GESTIÓN BANCARIA
Master en Banca y Finanzas
Cuantitativas (QF), 2007
Santiago Carbó Valverde
Universidad de Granada
TEMA 1
LA INDUSTRIA DE SERVICIOS FINANCIEROS: LAS
ENTIDADES DE DEPÓSITO
TEMA 2
¿POR QUÉ SON ESPECIALES LOS INTERMEDIARIOS
BANCARIOS?
TEMA 3
GOBIERNO Y ESTRUCTURA ORGANIZATIVA DE LA BANCA
TEMA 4
LA INTERMEDIACIÓN FINANCIERA: LA ACTIVIDAD
CREDITICIA
TEMA 5
TÉCNICAS DE CONCESIÓN DE CRÉDITO: SCREENING,
CREDIT SCORING Y MONITORING
TEMA 6
EL RIESGO DE CRÉDITO: RIESGO EN LOS PRÉSTAMOS
INDIVIDUALES Y EN CARTERA DE CRÉDITO
TEMA 7
EL RIESGO DE TIPO DE INTERÉS: MODELOS DE
MADURACIÓN, DE DURACIÓN Y DE “REPRICING”
TEMA 8
EL RIESGO DE MERCADO
TEMA 9
EL RIESGO DE LIQUIDEZ
2
 Santiago Carbó Valverde
Universidad de Granada
scarbo@ugr.es
Materiales docentes en:
http://www.ugr.es/local/scarbo
3
 Esquema de trabajo:
 Transparencias en inglés
 Presentaciones de papers en clase
 Examen final
 Referencia básica:
SAUNDERS, A. Y M.M. CORNETT (2000):
FINANCIAL INSTITUTIONS MANAGEMENT: A
MODERN PERSPECTIVE, 4ª EDICIÓN,
MCGRAW HILL, NEW YORK, ESTADOS
UNIDOS.
4
Tema 1
LA INDUSTRIA DE SERVICIOS
FINANCIEROS: LAS ENTIDADES DE
DEPÓSITO
Why study Financial Markets and
Institutions?
 They are the cornerstones of the overall
financial system in which financial
managers operate
 Individuals use both for investing
 Corporations and governments use both
for financing
7
Overview of Financial Markets
 Primary Markets versus
Secondary Markets
 Money Markets versus Capital
Markets
 Foreign Exchange Markets
8
Primary Markets versus
Secondary Markets
 Primary Markets
 markets in which users of funds (e.g.
corporations, governments) raise
funds by issuing financial instruments
(e.g. stocks and bonds)
 Secondary Markets
 markets where financial instruments
are traded among investors (e.g.
Bolsa Madrid, NYSE, NASDAQ)
9
Money Markets versus Capital
Markets
 Money Markets
 markets that trade debt securities with
maturities of one year or less (e.g.
Spanish Government bonds, U.S.
Treasury bills)
 Capital Markets
 markets that trade debt (bonds) and
equity (stock) instruments with
maturities of more than one year
10
Money Market Instruments Outstanding,
1990-1999 ($Bn)
1400
1200
1000
800
600
400
200
0
1990
Commercial paper
U.S. T-bills
1995
1999
Fed Funds and Repo
Banker's accept.
11
Capital Market Instruments Outstanding,
1990-1999 ($Bn)
20000
15000
10000
5000
0
1990
Corp. stocks
Comm/farm mort.
Treas. Sec.
U.S. gov owned agencies
Bank and consumer loans
1995
1999
Res. Mortgages
Corp. bonds
St. & Loc. Gov. bonds
U.S. gov sponsored agencies
12
Foreign Exchange Markets
 “FX” markets deal in trading one currency for
another (e.g. dollar for yen)
 The “spot” FX transaction involves the immediate
exchange of currencies at the current exchange
rate
 The “forward” FX transaction involves the
exchange of currencies at a specified date in the
future and at a specified exchange rate
13
Overview of Financial
Institutions (FIs)
 Institutions that perform the essential function
of channeling funds from those with surplus
funds to those with shortages of funds (e.g.
banks, thrifts, insurance companies, securities
firms and investment banks, finance companies,
mutual funds, pension funds)
14
Flow of Funds in a World without
FIs: Direct Transfer
Financial Claims
(Equity and debt
instruments)
Suppliers of
Funds
(Households)
Users of Funds
(Corporations)
Cash
Example: A firm sells shares directly to investors without going
through a financial institution
15
Flow of Funds in a world with
FIs: Indirect transfer
FI
(Brokers)
Users of Funds
Suppliers of Funds
FI
(Asset
transformers)
Financial Claims
(Equity and debt securities)
Financial Claims
(Deposits and Insurance policies)
16
Types of FIs
 Commercial banks
 depository institutions whose major assets are
loans and major liabilities are deposits
 Thrifts and savings banks
 depository institutions in the form of savings banks,
savings and loans, credit unions, credit
cooperatives
 Insurance companies
 financial institutions that protect individuals and
corporations from adverse events
(continued)
17
 Securities firms and investment banks
 financial institutions that underwrite
securities and engage in securities
brokerage and trading
 Finance companies
 financial institutions that make loans to
individuals and businesses
 Mutual Funds
 financial institutions that pool financial
resources and invest in diversified
portfolios
 Pension Funds
 financial institutions that offer savings
plans for retirement
18
Services Performed by Financial
Intermediaries
 Monitoring Costs
 aggregation of funds provides greater
incentive to collect a firm’s information
and monitor actions
 Liquidity and Price Risk
 provide financial claims to savers with
superior liquidity and lower price risk
19
(continued)
 Transaction Cost Services
 transaction costs are reduced through
economies of scale
 Maturity Intermediation
 greater ability to bear risk of mismatching
maturities of assets and liabilities
 Denomination Intermediation
 allow small investors to overcome
constraints imposed to buying assets
imposed by large minimum denomination
size
20
Services Provided by FIs
Benefiting the Overall Economy
 Money Supply Transmission
 Depository institutions are the conduit
through which monetary policy actions
impact the economy in general
 Credit Allocation
 often viewed as the major source of
financing for a particular sector of the
economy (e.g. farming and real estate)
(continued) 21
Services Provided by FIs Benefiting
the Overall Economy
 Intergenerational Wealth Transfers
 life insurance companies and pension
funds provide savers with the ability to
transfer wealth from one generation to
the next
 Payment Services
 efficiency with which depository
institutions provide payment services
directly benefits the economy
22
Risks Faced by Financial Institutions










Interest Rate Risk
Foreign Exchange Risk
Market Risk
Credit Risk
Liquidity Risk
Off-Balance-Sheet Risk
Technology Risk
Operation Risk
Country or Sovereign Risk
Insolvency Risk
23
Regulation of Financial
Institutions
 FIs provide vital financial services to all sectors
of the economy; therefore, their regulation is
in the public interest
 In an attempt to prevent their failure and the
failure of financial markets overall
24
Globalization of Financial Markets
and Institutions
 Financial Markets became more global as the
value of stocks traded in foreign markets
soared
 Foreign bond markets have served as a major
source of international capital
 Globalization also evident in the derivative
securities market
25
Factors Leading to Significant Growth in
Foreign Markets
 The pool of savings from foreign investors has
increased
 International investors have turned to U.S. and
other markets to expand their investment
opportunities
 Information on foreign investments and markets
is now more accessible (e.g. internet)
 Some mutual funds allow ability to invest in
foreign securities with low transaction costs
 Deregulation has enhanced globalization of capital
flows
26
Tema 2
¿POR QUÉ SON ESPECIALES LOS
INTERMEDIARIOS BANCARIOS?
Why Are Financial
Intermediaries Special?
 Objectives:
 Develop the tools needed to measure
and manage the risks of FIs.
 Explain the special role of FIs in the
financial system and the functions they
provide.
 Explain why the various FIs receive
special regulatory attention.
 Discuss what makes some FIs more
special than others.
28
Without FIs
Equity & Debt
Households
Corporations
(net savers)
(net borrowers)
Cash
29
FIs’ Specialness
 Without FIs: Low level of fund flows.
 Information costs:
 Economies of scale reduce costs for FIs to
screen and monitor borrowers
 Less liquidity
 Substantial price risk
30
With FIs
FI
Households
Cash
(Brokers)
FI
Corporations
Equity & Debt
(Asset
Transformers)
Deposits/Insurance
Policies
Cash
31
Financial Structure Puzzles: a
way to explain the role of FIs
 stocks are not the most important source of external
financing for businesses
 issuing debt and equity is not the main way that
businesses finance operations
 indirect financing is more important than direct financing
 banks are the most important source of external funds
for businesses
 financial industry is one of the most heavily regulated
industries
 only large, well-known firms have access to the
securities markets
 collateral is an important part of debt contracts for
businesses and households
 debt contracts are complex and often contain many
restrictions for the borrower
32
Transaction Costs
 information and other transaction costs in
financial system can be substantial
 How do transaction costs affect investing?
 How can financial intermediaries reduce
transaction costs?
33
Asymmetric Information
 one party to a transaction has better
information to make decisions than
the other party
 asymmetric information in financial
market causes two main problems
 adverse selection
 moral hazard
34
Adverse Selection
 asymmetric information problem that
occurs prior to a transaction
 examples of adverse selection
 result of adverse selection is that
lenders may decide not to make loans
if they can not distinguish between
“good” and “bad” credit risks
35
Moral Hazard
 asymmetric information problem that
occurs after a transaction
 risk that borrower will undertake risky
activities that will increase the
probability of default
 result of moral hazard is that lenders
may decide not to make a loan
36
Lemons Problem
 idea presented in article by George Akerlof
in terms of lemons in used car market
 used car buyers are unable to determine
quality of car - good car or lemon?
 What amount is buyer willing to pay for
this used car of unknown quality?
 How can buyer improve information on
quality?
37
Lemons Problem in Stock and Bond
Market
 asymmetric information prevents investors from
identifying good and bad firms
 What price will these investors pay for stock?
 Who has better information about the firm?
 Which firms will “come to the market” for financing
under these conditions?
38
Principal-Agent Problem
 define the principal-agent problem
 Who is the principal and who is the
agent?
 What problem does a separation of
ownership and control cause?
 How could we prevent principal-agent
problem?
39
Solutions to Financing
Puzzles
 lemons or adverse selection problem
tells why marketable securities are
not the primary source of financing
 situation is similar in corporate bond
market
 tells why stocks are not the most
important source of external financing
40
More Solutions to Financial
Structure Puzzles
 importance of financial intermediaries
explains importance of indirect financing
 explains why banks are most important
source of external financing
 explains why markets are only available
to large, well-known firms
41
Functions of FIs
 Brokerage function
 Acting as an agent for investors:
 e.g. Merrill Lynch, Charles Schwab
 Reduce costs through economies of scale
 Encourages higher rate of savings
 Asset transformer:
 Purchase primary securities by selling
financial claims to households
 These secondary securities often more
marketable
42
Role of FIs in Cost Reduction
 Information costs:
 Investors exposed to Agency Costs
 Role of FI as Delegated Monitor (Diamond,
1984)
 Shorter term debt contracts easier to monitor
than bonds
 FI likely to have informational advantage
43
Services Performed by FIs





