------------
28,050,000
$ 27,330,000
$ 27,522,000
5,720,000
5,400,000
5,400,000
$4.90
$5.06
$5.1
stockholders
Shares of common stock
outstanding
Earnings per share of
common stock
And again the capital notes would be the best option, although the preferred stock comes closer this
time.
If operating revenues drop to $110 million, then the situation would be the following:
(a)
(b)
(c)
Sale of
Sale of 9%
Common Stock
Preferred Stock
Sale of 10%
at $25 per share
at $12 per share
Capital Notes
Operating revenues
$110,000,000
$110,000,000
$110,000,000
Operating expenses
102,000,000
102,000,000
102,000,000
Net revenues
$ 8,000,000
$ 8,000,000
$ 8,000,000
-------------------
-------------------
800,000
$8,000,000
$8,000,000
$7,200,000
2,720,000
2,720,000
2,448,000
$ 5,280,000
$ 5,280,000
$ 4,752,000
Interest on capital notes
Before-tax income
Estimated income taxes
After-tax income
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Preferred stock dividends
Net income for common
----------------------
$
720,000
---------------------
5,280,000
$ 4,560,000
$ 4,752,000
5,720,000
5,400,000
5,400,000
$ 0.92
$0.84
$ 0.88
Stockholders
Shares of common Stock
outstanding
Earnings per share of
common stock
In this case issuing the common stock is the best alternative from the point of view of the common
stockholders.
CHAPTER 16
LENDING POLICIES AND PROCEDURES: MANAGING CREDIT RISK
Goal of This Chapter: The purpose of this chapter is to learn why sound lending policies are important to
banks and other lenders and the public they serve and how to spot and deal with problem loans when
they appear in an institution’s portfolio.
Key Topics in This Chapter
•
•
•
•
•
•
Types of Loans Banks Make
Factors Affecting the Mix of Loans Made
Regulation of Lending
Creating a Written Loan Policy
Steps in the Lending Process
Loan Review and Loan Workouts
Chapter Outline
I. Introduction
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II. Types of Loans
A. Types of Loans:
1. Real Estate Loans
2. Financial Institutions Loans
3. Agricultural Loans
4. Commercial and Industrial Loans
5. Loans to Individuals
6. Miscellaneous Loans
7. Lease Financing Receivables
B. Factors Determining the Growth and Mix of Loans
1. Characteristics of the Market Area
2. Loan Participations
3. Lender Size
4. Experience and Expertise of Management
5. Institution's Loan Policy
6. Expected Yield
7. Functional Cost Analysis
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III. Regulation of Lending
A. Relevant Regulations:
1. The Lending Limit
2. Limitation on Real Estate Lending
3. The Community Reinvestment Act (1977)
4. Equal Credit Opportunity Act (1974)
5. Truth-in-Lending Act
6. International Lending Rules
7. Examiner Loan Ratings
8. CAMELS Rating
B. Establishing A Written Loan Policy
IV. Steps in the Lending Process
1. Finding Prospective Loan Customers
2. Evaluating a Prospective Customer’s Character and Sincerity of Purpose
3. Making Site Visits and Evaluating a Prospective Customer’s Credit Record
4. Evaluating a Prospective Customer’s Financial Condition
5. Assessing Possible Loan Collateral and Signing the Loan Agreement
6. Monitoring Compliance with the Loan Agreement and Other Customer
Service Needs
V. Credit Analysis: What Makes a Good Loan?
A. Is the Borrower Creditworthy? The Cs of Credit
1. Character
2. Capacity
3. Cash
4. Collateral
5. Conditions
6. Control
B. Can the Loan Agreement Be Properly Structured and Documented?
C. Can the Lender Perfect Its Claim Against the Borrower's Earnings and Any Assets That May Be
Pledged as Collateral?
1. Reasons for Taking Collateral
2. Common Types of Loan Collateral
a. Accounts Receivable
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b. Factoring
c. Inventory
d. Real Property
e. Personal Property
f. Personal Guarantees
3. Other Safety Devices to Protect a Loan
VI. Sources of Information About Loan Customers
A. Credit Bureaus
B. Publications of Financial Information
C. Information on Economic Conditions
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VII. Parts of A Typical Loan Agreement
A. The Promissory Note
B. Loan Commitment Agreement
C. Collateral
D. Covenants (Affirmative and Negative)
E. Borrower Guaranties or Warranties
F. Events of Default
VIII. Loan Review
A. The Purpose of Loan Review
B. Elements of a Good Loan Review
IX. Loan Workouts
A. Signs of a Developing Problem Loan Situation
B. Steps in Maximizing the Recovery of Funds from a Problem Loan (the Loan Workout Problem)
X.
Summary of the Chapter
Concept Checks
16-1.
In what ways does the lending function affect the economy of its community or region?
Bank credit is one of the most important sources of capital that fuels local economic growth and
development. When banks make loans to support the development of new businesses and to aid the
growth of existing businesses, new jobs are created and there is a greater flow of income and spending
throughout the local economy.
16-2.
What are the principal types of loans made by banks?
Bank loans are usually classified by the purpose of the loans. The most common classifications are real
estate loans, commercial and industrial loans, loans to financial institutions, credit-card and other loans
to individuals, lease financing, and agricultural production loans. Bank loans may also be classified by
maturity - over one year and one year or less.
16-3.
What factors appear to influence the growth and mix of loans held by a lending institution?
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The particular mix of any lending institution's loan portfolio is shaped by the characteristics of its market
area, the expected yield and cost associated with each type of loan, loan participations, bank size, the
experience and expertise of management, and the institution’s written loan policy and regulations.
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16-4 A lender's cost accounting system reveals that its losses on real estate loans average 0.45
percent of loan volume and its operating expenses from making these loans average 1.85 percent of
loan volume. If the gross yield on real estate loans is currently 8.80 percent, what is this lender's net
yield on these loans?
The bank's net yield on real estate loans must be:
Net Yield on Real Estate Loans = 8.80% - 0.45% - 1.85% = 6.50%
16-5.
Why is lending so closely regulated by state and federal authorities?
Lending is closely regulated because it is the center of risk for most lending institutions. Lending
institutions in the U.S. are limited in the loans they can make to a single borrower by the size of their
capital and surplus. They also must limit their real estate loans based on the size of their total time and
savings deposits or capital. Discrimination against borrowers on the basis of their age, sex, religion, or
national origin is prohibited by U.S. law. They also cannot discriminate against borrowers from certain
neighborhoods in their service areas. Any loans made are subject to examination and review and many
are restricted or even prohibited by law.
16-6.
What is the CAMELS rating and how is it used?
The CAMELS rating is a system used by federal bank examiners for evaluating the overall condition of a
bank based upon the adequacy of its capital, the quality of its asset portfolio, its management quality,
the adequacy of its earnings, its liquidity position and its sensitivity to market risk.
16-7.
What should a good written loan policy contain?
A good written bank loan policy should specify the goals of the loan portfolio and program, describe an
ideal loan portfolio for the institution and indicate the types of loans they normally will refuse to make,
specify who has the authority to approve loans of varying type and size, the documentation
requirements of different types of loans, and supply guidelines on loan pricing and collateralization for
loan officers.
Lines of responsibility in making assignments and reporting information, operating procedures for
soliciting, evaluating, and making decisions on customer loan applications, and the required
documentation that is to accompany each loan application and what must be kept in the lender’s files,
lines of authority detailing who is responsible for maintaining and reviewing the institution’s credit files,
guidelines for taking, evaluating, and perfecting loan collateral, procedures for setting loan rates and
fees and the terms for repayment of loans, and a statement of quality standards applicable to all loans,
statement of the preferred upper limit for total loans outstanding, description of the lending
institution’s principal trade area, from which most loans
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should come, procedures for detecting and working out problem loan situations.
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16-8.
What are the typical steps followed in receiving a loan request from a customer?
A loan officer usually takes or receives such a request initially and passes it along to the credit analysis
division for technical review. Usually the recommendations of both the credit analyst and the loan
officer are directed to a loan supervisor or loan committee for approval.
16-9. What three major questions or issues must a lender consider in evaluating nearly all loan
requests?
The three key issues with every loan:
1. Is the borrower creditworthy?
2. Can the loan agreement be properly structured and documented?
3. Can the lender perfect its claim against the borrower's earnings and any assets that may be
pledged as collateral?
16-10. Explain the meaning of the following terms: character, capacity, cash, collateral, conditions, and
control?
a. Character -- is the borrower specific about the purpose of a loan and has a serious intent to repay?
b. Capacity -- does the borrower have the legal authority to sign and commit to a binding loan
agreement?
c. Capital -- does the borrower generate sufficient income or cash flow to properly service a loan?
d. Collateral -- does the borrower possess assets of sufficient quality and value to backstop a loan?
e. Conditions -- does the outlook for the economy and industry where a borrower is situated add
strength to a loan?
f. Control -- does the proposed loan meet the bank's own quality standards and the standards of bank
examiners?
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16-11. Suppose a business borrower projects that it will experience net profits of $2.1 million, compared
to $2.7 million the previous year and will record depreciation and other noncash expenses amounted of
$0.7 million this year versus $0.6 million last year. What is this firm’s projected cash flow for this year?
Is the firm’s cash flow rising or falling? What are the implications for a lending institution thinking of
loaning money to this firm? Suppose sales revenue rises by $0.5 million, costs of goods sold decreases
by $0.3 million, while cash tax payments increase by $0.1 million and noncash expenses decrease by
$0.2 million. What happens to the firm’s cash flow? What would the lender’s likely reaction to these
events?
The firm's projected cash flow can be estimated by either of two methods discussed in the text:
Cash Flow Estimate B
= $2.1 million + $0.7 million = $2.8 million
for the Current Year
The previous year the cash flows amounted to:
Cash Flow Estimate B = $2.7 million + $0.6 million = $3.3 million
For the Previous Year
Clearly the firm's cash flow is falling, which suggests that the lending institution needs to find out the
reasons for this decline before committing any of funds.
Sales Revenue
+$.5
Costs of Goods Sold
+$.3
Cash Tax Payments
-$.1
Noncash Expenses
-$.2
Total
+$0.5 increase in cash flows from these changes
These changes should make the lender happier because it means that cash flows are rising again.
16-12. What sources of information are available today that loan officers and credit analysts can use in
evaluating a customer loan application?
Among the most widely used sources of information used in evaluating loans are financial statements
supplied by the borrower and industry-wide performance ratios for comparison purposes supplied by
such organizations as Dun and Bradstreet and Risk Management Associates (RMA). To exchange credit
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information among business lending institutions and to organize conferences and publish educational
materials to help train loan officers and credit analysts.
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16-13. What are the principal parts of a loan agreement? What is each part designed to do?
The most important parts of loan agreements include a signed note which specifies the interest rate and
the terms of the loan, a listing of covenants which specify what the borrower must and must not do,
documents specifying loan collateral which protects the lender’s interests, and a section describing what
events or happenings will trigger default.
16-14. What is loan review? How should a loan review be conducted?
Loan review is a process of periodic investigation of outstanding loans on an institution's books to make
sure each loan is paying out as planned, all necessary documentation is present, and the bank's loan
officers are following the institution's loan policy. While lending institutions today use a variety of
different loan review procedures, a few general procedures are followed by nearly all lending
institutions. These include:
1. Carrying out reviews of all types of loans on a periodic basis.
2. Structuring the loan review process carefully to make sure the most important features of
each loan are checked.
3. Reviewing the largest loans most frequently.
4. Conducting more frequent reviews of troubled loans.
5. Accelerating the loan review schedule if the economy slows down or if industries in which the
bank has made a substantial portion of its loans develop significant problems.
Loan review is not a luxury but a necessity for a sound lending program. It not only helps management
spot problem loans more quickly but also acts as a continuing check on whether loan officers are
adhering to a bank's loan policy. For this reason, as well as to promote objectivity in the loan review
process, many of the largest institutions separate their loan review personnel from the loan department
itself. Loan reviews also aid senior management and the bank's board of directors in assessing the
overall exposure to risk and its possible need for more capital in the future.
16-15. What are some warning signs to management that a problem loan may be developing?
Problem loans are often characterized by reduced communication between borrower and lender, delays
in receiving financial reports, evidence of reevaluations of assets (such as inventory or pension-plan
assets), declining stock prices, changes in management, or the restructuring of other loans the borrower
has taken out.
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16-16. What steps should a lender go through in trying to resolve a problem loan situation?
The most important first step is to move quickly to contact the borrower, to ascertain if the borrower
understands the nature of the loan problem, to explore for creative solutions to the problem, and to get
the borrower to reach a decision on the best solution possible.
Problems & Projects
16-1. The lending function of depository institutions is highly regulated and this chapter gives some
examples of the structure of these regulations for national banks. In this problem you are asked to
apply those regulations to Tree Rose National Bank (TRNB). Tea Rose has the following sources of funds:
$250 million in capital and surplus, $200 million in demand deposits, $775 million in time and savings
deposits, and $200 million in subordinated debt.
a. What is the maximum dollar amount of real estate loans that TRNB can grant?
TRNB can grant ($775)*70% = $542.50 million in real estate loans
b. What is the maximum dollar amount TRNB may lend to a single customer?
TRNB may lend up to $250*15% = $37.50 million to a single customer.
16-2. Aspiration Corporation, seeking renewal of its $12 million credit line, reports the data in the
following table (in millions of dollar) to Hot Springs National Bank’s loan department. Please calculate
the firm’s cash flow as defined earlier in this chapter. What trends do you observe, and what are their
implications for the decision to renew or not renew the firm’s line of credit?
20X1
20X2
20X3
20X4
Next
Year
Costs of Goods Sold
$5.1
$5.5
$5.7
$6.0
$6.4
Selling and Admin Exp.
$8.0
$8.2
$8.3
$8.6
$8.9
Sales Revenue
$7.9
$8.4
$8.8
$9.5
$9.9
$11.2 $11.2 $11.1 $11.0
$10.9
Depreciation and
other noncash
expenses
Taxes Paid in Cash
$4.4
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$4.6
$4.9
$4.1
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Cash Flow = Sales Revenues – Cost of Goods Sold – Selling and Admin – Taxes Paid in Cash + Non Cash
Expenses
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20x1 $7.9 - $5.1 - $8.0 - $4.4 + $11.2 = $1.6 million
20x2
$8.4 - $5.5 - $8.2 – $4.6 + $11.2 = $1.3 million
20x3
$8.8 - $5.7 - $8.3 - $4.9 + $11.1 = $1.0 million
20x4
$9.5 - $6.0 - $8.6 - $4.1 + $11.0 = $1.8 million
Next
$9.9 - $6.4 - $8.9 - $3.6 + $10.9 = $1.9 million
Year
While this firm had an initial decrease in cash flows, in the last year its cash flows have rebounded
significantly, suggesting that the firm would have less trouble making required loan payments. The
lender needs to be sure to check to see if the projections for next year seem reasonable. Borrowers are
sometimes over optimistic about future opportunities. However, if the projections are reasonable, Hot
Springs National Bank should consider renewing the loan.
16-3. Crockett Manufacturing and Service Company holds a sizeable inventory of dryers and washing
machines, which it hopes to sell retail dealers over the next six months. These appliances have a total
estimated market value currently of $25 million. The firm also reports accounts receivable currently
amounting to $12,650,000. Under the guidelines for taking collateral discussed in this chapter, what is
the minimum size loan or credit line Crockett is likely to receive from its principal lender? What is the
maximum size loan or credit line Crockett is likely to receive?
These figures suggest that the minimum size credit line available would be:
Minimum-Size Credit Line Available = 0.30 x $25,000,000 + 0.40 x $12,650,000
= $7,500,000 + $5,060,000
= $12,560,000.
Maximum-Size Credit Line Available = 0.80 x $25,000,000 + 0.90 x $12,650,000
= $20,000,000 + $11,385,000
= $31,385,000
16-4. Under which of the six Cs of credit discussed in this chapter does each of the following pieces of
information belong?
