Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
The Effective Use of Capital
Chapter 9
Why Worry About Bank Capital?
 Capital requirements reduce the risk of
failure by acting as a cushion against
losses, providing access to financial
markets to meet liquidity needs, and
limiting growth
 Bank capital-to-asset ratios have fallen
from about 20% a hundred years ago
to around 8% today
Trends in Bank Capital: 1934 - 2004
24.0%
Growth rate in total capital
Total capital to total assets
19.0%
14.0%
9.0%
4.0%
'3
5
'3
8
'4
1
'4
4
'4
7
'5
0
'5
3
'5
6
'5
9
'6
2
'6
5
'6
8
'7
1
'7
4
'7
7
'8
0
'8
3
'8
6
'8
9
'9
2
'9
5
'9
8
'0
1
'0
4
-1.0%
Risk-Based Capital
 Historically, the minimum capital
requirements for banks were
independent of the riskiness of the
bank
 Prior
to 1990, banks were required to
maintain:
a primary capital-to-asset ratio of at
least 5% to 6%, and
 a minimum total capital-to-asset ratio
of 6%

Risk-Based Capital
 Primary Capital
 Common
stock
 Perpetual preferred stock
 Surplus
 Undivided profits
 Contingency and other capital reserves
 Mandatory convertible debt
 Allowance for loan and lease losses
Risk-Based Capital
 Secondary Capital
 Long-term subordinated debt
 Limited-life preferred stock
 Total Capital
 Primary Capital + Secondary Capital
 Capital requirements were
independent of a bank’s asset quality,
liquidity risk, interest rate risk,
operational risk, and other related
risks
The Basel Agreement
 In 1986, U.S. bank regulators proposed
that U.S. banks be required to maintain
capital that reflects the riskiness of
bank assets
 The
Basel Agreement grew to include
risk-based capital standards for banks
in 12 industrialized nations
 Regulations apply to both banks and
thrifts and have been in place since the
end of 1992
The Basel Agreement
 A bank’s minimum capital requirement is
linked to its credit risk

The greater the credit risk, the greater the
required capital
 Stockholders' equity is deemed to be the
most valuable type of capital
 Minimum capital requirement increased to
8% total capital to risk-adjusted assets
 Capital requirements were approximately
standardized between countries to ‘level the
playing field'
The Basel Agreement
 Risk-Based Elements of the Plan
1. Classify assets into one of four risk
categories
2. Classify off-balance sheet commitments
into the appropriate risk categories
3. Multiply the dollar amount of assets in each
risk category by the appropriate risk weight

This equals risk-weighted assets
4. Multiply risk-weighted assets by the
minimum capital percentages, currently 4%
for Tier 1 capital and 8% for total capital
Regional National Bank (RNB), Risk-based
Capital (Millions Of Dollars): Category 1 & 2
Assets
$ 1,000
Category 1: Zero Percent
Cash & reserve
Trading Account
U.S. Treasury & agency secs.
Federal Reserve stock
Total category 1
Category 2: 20 percent
Due form banks / in process
Int. bearing Dep./F.F.S.
Domestic dep. institutions
Repurchase agreements (U.S. Treas & agency)
U.S. Agencies (gov. sponsored)
State & Muni's secured tax auth
C.M.O. backed by agency secs.
SBAs (govt. guaranteed portion)
Other category 2 assets
Total category 2
Risk
Weight
Risk
Weighted
Assets
104,525
830
45,882
5,916
157,153
0.00%
0.00%
0.00%
0.00%
0
0
0
0
0
303,610
497,623
38,171
329,309
412,100
87,515
90,020
29,266
0
1,787,614
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
20.00%
60,722
99,525
7,634
65,862
82,420
17,503
18,004
5,853
0
357,523
Regional National Bank (RNB), Risk-based
Capital (Millions Of Dollars): Category 3 & 4
Assets
$ 1,000
Category 3: 50 percent
C.M.O. backed by mtge loans
State & Muni's / all other
Real estate: 1-4 family
Other category 3 assets
Total category 3
Category 4: 100 percent
Loans: comm/ag/inst/leases
Real estate, all other
Allowance for loan and lease losses
Other investments
Premises, eq. other assets
Other category 4 assets
Total category 4
Total Assets before Off-Balance Sheet
Risk
Weight
Risk
Weighted
Assets
10,000
68,514
324,422
0
402,936
50.00%
50.00%
50.00%
50.00%
5,000
34,257
162,211
0
201,468
1,966,276
388,456
(70,505)
168,519
194,400
0
2,647,146
100.00%
100.00%
0.00%
100.00%
100.00%
100.00%
1,966,276
388,456
0
168,519
194,400
0
2,717,651
4,994,849
3,276,642
Regional National Bank (RNB), Risk-based
Capital (Millions Of Dollars): Off Balance Sheet
Assets
$ 1,000
Total Assets before Off-Balance Sheet
Off-Balance Sheet Contingencies
0% collateral category
20% collateral category
50% collateral category
100% collateral category
Total Contingencies
Total Assets and Contingencies before allowance for
loan and lease losses and ATR
Risk
Weight
4,994,849
0
0
364,920
290,905
655,825
3,276,642
0.00%
20.00%
50.00%
100.00%
5,650,674
Capital requirements
Tier I @ 4%
Total capital @ 8%
0
0
182,460
290,905
473,365
3,750,007
(2,152)
Less: Excess allowance for loan and lease losses
Total Assets and Contingencies
Risk
Weighted
Assets
5,650,674
Actual
Capital
199,794
399,588
3,747,855
Minimum
Required
Capital
(%)
4.00%
8.00%
Required
Capital
(Minimum)
149,914
299,828
General Description Of Assets In Each Of
The Four Risk Categories
Asset
Category
Risk
Weight
Effective
Total Capital
Requirement*
1
0%
0%
2
20%
1.6%
3
50%
4%
4
100%
8%
Obligor, Collateral, or Guarantor of the Asset
Generally, direct obligations of OCED central government or
the U.S. federal government; e.g., currency and coin,
government securities, and unconditional government
guaranteed claims. Also, balances due or guaranteed by
depository institutions.
Generally, indirect obligations of OCED central government
or the U.S. federal government; e.g., most federal agency
securities, full faith and credit municipal securities, and
domestic depository institutions. Also, assets collateralized
by federal government obligations are generally included in
this category; e.g., repurchase agreements (when Treasuries
serve as collateral) and CMOs backed by government agency
securities.
Generally, loans secured by 1–4 family properties and
municipal bonds secured by revenues of a specific project
(revenue bonds).
All other claims on private borrowers; e.g., most bank loans,
premises, and other assets.
*Equals 8% of equivalent risk-weighted assets and represents the minimum requirement to
be adequately capitalized.
Regional National Bank (RNB), Off-balance
Sheet Conversion Worksheet
$ Amount
Contingencies 100% conversion factor
Direct Credit substitutes
Acquisition of participations in BA, direct credit
substitutes
Assets sold w/ recourse
Futures & forward contracts
Interest rate swaps
Other 100% collateral category
Total 100% collateral category
Contingencies 50% conversion factor
Transaction-related contingencies
Unused commitments > 1 year
Revolving underwriting facilities (RUFs)
Other 50% collateral category
Total 50% collateral category
Contingencies 20% conversion factor
Short-term trade-related contingencies
Other 20% collateral category
Total 20% collateral category
Contingencies 0% conversion factor
Loan commitments < 1 year
Other 0% collateral category
Total 0% collateral category
Total off-balance sheet commitment
*BA refers to bankers acceptance.
Credit
Conversion
Factor
Credit
Equivalent
$ Amount
165,905
100.00%
165,905
0
100.00%
0
0
50,000
75,000
0
290,905
100.00%
100.00%
100.00%
100.00%
0
50,000
75,000
0
290,905
0
364,920
0
0
364,920
50.00%
50.00%
50.00%
50.00%
0
182,460
0
0
182,460
0
0
0
20.00%
20.00%
0
0
0
0
0
0
655,825
0.00%
100.00%
0
0
0
473,365
Summary of Risk Categories and Risk Weights
for Risk-based Capital Requirements
Asset
Category
Risk
Weight
Effective
Total Capital
Requirement
1
0%
0%
2
20%
1.6%
3
50%
4%
4
100%
8%
Obligor, Collateral, or Guarantor of the Asset
Generally, direct obligations of the federal
government; e.g., currency and coin, government
securities, and unconditional government
guaranteed claims. Also balances due or
guaranteed by depository institutions.
Generally, indirect obligations of the federal
government; e.g.; most federal agency securities,
full faith and credit municipal securities, and
domestic depository institutions. Also assets
collaterlized by federal government obligations
are generally included in this category; e.g.,
repurchase agreements (when Treasuries serve as
collateral) and CMOs backed by government
agency securities.
Generally, loans secured by one to four family
properties and municipal bonds secured by
revenues of a specific project (revenue bonds).
All other claims on private borrowers.
What Constitutes Bank Capital?
 Capital (Net Worth)
 The cumulative value of assets minus the
cumulative value of liabilities
 Represents ownership interest in a firm
 Total Equity Capital
 Equals the sum of:
 Common stock
 Surplus
 Undivided profits and capital reserves
 Net unrealized holding gains (losses) on
available-for-sale securities
 Preferred stock
Risk-based capital standards
…two measures of qualifying bank capital
 Tier 1 (Core) Capital
 Equals the sum of:
 Common equity
 Non-cumulative perpetual preferred stock
 Minority interest in consolidated subsidiaries,
less intangible assets such as goodwill
 Tier 2 (Supplementary) Capital
 Equals the sum of:
 Cumulative perpetual preferred stock
 Long-term preferred stock
 Limited amounts of term-subordinated debt
 Limited amount of the allowance for loan loss
reserves (up to 1.25 percent of risk-weighted
assets)
What Constitutes Bank Capital?
 Leverage Capital Ratio
 Equals:
 Tier 1 capital divided by total assets net
of goodwill and disallowed intangible
assets and deferred tax assets
 Regulators are concerned that a bank
could acquire practically all low-risk
assets such that risk-based capital
requirements would be virtually zero
 To prevent this, regulators have also
imposed a 3 percent leverage capital
ratio
Risk-based Capital Ratios For Different-sized
U.S. Commercial Banks, 1995–2004
Asset Size
Number of Institutions Reporting
Equity capital ratio (percent)
Return on equity (percent)
Core capital (leverage) ratio (percent)
Tier 1 risk-based capital ratio (percent)
Total risk-based capital ratio (percent)
Year
2004
2000
1995
2004
2000
1995
2004
2004
2004
2004
< $100
Million
3,655
4,842
6,658
$100
Million to
$1 Billion
3,530
3,078
2,861
$1 to
$10
Billion
360
313
346
> $10
Billion
85
82
75
11.52
11.08
10.42
10.00
9.6
9.39
10.90
8.99
8.57
9.95
8.05
7.19
8.46
11.31
16.83
17.93
12.88
9.47
12.85
14.06
13.48
9.36
12.34
13.92
14.24
7.23
9.11
12.07
SOURCE: FDIC, Quarter Banking Profile, http://www2.fdic.gov/qbp.
All
Commercia
l Banks
7,630
8,315
9,940
10.10
8.49
8.11
13.82
7.83
10.04
12.62
FDICIA and Bank Capital Standards
 The Federal Deposit Insurance Improvement
Act (FDICIA) focused on revising bank
capital requirements to:



Emphasize the importance of capital
Authorize early regulatory intervention in
problem institutions
Authorized regulators to measure interest
rate risk at banks and require additional
capital when it is deemed excessive.
 The Act required a system for prompt
regulatory action