Monitoring Costs
Liquidity and Price Risk
Transaction Cost Services
Maturity Intermediation
Denomination Intermediation
44
Services Provided by FIs
 Money Supply Transmission
 Credit Allocation
 Intergenerational Wealth
Transfers
 Payment Services
(continued) 45
Regulation of FIs
 Regulation is not costless
 Net regulatory burden.






Safety and soundness regulation
Monetary policy regulation
Credit allocation regulation
Consumer protection regulation
Investor protection regulation
Entry regulation
46
Changing Dynamics of
Specialness
 Trends in the United States
 Decline in share of depository institutions.
 Increases in pension funds and investment
companies.
 May be attributable to net regulatory burden
imposed on depository FIs.
 Technological changes affect delivery of financial
services and regulatory issues
 Potential for regulations to be extended to hedge
funds
 Result of Long Term Capital Management
disaster
47
Future Trends
 Weakening of public trust and confidence in FIs may
encourage disintermediation
 Increased merger activity within and across sectors
 Citicorp and Travelers, UBS and Paine Webber
 More large scale mergers such as J.P. Morgan
and Chase, and Bank One and First Chicago
 Growth in Online Trading
 Increased competition from foreign FIs at home and
abroad
 Mergers involving world’s largest banks
 Mergers blending together previously separate
financial services sectors
48
Tema 3
GOBIERNO Y ESTRUCTURA
ORGANIZATIVA DE LA BANCA
“It is the ability to foretell what is going to happen
tomorrow, next week, next month, and next year. And to
have the ability afterwards to explain why it didn’t
happen.”
Sir Winston Churchill
What are Financial
Intermediaries (FIs)?
 Financial Securities: contingent claims on
future cash flows – debt, equity,
derivatives, hybrids.
 All firms’ liabilities & net worth are
predominately comprised of financial
securities.
 But most firms hold real assets such as
inventory, plant & equipment, buildings.
 FIs’ assets are predominately comprised of
financial securities.
51
Transparent, Transluscent and Opaque FIs
Financial Intermediation: The Flow of Funds and Primary Securities
Funds Surplus Units
Brokers
Funds Deficit Units
Funds Surplus Units
Dealers
Funds Deficit Units
Funds Surplus Units
Underwriters
Investment Banks
Funds Deficit Units
Funds Surplus Units
Mutual Funds
Funds Deficit Units
Funds Surplus Units
Banks
Funds Deficit Units
Funds Surplus Units
Insurance Companies
Funds Deficit Units
52
What Services Do FIs Provide?







Information
Liquidity
Reduced Transaction Costs
Transmission of Monetary Policy
Credit Allocation
Payment Services
Intergenerational Wealth Transfer
53
FIs are the most regulated of
all firms
 Safety and Soundness Regulation
 Deposit Insurance
 Monetary Policy Regulation
 Reserve Requirements
 Credit Allocation Regulation (eg.,
mortgages)
 Consumer Protection Regulation
 Community Reinvestment Act, Home Mortgage
Disclosure Act, Truth in Lending Protection
 Investor Protection Regulation
 Entry Regulation
54
Types of FIs
 Depository Institutions
 Insurance Companies
 Securities Firms and Investment
Banks
 Mutual Funds
 Finance Companies
 Distinctions blurred by the GrammLeach-Bliley Act of 1999 that created
Financial Holding Companies (FHCs).
55
Features Common to Most FIs
 High Amount of Financial Leverage
 Low equity/assets ratios. Capital
requirements.
 Off-balance sheet items
 Contingent claims that under certain
circumstances may eventually become
balance sheet items (ex. Derivatives,
commitments)
 Revenue: Interest Income & Fees
 Costs: Interest Expenses and Personnel
56
Depository Institutions
 Commercial Banks: accept deposits and make loans to
consumers and businesses.
 Money Center Banks: Citigroup, Bank of NY,
BankOne, Bankers Trust (Deutschebank), JP
Morgan Chase and HSBC Bank USA.
 Savings Associations (S&Ls)
 Qualified Thrift Lender (QTL) mortgages must
exceed 65% of thrift’s assets.
 Savings Banks
 Use deposits to fund mortgages & other assets.
 Credit Unions and Credit cooperatives
 Nonprofit mutually owned institutions (owned by
depositors).
57
Overview of Depository Institutions
 In this segment, we explore the
depository FIs:




Size, structure and composition
Balance sheets and recent trends
Regulation of depository institutions
Depository institutions performance
58
Products of FIs
 Comparing the products of FIs in 1950, to
products of FIs in 2003:
 Much greater distinction between types of
FIs in terms of products in 1950 than in
2003
 Blurring of product lines and services over
time
 Wider array of services offered by all FI
types
59
Specialness of Depository FIs
 Products on both sides of the balance
sheet
 Loans
 Business and Commercial
 Deposits
60
Other outputs of depository FIs
 Other products and services 1950:
 Payment services, Savings products,
Fiduciary services
 By 2003, products and services
further expanded to include:
 Underwriting of debt and equity,
Insurance and risk management
products
61
Size of Depository FIs
 Consolidation has created some very
large FIs
 Combined effects of
disintermediation, global competition,
regulatory changes, technological
developments, competition across
different types of FIs
62
Largest Depository Institutions in the
US
Total Assets ($Billions)
Citigroup
J.P. Morgan Chase*
Bank of America**
Wells Fargo
Wachovia
Bank One*
Washington Mutual
Fleet Boston**
U.S. Bancorp
SunTrust Banks
$1,208.9
770.9
736.4
393.9
388.0
326.6
275.2
200.2
188.8
181.0
63
Organization of Depository
Institutions
 Commercial Banks
 Largest depository institutions are commercial
banks.
 Differences in operating characteristics and
profitability across size classes.
 Notable differences in ROE and ROA as well
as the spread
 Thrifts
 S&Ls
 Savings Banks
 Credit Unions
 Mix of very large banks with very small banks
64
Functions & Structural
Differences
 Functions of depository institutions
 Regulatory sources of differences across
types of depository institutions.
 Structural changes generally resulted
from changes in regulatory policy.
 Example: changes permitting interstate
branching
 Reigle-Neal Act (1994) in the US
 In Spain, deregulation in 1989 concerning
savings banks operations
65
Commercial Banks
 Primary assets:




Real Estate Loans: $2,272.3 billion
C&I loans: $870.6 billion
Loans to individuals: $770.5 billion
Investment security portfolio: $1,789.3
billion
 Of which, Treasury bonds: $1,005.8 billion
 Inference: Importance of Credit Risk
66
Commercial Banks
 Primary liabilities:
 Deposits: $5,028.9 billion
 Borrowings: $1,643.3 billion
 Other liabilities: $238.2 billion
 Inference:
 Highly leveraged
67
Small Banks, US
C&I
14%
Credit Card
1%
Consumer
8%
Real Estate
63%
Other
14%
68
Large Banks, US
C&I
18%
Credit Card
7%
Real Estate
44%
Consumer
10%
Other
21%
69
Structure and Composition
 Shrinking number of banks:
 14,416 commercial banks in 1985
 12,744 in 1989
 7,769 in 2004
 Mostly the result of Mergers and
Acquisitions
 M&A prevented prior to 1980s, 1990s
 Consolidation has reduced asset share of
small banks
70
Structure & Composition
of Commercial Banks
 Financial Services Modernization Act
1999
 Allowed full authority to enter
investment banking (and insurance)
 Limited powers to underwrite
corporate securities have existed only
since 1987
71
Composition of
Commercial Banking Sector
 Community banks
 Regional and Super-regional
 Access to federal funds market to finance
their lending activities
 Money Center banks
 Bank of New York, Deutsche Bank (Bankers
Trust), Citigroup, J.P. Morgan Chase, HSBC
Bank USA
 declining in number
72
Balance Sheet and Trends
 Business loans have declined in
importance
 Offsetting increase in securities and
mortgages
 Increased importance of funding via
commercial paper market
 Securitization of mortgage loans
73
Some Terminology
 Transaction accounts
 Negotiable Order of Withdrawal
(NOW) accounts (“cuenta a la vista”)
 Money Market Mutual Fund
 Negotiable CDs (“certificados de
depósito”): Fixed-maturity interest
bearing deposits with face values
over $100,000 that can be resold in
the secondary market.
74
Off-balance Sheet Activities
 Heightened importance of off-balance
sheet items
 Large increase in derivatives positions is
a major issue
 Standby letters of credit
 Loan commitments
 When-issued securities
 Loans sold
75
Trading and Other Risks
 Allied Irish / Allfirst Bank
 $750 million loss (2001)
 National Australian Bank
 $450 million loss (2004)
Failure of the U.K. investment bank
Barings
The Bankruptcy of Orange County in
California.
76
Other Fee-generating Activities
 Trust services
 Correspondent banking




Check clearing
Foreign exchange trading
Hedging
Participation in large loan and security
issuances
 Payment usually in terms of noninterest
bearing deposits
77
Key Regulatory Agencies
 FDIC and the Office of the Comprotroller of
the Currency in the US.
 European Central Bank
 National central banks
 National Governments
 Regional Governments
78
Web Resources
 For more detailed information on the
regulators, visit:
http://www.ecb.int
http://www.bde.es
http://www.fdic.gov
http://www.occ.treas.gov
http://federalreserve.gov
79
Banking and Ethics
Some cases for the US:
 Bank of America and Fleet Boston
Financial 2004
 J.P. Morgan Chase and Citigroup 2003
role in Enron
 Riggs National Bank and money
laundering concerns 2003
80
Savings Institutions
 Comprised of:
 Savings and Loans Associations
 Savings Banks
 Effects of moral hazard and regulator
forbearance. Quite a debate worldwhile.
81
Savings Institutions: Recent Trends
 Industry is smaller overall
 Intense competition from other FIs
 mortgages for example
 Concern for future viability in certain
countries.
82
Credit Unions
 Nonprofit depository institutions owned by
member-depositors with a common bond.
 Exempt from taxes and Community
Reinvestment Act (CRA) in the US.
 Expansion of services offered in order to
compete with other FIs.
 Very important in certain European
countries (Germany, Spain).
83
Global Issues
 Near crisis in Japanese Banking
 Eight biggest banks reported positive sixmonth profits
 China
 Deterioration, NPLs (nonperforming
loans) at 50% levels
 Opening to foreign banks (WTO entry)
 German bank problems in early 2000s
 Implications for future competitiveness
84
Largest Banks in the World
Bank
Assets
($Millions)
Citigroup (USA)
1,097,000
Mizuho Financial Group (Japan)
945,688
UBS (Switzerland)
825,000
Sumitomo Mitsui Fin. (Japan)
802,674
Deutsche Bank (Germany)
794,984
Bank of Tokyo-Mitsubishi (Japan)
789,495
85
Tema 4
LA INTERMEDIACIÓN FINANCIERA: LA
ACTIVIDAD CREDITICIA.
Análisis por tipos de instituciones
Commercial Banks
 Represent the largest group of depository
institutions measured by asset size.
 Perform functions similar to those of savings
institutions and credit unions - they accept
deposits (liabilities) and make loans (assets)
 Liabilities include nondeposit sources of funds
such as subordinated notes and debentures
 Loans are broader in range, including
consumer, commercial, international, and real
estate
87
Differences in Balance Sheets
Depository Institutions
Assets
Loans
Liabilities
Deposits
Other
financial
assets
Other
nonfinancial
assets
Nonfinancial Firms
Assets
Deposits
Liabilities
Loans
Other
financial
assets
Other
liabilities
and
equity
Other
nonfinancial
assets
Other
liabilities
and
equity
88
Commercial Bank Balance Sheet
Assets
Total cash assets……………….
$ 253.8
U.S. gov securities……………
$ 801.4
Other………………………….
391.6
Investment securities…………..
1,193.0
Interbank loans……………….
223.0
Loans exc. Interbank…………
3,314.3
Comm. and Indust…………..$ 948.5
Real estate…………………… 1,343.0
Individual……………………. 496.4
All other……………………… 526.4
Less: Reserve for losses……… 58.7
Total loans………………………
$3,478.6
Other assets……………………..
347.6
Total assets……………………..
$5,273.0
4.8%
22.6%
66.0%
6.6%
89
Commercial Bank Balance
Statement (liabilities)
Liabilities and Equity
Transaction accounts……………
Nontransaction accounts………...
Total deposits……………………
Borrowings………………………
Other liabilities…………………..
Total liabilities…………………..
Equity……………………………
$ 667.4
2,688.5
12.8%
54.4%
$3,355.9
1,006.0
462.3
$4,824.2
448.8
21.3%
2.8%
8.7%
*Aggregate balance sheet and percentage distributions for all U.S.
commercial banks as of May 26, 1999 in billions of dollars
90
The importance of lending (I)
 The history of banking institutions is the
history of lending itself.
 Banks solve asymmetric information
problems through lending.
 The relevance of lending is not exclusive of
commercial banks. It is even more
important at other depository instituions (in
relative terms).
91
The importance of lending (II)
 Lending and the resolution of asymmetric
information problems are usually studied
within an IO perspective.
 A large amount of contracts is needed to
achieve efficiency and to solve asymmetric
information problems: relevance of scale
and scope economies and efficiency.
92
Economies of Scale and Scope
 Economies of scale - the degree to which a firm’s
average unit costs of producing financial services fall
as its output of services increase
 Economies of scope - the degree to which a firm can
generate cost synergies by producing multiple financial
service products
 Megamerger - the merger of banks with assets of $1
billion or more
 X efficiencies - cost savings due to the greater
managerial efficiency of the acquiring firm
93
Measuring Economies of Scale
ACi = TC i
Si
Where:
ACi = Average costs of the ith bank
TCi = Total costs of the ith bank
Si = Size of the bank measured by assets, deposits
or loans
94
Economies of Scale and the
Effect of Technology
Improvement
Average
Cost
Old Technology
AC1
New Technology
AC2
Size
0
95
Economies of Scope
 By offering more services to a given customer;
 revenue can be enhanced
 costs can be reduced
 Cost economies of scope
 investments in one financial service (such as
lending) may reduce costs to produce financial
services in other areas (such as securities
underwriting or brokerage)
 Revenue economies of scope
96
Bank Size and Activities
 Large banks have easier access to capital markets
and can operate with lower amounts of equity
capital
 Large banks tend to use more purchased funds
(such as fed funds) and have fewer core deposits
 Large banks lend to larger corporations which
means that their interest rate spread is narrower
 the difference between lending and
deposit rates
 Large banks are more diversified and generate
more noninterest income
97
Industry Performance
 Provision for loan losses - bank management’s
recognition of expected bad loans for the
period
 Net charge-offs - actual losses on loans and
leases
 Net operating income - income before taxes and
extraordinary items
98
Thrift Institutions and Savings
& Cooperative Banks
 Savings Associations
 concentrated primarily on residential mortgages
 Savings Banks
 large concentration of residential mortgages
 commercial loans
 corporate bonds
 corporate stock
 Credit Unions
 consumer loans funded with member deposits
99
 IN THE US: Regulator forbearance - a policy of the
FSLIC not to close economically insolvent FIs,
allowing them to continue in operation
 IN EUROPE: More variety and diversity. All sorts of savings
banks and credit cooperative structures (private, public,
semi-public).
 Mutual organization - an institution in which the
liability holders are also the owners:
 THE CASE OF PROXIMITY BANKING:
 COMMUNITY BANKS IN THE US
 SAVINGS BANKS IN EUROPE
100
Financial Statements of
Commercial Banks
 Report of condition - balance sheet of a
commercial bank reporting information at a
single point in time
 Report of income - income statement of a
commercial bank reporting revenues, expenses,
net profit or loss, and cash dividends over a
period of time
 Retail bank - one that focuses its business
activities on consumer banking relationships
 Wholesale bank - one that focuses its business
activities on commercial banking relationships
101
Assets
 Four major subcategories
 cash and balances due from other depository institutions
 vault cash, deposits at the Federal Reserve, deposits at
other FIs, and cash items in the process of collection
 investment securities
 interest-bearing deposits at other FIs, fed funds sold,
RPs, U.S. Treasury and agency securities, securities
issued by states and political subdivisions, mortgagebacked securities, and other debt and equity securities
 loans and leases
 other assets
 premises and fixed assets, real estate owned,
investments in unconsolidated subsidiaries, intangible
assets, other fees receivable
102
Liabilities
 NOW account - negotiable order of withdrawal
account, similar to a demand deposit with
minimum balance
 MMDAs - money market deposit accounts with
retail savings accounts and limited checking
account (IN THE US)
 Other savings deposits - other than MMDAs (IN
EUROPE): basically customer (savings and term)
deposits)
103
Liabilities
 Negotiable instrument - an instrument whose
ownership can be transferred in the secondary
market
 Purchased funds - rate-sensitive funding sources
of the bank (ej. “cesiones temporales de
activos”).
104
Equity Capital
 Preferred and common stock (listed at par
value)
 Surplus or additional paid-in capital
 Retained earnings
 Regulations require banks to hold a minimum
level of equity capital to act as a buffer against
losses from their on- and off-balance sheet
assets
105
Off-Balance-Sheet Assets and
Liabilities
 Contingent assets and liabilities that may affect the
future status of the FIs balance sheet
 OBS activities grouped into 5 major categories
 Loan commitments - contractual commitment to
loan to a firm a certain maximum amount at given
interest rate terms
 up-front fee - fee charged for making funds
available through a loan commitment
 back-end fee - fee charged on the unused
component of a loan commitment
(continued)
106
 Loans Sold (securitization)
 loans that a bank originated and then sold to other
investors that may be returned (with recourse) to
the originating institution in the future
 recourse - the ability to put an asset or loan back to
the seller should the credit quality of that asset
deteriorate
 Derivative Contracts
 futures, forward, swap, and option positions taken
by the FI for hedging or other purposes
107
Income Statement










