Managing Liquidity
1
Meeting Liquidity Needs
 Bank Liquidity
A
bank’s capacity to acquire
immediately available funds at a
reasonable price
 Firms can acquire liquidity in three
distinct ways:
1.
2.
3.
Selling assets
New borrowings
New stock issues
2
Meeting Liquidity Needs
 How effective each liquidity source is
at meeting the institution’s liquidity
needs, depends on:
 Market
conditions
 The market’s perception of risk at the
institution as well as in the
marketplace
 The market’s perception of bank
management and its strategic direction
 The current economic environment
3
Meeting Liquidity Needs
 Holding Liquid Assets
 “Cash Assets”
 Do not earn any interest
 Represents a substantial opportunity
cost for banks
 Banks attempt to minimize the amount of
cash assets held and hold only those
required by law or for operational needs
 Liquid

Assets
Can be easily and quickly converted
into cash with minimum loss
4
Meeting Liquidity Needs
 Holding Liquid Assets
 “Cash
Assets” do not generally satisfy
a bank’s liquidity needs

If the bank holds the minimum amount
of cash assets required, an unforeseen
drain on vault cash (perhaps from an
unexpected withdrawal) will cause the
level of cash to fall below the minimum
for legal and operational requirements
5
Meeting Liquidity Needs
 Holding Liquid Assets
 Banks hold cash assets to satisfy
four objectives:
1.
To meet customers’ regular
transaction needs
2.
To meet legal reserve requirements
3.
To assist in the check-payment
system
4.
To purchase correspondent banking
services
6
Meeting Liquidity Needs
 Holding Liquid Assets
 Banks own five types of liquid assets
1.
Cash and due from banks in excess of
requirements
2.
Federal funds sold and reverse
repurchase agreements
3.
Short-term Treasury and agency
obligations
4.
High-quality short-term corporate and
municipal securities
5.
Government-guaranteed loans that can
be readily sold
7
Meeting Liquidity Needs
 Borrowing Liquid Assets
 Banks
can provided for their liquidity
by borrowing
 Banks historically have had an
advantage over non-depository
institutions in that they could fund
their operations with relatively lowcost deposit accounts
8
Meeting Liquidity Needs
 Objectives of Cash Management
 Banks
must balance the desire to hold
a minimum amount of cash assets
while meeting the cash needs of its
customers
 The fundamental goal is to accurately
forecast cash needs and arrange for
readily available sources of cash at
minimal cost
9
Reserve Balances at the Federal
Reserve Bank
 Banks hold deposits at the Federal
Reserve because:
 The
Federal Reserve imposes legal
reserve requirements and deposit
balances qualify as legal reserves
 To help process deposit inflows and
outflows caused by check clearings,
maturing time deposits and securities,
wire transfers, and other transactions
10
Reserve Balances at the Federal
Reserve Bank
 Required Reserves and Monetary
Policy
 The
purpose of required reserves is to
enable the Federal Reserve to control
the nation’s money supply
 The Fed has three distinct monetary
policy tools:
Open market operations
 Changes in the discount rate
 Changes in the required reserve ratio

11
Reserve Balances at the Federal
Reserve Bank
 Required Reserves and Monetary Policy
 Example
 A required reserve ratio of 10% means that
a bank with $100 in demand deposits
outstanding must hold $10 in legal
required reserves in support of the DDAs
 The bank can thus lend out only 90% of its
DDAs

If the bank has exactly $10 in legal
reserves, the reserves do not provide the
bank with liquidity
 If the bank has $12 in legal reserves, $2 is
excess reserves, providing the bank with $2 in
immediately available funds
12
Reserve Balances at the Federal
Reserve Bank
 Impact of Sweep Accounts on
Required Reserve Balances
 Under
Reg. D, banks have reserve
requirements of 10% on demand
deposits, ATS, NOW, and other
checkable deposit (OCD) accounts
 not reservable
13
Reserve Balances at the Federal
Reserve Bank
 Impact of Sweep Accounts on
Required Reserve Balances
 MMDAs
are considered personal
saving deposits and have a zero
required reserve requirement ratio
14
Reserve Balances at the Federal
Reserve Bank
 Impact of Sweep Accounts on
Required Reserve Balances
 Sweep
accounts are accounts that
enable depository institutions to shift
funds from OCDs, which are
reservable, to MMDAs or other
accounts, which are not reservable
15
Reserve Balances at the Federal
Reserve Bank
 Impact of Sweep Accounts on Required
Reserve Balances

Sweep Accounts

Two Types
 Weekend Program
 Reclassifies transaction deposits as
savings deposits at the close of business
on Friday and back to transaction accounts
at the open on Monday
 On average, this means that for three days
each week, the bank does not need to hold
reserves against those balances
16
Reserve Balances at the Federal
Reserve Bank
 Impact of Sweep Accounts on Required
Reserve Balances

Sweep Accounts

Two Types
 Threshold Account
 The bank’s computer moves the
customer’s DDA balance into an MMDA
when the dollar amount reaches some
minimum and returns funds as needed
 The number of transfers is limited to 6 per
month, so the full amount of funds must be
moved back into the DDA on the sixth
transfer of the month
17
18
Meeting Legal Reserve
Requirements
 Required reserves can be met over a
two-week period
 There are three elements of required
reserves:
 The
dollar magnitude of base liabilities
 The required reserve fraction
 The dollar magnitude of qualifying
cash assets
19
Meeting Legal Reserve
Requirements
20
Meeting Legal Reserve
Requirements
 Historical Problems with Reserve
Requirements
 Reserve
requirements varied by type of
bank charter and by state.
 Non-Fed member banks had lower
reserve requirements than Fed member
banks
21
Meeting Legal Reserve
Requirements
 Lagged Reserve Accounting
 Computation

