Chapter 14. Net Noninterest Income,
Operational Risk, Securitization, and
Derivatives Activities
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Learning Objectives:
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To understand a bank's net noninterest
income ("burden") and operational risk
To understand the process of securitization
and its net benefits
To understand banks' derivatives activities
and domination by the five largest U.S.
banks
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Chapter Theme

Although securitization and
derivatives activities capture two
important aspects of modern banking,
banks have been doing traditional offbalance sheet activities (OBSAs)
such as loan commitments and lines
of credit for centuries.
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Theme (continued)

Banks face pressure, especially the
largest ones, to generate fee or
noninterest income, to reduce
noninterest or operating expenses,
and to improve capital adequacy. In
the context of the return-on-equity
model, the competitive and regulatory
pressures on both ROA and EM reflect,
in part, these forces of change.
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Theme (continued)

These pressures get bankers' attention
because they affect two pillars of bank
performance: profitability (ROA) and
capital adequacy (EM). On balance, OBSAs
(including the selling of risk-management
services) present banks with opportunities to
strengthen customer relationships and to
reduce the probability of financial
distress for client firms, thereby reducing
the bank's risk exposure to these customers.
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Theme (concluded)

While net interest income and net interest
margin (NIM) capture the intermediation
aspect of a bank's business, net
noninterest income ("burden") reflects
the nonintermediation and operational
aspects of a bank's business. Operational
risk refers to the risk of loss that banks and
other financial institutions face from
catastrophic events, human error, and other
unpredictable happenings, e.g., the collapse
of Barings, a UK investment bank.
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Motives for OBSAs

Think of the ROE model
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ROE = ROA x EM
All other things being equal (ceteris
paribus), OBSAs can increase ROA without
adding leverage to the balance sheet
Effective risk-based capital requirements,
however, price the risk of OBSAs and
restrict opportunities for regulatory capital
arbitrage
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Net Noninterest Income
(“Burden”)

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Net noninterest income is the difference
between noninterest income and
noninterest income
For almost all banks, this measure is
less than zero – hence, it is a bank’s
“burden”
Fee income and operating efficiency are
the focal variables
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Net Noninterest Income by
Bank Size (1999)
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Size class
% of assets
Change*
Top ten
-0.90
38
11-100
-0.78
88
101-1,000 -1.39
62
All others
-2.28
20
All banks
-1.11
72
*Change since 1990 in basis points
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The Components of
Noninterest (Fee) Income
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Services charges on deposits
Income from trust activities
Trading income
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The 100 largest banks, especially the 10
largest, dominate this business activity
Other (noninterest) income
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Insights from the Second
Stage of the ROE Model
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ROA = PM x AU
Data for all banks:
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1985: ROA = 0.0640 x 0.1084 = 0.0069
1999: ROA = 0.1556 x 0.0942 = 0.0131
ROA almost doubled over this period.
Why? How?
PM surged while AU dropped slightly
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Further Insights

The components of PM and AU are
three:

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Profits or net income
“Sales” (interest income + noninterest
income)
Assets
Think of the growth rates for these
three variables
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Further Insights (continued)
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For PM to increase, the growth of NI >
the growth rate of sales
For AU to decline, the growth of sales <
the growth of assets
On balance, g(NI) > g(A) > g(sales)
After improvement in loan quality, the
rapid growth o NI traces to noninterest
income (see Table 14-1, p. 471)
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Operating Efficiency and
Noninterest Expense
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The components of noninterest
expense:
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Salaries, wages, and employee benefits
Expense of premises and fixed assets
Other noninterest expense
Data for 1999 (% of assets),
respectively, are: 1.59, 0.48, and 1.70
(3.77 total up from 3.49 for 1990)
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Noninterest Expense by Bank
Size (1999)
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Size class
Top ten
11-100
101-1,000
All others
All banks
% of assets
3.45
4.15
3.70
3.71
3.77
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Operational Risk Management:
The Next Frontier (Box 14-1)

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It is the uncertainty associated with direct or
indirect losses from inadequate or failed
internal systems, processes, or people or
from external events (e.g., 11 Sept. 2001)
It has become a discipline unto itself with its
own management structure, processes, and
tools
The Basel Committee plans to include a
capital charge of operational risk for large
international banks
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Why Focus on Operational
Risk?
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Concern about losses due to ineffective
operations
Regulators concerns about operational risk
Increased operational risk associated with
globalization
Growing attention on enterprise-wide risk
management (holistic approach)
Threat of terrorism
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September 11, 2001 and
Catastrophic Risk