Interest Income
Interest Expenses
Net Interest Income
Provision for Loan Losses
Noninterest Income
Noninterest Expense
Income before Taxes and Extraordinary Items
Income Taxes
Extraordinary Items
Net Income
108
The Direct Relationship between the Income Statement
and the Balance Sheet
N
NI =
M
 rnAn -  rmLm n=1
P + NII
-
NIE
-
T
m=1
where
NI = Bank’s net income
An = Dollar value of the bank’s nth asset
Lm = Dollar value of the bank’s nth liability
rn = Rate earned on the bank’s nth asset
rm = Rate paid on the bank’s nth liability
P = Provision for loan losses
NII = noninterest income earned, including OBS
NIE = noninterest expenses incurred
T = Bank’s taxes
N = number of assets the bank holds
M = number of liabilities the bank holds
109
Financial Statement Analysis Using a Return
on Equity Framework
Time series analysis - analysis of financial statements
over a period of time
Cross-sectional analysis - analysis of financial
statements comparing one firm with others
Return on equity (ROE) - measures overall profitability of the FI per dollar of equity
ROE =
Net income
Total Assets

Total Assets
Total equity capital
= ROA  EM
110
Return on Assets and Its
Components
Return on Assets (ROA) - measures profit generated
relative to the FI’s assets
ROA =
Net Income
 Total operating income
Total operating income
Total assets
= PM (profit margin) 
AU (assets utilization)
111
Profit Margin
Profit Margin (PM) - measures the ability to pay expenses
and generate income from interest and noninterest income
Interest expense ratio =
Interest expense
Total operating income
Provision for loan loss ration = Provision for loan losses
Total operating income
Noninterest expense ratio = Noninterest expense
Total operating income
Tax Ratio =
Income taxes
Total operating income
112
Asset Utilization
Asset utilization (AU) - measures the amount of interest/
noninterest income generated per dollar of total assets
AU = Total operating income = Interest + Noninterest
Total assets
income
income
ratio
ratio
113
Net Interest Margin
Net interest margin - interest income minus interest
expense divided by earning assets
Net
interest =
margin
=
Net interest income
Earning assets
Interest income - Interest expense
Investment securities + Net loans and leases
114
Spread
Spread - the difference between lending and deposit
rates
spread = Interest income Interest expense
Earning assets Interest-bearing liabilities
115
Overhead Efficiency
Overhead efficiency - a bank’s ability to generate
noninterest income to cover noninterest expenses
Overhead efficiency = Noninterest income
Noninterest expense
116
Tema 5
Técnicas de concesión de
crédito: screening, credit
scoring y monitoring
Risks Faced by Financial
Intermediaries