It divides banks into categories according to
their capital positions and mandates action
when capital minimums are not met
Minimum Capital Requirements across Capital
Categories
Total RiskBased
Ratio
Tier 1 RiskBased Ratio
Tier 1
Capital Directive / Requirement
Leverage
Ratio
Not subject to a capital
5%
directive to meet a specific level
for any capital measure
Does not meet the definition of
4%
well capitalized
Well capitalized
10%
&
6%
&
Adequately capitalized
8%
&
4%
&
Undercapitalized
< 8%
or
< 4%
or
< 4%
Significantly
undercapitalized
Critically
undercapitalized
< 6%
or
< 3%
or
< 3%
Ratio of tangible equity to total assets is  2%
Provisions for Prompt Corrective Action
Category
Mandatory Provisions
Discretionary Provisions
Well capitalized
None
None
Adequately capitalized
1. No brokered deposits, except with
FDIC approval
1. Suspend dividends and management
fees
2 Require capital restoration plan
3. Restrict asset growth
4. Approval required for acquisitions,
branching, and new activities
5. No brokered deposits
None
1.
2.
3.
4.
5.
1. Any Zone 3 discretionary actions
2. Conservatorship or receivership if
fails to submit or implement plan or
recapitalize pursuant to order
3. Any other Zone 5 provision, if such
action is necessary to carry out
prompt corrective action
Undercapitalized
Significantly
undercapitalized
Critically undercapitalized
Same as for Category 3
Order recapitalization
Restrict interaffiliate transaction
Restrict deposit interest rates
Pay of officers restricted
1. Same as for Category 4
2. Receiver/conservator
within 90
daysd
3. Receiver if still in Category 5 four
quarters after becoming critically
undercapitalized
4. Suspend
payments on subordinated
debtd
5. Restrict certain other activities
Order recapitalization
2. Restrict interaffiliate transactions
3. Restrict deposit interest rates
4. Restrict certain other activities
5. Any other action that would better
carry out prompt corrective action
Tier 3 Capital Requirements for Market Risk
 Many large banks have increased the size
and activity of their trading accounts,
resulting in greater exposure to market risk


Market risk is the risk of loss to the bank
from fluctuations in interest rates, equity
prices, foreign exchange rates, commodity
prices, and exposure to specific risk
associated with debt and equity positions in
the bank’s trading portfolio
Market risk exposure is, therefore, a function
of the volatility of these rates and prices and
the corresponding sensitivity of the bank’s
trading assets and liabilities
Tier 3 Capital Requirements for Market Risk
 Risk-based capital standards now require all
banks with significant market risk to
measure their market risk exposure and
hold sufficient capital to mitigate this
exposure
 A bank is subject to the market risk capital
guidelines if its consolidated trading activity
equals 10% or more of the bank’s total
assets or $1 billion or more in total dollar
value

Banks subject to the market risk capital
guidelines must maintain an overall
minimum 8 percent ratio of total qualifying
capital to risk-weighted assets and market
risk equivalent assets
Capital Requirements for Market Risk Using
Internal Models
 Value-at-Risk (VAR)
 An internally generated risk
measurement model to measure a
bank’s market risk exposure
 It estimates the amount by which the
value of a bank’s position in a risk
category could decline due to expected
losses in the bank’s portfolio because
of market movements during a given
period, measured with a specified
confidence level
What is the Function of Bank Capital?
 For regulators, bank capital serves to
protect the deposit insurance fund in
case of bank failures
 Bank capital reduces bank risk by:
 Providing
a cushion for firms to absorb
losses and remain solvent
 Providing ready access to financial
markets, which provides the bank with
liquidity
 Constraining growth and limits risk
taking
How Much Capital is Adequate?
 Regulators prefer more capital
 Reduces
the likelihood of bank failures
and increases bank liquidity
 Bankers prefer less capital
 Lower
capital increases ROE, all other
things the same
 Riskier banks should hold more
capital while low-risk banks should be
allowed to increase financial leverage
How much is “enough” capital?
 A “well capitalized” bank:
≥
5% Core (leverage) capital
 ≥ 6% Tier 1 risk-based capital
 ≥ 10 % total risk-based capital
 Clearly, additional capital is needed for
higher risk assets and future growth.
Full Year: 2004
Source: FDIC
All
<
$100
$1 Comm $100 Mil $10
> $10
Banks Commercial
Mil
$1 Bil Banks
Bil
Bil
TABLE III-A. Full Year 2004, FDIC-Insured
Number of institutions reporting
Capital Ratios
Core capital (leverage) ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
Trend with
Size
360
85

7.83 11.31 9.47 9.36
10.04 16.83 12.85 12.34
12.62 17.93 14.06 13.92
7.23
9.11
12.07



7,630 3,655 3,530
Weakness of the Risk-Based Capital Standards
 Standards only consider credit risk

Ignores interest rate risk and liquidity risk
 It ignores:




Changes in the market value of assets
Unrealized gains (losses) on held-to-maturity
securities
The value of the bank’s charter
The value of deposit insurance
 99% of banks are considered “well
capitalized” in 2004-2005

Not a binding constraint for most banks
The Effect of Capital Requirements on Bank
Operating Policies
 Limiting Asset Growth

The change in total bank assets is restricted
by the amount of bank equity
ROA  (1  DR)  ΔEC/TA
ΔTA/TA 
EQ/TA  ROA  (1  DR)

Where





TA = Total Assets
EQ = Equity Capital
ROA = Return on Assets
DR = Dividend Payout Ratio
EC = New External Capital
Maintaining Capital Ratios With Asset
Growth: Application
Ratio
Asset growth rate (percent)
Asset size (millions of $)
ROA (percent)a
Dividend payout rate (percent)
Undivided Profits (millions of $)
Total capital less undivide profits (millions of $)
Total capital / total assets (percent)
Case 1 Case 2 Case 3
Case 4
Intitial Initial 8%
12%
12% 12% Growth:
Position Asset Growth: Growth:  External
Growth  ROA  ROA
Capital
8.00% 12.00% 12.00%
12.00%
100.00
108.00 112.00 112.00
112.00
4.00
4.00
8.00%
0.99%
40.00%
4.64
4.00
8.00%
1.43%
40.00%
4.96
4.00
8.00%
0.99%
13.42%
4.96
4.00
8.00%
0.99%
40.00%
4.665
4.295
8.00%
Maintaining Capital Ratios With Asset
Growth: Application
Case 1: 8% asset growth, dividend payout = 40%, and capital ratio = 8%.
What is ROA?
ROA(1  0.40)  0
0.08 
0.08  ROA(1  0.40)
Solve for ROA  0.99%
Case 2: 12% asset growth, dividend payout = 40%, and capital ratio = 8%.
What is required ROA to support the 12% asset growth?
ROA(1  0.40)  0
0.12 
0.08  ROA(1  0.40)
Solve for ROA  1.43%
Case 3: ROA = 0.99%, 12% asset growth, and capital ratio = 8%.
What is the required  dividend payout to support the 12% asset growth?
0.99(1 DR)  0
0.12 
0.08  0.99(1 DR)
Solve for DR  13.42%
Case 4: ROA = 0.99%, 12% asset growth, capital ratio = 8%, and dividend payout = 40%.
What is the required  external capital to support the 12% asset growth?
0.99(1 0.40)  ΔEC/TA
0.12 
0.08  0.99(1 0.40)
Solve for EC/TA  0.29%
ΔEC  $294,720
Operating Policies Effect on Capital
Requirements
 Changing the Capital Mix
 Internal
versus External capital
 Change Asset Composition
 Hold
fewer high-risk category assets
 Pricing Policies
 Raise
rates on higher-risk loans
 Shrinking the Bank
 Fewer
assets requires less capital
Characteristics of External Capital Sources
 Subordinated Debt

Advantages




Interest payments are tax-deductible
No dilution of ownership interest
Generates additional profits for shareholders
as long as earnings before interest and taxes
exceed interest payments
Disadvantages



Does not qualify as Tier 1 capital
Interest and principal payments are
mandatory
Many issues require sinking funds
Characteristics of External Capital Sources
 Common Stock
 Advantages
Qualifies as Tier 1 capital
 It has no fixed maturity and thus
represents a permanent source of funds
 Dividend payments are discretionary
 Losses can be charged against equity,
not debt, so common stock better
protects the FDIC

Characteristics of External Capital Sources
 Common Stock
 Disadvantages
Dividends are not tax-deductible,
 Transactions costs on new issues
exceed comparable costs on debt
 Shareholders are sensitive to earnings
dilution and possible loss of control in
ownership
 Often not a viable alternative for smaller
banks

Characteristics of External Capital Sources
 Preferred Stock
A
form of equity in which investors'
claims are senior to those of common
stockholders
 Dividends are not tax-deductible
 Corporate investors in preferred stock
pay taxes on only 20 percent of
dividends
 Most issues take the form of adjustablerate perpetual stock
Characteristics of External Capital Sources
 Trust Preferred Stock
 A hybrid form of equity capital at banks
 It effectively pays dividends that are tax
deductible
 To issue the security, a bank establishes a trust
company
 The trust company sells preferred stock to
investors and loans the proceeds of the issue
to the bank
 Interest on the loan equals dividends paid on
preferred stock
 The interest on the loan is tax deductible such
that the bank deducts dividend payments
 Counts as Tier 1 capital
Characteristics of External Capital Sources
 Leasing Arrangements
 Many
banks enter into sale and
leaseback arrangements

Example:
 The bank sells its headquarters and
simultaneously leases it back from the
buyer
 The bank receives a large amount of cash
and still maintains control of the property
 The net effect is that the bank takes a fully
depreciated asset and turns it into a tax
deduction
Capital Planning
 Process of Capital Planning
 Generate
pro formal balance sheet and
income statements for the bank
 Select a dividend payout
 Analyze the costs and benefits of
alternative sources of external capital
Capital Planning: Forecast Performance Measures
For A Bank With Deficient Capital Ratios
2005
Historical 10% Growth
Total assets
Net interest margin
ROA
Total capital
Capital ratio
2006
2007
2008
in Assets: $250,000 In Dividends
$ 80.00
$ 88.00
$ 96.80 $ 106.48
4.40%
4.40%
4.50%
4.60%
0.45%
0.45%
0.60%
0.65%
$ 5.60
$ 5.75
$ 6.08
$ 6.52
7.00%
6.53%
6.28%
6.12%
2009
$ 117.13
4.70%
0.75%
$ 7.15
6.10%
Shrink the Bank, reduce assets by $1 million a year: $250,000 In
Total assets
$ 80.00
$ 79.00
$ 78.00
$ 77.00
Net interest margin
4.40%
4.40%
4.50%
4.60%
ROA
0.45%
0.45%
0.60%
0.65%
Total capital
$ 5.60
$ 5.71
$ 5.92
$ 6.17
Capital ratio
7.00%
7.22%
7.59%
8.02%
Dividends
$ 76.00
4.70%
0.75%
$ 6.49
8.54%
Slow Growth, $2 million increase in assets each year: No Dividends
Total assets
$ 80.00
$ 82.00
$ 84.00
$ 86.00
$ 88.00
Net interest margin
4.40%
4.40%
4.50%
4.60%
4.70%
ROA
0.45%
0.45%
0.60%
0.65%
0.75%
Total capital
$ 5.60
$ 5.97
$ 6.47
$ 7.03
$ 7.69
Capital ratio
7.00%
7.28%
7.71%
8.18%
8.74%
Slow Growth, $2 million increase in assets each year:
$250,000 In Dividends, $800,000 External Capital Injection In 2004
Total assets
$ 80.00
$ 82.00
$ 84.00
$ 86.00
$ 88.00
Net interest margin
4.40%
4.40%
4.50%
4.60%
4.70%
ROA
0.45%
0.45%
0.60%
0.65%
0.75%
Total capital
$ 5.60
$ 5.72
$ 5.97
$ 7.08
$ 7.49
Capital ratio
7.00%
6.97%
7.11%
8.23%
8.51%
Federal Deposit Insurance
 Federal Deposit Insurance Corporation
 Established in 1933
 Coverage is currently $100,000 per depositor
per institution
 Original coverage was $2,500
 Initial Objective:
 Prevent liquidity crises caused by large-scale
deposit withdrawals
 Protect depositors of modes means against a
bank failure.
 The large number of failures in the late 1980s
and early 1990s put pressure on the FDIC by
slowly depleting the reserve fund
FDIC RESERVE RATIOS, FUND BALANCE,
AND INSURED DEPOSITS
The Deposit Insurance Funds Act of 1996
(DIFA)
 Included both a one-time assessment
on SAIF deposits to capitalize the SAIF
fund
 Mandated the ultimate elimination of
the BIF and SAIF funds by merging
them into a new Deposit Insurance
Fund
Risk-Based Deposit Insurance
 FDIC insurance premiums are based
on a risk-based deposit insurance
system
 The deposit insurance fund reserve
ratios are maintained at or above the
target Designated Reserve Ratio of
1.25% of insured deposits
 Deposit
insurance premiums are
assessed as basis points per $100 of
insured deposits
The Current Assessment Rate Schedule For BIF
Insured And SAIF-insured Institutions
 Over 90% of all BIF-insured
institutions pay no assessments
Capital Group
Well capitalized
Adequately capitalized
Undercapitalized
Insurance Premiums
Supervisory Subgroups
A
B
C
0 bp
3 bp
17 bp
3 bp
10 bp
24 bp
10 bp
24 bp
27 bp
bp = basis point, which equals 1/100 of one percent. An FDIC assessment of 20 basis
points amount to 20 cents per $100 of insured deposits
Subgroup A - Financially sound institutions
Subgroup B - Institutions that demonstrate weaknesses that could
result in significant deterioration of the institution
Subgroup C - Institutions that pose a substantial probability of loss
to the BIF or SAIF
Federal Deposit Insurance
 Problems with Deposit Insurance
 Deposit insurance acts similarly to bank
capital
 In banking, a large portion of borrowed funds
come from insured depositors who do not
look to the bank’s capital position in the event
of default
 A large number of depositors, therefore, do
not require a risk premium to be paid by the
bank since their funds are insured
 Normal market discipline in which higher risk
requires the bank to pay a risk premium does
not apply to insured funds
Problems with Deposit Insurance
 Too-Big-To-Fail
 Many
large banks are considered to be
“too-big-to-fail”
 As such, any creditor of a large bank
would receive de facto 100 percent
insurance coverage regardless of the
size or type of liability
Problems with Deposit Insurance
 Deposit insurance has historically ignored
the riskiness of a bank’s operations, which
represents the critical factor that leads to
failure