Consists of two one-week reporting
periods beginning on a Tuesday and
ending on the second Monday
thereafter
 Maintenance

Period
Period
Consists of 14 consecutive days
beginning on a Thursday and ending
on the second Wednesday thereafter
22
Meeting Legal Reserve
Requirements
 Lagged Reserve Accounting
 Reserve

Balance Requirements
The balance to be maintained in any
given maintenance period is measured
by:
 Reserve requirements on the reservable
liabilities calculated as of the computation
period that ended 17 days prior to the start
of the maintenance period
 Less vault cash as of the same
computation period
23
Meeting Legal Reserve
Requirements
 Lagged Reserve Accounting
 Reserve
Balance Requirements
Both vault cash and Federal Reserve
Deposits qualify as reserves
 The portion that is not met by vault
cash is called the reserve balance
requirement

24
25
26
Meeting Legal Reserve
Requirements
 An Application: Reserve Calculation
Under LRA
 Four
1.
2.
3.
4.
steps:
Calculate daily average balances
outstanding during the lagged
computation period.
Apply the reserve percentages.
Subtract vault cash.
Add or subtract the allowable reserve
carried forward from the prior period
27
28
Meeting Legal Reserve
Requirements
 Correspondent Banking Services
 System
of interbank relationships in
which the correspondent bank
(upstream correspondent) sells
services to the respondent bank
(downstream correspondent)
29
Meeting Legal Reserve
Requirements
 Correspondent Banking Services

Common Correspondent Banking Services










Check collection, wire transfer, coin and
currency supply
Loan participation assistance
Data processing services
Portfolio analysis and investment advice
Federal funds trading
Securities safekeeping
Arrangement of purchase or sale of securities
Investment banking services
Loans to directors and officers
International financial transactions
30
Meeting Legal Reserve
Requirements
 Correspondent Banking Services
 Banker’s

Bank
A firm, often a cooperative owned by
independent commercial banks, that
provides correspondent banking
services to commercial banks and not
to commercial or retail deposit and loan
customers
31
Liquidity Planning
 Short-Term Liquidity Planning
 Objective
is to manage a legal reserve
position that meets the minimum
requirement at the lowest cost
32
Liquidity Planning
33
Liquidity Planning
 Managing Float
 During any single day, more than $100
million in checks drawn on U.S.
commercial banks is waiting to be
processed
 Individuals, businesses, and governments
deposit the checks but cannot use the
proceeds until banks give their approval,
typically in several days
 Checks in process of collection, called
float, are a source of both income and
expense to banks
34
Liquidity Planning
 Liquidity versus Profitability
 There
is a short-run trade-off between
liquidity and profitability

The more liquid a bank is, the lower are
its return on equity and return on
assets, all other things equal
 In a bank’s loan portfolio, the highest
yielding loans are typically the least liquid
 The most liquid loans are typically
government-guaranteed loans
35
Liquidity Planning
 The Relationship Between Liquidity,
Credit Risk, and Interest Rate Risk

Liquidity risk for a poorly managed bank
closely follows credit and interest rate
risk


Banks that experience large deposit
outflows can often trace the source to
either credit problems or earnings
declines from interest rate gambles that
backfired
Potential liquidity needs must reflect
estimates of new loan demand and
potential deposit losses
36
Liquidity Planning
 The Relationship Between Liquidity,
Credit Risk, and Interest Rate Risk
37
Traditional Aggregate Measures
of Liquidity Risk
 Asset Liquidity Measures
 The
most liquid assets mature near
term and are highly marketable
 Any security or loan with a price above
par, in which the bank could report a
gain at sale, is viewed as highly liquid
 Liquidity measures are normally
expressed in percentage terms as a
fraction of total assets
38
Traditional Aggregate Measures
of Liquidity Risk
 Asset Liquidity Measures
 Highly Liquid Assets
 Cash and due from banks in excess of
required holdings
 Federal funds sold and reverse RPs.
 U.S. Treasury securities and agency
obligations maturing within one year
 Corporate obligations and municipal
securities maturing within one year and
rated Baa and above
 Loans that can be readily sold and/or
securitized
39
Traditional Aggregate Measures
of Liquidity Risk
 Asset Liquidity Measures
 Pledging

Requirements
Not all of a bank’s securities can be
easily sold
 Like their credit customers, banks are
required to pledge collateral against
certain types of borrowings
 U.S. Treasuries or municipals normally
constitute the least-cost collateral and, if
pledged against debt, cannot be sold until
the bank removes the claim or substitutes
other collateral
40
Traditional Aggregate Measures
of Liquidity Risk
 Asset Liquidity Measures
 Pledging

Requirements
Collateral is required against four
different liabilities:
 Repurchase agreements
 Discount window borrowings
 Public deposits owned by the U.S.
Treasury or any state or municipal
government unit
 FLHB advances
41
Traditional Aggregate Measures
of Liquidity Risk
 Asset Liquidity Measures
 Loans
 Many banks and bank analysts monitor
loan-to-deposit ratios as a general
measure of liquidity
 Loans are presumably the least liquid
of assets, while deposits are the
primary source of funds
 A high ratio indicates illiquidity
because a bank is fully loaned up
relative to its stable funding
42
Traditional Aggregate Measures
of Liquidity Risk
 Liability Liquidity Measures
 Liability
Liquidity:
The ease with which a bank can issue
new debt to acquire clearing balances
at reasonable costs
 Measures typically reflect a bank’s
asset quality, capital base, and
composition of outstanding deposits
and other liabilities

43
Traditional Aggregate Measures
of Liquidity Risk
 Liability Liquidity Measures

Commonly used measures:









Total equity to total assets
Risk assets to total assets
Loan losses to net loans
Reserve for loan losses to net loans
The percentage composition of deposits
Total deposits to total liabilities
Core deposits to total assets
Federal funds purchased and RPs to total
liabilities
Commercial paper and other short-term
borrowings to total liabilities
44
Traditional Aggregate Measures
of Liquidity Risk
 Liability Liquidity Measures
 Core

Deposits
A base level of deposits a bank expects
to remain on deposit, regardless of the
economic environment
 Volatile

Deposits
The difference between actual current
deposits and the base estimate of core
deposits
45
Longer-Term Liquidity Planning
 This stage of liquidity planning involves
projecting funds needs over the coming
year and beyond if necessary
Forecasts in deposit growth and loan
demand are required
 Projections are separated into three
categories: base trend, short-term
seasonal, and cyclical values
 The analysis assesses a bank’s liquidity
gap, measured as the difference between
potential uses of funds and anticipated
sources of funds, over monthly intervals

46
47
Longer-Term Liquidity Planning
 The bank’s monthly liquidity needs are
estimated as the forecasted change in
loans plus required reserves minus
the forecast change in deposits:
Liquidity needs = Forecasted Δloans +
ΔRequired reserves - Forecasted
Δdeposits
48
Longer-Term Liquidity Planning
49
Longer-Term Liquidity Planning
50
Longer-Term Liquidity Planning
51
Longer-Term Liquidity Planning
 Considerations in the Selection of
Liquidity Sources
The costs should be evaluated in present
value terms because interest income and
expense may arise over time
 The choice of one source over another
often involves an implicit interest rate
forecast

52
Contingency Funding
 Financial institutions must have
carefully designed contingency plans
that address their strategies for
handling unexpected liquidity crises
and outline the appropriate procedures
for dealing with liquidity shortfalls
occurring under abnormal conditions
53
Contingency Funding
 Contingency Planning
A

contingency plan should include:
A narrative section that addresses the
senior officers who are responsible for
dealing with external constituencies,
internal and external reporting
requirements, and the types of events
that trigger specific funding needs
54
Contingency Funding
 Contingency Planning
 A contingency plan should include:
 A quantitative section that assesses the
impact of potential adverse events on the
institution’s balance sheet (changes),
incorporates the timing of such events by
assigning deposit and wholesale funding
run-off rates, identifies potential sources
of new funds, and forecasts the
associated cash flows across numerous
short-term and long-term scenarios and
time intervals
55
Contingency Funding
 Contingency Planning
A

contingency plan should include:
A section that summarizes the key
risks and potential sources of funding,
identifies how the modeling will
monitored and tested, and establishes
relevant policy limits
56
Contingency Funding
 Contingency Planning
 The
institution’s liquidity contingency
strategy should clearly outline the
actions needed to provide the
necessary liquidity
 The institution’s plan must consider
the cost of changing its asset or
liability structure versus the cost of
facing a liquidity deficit
57
Contingency Funding
 Contingency Planning
 The
contingency plan should prioritize
which assets would have to be sold in
the event that a crisis intensifies
 The institution’s relationship with its
liability holders should also be
factored into the contingency strategy
 The institution’s plan should also
provide for back-up liquidity
58
The Effective Use of
Capital
59
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
60
61
Risk-Based Capital Standards
 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%
62
Risk-Based Capital Standards
 Primary Capital
 Common
stock
 Perpetual preferred stock
 Surplus
 Undivided profits
 Contingency and other capital reserves
 Mandatory convertible debt
 Allowance for loan and lease losses
63
Risk-Based Capital Standards
 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
64
Risk-Based Capital Standards
 The 1986 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 riskbased 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
Today, countries that are members of the
Organization for Economic Cooperation and
Development (OECD) enforce similar riskbased requirements on their own financial
institutions
65
Risk-Based Capital Standards
 The 1986 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
66
Risk-Based Capital Standards
 The 1986 Basel Agreement
 Minimum
capital requirement
increased to 8% total capital to riskadjusted assets
 Capital requirements were
approximately standardized between
countries to ‘level the playing field'
67
Risk-Based Capital Standards
 Risk-Based Elements of Basel I
1.
2.
3.
Classify assets into one of four risk
categories
Classify off-balance sheet commitments
into the appropriate risk categories
Multiply the dollar amount of assets in each
risk category by the appropriate risk weight

4.
This equals risk-weighted assets
Multiply risk-weighted assets by the
minimum capital percentages, currently 4%
for Tier 1 capital and 8% for total capital
68
69
Risk-Based Capital Standards
70
Risk-Based Capital Standards
71
72
73
74
75
What Constitutes Bank Capital?
 Capital (Net Worth)
 The
cumulative value of assets minus
the cumulative value of liabilities
 Represents ownership interest in a
firm
76
What Constitutes Bank Capital?
 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

77
What Constitutes 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

78
What Constitutes Bank Capital?
 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)

79
What Constitutes Bank Capital?
 Leverage Capital Ratio
 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
80
81
What Constitutes Bank Capital?
82
What Constitutes Bank Capital?
83
What Constitutes Bank Capital?
 Tier 3 Capital Requirements for Market
Risk Under Basel I
 Market

Risk
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
84
What Constitutes Bank Capital?
 Tier 3 Capital Requirements for Market
Risk Under Basel I
 Banks
subject to the market risk
capital guidelines must maintain an
overall minimum 8 percent ratio of total
qualifying capital [the sum of Tier 1
capital, Tier 2 capital, and Tier 3 capital
allocated for market risk, net of all
deductions] to risk-weighted assets
and market risk–equivalent assets
85
What Constitutes Bank Capital?
 Basel II Capital Standards
Risk-based capital standards that
encompass a three-pillar approach for
determining the capital requirements for
financial institutions
 Basel II capital standards are designed to
produce minimum capital requirements
that incorporate more types of risk than
the credit risk-based standards of Basel I