The particular C of credit represented by each piece of information presented in this problem was as
follows:
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a. First National Bank discovers there is already a lien against the fixed assets of one of its customers
asking for a loan.
Collateral
b. Xron Corporation has asked for a type of loan its lender normally refuses to make.
Control
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c. John Selman has an excellent credit rating.
Character
d. Smithe Manufacturing Company has achieved higher earnings each year for the
past six years.
Cash
e. Consumers Savings Association’s auto loan officer asks a prospective customer,
Harold Ikels, for his driver’s license.
Capacity
f. Merchants Center National Bank is concerned about extending a loan for another
year to Corrin Motors because a recession is predicted in the economy.
Conditions
g. Wes Velman needs an immediate cash loan and has gotten his brother, Charles, to
volunteer to cosign the note should the loan be approved.
Character
h. ABC Finance Company checks out Mary Earl’s estimate of her monthly take home
pay with Mary’s employer, Bryan Sims Doors and Windows.
Cash
i. Hillsoro Bank and Trust would like to make a loan to Pen-Tab Oil and Gas Company
but fears a long-term decline in oil and gas prices.
Conditions
j. First State Bank of Jackson seeks the opinion of an expert on the economic outlook in Mexico before
granting a loan to a Mexican manufacturer of auto parts.
Control
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k. The history of Membres Manufacture and Distributing Company indicates the firm has been through
several recent changes of ownership and there has been a substantial shift in its principal suppliers and
customers in recent years.
Capacity
l. Home and Office Savings Bank has decided to review the insurance coverages maintained by its
borrowing customer, Plainsman Wholesale Distributors.
Collateral
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16-5. Butell Manufacturing has an outstanding $11 million loan with Citicenter Bank for the current
year. As required in the loan agreement, Butell reports selected data items to the bank each month.
Based on the following information, is there any indication of a developing problem loan? About what
dimensions of the firm’s performance should Citicenter Bank be concerned?
Cash account (millions of dollars)
Projected sales (millions of dollars)
Stock price per share
(monthly average)
Capital structure (equity/debt ratio
in percent)
Liquidity ratio (current assets/
current liabilities)
Earnings before interest and taxes
(EBIT; in millions of dollars)
Return on assets (ROA; percent)
Sales revenue (millions of dollars)
One
Two
Three
Four
Current Month
Months Months Months
Month
Ago
Ago
Ago
Ago
$
33 $
57 $
51 $
44 $
43
$ 298 $ 295 $ 294 $ 291 $ 288
$
6.60
32.8%
1.10x
$
6.50
33.9%
1.23x
$ 6.40
34.6%
1.35x
$ 6.25
34.9%
1.39x
$ 6.50
35.7%
1.25x
$
15 $
14 $
13 $
11 $
13
3.32%
3.25%
2.98%
3.13%
3.11%
$ 290 $ 289 $ 290 $ 289 $ 287
Butell has announced within the past 30 days that it is switching to new methods for calculating
depreciation of its fixed assets and for valuing inventories. The firm’s board of directors is planning to
discuss at its next meeting a proposal to reduce stock dividends in the coming year.
Selected items reported to the bank by the company do indicate the possible development of a problem
loan situation. For one thing, Butell's cash account has fallen sharply in the latest month after several
months of a substantial uptrend and the firm's liquidity ratio of current assets to current liabilities has
declined significantly in the last 3 months. Decreases in the firm's liquidity position may be signaling
declining sales and/or difficulty in maintaining enough cash to meet near-term liabilities. Another
possible cause for concern centers around Butell's capital structure as its ratio of equity capital relative
to debt financing is falling, indicating that creditors (including Citicenter Bank) are providing a larger
share of the firm's capitalization. Thus, each creditor is becoming less well secured. However, these
changes in liquidity and capital structure may only reflect normal seasonal pressures and may not be
real problems for the bank, especially because other aspects of Butell's recent performance--its stock
price, earnings before interest and taxes, and ROA seem to be improving.
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Perhaps of greater moment is the decline of sales revenue below Butell's projections. As of the latest
month sales revenue reached $290 million versus a projection of $298 million. Citicenter Bank must
determine the causes of this sales shortfall to see if the firm is encountering increasing resistance to
sales of its product lines. However, even this trend may not be cause for alarm because sales may be so
volatile in Butell's industry that few analysts put any faith in sales projections. The bank's loan officer
needs to review the customer's earlier sales projections and sales revenue to determine if there is a real
cause for concern.
Butell has indicated a recent switch in inventory and depreciation accounting methods. Citicenter's loan
officer would do well to inquire into the reasons for these changes because they may reflect an attempt
by the firm to offset actual or potential future losses in some aspect of its operations.
16-6. Identify which of the following loan covenants are affirmative and which are negative
covenants?
a. Nige Trading Corporation must pay no dividends to its shareholders above $3 per share without
express lender approval.
Restrictions on payment of dividends represent negative loan covenants.
b. HoneySmith Company pledges to fully insure its production line equipment against loss due to fire,
theft, or adverse weather.
A requirement to insure selected assets is an affirmative loan covenant.
c. Soft-Tech Industries cannot take on new debt without notifying its principal lending institution first.
Restrictions against taking on new debt represent negative loan covenants.
d. PennCost Manufacturing must file comprehensive financial statements each month with its principal
bank.
The requirement 6f filing periodic financial statements with the bank is an affirmative
loan covenant.
e. Dolbe King Company must secure lender approval prior to increasing its stock of
fixed assets.
A requirement of securing bank approval before adding to a borrower's stock of fixed
assets is considered a negative loan covenant.
f. Crestwin Service Industries must keep a minimum current (liquidity) ratio of 1.5
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under the terms of its loan agreement.
Requiring a borrowing customer to maintain a current ratio -- a liquidity measure --no
lower than 1 .5x is an affirmative loan covenant.
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g. Dew Dairy Products is considering approaching Selwin Farm Transport Company about a possible
merger but must first receive lender approval.
The stipulation that prior bank approval of a proposed merger must be obtained is a
negative loan covenant.
16-7. Please identify which of the basic Cs of lending — character, capacity, cash, collateral,
conditions, and control —applies to each of the loan factors listed here:
Insurance coverage
Competitive climate for customer’s
product
Credit rating
Corporate resolution
Liquid reserves
Asset specialization
Driver’s license
Expected market share
Economists’ forecasts
Business cycle
Performance of comparable firms
Guarantees/warranties
Expense controls
Inventory turnover
Projected cash flow
Experience of other lenders
Social Security card
Price-earnings ratio
Industry outlook
Future financing needs
Asset liquidation
Inflation outlook
Adequate documentation
Changes in accounting standards
Written loan policy
Coverage ratios
Purpose of loan
Laws and regulations that apply to the
making of loans
Wages in the labor market
Changes in technology
Obsolescence
Liens
Management quality
Leverage
History of firm
Customer identity
Payment record
Partnership agreement
Accounts receivable turnover
Accounts payable turnover
The particular C of lending which applies to each loan factor is listed below:
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Character
Capacity
Cash
Collateral
Conditions
Control
Credit rating
Corporate
resolution
Liquid reserves
Insurance
coverage
Competitive
climate for
customers
product
Adequate
documentation
Experience of
other lenders
Driver’s license
Expense
controls
Asset
specialization
Expected
market share
Written loan
policy
Purpose of
loan
Social security
card
Inventory
turnover
Guarantees
and
warrantees
Business cycle
Changes in
accounting
standards
Payment
record
History of firm
Projected cash
flows
Asset
liquidation
Performance
of comparable
firms
Laws and
regulations that
apply to the
making of loans
Customer
identity
Price earnings
ratio
Changes in
technology
Industry
outlook
Partnership
agreement
Coverage
ratios
Obsolescence
Inflation
outlook
Management
quality
Liens
Wages in the
labor market
Leverage
Future
financing
needs
Economists’
Forecasts
Accounts
Receivables
Turnover
Accounts
Payable
Turnover
CHAPTER 17
LENDING TO BUSINESS FIRMS AND PRICING BUSINESS LOANS
Goal of This Chapter: The purpose of this chapter is to explore how bankers can respond to a business
customer seeking a loan and to reveal the factors they must consider in evaluating a business loan
request. In addition, we explore the different methods used today to price business loans and to
evaluate the strengths and weaknesses of these pricing methods for achieving a financial institution’s
goals.
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Key Topics in This Chapter
•
•
•
•
•
•
Types of Business Loans: Short-Term and Long-Term
Analyzing Business Loan Requests
Collateral and Contingent Liabilities
Sources and Uses of Business Funds
Pricing Business Loans
Customer Profitability Analysis
Chapter Outline
I. Introduction
II. Brief History of Business Lending
III. Types of Business Loans
IV. Short-Term Loans to Business Firms
A. Self-Liquidating Inventory Loans
B. Working Capital Loans
C. Interim Construction Financing
D. Security Dealer Financing
E. Retailer and Equipment Financing
F. Asset-Based Financing
G. Syndicated Loans (SNCs)
V. Long-Term Loans to Business Firms
A. Term Business Loans
B. Revolving Credit Financing
C. Long-Term Project Loans
D. Loans to Support the Acquisition of Other Business Firms-Leveraged Buyouts
VI. Analyzing Business Loan Applications
A. Most Common Sources of Loan Repayment
B. Analysis of a Business Borrower's Financial Statements
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VII Financial Ratio Analysis of a Customer's Financial Statements
A. The Business Customer's Control over Expenses
B. Operating Efficiency: Measure of a Business Firm's Performance Effectiveness
C. Marketability of the Customer's Product or Service
D. Coverage Ratios: Measuring the Adequacy of Earnings
E. Liquidity Indicators for Business Customers
F. Profitability Indicators
G. The Financial Leverage Factor as a Barometer of a Business Firm's Capital Structure
VIII Comparing a Business Customer’s performance to the Performance of Its Industry
A. Contingent Liabilities
B. Environmental Liabilities
C. Underfunded Pension Liabilities
IX. Preparing Statements of Cash Flows from Business Financial Statements
A. Cash Flow Statements
B. Pro Forma Statements of Cash Flow and Balance Sheets
C. The Loan Officer's Responsibility to the Lending Institution and the Customer
X. Pricing Business Loans
A.
B.
C.
D.
The Cost-Plus Loan pricing Method
The Price Leadership Model
Below-Prime Market Pricing
Customer Profitability Analysis (CPA)
1. An Example of Annualized Customer profitability Analysis
2. Earnings Credits for Customer Deposits
3. The Future of Customer Profitability Analysis
XI. Summary of the Chapter
Concept Checks
17-1. What special problems does business lending present to the management of a business lending
institution?
While business loans are usually considered among the safest types of lending (their default rate, for
example, is usually well below default rates on most other types of loans), these loans average much
larger in dollar volume than other loans and, therefore, can subject an institution to excessive risk of
loss and, if a substantial number of loans fail, can lead to failure. Moreover, business loans are usually
much more complex financial deals than most other kinds of loans, requiring larger numbers of
personnel with special skills and knowledge. These additional resources required increase the
magnitude of potential losses unless the business loan portfolio is managed with great care and skill.
17-2. What are the essential differences among working capital loans, open credit lines, asset-based
loans, term loans, revolving credit lines, interim financing, project loans, and acquisition loans?
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a. Working Capital Loans -- Loans to fund the current assets of a business, such as
accounts receivable, inventories, or to replenish cash.
b. Open Credit Lines -- A credit agreement allowing a business to borrow up to a
specified maximum amount of credit at any time until the point in time when the credit
line expires.
c. Asset-based Loans -- Credit secured by the shorter-term assets of a firm that are expected to
roll over into cash in the future. Credit whose amount and timing is based directly upon the
value, condition, and maturity of certain assets held by a business firm (such as accounts
receivable or inventory) with those assets usually being pledged as collateral behind the loan.
d. Term Loans -- Business loans that have an original maturity of more than one year and
normally are used to fund the purchase of new plant and equipment or to provide for a
permanent increase in working capital. Term loans usually look to the flow of future earnings of
a business firm to amortize and retire the credit.
e. Revolving Credit Lines -- Lines of credit that promise the business borrower access to any
amount of borrowed funds up to a specified maximum amount; moreover, the customer may
borrow, repay, and borrow again any number of times until the credit line reaches its maturity
date.
f. Interim Financing -- Bank funding to start construction or to complete construction of a
business project in the form of a short-term loan; once the project is completed, long-term
funding will normally pay off and replace the interim financing.
g. Project Loans -- Credit to support the start up of a new business project, such as the
construction of an offshore drilling platform or the installation of a new warehouse or assembly
line; often such loans are secured by the property or equipment that are part of the new
project.
h. Acquisition Loans--Loans to finance mergers and acquisitions of businesses. Among the most
noteworthy of these acquisition credits are leveraged buyouts of firms by small groups of
investors.
17-3. What aspects of a business firm's financial statements do loan officers and credit analysts
examine carefully?
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Loan officers and credit analysts examine the following aspects of a business firm's financial statements:
a. Control Over Expenses? Key ratios here include cost of goods sold/net sales; selling,
administrative and other expenses/net sales; wages and salaries/net sales; interest expenses on
borrowed funds/net sales; overhead expenses/net sales; depreciation expenses/net sales and
taxes/net sales.
b. Operating Efficiency? Important ratios here are net sales/total assets, annual cost of goods
sold divided by average inventory levels, net sales/net fixed assets and net sales/accounts and
notes receivable.
c. Marketability of a Product, Service, or Skill? Key ratio measures in this area are the gross
profit margin, or net sales less cost of goods sold to net sales, and the net profit margin, or net
income after taxes to net sales.
d. Coverage? Important measures here include interest coverage (such as income before
interest and taxes divided by total interest payments), coverage of interest and principal
payments (such as earnings before interest and taxes divided by annual interest payments plus
principal payments adjusted for the tax effect), and the coverage of all fixed payments (such as
income before interest, taxes and lease payments divided by interest payments plus lease
payments).
e. Profitability Indicators? Key barometers in this area can include such ratios as before-tax net
income divided by total assets, net worth, or sales, and after-tax net income divided by total
assets (or ROA), net worth (or ROE), or total sales (or ROS) or profit margin.
f. Liquidity Indicators? Important ratio measures here usually include the current ratio (current
assets divided by current liabilities), and the acid-test ratio (current assets less inventories
divided by current liabilities).
g. Leverage indicators? Ratios indicating trends in this dimension of business performance
usually include the leverage ratio (total liabilities/total assets or net worth), the capitalization
ratio (of long-term debt divided by total long-term liabilities and net worth), and the debt-tosales ratio (of total liabilities divided by net sales).
One problem with employing ratio measures of business performance is that they only reflect symptoms
of a possible problem but usually don't tell us the nature of the problem or its causes. Management
must look much more deeply into the reasons behind any apparent trend in a ratio. Moreover, any time
the value of a ratio changes that change could be due to a shift in the numerator of the ratio, in the
denominator, or both.
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17-4. What aspect of a business firm's operations is reflected in its ratio of cost of goods sold to net
sales? In its ratio of net sales to total assets? In its GPM ratio? In its ratio of income before interest and
to taxes to total interest payments? In its acid-test ratio? In its ratio of before-tax net income to net
worth? In its ratio of total liabilities to net sales? What are the principal limitations of these ratios?
The ratio of cost of goods sold to net sales is a widely used indicator of a business firm's expense
controls and operating efficiency. The ratio of net sales to total assets reflects activity or operating
efficiency, while the gross profit margin (GPM) measure reflects the marketability of the customer's
products or services. A firm's ratio of income before interest expense and taxes to total interest
payments indicates how effectively a business is covering its interest expenses through the generation
of before-tax income. The acid-test ratio provides a rough measure of a firm's liquidity position, while
the ratio of before-tax income to net worth represents a measure of profitability. Finally, the ratio of
liabilities to sales is an indicator of management's use of financial leverage. These ratios are affected by
changes in the numerator or the denominator or both; a financial or credit analyst would want to know
the source of any change in a ratio's value. These ratios only measure problem symptoms; you must dig
deeper to find the cause.