Two banks with equal amounts of domestic
deposits paid the same insurance premium,
even though one invested heavily in risky
loans and had no uninsured deposits while
the other owned only U.S. government
securities and just 50 percent of its deposits
were fully insured.
The creates a moral hazard problem.
Problems with Deposit Insurance
 Moral hazard problem, whereby bank
managers have an incentive to increase
risk.



For example, suppose that a bank had a
large portfolio of problem assets that was
generating little revenue.
Managers could use deposit insurance to
access funds via brokered CDs in $100,000
blocks.
They might invest the funds in risky assets
knowing that any profits would offset losses
on the problem assets. Losses would be
absorbed by the insurance fund in the event
of default.
Problems with Deposit Insurance
 Deposit insurance funds were always viewed as
providing basic insurance coverage

Historically, there has been fundamental problem
with the pricing of deposit insurance
 Premium levels were not sufficient to cover
potential payouts
 The FDIC and FSLIC were initially expected to
establish reserves amounting to 5 percent of
covered deposits funded by premiums
 Actual reserves never exceeded two percent of
insured deposits as Congress kept increasing
coverage while insurance premiums remained
constant
 The high rate of failures during the 1980s and
the insurance funds demonstrate that
premiums were inadequate
Problems with Deposit Insurance
 Historically, premiums were not assessed
against all of a bank’s insured liabilities



Insured deposits consisted only of domestic
deposits while foreign deposits were exempt.
Too-big-to-fail doctrine toward large banks
means that large banks would have coverage
on 100 percent of their deposits but pay for
the same coverage as if they only had
$100,000 coverage as smaller banks do
This means that regulators were much more
willing to fail smaller banks and force
uninsured depositors and other creditors to
take losses.
Percentage Of Failed Commercial Banks By
Uninsured Depositor Treatment, 1986–1996
100
Uninsured
Protected
80
Uninsured
Unprotected
60
40
20
0
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
BASEL II Capital Standards
 The Basel Accord’s approach to
capital requirements was primarily
based on credit risk, it did not address
operational or other types of risk
 Three
Pillars of Regulation
Minimum Capital Requirements
 Supervisory Review
 Market Discipline

BASEL II Capital Standards
 Credit Risk
 Banks
are allowed to choose between
two approaches to calculate minimum
capital

External Credit Assessments
 Rating Agencies

Internal Rating Systems
 The bank’s own assessment
BASEL II Capital Standards
 Operational Risk
 The
risk of loss resulting from
inadequate or failed internal
processes, people, systems, for from
external events

Example: 9/11/01
 Look
at occurrences of fraud
BASEL II Capital Standards
 Trading Book (Including Market Risk)
 Management
must demonstrate an
ability to value the positions with an
emphasis on marking-to-market
exposures
BASEL II Capital Standards
 Supervisory Review and Market
Discipline
 Banks
should have a process for
assessing overall capital adequacy in
relation to their risk profile and a
strategy for maintaining their capital
levels
 Supervisors should review and
evaluate banks’ internal capital
adequacy assessments and strategies
BASEL II Capital Standards
 Supervisory Review


Banks should have a process for assessing
overall capital adequacy in relation to their
risk profile and a strategy for maintaining
their capital levels
Supervisors should:



Review and evaluate banks’ internal capital
adequacy assessments and strategies
Expect banks to operate with capital above
the minimum regulatory ratios
Intervene at an early stage to prevent capital
from falling below regulatory minimums
BASEL II Capital Standards
 Market Discipline
 Regulators
will encourage market
discipline for banks by forcing
disclosure of key information
pertaining to risk

Market participants will be provided
with information regarding specific risk
exposures, risk assessment practices,
actual capital, and required capital so
that they can assess the adequacy of
capital
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
Managing the Investment
Portfolio
Chapter 13
The Investment Portfolio
 Most banks concentrate their asset
management efforts on loans
 Managing
investment securities is
typically a secondary role, especially at
smaller banks
 Historically, small banks have
purchased securities and held them to
maturity
The Investment Portfolio
 Large banks, in contrast, not only buy
securities for their own portfolios, but
they also:
 Manage
a securities trading account
 Manage an underwriting subsidiary
that helps municipalities issue debt in
the money and capital markets
The Investment Portfolio
 Historically, bank regulators have
limited the risk associated with banks
owning securities by generally:
 Prohibiting
banks from purchasing
common stock (for income purposes)
 Limiting debt instruments to
investment grade securities
 Increasingly, banks are pursuing
active strategies in managing
investments in the search for higher
yields
Dealer Operations and the Securities Trading
Account
 When banks purchase securities, they
must indicate the underlying objective
for accounting purposes:
 Held-to-Maturity
 Trading
 Available-for-Sale
Dealer Operations and the Securities Trading
Account
 Held to Maturity
 Securities
purchased with the intent
and ability to hold to final maturity
 Carried at historical (amortized) cost
on the balance sheet
 Unrealized gains and losses have no
impact on the income statement
Dealer Operations and the Securities Trading
Account
 Trading:
 Securities
purchased with the intent to
sell them in the near term
 Carried at market value on the balance
sheet with unrealized gains and losses
included in income
Dealer Operations and the Securities Trading
Account
 Available for Sale:
 Securities
that are not classified as
either held-to-maturity securities or
trading securities
 Carried at market value on the balance
sheet with unrealized gains and losses
included as a component of
stockholders’ equity
Dealer Operations and the Securities Trading
Account
 Banks perform three basic functions
within their trading activities:
 Offer
investment advice and assistance
to customers managing their own
portfolios
 Maintain an inventory of securities for
possible sale to investors

Their willingness to buy and sell
securities is called making a market
 Traders
speculate on short-term interest
rate movements by taking positions in
various securities
Dealer Operations and the Securities Trading
Account
 Banks earn profits from their trading
activities in several ways:
 When
making a market, they price
securities at an expected positive spread

Bid
 Price the dealer is willing to pay

Ask
 Price the dealer is willing to sell
 Traders
can also earn profits if they
correctly anticipate interest rate
movements
Objectives of the Investment Portfolio
 A bank’s investment portfolio differs
markedly from a trading account
 Objectives
of the Investment Portfolio
Safety or preservation of capital
 Liquidity
 Yield
 Credit risk diversification
 Help in manage interest rate risk
exposure
 Assist in meeting pledging requirements

Objectives of the Investment Portfolio
 Accounting for Investment Securities
 FASB
115 requires security holdings to
be divided into three categories
Held-to-Maturity (HTM)
 Trading
 Available-for-Sale

 The
distinction between investment
motives is important because of the
accounting treatment of each
Objectives of the Investment Portfolio
 Accounting for Investment Securities
A
change in interest rates can
dramatically affect the market value of
a security

The difference between market value
and the purchase price equals the
unrealized gain or loss on the security;
assuming a purchase at par:
 Unrealized Gain/Loss =
Market Value – Par Value
Objectives of the Investment Portfolio
 Accounting for Investment Securities
 Assume
interest rates increase and bond
prices fall:

Held-to-Maturity Securities
 There is no impact on either the balance
sheet or income statement

Trading Securities
 The decline in value is reported as a loss on
the income statement

Available-for-Sale Securities
 The decline in value reduces the value of
bank capital
Objectives of the Investment Portfolio
 Safety or Preservation of Capital
A
primary objective of the investment
portfolio is to preserve capital by
purchasing securities when there is only
a small risk of principal loss.
 Regulators encourage this policy by
requiring that banks concentrate their
holdings in investment grade securities,
those rated Baa (BBB) or higher.
Objectives of the Investment Portfolio
 Liquidity
 Commercial banks purchase debt
securities to help meet liquidity
requirements
 Securities with maturities under one year
can be readily sold for cash near par
value and are classified as liquid
investments
 In reality, most securities selling at a
premium can also be quickly converted
to cash, regardless of maturity, because
management is willing to sell them
Investment Portfolio for a Hypothetical
Commercial Bank
 Liquidity
Purchase
Date
Current Date: September 30, 2005
Annual
Book
Coupon
Value
Description
Income
12/15/95
$4,000,000
10/15/95
2,000,000
6/6/99
500,000
10/l/94
1,000,000
$4,000,000 par value U.S.
Treasury note at 11%, due
11/15/08
$2,000,000 par value
Federal National Mortgage
Association bonds at
8.75%, due 10/15/10
$500,000 par value
Allegheny County, PA, Arated general obligations at
5.15%, due 3/l/11
$1,000,000 par value State
of Illinois Aaa-rated
general obligations at 11%,
due 10/1/19
Market
Value
$440,000
$4,099,000
175,000
1,824,000
25,750
482,500
110,000
1,190,000
Objectives of the Investment Portfolio
 Yield
 To
be attractive, investment securities
must pay a reasonable return for the
risks assumed
 The return may come in the form of
price appreciation, periodic coupon
interest, and interest-on-interest
 The return may be fully taxable or
exempt from taxes
Objectives of the Investment Portfolio
 Diversify Credit Risk
 The diversification objective is closely
linked to the safety objective and
difficulties that banks have with
diversifying their loan portfolios
 Too often loans are concentrated in
one industry that reflects the specific
economic conditions of the region
 Investment portfolios give banks the
opportunity to spread credit risk
outside their geographic region and
across different industries
Objectives of the Investment Portfolio
 Help Manage Interest Rate Exposure
 Investment
securities are very flexible
instruments for managing a bank’s
overall interest rate risk exposure
 Banks can select terms that meet their
specific needs without fear of
antagonizing the borrower
 They can readily sell the security if
their needs change
Objectives of the Investment Portfolio
 Pledging Requirements
 By
law, commercial banks must pledge
collateral against certain types of
liabilities.
Banks that borrow via repurchase
agreements essentially pledge part of
their government securities portfolio
against this debt
 Public deposits
 Borrowing from the Federal Reserve
 Borrowing from FHLBs