Basel II standards have not been finalized
86
What Constitutes Bank Capital?
 Basel II Capital Standards
 Pillar I
 Credit risk
 Market risk
 Operational risk
 Pillar II
 Supervisory review of capital adequacy
 Pillar III
 Market discipline through enhanced
public disclosure
87
What Constitutes Bank Capital?
 Weaknesses of the Risk-Based Capital
Standards
 Standards

only consider credit risk
Ignores interest rate risk and liquidity
risk
 Core
banks subject to the advanced
approaches of Basel II use internal
models to assess credit risk

Results of their own models are
reported to the regulators
88
What Constitutes Bank Capital?
 Weaknesses of the Risk-Based Capital
Standards
 The new risk-based capital rules of Basel II
are heavily dependent on credit ratings,
which have been extremely inaccurate in the
recent past
 Book value of capital is often not meaningful
since It ignores:



changes in the market value of assets
unrealized gains (losses) on held-to-maturity
securities
97% of banks are considered “well
capitalized” in 2007

Not a binding constraint for most banks
89
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

90
What is the Function of Bank
Capital
91
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 lower-risk banks should
be allowed to increase financial
leverage
92
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 2
ΔTA/TA 1 
EQ1/TA 1
 where





TA = Total Assets
EQ = Equity Capital
ROA = Return on Assets
DR = Dividend Payout Ratio
EC = New External Capital
93
94
The Effect of Capital Requirements
on Bank Operating Policies
 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
95
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

96
Characteristics of External
Capital Sources
 Subordinated Debt
 Disadvantages
Does not qualify as Tier 1 capital
 Interest and principal payments are
mandatory
 Many issues require sinking funds

97
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

98
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

99
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
adjustable-rate perpetual stock
100
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
101
Characteristics of External
Capital Sources
 TARP Capital Purchase Program
 The
Troubled Asset Relief Program’s
Capital Purchase Program (TARPCPP), allows financial institutions to
sell preferred stock that qualifies as
Tier 1 capital to the Treasury

Qualified institutions may issue senior
preferred stock equal to not less than
1% of risk-weighted assets and not
more than the lesser of $25 billion, or
3%, of risk-weight assets
102
103
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
104
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
105
Capital Planning
 Application
 Consider a bank that has exhibited a
deteriorating profit trend
 Assume as well that federal regulators
who recently examined the bank indicated
that the bank should increase its primary
capital-to-asset ratio to 8.5% within four
years from its current 7%
 The $80 million bank reported an ROA of
just 0.45 percent
 During each of the past five years, the
bank paid $250,000 in common dividends
106
Capital Planning
 Application
 Consider
a bank that has exhibited a
deteriorating profit trend

The following slide extrapolates
historical asset growth of 10%
 Under this scenario, the bank will actually
see its capital ratio fall

The following slide also identifies three
different strategies for meting the
required 8.5% capital ratio
107
108
Depository Institutions 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
109
Depository Institutions Capital
Standards
 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
110
Depository Institutions Capital
Standards
111
112
Federal Deposit Insurance
 Federal Deposit Insurance Corporation
 Established
in 1933
 Coverage is currently $100,000 per
depositor per institution

Original coverage was $2,500
113
Federal Deposit Insurance
 Federal Deposit Insurance Corporation
 Initial
Objective:
Prevent liquidity crises caused by
large-scale deposit withdrawals
 Protect depositors of modes means
against a bank failure

114
Federal Deposit Insurance
 Federal Deposit Insurance Corporation
 The
Financial Institution Reform,
Recovery and Enforcement Act of 1989
authorized the issuance of bonds to
finance the bailout of the FSLIC

The act also created two new insurance
funds, the Savings Association
Insurance Fund (SAIF) and the Bank
Insurance Fund (BIF); both were
controlled by the FDIC
115
Federal Deposit Insurance
 Federal Deposit Insurance Corporation

The large number of failures in the late 1980s
and early 1990s depleted the FDIC fund



During 1991 - 92, the FDIC ran a deficit and
had to borrow from the Treasury
In 1991 FDIC began charging risk-based
deposit insurance premiums ranging from
$0.23 to $0.27 per $100, depending on a
bank’s capital position.
By 1993, the reduction in bank failures and
increased premiums allowed the FDIC to pay
off the debt and put the fund back in the black
116
Federal Deposit Insurance
117
Federal Deposit Insurance
 FDIC Insurance Assessment Rates



FDIC insurance premiums are assessed
using a risk-based deposit insurance system
Deposit insurance assessment rates are
reviewed semiannually by the FDIC to ensure
that premiums appropriately reflect the risks
posed to the insurance funds and that fund
reserve ratios are maintained at or above the
target designated reserve ratio (DRR) of
1.25% of insured deposits
Deposit insurance premiums are assessed
as basis points per $100 of insured deposits
118
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
 FDIC Improvement Act
 Merged the BIF and SAIF into the
Deposit Insurance Fund (DIF)
 Increasing coverage for retirement
accounts to $250,000 and indexing the
coverage to inflation
 Established a range of 1.15% to 1.50%
within which the FDIC Board of
Directors may set the Designated
Reserve Ratio (DRR)
119
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
120
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
 Subgroup
A
Financially sound institutions with only
a few minor weaknesses
 This subgroup assignment generally
corresponds to the primary federal
regulator’s composite rating of “1” or
“2”

121
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
 Subgroup
B
Institutions that demonstrate
weaknesses that, if not corrected,
could result in significant deterioration
of the institution and increased risk of
loss to the BIF or SAIF
 This subgroup assignment generally
corresponds to the primary federal
regulator’s composite rating of “3”