17-5. What are contingent liabilities, and why might they be important in deciding whether to
approve or disapprove a business loan request?
Contingent liabilities include such pending or possible future obligations as lawsuits against a business
firm, and warranties or guarantees the firm has given to others regarding the quality, safety, or
performance of its product or service. Another example is a credit guaranty in which the firm may have
pledged its assets or credit to back up the borrowings of another business, such as a subsidiary.
Environmental damage caused by a business borrower also has recently become of great concern as a
contingent liability for many banks because a bank foreclosing on business property for nonpayment of
a loan could become liable for cleanup costs, especially if the bank becomes significantly involved with a
customer's business or treats foreclosed property as an investment rather than a repossessed asset that
is quickly liquidated to recover the unpaid balance on a loan. Loan officers must be aware of all
contingent liabilities because any or all of them could become due and payable claims against the
business borrower, weakening the firm's ability to repay its loan to the bank.
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17-6. What is cash-flow analysis, and what can it tell us about a business borrower’s financial
condition and prospects?
A cash flow statement shows the changes in a business firm's assets and liabilities as well as its flow of
net profit and noncash expenses (such as depreciation) over a specific time period. It shows where the
firm raised its operating capital during the time period under examination and how it spent or used
those funds in acquiring assets or paying down liabilities. From the perspective of a loan officer the cash
flow statement indicates whether the firm is relying heavily upon borrowed funds and sales of assets.
These are two less desirable funding sources from the point of view of lending money to a business firm.
In contrast, loan officers usually prefer to focus upon cash flow - whether the firm is generating
sufficient cash flow (net income plus noncash expenses) to repay most of its debt. The Statement of
Cash Flows shows how cash receipts and disbursements are generated by operating, investing, and
financing activities.
17-7.
What is a pro forma statement of cash flows, and what is its purpose?
A pro forma statement of cash flows is useful not only to look at historical data in a Statement of Cash
Flows, but also to estimate the business borrower’s future cash flows and financial condition and its
ability to repay the loan.
17-8. Should a loan officer ever say “no” to a business firm requesting a loan? Please explain when
and where.
Loan officers will inevitably be confronted with some loan requests that will have to be flatly rejected,
particularly in those cases where the borrower has falsified information or has a credit history of
continually "walking away" from debt obligations. Even in these cases, however, the loan officer should
be as polite as possible, suggesting to the customer what needs to be changed or improved for the
future to permit the customer to be seriously considered for a loan.
17-9.
What methods are used today to price business loans?
The following methods are in use today to price business loans:
a. Cost-plus pricing
d. Customer Profitability Analysis
b. Price leadership pricing model
c. Below-prime market pricing
Cost-plus-profit pricing requires the bank to estimate the total cost involved in making a
loan and then adds to that cost estimate a small margin for profit.
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The price-leadership model, on the other hand, bases the loan rate upon a national or international rate
(such as prime or LIBOR) posted by major banks and then adds a small increment on top for profit or
risk.
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The below-prime market prices a loan on the basis of cost of borrowing in the money market plus a
small profit margin. Customer profitability analysis looks at all the revenues and costs involved in serving
a customer and then requires the bank to calculate the net rate of return from this particular customer.
17-10. Suppose a bank estimates that the marginal cost of raising loanable funds to make a $10 million
loan to one of its corporate customers is 4 percent, its nonfunds operating costs to evaluate and offer
this loan are 0.5 percent, the default-risk premium on the loan is 0.375 percent, a term-risk premium of
0.625 percent is to be added, and the bank’s desired profit margin is 0.25 percent. What loan rate
should be quoted this borrower? How much interest will the borrower pay in a year?
The loan rate quoted for this $10 million corporate loan would be:
Loan Rate
= 4 percent loan funds cost + .5 percent nonfunds operating cost
+ .375 percent default-risk premium
+ .625 percent term-risk premium
+ .25 percent profit margin
= 5.75 percent
Based on a $10 million loan this customer will pay in interest in a year:
$10,000,000*.0575 = $575,000.
17-11. What are the principal strengths and weaknesses of the different loan-pricing methods in use
today?
Cost plus pricing is the simplest loan pricing model. However, it assumes that a lending institution can
accurately know what its costs are and often they don’t.
Price leadership overcomes the problems of accurately predicting what the costs of a loan will be to a
lending institution. However, it is still difficult to assign risk premiums to loans. In addition, using
something like the prime rate as the base rate has been challenged by LIBOR and other market based
rates.
Below prime market pricing uses LIBOR as the base rate and includes only a small profit margin as part
of the loan price. This works well for short term loans for large, well known corporations but is not
generally used for small and medium sized companies or longer term loans
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Customer profitability analysis is similar to cost plus pricing but differs in that it considers the whole
customer relationship into account when pricing a loan. Customer profitability analysis has become
increasingly sophisticated as computer models have been designed to help with the analysis.
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17-12. What is customer profitability analysis? What are its advantages for the borrowing customer
and the lender?
Customer profitability analysis is a loan pricing method that takes into account the lender’s entire
relationship (all revenues and expenses associated with a particular Customer) with the customer when
pricing the loan. It is based on the difference between revenues from loans and other services provided
and expenses from providing loans and other services is taken over net loanable funds. Net loanable
funds are those funds used in excess of the customer’s deposits. If the calculated net rate of return from
a customer’s relationship is positive the loan is made and if it is not, the rate is raised or the loan is not
made. Because it takes the entire relationship into account it gives a better picture of what customer
relationships are profitable. The chief problem with it is that it is a more complex model and takes an
accurate picture of all of the relationships the lender has with the customer. It has also become
increasingly complex as computer systems have put in place to help with the analysis of the total
relationship a customer has with a lender.
Problems and Projects
17-1.
From the descriptions below please identify what type of business loan is involved.
a. A temporary credit supports construction of homes, apartments, office buildings, and other
permanent structures.
b. A loan is made to an automobile dealer to support the shipment of new cars.
c. Credit extended on the basis of a business’s accounts receivable.
d. The term of an inventory loan is being set to match the length of time needed to generate cash to
repay the loan.
e. Credit extended up to one year to purchase raw materials and cover a seasonal need for cash.
f. A security dealer requires credit to add new government bonds to his security portfolio.
g. Credit granted for more than a year to support purchases of plant and equipment.
h. A group of investors wishes to take over a firm using mainly debt financing.
i. A business firm receives a three-year line of credit against which it can borrow,
borrow again if necessary during the loan’s term.
repay, and
j. Credit extended to support the construction of a toll road.
Based upon the descriptions given in the text the type of business loan being discussed is:
A.Interim construction financing.
B. Retailer financing or floor planning loan.
C. Asset-based financing or factoring.
D. Self-liquidating inventory loan.
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E. Working capital loan.
F. Security capital loan.
G. Term loan.
H. Acquisition loan or leveraged buyout.
I. Revolving credit line.
J. Project loan.
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17-2. As a new credit trainee for Evergreen National Bank, you have been asked to evaluate the
financial position of Hamilton Steel Castings, which has asked for renewal of and an increase in its sixmonth credit line. Hamilton now requests a $7 million credit line, and you must draft your first credit
opinion for a senior credit analyst. Unfortunately, Hamilton just changed management, and its financial
report for the last six months was not only late but also garbled. As best as you can tell, its sales, assets,
operating expenses, and liabilities for the six month period concluded display the following patterns:
Millions of Dollars
January
Net sales
48.1
Cost of goods sold
27.8
Selling, administrative,
and other expenses
19.2
Depreciation
3.1
Interest cost on
borrowed funds
2.0
Expected tax obligation
1.3
Total assets
24.5
Current assets
6.4
Net fixed assets
17.2
Current liabilities
4.7
Total liabilities
15.9
February
47.3
28.1
March
45.2
27.4
April
43.0
26.9
May
43.9
27.3
June
39.7
26.6
18.9
3.0
17.6
3.0
16.5
2.9
16.7
3.0
15.3
2.8
2.2
1.0
24.3
6.1
17.4
5.2
16.1
2.3
0.7
23.8
5.5
17.5
5.6
16.4
2.3
0.9
23.7
5.4
17.6
5.9
16.5
2.5
0.7
23.2
5.0
18.0
5.8
17.1
2.7
0.4
22.9
4.8
18.0
6.4
17.2
Hamilton has a 16-year relationship with the bank and has routinely received and paid off a credit line of
$4 million to $5 million. The department’s senior analyst tells you to prepare because you will be asked
for your opinion of this loan request (though you have been led to believe the loan will be approved
anyway, because Hamilton’s president serves on Evergreen’s board of directors).
What will you recommend if asked? Is there any reason to question the latest data
supplied by this customer? If this loan request is granted, what do you think the customer will do
with the funds?
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The figures given in the case as well as the supporting background information suggest several
developing problems. Hamilton has had a recent shakeup in its senior management, which usually leads
to loss in control of the firm until the new management gains sufficient experience. Among the obvious
problems are declines in sales (from $48.1 million to $39.7 million) in the past six months. Hamilton's
cost of goods sold dropped but by less than the decline in sales, thereby squeezing the firm's margin and
net income. We also noted that the firm, faced with declining cash flows, has been forced to rely more
heavily on borrowings which will mean that the bank's position will be less secure. Current assets have
also declined while current liabilities are on the rise, thus reducing the firm's net liquidity position. The
bank's relationship with Hamilton needs to be reviewed carefully with an eye to gaining additional
collateral or reducing the bank's total credit commitment to the firm.
Additional information that would be desirable and helpful, if not essential, should include:
1) Past financial statements for the last two or three years, preferably on a monthly basis. This
could help us verify seasonality and improvement.
2) Industry outlook for the next six to eighteen months would also help in reinforcing Hamilton's
ability to service the debt from the summer and fall cash flows.
3) Additionally, information about the company's suppliers, other creditors, customers, and
competitors would be helpful.
4) Also, more information about other relationships that Hamilton has with Evergreen would
certainly be helpful.
In summary, the more information we have, the better our analysis and subsequent decisions will be.
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17-3. From the data given in the following table, please construct as many of the financial ratios
discussed in this chapter as you can and then indicate the dimension of a business firm’s performance
each ratio represents.
Business Assets
Cash account
Accounts receivable
Inventories
Fixed assets
Miscellaneous assets
50
155
128
286
96
715
Liabilities and Equity
Short-term debt:
Accounts payable
Notes payable
Long-term debt (bonds)
Miscellaneous liabilities
Equity capital
108
107*
325*
15
160
715
Annual Revenue and Expense Items
Net sales
Cost of goods sold
Wages and salaries
Interest expense
Overhead expenses
Depreciation expenses
Selling, administrative,
and other expenses
Before-tax net income
Taxes owed
After-tax net income
650
485
58
28
29
12
28
10
3
7
* Annual principal payments on bonds and notes payable total $55. The firm’s marginal tax rate is 35
percent.
Among the many financial ratios that could be computed given the data in this problem are the
following:
Expense Control Ratios
Wages and salaries
Net Sales
= 58 = .0892
Inventory turnover ratio = 485 = 3.79 x
650
Overhead expenses
Net sales
Operating Efficiency Measures
128
= 29 = .0446
Net sales/
650
Total assets
Depreciation expenses = 12 = .0185
Net sales
650
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= 650 = .909 x
715
Net sales/
= 650 = 2.27 x
Fixed assets
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Interest expense
Net sales
= 28 = .0431
Net sales/Accounts
650
receivable
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= 650 = 4.194 x
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Cost of goods sold/
= 485 = .7462
Net sales
Average = (155) / (650 /360) = 85.85 days
650
collection period
Taxes/Net sales = 3 / 650 = .0046
Selling, administrative,
and other expenses/Net
sales
=28/650 = .0431
Coverage Ratios
Marketability Indicators
GPM = 650 – 485 = .2538
650
Interest coverage
= 38 = 1.36 x
28
NPM = 7 = .0108
650
Coverage of principal and
interest payments
=
Profitability Measures
Liquidity Indicators
Before-tax net income/ = 10 = .014
Current ratio
Total assets
715
Acid-test ratio =
715
$333 - $128 = .95 x
$215
Before-tax net income/ = 10 = .0625
Net worth or equity
$333 = 1.549 x
$215
After-tax net income/ = 7 = .0098
Total assets
=
Net liquid assets =
160
$333 - $128 -$215
= - 10
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capital
Net working capital= $333 - $215
After-tax net income/= 7 = .0438
Net worth or equity
= $118
160
capital
Leverage Ratios
Before-tax net income/ = 10 = .0154 Total liabilities/Total
555 = .7762
Net sales
=
650
assets
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After-tax net income/ = 7 = .0108
Long-term debt =
Net sales
Long-term liabilities
485
Total liabilities =
555 = .8538
Net sales
650
650
325 = .6701
17-4. Pecon Corporation has placed a term loan request with its lender and submitted the following
balance sheet entries for the year just concluded and the pro forma balance sheet expected by the end
of the current year. Construct a pro forma Statement of Cash Flows for the current year using the
consecutive balance sheets and some additional needed information. The forecast net income for the
current year is $225 million with $50 million being paid out in dividends. The depreciation expense for
the year will be $100 million and planned expansions will require the acquisition of $300 million in fixed
assets at the end of the current year. As you examine the pro forma Statement of Cash Flows, do you
detect any changes that might be of concern either to the lender’s credit analyst, loan officer, or both?
Pecon Corporation
(all amounts in millions of dollars)
Assets
Asstes at Projected
the End of for the End
the Most
of the
Recent
Curreny
Year
Year
Cash
$
532 $
624 Accounts payable
Accounts receivable
1,018
1,210 Notes payable
Inventories
894
973 Taxes payable
Net fixed assets
Other assets
Total assets
2,740
66
$
5,250
2,940
87
$
5,834
Liabilities
Liabilities and Equity
and Equity for the End
at the End
of the
of the most Current
recent Year
Year
$
970 $
1,279
2,733
2,950
327
216
Long-term debt obligations
Common stock
Undivided profits
Total liabilities and equity capital $
The Sources and Uses of Funds Statement for Pecon Corporation would appear as follows:
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85
263
5,250
$
931
85
373
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Cash Flows from Operations
Net income
225
Add: Depreciation
100
Subtract: increase in acc/rec
(192)
Subtract: increase in inventory
(79)
Subtract: increase in other assets
(21)
Add: increase in accounts payable
309
Subtract: decrease in taxes payable
(111)
Net cash flow from operations
231
Cash Flows from Investment Activities
Acquisition of fixed assets
(300)
Net cash flow from investment activities
(300)
Cash Flows from Financing Activities
Increase in notes payable
Increase in long term debt
Dividends paid
Net Cash Flows from Financing Activities
217
59
(50)
226
Increase (Decrease) in Cash
157
There are several areas of possible concern for a bank loan officer viewing Pecon's projected figures.
First, the firm is relying heavily upon increasing debt of all kinds to finance its growth in assets. The
increase in notes payable of $217 million indicates growing reliance on bank debt supplemented by
sizable increases in supplier-provided credit (accounts payable) and long-term debt obligations (most
likely, bonds) with no change in funds provided by issuing stock. The bank could experience a serious
weakening in the strength of its claim against the firm as other creditors post a more substantial claim
against Conway's assets.
Pecon is projecting a sizable increase in its retained earnings (undivided profits) which suggests that
management is counting on a year of strong earnings. However, both accounts receivable and
inventories (as well as net fixed assets) are growing rapidly, perhaps reflecting troubles in collecting
from the firm's customers and in marketing Pecon's products and services. The bank's loan officer would
want to explore with the company the bases for its projected jump in net income and why accounts
receivable and inventories are expected to rise in such large amounts.