Composition of the Investment Portfolio
 Money market instruments with short
maturities and durations include:
 Treasury
bills
 Large negotiable CDs
 Bankers acceptances
 Commercial paper
 Repurchase agreements
 Tax anticipation notes.
Composition of the Investment Portfolio
 Capital market instruments with longer
maturities and duration include:
 Long-term
U.S. Treasury securities
 Obligations of U.S. government agencies
 Obligations of state and local
governments and their political
subdivisions labeled municipals
 Mortgage-backed securities backed both
by government and private guarantees
 Corporate bonds
 Foreign bonds
Composition of the Investment Portfolio
A.
All Banks Over Time
Percentage of Total Assets
1975 1980
1985
1990
1995
Billions of dollars
1970
U.S. Treasury securities
Agency securities
Municipal securities
Corporate & foreign securities
Total
Total financial assets (billions of $)
12.1% 9.8% 7.8% 8.3% 5.4% 6.2% 2.9% 1.3%
2.7
3.9
4.1
3.2
8.4
10.4
11.2
12.9
13.6
11.6
10.0
9.7
3.5
2.1
1.8
1.7
0.6
0.9
0.5
1.0
2.7
2.5
4.1
6.6
29.0% 26.2% 22.4% 22.2% 20.0% 21.2% 20.0% 22.5%
$517 $886 $1,482 $2,375 $3,334 $4,488 $6,469 $8,487
B.
2000
Percentage of Total Consolidated Assets, December 31, 2000
Commercial Banks Ranked by Assets
10
11-100
101-1,000
>1,000
Largest
Largest
Largest
Largest
Investment securities
U.S. Treasury securities
0.80%
1.00%
1.00%
0.90%
U.S. Gov't. agency & corporate securities
9.20%
13.00%
17.00%
16.20%
Private mortgage-backed securities
1.10%
2.10%
0.90%
0.20%
Municipal securities
0.60%
1.00%
3.00%
4.70%
Other securities
3.40%
2.90%
2.00%
1.10%
Equities
0.20%
0.20%
0.40%
0.30%
Total investment securities
15.30%
20.20%
24.30%
23.40%
Trading account securities
5.90%
1.10%
0.10%
0.00%
Total
21.20%
21.30%
24.40%
23.40%
2004
Characteristics of Taxable Securities
 Money Market Investments
 Highly
liquid instruments which mature
within one year that are issued by
governments and large corporations
 Very low risk as they are issued by wellknown borrowers and a active
secondary market exists
 Banks purchase money market
instruments in order to meet liquidity
and pledging requirements and earn a
reasonable return
Characteristics of Taxable Securities
 Capital Market Investments
 Consists
of instruments with original
maturities greater than one year
 Banks are restricted to “investment
grade” securities, those rated Baa
(BBB) or above; i.e., no junk bonds
 If banks purchase non-rated securities,
they must perform a credit analysis to
validate that they are of sufficient
quality relative to the promised yield .
Money Market Investments
 Repurchase Agreements (Repos)
A
loan between two parties, with one
typically either a securities dealer or
commercial bank
 The lender or investor buys securities
from the borrower and simultaneously
agrees to sell the securities back at a
later date at an agreed-upon price plus
interest
 Essentially are collateralized federal
funds transactions
Money Market Investments
 Repurchase Agreements (Repos)


The minimum denomination is generally $1
million, with maturities ranging from one day to
one year
The rate on one-day repos is referred to as the
overnight repo rate and is quoted on an add-on
basis assuming a 360-day year


$ Interest = Par Value x Repo Rate x Days/360
Longer-term transactions are referred to as term
repos and the associated rate the term repo rate
Money Market Investments
 Treasury Bills
 Marketable obligations of the U.S.
Treasury that carry original maturities of
one year or less
 They exist only in book-entry form, with
the investor simply holding a dated
receipt
 Investors can purchase bills in
denominations as small as $1,000, but
most transactions involve much larger
amounts
Money Market Investments
 Treasury Bills
 Each
week the Treasury auctions
bills with 13-week and 26-week
maturities

Investors submit either competitive
or noncompetitive bids
 With a competitive bid, the purchaser
indicates the maturity amount of bills
desired and the discount price
offered
 Non-competitive bidders indicate only
how much they want to acquire
Money Market Investments
 Treasury Bills
 Treasury bills are purchased on a discount
basis, so the investor’s income equals price
appreciation
 The Treasury bill discount rate is quoted in
terms of a 360-day year:
FV  P 360
DR 

FV
N

Where




DR = Discount Rate
FV = Face Value
P = Purchase Price
N = Number of Days to Maturity
Money Market Investments
 Treasury Bills Example:


A bank purchases $1 million in face value of
26-week (182-day) bills at $990,390. What is
the discount rate and effective yield?
The discount rate is:
$1,000,000  $990,390 360
DR 

 1.90%
$1,000,000
182

The true (effective) yield is:
$1,000,000  $990,390 
Effective Yield  1 

$990,390

(365/182)
 1  1.956%
Money Market Investments
 Certificates of Deposit
 Dollar-denominated
deposits issued by
U.S. banks in the United States
 Fixed maturities ranging from 7 days to
several years
 Pay yields above Treasury bills.
 Interest is quoted on an add-on basis,
assuming a 360-day year
Money Market Investments
 Eurodollars
 Dollar-denominated
deposits issued by
foreign branches of banks outside the
United States
 The Eurodollar market is less regulated
than the domestic market, so the
perceived riskiness is greater.
Money Market Investments
 Commercial Paper
 Unsecured promissory notes issued by
corporations
 Proceeds are use to finance short-term working
capital needs
 The issuers are typically the highest quality
firms
 Minimum denomination is $10,000
 Maturities range from 3 to 270 days
 Interest rates are fixed and quoted on a
discount basis
 Small banks purchase large amounts of
commercial paper as investments
Money Market Investments
 Bankers Acceptances
A
draft drawn on a bank by firms that
typically are importer or exporters of
goods
 Has a fixed maturity, typically up to nine
months
 Priced as a discount instrument like Tbills
Capital Market Investments
 Treasury Notes and Bonds
 Notes have a maturity of 1 - 10 years
 Bonds have a maturity greater than 10
years
 Most pay semi-annual coupons
 Some are zeros or STRIPS
 Sold via closed auctions
 Rates are quoted on a coupon-bearing
basis with prices expressed in thirtyseconds of a point, $31.25 per $1,000
face value
Capital Market Investments
 Treasury STRIPS



Many banks purchase zero-coupon Treasury
securities as part of their interest rate risk
management strategies
The U.S. Treasury allows any Treasury with an
original maturity of at least 10 years to be
“stripped” into its component interest and
principal pieces and traded via the Federal
Reserve wire transfer system.
Each component interest or principal payment
constitutes a separate zero coupon security
and can be traded separately from the other
payments
Capital Market Investments
 Treasury STRIPS Example
 Consider a 10-year, $1 million par value
Treasury bond that pays 9 percent
coupon interest semiannually ($45,000
every six months)
 This security can be stripped into 20
separate interest payments of $45,000
each and a single $1 million principal
payment, or 21 separate zero coupon
securities.
Capital Market Investments
 U.S. Government Agency Securities
 Composed

of two groups
Members who are formally part of the
federal government
 Federal Housing Administration
 Export-Import Bank
 Government National Mortgage Association
(Ginnie Mae)
Capital Market Investments
 U.S. Government Agency Securities

Composed of two groups

Members who are government-sponsored
agencies
 Federal Home Loan Mortgage Corporation (Freddie
Mac)
 Federal National Mortgage Association (Fannie Mae)
 Student Loan Marketing Association (Sallie Mae)


Default risk is low even though these securities
are not direct obligations of the Treasury; most
investors believe there is a moral obligation.
These issues normally carry a risk premium of
about 10 to 100 basis points.
Capital Market Investments
 Callable Agency Bonds
 Securities issued by governmentsponsored enterprises in which the
issuer has the option to call the bonds
prior to final maturity
 Typically, there is a call deferment period
during which the bonds cannot be called
 The issuer offers a higher promised yield
relative to comparable non-callable
bonds
 The present value of this rate differential
essentially represents the call premium
Capital Market Investments
 Callable Agency Bonds
 Banks find these securities attractive
because they initially pay a higher yield
than otherwise similar non-callable
bonds
 The premium reflects call risk

If rates fall sufficiently, the issuer will
redeem the bonds early, refinancing at
lower rates, and the investor gets the
principal back early which must then be
invested at lower yields for the same risk
profile
Capital Market Investments
 Conventional Mortgage-Backed
Securities (MBSs)
 Any
security that evidences an
undivided interest in the ownership of
mortgage loans
 The most common form of MBS is the
pass-through security
 Even though many MBSs have very low
default risk, they exhibit unique interest
rate risk due to prepayment risk

As rates fall, individuals will refinance
Capital Market Investments
 GNMA Pass-Through Securities
 Government
National Mortgage
Association (Ginnie Mae)

Government entity that buys mortgages
for low income housing and guarantees
mortgage-backed securities issued by
private lenders
Structure of the GNMA Mortgage-Backed
Pass-Through Security Issuance Process
Capital Market Investments
 FHLMC

Federal Home Loan Mortgage Corporation
(Freddie Mac)
 FNMA securities

Federal National Mortgage Association (Fannie
Mae)
 Both are:



Private corporations
Operate with an implicit federal guarantee
Buy mortgages financed largely by mortgagebacked securities
Capital Market Investments
 Privately Issued Pass-Through
 Issued
by banks and thrifts, with private
insurance rather than government
guarantee
Prepayment Risk on Mortgage-Backed
Securities
 Borrowers may prepay the
outstanding mortgage principal at any
point in time for any reason
 Prepayments generally occur because
of fundamental demographic trends as
well as movements in interest rates
 Prepayments
typically increase as
interest rates fall and slow as rates
increase
 Forecasting prepayments is not an
exact science
Prepayment Risk on Mortgage-Backed
Securities
 Example:
 Current mortgage rates are 8% and you
buy a MBS paying 8.25%
 Because rates have fallen, you paid a
premium to earn the higher rate
 With rates only .25% lower, it is unlikely
individuals will refinance
 If rates fall 3%, there will be a large
increase in prepayments due to
refinancing
 If the prepayments are fast enough, you
may never recover the premium you paid
The value of the MBS if the
pre-payment rate varies
from 6%
B. The Effect of Relative Coupon on the Prepayment Rate
C. The Effect of Mortgage Age on the Prepayment Rate
3
Pre-payment
experience is
low on new
mortgages,
increases
through five
years then
declines.
2
1
0
-8
-6
-4
-2
0
2
4
6
8
Relative Coupon Rate (Percent)
1.25
Percent per Month
Prepayment risk on mortgage-backed
securities
Percent per Month
Measures the value of
the MBS if the
prepayment rate
remains at 6%
regardless of the level of
mortgage rates.
Pre-payment
rates increase
sharply when
mortgage rates
fall
1.00
.75
.50
.25
0
1
5
10
15
20
25
Mortgage Age (Years)
Unconventional Mortgage-Backed Securities
 Collateralized Mortgage Obligations
(CMOs)
 Security
backed by a pool of mortgages
and structured to fall within an estimated
maturity range (tranche) based on the
timing of allocated interest and principal
payments on the underlying mortgages

Tranche:
 The principal amount related to a specific
class of stated maturities on a collateralized
mortgage obligation. The first class of bonds
has the shortest maturities
Unconventional Mortgage-Backed Securities
 Collateralized Mortgage Obligations
(CMOs)
 CMOs
were introduced to circumvent
some of the prepayment risk associated
with the traditional pass-through
security
 CMOs are essentially bonds
 An originator combines various
mortgage pools to serve as collateral
and creates classes of bonds with
different maturities
Unconventional Mortgage-Backed Securities
 Collateralized Mortgage Obligations
(CMOs)
 The
first class, or tranche, has the
shortest maturity

Interest payments are paid to all classes
of bonds but principal payments are paid
to the first tranche until they have been
paid off
 After
the first tranche is paid, principal
payments are made to the second
tranche, etc
Unconventional Mortgage-Backed Securities
 Types of CMOs

Planned Amortization Class CMO (PAC)




A security that is retired according to a planned
amortization schedule, while payments to other
classes of securities are slowed or accelerated
Least risky of the CMOs
Objective is to ensure that PACs exhibit highly
predictable maturities and cash flows
Z-Tranche