122
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
 Subgroup
C
Institutions that pose a substantial
probability of loss to the BIF or the
SAIF unless effective corrective action
is taken
 This subgroup assignment generally
corresponds to the primary federal
regulator’s composite rating of “4” or
“5”

123
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
124
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
125
Federal Deposit Insurance
 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

126
Federal Deposit Insurance
 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
127
Federal Deposit Insurance
 Problems With Deposit Insurance
 Moral

Hazard
A lack of incentives that would
encourage individuals to protect or
mitigate against risk
 In some cases of moral hazard, incentives
are created that would actually increase
risk-taking behavior
128
Federal Deposit Insurance
 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
129
Federal Deposit Insurance
 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 the same $250,000 coverage as
smaller banks do
130
Federal Deposit Insurance
 Weakness of the Current Risk-Based Deposit
Insurance System
 Risk-based deposit system is based on
capital and risk


Hence, banks that hold higher capital,
everything else being equal, pay lower
premiums
“Too Big to Fail”

The FDIC must follow the “least cost”
alternative in the resolution of a failed bank.
Consequently, the FDIC must consider all
alternatives and choose the one that
represents the lowest cost to the insurance
fund
131
Managing the
Investment Portfolio
132
Managing 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
133
Managing 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
134
Managing 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
135
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
136
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
137
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
138
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
139
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
140
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
141
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

142
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
143
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
144
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
145
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
146
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
147
Objectives of the Investment
Portfolio
148
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
149
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
150
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
151
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
152
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
153
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

154
155
Characteristics of Taxable
Securities
 Money Market Investments
 Highly
liquid instruments which mature
within one year that are issued by
governments and large corporations
 Very low risk as they are issued by
well-known borrowers and a active
secondary market exists
156
Characteristics of Taxable
Securities
 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

157
Characteristics of Taxable
Securities
 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
158
Characteristics of Taxable
Securities
 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
159
Characteristics of Taxable
Securities
 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
160
Characteristics of Taxable
Securities
 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:

where




FV  P 360
DR 

FV
N
DR = Discount Rate
FV = Face Value
P = Purchase Price
N = Number of Days to Maturity
161
Characteristics of Taxable
Securities
 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%
162
Characteristics of Taxable
Securities
 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

163
Characteristics of Taxable
Securities
 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

164
Characteristics of Taxable
Securities
 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

165
Characteristics of Taxable
Securities
 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

166
Characteristics of Taxable
Securities
 Capital Market Investments
 Consists
of instruments with original
maturities greater than one year
 Banks are restricted to “investment
grade” securities
 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
167
Characteristics of Taxable
Securities
 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

168
Characteristics of Taxable
Securities
 Capital Market Investments
 Treasury

STRIPS
Many banks purchase zero-coupon
Treasury securities as part of their
interest rate risk management
strategies
169
Characteristics of Taxable
Securities
 Capital Market Investments
 Treasury

STRIPS
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
170
Characteristics of Taxable
Securities
 Capital Market Investments
 Treasury

STRIPS
Each component interest or principal
payment constitutes a separate zero
coupon security and can be traded
separately from the other payments
171
Characteristics of Taxable
Securities
 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)
172
Characteristics of Taxable
Securities
 Capital Market Investments
 Treasury

STRIPS Example
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
173
Characteristics of Taxable
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)
174
Characteristics of Taxable
Securities
 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)
175
Characteristics of Taxable
Securities
 Capital Market Investments
 U.S.
Government Agency Securities
 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.
176
Characteristics of Taxable
Securities
 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
177
Characteristics of Taxable
Securities
 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
178
Characteristics of Taxable
Securities
 Capital Market Investments
 Callable

Agency Bonds
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
179
Characteristics of Taxable
Securities
 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
180
Characteristics of Taxable
Securities
 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
181
182
Characteristics of Taxable
Securities
 Capital Market Investments
 FHLMC

Federal Home Loan Mortgage
Corporation (Freddie Mac)
 FNMA

securities
Federal National Mortgage Association
(Fannie Mae)
183
Characteristics of Taxable
Securities
 Capital Market Investments
 Both
are:
Private corporations
 Operate with an implicit federal
guarantee
 Buy mortgages financed largely by
mortgage-backed securities

184
Characteristics of Taxable
Securities
 Capital Market Investments
 Privately

Issued Pass-Through
Issued by banks and thrifts, with
private insurance rather than
government guarantee
185
Prepayment Risk on MortgageBacked Securities
 Borrowers may prepay the
outstanding mortgage principal at any
point in time for any reason
 Prepayments typically increase as
interest rates fall and slow as rates
increase
 Forecasting prepayments is not an
exact science
186
Prepayment Risk on MortgageBacked 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
187
188
Prepayment Risk on MortgageBacked Securities
 Alternative 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
189
Prepayment Risk on MortgageBacked Securities
 Alternative Mortgage-Backed
Securities
 Collateralized
Mortgage Obligations
(CMOs)

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
190
Prepayment Risk on MortgageBacked Securities
 Alternative 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

191
Prepayment Risk on MortgageBacked Securities
 Alternative 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
192
Prepayment Risk on MortgageBacked Securities
 Alternative Mortgage-Backed Securities

Collateralized Mortgage Obligations
(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
193
Alternative Mortgage-Backed
Securities
 Alternative Mortgage-Backed
Securities
 Collateralized
Mortgage Obligations
(CMOs)

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
194
Prepayment Risk on MortgageBacked Securities
 Alternative Mortgage-Backed Securities

Collateralized Mortgage Obligations
(CMOs)

CMOs’ Advantages over MBS PassThroughs
 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
195
Prepayment Risk on MortgageBacked Securities
 Alternative 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
196
Prepayment Risk on MortgageBacked Securities
 Alternative Mortgage-Backed
Securities
 Stripped