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17-5 Finch Corporation is a new business client for First Commerce National Bank and has asked for a
one-year, $10 million loan at an annual interest rate of 6 percent. The company plans to keep a 4.25
percent, $3 million CD with the bank for the loan’s duration. The loan officer in charge of the case
recommends at least a 4 percent annual before-tax rate of return over all costs. Using customer
profitability analysis (CPA) the loan committee hopes to estimate the following revenues and expenses
which it will project using the amount of the loan requested as a base for the calculations:
Estimated Revenues:
Interest income from loan ?
Loan commitment fee (0.75%) ?
Cash management fees (3%) ?
(on an annual average of
$15 million)
Estimated Expenses:
Interest to be paid on customer’s $3 million deposit ?
Expected cost of additional funds needed
to support the loan (4%) ?
Labor costs and other operating expenses
associated with monitoring
the customer’s loan (2%) ?
Cost of processing the loan (1.5%) ?
a. Should this loan be approved on the basis of the suggested terms?
b. What adjustments could be made to improve this loan’s projected return?
c. How might competition from other prospective lenders impact the adjustments you have
recommended?
Estimated Revenues:
Interest Income from Loan
$10,000,000*.06
= $600,000
Loan Commitment Fee
$10,000,000*.0075
= $75,000
Cash Management Fee
$10,000,000*.03
= $300,000
Total Revenues
$975,000
Estimated Expenses:
Interest on Deposit
$3,000,000*.0425
= $127,500
Expected Cost of Additional Funds
$10,000,000*.04
= $400,000
Labor Costs and Other Operating Costs $10,000,000*.02
Costs of Processing the Loan
= $200,000
$10,000,000*.015
Total Expenses
= $150,000
$877,500
Net Before Taxes Rate of Return = ($975,000 - $877,500)/$7,000,000 = 0.0139 or 1.39 percent
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a. No, it should not because the bank is earning less than the 4 percent annual before tax rate of return.
b. The fees that are charged could be made higher and the lender could try and find a way to reduce the
expenses on the loan. Both of these would have the effect of increasing the rate of return on the loan.
c. In particular, it would be difficult to raise fees for this customer if they can get these same services
from other lenders more cheaply. It would not necessarily cause a direct impact on expenses but other
lenders might already be more efficient in providing these services and they may already be charging a
lower interest rate on this loan based on the customer profitability analysis.
17-6. As a loan officer for Sun Flower National Bank, you have been responsible for the bank’s
relationship with USF Corporation, a major producer of remote-control devices for activating television
sets, DVDs, and other audio-video equipment. USF has just filed a request for renewal of its $10 million
line of credit, which will cover approximately nine months. USF also regularly uses several other services
sold by the bank. Applying customer profitability analysis (CPA) and using the most recent year as a
guide, you estimate that the expected revenues from this commercial loan customer and the expected
costs of serving this customer will consist of the following:
Expected Revenues
Expected Costs
Interest income from the
requested loan (assuming an
annualized loan rate of 4%
for 9 months)
Loan commitment fee (1%)
Deposit management fees
Wire transfer fees
Fees for agency services
Interest paid on customer
deposits (3.5%)
Cost of other funds raised
Account activity costs
Wire transfer costs
Loan processing costs
Recordkeeping costs
—?
100,000
4,500
3,500
4,500
—?
180,000
5,000
1,300
12,400
4,500
The bank’s credit analysts estimated the customer probably will keep an average deposit
balance of $2,125,000 for the year the line is active. What is the expected net rate of return from this
proposed loan renewal if the customer actually draws down the full amount of the requested line for
nine months? What decision should the bank make under the foregoing assumptions? If you decide to
turn down this request, under what assumptions regarding revenues, expenses, and customer deposit
balances would you be willing to make this loan?
The expected revenues and costs from continuing the present relationship between Sun Flower National
Bank and USF Corporation were given in this problem and the reader is asked to estimate the expected
net rate of return if the bank renews its loan to USF.
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The total of expected revenues and expected costs is:
Expected Revenues
Expected Costs
Interest Revenue
$400,000
Commitment Fees
100,000
Deposit Service
Deposit Interest
Cost of Other Funds Raised
4,500
Wire Transfer Costs
(Maintenance) Fees
Loan Processing Costs
$
74,375
180,000
1,300
12,400
Wire Transfer Fees
3,500
Record keeping Expenses
4,500
Agency Fees
4,500
Account Activity Cost
5,000
$512,500
Total Expected Costs
$ 277,575
Total Expected Revenues
Given: Total Expected Revenues
Total Expected Costs
Net Revenue
= $512,500
= $277,575
= $512,500 - $277,575 = $234,925
Net Funds Loaned = $10,000,000 - $2,125,000 = $7,875,000
Expected Net Rate of Return = $$234,925/ $7,875,000 = .0298 or 2.98%
Because the estimated net rate of return is positive, the bank should strongly consider approving the
loan as requested because the bank can earn a premium over its costs.
If you decide to turn down this request, under what assumptions regarding revenues, expenses, and
customer-maintained deposit balances would you make this loan?
An initial reaction might be to increase loan revenues by raising the interest rate on the loan or
increasing the loan commitment fee. Depending on the customer's relationship with the bank and with
other banks, this may prove to be extremely difficult. Initially, it was assumed that the customer would
draw down the entire line of credit, that is, borrow the full $10,000,000. If the customer were to borrow
less than the full amount, the cost of funds raised to support this loan could be reduced, increasing the
net revenue from the loan. Relative to expenses, it would be more likely that some adjustment in the
expenses associated with the relationship would be more appropriate. For example, a careful
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examination of the relationship activities could allow for a revision of estimated costs incurred by the
bank to manage the various aspects of the relationship. As far as the customer-maintained balances are
concerned, there could be an opportunity to revise these estimates upward, making the net funds
loaned smaller and the expected net rate of return greater.
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17-7. In order to help fund a loan request of $10 million for one year from one of its best customers,
Lone Star Bank sold negotiable CDs to its business customers in the amount of $6 million at a promised
annual yield of 3.50 percent and borrowed $4 million in the Federal funds market from other banks at
today’s prevailing interest rate of 3.25 percent.
Credit investigation and recordkeeping costs to process this loan application were an estimated
$25,000. The Credit Analysis Division recommends a minimal 1 percent risk premium on this loan and a
minimal profit margin of one-fourth of a percentage point. The bank prefers using cost-plus loan pricing
in this cases. What loan rate would it charge?
Lone Star Bank has sold negotiable CDs in the amount of $6 million at a yield of 3.50% and purchased $4
million in federal funds at a rate of 3.25%. The weighted average cost of bank funds in this case would
be:
$ 6,000,000 * .0350
= $210,000
$ 4,000,000 * .0325
= $130,000
Total Interest Cost
= $340,000
On a $10 million loan this is an average annual interest cost of $340,000/$10,000,000 or 0.034 which is
3.4 %. There was also $25,000 in noninterest costs or 0.25% of the loan total of $10 million. With a one
percent risk premium and a 0.25% minimal profit margin, the loan rate on a cost-plus basis would be:
Interest Cost + Non-interest Cost + Risk Premium + Profit Margin =
3.40% + 0.25% + 1.00% + 0.25% = 4.90%.
To break even we take out the profit margin, thus the loan rate would be 4.90 -.25 = 4.65%
Interest Cost = Loan rate -Non-interest cost - risk premium
Interest cost = 4.90 – 0.25 – 1.00 = 3.65%
17-8. Many loans to corporations are quoted today at small risk premiums and profit margins over the
London Interbank Offered rate (LIBOR). Englewood Bank has a $25 million loan request for working
capital to fund accounts receivable and inventory from one of its largest customers, APEX Exports. The
bank offers its customer a floating-rate loan for 90 days with an interest rate equal to LIBOR on 30-day
Euro deposits (currently trading at a rate of 4 percent) plus a one-quarter percentage point markup over
LIBOR. APEX, however, wants the loan at a rate of 1.014 times LIBOR. If the bank agrees to this loan
request, what interest rate will attach to the loan if it is made today? How does this compare with the
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loan rate the bank wanted to charge? What does this customer’s request reveal about the borrowing
firm’s interest rate forecast for the next 90 days?
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At today’s prevailing LIBOR rate the customer's requested loan-rate formula would generate a loan
interest rate of 1.014 * 4.0% = 4.056%. The bank wanted to charge a rate of 4.0% + 0.25% = 4.25%. Loan
rates tend to move up and down faster with the customer's loan-rate formula than with the bank's
LIBOR-plus formula. This customer appears to believe interest rates will soon decline, pulling its loan
rate lower.
17-9. Five weeks ago, Robin Corporation borrowed from the commercial finance company that
employs you as a loan officer. At that time, the decision was made (at your personal urging) to base the
loan rate on below-prime market pricing, using the average weekly Federal funds interest rate as the
money market borrowing cost. The loan was quoted to Robin at the Federal funds rate plus threeeighths percentage point markup for risk and profit.
Today, this five-week loan is due, and Robin is asking for renewal at money market borrowing
cost plus one-fourth of a point. You must assess whether the finance company did as well on this
account using the Federal funds rate as the index of borrowing cost as it would have done by quoting
Robin the prevailing CD rate, the commercial paper rate, the Eurodollar deposit rate or possibly the
prevailing rate on U.S. Treasury bills plus a small margin for risk and probability. To assess what would
have happened (and might happen over the next five weeks if the loan is renewed at a small margin
over any of the money market rates listed above), you have assembled these data from the Federal
Reserve Statistical Releases H15
What conclusion do you draw from studying the behavior of these common money market base
rates for business loans? Should the Robin loan be renewed as
Weekly Averages of Money Market Rates over the Most Recent 5 Weeks
Week 1
Week 2 Week 3 Week 4
Week 5
Money Market Interest Rates (1 week ago)
(5 week ago)
Federal funds
1.99%
2.04%
1.98%
2.06%
2.02%
Commercial paper
(one-month maturity)
2.13
2.17
2.17
2.20
2.05
CDs (one-month maturity)
2.47
2.58
2.52
2.53
2.43
Eurodollar deposits
(three-month maturity)
3.00
3.00
3.00
3.10
2.85
U.S. Treasury bills
(three-month, secondary market)
1.84
1.87
1.85
2.04
1.86
requested, or should the lender press for a different loan pricing arrangement? Please explain your
reasoning. If you conclude that a change is needed, how would you explain the necessity for this change
to the customer?
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Robin Corporation was quoted a loan rate equal to the prevailing federal funds interest rate plus 3/8 of
a percentage point (or 0.375%). Robin wanted the loan renewed at money-market borrowing cost plus
0.25%. If the base rate is set at the federal funds rate the loan rate as requested by Robin would be:
Week 1
Week 2
Week 3
Week 4
Week 5
Fed Funds
1.99%
2.04%
1.98%
2.06%
2.02%
Margin
0.25%
0.25%
0.25%
0.25%
0.25%
Loan Rate
2.24%
2.29%
2.23%
2.31%
2.27%
Clearly the other money-market interest rates would have generated somewhat lower loan rates,
especially the CP and Treasury bill rates. However, interest rates fell over the period examined, resulting
in lower loan revenues for the bank. The bank would have been better off to offer its customer a fixed
interest rate over the next five weeks.
17-10. Wren Corporation has posted an average deposit balance this past month of $265,500. Float
included in this one-month average balance has been estimated at $50,000. Required legal reserves are
3 percent of net collected funds. What is the amount of net investable (usable) funds available to the
bank holding the deposit?
Suppose Wren’s bank agrees to give the firm credit for an annual interest return of 2.25 percent
on the net investable funds the company provides the bank. Measured in total dollars, how much of an
earnings credit from the bank will Wren earn?
Net investable funds = 265,500 – 50,000 – (3% x 215,500) = $209,035
Earnings credit =2.25% x 1/12 x 209,035 = $391.94
CHAPTER 18
CONSUMER LOANS, CREDIT CARDS, AND REAL ESTATE LENDING
Goal of This Chapter: To learn about the many types of loans lenders make to consumers (individuals
and families) and to real estate borrowers and to understand the factors that influence the profitability
and risk of consumer and real estate loans. In addition, the chapter examines how consumer and real
estate loan rates may be determined and the options a loan officer has today in pricing loans extended
to individuals and families.
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Key Topics in This Chapter
•
•
•
•
•
•
Types of Loans for Individuals and Families
Unique Characteristics of Consumer Loans
Evaluating a Consumer Loan Request
Credit Cards and Credit Scoring
Disclosure Rules and Discrimination
Consumer Loan Pricing and Refinancing
Chapter Outline
I. Introduction
II. Types of Loans Granted to Individuals and Families
A. Residential Mortgage Loans
B. Nonresidential Loans
a. Installment Loans
b. Noninstallment Loans
C. Credit Card Loans and Revolving Credit
D. New Credit Card Regulations
E. Debit Cards: A Partial Substitute for Credit Cards?
F. Rapid Consumer Loan Growth: Rising Debt-to-Income Ratios
Ill. Characteristics of Consumer Loans
IV. valuating a Consumer Loan Application
A. Character and Purpose
B. Income Levels
C. Deposit Balances
D. Employment and Residential Stability
E. Pyramiding of Debt
F. How to Qualify for a Consumer Loan
G. The Challenge of Consumer Lending
V. Example of a Consumer Loan Application
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VI. Credit Scoring Consumer Loan Applications
A. The Theory of Credit Scoring
B. An Example of Credit Scoring
C. The FICO Scoring System
VII. Laws and Regulations Applying to Consumer Loans
1. Disclosure Rules
2. Antidiscrimination Laws
A. Customer Disclosure Requirements
1. Truth-in-Lending Act, 1968
2. Fair Credit Reporting Act
3. Fair Credit Billing Act, 1974
4. Fair Credit and Charge-Card Disclosure Act
5. Fair Debt Collection Practices Act
B. Outlawing Credit Discrimination
1. Equal Credit Opportunity (ECO) Act
2. Community Reinvestments Act (CRA)
C. Predatory Lending and Subprime Loans
VIII. Real Estate Loans
A.
B.
C.
D.
Differences between Real Estate Loans and Other Loans
Factors in Evaluating Applications for Real Estate Loans
Home Equity Lending
The Most Controversial of Home Mortgage Loans: Interest-Only and Adjustable Mortgages
and the Recent Mortgage Crisis
IX. A New Federal Bankruptcy Code as Bankruptcy Filings Soar
X. Pricing Consumer and Real Estate Loans: Determining the Rate of Interest and Other Loan Terms
A. The Interest Rate Attached to Nonresidential Consumer Loans
1. The Cost-Plus Model
2. Annual Percentage Rate
3. Simple Interest
4. The Discount Rate Method
5. The Add-On Loan Rate Method
6. Rule of 78s
B. Interest Rates on Home Mortgage Loans
1. Fixed-Rate Mortgages (FRMs)
2. 2. Adjustable-Rate Mortgages (ARMs)
3. Charging the Customer Mortgage Points
XI. Summary of the Chapter
Concept Checks
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18-1. What are the principal differences among residential loans, nonresidential installment loans,
noninstallment loans, and credit card or revolving loans?
Residential loans are credit to finance the purchase of a home or fund improvements on a private
residence. Nonresidential loans to individuals and families include installment loans and noninstallment
loans. Short-term to medium-term loans, repayable in two or more consecutive payments (usually
monthly or quarterly), are known as installment loans. Installment loans are paid off gradually over time
whereas short-term loans individuals and families draw upon for immediate cash needs that are
repayable in a lump sum at the end of the loan are known as noninstallment loans.
Installment loans usually finance large-ticket purchases, such as automobiles or household furniture,
whereas noninstallment loans usually are directed at current living expenses. Installment loans help the
bank recover funds that can be reloaned more quickly but they generally require a more intensive credit
investigation by the bank. Bank credit cards offer convenience and a revolving line of credit that the
customer can access whenever the need arises.
18-2. Why do interest rates on consumer loans typically average higher than on most other kinds of
loans?