Credit Risk
Liquidity Risk
Interest Rate Risk
Market Risk
Off-Balance-Sheet Risk
Foreign Exchange Risk
Country or Sovereign Risk
Technology Risk
Operational Risk
Insolvency Risk
118
Market Risk
 Incurred in trading of assets and liabilities (and
derivatives).
 Examples: Barings & decline in ruble.
 DJIA dropped 12.5 percent in two-week period July,
2002.
 Heavier focus on trading income over traditional
activities increases market exposure.
 Trading activities introduce other perils as was
discovered by Allied Irish Bank’s U.S. subsidiary,
AllFirst Bank when a rogue trader successfully
masked large trading losses and fraudulent
activities involving foreign exchange positions
119
Market Risk
 Distinction between Investment Book
and Trading Book of a commercial
bank
 Heightened focus on Value at Risk (VAR)
 Heightened focus on short term risk
measures such as Daily Earnings at Risk
(DEAR)
 Role of securitization in changing
liquidity of bank assets and liabilities
120
Credit Risk
 Risk that promised cash flows are not
paid in full.
 Firm specific credit risk
 Systematic credit risk
 High rate of charge-offs of credit card
debt in the 1980s, most of the 1990s
and early 2000s
 Credit card loans (and unused
balances) continue to grow
121
Implications of Growing Credit Risk
 Importance of credit screening
 Importance of monitoring credit
extended
 Role for dynamic adjustment of credit
risk premia
 Diversification of credit risk
122
Off-Balance-Sheet Risk
 Striking growth of off-balance-sheet
activities
 Letters of credit
 Loan commitments
 Derivative positions
 Speculative activities using offbalance-sheet items create
considerable risk
123
Technology and Operational Risk
 Risk that technology investment fails to
produce anticipated cost savings.
 Risk that technology may break down.
 CitiBank’s ATM network, debit card system
and on-line banking out for two days
 Wells Fargo
 Bank of New York: Computer system failed
to recognize incoming payment messages
sent via Fedwire although outgoing
payments succeeded
124
Technology and Operational Risk
 Operational risk not exclusively
technological
 Employee fraud and errors
 Losses magnified since they affect
reputation and future potential
 Merrill Lynch $100 million penalty
125
Country or Sovereign Risk
 Result of exposure to foreign government
which may impose restrictions on repayments
to foreigners.
 Often lack usual recourse via court system.
 Examples:
• Indonesia
 Argentina
• Malaysia
 Russia
• Thailand.
 South Korea
126
Country or Sovereign Risk
 In the event of restrictions, reschedulings, or
outright prohibition of repayments, FIs’
remaining bargaining chip is future supply of
loans
 Weak position if currency collapsing or
government failing
 Role of IMF
 Extends aid to troubled banks
 Increased moral hazard problem if IMF
bailout expected
127
Liquidity Risk
 Risk of being forced to borrow, or sell assets in a very
short period of time.
 Low prices result.
 May generate runs.
 Runs may turn liquidity problem into solvency
problem.
 Risk of systematic bank panics.
 Example: 1985, Ohio savings institutions insured by
Ohio Deposit Guarantee Fund
 Interaction of credit risk and liability risk
 Role of FDIC (see Chapter 19)
128
Insolvency Risk
 Risk of insufficient capital to offset
sudden decline in value of assets to
liabilities.
 Continental Illinois National Bank and
Trust
 Original cause may be excessive
interest rate, market, credit, offbalance-sheet, technological, FX,
sovereign, and liquidity risks.
129
Credit Risk Management
 An FI’s ability to evaluate information and
control and monitor borrowers allows
them to transform financial claims of
household savers efficiently into claims
issued to corporations, individuals, and
governments
 An FI accepts credit risk in exchange for a
fair return sufficient to cover the cost of
funding (e.g., covering the cost of
borrowing, or issuing deposits)
130
Credit Analysis
 Real Estate Lending
 residential mortgage loan applications are among the most
standardized of all credit applications
 Two considerations
 the applicant’s ability and willingness to make timely
interest and principal repayments
 the value of the borrower’s collateral
 GDS (gross debt service) ratio - gross debt service
ratio calculated as total accommodation expenses
(mortgage, lease, condominium, management fees, real
estate taxes, etc.) divided by gross income
 TDS (total debt service) ratio - total debt ratio
calculated as total accommodation expenses plus all other
debt service payments divided by gross income
131
Credit Scoring
 Credit scoring system
 a mathematical model that uses observed loan
applicant’s characteristics to calculate a score that
represents the applicant’s probability of default
 Perfecting collateral
 ensuring that collateral used to secure a loan is free
and clear to the lender should the borrower default
 Foreclosure
 taking possession of the mortgaged property to
satisfy a defaulting borrower’s indebtedness
 Power of sale
 taking the proceedings of the forced sale of property
to satisfy the indebtedness
132
Credit Scoring
 Consumer (individual) and Small-business lending
 techniques for scoring consumer loans very similar to
mortgage loan credit analysis but more emphasis
placed on personal characteristics such as annual
gross income and the TDS score
 small-business loans more complicated and has
required FIs to build more sophisticated scoring
models combining computer-based financial analysis
of borrower financial statements with behavioral
analysis of the owner
133
Ratio Analysis
 Historical audited financial statements and projections
of future needs
 Calculation of financial ratios in financial statement
analysis
 Relative ratios offer information about how a business
is changing over time
 Particularly informative when they differ either from
an industry average or from the applicant’s own past
history
134
Calculating Ratios
Liquidity Ratios
Current Ratio =
Current assets
Current liabilities
Quick ratio = Cash + Cash equivalents + Receivables
Current liabilities
(continued)
135
Asset Management Ratios
Number of days sales = Accounts receivable x 365
in receivables
Credit sales
Number of days = Inventory x 365
in inventory
Cost of goods sold
Sales to working =
Sales
capital
Working capital
Sales to fixed =
Sales
assets
Fixed assets
Sales to total assets =
Sales
Total assets
(continued)
136
Debt and Solvency ratios
Debt-asset ratio = Short-term liabilities + Long-term liabilities
Total assets
Fixed-charge = Earnings available to meet fixed charges
coverage ratio
Fixed charges
Cash-flow-to-debt = EBIT + Depreciation
ratio
Debt
where EBIT represents earnings before interest and taxes
(continued)
137
Profitability Ratios
Gross margin = Gross profit
Sales
Income to Sales = EBIT
Sales
Operating profit margin = Operating profit
Sales
Return on assets =
EAT
Average total assets
Return on equity = EAT
Total equity
Dividend payout = Dividends
EAT
where EAT represents earnings after taxes, or net income
138
Common Size Analysis and
After the Loan
 Analyst can divide all income statement amounts
by total sales revenue and all balance sheet
amounts by total assets
 Year to year growth rates give useful ratios for
identifying trends
 Loan covenants reduce risk to lender
 Conditions precedent
 those conditions specified in the credit agreement or
terms sheet for a credit that must be fulfilled before
drawings are permitted
139
Large Commercial and
Industrial Lending
 Very attractive to FIs because transactions are
often large enough make them very profitable
even though spreads and fees are small in
percentage
 FIs act as broker, dealer, and adviser in credit
management
 The standard methods of analysis used for midmarket corporates applied to large corporate
clients but with additional complications
 Financial ratios such as the debt-equity ratio are
usually key factors for corporate debt
140
Altman’s Z-Score
Used for analyzing publicly traded manufacturing firms
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
where
Z = an overall measure of the borrower’s default risk
X1 = Working capital/Total assets ratio
X2 = Retained earnings/Total assets ratio
X3 = Earnings before interest and taxes/Total assets ratio
X4 = Market value of equity/Book value of long-term debt ratio
X5 = Sales/Total assets ratio
The higher the value of Z, the lower the default risk
141
The KMV Model
 Banks can use the theory of option pricing to
assess the credit risk of a corporate borrower
 The probability of default is positively related to:
 the volatility of the firm’s stock
 the firm’s leverage
 A model developed by KMV corporation is being
widely used by banks for this purpose
142
Calculating the Return on a
Loan
 A number of factors impact the promised return that an
FI achieves on any given dollar loan
 the interest rate on the loan
 any fees relating to the loan
 the credit risk premium on the loan
 the collateral backing the loan
 other nonprice terms (such as compensating
balances and reserve requirements)
143
Return on Assets (ROA)
1 + k = 1 + f + (L + m)
1 - (b(1 - R))
where
k = the contractually promised gross return on the loan
f = direct fees, such as loan origination fee
L = base lending rate
m = risk premium
b = compensating balances
R = reserve requirement charge
144
Risk-Adjusted Return on Capital
(RAROC)
 Rather than evaluating the actual or
promised annual cash flow on a loan as a
percentage of the amount lent (ROA), the
lending officer balances the loan’s
expected income against the loan’s
expected risk
 RAROC = One-year income on a
loan/Loan (asset risk or capital at risk
145
Tema 6
EL RIESGO DE CRÉDITO:
RIESGO EN LOS PRÉSTAMOS
INDIVIDUALES Y EN CARTERA
DE CRÉDITO
Overview
 The aim is to discuss the existence of
different types of loans, and the
analysis and measurement of credit risk
on individual loans. This is important
for purposes of:
 Pricing loans and bonds
 Setting limits on credit risk exposure
147
Credit Quality Problems
 Problems with junk bonds, residential and
farm mortgage loans.
 More recently, credit card and auto loans.
 Crises in Asian countries such as Korea,
Indonesia, Thailand, and Malaysia.
 Default of one major borrower can have
significant impact on value and reputation of
many FIs
 Emphasizes importance of managing credit
risk
148
Credit Quality Problems
 Over the early to mid 1990s, improvements in NPLs
(non-performing loans) for large banks and overall
credit quality.
 Late 1990s concern over growth in low quality auto
loans and credit cards, decline in quality of lending
standards.
 Exposure to Enron.
 Late 1990s and early 2000s: telecom companies,
tech companies, Argentina, Brazil, Russia, South
Korea
 New types of credit risk related to loan guarantees
and off-balance-sheet activities.
 Increased emphasis on credit risk evaluation.
149
Types of Loans:
 C&I (commercial and industrial) loans: secured and
unsecured
 Syndication
 Spot loans, Loan commitments
 Decline in C&I loans originated by commercial
banks and growth in commercial paper market.
 Downgrades of Ford, General Motors and Tyco
 RE (real state) loans: primarily mortgages
 Fixed-rate, variable rates
 Mortgages can be subject to default risk when
loan-to-value declines.
150
*CreditMetrics (sistema patentado)
 “If next year is a bad year, how much will I lose on my
loans and loan portfolio?”
VAR = P × 1.65 × s
 Neither P, nor s observed.
Calculated using:
 (i)Data on borrower’s credit rating; (ii) Rating
transition matrix; (iii) Recovery rates on defaulted
loans; (iv) Yield spreads.
151
* Credit Risk+ (sistema patentado)
 Developed by Credit Suisse Financial Products.
 Based on insurance literature:
 Losses reflect frequency of event and severity of
loss.
 Loan default is random.
 Loan default probabilities are independent.
 Appropriate for large portfolios of small loans.
 Modeled by a Poisson distribution.
152
 Credit risk measurement has evolved
dramatically over the last 20 years.
 The five forces made credit risk
measurement become more important
than ever before:
(i) A worldwide structural increase in the
number of bankruptcies.
(ii) A trend towards disintermediation by
the highest quality and largest
borrowers.
153
(iii) More competitive margins on loans.
(iv) A declining value of real assets in
many markets.
(v) A dramatic growth of off-balance
sheet instrument with inherent
default risk exposure, including
credit risk derivatives.
154

Responses of academics and practitioners:
(i) Developing new and more sophisticated
credit-scoring/early-warning systems
(ii) Moved away from only analyzing the credit
risk of individual loans and securities
towards developing measures of credit
concentration risk
(iii) Developing new models to price credit risk
(e.g. RAROC)
(iv) Developing models to measure better the
credit risk of off-balance sheet instruments
155
Measurement of the Credit risk of Offbalance Sheet Instruments
 The expansion in off-balance sheet
instrument – such as swaps, options,
forwards, futures, etc.
 Default risk of the instruments have been
concerned. It has been reflected in the
BIS risk-based capital ratio.
 The models like KMV, OPM can be applied
to measure the probability of default on
off-balance sheet instruments.
156
Measurement of the Credit risk of Offbalance Sheet Instruments (cont.)
Differences between the default risk on loans
and off-balance sheet instruments:
(i) Even if the counter-party is in financial distress,
it will only default on out-of-the-money
contracts.
(ii) For any given probability of default, the amount
lost on default is usually less for off-balance
sheet instruments than for loans.