Mortgage-Backed Securities
Example:
 There will be 30 x 12 (360) payments
(principal plus interest)
197
Prepayment Risk on MortgageBacked Securities
 Alternative Mortgage-Backed
Securities
 Stripped

Mortgage-Backed Securities
Example:
 Loan amortization means the principal only
payments are smaller in the beginning:
P1 < P2 < … < P360
 Interest only payments decrease over time:
I1 > I2 > … > I360
198
Prepayment Risk on MortgageBacked Securities
 Corporate, Foreign Bonds, and
Taxable Municipal Bonds
 In
mid-2008, banks held $563 billion in
corporate and foreign bonds, which
was almost more than triple their
holdings of municipals
199
Prepayment Risk on MortgageBacked Securities
 Corporate, Foreign Bonds, and
Taxable Municipal Bonds
 By
regulation, banks can invest no
more than 10% of capital in the
securities of any single firm
200
Prepayment Risk on MortgageBacked Securities
 Corporate, Foreign Bonds, and
Taxable Municipal Bonds
 In
most cases, banks purchase
securities that mature within 10 years
 Occasionally, banks also purchase
municipal bonds that pay taxable
interest
201
202
Prepayment Risk on MortgageBacked Securities
 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
203
Prepayment Risk on MortgageBacked Securities
 Asset-Backed Securities
 Two
popular asset-backed securities
are:
Collateralized automobile receivables
(CARS)
 CARDS

 Securities backed by credit card loans to
individuals
204
Prepayment Risk on MortgageBacked Securities
 Asset-Backed Securities
 Collateralized

Debt Obligations
Securitized interests in pools of assets,
typically bank loans and/or bonds
 When the underlying collateral is loans or
bonds, these securities are labeled CLOs
or CBOs, respectively
205
Prepayment Risk on MortgageBacked Securities
 Asset-Backed Securities
 Collateralized
Debt Obligations
As with CMOs, the originator creates
tranches, typically labeled senior,
mezzanine, or subordinated (or equity)
 Promised payments go initially to
service senior debt followed by
mezzanine and subordinated debt,
respectively

206
Prepayment Risk on MortgageBacked Securities
 Asset-Backed Securities
 Mutual

Funds
Banks have increased their holdings in
mutual funds to over $75 billion in 2008
 Mutual fund investments must be markedto-market and can cause volatility on the
values reported on the bank’s balance
sheet
207
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
208
Characteristics of Municipal
Securities
 Revenue

Bonds
Backed by revenues generated from
the project the bond proceeds are used
to finance
 Industrial

Development Bonds
Expenditures of private corporations
209
210
Characteristics of Municipal
Securities
 Money Market Municipals
 Municipal

Provide operating funds for
government units
 Tax

Notes
and Revenue Anticipation Notes
Issued in anticipation of tax receipts or
other revenue generation
211
Characteristics of Municipal
Securities
 Money Market Municipals
 Bond

Anticipation Notes
Provide interim financing for capital
projects that will ultimately financed
with long-term bonds
 Project

Notes
Used to finance urban renewal, local
neighborhood development , and lowincome housing
212
Characteristics of Municipal
Securities
 Money Market Municipals
 Tax-Exempt

Commercial Paper
issued by the largest municipalities,
which regularly need blocks of funds in
$1 million multiples for operating
purposes
 Because only large, well-known borrowers
issue this paper, yields are below those
quoted on comparably rated municipal
notes
213
Characteristics of Municipal
Securities
 Money Market Municipals
 Banks
buy large amounts of short-term
municipals

They often work closely with
municipalities in placing these
securities
214
Characteristics of Municipal
Securities
 Capital Market Municipals
 General
Obligation Bonds
Interest and principal payments are
backed by the full faith, credit, and
taxing power of the issuer
 This backing represents the strongest
commitment a government can make in
support of its debt

215
Characteristics of Municipal
Securities
 Capital Market Municipals
 Revenue

Bonds
Issued to finance projects whose
revenues are the primary source of
repayment
 Banks buy both general obligation and
revenue bonds
 The
only restriction is that the bonds
be investment grade or equivalent
216
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), Jefferson
County, AL (2008)
217
Characteristics of Municipal
Securities
 Liquidity Risk
 Municipals
exhibit substantially lower
liquidity than Treasury or agency
securities
218
Characteristics of Municipal
Securities
 Liquidity Risk
 The secondary market for municipals
is fundamentally an over-the-counter
market
 Small, non-rated issues trade
infrequently and at relatively large bidask dealer spreads
 Large issues of nationally known
municipalities, state agencies, and
states trade more actively at smaller
spreads
219
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
220
Characteristics of Municipal
Securities
 Liquidity Risk
 Municipals
are less volatile in price
than Treasury securities

This is generally attributed to the
peculiar tax features of municipals
221
Characteristics of Municipal
Securities
 Liquidity Risk
 The municipal market is segmented
 On the supply side, municipalities cannot
shift between short- and long-term
securities to take advantage of yield
differences because of constitutional
restrictions on balanced operating budgets
 Thus long-term bonds cannot be
substituted for short-term municipals to
finance operating expenses, and
 Capital expenditures are not financed
by ST securities
222
Characteristics of Municipal
Securities
 Liquidity Risk
 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
 Municipals
are less volatile in price
than Treasury securities
223
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
224
Establishing Investment Policy
Guidelines
 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
225
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
226
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
227
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
228
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
229
Active Investment Strategies
 Advantage is that active portfolio
managers can earn above-average
returns by capturing pricing
discrepancies in the marketplace
 Disadvantages:
 Managers
must consistently out
predict the market for the strategies to
be successful
 High transactions costs
230
Active Investment Strategies
 The Maturity or Duration Choice for
Long-Term Securities
 The
optimal maturity or duration is
possibly the most difficult choice
facing portfolio managers
 It is very difficult to outperform the
market when forecasting interest rates
231
Active Investment Strategies
 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