Interest rates on consumer loans are typically higher than on most other kinds of loans since they are
among the most costly and most risky to make per dollar of loanable funds. Consumer loans also tend
to be cyclically sensitive. Moreover, consumers tend to be relatively unresponsive to changes in interest
rates when they go out and borrow money.
18-3.
What features of a consumer loan application should a loan officer examine most carefully?
A loan officer should examine character and purpose, income levels, employment and residential
stability, and pyramiding of debt when evaluating a consumer loan application.
18-4.
How do credit-scoring systems work?
Credit-scoring systems use statistical techniques (usually multiple discriminant analysis) to classify
borrowers based on selected characteristics of each borrower as to whether they are likely or unlikely to
repay the loan they have requested.
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Credit-scoring systems are usually based on discriminant models or related techniques, such as logit or
probit analysis or neural networks, in which several variables are used jointly to establish a numerical
score for each credit applicant. If the applicant’s score exceeds a critical cutoff level, he or she is likely to
be approved for credit in the absence of other damaging information. If the applicant’s score falls below
the cutoff level, credit is likely to be denied in the absence of mitigating factors.
18-5.
What are the principal advantages to a lending institution of using a credit-scoring system?
The credit scoring method has the advantage of being objective, requiring less loan officer judgment,
possibly lowering loan losses, and lowering operating costs when a large volume of consumer loans is
processed.
18-6.
Are there any significant disadvantages to a credit-scoring system?
Credit scoring systems do not take into account motivational factors or individual differences and may
become outdated unless frequently retested for statistical accuracy.
18-7. In the credit-scoring system presented in this chapter, would a loan applicant who is a skilled
worker, lives with a relative, has an average credit rating, has been in his or her present job and at his or
her current address for exactly one year, has four dependents and a telephone, and holds a checking
account be likely to receive a loan? Please explain why.
Given, the credit scoring model in the chapter, the skilled worker would have the following credit score:
Skilled worker
80 points
Lives with friend or relative
20
Average credit rating
50
One year in current job 20
One year in current residence 10
Telephone in home
20
Number of Dependents:
More than three
40
Bank Accounts Held:
Checking Account only
Total Score
20
260 points
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Because this loan applicant's criterion score is below 280 points the loan request is likely to be denied.
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18-8. What is FICO and what does it do for lenders? Why is this credit-scoring system so popular
today?
FICO is a credit scoring system developed by Fair Isaac Corporation. It is fast, objective and impartial and
that makes it very useful for regulated financial institutions.
18-9. What laws exist today to give consumers fuller disclosure about the terms and risks of taking on
credit?
The following federal laws give consumers who are borrowing money fuller disclosure about the terms
and risks of taking on credit:
a. Truth-in-Lending Act, 1968
b. Fair Credit Reporting Act
c. Fair Credit Billing Act, 1974
d. Fair Credit and Charge-Card Disclosure Act
e. Fair Debt Collection Practices Act
The Truth-in-Lending Act makes household borrowers better informed about the terms of credit so they
can shop around. The Fair Credit Reporting Act gives individuals easier access to their credit-bureau
records and the right to challenge information contained therein and to insist on the prompt correction
of errors. The Fair Credit Billing Act gives consumers the right to dispute billing errors and have those
errors corrected. Fair Credit and Charge-Card Disclosure Act informs any change in credit card insurance
coverage or fees by direct mail, by telephone, or through advertisements that reach the general public.
The Fair Debt Collection Practices Act limits how far a creditor or credit collection agency can go in
pressing that customer to pay up.
18-10. What legal protections are available today to protect borrowers against discrimination? Against
predatory lending?
The Equal Credit Opportunity Act outlaws discrimination in lending based on race, age, sex, religious
preference, receipt of public assistance, and similar factors. The Community Reinvestment Act requires
banks and other lending institutions to make an "affirmative effort" to serve all segments of their
designated market areas without discriminating against certain neighborhoods.
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Predatory lending is an abusive practice among some lenders that consists of making loans to weak
borrowers and then charging them excessive fees and interest rates, thereby increasing the risk of
default. In 1994 Congress passed the Home Ownership and Equity Protection Act which was aimed to
protect home owners from loan agreements they could not afford. Loans whose annual percentage
rates (APR) is 10 percentage points or more above the yield on comparable maturity U.S. Treasury
securities and closing fees above 8 percent of the loan amount are defined as “abusive” and consumers
have 6 days in which to decide whether to proceed with the loan. Credit granting institutions must fully
disclose all fees and risks. If these are not disclosed, then the borrower has up to 3 years to rescind the
transaction and lenders might be liable for all damages that occur.
18-11. In your opinion, are any additional laws needed in these areas?
This question does not have a right or wrong answer. Depending on one's point of view, more or less
regulation in these areas can be supported. Most, if not all, bankers and bank trade associations, as well
as many of the regulatory agencies, tend to agree that there are already more than enough laws and
regulations in these areas. Consumer groups and some elected officials would argue that consumers,
particularly in certain economic groups or communities, need more legislation and/or regulation to
protect their interests.
18-12. In what ways is a real estate loan unique compared to other kinds of bank loans?
Real estate loans are longer-term than most other loans and usually involve above-average amounts of
funds at risk. Moreover, they depend more heavily on the value and maintenance of collateral than
most other types of loans.
18-13. What factors should a lender consider in evaluating real estate loan applications?
Among the factors to be considered in evaluating a real estate loan applications are:
1. What is the borrower's monthly income and monthly debt repayments? The bank must be
assured there is adequate cushion to comfortably absorb the home loan repayments.
2. Does the borrower have good prospects for continued employment? Because the loan is long
term the bank must have reasonable assurance the borrower can service a long-term loan.
3. Is the current market value of the home to be purchased sufficiently larger than the amount
of the loan to give the bank adequate cushion if local real estate values decline?
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18-14. What is home equity lending, and what are its advantages and disadvantages for banks and
other consumer lending institutions?
Home-equity loans use the residual market value of a home (over and above the amount of any
outstanding liens against the home) as a borrowing base. Financial institutions often lend a fraction of
this residual value, which subjects them to the risk that the market value of a home will fall, significantly
eroding the cushion of protection for a loan of this type. If the customer fails to make any promised
loan payments, the bank or other lender could foreclose and take over the home to sell it and recover at
least a portion of loaned funds.
18-15. How is the changing age structure of the population likely to affect consumer loan programs?
What other forces are reshaping household lending today?
As people grow older, especially beyond the age of 40 or 45, they tend to make less use of credit and to
pay down outstanding debt obligations. This suggests that the total demand for consumer credit per
capita may fall, forcing banks and other consumer lenders to fight hard for profitable consumer loan
accounts.
18-16. What challenges have U.S. bankruptcy laws provided for consumer and those lending money to
them?
Recent changes in U.S. bankruptcy laws present serious challenges to consumer lending institutions.
Congress passed the Bankruptcy Reform Act in 1978, amending a federal bankruptcy code that had
stood since the turn of the century. While amendments in 1984 tightened up some of the loopholes in
the 1978 law, the most recent reforms tipped the legal scales substantially in favor of individuals filing
bankruptcy petitions and more severely limited the amount and kinds of debtors' assets that could be
converted into cash for distribution to banks and other creditors. However, the Bankruptcy Abuse
Prevention and Consumer Protection Act was signed in April of 2005. This law is likely to make it more
difficult, expensive and time consuming to file for bankruptcy. Consumers must complete a credit
counseling program before becoming eligible for filing bankruptcy and a ‘means test’ has been added.
This test will let consumers know whether they are eligible to file for Chapter 7 bankruptcy which wipes
out most debt or whether they will have to file Chapter 13 which requires them to have a court
approved repayment plan for their outstanding debt.
18-17. What options does a loan officer have in pricing consumer loans?
Most consumer loans, like most business loans, are priced off some base or cost rate, with a profit
margin and compensation for risk added on. The rate on a consumer loan may be figured from the costplus model or the base-rate model. Most installments and lump-sum payment loans are made with
fixed interest rates. However, due to the volatility of interest rates in the 1970’s and 1980's, a greater
number of floating rate consumer loans have appeared.
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18-18. Suppose a customer is offered a loan at a discount rate of 8 percent and pays $75 in interest at
the beginning of the term of the loan. What net amount of credit did this customer receive? Suppose
you are told that the effective rate on this loan is 12 percent. What is the average loan amount the
customer has available during the year?
The relevant formula is:
Discount
loan rate
$75
Interest Owed
=
Net Amount
=
x
=
0.08
of Credit Received
Then the net amount of credit received must be $75/.08 or $937.50.
Suppose you are told that the effective rate on this loan is 12 percent. What is the average loan amount
the customer had available during the year?
In this instance:
$75
Interest Owed
Effective loan
ratio
=
Average Loan Amount
During the Year
=
x
=
0.12
Then the average loan amount during the year must be:
x = $75 = $625.
0.12
18-19. See if you can determine what APR you are charging a consumer loan customer if you grant the
customer a loan for five years payable in monthly installments, and the customer must pay a finance
charge of $42.74 per $100.
The terms quoted mean that the customer must pay an APR of 15 percent (using a financial calculator
and using 142.74/60 as the monthly payments, $100 as the amount borrowed and 60 months as the
number of periods and then adjusting the interest rate to be an annual interest rate)
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PV = A*PVIFA k/m,n*m
$100 = 2.379 PVIFA ?, 60 k/m = 1.25% so k = 15%
18-20. If you quote a consumer loan customer an APR of 16 percent on a $10,000 loan with a term of
four years that requires monthly installment payments, what finance charge must this customer pay.
The Finance charge per $100 of amount financed must be $36.03 or $36.03 *100 = $3603 in total
finance charges.
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18-21. What differences exist between ARMs and FRMs?
An ARM is a mortgage whose interest rate changes over time, usually based upon changes in some base
or reference rate. A FRM is a mortgage whose interest rate does not change with current market
conditions.
18-22. How is the loan rate figured on a home mortgage loan? What are the key factors or variables?
The best way to figure out the affordability of a home mortgage loan is to calculate the required
monthly mortgage payment. This is a time value of money calculation and the payment depends upon
the loan principal, the interest rate, and the length of the mortgage loan.
18-23. What are points? What is their function?
Points are an additional charge up front in which each point to be paid equals one percent of the face
value of the loan. Requiring the borrower to pay something extra over and above the interest owed on
the loan, enable the lending institution to earn a higher effective interest rate.
Problems
18-1. The Childress family has applied for a $5,000 loan to make home improvements, especially to
install a new roof and add new carpeting. Bob Childress is a welder at Ford Motor Co., the first year he
has held that job, and his wife sells clothing at Wal-Mart. They have 3 children. The Childresses own
their home, which they purchased six month ago, and have an average credit rating, with some late bill
payments. They have a telephone, but hold only a checking account with a bank and a few savings
bonds. Mr. Childress has a $35,000 life insurance policy with a cash surrender value of $1,100. Suppose
the lender uses the credit scoring system presented in this chapter and denies all credit applications
scoring fewer than 360 points. Is the Childress family likely to get their loan? What is the family’s credit
score? (Hint: For the occupation factor take the average for the husband’s and wife’s occupations.)
The credit-scoring system presented in Chapter 18 is assumed here to have a cut off point of 360 with
denials of credit requests imposed when applicants score below 360. The Childress family would score
approximately as follows under the scoring system in the chapter:
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Occupation (for skilled or clerical workers)
75 (average of 70 and 80)
Housing Status (own home)
60
Credit Rating
50
Time in Job (one year or less)
20
Time at Current Address (one year or less)
10
Telephone (years)
20
Number of Dependents (3)
40
Bank Accounts Held (checking only) Total
20
295points
This credit request, in the absence of other mitigating factors, would be denied.
18-2. Mr. and Mrs. Napper are interested in funding their children's college education by taking out a
home equity loan in the amount of $24,000. Eldridge National Bank is willing to extend a loan, using the
Napper's home as collateral. Their home has been appraised at $110,000, and Eldridge permits a
customer to use no more than 70 percent of the appraised value of the home as a borrowing base. The
Nappers still owe $60,000 on the first mortgage against their home. Is there enough residual value left
in the Nappers’ home to support their loan request? How could the lender help them meet their credit
needs?
The maximum credit line available to the Nappers under the bank's current home-equity loan policy is:
$110,000 x 0.70 - $60,000 = $77,000 - $60,000 = $17,000.
This would clearly not result in a large enough borrowing base to cover the $24,000 loan requested.
Many banks make adjustments in the permissible loan amount if the customer has an above-average
level of income, other assets to pledge, relatively low mortgage debt obligations, and an excellent credit
rating. Thus, the Nappers may be able to qualify for an additional $17,000 in loanable funds (perhaps by
pledging other collateral) to make up the $24,000 they need.
18-3. Ben James has just been informed by a finance company that he can access a line of credit of no
more than $75,000 based upon the equity value in his home. James still owes $125,000 on a first
mortgage against his home and $25,000 on a second mortgage claim against the home, which was
incurred last year to repair the roof and driveway. If the appraised value of James’s residence is
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$300,000, what percentage of the home's estimated market value is the lender using to determine
James’s maximum available line of credit?
Maximum Credit Line Available = Appraised Value * Allowable Percentage of Market Value
- Mortgage Loans Outstanding
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Substituting in what we know:
$75,000 = $300,000 *Allowable Percentage of Market Value -$150,000
Or
$225,000 = $300,000 * Allowable percentage of Market Value
0.75 = Allowable Percentage of Market Value
Or about 75%.
18-4.
What term in the consumer lending field does each of the following statements describe?
a. Plastic card used to pay for goods and services without borrowing money. – Debit card
b. Loan to purchase an automobile and pay it off monthly. – Installment Loan
c. If you fail to pay the lender seizes your deposit. – Right of offset
d. Numerical rating describing likelihood of loan repayment. – Credit score
e. Loans extended to low-credit-rated borrowers. – Sub prime loans
f. Loan based on spread between a home’s market value and its mortgage balance. – Home equity loans
g. Method for calculating rebate borrower receives from retiring a loan early – Rule of 78s
h. Lender requires excessive insurance fees on a new loan. – Predatory lending
i. Loan rate lenders must quote under the Truth in Lending Act – APR
j. Upfront payment required as a condition for getting a home loan. - points
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18-5.
Which federal law or laws apply to each of the situations described below?
a. A loan officer asks an individual requesting a loan about his or her race - prohibited by the Equal
Credit Opportunity Act.
b. A bill collector calls Jim Jones three times yesterday at his work number without first asking
permission - prohibited by the Fair Debt Collection Practices Act.
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c. Sixton National Bank has developed a special form to tell its customers the finance charges they must
pay to secure a loan - disclosure of all charges required by Truth in Lending legislation (Consumer Credit
Protection Act).
d. Consumer Savings Bank has just received an outstanding rating from federal examiners for its efforts
to serve all segments of its community - ratings required by the Community Reinvestment Act.
e. Presage State Bank must disclose once a year the areas in the local community where it has made
home mortgages and home improvement loans - required by the Home Mortgage Disclosure Act.
f. Reliance Credit Card Company is contacted by one of its customers in a dispute over amounts of
charges at a local department store - the Fair Credit Billing Act applies.
g. Amy Imed, after requesting a copy of her credit report, discovers several errors and demands a
correction - the Fair Credit Reporting Act applies.
18-6. James Smithern has asked for a $3,500 loan from Beard Center National Bank to repay some
personal expenses. The bank uses a credit-scoring system to evaluate such requests, which contains the
following discriminating factors along with their associated point weights in parentheses:
Credit Rating (excellent 3; average 2; poor or no record 0)
Time in Current Job (5 years or more 6; one to five years 3)
Time at Current Residence (more than 2 years, 4; one to two years 2; less than one year 1)
Telephone in Residence (yes 1; no 0)
Holds Account at Bank (yes 2; no 0)
The bank generally grants a loan if a customer scores 9 or more points. Mr. Smithern has an average
credit rating, has been in his current job for three years and at his current residence for two years, has a
telephone, but has no account at the bank. Is James Smithern likely to receive the loan he has
requested?