157
Measures of credit concentration
risk
 The measurement of credit
concentration risk is also important
 Early approaches to concentration
risk analysis were based either on:
(i) Subjective analysis
(ii) Limiting exposure in an area to a
certain percent of capital (e.g. 10%)
(iii)Migration analysis
158
Measures of credit
concentration risk (cont.)
 Modern portfolio theory (MPT)
- By taking advantage of its size, an FI can
diversify considerable amounts of credit risk as
long as the returns on different assets are
imperfectly correlated
 increasingly being applied to loans and other
fixed income instruments recently
159
Accounting based credit-scoring
systems
 Four methodological approaches to
developing multivariate creditscoring systems:
(i) The linear probability model
(ii) The logit model
(iii)The probit model
(iv)The discriminant analysis model
160
Other (newer) models of credit
risk measurement
 Three criticisms of accounting based
credit-scoring models
1. Accounting data fails to pick up fastmoving changes in borrower conditions
2. The world is inherently non-linear
3. They are only tenuously linked to an
underlying theoretical model
161
Other (newer) models –KMV model
(cont.)
Step 2: calculate distance to default (D)
D = (A-B)/ σA
Step 3: calculate EDF
Probability distribution of
asset value (A) in one year
value
A
Distance to
default
B
EDF (A<B)
0
1
time
162
Other (newer) models- Term
structure applications
 Jonkhart(1979), seek to impute implied probabilities of
default(1-p) from term structure of yield spreads
between default free and risky corporate securities.
-the spreads between Treasury strips and zero-coupon
corporate bond reflect perceived credit risk exposures
Corporate bond
yield
T-bond
1
2
maturity
163
APPENDIX: Bank regulation and credit
risk: an example from Basel II and
savings banks
 Historically, regulation has limited who can:
 open or charter new banks and
 what products and services banks can offer.
 Imposing barriers to entry and restricting the
types of activities banks can engage in clearly
enhance safety and soundness, but also hinder
competition.
164
 It assumed that the markets for bank products,
largely bank loans and deposits, could be
protected and that other firms could not
encroach upon these markets.
 Not surprisingly, investment banks, hybrid
financial companies, insurance firms, and
others found ways to provide the same
products as banks across different geographic
markets.
165
 However, there is another type of
regulation that has concentrated most
of the attention in the last three
decades, the bank capital regulation.
 Changes in reserve requirements
…directly affect the amount of legal
required reserves and thus change the
amount of money a bank can lend out. The
main recent example is BASEL II.
166
 Basel 2 is a ‘step change’ in the regulation of
capital adequacy. It will alter the industry ‘frame
of reference’ for banks in many ways:
 Regulators are clearly recognizing market
realities and seeking a much closer
congruence between regulatory and economic
capital.
 The new proposals are more complex and
sophisticated than earlier schemes. They will
also have to evolve as market conditions,
technology and financial management
techniques develop.
167
 The calibration exercises that have resulted from
the various Quantitative Impact Studies (QIS)
are targeted (initially at least) to deliver broadly
the same amount of capital as the current
Accord. However, the mix of capital charges
will change significantly with the wider range
of risk weights and greater risk sensitivity of
Basel 2.
 Basel 2 will clearly be much more risksensitive in assigning capital charges. Mortgage
lending and lending to higher quality borrowers
will be incentivied under Basel 2.
168
 It is not clear whether the present or new Basel
Accord are a binding constraint on bank’s
current credit operations. Jackson et al (2001,
Bank of England WP) suggest that banks may
employ more conservative capital
standards than those imposed under Basel 1 or
likely under Basel 2.
 Compliance costs are likely to increase.
Banks will have to evaluate (as a kind of capital
investment decision) whether the costs
(including compliance costs) of moving to the
more advanced Basel 2 systems are worthwhile.
169
 Banks will increasingly target better risk
management as a source of competitive
advantage. Increasingly, superior risk
management will become a ‘key success
factor’ for those banks who are able to respond
successfully to the new environment.
 Nevertheless, specialist banks who focus on a
smaller number of core products and services
should similarly be able to obtain risk
management benefits of specialization.
170
 Basel 2 will enhance present securitisation
trends in banking. This will help in its turn to
emphasise further the strategic importance of
investment banking. At the same time, lending
bankers will face increasing ‘adverse selection’
trends as the better credits are able to access
directly the capital markets.
 This trend will help to re-emphasise the
importance of credit skills in lending banks.
It will also put pressure on these banks to widen
their margins (in order to achieve the higher risk
premia needed to cover their more risky
lending).
171
 Governance will be an increasingly important
issue in the new regime. More disclosure is not
enough by itself to secure market discipline (the aim
of Pillar 3). A wide collection of new and improved
governance structures will be needed. These include:
a freer market in bank corporate control;
 good corporate governance in banks;
 incentive-compatible safety nets;
 ‘no bail-out’ policies;
 and proper accounting standards.
 Banks will be required to disclose more
information than ever before to the external
market. This will involve additional compliance costs.
Strategically, it will reinforce any competitive
advantage gained by good risk-management banks.
172
 Under Pillar 3 and with likely changes in bank
governance arrangements, the prospects of takeovers (and no bail-outs) for individual banks who
are ‘inefficient’ are likely to increase. This ‘new
world’ is a likely further threat to concepts like
mutuality and subsidised (or at least protected from
competition) regional banking.
 Insofar as the new capital regime allows nonbank financial companies a competitive
advantage (via lesser capital backing), banks will
attempt to alter the balance of competitive
advantage through regulatory arbitrage
173
 More work is needed on stress testing under
Basel 2 and banks can expect further, more
detailed efforts from regulators in this area.
Already, stress testing appears to be a
standard management technique for many
banks and most banks that stress test do so at a
high frequency (daily or weekly): see Fender
and Gibson (Risk, 2001).
174
 Perhaps the most fundamental strategic impact of
Basel 2 is that it will enhance the SWM
(Shareholder Wealth Maximisation) model as
the major strategic and managerial model for
banks. The essence of this model is its focus on
risk and return and the impact of this tradeoff on
bank value; the model also emphasises the need
for greater risk sensitivity in risk assessments and
pricing. Within this model, better risk
management is rewarded.
175

Although most of the strategic implications mentioned
earlier for retail banks apply also to Spanish savings
banks, there are some specific features of the
Spanish savings banks that may modify some of
these conclusions. These specific features are explored
in this section (and summarised in Diagram 1):

There have been some recent regulatory actions
regarding risk and capital in the Spanish banking
system that should be taken into account when defining
the threats and opportunities of the new framework for
savings banks. The development of a Default Hedging
Statistical Fund (the so-called FECI) by the Bank of
Spain are two of the recent developments in the
regulatory field that impact on the current solvency risk
of Spanish savings banks
176
DIAGRAM 1. SPANISH SAVINGS BANKS AND THE NEW REGULATORY
CAPITAL FRAMEWORK. KEY FEATURES
REGULATION: MARKET
DEVELOPMENTS–
BASEL2
STRATEGIC
IMPLICATIONS
SPANISH SAVINGS
BANKS AND THE NEW
REGULATORY CAPITAL
FRAMEWORK
CAPITAL REGULATION
AND OWNERSHIP
SECTORAL PROJECT
FOR THE GLOBAL
CONTROL OF RISK
177