Final class of securities in a CMO, exhibiting the
longest maturity and greatest price volatility
These securities often accrue interest until all
other classes are retired
Unconventional Mortgage-Backed Securities
 CMOs’ Advantages over MBS Pass-
Throughs
 Some
classes (tranches) exhibit less
prepayment risk; some exhibit greater
prepayment risk
 Appeal to investors with different
maturity preferences by segmenting the
securities into maturity classes
Unconventional Mortgage-Backed Securities
 Stripped Mortgage-Backed Securities
 More complicated in terms of structure and
pricing characteristics
 Example:
 Consider a 30 year, 12% fixed-rate mortgage
 There will be 30 x 12 (360) payments (principal plus
interest
 Loan amortization means the principal only payments
are smaller in the beginning:
P1 < P2 < … < P360
 Interest only payments decrease over time:
I1 > I2 > … > I360
Asset-Backed Securities
 Conceptually, an asset-backed security is
comparable to a mortgage-backed security
in structure
 The securities are effectively “passthroughs” since principal and interest are
secured by the payments on the specific
loans pledged as security
 Two popular asset-backed securities are:


Collateralized automobile receivables (CARS)
CARDS

Securities backed by credit card loans to
individuals
Other Investments
 Corporate and Foreign Bonds
 At
the end of 2004, banks held $560
billion in corporate and foreign bonds
 Mutual Funds
 Banks
have increased their holdings in
mutual funds to over $25 billion in 2004

Mutual fund investments must be
marked-to-market and can cause
volatility on the values reported on the
bank’s balance sheet
Characteristics of Municipal Securities
 Municipals are exempt from federal income
taxes and generally exempt from state or
local as well
 General obligation

Principal and interest payments are backed
by the full faith, credit, and taxing authority of
the issuer
 Revenue Bonds
 Backed by revenues generated from the
project the bond proceeds are used to
finance
 Industrial Development Bonds
 Expenditures of private corporations
Summary of Terms for a
Municipal School Bond
Due Date Amount Coupon Yield
Sequoia Union High School District
$30,000,000
General Obligation Bonds Election of 2001
Dated: May 1, 2002
Due: July 1, 2003 through July 1, 2031
Callable: July 1, 2011 at 102.0% of par, declining
to par as of July 1, 2013
Winning Bid: Salomon Smith Barney, at
100.0000, True interest cost (TIC) of 5.0189%
Other Managers: Bear, Stearns & Co., Inc., CIBC
World Markets Corp.,
7/1/2003
7/1/2004
7/1/2005
7/1/2006
7/1/2007
7/1/2008
7/1/2009
7/1/2010
7/1/2011
7/1/2012
7/1/2013
7/1/2014
7/1/2015
7/1/2016
7/1/2017
7/1/2018
7/1/2019
7/1/2020
7/1/2021
7/1/2022
7/1/2023
7/1/2024
7/1/2025
7/1/2026
$225,000
$520,000
$545,000
$575,000
$605,000
$635,000
$665,000
$700,000
$735,000
$765,000
$800,000
$835,000
$870,000
$910,000
$950,000
$995,000
$1,045,000
$1,095,000
$1,150,000
$1,210,000
$1,270,000
$1,335,000
$1,405,000
$1,480,000
7/1/2031 $8,650,000
7.00%
7.00%
7.00%
7.00%
7.00%
7.00%
7.00%
4.00%
4.00%
4.13%
4.25%
4.38%
4.50%
4.60%
4.70%
4.80%
4.90%
5.00%
5.00%
5.00%
5.00%
5.00%
5.00%
5.00%
2.00%
2.50%
3.00%
3.25%
3.50%
3.70%
3.80%
3.90%
4.00%
4.13%
4.25%
4.38%
4.50%
4.60%
4.70%
4.80%
4.90%
5.00%
5.00%
5.00%
5.00%
5.00%
5.20%
5.21%
5.13% 5.21%
Characteristics of Municipal Securities
 Money Market Municipals
 Municipal notes provide operating
funds for government units
 Banks buy large amounts of short-term
municipals
 They often work closely with
municipalities in placing these
securities
 Capital Market Municipals
 Includes general obligation bonds and
revenue bonds
Characteristics of Municipal Securities
 Credit Risk in the Municipal Portfolio
 Until
the 1970s, few municipal securities
went into default
 Deteriorating conditions in many large
cities ultimately resulted in defaults by:

New York City (1975), Cleveland (1978),
Washington Public Power & Supply
System (WHOOPS) (1983)
Characteristics of Municipal Securities
 Liquidity Risk


Municipals exhibit substantially lower liquidity
than Treasury or agency securities
The secondary market for municipals is
fundamentally an over-the-counter market


Small, non-rated issues trade infrequently and
at relatively large bid-ask dealer spreads
Large issues of nationally known municipalities,
state agencies, and states trade more actively at
smaller spreads
Characteristics of Municipal Securities
 Liquidity Risk
 Name
recognition is critical, as investors
are more comfortable when they can
identify the issuer with a specific
location
 Insurance also helps by improving the
rating and by association with a known
property and casualty insurer
Characteristics of Municipal Securities
 Municipals are less volatile in price than
Treasury securities


This is generally attributed to the peculiar tax
features of municipals
The municipal market is segmented

On the supply side, municipalities cannot shift
between short- and long-term securities to take
advantage of yield differences because of
constitutional restrictions on balanced
operating budgets
 Thus long-term bonds cannot be substituted for shortterm municipals to finance operating expenses, and
 Capital expenditures are not financed by ST securities
Characteristics of Municipal Securities
 Municipals are less volatile in price than
Treasury securities
 The
municipal market is segmented.
On the demand side, banks once
dominated the market for short-term
municipals
 Today, individuals via tax-exempt money
market mutual funds dominate the short
maturity spectrum

Establishing Investment Policy Guidelines
 Each bank’s asset and liability or risk
management committee is responsible for
establishing investment policy guidelines


These guidelines define the parameters
within which investment decisions help meet
overall return and risk objectives
Because securities are impersonal loans that
are easily bought and sold, they can be used
at the margin to help achieve a bank’s
liquidity, credit risk, and earnings sensitivity
or duration gap targets
Establishing Investment Policy Guidelines
 Investment guidelines identify specific
goals and constraints regarding:
 Return
Objective
 Composition of Investments
 Liquidity Considerations
 Credit Risk Considerations
 Interest Rate Risk Considerations
 Total Return Versus Current Income
Active Investment Strategies
 Portfolio managers can buy or sell
securities to achieve aggregate risk
and return objectives
 Investment strategies can
subsequently play an integral role in
meeting overall asset and liability
management goals
 Unfortunately, not all banks view their
securities portfolio in light of these
opportunities
Active Investment Strategies
 Many smaller banks passively manage
their portfolios using simple buy and
hold strategies
 The purported advantages are that
such a policy requires limited
investment expertise and virtually no
management time; lowers transaction
costs; and provides for predictable
liquidity
Active Investment Strategies
 Other banks actively manage their portfolios
by:



Adjusting maturities
Changing the composition of taxable versus
tax-exempt securities
Swapping securities to meet risk and return
objectives
 Advantage is that active portfolio managers
can earn above-average returns by capturing
pricing discrepancies in the marketplace
 Disadvantages are:


that managers must consistently out predict
the market for the strategies to be successful,
and
high transactions costs
The Maturity or Duration Choice for LongTerm Securities
 The optimal maturity or duration is possibly
the most difficult choice facing portfolio
managers
 It is very difficult to outperform the market
when forecasting interest rates
 Some managers justify passive buy and
hold strategies because of a lack of time
and expertise
 Other managers actively trade securities in
an attempt to earn above average returns
Passive Maturity Strategies
 Laddered (or Staggered) maturity
strategy
 Management
initially specifies a
maximum acceptable maturity and
securities are evenly spaced
throughout maturity
 Securities are held until maturity to
earn the fixed returns
Passive Maturity Strategies
 Barbell Maturity Strategy
 Differentiates
investments between
those purchased for liquidity and those
for income
 Short-term securities are held for
liquidity
 Long-term securities for income
 Also labeled the long and short
strategy
Active Maturity Strategies
 Active portfolio management involves
taking risks to improve total returns by:
 Adjusting
maturities
 Swapping securities
 Periodically liquidating discount
instruments
 To be successful, the bank must avoid
the trap of aggressively buying fixedincome securities at relatively low rates
when loan demand is low and deposits
are high
Active Maturity Strategies
 Riding the Yield Curve


This strategy works best when the yield curve
is upward-sloping and rates are stable.
Three basic steps:



Identify the appropriate investment horizon
Buy a par value security with a maturity longer
than the investment horizon and where the
coupon yield is higher in relationship to the
overall yield curve
Sell the security at the end of the holding period
when time remains before maturity
Riding the Yield Curve Example
Initial conditions and
assumptions:
• 5-year investment Period:
horizon
Year-End
• yield curve is
upward-sloping,
1
2
• 5-year securities
3
yielding 7.6 % and
4
• 10-year securities
5
yielding 8 %.
Total
• Annual coupon
5
interest is reinvested
at 7%.
Buy a 5-Year Security
Coupon
Interest
Buy a 10-Year Security
and Sell It after 5 Years
Reinvestment Coupon Reinvestment
Income at
Interest
Income at
7%
7%
$7,600
$ 8,000
7,600
$ 532
8,000
$ 560
7,600
1,101
8,000
1,159
7,600
1,710
8,000
1,800
7,600
2,362
8,000
2,486
$38,000
$5,705
$40,000
$6,005
Principal at Maturity = $100,000 Price at Sale after 5 years =
$101,615 when rate = 7.6%
Expected Total Return Calculation
 100,000  38,000  5,705 
i5yr  

100,000


 0.0752
1/5
 1 y10yr
1/5


101,615

40,000

6,005



1


 0.0810
100,000


Interest Rates and the Business Cycle
 Expansion
 Increasing Consumer Spending
 Inventory Accumulation
 Rising Loan Demand
 Federal Reserve Begins to Slow Money
Growth
 Peak
 Monetary Restraint
 High Loan Demand
 Little Liquidity
Interest Rates and the Business Cycle
 Contraction
 Falling Consumer Spending
 Inventory Contraction
 Falling Loan Demand
 Federal Reserve Accelerates Money
Growth
 Trough
 Monetary Policy Eases
 Limited Loan Demand
 Excess Liquidity
Passive Strategies Over the Business Cycle
 One popular passive investment strategy
follows from the traditional belief that a
bank’s securities portfolio should consist of
primary reserves and secondary reserves
 This view suggests that banks hold shortterm, highly marketable securities primarily
to meet unanticipated loan demand and
deposit withdrawals
 Once these primary liquidity reserves are
established, banks invest any residual
funds in long-term securities that are less
liquid but offer higher yields
Passive Strategies Over the Business Cycle
 A problem arises because banks
normally have excess liquidity during
contractionary periods when loan
demand is declining and the Fed starts
to pump reserves into the banking
system
 Interest rates are thus relatively low.
Passive Strategies Over the Business Cycle
 Banks employing this strategy add to
their secondary reserve by buying longterm securities near the low point in the
interest rate cycle
 Long-term
rates are typically above
short-term rates, but all rates are
relatively low
 With a buy and hold orientation, these
banks lock themselves into securities
that depreciate in value as interest rates
move higher
Active Strategies Over the Business Cycle
 Many portfolio managers attempt to
time major movements in the level of
interest rates relative to the business
cycle and adjust security maturities
accordingly
 Some try to time interest rate peaks by
following a counter-cyclical
investment strategy defined by
changes in loan demand and the yield
curve’s shape
Active Strategies Over the Business Cycle
 The strategy entails both expanding the
investment portfolio and lengthening
maturities at the top of they business cycle,
when both interest rates and loan demand are
high

Note that the yield curve generally inverts
when rates are at their peak prior to a
recession
 Alternatively, at the bottom of the business
cycle when both interest rates and loan
demand are low, a bank contracts the
portfolio and shorten maturities
The Impact of Interest Rates on the Value of
Securities with Embedded Options
 Issues for Securities with Embedded
Options


Callable agency securities or mortgagebacked securities have embedded options
To value a security with an embedded option,
three questions must be addressed