Credit rating: average,
2 points
Time in current job: one to five years,
3 points
Time in current residence: one to two years,
2 points
Telephone:
1 point
yes,
Holds Bank Account: No,
0 points
Smithern's point total is 8. If the bank grants loans to applicants with credit scores of 9 or more points,
then Smithern is not likely to receive a loan under this scoring system.
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18-7. Jamestown Savings Bank, in renewing its credit card customers finds that of those customers
scoring 40 points or less on its credit-scoring system, 35 percent (or a total of 10,615 credit customers)
turned out to be delinquent credits resulting in total losses. This group of bad credit card loans
averaged $6,800 in size per customer account. Examining its successful credit accounts Jamestown finds
that 12% of its good customers (or a total of 3,640 customers) scored 40 points or less on the bank’s
scoring system. These low scoring but good accounts generated about $1,700 in revenues each. If
Jamestown’s credit card division follows the decision rule of granting credit cards only to those
customers scoring more than 40 points and future credit accounts generate about the same average
revenues and losses, about how much can the bank expect to save in net losses.
The total loss to the bank from delinquent customers is $72.182 million or 10,615 customers * $6,800.
On the other hand, paying credit-card customers (amounting to 3640 customers) averaged a score of 40
points or less, but successfully generated about $1700 a piece in revenues, resulting in aggregate
revenues of $6.188 million or $1700 * 3640 customers. By adopting a decision rule to grant credit-card
privileges only to customers scoring more than 40 points (and assuming about the same average
revenues and losses) the bank will save about $22.473 million.
18-8 The Lathrop family needs some extra funds to put their two children through college starting
this coming fall and to buy a new computer system for a part-time home business. They are not sure of
the current market value of their home, though comparable 4-bedroom homes are selling for about
$410,000 in the neighborhood. The Monarch University Credit Union will loan 75 percent of the
property’s appraised value, but the Lathrops still owe $265,000 on their home mortgage and home
improvement loan combined. What maximum amount of credit is available to this family should it elect
to seek a home equity credit line?
Maximum credit available = Current Market Value of Home *Allowable Percentage of Market Value Mortgage Loans Outstanding
= $410,000 * 0.75 - $265,000 = $63,000
is the amount available for their needs.
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18-9 San Carlos Bank and Trust Company uses a credit-scoring system to evaluate most consumer
loans that amount to more than $2,500. The key factors used in its scoring system are as follows:
Borrower’s length of employment in his/her
present job:
More than one year
6 points
Less than one year
3 points
Borrower’s length of time at current address:
More than 2 years
8 points
One to two years
4 points
Less than one year
2 points
Borrower’s current home situation:
Owns home
7 points
Rents home or apartment 4 points
Lives with friend or relative 2 points
Credit bureau report:
Excellent
Average
Below average or no record
Credit cards currently active:
One card
Two cards
More than two cards
Deposit account(s) with bank:
Yes
No
8 points
5 points
2 points
6 points
4 points
2 points
5 points
2 points
The Mulvaney family has two wage earners who have held their present jobs for 18 months. They have
lived at their current street address for one year, where they rent on a six month lease. Their credit
report is excellent but shows only one previous charge. However, they are actively using two credit
cards right now to help with household expenses. Yesterday, they opened an account at San Carlos and
deposited $250. The Mulvaneys have asked for a $4,500 loan to purchase a used car and some
furniture. The bank has a cutoff score in its scoring system of 30 points. Would you make this loan for
two years as they have requested? Are there factors not included in the scoring system that you would
like to know more about? Please explain.
The Mulvaney family wants to borrow $4500 from San Carlos Bank and Trust to purchase a used car and
some furniture. The credit scoring system considers the following factors?
Length of Employment: More than one year –
6 points
Length of time at Current Address: One to Two Years – 4 points
Current Home Situation: Rents Home –
4 points
Credit Bureau Report: Excellent –
8 points
Credit Cards Currently Active: 2 Cards –
4 points
Deposit Accounts with Bank: Yes –
5 points
Total
31 points
The Mulvaney family has a point total of 31. San Carlos Bank and Trust has a cutoff score of 30 points so
the Mulvaneys are likely to receive their loan.
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18-10. Ray Volkers wants to start his own business. He has asked his bank for a $30,000 new-venture
loan. The bank has a policy of making discount-rate loans in these cases if the venture looks good, but
at an interest rate of prime plus 2. (The prime rate is currently posted at 5 percent). If Mr. Volker’s loan
is approved for the full amount requested, what net proceeds will he have to work with from this loan?
What is the effective interest rate on this loan for one year?
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This means Volker will receive net loan proceeds of $30,000 - ($30,000 * 0.07) = $27,900.
Using this net figure as a base, Volker will pay an effective interest rate of
$2,100 / $27,900 or 7.53%.
18-11. The Crockett family has asked for a 30-year mortgage in the amount of $325,000 to purchase a
home. At a 7 percent loan rate, what is the required monthly payment?
$325,000 * 0.07/12 * (1 + 0.07/12) 30*12
= $2,162.33
(1 + 0.07/12) 30*12 - 1
or use a financial calculator.
18-12. Catherine Jones received an $5,000 loan last month with the intention of repaying the loan in 12
months. However, Jones now discovers she has cash to repay the loan right now after making just two
payments. What percentage of the total finance charge is Jones entitled to receive as a rebate and what
percentage of the loan's finance charge is the lender entitled to keep?
The Rule of 78s applies here. James Jones is entitled to receive back as an interest rebate:
1 + 2 + . . . + 10
55
=
x 100 = 70.51percent
1 + 2 + ... + 11+ 12 78
of the total finance charges on the loan: the lender is entitled to keep 29.49 percent of the finance
charges associated with this loan.
18-13. The Watson family has been planning a vacation to Europe for the past two years. Gratton
Savings agrees to advance a loan of $7,200 to finance the trip provided the Watsons pay the loan back in
12 equal monthly installments. Gratton will charge an add-on loan rate of 6%. How much in interest
will the Watsons pay under the add-on loan rate method? What is the amount of each required
monthly payment? What is the effective loan rate in this case?
Interest Paid = Loan principal * Loan Rate = $7,200 * 0.06 = $432
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What is the amount of each required monthly payment?
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Amount of Monthly Payment =
$7200 + $432
= $636
12
What is the effective loan rate in this case?
Effective Loan Rate =
Interest Owed
$432
=
= 0.12 or 12%
Average Amount During the Year $3600
18-14. Jane Zahrley’s request for a four year automobile loan for $33,000 has been approved. Reston
Center Bank will require equal monthly installment payments for 48 months. The bank tells Jane that
she must pay a total of $5,500 in finance charges. What is the loan’s APR?
Loan payments would be ($33,000+$5,500)/48 = $802.08 per month
Using a financial calculator and solving for the interest: APR = 7.77%
18-15. Sue Bender has asked for a 25 year mortgage to purchase a home on Long Island. The purchase
price is $465,000 of which Bender must borrow $375,000 to be repaid in monthly installments. If Kyle
can get his loan for an APR of 6.25%, how much in total finance charges must he pay?
Using a financial calculator calculate monthly payments: payment = $2,473.76
Total payments over the life of the loan = 300 x $2,473.76 = $742,128.05
Finance charges = $742,128.05 - $375,000 = $367,128.05
18-16. Mary Cantrary is offered a $1,600 loan for a year to be paid back in equal quarterly installments
of $400 each. If Mary is offered the loan at 8 percent simple interest, how much in total interest
charges will she pay? Would Mary be better off (in terms of lower interest cost) if she were offered the
$1,600 at 6 percent simple interest with only one principal payment when the loan reaches maturity?
What advantage would this second set of loan terms have over the first set of loan terms?
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Mary Cantrary will pay the following in interest on her $1200 loan for one year at 8 percent
simple interest:
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First Quarter: I = $1,600 x 0.08 x 1/4 = $32
Second Quarter: I = $1,200 x 0.08 x 1/4 = $24
Third Quarter: I = $800 x 0.08 x 1/4 = $16
Fourth Quarter: I = $400 x 0.08 x 1/4 = $8
Total Interest owed = $32 + $24 + $16 + $8 = $80.
If Mary were offered the $,1600 loan at a 6 percent simple interest rate and the loan is paid in lump sum
at maturity, she will pay total interest of:
$1,600 * 0.06 x 1 = $96.
She clearly would pay more in interest but would have the full $1,600 available for her use for one year.
18-17. Buck and Anne Rogers are negotiating with their local bank to secure a home mortgage loan in
order to buy their first home. With only a limited down payment available to them, Buck and Anne
must borrow $280,000. Moreover, the bank has assessed them a half points on the loan. What is the
dollar amount of points they must pay to receive this loan? How much home mortgage credit will they
actually have available for their use?
The dollar amount of points they must pay upfront is:
Dollar Value of Points = $280,000 * 0.005 = $1,400.
The Rogers will have available for their use only $278,600 or $280,000 - $1,400.
18-18. Dryden Bank’s personal loan department quotes Lance Davenport a finance charge of $4.25 for
each $100 in credit the bank is willing to extend to him for a year (assuming the balance of the loan will
be paid off in 12 equal installments). What APR is the bank quoting Lance? How much would he save
per $100 borrowed if he could retire the loan in six months?
The APR on this loan is 7.76 percent
CHAPTER 19
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ACQUISITIONS AND MERGERS IN FINANCIAL-SERVICES MANAGEMENT
Goal of This Chapter: The purpose of this chapter is to understand why the financial services industry
undertakes so many mergers each year and to determine what legal, regulatory and economic factors
should be considered when the management of a financial services provider wants to pursue a merger.
Key Topics in This Chapter
•
•
•
•
•
•
Merger Trends in the United States and Abroad
Motives for Merger
Selecting a Suitable Merger Partner
U.S. and European Merger Rules
Making a Merger Successful
Research on Merger Motives and Outcomes
Chapter Outline
I. Introduction
II. Mergers on the Rise
III. The Motives behind the Rapid Growth of Financial-Service Mergers
A. Profit Potential
B. Risk Reduction
C. Rescue of Failing Institutions
D. Tax and Market-Positioning Motives
E. The Cost Savings or Efficiency Motive
F. Mergers as a Device for Reducing Competition
G. Mergers as a Device for Maximizing Management’s Welfare
H. Other Merger Motives
I. Merger Motives that Executives and Employees Identify
IV. Selecting a Suitable Merger Partner
A. Merger Premiums
B. Exchange Ratios
C. Dilution of ownership
D. Dilution of earnings
V. The Merger and Acquisition Route to Growth
VI. Methods of Consummating Merger Transactions
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A. Purchase-of-Assets Method
B. Purchase-of-Stock Method
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VII. Regulatory Rules for Bank Mergers in the United States
A. Bank Merger Act of 1960
B. Competitive Effects of Mergers
C. The Public Benefits Test
D. Justice Department Guidelines and the Herfindahl - Hirschman Index
E. The Merger Decision-Making Process by U.S. Federal Regulators
VIII. Merger Rules in Europe and Asia
IX. Making a Success of a Merger
X. Research Findings on the Impact of Financial-Service Mergers
A. The Financial and Economic Impact of Acquisitions and Mergers
B. Public Benefits from Mergers and Acquisitions
XI. Summary of the Chapter
Concept Checks
19-1.
Exactly what is a merger?
Mergers result in the combining of the assets and liabilities of two or more firms. To affect a merger the
shareholders of all the parties involved must approve the merger transaction once it is negotiated
among the management of the parties to the merger. Once the shareholders of each firm involved give
approval to the merger, approval must then be sought from the Department of Justice and the principal
federal regulatory agency of each firm in the merger.
19-2.
Why are there so many mergers each year in the financial services industries?
Many (if not most) mergers occur because the shareholders of the institutions involved expect increased
profit potential once the merger is consummated. Alternatively, many partners to mergers anticipate
reduced cash-flow risk and possibly reduced earnings risk as well.
19-3.
What factors seem to motivate most mergers?
Among the most powerful merger motivations are the belief in greater profit potential if a merger is
consummated, the expectation of a possible reduction of cash flow risk or earnings risk, the possible
rescue of failing institutions, the gaining of a tax advantage where profits of one merger partner may be
offset by the losses of another merger partner, the search for market-positioning benefits in new
markets or in superior locations in existing markets, and the pursuit of lower cost and greater efficiency
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so that the merged institution achieves a greater margin of revenues over operating expense as well as
maximizing the welfare of management.
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19-4.
What factors should a financial firm consider when choosing a good merger partner?
The following items are the principal factors usually reviewed by the acquiring organization:
1. The firm’s history, ownership, and management.
2.The condition of its balance sheet.
3. The firm’s track record of growth and operating performance.
4. The condition of its income statement and cash flow.
5. The condition and prospects of the local economy served by the targeted institution.
6. The competitive structure of the market in which the firm operates.
7. The comparative management styles of the merging organizations.
8. The principal customers the targeted institution serves.
9. Current personnel and employee benefits.
10. Compatibility of accounting and management information systems among the merging
companies
11. Condition of the targeted institution’s physical assets
12. Ownership and earnings dilution before and after the proposed merger
19-5. What factors must the regulatory authorities consider when deciding whether to approve or
deny a merger?
Mergers that would significantly damage competition cannot be approved unless there are mitigating
instigating circumstances (e.g., one of the firms involved is failing). Public convenience must also be
weighed by the regulatory agencies to determine if the merger would improve the supply of needed
services that are perhaps currently not being conveniently and efficiently provided to the public.
19-6. When is a market too concentrated to allow a merger to proceed? What could happen if a
merger were approved in an excessively concentrated market area?
The Department of Justice guidelines state that the market area is too concentrated if the postmerger
Herfindahl index increases 200 or more points to a level of 1,800 or more or if the postmerger market
share rises to 35 percent or more. If the Justice Department decides that the resultant merger will make
the banking market too concentrated they are likely to challenge the merger in federal court.
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19-7. What steps that management can take appear to contribute to the success of a merger? Why
do you think many mergers produce disappointing results?
• There are several steps management can take to improve their chances of success of a merger.
they can know themselves, its own financial condition, track record of performance, strengths
and weaknesses of the markets it already serves, and strategic objectives.
• They can also get a team together before any merger to do a detailed analysis of the potential
merger and new market area.
• Establish a realistic price for the target firm based on a careful assessment of its projected future
earnings discounted by a capital cost rate that fully reflects the risks of the target market and
target firm.
• Once a merger is agreed upon, create a combined management team with capable managers
from both acquiring and acquired firms that will direct, control, and continually assess the quality
of progress toward the consolidation of the two organizations into a single effective unit that
satisfies all federal and state rules.
• They should also establish lines of communication between senior management and branch and
line management and staff that promotes rapid two-way communication of operating problems
and ideas for improved technology and procedures.
• Create communications channels for both employees and customers to promote ( a )
understanding of why the merger was pursued and ( b ) what the consequences are likely to be
for both anxious customers and employees who may fear interruption of service, loss of jobs,
higher service fees, the disappearance of familiar faces, and other changes.
• Finally they should set up customer advisory panels to comment on the merged institution’s
community image, availability of services and helpfulness.
Mergers sometimes produce disappointing results because of ill-prepared management, a mismatch of
corporate cultures, excess prices paid by the acquirer, inattention to customers’ feelings and concerns
and a general lack of fit between the two firms.
19-8. What does recent research evidence tell us about the impact of most mergers in the financial
sector?
A recent study, which looked at the earnings impact of approximately 600 national bank mergers, found
no significant differences in profitability between merging and comparably sized nonmerging banks
serving the same local markets. However, CEOs at a substantial majority of the nearly 600 U.S. bank
mergers occurring from 1970-1985 believed their capital base improved and they were now a more
efficient banking organization. However, as a study by Rose found there is no guarantee of success in a
merger. This study of 572 banks which purchased nearly 650 other banks found a symmetric distribution
of earnings outcomes for these mergers – nearly half displaying negative earnings results. Finally, a
recent study by the Federal Reserve Board finds that mergers and acquisition in the financial sector
often produce operating cost savings. However, these are generally very small and there is no evidence
for cost reductions among large financial firms.