232
Active Investment Strategies
 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

233
Active Investment Strategies
 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
234
Active Investment Strategies
 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
235
236
Active Investment Strategies
 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
237
Active Investment Strategies
 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
238
239
Active Investment Strategies
 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
240
Active Investment Strategies
 Passive Strategies Over the Business
Cycle
 Once
these primary liquidity reserves
are established, banks invest any
residual funds in long-term securities
that are less liquid but offer higher
yields
241
Active Investment Strategies
 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
242
Active Investment Strategies
 Passive Strategies Over the Business
Cycle
 Banks
employing this strategy add to
their secondary reserve by buying
long-term securities near the low point
in the interest rate cycle

Long-term rates are typically above
short-term rates, but all rates are
relatively low
243
Active Investment Strategies
 Passive Strategies Over the Business
Cycle
 With
a buy and hold orientation, these
banks lock themselves into securities
that depreciate in value as interest
rates move higher
244
Active Investment Strategies
 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

245
Active Investment Strategies
 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
246
Active Investment Strategies
 Active Strategies Over the Business
Cycle

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
247
The Impact of Interest Rates on the Value
of Securities with Embedded Options
 Issues for Securities with Embedded
Options
 Callable
agency securities or
mortgage-backed securities have
embedded options
248
The Impact of Interest Rates on the Value
of Securities with Embedded Options
 Issues for Securities with 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?

249
250
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) 
251
252
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
253
The Roles of Duration and Convexity
in Analyzing Bond Price Volatility
 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
254
The Roles of Duration and Convexity
in Analyzing Bond Price Volatility
 Convexity
 The
rate of change in duration when
yields change
 It attempts to improve upon duration
as an approximation of price
ΔPrice Due to Convexity  Convexity(i2 )Price
 This
is positive feature for buyers of
bonds because as yields decline, price
appreciation accelerates
255
The Roles of Duration and Convexity
in Analyzing Bond Price Volatility
 Convexity
 As
yields increase, duration for option
free bonds decreases, 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
256
Impact of Prepayments on Duration
and Yield for Bonds with Options
 Embedded options affect the
estimated duration and convexity of
securities
257
Impact of Prepayments on Duration
and Yield for Bonds with Options
 Prepayments will affect the duration of
mortgage-backed securities

Market participants price mortgagebacked 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

258
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
259
Impact of Prepayments on Duration
and Yield for Bonds with Options
 Positive and Negative Convexity
 Option-free securities exhibit positive
convexity because as rates increase, the
percentage price decline is less than the
percentage price increase associated with
the same rate decline
 Securities with embedded options may
exhibit negative convexity
 The percentage price increase is less than
the percentage price decrease for equal
negative and positive changes in rates
260
Impact of Prepayments on Duration
and Yield for Bonds with Options
 Effective Duration and Effective
Convexity
Both are used to estimate a security’s price
sensitivity when the security contains embedded
options
P -P
Effective Duration  i-  iP0 (i  i )
Pi-  Pi  2P *
Effective Convexity 
P * [0.5(i  i- )]2
Where:
Pi- = price if rates fall
+ =initial market rate plus
i
Pi+ = price if rates rise
the increase in rate
P0 = initial (current) price
i- = initial market rate minus
the decrease in rate 261
P* = initial price

Impact of Prepayments on Duration
and Yield for Bonds with Options
 Effective Duration and Effective
Convexity
 Example:

Consider a GNMA pass-through which
has 28-years and 4-months weighted
average maturity
 The MBS is initially priced at 102 and
17/32nds to yield 6.912%, at 258 PSA
 At this price and PSA, MBS has an
estimated average life of 5.57 years and a
modified duration of 4.01 years
262
Impact of Prepayments on Duration
and Yield for Bonds with Options
 Effective Duration and Effective
Convexity
 Example:

Assume a 1% decline in rates will
accelerate prepayments and lead to a
price of 102 while a 1% increase will slow
prepayments and produce a price of 103
263
Impact of Prepayments on Duration
and Yield for Bonds with Options
 Effective Duration and Effective
Convexity
 Example:

The effective duration and convexity for
this security are thus:
 Effective GNMA duration
= [102-103]/ 102.53125x(.05921 .07921)
= -0.4877 years
 Effective GNMA convexity
= [102+103-2 x
(102.53125)]÷102.53125[0.52(.02)2]
= -6.096 years
264
Total Return and Option-Adjusted Spread
Analysis of Securities with Options
 Total Return Analysis
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
 An
265
Total Return and Option-Adjusted Spread
Analysis of Securities with Options
 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

266
Total Return and Option-Adjusted Spread
Analysis of Securities with Options
 Total Return Analysis
 When
rates rise
Borrowers prepay slower
 Coupon income increases
 Reinvestment income increases
 The price at sale may rise or fall