Is the investor the buyer or seller of the
option?
How and by what amount is the buyer being
compensated for selling the option, or how
much must it pay to buy the option?
When will the option be exercised and what is
the likelihood of exercise?
Price-Yield Relationship for Securities
with Embedded Options
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
 Recall that the duration for an option-
free security is a weighted average of
the time until the expected cash flows
from a security will be received
P
Duration  - P
i
(1  i)
 i 
P  - Duration 
P

 (1  i) 
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
Yield %
Price
Price - $10,000 Duration
8
10,524.21
524.21
5.349
9
10,257.89
257.89
5.339
10
10,000.00
0.00
5.329
11
9,750.00
(249.78)
5.320
12
9,508.27
(491.73)
5.310
$ Price
10,524.21
10,507.52
Actual price increase is greater
when interest rates fall for option
free bonds.
10,000.00
Price-yield curve
Tangent line representing the
slope at 10%
8%
10%
Interest Rate %
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
 From the previous slide, we can see:
 The difference between the actual
price-yield curve and the straight line
representing duration at the point of
tangency equals the error in applying
duration to estimate the change in
bond price at each new yield
 For both rate increases and rate
decreases, the estimated price based
on duration will be below the actual
price
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
 From the previous slide, we can see:
 Actual
price increases are greater and
price declines less than that suggested
by duration when interest rates fall or
rise, respectively, for option-free bonds
 For small changes in yield the error is
small
 For large changes in yield the error is
large
The Roles of Duration and Convexity in
Analyzing Bond Price Volatility
 Convexity
 As
yields increase, duration for option
free bonds decreases, once again
reducing the rate at which price declines
 This characteristic is called positive
convexity

The underlying bond becomes more
price sensitive when yields decline and
less price sensitive when yields increase
Impact of Prepayments on Duration and Yield
for Bonds with Options
 Embedded options affect the estimated
duration and convexity of securities
 For example, prepayments will affect the
duration of mortgage-backed securities

Market participants price mortgage-backed
securities by following a 3-step procedure:



Estimate the duration based on an assumed
interest rate environment and prepayment
speed
Identify a zero-coupon Treasury security with
the same (approximate) duration.
The MBS is priced at a mark-up over the
Treasury
Impact of Prepayments on Duration and Yield
for Bonds with Options
 The MBS yield is set equal to the yield
on the same duration Treasury plus a
spread
 The
spread can range from 50 to 300
basis points depending on market
conditions
 The MBS yields reflect the zero-coupon
Treasury yield curve plus a premium
Total Return Analysis
 An investor’s actual realized return
should reflect the coupon interest,
reinvestment income, and value of the
security at maturity or sale at the end
of the holding period
 When a security carries embedded
options, these component cash flows
will vary in different interest rate
environments
Total Return Analysis
 If rates fall and borrowers prepay
faster than originally expected:
 Coupon
interest will fall
 Reinvestment income will fall
 The price at sale (end of the holding
period) may rise or fall depending on
the speed of prepayments
Total Return Analysis
 When rates rise
 Borrowers
prepay slower
 Coupon income increases
 Reinvestment income increases
 The price at sale may rise or fall
Total Return Analysis for a Callable FHLB Bond
Total Return Analysis for a Callable FHLB Bond
Option-Adjusted Spread
 The standard calculation of yield to maturity is
inappropriate with prepayment risk
 Option-adjusted spread (OAS) accounts for
factors that potentially affect the likelihood and
frequency of call and prepayments
 Static spread is the yield premium, in percent,
that (when added to Treasury zero coupon
spot rates along the yield curve) equates the
present value of the estimated cash flows for
the security with options equal to the
prevailing price of the matched-maturity
Treasury
Comparative Yields on Taxable versus TaxExempt Securities
 Interest on most municipal securities is
exempt from federal income taxes and,
depending on state law, from state
income taxes
 Some
states exempt all municipal
interest
 Most states selectively exempt interest
from municipals issued in-state but tax
interest on out-of-state issues
 Other states either tax all municipal
interest or do not impose an income tax
Comparative Yields on Taxable versus TaxExempt Securities
 Capital gains on municipals are taxed as
ordinary income under the federal
income tax code
 This
makes discount municipals less
attractive than par municipals because a
portion of the return, the price
appreciation, is fully taxable
 When making investment decisions,
portfolio managers compare expected
risk-adjusted after-tax returns from
alternative investments
Comparative Yields on Taxable versus TaxExempt Securities
 After-Tax and Tax-Equivalent Yields
 Once
the investor has determined the
appropriate maturity and risk security,
the investment decision involves
selecting the security with the highest
after-tax yield
Comparative Yields on Taxable versus TaxExempt Securities
 After-Tax and Tax-Equivalent Yields
 Tax-exempt
and taxable securities can
be compared as:
R

m 
R t (1  t)
where
Rm = pretax yield on a municipal security
Rt
= pretax yield on a taxable security
t
= investor’s marginal federal income tax rate
Comparative Yields on Taxable versus TaxExempt Securities
 After-Tax and Tax-Equivalent Yields
 Example

Let:
Rm = 5.75%
Rt
= 7.50%
Marginal Tax Rate
= 34%
 The investor would choose the municipal
because it pays a higher after tax return:
Rm
Rt
= 5.75% after taxes
= 7.50% (1 - 0.34)
= 4.95% after taxes
Comparative Yields on Taxable versus TaxExempt Securities
 Marginal Tax Rates Implied in the
Taxable - Tax-Exempt Spread
 If
taxable securities and tax-exempt
securities are the same for all other
reasons then:

t* = 1 - (Rm / Rt)
 where
 Rm = pretax yield on a municipal security
 Rt = pretax yield on a taxable security
Comparative Yields on Taxable versus TaxExempt Securities
 Marginal Tax Rates Implied in the
Taxable - Tax-Exempt Spread
 t*
represents the marginal tax rate at
which an investor would be indifferent
between a taxable and a tax-exempt
security equal for all other reasons
 Higher marginal tax rates or high tax
individuals (companies) will prefer taxexempt securities
Comparative Yields on Taxable versus TaxExempt Securities
 Example

Let:
Rm
Rt
= 5.75%
= 7.50%
Marginal Tax Rate = 34%
5.75%
t  1
 23.33%
7.50%
*

An investor would be indifferent between
these two investment alternatives if her
marginal tax rate were 23.33%
Comparative Yields on Taxable versus TaxExempt Securities
 Municipals and State & Local Taxes
 The
analysis is complicated somewhat
when state and local taxes apply to
municipal securities:

m 
Rm (t  t ) R t [1 (t  t m )]
Comparison of After-Tax Returns on Taxable and TaxExempt Securities for a Bank as Investor
After-Tax Interest Earned on Taxable versus Exempt Securities
Taxable
$
10,000
10.00%
$
1,000
$
340
$
660
Par Value
Coupon Rate
Annual Coupon interest
Federal income taxes (34%)
After-tax income
Municipal
$ 10,000
8.00%
$
800
$0
$
800
After-Tax Interest Earned Recognizing Partial Deductibility of Interest Expense
Par Value
Coupon Value
Annual coupon interest
Federal income taxes (34%)
Polled interest expense (7.5%)
Lost interest deduction (20%)
Increased tax liability (34%)
Effective after-tax interest income
$
$
$
$
$
$
$
$
10,000
0
1,000
340
750
660
$
$
$
$
$
$
$
$
10,000
0
800
750
150
51
749
The Impact of the Tax Reform
Act of 1986 (TRA 1986)
 The TRA of 1986 created two classes
of municipals


Qualified
Nonqualified Municipals
 After 1986, banks could no longer
deduct interest expenses associated
with municipal investments, except
for qualified municipal issues
The Impact of the Tax Reform
Act of 1986 (TRA 1986)
 Qualified versus Non-Qualified
Municipals
 Qualified

Municipals
Banks can still deduct 80 percent of the
interest expense associated with the
purchase of certain small issue publicpurpose bonds (bank qualified)
 Nonqualified

Municipals
All municipals that do not meet the
qualified criteria
The Impact of the Tax Reform
Act of 1986 (TRA 1986)
 Qualified versus Non-Qualified
Municipals
 Municipals
issued before August 7,
1986, retain their tax exemption; i.e.,
can still deduct 80 percent of their
associated financing costs
(grandfathered in)
The Impact of the Tax Reform
Act of 1986 (TRA 1986)
 Example:
 Implied tax on a bank’s purchase of
nonqualified municipal securities
(100% lost deduction)
 Assume
 t =34%
 20% not deductible
 7.5% pooled interest cost
 Rmuni = 7%
t muni
(0.34)  (1.00)  (0.075)

 0  31.88%
0.08
at
Rmuni
 8.0  (1 0.3188) 5.45%
Strategies Underlying Security Swaps
 Active portfolio strategies also enable
banks to sell securities prior to maturity
whenever economic conditions dictate
that returns can be earned without a
significant increase in risk
 When a bank sells a security at a loss
prior to maturity, because interest rates
have increased, the loss is a deductible
expense
 At
least a portion of the capital loss is
reduced by the tax-deductibility of the
loss
Strategies Underlying Security Swaps
 In general, banks can effectively
improve their portfolios by:
 Upgrading
bond credit quality by
shifting into high-grade instruments
when quality yield spreads are low
 Lengthening maturities when yields
are expected to level off or decline
 Obtaining greater call protection when
management expects rates to fall
Strategies Underlying Security Swaps
 In general, banks can effectively
improve their portfolios by:
 Improving
diversification when
management expects economic
conditions to deteriorate
 Generally increasing current yields by
taking advantage of the tax savings
 Shifting into taxable securities from
municipals when management expects
losses
Bank Management, 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning
GLOBAL BANKING
ACTIVITIES
Chapter 21
Global banking business
 One clear trend in the evolution of financial
institutions and markets is the expansion of
activities across national boundaries.
 Technology has made it possible to conduct
business around the world with relative
ease and minimal cost.
 Producers recognize that export markets
are as important as domestic markets, and
that the range of competitors includes both
domestic and foreign operations.
Global banking activities
…involve both traditional commercial banking
and investment banking operations.