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19-9.
Does it appear that most mergers serve the public interest?
Most studies that have looked at this issue find few real public benefits. However, there is also no
convincing evidence that the public has suffered a decline in service quality or availability following most
bank mergers. On the positive side, mergers may significantly lower the bank failure rate.
Problems and Projects
19-1. Evaluate the impact of the following proposed mergers upon postmerger earnings per share of
the combined organizations:
a. An acquiring bank reports that the current a stock price is $25 per share and the bank earns $6 per share for
its stockholders; the acquired bank’s stock is selling for $20 per share and that bank is earning $5 per
share. The acquiring institution has issued 200,000 shares of common stock, whereas the acquired
institution has 50,000 shares of stock outstanding. Stock will be exchanged in this merger transaction
exactly at its current market price. Most recently, the acquiring bank turned in net earnings of $1,200,000
and the acquired banking firm reported net earnings of $300,000. Following this merger, combined
earnings of $1,600,000 are expected.
b. Suppose everything is the same as described in part a; however, the acquired bank’s shares sell for $40.00
per share rather than $20.00. How does this affect the postmerger EPS?
a. If earnings total $1,600,000 after the merger occurs, the acquired bank's shareholders will receive
$20 / $25 or 0.80 of a share of stock in the acquiring bank for each share they held in the acquired
institution. This means 0.80 x 50,000 or 40,000 additional shares of the acquiring bank will be issued for
a post-merger total of 240,000 shares outstanding. Therefore, the post-merger EPS will be $1,600,000
/ 240,000 shares or $6.67 per share.
b. If earnings total $1,600,000 after the merger occurs, the acquired bank's shareholders will receive
$40 / $25 or 1.60 of a share of stock in the acquiring bank for each share they held in the acquired
institution. This means 1.60 x 50,000 or 80,000 additional shares of the acquiring bank will be issued for
a post-merger total of 280,000 shares outstanding. Therefore, the post-merger EPS will be $1,600,000
/ 280,000 shares or $5.71 per share.
19-2.
Under the following scenarios, calculate the merger premium and the exchange ratio:
a. The acquired financial firm’s stock is selling in the market today at $12 per share, while the acquiring
institution's stock is trading at $20 per share. The acquiring firm’s stockholders have agreed to extend
to shareholders of the target firm a bonus of $5 per share. The acquired firm has 30,000 shares of
common stock outstanding, and the acquiring institution has 50,000 common equity shares. Combined
earnings after the merger are expected to remain at their premerger level of $1,625,000 (where the
acquiring firm earned $1,000,000 and the acquired institution $625,000). What is the postmerger EPS?
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b. The acquiring financial-service provider reports that its common stock is selling in today’s market at
$30 per share. In contrast, the acquired institution’s equity shares are trading at $20 per share. To
make the merger succeed, the acquired firm’s shareholders will be given a bonus of $1 per share. The
acquiring institution has 120,000 shares of common stock issued and outstanding, while the acquired
firm has issued 40,000 equity shares. The acquiring firm reported premerger annual earnings of
$850,000, and the acquired institution earned $150,000. After the merger, earnings are expected to
decline to $900,000. Is there any evidence of dilution of ownership or earnings in either merger
transaction?
a. A merger premium will be paid amounting to:
Merger Premium (in Percent) = [($12 + $5) / $12] x 100 = 141.67 percent.
With an additional $5 per-share bonus the acquired thrift's stock will be valued at $17, slightly lower
than the acquiring institution's stock for a $17 / $20 or .85:1 exchange ratio. Earnings per share
from the merger will be:
EPS = $1,625,000 / 75,500 shares = $21.52
Before the merger, the acquiring institution had an EPS of $20, while the acquired thrift reported an
EPS of $20.83. This suggests there will be some earnings dilution for the shareholders of the acquiring
institution.
b. If the acquiring bank's stock is currently selling for $30 per share and the acquired institution's shares
are trading at $20 per share and the acquired firm's shareholders are offered a $1 per-share bonus to
merge, the merger premium will be:
Merger Premium (in Percent) = [($20 + $1) / $20] x 100 = 105 percent.
Thus, the acquired bank's stock will exchange in a ratio of $21 to $20 for the acquiring bank's stock or
1.05 to 1. Thus, the acquired bank's shareholders will receive 1.05 x 40,000 or 42,000 shares in the
merged institution which will then have a total of 162,000 shares outstanding.
Post-merger EPS should be: $900,000 / 162,000 shares = $ 5.55
Before the merger, the acquiring institution reported an EPS of $7.08 and the acquired institution had
an EPS of $3.75. The acquiring institution's shareholders will experience some earnings dilution as well
as some decline in their ownership share.
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19-3. The Silverton metropolitan area is presently served by five depository institutions with total
deposits as follows:
Silverton National Bank
Silverton County Merchants Bank
Commerce National Bank of Silverton
Rocky Mountain Trust Company
Security National Bank and Trust
Current Deposits
$725 million
400 million
295 million
175 million
107 million
Calculate the Herfindahl-Hirschman Index (HHI) for the Silverton metropolitan area. Suppose that Rocky
Mountain Trust Company and Security National Bank propose to merge. What would happen to the HHI
in the metropolitan area? Would the U.S. Department of Justice be likely to approve this proposed
merger? Would your conclusion change if the Silverton County Merchants Bank and the Rocky Mountain
Trust Company planned to merge?
The Herfindahl-Hirschman Index for the Silverton Metropolitan Area is calculated as follows:
Bank
Current Deposits
Current Deposit
Market Share
Silverton National Bank
Current Deposit
Market Share Squared
$ 725 million
42.60 %
1814.76
Silverton County Merchants
Bank
400 million
23.50%
552.25
Commerce National Bank of
Silverton
295 million
17.33%
300.33
Rocky Mountain Trust
Company
175 million
10.28%
105.68
Security National Bank and
Trust
107 million
6.29%
39.56
$1702 million
100.0 %
2812.58
Total
The Silverton market has an HHI above 1800 and is, therefore, highly concentrated. If Rocky Mountain
Trust Co. and Security National Bank merge, their combined market share is 16.57 percent and the HHI
climbs to 2941.9, a change of only 129.32 points which may be acceptable to the regulatory authorities.
However, if Silverton County Merchants Bank and Rocky Mountain Trust Company plan to merge, the
combined market share of these two banks is 33.78 percent and the HHI rises to 3295.74, a change of
483.16 points which will, in all probability, be challenged by the regulatory authorities.
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19-4. Light Years Savings Association has just received an offer to merge from Courthouse County
Bank. Light Years’ stock is currently selling for $70 per share. The shareholders of Courthouse County
agree to pay Light Years’ stockholders a bonus of $10 per share. What is the merger premium in this
case? If Courthouse County's shares are currently trading for $85 per share, what is the exchange ratio
between the equity shares of the two institutions? Suppose that Light Years has 20,000 shares and
Courthouse County has 30,000 shares outstanding. How many shares in the merged firm will Light Years’
shareholders wind up with after the merger? How many total shares will the merged bank have
outstanding?
The merger premium must be:
$70 +$ 10 x 100 = $114.29
$70
The exchange ratio between the respective banks' shares is:
($70 + $10) / $85 = 0.94 to 1.
If Light Years has 20,000 shares outstanding and Courthouse County has 30,000 shares, Light Years'
shareholders will receive 0.94 x 20,000 or 18,800 shares in the consolidated banking company. The
merged firm will have 48,800 shares of stock outstanding.
19-5. The city of Dryden is served by three banks, which recently reported total deposits of $265
million, $180 million, and $45 million, respectively. Calculate the Herfindahl index for the Dryden market
area. If the second and third largest banks merge, what would the postmerger Herfindahl index be?
Under the Department of Justice guidelines discussed in the chapter, would the Justice. Department be
likely to challenge this merger?
The banking market in Dryden has the following structure:
Deposits
Market Share
Square of Each Market
Share
Bank A
$265 million
54.08 %
2924.65
Bank B
180 million
36.74%
1349.83
Bank C
45 million
9.18%
84.27
$490 million
100.0%
4358.57
Totals
Thus, the Herfindahl-Hirschman Index is 4358.57 in the Dryden market area. This is a relatively
concentrated market to begin with. If the second and third largest banks merge, the post-merger
Herfindahl Index climbs to 5,033.3 because the combined share of banks B and C jumps to over 45
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percent. Clearly, the Herfindahl Index rises by more than 200 points and far exceeds 1800 in total. This
merger would be challenged by the Department of Justice in the absence of mitigating factors.
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19-6. In which of the situations described in the accompanying table do stockholders of both acquiring
and acquired firms experience a gain in earnings per share as a result of a merger?
P-E Ratio of
Acquiring
Firm
P-E Ratio of
Acquired
Firm
Premerger
Earnings of
Acquiring
Firm
Premerger
Earnings of
Acquired Firm
Combined
Earnings
after the
Merger
A.
5
3
$ 750,000
$425,000
$1,200,000
B.
4
6
$ 470,000
$490,000
$ 850,000
C.
8
7
$ 890,000
$650,000
$1,540,000
D.
12
12
$1,615,000
$422,000
$2,035,000
The rule is that the stockholders of both acquiring and acquired institution will experience a gain in
earnings per share of stock if an institution with a higher P/E ratio acquired an institution with a lower
P/E ratio and combined earnings do not fall after the merger. Only cases A and C meet these criteria and
the shareholders in these two cases should experience an earnings-per-share gain.
19-7. Please list the steps you believe should contribute positively to success in a merger transaction
in the financial-services sector. What management decisions or goals? On average, what proportion of
mergers among financial firms would you expect would be likely to achieve the goals of management
and/or the owners and what proportion would likely fall short of the mergers’ objectives? Why?
The steps an institution can take that will contribute positively to the success in a merger include the
following:
A. The institution must first evaluate its own financial condition, understand its own strengths
and weaknesses and its own goals. Mergers can then magnify strengths and minimize
weaknesses.
B. The institution should form a team to perform a detailed analysis of all potential new
markets and acquisitions.
C. The institution must establish a realistic price for the acquisition
D. After the merger, a combined management team should be formed to continually work
towards and assess the progress towards the consolidation of the two firms.
E. A communication system needs to be formed between senior management and other
managers so everyone feels involved in the merger.
F. Communication channels need to be formed so customers and employees understand why
the merger took place and what the consequences of the merger are likely to be.
G. Customer advisory panels need to be formed to evaluate and comment on the bank’s image
in the community, marketing effectiveness and general helpfulness to customers.
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Management decisions and actions which could cause problems for the merger include managers that
are ill-prepared, mergers where there is a poor understanding of each other’s culture, mergers where an
excessive price is paid for the merger, mergers where customers feelings and concerns are ignored and
mergers where the new firm cannot move forward in a cohesive manner.
According to some research, it appears that only half of all mergers achieve the goal of an increase in
earnings (or profitability). The other half of mergers see a decrease in earnings for the new firm.
CHAPTER 20
INTERNATIONAL BANKING AND THE FUTURE OF BANKING AND FINANCIAL SERVICES
Goal of the Chapter: The purpose of this chapter is to learn what services international banks offer their
customers and to discover the options a bank manager has under law and regulation to organize a
multinational bank.
Key Topics in This Chapter
•
•
•
•
•
•
•
Types of International Banking Organizations
Regulation of International Banking
Foreign Banking Activity in the United States
Services Provided by International Banks
Managing Currency Risk Exposure
Challenges for International Banks in Foreign Markets
The Future of Banking and Financial Services
Chapter Outline
I. Introduction
II. Types of International Banking Organizations
A. Representative Offices
B. Agency Offices
C. Branch Offices
D. Subsidiaries
E. Joint Ventures
F. Edge Act Corporations
G. Agreement Corporations
H. International Banking Facilities (IBFs)
I. Shell Branches
J. Export Trading Companies (ETCs)
III. Regulation of International Banking
A. Goals of International Banking Regulation
B. U.S. Banks’ Activities Abroad
C. Expansion and Regulation of Foreign Bank Activity in the U.S.
1. The International Banking Act of 1978
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2. The Foreign Bank Supervision Enhancement Act of 1991
D. New Capital Regulations for Major Banks Worldwide
1. International Lending and Supervision Act
2. Basel Agreement
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IV. Services Supplied by Banks in International Markets
A. Making Foreign Currencies Available to Customer
B. Hedging Against Foreign Currency Risk Exposure
1. Forward Contracts
2. Currency Futures Contracts
C. Other Tools for Reducing Currency Risks
1. The Development of Currency Options
2. Currency Swaps
D. Supplying Customers with Short- and Long-Term Credit or Credit Guarantees
1. Note Issuance Facilities
2. Europaper
3. Issuing and Managing Depository Receipts
E. Supplying Payments and Thrift (Savings) Instruments to International Customers
1. Payments Services
2. Savings (Thrift) Services
F. Underwriting Customer Note and Bond Issues in the Eurobond Market
G. Protecting Customers Against Interest Rate Risk
1. Interest-Rate Swaps
2. Interest-Rate Caps
3. Financial Futures and Options
H. Helping Customers Market Their Products through Export Trading Companies
V. Challenges for International Banks in Foreign Markets
A. Growing Customer Use of Securities Markets to Raise Funds in a More Volatile and
Risky World
B. Developing Better Methods for Assessing Risk in International Lending
1. International Loan Risks
2. Possible Solutions to Troubled International Loans
3. International Loan Risk Evaluation Systems
C. Adjusting to New Market Opportunities Created by Deregulation and New International Agreements
1. Opportunities Created by NAFTA and CAFTA
2. Opportunities in the Expanding European Community
3. Opportunities in Asia as Barriers Erode
VI. The Future of Banking and Financial Services
A. Convergence
B. Consolidation
C. Survival of Community Financial-Service Institutions
D. Reaching the Mass Media
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E. Invasion by Industrial and Retailing Companies
F. The Wal-Mart Challenge
G. Fighting for Ultimate Survival in a Global Financial System
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VII. Summary of the Chapter
Concept Checks
20-1.
What organizational forms do international banks use to reach their customers?
These forms include representative offices, branch offices, subsidiaries, joint ventures, Edge Act
corporations, IBFs, shell branches, and ETCs. Representative offices generally do not provide
conventional banking services but serve as a channel to route customer service needs back to a bank's
home office, while branch offices generally offer a full line of banking services. Subsidiaries are separate
corporations that are owned by a banking firm, while joint ventures are shared business operations
usually jointly owned by a foreign bank or bank holding company and a domestic firm, sharing both
profits and expenses. Edge Act corporations are operated inside the United States by both domestic
and foreign banks and must, by regulation, devote the bulk of their service activities to providing
international banking services to offshore customers. IBFs are international banking facilities located in
U.S. territory that reflects transactions carried out on behalf of international customers. Both foreign
and domestic U.S. banks may operate these computerized sets of account records known as IBFs. Shell
branches are merely offshore offices that record the receipts of deposits and other transactions,
basically to escape the burden of regulation. Finally, ETCs are export trading companies that provide
trade financing, export insurance coverage, research into markets abroad, and other services needed by
businesses exporting from abroad.
20-2. Why are there so many different types of international organizations in the financial institutions’
sector?
Different organizational forms are used for several reasons. These different organizational forms often
serve different functions. Any one of the institution can be chosen depending on their goals and
objectives. In addition, the laws in one country may restrict or prohibit the use of a particular type of
organizational form. Finally, there may be tax advantages of one form over another and there may be
differing abilities to raise capital and other funds.
20-3.
What are the principal goals of international banking regulation?
The principal goals of international banking regulation include:
1. protecting the safety of depositor funds,
2. promoting stable growth in money and credit,
3. protecting a nation against loss of its foreign currency reserves,
4. restricting the outflow of scarce capital, and
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5. protecting domestic financial institutions and markets from foreign competition.