267
268
Total Return and Option-Adjusted Spread
Analysis of Securities with Options
 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
269
Total Return and Option-Adjusted Spread
Analysis of Securities with Options
 Option-Adjusted Spread
 OAS represents the incremental yield
earned by investors from a security with
options over the Treasury spot curve,
after accounting for when and at what
price the embedded options will be
exercised
 OAS analysis is one procedure to
estimate how much an investor is being
compensated for selling an option to the
issuer of a security with options
 OAS is often calculated as an incremental
yield relative to the LIBOR swap curve
270
Total Return and Option-Adjusted Spread
Analysis of Securities with Options
 Option-Adjusted Spread
 The
approach starts with estimating
Treasury spot rates (zero coupon
Treasury rates) using a probability
distribution and Monte Carlo
simulation, identifying a large number
of possible interest rate scenarios over
the time period that the security’s cash
flows will appear
271
Total Return and Option-Adjusted Spread
Analysis of Securities with Options
 Option-Adjusted Spread
 The
analysis then assigns probabilities
to various cash flows based on the
different interest rate scenarios
 For mortgages, one needs a
prepayment model and for callable
bonds, one needs rules and prices
indicating when the bonds will be
called and at what values
272
273
274
Comparative Yields on Taxable
versus Tax-Exempt Securities
 Interest on most municipal securities is
exempt from federal income taxes and,
depending on state law, from state
income taxes
Some states exempt all municipal interest
 Most states selectively exempt interest
from municipals issued in-state but tax
interest on out-of-state issues
 Other states either tax all municipal
interest or do not impose an income tax

275
Comparative Yields on Taxable
versus Tax-Exempt 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
276
Comparative Yields on Taxable
versus Tax-Exempt 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
277
Comparative Yields on Taxable
versus Tax-Exempt 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
278
Comparative Yields on Taxable
versus Tax-Exempt Securities
 After-Tax and Tax-Equivalent Yields
 Example

Let:
Rm = 5.75%
Rt
= 7.50%
Marginal Tax Rate
= 34%
279
Comparative Yields on Taxable
versus Tax-Exempt Securities
 After-Tax and Tax-Equivalent Yields
 Example

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
280
Comparative Yields on Taxable
versus Tax-Exempt Securities
 After-Tax and Tax-Equivalent Yields

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
281
Comparative Yields on Taxable
versus Tax-Exempt Securities
 After-Tax and Tax-Equivalent Yields
 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

282
Comparative Yields on Taxable
versus Tax-Exempt Securities
 After-Tax and Tax-Equivalent Yields
 Example
 Let:
Rm
= 5.75%
Rt
= 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%
283
Comparative Yields on Taxable
versus Tax-Exempt Securities
 After-Tax and Tax-Equivalent Yields
 Municipals

and State & Local Taxes
The analysis is complicated somewhat
when state and local taxes apply to
municipal securities:

m 
R m (t  t ) R t [1  (t  t m )]
284
Comparative Yields on Taxable
versus Tax-Exempt Securities
 After-Tax and Tax-Equivalent Yields
 Municipals
and State & Local Taxes
Many analysts compare securities on a
pre-tax basis
 To compare municipals on a tax
equivalent basis (pre-tax):

R m (t  t m )
Tax  Equivalent Yield 
1  (t m  t)
285
Comparative Yields on Taxable
versus Tax-Exempt Securities
 The Yield Comparison for Commercial Banks

Assume a bank portfolio manager wants to
compare potential returns between a taxable
security and a municipal security that
currently yield 10% and 8%, respectively


Both securities are new issues trading at
$10,000 par with identical maturities, call
treatment, and default risk
The primary difference is that the bank pays
federal income taxes at a 34% marginal rate
on the taxable security while municipal
interest is entirely exempt
286
Comparative Yields on Taxable
versus Tax-Exempt Securities
 The Yield Comparison for Commercial
Banks
 The
portfolio manager would earn
more in after-tax interest from buying
the municipal
8%(1 − 0) = 8% > 10%(1 − 0.34) = 6.6%
287
288
Comparative Yields on Taxable
versus Tax-Exempt Securities
 The Effective Tax on Incremental
Municipal Interest Earned by
Commercial Banks
 Prior
to 1983, banks could deduct the
full amount of interest paid on
liabilities used to finance the purchase
of muni's
 After 1983 15% was not deductible and
after 1984 20% was not deductible
289
Comparative Yields on Taxable
versus Tax-Exempt Securities
 The Effective Tax on Incremental
Municipal Interest Earned by
Commercial Banks
 The
1986 tax reform act made 100% not
deductible except for qualified muni's,
small issue (less than $10 million)
 The loss of interest expense
deductibility is like an implicit tax on
the bank's holding of municipal
securities
290
Comparative Yields on Taxable
versus Tax-Exempt Securities
 The Effective Tax on Incremental
Municipal Interest Earned by
Commercial Banks
 To
calculate after tax yields on muni's,
if interest expense is not fully
deductible, calculate the bank’s
effective tax rate on municipals (tm):
t muni 
 Pooled 
 %not  
  state and local income tax rate
tr  

interest
 

Deductable

  cost 


R muni
291
Comparative Yields on Taxable
versus Tax-Exempt Securities
 Example:
 Assume
t =34%,
 20% Not Deductible
 7.5% Pooled Interest Cost
 Rmuni = 7%.

t muni
(0.34)  (0.20)  (0.075)

 0  6.38%
0.08
at
R muni
 8.0  (1  0.0638)  7.49%
292
The Impact of the Tax Reform
Act of 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
293
The Impact of the Tax Reform
Act of 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
294
The Impact of the Tax Reform
Act of 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)
295
The Impact of the Tax Reform
Act of 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%
296
The Impact of the Tax Reform
Act of 1986
 Example:
t muni
(0.34)  (1.00)  (0.075)

 0  31.88%
0.08
at
R muni
 8.0  (1  0.3188)  5.45%
297
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
298
Strategies Underlying Security
Swaps
 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
299
300
Strategies Underlying Security
Swaps
 Security Swap Example
 Tax
Savings:
= (2,000,000 - 1,926,240) * 0.35 = 25,816
 After
Tax Proceeds
= 1,926,240 + 25,816 = 1,952,056
 Present
Value of the Difference:
14,075  47,944  14,075
PV  

 $35,380
t
6
1.061
t 1 1.061
6
301
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
302
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
303