U.S. commercial banks now accept deposits,
make loans, provide letters of credit, trade
bonds and foreign exchange, and underwrite
debt and equity securities in dollars and
other currencies.
With the globalization of financial markets,
all firms compete directly with other major
commercial and investment banks
throughout the world.
Foreign banks offer the same products and
services denominated in their domestic
currencies and in U.S. dollars.
Still, it was not always this way.
U.S. banks, although a dominant player in some
world markets, have not been considered “large”
by international standards
 Restrictive branching laws,
 Restrictions on the types of activities U.S.
banks could engage in, and
 Other regulatory factors generally meant
that
U.S. banks were greater in number,
but smaller in size.
U.S. banks, although a dominant player in some
world markets, have not been considered “large”
by international standards.
Rank
1
2
3
4
5
6
7
8
9
10
17
26
Company Name
Bank of Tokyo-Mitsubishi Ltd., Tokyo, Japan
Deutsche Bank AG, Frankfurt, Germany
Credit Agricole Mutual, Paris, France (2)
Credit Suisse Group, Zurich, Switzerland (1)
Dai-Ichi Kangyo Bank Ltd., Tokyo, Japan
Fuji Bank Ltd., Tokyo, Japan
Sanwa Bank Ltd., Osaka, Japan
Sumitomo Bank Ltd., Osaka, Japan
Sakura Bank Ltd., Tokyo, Japan
HSBC Holdings, Plc., London, United Kingdom
Chase Manhattan Corp., New York, United States
Citicorp, New York, United States (b)
12/31/1996
$648,161.00
575,072.00
479,963.00
463,751.40
434,115.00
432,992.00
427,689.00
426,103.00
423,017.00
404,979.00
333,777.00
278,941.00
Billions of dollars
Source: The AmericanBanker: http://www.americanbanker.com.
By the end of the 20th century, many factors had
changed in the U.S. system.
 The Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 effectively eliminated interstate
branching restrictions in the U.S. such that:
 by early 1994, there were 10 U.S. banks with 30
interstate branches.
 by June 2001, there were 288 U.S. banks with 19,298
interstate branches.
 U.S. banks were hampered competing internationally by
the Glass-Steagall Act, which effectively separated
commercial banking from investment banking.
 As such, U.S. commercial banks essentially provided
two products: loans and FDIC-insured deposits.
 In 1999, the Gramm-Leach-Bliley allowed U.S. banks to
fully compete with the largest global diversified financial
companies by offering the same broad range of products.
 The Gramm-Leach-Bliley Act repealed restrictions on
banks affiliating with securities firms and modified
portions of the Bank Holding Company Act to allow
By the end of 2000, the largest banking company in the
world was Citigroup at just under one-trillion dollars
and three of the largest ten banking companies in the
world were U.S. banks.
World Rankings of Financial Companies (by Assets) after Mergers, the full enactment of
Riegle-Neal Interstate Banking and Branching Efficiency Act and Gramm-Leach-Bliley Act
2000
Rank
1
2
3
4
5
6
7
8
9
10
Company Name
Citigroup Inc , New York
Deutsche Bank , Frankfurt, Germany
Bank Of Tokyo-Mitsubishi Ltd. , Tokyo
J.P. Morgan Chase & Co. , New York
UBS, Zurich
HSBCHoldings , London
BNP Paribas , Paris
Bank of America Corp. , Charlotte, N.C.
Credit Suisse Group , Zurich
Fuji Bank Ltd. , Tokyo
Total
Assets
2000
$902,210.00
872,626.68
720,808.94
715,348.00
673,705.58
673,475.21
651,431.86
642,191.00
612,098.13
557,111.70
Note: Assets are in billions of dollars.
Source: American Banker, http://www.americanbanker.com/
Total
Assets
1999
$716,937.00
829,155.67
638,926.83
406,105.00
615,324.33
600,680.41
702,370.25
632,574.00
451,062.77
467,410.23
%
Change
25.84%
5.24
12.82
76.15
9.49
12.12
-7.25
1.52
35.7
19.19
The merger between Citicorp and Travelers created
Citigroup, the first diversified financial services
company in the U.S.
 The merger, however, was not completely
permissible at the time it was approved under
provisions of the Glass-Steagall Act.
 Gramm-Leach-Bliley Act, made this merger
permissible and thereby allowed Citigroup to
legally be the world’s largest banking company.
 Citigroup formed a financial holding company
under the provisions of the Gramm-Leach-Bliley
Act and became one of the first integrated
financial services companies engaged in
investment services, asset management, life
insurance and property casualty insurance, and
consumer lending.
 Operating companies include Salomon Smith
Barney, Salomon Smith Barney Asset
Management, Travelers Life & Annuity,
Primerica Financial Services, Travelers
Today, the product offerings of Citigroup are
similar to that of Deutsche Bank in Germany
 Prior to the merger between Citibank and
Travelers, however, Citibank’s product line was
more limited.
 Outside the U.S., Citibank was able to offer a
diversified set of products using an Edge Act
corporation.

Edge Act corporations are domestic subsidiaries
of banking organizations chartered by the
Federal Reserve.
 All “Edges” are located in the United States
and may be established by U.S. or foreign
banks and bank holding companies, but are
limited to activities involving foreign
customers.
 They can establish overseas branches and
international banking facilities (IBFs) and own
100.0%
50.0%
95.0%
45.0%
90.0%
40.0%
85.0%
35.0%
80.0%
30.0%
75.0%
25.0%
70.0%
20.0%
65.0%
15.0%
60.0%
10.0%
55.0%
5.0%
50.0%
0.0%
Domestic total assets
Foreign owned total assets
Domestic total deposits
Foreign owned total deposits
Percent of total foreign owned
Percent of total domestic
Foreign banks operating through their
American banking offices have also aggressively
pursued U.S. business.
100.0%
50.0%
95.0%
45.0%
90.0%
40.0%
85.0%
35.0%
80.0%
30.0%
75.0%
25.0%
70.0%
20.0%
65.0%
15.0%
60.0%
10.0%
55.0%
5.0%
50.0%
0.0%
Domestic total loans
Foreign owned total loans
Domestic business loans
Foreign owned business loans
Percent of total foreign owned
Percent of total domestic
The growth in market share of U.S. offices of
foreign banks in total loans and business loans.
The largest U.S. banks with significant
international operations.
Total
Name
Assets
Citibank NA, New York NY
452,343
JPMorgan Chase Bk, New York NY537,826
Bank of America NA, Charlotte NC 551,691
Fleet NA Bk, Providence RI
187,949
Bank of New York, New York NY 78,019
Bank One NA, Chicago IL
161,023
MBNA America Bk NA, Wilmington DE
43,066
First Union NB, Charlotte NC
232,785
State Street B&TC, Boston MA
65,410
Wachovia Bk NA, Winston-Salem NC
71,555
Keybank NA, Cleveland OH
71,526
PNC Bk NA, Pittsburgh PA
62,610
Mellon Bk NA, Pittsburgh PA
27,813
Bank of Hawaii, Honolulu HI
10,493
Northern Trust Co, Chicago IL
32,758
National City Bk, Cleveland OH
39,214
Wells Fargo Bk NA, San Francisco140,675
CA
Wells Fargo Bk MN NA, Minneapolis52,428
MN
Deposits Held in:
Domestic Foreign Offices
Offices
$ Mill
% TA
98,899 208,024 46.0%
160,102 120,371 22.4%
334,909
56,634 10.3%
110,148
22,316 11.9%
28,786
27,024 34.6%
81,020
26,358 16.4%
26,187
1,448 3.4%
135,276
12,473 5.4%
12,137
26,718 40.8%
42,684
3,627 5.1%
40,010
2,721 3.8%
44,079
2,307 3.7%
9,947
4,949 17.8%
5,621
1,369 13.0%
10,380
9,424 28.8%
20,464
1,007 2.6%
73,644
5,433 3.9%
26,311
7,459 14.2%
Net Loans and leasses:
Domestic Foreign Offices
# of US
Offices
$ Mill
% TA Branches
121,901 157,462 34.8%
277
135,872 39,022 7.3%
612
287,364 20,867 3.8%
4,350
102,956 19,737 10.5%
1,709
19,822 16,879 21.6%
362
76,440
4,991 3.1%
804
18,733
4,123 9.6%
3
118,053
3,479 1.5%
2,143
4,519
1,402 2.1%
1
45,434
807 1.1%
790
54,047
785 1.1%
980
39,072
777 1.2%
735
6,269
548 2.0%
346
5,312
495 4.7%
78
11,331
397 1.2%
1
31,022
154 0.4%
353
93,799
20 0.0%
939
34,277
1 0.0%
169
The largest “foreign owned” banks
operating in the U.S.
Deposits Held in: Loans in
%
# of
Total Domestic Foreign
Frgn
Foreign # of US
Foreign
Name
Assets Offices Offices Offices
Top Holding Company
Owned Branches Branches
HSBC Bank USA, Buffalo NY
84,230 37,067 21,153
3,194 HS BC Holdings PLC, LONDON NA
100
440
19
Lasalle Bank NA, Chicago IL
54,731 24,963
4,226
0 ABN Amro, AMS TERDAM NA
100
122
2
Bankers Trust Co, New York NY
42,678 11,423 10,000
253 Taunus Corporation, NEW YORK NY
100
4
14
Standard Federal Bk NA, Troy MI
42,088 19,702
624
0 ABN Amro, AMS TERDAM NA
100
385
2
Union Bk of CA NA, San Francisco CA
35,591 26,518
3,305
1,041 Bank of Tokyo-Mitsubishi, TOKYO NA
66
286
6
Banco Popular De PR, San Juan PR
20,477 11,459
190 10,306 Popular Inc., S AN JUAN PR
100
2
204
Harris T&SB, Chicago IL
19,673
9,498
1,708
151 Bank of Montreal, MONTREAL NA
100
57
2
Allfirst Bk, Baltimore MD
17,762 12,758
545
249 Allied Irish Banks Limited, DUBLIN NA
100
270
2
RBC Centura Bk, Rocky Mount NC
13,732
7,388
273
0 Royal Bank of Canada, MONTREAL NA
100
241
1
Bank of The West, San Francisco CA
13,412
9,212
N/A
0 Bancwest Corporation, HONOLULU HI
44
193
0
United CA Bk, San Francisco CA
10,524
8,285
428
0 S anwa Bank, Limited, OS AKA NA
100
121
1
First Hawaiian Bk, Honolulu HI
8,682
5,691
463
364 Bancwest Corporation, HONOLULU HI
44
56
6
Firstbank PR, San Juan PR
8,143
4,117
N/A
0 First Bancorp, S AN JUAN PR
100
1
49
Banco Santander PR, Hato Rey PR
7,656
4,811
0
0 Banco S antander S .A., S ANTANDER NA
80
1
72
TD Waterhouse Bk NA, Jersey City NJ
6,069
5,546
N/A
0 TD Waterhouse Holdings, Inc., NEW YORK NY 80
2
0
Israel Discount Bk of NY, New York NY
6,021
2,112
2,094
415 Israel Discount Bank Limited, TEL-AVIV NA 100
7
1
Westernbank Puerto Rico, Mayaguez PR
5,887
3,214
N/A
0 W Holding Company, Inc., MAYAGUEZ PR
100
1
35
Banco Popular North America, New York City NY
5,606
4,761
0
0 Popular Inc., S AN JUAN PR
100
98
0
Safra NB, New York NY
5,010
2,548
320
875 S NBNY Holdings Limited, MARINA BAY NA 99
2
1
Banco Bilbao Vizcaya Argenta, San Juan PR 4,801
2,971
N/A
0 BBVAPR Holding Corporation, S AN JUAN PR 100
1
61
Bank of Tokyo Mitsubishi TC, New York NY 4,337
1,491
1,310
46 Bank of Tokyo-Mitsubishi, TOKYO NA
100
1
1
Bank Leumi USA, New York NY
4,082
1,496
1,800
169 Bank Leumi Le-Israel B.M., TEL-AVIV NA
99
8
1
R-G Premier Bk of PR, San Juan PR
3,963
2,115
N/A
0 R&G Financial Corporation, S AN JUAN PR 100
1
25
Doral Bk, San Juan PR
3,486
1,528
N/A
0 Doral Financial Corporation, S AN JUAN PR 100
1
26
Laredo NB, Laredo TX
2,349
2,029
N/A
0 Incus Co. Ltd., ROAD TOWN NA
71
24
0
Universal banking model
 Universal banking is the conduct of a variety
of financial services such as:

trading of financial instruments; foreign
exchange activities; underwriting new debt
and equity issues; investment management,
insurance; as well as extension of credit and
deposit gathering
 Universal banks have long dominated
banking in most of continental Europe.
Universal banks engage in everything from
insurance to investment banking and retail
banking—

similar to U.S. banks prior to the enactment of
the Banking Act of 1933 and Glass-Steagall
Three events changed the historical
development of banking in the U.S.
1. The first was the stock market crash of 1929
and the following Great Depression.

Many people blamed the banks and the
universal banking activities for the problems
although there is no strong evidence to link
the speculative activities of banks with the
crash.
2. The second was the enactment of the
Banking Act of 1933 and the Glass-Steagall
provision, which separated commercial
banking from investment banking activities.
3. The third was the rising importance of the
federal government in financial markets.
Prior to these events, the U.S. banking
system operated more of less under a
The advantages of universal banking
…risk diversification and expanded business opportunities.
 A universal bank can spread its costs over a
broader base of activities and generate more
revenues by offering a bundle of products.
 Diversification, in turn, reduces risk.

insurance companies, investment banks and
other suppliers of financial services are
moving toward building financial
conglomerates
 The GLB Act repealed Glass-Steagall and
allows U.S. banks to operate in the business
of commercial banking, investment banking,
and insurance.

Although there are many restrictions, U.S.
banks are allowed to compete with foreign
banks on an equal footing for the first time
Disadvantages of universal banking
…inherent conflict of interest
 A universal bank might use pressure tactics
to coerce a corporation into using its
underwriting services or buy insurance from
its subsidiary by threatening to cut off credit
facilities.
 It could force a borrower in financial
difficulties to issue risky securities in order
to pay off loans.
 A universal bank could also abuse
confidential information supplied by a
company issuing securities as well.