The establishment of so-called statistical, pro-cyclical or
dynamic provisions:
 Requiring banks to increase these provisions when the
business cycle is positive and reducing them during
downturns in order to favor intertemporal risk
smoothing and loan supply.
 Basel 2 does not appear to change the view of banking
as a pro-cyclical business. Basel 2 could even
exacerbate cyclical effects. It is this contingency
that has led the Bank of Spain to establish the so-called
pro-cyclical or dynamic provisions.
 The recent lending patterns of the Spanish
savings banks are known to reduce these procyclical effects since they have increased credit supply
almost linearly over the business cycle.
178
 The lending behavior of savings banks has not
resulted in higher defaults. On the contrary,
default risk management at savings banks has
apparently been more efficient than for commercial
banks, a fact that may be largely explained by the
intertemporal risk smoothing advantages achieved
via a close contractual relationship with their
customers.
179
 There are three main types of “savings-bank”
specific effects:
(1) those concerning the aim of Basel 2 and the
differences between economic and regulatory
capital;
(2) those that refer to specialisation, size and
lending diversification;
(3) those related to the implementation of the new
capital adequacy requirements, including the
sectoral project of Spanish savings banks for the
global control of risk.
180
(i) Aim of Basel 2 and Economic and Regulatory
Capital Differences
 While the objective of Stakeholder Wealth
Maximisation (STWM) may match more closely
the nature of Spanish savings banks, SWM
should not be a problem for savings institutions
since they have to compete with commercial
banks. Nevertheless, the SWM model will be
reinforced by Basel 2 and Spanish savings
banks may benefit from recent regulatory
changes that stress their ownership status
as private and non-subsidised.
181
(ii) Size, specialisation and lending diversification
 Specialist banks (like savings banks) focusing
on a smaller number of core products may also
be able to obtain the risk management
benefits of specialisation. Continuous
calibration and capital treatment may reduce the
potential loss of competitiveness in retail
banking. Servicing, relationship banking and
dynamic lending will also be valued positively.
182
(iii)
Final implementation of Basel 2 on Spanish
savings banks: the sectoral project for the global
control of risk
 The Spanish Confederation of Savings Banks
(CECA) has led an ambitious initiative to
undertake a sectoral project for the global
control of risk. Since this project is oriented to
the whole savings bank sector, it has to deal
with various problems, like the rigidities of
employing a single model for all institutions.
 However, the project is targetted to provide
savings banks with adequate and
centralised human and technological
resources in order to implement their own
model with a high standard of quality.
183
 The model for each line of business
incorporates risk measurement, control and
management operating with three different
working groups:
 information management;
 organization and procedures;
 quantitative tools.
184
COMPARATIVE DESCRIPTIVE
STATISTICS
 The credit risk of Spanish depository
institutions does not seem to be a concern in
the short-run.
 The ratios “doubtful assets/total exposures”
and “doubtful loans of other resident
sectors/total exposures of resident
sectors” have decreased in recent years and
are lower than 1% (Table 1).
 “Statistical” provisions have increased over
time as a percentage of total provisions (Table
1).
185
TABLE 1.
186
Source: Bank of Spain (Memory of Bank Supervision 2004)
 Savings banks and credit co-operatives
have enjoyed higher margins compared to
commercial banks (Table 2). The margins are in
line with the European standards.
 However, competitive presures have resulted in
a decrease of margins over time during the
last years.
187
TABLE 2.
188
Source: Bank of Spain (Memory of Bank Supervision 2004)
 As shown in Table 3, Spanish banks have
progressively changed their financial
structure to fulfill the requirements of
Basel 2.
 Both Tier 1 and Tier 2 capital have
increased significantly in recent years.
 Banks have increased both the average
weight of credit risk exposure and offbalance sheet exposure.
189
TABLE 3.
190
Source: Bank of Spain (Memory of Bank Supervision 2004)
 Changes in capitalization structure have led to an
anticipated fulfillment of Basel 2 requirements
(Figure 1a).
 Tier 1 capital has largely contributed to a
reduction in capital requirements, in a context of
a significant increase in risk-weighted assets (rise in
overall business and Santander’s purchase of Abbey
National) (Figure 1b).
 However, Tier 1 capital has contributed to the
growth rate of capital (Figure 1c).
 Reserves have contributed largely to the
growth of Tier 1 capital while the contribution of
intangible assets has been negative (Figure 1d).
191
FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS
BANKS IN SPAIN (1)
Source: Bank of Spain (Financial Stability Report, n.8, 2005, May)
192
FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS BANKS
IN SPAIN (2)
Source: Bank of Spain (Financial Stability Report, n.8, 2005, May)
193
Tema 7
EL RIESGO DE TIPO DE
INTERÉS: MODELOS DE
MADURACIÓN, DE DURACIÓN Y
DE “REPRICING”
Interest Rate Risk Measurement
 Repricing or funding gap
 GAP: the difference between those assets whose interest rates
will be repriced or changed over some future period (RSAs)
and liabilities whose interest rates will be repriced or
changed over some future period (RSLs)
 Rate Sensitivity
 the time to reprice an asset or liability
 a measure of an FI’s exposure to interest rate changes in each
maturity “bucket”
 GAP can be computed for each of an FI’s maturity buckets
195
Calculating GAP for a Maturity Bucket
NIIi = (GAP)i Ri = (RSAi - RSLi) Ri
where
NIIi = change in net interest income in the ith
maturity bucket
GAPi = dollar size of the gap between the book
value of rate-sensitive assets and ratesensitive liabilities in maturity bucket i
Ri = change in the level of interest rates
impacting assets and liabilities in the
ith maturity bucket
196
Simple Bank Balance Sheet and Repricing
Gap
Assets
1. Cash and due from
2. Short-term consumer
loans (1 yr. maturity)
3. Long-term consumer
loans (2 yr. maturity)
4. Three-month T-bills
5. Six-month T-notes
6. Three-year T-bonds
7. 10-yr. Fixed-rate mort.
8. 30-yr. Floating-rate m.
9. Premises
Liabilities
$ 5
50
25
30
35
60
20
40
5
$270
1. Two-year time deposits
2. Demand deposits
$ 40
40
3. Passbook Savings
4. Three-month CDs
5. Three-month banker’s
acceptances
6. Six-month commercial
7. One-year time deposits
8. Equity capital (fixed)
30
40
20
60
20
20
$270
197
Weakness in the Repricing Model
 Four major weaknesses
 it ignores market value effects of interest rate changes
 it ignores cash flow patterns within a maturity bucket
 it fails to deal with the problem of rate-insensitive asset
and liability cash flow runoffs and prepayments
 it ignores cash flows from off-balance-sheet activities
198
Duration Model
Duration gap - a measure of overall interest rate
risk exposure for an FI
D = - % in market value of a security
R(1 + R)
199
Insolvency Risk Management
 Net worth
 a measure of an FI’s capital that is equal to the difference
between the market value o its assets and the market value of
its liabilities
 Book Value
 value of assets and liabilities based on their historical costs
 Market value or mark-to-market value basis
 balance sheet values that reflect current rather than historical
prices
200
Effects of Changes in Loan Values and
Interest Rates on the Balance Sheet
Assets
Base case
Long-term securities
Long-term bonds
Liabilities
$ 80
20
$100
Short-term floating
Net worth
$ 90
10
$100
After major decline in value of loans
Long-term securities
Long-term bonds
$ 80
8
$88
Liabilities
Net worth
$90
-2
$88
Liabilities
Net worth
$90
2
$92
201
After rise in interest rates
Long-term securities
Long-term loans
$ 75
17
$92
The Book Value of Shares
 The book value of capital usually comprises three
components in banking
 Par value of shares - the face value of the common shares
issued by the FI time the number of shares outstanding
 Surplus value of shares - the difference between the price the
public paid for common shares and their par values
 Retained earnings - the accumulated value of past profits not
yet paid in dividends to shareholders
 Book value of its capital = Par value + Surplus +
Retained earnings
202
The Discrepancy between the Market and
Book Values of Equity
 The degree to which the book value of an FI’s capital
deviates from its true economic market value depends
on a number of values
 Interest Rate Volatility - the higher the interest rate, the
greater the discrepancy
 Examination and Enforcement - the more frequent the
examinations and the stiffer the examiner’s standards, the
smaller the discrepancy
 Loan Trading - the more loans traded the easier to assess the
true market value of the loan portfolio
203
Calculating Discrepancy Between Book
Values (BV) and Market Values (MV)
MV = Market value of equity ownership in shares outstanding
Number of shares
BV =
Par value of equity + Surplus value +
Retained earnings + Loan loss reserves
Number of shares
Market-to-book ratio
A ratio that shows the discrepancy between the
stock market value of an FI’s equity and the book
value of its equity
204
Central Bank & Interest Rate Risk
 Federal Reserve Bank: U.S. central bank
 Open market operations influence money supply,
inflation, and interest rates
 Oct-1979 to Oct-1982, nonborrowed reserves target
regime – did not work
 Implications of reserves target policy:
 Increases importance of measuring and managing
interest rate risk.
 Effects of interest rate targeting.
 Lessens interest rate risk
 Greenspan view: Risk Management
 Focus on Federal Funds Rate
 Simple announcement of Fed Funds increase,
decrease, or no change.
205
Repricing Model
 Repricing or funding gap model based on book
value.
 Contrasts with market value-based maturity
and duration models recommended by the
Bank for International Settlements (BIS).
 Rate sensitivity means time to repricing.
 Repricing gap is the difference between the
rate sensitivity of each asset and the rate
sensitivity of each liability: RSA - RSL.
 Refinancing risk
206
Maturity Buckets
 Commercial banks must report repricing gaps for
assets and liabilities with maturities of:
 One day.
 More than one day to three months.
 More than 3 three months to six months.
 More than six months to twelve months.
 More than one year to five years.
 Over five years.
207
Repricing Gap Example
Assets
1-day
$ 20
>1day-3mos.
30
>3mos.-6mos.
70
>6mos.-12mos. 90
>1yr.-5yrs.
40
>5 years
10
Liabilities Gap Cum. Gap
$ 30
$-10
$-10
40
-10
-20
85
-15
-35
70
+20
-15
30
+10
-5
5
+5
0
208
Repricing Gap
Dollar GAP
Positive
Negative
Spread Effect
Positive
R
Increase
Direction of NII
Increase
Negative
Increase
Ambiguous
Positive
Decrease
Ambiguous
Negative
Decrease
Decrease
Positive
Increase
Ambiguous
Negative
Increase
Decrease
Positive
Decrease
Increase
Negative
Decrease
Ambiguous
209
Applying the Repricing Model