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20-4. What were the key provisions of the U.S. International Banking Act of 1978 and the International
Lending and Supervision Act of 1983?
The U.S. International Banking Act of 1978 brought foreign banks operating in the United States under
federal regulation for the first time. It required foreign banking offices taking deposits from the public
to post reserve requirements and allowed them to apply for deposit insurance. The International
Lending and Supervision Act of 1983 required American banks to restrict the size of fees charged for
rescheduling payments on loans made overseas in order to avoid excessive burdens on debtor
countries, report their foreign loan exposures to bank examiners, and hold adequate reserves to protect
depositors against possible losses on foreign loans.
20-5.
Explain what the Basel Agreement is and why it is so important.
The Basle Agreement is a negotiated agreement between bank regulatory authorities in the United
States, Canada, Great Britain, Japan, and eight other nations in Western Europe to set common capital
requirements for all banks under their jurisdiction. The importance of the Basle Agreement is twofold:
(1) to strengthen international banks, thereby strengthening public confidence in them, and
(2) to remove important inequalities in banking regulation between nations that contribute to
competitive inequalities between banks.
20-6. Describe the principal customer services supplied by international banks serving foreign
markets.
The principal customer services supplied by international banks are:
(1) making foreign currencies available to customer,
(2) helping shelter customers' currency risk exposure through the use of forward contracts, currency
futures contracts, currency options, and currency swaps,
(3) supplying customers with short-and long-term credit or credit guarantees,
(4) supplying payments and thrift (savings) instruments to international customers,
(5) underwriting customer note and bond issues in the Eurobond market,
(6) protecting customers against interest rate risk, and
(7) helping customers market their products through export trading companies.
20-7. What types of risk exposure do international banks strive to control in order to aid their
customers?
International banks strive to control currency risk exposure and interest rate risk exposure in order to
aid their customers.
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20-8.
What is a NIF? A DR?
A note issuance facility (NIF) is a medium-term credit agreement between an international banks and its
larger corporate and governmental customers, where the customer is authorized to periodically issue
short-term notes, each of which usually comes due in 90 to 180 days, over a stipulated period (such as
five years). International banks pledge either buy up any notes not bought by other investors or grant
supplemental loans.
A DR is a negotiable instrument representing an ownership interest in the stock or debt securities of a
foreign institution. With an American depository receipt (ADR), the value of a foreign security is literally
converted into U.S. dollars that makes it easier for a foreign business borrower to sell its securities in the
United States.
20-9.
Of what benefit might NIFs and DRs be to international banks and their customers?
Both NIFs and DRs provide fee income to international banks, and allow the banks to offer additional
services to their customers. NIFs provide credit guarantees for customers' borrowings in the open
market. A DRs make it easier for a foreign business borrower to sell its securities in the global market
place. Moreover, an investor usually can recover his or her funds more quickly by liquidating DRs than
by attempting to sell a foreign-issued security.
20-10. What are ETCs? What services do they provide, and what problems have they encountered
inside the United States?
An ETC is an export trading company launched by large banks. The purpose of these ETCs is to research
foreign markets, identify firms in those foreign markets that could distribute products, and then provide
or arrange the funding, insurance, and transportation needed to move goods to market.
20-11. What do the terms Europaper and Eurobonds refer to? Why are these instruments important to
international banks and to their customers?
Europapers consist of short term IOUs and Eurobonds are long term debt securities placed in
denomination that are not the currency of the country where they are issued. The main market for
these securities is in London. These instruments allow companies that are not able to crack the US
market to launch dollar denominated securities. In addition, Eurobonds are used by companies to
finance their foreign investments.
20-12. What types of tools have international banks developed to help protect themselves and their
customers against currency and interest rate risk? How does each tool accomplish its purpose?
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Tools to hedge against currency risk include forward contracts and currency futures contracts. Both of
these instruments allow for buying or selling a currency at a predetermined price at a given point in
time, thus protecting the customer from changes in the exchange rate. While forward contracts are
negotiated agreements, currency futures contracts are standardized instruments. Currency options give
the buyer the right but not the obligation to buy or sell a currency at a predetermined price, thus giving
the customer the chance to benefit from possible gains in the exchange market. Currency swaps allow
two parties to exchange cash flows in one currency with cash flows of a different currency at a specified
price on or before a terminal date. Thereby a company can match the currency of their inflows and
outflows and thereby help to reduce the risk of loss as currency prices changes.
Tools to protect against interest rate risk include interest rate swaps and financial futures and options,
which work similar to their currency counterparts. In addition, banks offer to impose caps (maximum
rates) on loans, thus protecting the customer from increases in interest rates.
20-13. This chapter focuses on several major problem areas that international banks must deal with in
the future. What are these three problem areas?
The major problem areas that international banks must deal with in the future are:
1. Growing customer use of securities markets to raise funds in a more volatile and risky
world.
2. Developing better methods for assessing risk in international lending.
3. Adjusting to New Market Opportunities Created by Deregulation
and New International Agreements.
20-14. What different approaches to country-risk evaluation have international banks developed in
recent years?
New approaches to country risk evaluation developed by international banks in recent years include:
(1) the checklist approach, which lists economic and political factors believed to be significantly
correlated with loan risk,
(2) the Delphi method, which uses business analyst, economists and expert opinion to make an
assessment of country risk, and
(3) using market interest rates attached to deposits traded in the Eurocurrency markets to develop
implied risk premium measures for bank loan rates.
Recently advanced statistical models have been used which are based on changes in selected key
variables, including growth of the domestic money supply, the ratio of real investment to gross national
product, and the ratio of a nation's imports to foreign exchange reserves. Many analysts also follow the
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Euromoney index, the Institutional Investor Index as well as the International Country Risk Guide
published by leading financial magazines that can help assess the risk of a loan in a particular country.
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20-15. What different regions around the globe today appear to offer the greatest opportunities for
expansion for international banks? Why do you think so?
The most promising areas for expansion lie in Asia, especially in fast growing countries like China, India
or South Korea, to name just a few. The large population size of these countries represents
opportunities for international banks, securities dealers, insurance companies and other financial
service providers.
20-16. In looking at the future of the banking and financial-services industry does it appear likely that
the powerful trends of convergence and consolidation will continue into the future? Why or why not?
Is this likely to occur at the same pace as in the past?
From what has been seen convergence and consolidation will continue into the foreseeable future.
Convergence is relatively new in the U.S. and many firms are looking to expand into new markets
because of lower profit potentials in their traditional markets and possibilities for economies of scope
and diversification effects. Consolidation has been a long run trend and continues because financial
service firms continue to look for economies of scale. However, these trends may continue at a slower
pace in the future. Consolidation is speculated to have slowed because the best targets have already
been taken. Convergence may be slower because not all of the mergers that have taken place have
worked well and financial service firms may want to be more careful entering into these new markets in
the future.
20-17. What appears to be the future of community banking? What significant threats does community
banking seem to face?
Community banks may well survive and thrive because economies of scale appear to be modest in
banking. In addition, these banks appear to be better at small business loans because they know their
customers better. They also can provide that personal service that some customers want and need as
well as serve other niche markets well.
Since, community banks have a relatively narrow menu of services (such as loans, credit cards, deposits,
and investment advice and do not have global services capacity, they do not effectively use the mass
media. Also, due to increasing mobile population, retaining of customers migrating into distant markets
adds to the threat for community banking.
20-18. Are banking and commerce – financial and nonfinancial firms – on a collision courses for the
future? What challenges do companies like Wal-Mart pose for small community banks? For the largest
financial firms? For regulation? For ongoing efforts to maintain a safety net to protect the public’s
deposits and preserve public confidence in the financial system?
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They may be. Nonfinancial companies have been exploring several avenues for expanding its current
beachhead in the financial-services industry for decades and this may be their biggest competition in the
future. Right now American laws erect walls to separate financial and nonfinancial firm to protect
financial firms from affiliations with more risk ventures. It is possible that banks affiliated with industrial
firms may make unprofitable loans to the parent company leaving them vulnerable to losses and
potential bankruptcy. Also, losses from the industrial firm could be transferred to the banking firm.
These potential losses could then have serious consequences for the deposit insurance system designed
to protect small depositors. It could force the government to subsidize losses in industrial firms through
their bank affiliates. There are strong laws in place today to prevent this from happening but some
firms are continuously looking for ways around regulations because of the profit potential in this huge
market.
Problems and Projects
20-1. Pacific Trading Company purchased Canadian dollars yesterday in anticipation of a purchase of
electric equipment through a Canadian supply house. However, Pacific was contacted this morning by a
Japanese trading company that says equipment closer to its specifications is available in 48 hours from
an electronics manufacturer in Osaka. A phone call to Pacific’s bank this morning indicated that another
of the bank’s customers, a furniture importer located in San Francisco, purchased a comparable amount
of yen in order to pay for an incoming shipment from Tokyo, only to discover that the shipment will be
delayed until next week. Meanwhile, the furniture company must pay off an inventory loan tomorrow
that it received 30 days ago from Toronto-Dominion Bank.
Which of the instruments described in this chapter would be most helpful to these two
companies? Construct a diagram that illustrates the transaction you, as an international banker,
recommend to these two firms to help solve their current problems.
A San Francisco importer with yen needs Canadian dollars to retire a loan taken out with a Toronto
bank. In this case Pacific Trading Company and the import firm in San Francisco need to agree on a
currency swap of yen for Canadian dollars. At the termination of the swap Pacific Trading Company will
need to return yen to the importer who will reciprocate with a counter-payment of Canadian dollars.
Pays out yen
Pacific Trading
Company
(borrowing yen)
Makes payment in
yen
Pays out Canadian dollars
Grants amounts
denominated in
Yen
Grants amounts
denominated in
Canadian dollars
International Bank
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Furniture importer (San
Francisco)
borrowing Canadian
dollars
Makes payment in
dollars
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20-2. Art’s Sporting Goods ordered a shipment of soccer equipment from a manufacturer and
distributor in Munich. Payment for the shipment (which is valued at $3.5 million U.S.) must be made in
Euros that have changed in value over the last 30 days from .6423 €/$ to 0.6673 €/$. If this trend is
expected to continue, would you as Art's banker recommend that this customer use a currency futures
hedge? Why or why not?
The exchange rate change, from 0.6423 €/$ to 0.6673 €/$, means a more expensive Euro in terms of
dollars. This would reduce Art's expected profits from the sale of the soccer equipment. Yes, we should
recommend that Art use a currency futures hedge. In this instance, Art, working through its bank, will
probably use some version of a currency futures hedge with a purchase of Euro futures contracts
through a broker. When the payment date approaches, the Euro futures can be sold at a profit if the
Euro-dollar exchange rate has risen. On the other hand, if the market falls in value against the dollar,
there will be a loss on sale of the futures contracts. However, this loss will be offset by an expanded
profit margin on the soccer equipment.
20-3. Pinochio Corporation will import new wooden toys from a French manufacturer this week at a
price of 200 Euros per item for eventual distribution to retail stores. The current Euro-dollar exchange
rate is 0.6423 Euros per U.S. dollar. Payment for the shipment will be made by Pinochio next month,
but Euros are expected to appreciate significantly against the dollar. Pinochio asks its bank, Southern
Merchants Bank, N.A. for advice on what to do. What kind of futures transaction could be used to deal
with this problem faced by Pinochio? Futures contracts calling for delivery of Euros next month are
priced currently at 0.6418 Euros per dollar and are expected to be priced next month at 0.6012 Euros
per dollar.
This problem could be attacked by a long hedge in currency futures transactions. Pinochio's bank could
assist its customer by brokering a purchase of Euro futures contracts on the Chicago Mercantile
Exchange, agreeing to take delivery of francs next month at a fixed price of 0.6418 Euros per U.S. dollar.
The following month close to the payment date the purchased futures contracts will be counterbalanced
by the sale of similar futures contracts, which are now priced at 0.6012 Euros per dollar. The resulting
profit from the purchase and subsequent sale of Euro futures will help offset the loss to Pinochio due to
its required acquisition of Euros at a higher market price.
20-4. Watson Hardware Corporation regularly ships tools to the United States to retail outlets from its
warehouse located in Stuttgart, Germany. Its normal credit terms call for full payment in U.S. dollars for
the hardware that it ships within 90 days of the shipment date. However, Watson must convert all U.S.
dollars received from its customers into Euros in order to compensate its local workers and suppliers.
Watson has just made a large shipment to retail dealers in the U.S. and is concerned about a forecast
just received from its local bank that the U.S. dollar-Euro exchange rates will fall sharply over the next
month. The current Euro-U.S dollar exchange rate is 0.64 Euros per dollar. However, the local bank’s
current forecast calls for the exchange rate to rise to 0.70 Euros per dollar, so that Watson will receive
substantially less in Euros for each dollar it receives in payment. Please explain how Watson, with the
aid of its bank, could use currency futures to offset at least a portion of its projected loss due to the
expected change in the Euro-dollar exchange rate.
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This situation can be addressed with the use of a short hedge in currency futures contracts. Anticipating
a decline in the dollar's purchasing power in terms of Euros, Watson, working through its bank, can sell
90 day dollar futures contracts. Then, on or before the expiration date of these contracts, Watson, with
its bank's assistance, will purchase dollar futures contracts at a lower price. Thus, a profit will result
from this short hedge to help offset the potential loss from converting dollar payments into Euros.
20-5. Johanna International Mercantile Corporation has made a $15 million investment in a stamping
mill located in northern Germany and fears a substantial decline in the Euro's spot price from $1.56 to
$1.50, lowering the value of the firm's capital investment. Johanna's principal U.S. bank advises the firm
to use an appropriate option contract to help reduce Johanna's risk of loss. What currency option
contract would you recommend? Explain why the contract you selected would help reduce the firm’s
currency risk .
In this instance the purchase of a put option in Euros at a price close to the current spot value of $1.56
per Euro is appropriate. Then if the Euro's exchange value drops to $1.50 per Euro as feared, the firm
can purchase Euros at $1.50 and deliver Euros under the put option contract at $1.58 per Euro. The
resulting profit will help to offset Johanna's loss due to a decline in the Euro’s value.
20-6. Takako International Bank of Japan holds U.S dollar denominated assets of $510 million and
dollar-denominated liabilities of $469 million, has purchased U.S. dollars in the currency markets
amounting to $25 million, and sold U.S. dollars totaling $96 million. What is Takako’s net exposure to
risk from fluctuations in U.S. dollar prices relative to the bank’s domestic currency? Under what
circumstances could Takako lose if dollar prices change relative to the yen?
Takako International Bank's net exposure to risk from U.S. dollars can be found from the formula:
Net Risk
Exposure
from
Dollars
Dollar
=
(
Valued
Assets
Dollar
-
Valued
Dollars
)
+ (
Purchased
Dollars
-
Sold
)
Liabilities
= [$510 - $469] + [$25 - $96]
= $41 + (-$71) = -$30 million
In this instance Takako has a loss from its sizable net long position in U.S. dollars, due to dollar fall in
value relative to yen, Takako’s domestic currency.
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20-7. Suppose that Canterbury Bank has a net short position in U.S. dollars of $8 million, dollar
denominated liabilities of $115 million, U.S dollar purchases of $258 million, and dollar sales of $173
million. What is the current value of the bank’s dollar-denominated assets? Suppose the U.S. dollar’s
exchange value rises against the pound. Is Canterbury likely to gain or lose? Why?
Canterbury Bank has a net short exposure in U.S. dollars of $8 million as follows:
-$8 million = [Dollar-Valued Assets - $115 mill.] + [$258 mill. - $173 mill.]
So that it’s dollar-valued assets must total:
Dollar-Valued Assets = -$8 mill. +$115 mill. - $258 mill. + $173 mill. = $22 million.
If the dollar rises in value, Canterbury will lose from its net short position in U.S. dollars.
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