One area of the new GLB Act that has
Formation and development of the European
Community (EC) will provide new opportunities
for U.S. Banks.
 By abolishing trade restrictions, the
EC exposes European banks to
outside competition.
 In order to increase their competitive
advantage, many banks are looking
into merging with banks from other
countries.
 Today, most of Europe uses a unified
currency, the Euro.
Organizational structures in international
markets
 Head office
 International divisions or departments are
operated as a part of the head office's
organizational structure, with the division
managers reporting to senior management
(supervisory function).
 Representative office
 International office which does not conduct
normal banking business but simply
represents the corporation, with the purpose
of promoting the corporation's name and
developing business to be funneled to the
home office (exploratory function).
Foreign offices
 Foreign branch
 A legal part of the home bank which is
subject to the laws and regulations of the
host nation
 Shell office
 Does not conduct business with local
individuals; serves as a conduit for Eurodollar
activities that originate in the head office
 Full-service branch
 Performs all the activities of domestic banks
 Foreign Subsidiary
 Foreign banks or non-bank corporations
acquired by domestic commercial banks or
bank holding companies; distinct from the
Edge act and agreement corporations
 Edge Act corporations:
 Domestic
subsidiaries of banks
chartered by the Federal Reserve
which may be established by U.S. or
foreign banks and are limited to
activities involving foreign customers.
 Agreement corporations:
 State-chartered
equivalents of Edge
Act Corporations.
International banking facilities
 Subparts of banks that are created to
conduct international business without
the cost and effort of avoiding
regulatory requirements through shell
units.
 Exist as a set of accounting entries on
the books of the parent company.
Export trading companies
 Companies that are acquired by banks
and are organized and operated
principally for purposes of exporting
goods and services produced in the
U.S. by unaffiliated persons.
Agencies of foreign banks
 Parts of foreign banks that can offer
only a limited range of banking
services (cannot accept transactions
deposits from U.S. residents or issue
CDs) with the primary purpose of
financing trade originating from firms
in their own country.
International financial markets
 International markets have evolved to
facilitate funds flow in international
exchange of goods and services and
to reduce the risk of doing business
outside the home country.
The Eurocurrency market
 Eurocurrency:
A
deposit liability in any currency
except that of the country in which the
bank is located.
 Eurobank:
 Bank
that issues Eurocurrency claims.
Eurodollars
 Arise when a Eurobank accepting the
deposit receives a dollar claim on the U.S.
bank from which the funds were transferred.
 Eurobanks will redeposit the Eurodollar
proceeds in another bank until the funds are
given out as a loan by one of the banks.
 The initial Eurodollar deposit is accepted at
the base rate called LIBOR (London
Interbank Offer Rate).
 Each redeposit and the final loan will then
be priced at a markup over LIBOR.
The Eurobond market
 Bonds issued in the international
Euromarket, underwritten by an
international banking syndicate, not subject
to any one country's securities laws, and
denominated in any major national currency.
 Floating-rate Note:

Issued in denominations as low as $5,000
with maturities ranging from two to five
years, carrying interest rates that vary with
LIBOR.
Eurocredits
…term loans priced at a premium over LIBOR,
with the rate floating every three or six months in
most cases, thereby reducing the mismatch
between asset and liability maturities
 Eurocredits are created to overcome
interest rate risk.
International lending
 International operations generate a
considerable portion of earnings for money
center banks

Citigroup earns about two-thirds of their
earnings globally.
 International lending, however, carries risks
not associated with domestic lending


Country risk
…default risk associated with loans to
borrowers outside the home country
Foreign exchange risk
…the current and potential volatility in
earnings and stockholders’ equity due to
changes in foreign exchange rates.
Short-term foreign trade financing
…international trade and international trade financing are
considerably more complex than simply dealing with trading
partners within the same country
 To facilitate trade, someone must enter the
transaction and assume the risk that the importer
may not pay.
 Commercial banks fulfill this role through bankers
acceptance financing.
 Trading partners must also have the opportunity to
convert one currency into another, which creates a
demand for foreign exchange services as well.
 Bankers acceptance
…A time draft that represents a guarantee under
which the accepting bank agrees to remit the face
value of the draft at maturity.
Bankers Acceptance
financing of U.S.
Imports
…a bankers acceptance is
created, discounted, sold, and
paid at maturity
Direct international loans
…originate from international departments of domestic
banks, Edge Act corporations, credit offices of foreign
branches and subsidiaries.
 Credit extended to less-developed countries
(LDCs) has exhibited a poor repayment history
and many of the banks have chosen to
withdraw from lending to these countries after a
large number of default incidents that took
place in the 1980s.
 Banks prefer to have foreign exposure
in the form of equity investments rather
than long-term, constantly renegotiated
loans to foreign central banks.
Credit analysis of foreign loans
 Credit analysis for international loans
follow the same procedures adopted
frequently for domestic loans:
 evaluation
of the required loan amount,
 use of proceeds,
 source and timing of expected
payment,
 availability of secondary collateral
sources.
Foreign exchange activities
 Because different countries use different
monetary units, traders must be able to
convert one unit into another.
 Foreign exchange markets are where these
monetary units are traded.


Foreign exchange
…currency other than the monetary unit of
the home country
Exchange rate
…the price of one currency in terms of
another currency.
Risks unique to international lending:
 Foreign exchange risk
…the current and potential risk to earnings and
stockholders’ equity arising from changes in
foreign exchange rates
 Country risk
…default risk associated with loans to
borrowers outside the home country
 Economic risks
…quantifiable economic and business risks
(mostly examined under regular credit analysis).
 Political (sovereign) risks
…the likelihood that foreign governments will
unilaterally alter their debt service payments,
regardless of the formal repayment schedule
Foreign Exchange:
…currency other than the monetary unit of the
home country
 Exchange Rate
…price of one currency in terms of another
currency.
 Spot Market:
…market for exchange of currencies for
immediate delivery.
 Forward Market
…market for transactions that represent a
commitment to exchange currencies at a
specified time in the future at an exchange
rate determined at the time the contract is
signed.
Foreign exchange risk
…current and potential risk to earnings and
stockholder’s equity arising from changes in
foreign exchange rates
 Found when changing exchange rates affect
a bank’s cash inflows differently than cash
outflows associated with positions
denominated in different currencies
 Changes in values of foreign currency
positions (buying and selling foreign
currencies for their own account) due to
changing foreign exchange rates is price risk
Example: Foreign exchange risk
 Commerce Bank’s (CB) home country is
Poland and home currency is the zloty.
current (spot) exchange rate is $1 = 150 zlotys.
2. Commerce Bank:
1.
1.
2.
3.
4.
$1,000 in loans
$250 in liabilities denominated in U.S. dollars
assets are worth 150,000 zlotys
liabilities are worth 37,500 zlotys at the
prevailing exchange rate.
 If the exchange rate moved to $1 = 160 zlotys,
1. assets increase in value by 10,000 zlotys,
2. liabilities increase by 2,500 zlotys.
3. the bank’s equity would rise by 7,500 zlotys.
Example (continued): Foreign exchange risk
 If the exchange rate moved to $1 = 140
zlotys,
1.
2.
3.
assets decrease in value by 10,000
zlotys,
liabilities decrease by 2,500 zlotys
the bank’s would see stockholders’
equity decrease by 7,500 zlotys
 These same exposures exist for off-
balance sheet commitments and
guarantees when counterparties effect
Managing foreign exchange rate risk
 A bank’s risk managers analyze aggregate
foreign exchange risk by currency.
 A bank’s net balance sheet exposure in
currency j (NEXPj) is the amount of assets
minus the amount of liabilities denominated
in currency j:

NEXPj = Aj – Lj
where
Aj = assets denominated in currency j,
Lj = liabilities denominated in currency j.
 If NEXPj > 0, the bank is long on currency j
and if NEXPj < 0, the bank is short currency j.
Gain/Loss in a position
 The bank will lose if:
 it is long a currency (NEXPj > 0) and the
currency depreciates in value (the currency
buys less of another currency).
 if it is short a currency (NEXPj < 0) and the
currency appreciates in value (the currency
buys more of another currency).
 The gain/loss in a position with a currency
is indicated by:

Gain/Loss in a Position With Currency j
= NEXPj x [spot exchange rate at time t
– spot exchange rate at time t-1]
Example: gain/loss in a position
 Current (spot) exchange rate is $1 = 150
zlotys.
 Commerce Bank’s (CB) would lose if
 long U.S. dollars
 the dollar depreciates as indicated by a
movement in the exchange rate to $1 = 140
zlotys.
 Loss = [1,000 - 250] x [140 - 150]
= -7,500 zlotys
 CB would gain if
 the dollar appreciates as indicated by a
exchange rate change to $1 = 160 zlotys.
Example: forward markets
 A bank commits to buy 1 million yen,
90 days forward for $9804.
 This
means that after 90 days, the bank
pays $9804 and receives 1 million yen,
regardless of movements in exchange
rates during the 90-day period.
Forward markets: forward premium.
 Forward premium
…the forward price of a currency is higher
than its spot price, the foreign currency is
priced at a premium.
 Example:


a bank agrees to buy 1 million yen 90 days
forward for 102 yens per dollar.
If the spot rate is 105 yens per dollar, the yen
is priced at a forward premium against the
dollar.
Forward markets: forward discount.
 Forward discount
…the forward price of a currency is lower
than its spot price, the foreign currency is
priced at a discount.
 Example:

a bank agrees to buy 1 million yen 90 days
forward for 102 yens per dollar.

if the spot rate is 100 yens per dollar, the yen
is priced at a forward discount against the
dollar.
Relationship between foreign exchange rates
and interest rates.
 Arbitrage transactions between countries
guarantee that interest rate changes
produce changes in foreign exchange rates,
and vice versa.
 If the interest rate differential between
securities in two countries falls out of line
with the spot-to-forward exchange rate
differential, a covered interest arbitrage will
take place and investors will make net
profits from the series of transactions.
Continuing arbitrage will go on until prices move
back into line to eliminate the riskless return from
covered interest arbitrage.
Covered interest arbitrage
2. Convert dollars to francs at $1 = 1.7 francs
 $1,090,000
 1  0.09 (1.7)  1.7 millionfrancs
$1,009,000
 $1,000,000

1 0.09
1. Borrow dollars at 9%
3. Invest in Swiss securities yielding 10%
 $1,090,000
 1  0.09 (1.7)(1.10)  1.87 millionfrancs
$1,090,000(1.7)(1.10)
 $1,121,776
1  0.09 (1.667)
4. Sell francs for doll
ars 1 year forward at $1
= 1.667 francs
Sample Transaction: Borrow $1,000,000
1. Borrow $1,000,000 at 9%; agree to repay $1,090,000 in one year.
2. Convert $1,000,000 to 1.7 million francs in spot market at $1 = 1.7 francs.
3. Invest 1.7 million francs in 1-year security yielding 10%; will receive 1.87 million francs after 1 yea
4. Sell 1.87 million francs 1 year forward for $1,121,776 at $1 = 1.667 francs.
Net profit = $1,121,776- $1,090,000 = $ 31,776
Foreign exchange rates and interest rates
 Covered interest arbitrage
…exists when the interest rate differential
between securities in two countries is out of
line with the spot-to-forward exchange rate
differential.
 Interest rate parity
…exist when covered interest arbitrage
profit potential is eliminated.
Interest rate parity implies:
Where
i1: Annual interest rate in
Country 1.
i2: Annual interest rate in
Country 2.
1  i 2  s1,2 
s1,2: Spot exchange rate equal to


1,
the number of units of

Country 2's currency for
1  i1  f1,2 
one unit of Country 1's
currency.
or
f1,2: One-year forward exchange
rate equal to the number of
Country 2's
i 2  i1  f1,2  s1,2  units ofcurrency
for one unit

 of Country 1's currency.
1  i1

s1,2

The interest rate parity equilibrium
condition suggests that:
 The forward exchange rate differential, as a
fraction of the spot rate, should equal the
interest rate differential relative to 1 plus an
interest factor to eliminate arbitrage profits.
 Example:
 i1



is 9%,
i2 is 10%, and
s1,2 is 1.7 as in the previous example,
then f1,2 should be equal to 1.7156:
0.10  0.09  f1,2  1.7 


1  0.09
 1.7 