NIIi = (GAPi) Ri = (RSAi - RSLi) ri
Example:
In the one day bucket, gap is -$10 million. If
rates rise by 1%,
NII(1) = (-$10 million) × .01 = -$100,000.
210
Restructuring Assets &
Liabilities
 The FI can restructure its assets and liabilities, on or off
the balance sheet, to benefit from projected interest rate
changes.
 Positive gap: increase in rates increases NII
 Negative gap: decrease in rates increases NII
 Example: State Street Boston
 Good luck?
 Or Good Management?
211
Repricing Model
 Problems with model:
 measures only short-term profit changes not
shareholder wealth changes
 maturity buckets are arbitrarily chosen
 assets and liabilities within a bucket are considered
equally rate sensitive
 ignores runoffs
 ignores prepayments
212
The Maturity Model
 Explicitly incorporates market value effects.
 For fixed-income assets and liabilities:
 Rise (fall) in interest rates leads to fall (rise) in
market price.
 The longer the maturity, the greater the effect
of interest rate changes on market price.
 Fall in value of longer-term securities increases
at diminishing rate for given increase in interest
rates.
213
Maturity Model
 Leverage also affects ability to eliminate
interest rate risk using maturity model
 Example:
Assets: $100 million in one-year 10-percent
bonds, funded with $90 million in one-year
10-percent deposits (and equity)
Maturity gap is zero but exposure to interest
rate risk is not zero.
214
Duration
 Duration
 Weighted average time to maturity using the
relative present values of the cash flows as
weights.
 Combines the effects of differences in
coupon rates and differences in maturity.
 Based on elasticity of bond price with
respect to interest rate.
215
Duration and Duration Gap
 market-value based model for managing interest rate
risk
 more accurate measures of interest rate risk
exposure than simple maturity model
 duration gap considers market values and maturity
distributions of assets and liabilities unlike repricing
model
 duration
 measures average life of asset or liability
 has economic meaning of interest sensitivity of that
asset’s or liability’s value
216
Duration
 Duration
D = Snt=1[CFt• t/(1+R)t]/ Snt=1
[CFt/(1+R)t]
Where
D = duration
t = number of periods in the future
CFt = cash flow to be delivered in t periods
n= term-to-maturity
R = yield to maturity.
217
Duration Gap
 duration of asset portfolio or liability
portfolio is just weighted-average duration
of each individual asset or liability
 also the accounting identity holds A = L + E
or E = A - L
 when rates change, the change in the equity or
net worth is equal to the difference between the
change in the MV of the assets and liabilities
 instead of how we used maturity model, here we
want to relate sensitivity of net worth to its
duration mismatch instead of its maturity
mismatch because duration is a more accurate
measure of interest rate sensitivity
218
Duration Gap
 assuming similar rate changes for assets and liabilities
Duration Gap
Positive
Negative
Interest Rate
Change
Increase
Decrease
Biggest Value
Change
Assets
Assets
Equity
Value
Decreases
Increases
Increase
Decrease
Liabilities
Liabilities
Increases
Decreases
219
Tema 8
EL RIESGO DE MERCADO
Trading Risks
 Trading exposes banks to risks
 1995 Barings Bank
 1996 Sumitomo Corp. lost $2.6 billion in commodity
futures trading
 1997 market volatility in Eastern Europe and Asia
 1998 continuation with Russian bonds
 AllFirst/ Allied Irish $691 million loss
 Partly preventable with software
 Rusnak currently serving 7 ½ year sentence for
fraud
 Allfirst sold to Buffalo based M&T Bank
221
Implications
 Emphasizes importance of:
 Measurement of exposure
 Control mechanisms for direct market
risk—and employee created risks
 Hedging mechanisms
222
Market Risk
 Market risk is the uncertainty resulting from
changes in market prices .
 Affected by other risks such as interest rate
risk and FX (foreign exchange) risk
 It can be measured over periods as short as
one day.
 Usually measured in terms of dollar
exposure amount or as a relative amount
against some benchmark.
223
Market Risk Measurement
 Important in terms of:
 Management information
 Setting limits
 Resource allocation (risk/return tradeoff)
 Performance evaluation
 Regulation
 BIS and Fed regulate market risk via capital
requirements leading to potential for overpricing
of risks
 Allowances for use of internal models to calculate
capital requirements
224
Calculating Market Risk Exposure
 Generally concerned with estimated
potential loss under adverse
circumstances.
 Three major approaches of
measurement
 JPM RiskMetrics (or variance/covariance
approach)
 Historic or Back Simulation
 Monte Carlo Simulation
225
JP Morgan RiskMetrics Model
 Idea is to determine the daily earnings at
risk = dollar value of position × price
sensitivity × potential adverse move in yield
or,
DEAR = Dollar market value of position × Price
volatility.
 Can be stated as (-MD) × adverse daily
yield move where,
MD = D/(1+R)
Modified duration = MacAulay duration/(1+R)
226
Confidence Intervals
 If we assume that changes in the yield are
normally distributed, we can construct
confidence intervals around the projected
DEAR. (Other distributions can be
accommodated but normal is generally
sufficient).
 Assuming normality, 90% of the time the
disturbance will be within 1.65 standard
deviations of the mean.
227
Historic or Back Simulation
 Advantages:
 Simplicity
 Does not require normal distribution of
returns (which is a critical assumption
for RiskMetrics)
 Does not need correlations or
standard deviations of individual asset
returns.
228
Historic or Back Simulation
 Basic idea: Revalue portfolio based on
actual prices (returns) on the assets
that existed yesterday, the day
before, etc. (usually previous 500
days).
 Then calculate 5% worst-case (25th
lowest value of 500 days) outcomes.
 Only 5% of the outcomes were lower.
229
Estimation of VAR: Example
 Convert today’s FX positions into dollar
equivalents at today’s FX rates.
 Measure sensitivity of each position
 Calculate its delta.
 Measure risk
 Actual percentage changes in FX rates for
each of past 500 days.
 Rank days by risk from worst to best.
230
Weaknesses
 Disadvantage: 500 observations is
not very many from statistical
standpoint.
 Increasing number of observations by
going back further in time is not
desirable.
 Could weight recent observations
more heavily and go further back.
231
Monte Carlo Simulation
 To overcome problem of limited number of
observations, synthesize additional
observations.
 Perhaps 10,000 real and synthetic
observations.
 Employ historic covariance matrix and random
number generator to synthesize observations.
 Objective is to replicate the distribution of
observed outcomes with synthetic data.
232
Regulatory Models
 BIS (including Federal Reserve) approach:
 Market risk may be calculated using standard BIS
model.
 Specific risk charge.
 General market risk charge.
 Offsets.
 Subject to regulatory permission, large banks may
be allowed to use their internal models as the basis
for determining capital requirements.
233
BIS Model
 Specific risk charge:
 Risk weights × absolute dollar values of
long and short positions
 General market risk charge:
 reflect modified durations  expected
interest rate shocks for each maturity
 Vertical offsets:
 Adjust for basis risk
 Horizontal offsets within/between time
zones
234
Tema 9
EL RIESGO DE LIQUIDEZ
Causes of Liquidity Risk
 Two types of liquidity risk:
 when depositors or insurance policyholders seek
to cash in or withdraw their financial claims
 when OBS commitments are exercised
 Fire-sale price
 the price received for an asset that has to be
liquidated (sold) immediately
236
Liability Side Liquidity Risk
 Core deposits
 deposits that provide a relatively stable, long-term
funding source to a bank
 Net deposit drains
 the amount by which cash withdrawals exceed
additions; a net cash outflow
 can be managed two ways:
 purchased liquidity management
 stored liquidity management
(continued)
237
Liability Side Liquidity Risk
 Purchased liquidity
 federal funds market
 repurchased (repo) agreement market
 issue additional fixed-maturity CD’s, notes, and/or
bonds
 Stored liquidity
 can use or sell off some of it’s assets (such as Tbills)
 utilize its stored liquidity (i.e., cash in vault)
238
Measuring a Bank’s Liquidity Exposure
 Net liquidity statement
 measures liquidity position by listing sources and uses of
liquidity
 Peer group ratio comparisons
 a comparison of its key ratios and balance sheet features
with those for banks of a similar size and geographic location
 Liquidity index
 measures the potential losses an FI could suffer from a
sudden or fire-sale disposal of assets compared to the amount
it would receive at a fair market value established under
normal market conditions
239
Calculation of the Liquidity Index
N
I =  [(wi)(Pi / Pi*)]
i=1
where
wi = Percentage of each asset in the FI’s portfolio
 wi = 1
240
Financing Gap and the Financing
Requirement
 Financing gap
 the difference between a bank’s average loans and average (core)
deposits
 if the financing gap is positive, the bank must fund it by using its
cash and liquid assets and/or borrowing funds in the money market
 Financing requirement
 the financing gap plus a bank’s liquid assets
 the larger a bank’s financing gap and liquid asset holdings, the
higher the amount of funds it needs to borrow on the money
markets and the greater is its exposure to liquidity problems
241
Liquidity Planning
 Allows managers to make important borrowing priority
decisions
 Components of a liquidity plan
 delineation of managerial details and responsibilities
 detailed list of fund providers most likely to withdraw and
the pattern of fund withdrawals
 identification of the size of potential deposit and fund
withdrawals over various time horizons in the future
 sets internal limits on separate subsidiaries and branches
borrowing and bounds for acceptable risk premiums to pay
 details a sequencing of assets for disposal
242
Deposit Drains and Bank Run Liquidity
Risk
 Deposit drains may occur for a variety of reasons
 concerns about a bank’s solvency
 failure of a related bank
 sudden changes in investor preferences
 Bank run
 a sudden and unexpected increase in deposit withdrawals
from a bank
 Bank panic
 a systemic or contagious run on the deposits of the banking
industry as a whole
243
Deposit Insurance and Discount Window
 Deposits insured for $100,000
 Federal Reserve provides a discount window facility to meet
banks’ short-term nonpermanent liquidity needs
 loans made by discounting short-term high-quality securities
such as T-bills and banker’s acceptances with central bank
 leads to increased monitoring from the Federal Reserve
which acts as a disincentive for banks to use for ‘cheap’
funding
244
Liquidity Risk and Insurance Companies
 Early cancellation of a life insurance policy results
in the insurer having to pay the surrender value
 the amount that an insurance policyholder receives when cashing
in a policy early
 when premium income is insufficient to meet surrenders, the
insurer can sell liquid assets such as government bonds
 Property-Casualty
 PC insurers have greater need for liquidity due to uncertainty so
ten to hold shorter term assets
 Guarantee Programs for Life and PC Insurance
Co.
245
Liquidity Risk and Mutual Funds
 Open-end mutual funds must stand ready to
buy back issued shares from investors at
their current market price or net asset value
 If a mutual fund is closed and liquidated, the
assets would be distributed on a pro rata
basis
246