The banks and securities firms affected
by this dastardly act had secondary and
tertiary backup systems
Although backing up personnel can’t be
done on a large scale, geographic
diversification would reduce
concentration risk
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Risk Removal Techniques:
Securitization and Loan Participations
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Loan participations
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The traditional method achieved by using loan
syndications
Credit of $50 million or more are regarded as
syndicated loans
Large syndications have 100 or more banks
participating (see Box 14-2 on page 477 for the
major players)
Almost $2 trillion in syndicated loans at year-end
2000
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The Modern Approach:
Securitization

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John Reed said: “Securitization is the
substitution of more efficient public capital
markets for less efficient, higher cost financial
intermediaries in the funding of debt
instruments.”
Good news: Several benefits (next slide)
Bad news: Threatens existence of traditional
intermediaries
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The Benefits of Securitization

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Increased liquidity from the ability to
sell assets
Enhanced revenue/profits from asset
sales
Increased servicing income
Conservation of capital
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Understanding the Process of
Securitization
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Five basic parties:

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1.
2.
3.
4.
5.
Loan originator (bank)
Loan purchaser (affiliated trust)
Loan packager (underwriter of the securities)
Credit enhancer (guarantor)
Investors (individuals and banks)
Table 14-2 and Figure 14-1 (pp. 479-480)
summarize the process in terms of the
structure of deals and cash flows
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Terminology
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Asset-backed securities
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The underlying loans represent the cash
flows that stand behind and give value to
asset-backed securities
Mortgage-backed securities – securitization
began with these instruments and spread
such that the modern banker’s calling card
reads: “Have Loans, Will Securitize” (see
Table 14-3, p. 481)
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Terminology (continued)

Pass-through securities are not
collateralized or secured by “hard
assets” but are backed by unsecured
credits such as credit-card receivables
(Some confusion exists here because
the cash flows “pass through” whether
the underlying asset is “hard” or “soft”)
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Terminology (continued)
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Collateralized debt obligations (CDOs)
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Two main sources of underlying assets or
collateral are: loans (CLOs) and bonds
(CBOs)
A CDO has a legal structure called a
special-purpose vehicle (SPV) set up as
a subsidiary of a holding company –
view it as a balance sheet
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Terminology (continued)
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Collateralized-loan obligations (CLOs)
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In a traditional CLO, the originating bank
physically transfers the loan portfolio to the
SPV, which issues the securities backed by
the underlying loans
In a synthetic CLO, the assets are not
physically transferred and a credit
derivative (see Chapter 11) transfer the
credit risk of the collateral to the SPV
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Terminology (continued)
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Three kinds of synthetic CLOs exist:
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1. Fully funded in which all the credit risk
transfers to the SPV
2. Partially funded in which part of the
credit risk is transferred to the SPV
3. Unfunded in which none of the credit
risk transfers to the SPV – the transfer is
achieved with a credit derivative
Chapter 14
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Securitization: A Two-Way
Street


It’s a risk-removal technique
Use it to add assets and risk to an
existing balance sheet
Chapter 14
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Value-Added Through
Securitization (Table 14-3)
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Underlying asset Securitized Asset
Illiquid
Liquid
Weak valuation Market values
Lender monitoringThird party monitors
Higher oper exp Lower oper exp
Product limits
Wider offerings
Limited market
Broader market
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Derivatives: Hedging, Speculating,
Selling Risk-Management Services
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Two basic kinds of derivatives:
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1. Futures and forwards (linear contracts)
2. Options (nonlinear contracts)
Value based on or “derived” from the
underlying which can be an interest rate,
exchange rate, equity return, or a commodity
price
Trading: Exchange versus OTC
As a hedging tool, see Box 14-3 (p. 487)
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Derivative Securities
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Three classes:
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1. Structured securities and deposits (e.g.,
duel-currency bonds)
2. Stripped securities (e.g., IOs and POs)
3. Securities with option characteristics
(e.g., callable bonds)
See Table 14-5 (p. 485) for additional
examples of derivative securities)
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Discussions Topics
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Bankers Trust and Derivatives Liability
Who dominates the world of derivatives
and why?
Are derivatives the basic business of
banking?
Have derivatives fundamentally
changed financial management?
A framework for risk management
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The Risk of Derivatives
Activities
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IS MORC ILL? (see Table 14-6, p. 491)
These nine risks can be condensed into
four broad risk categories
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1.
2.
3.
4.
Market risk
Credit risk
Liquidity risk
Operational and legal risk
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Measuring Risk Exposure
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Notional value is not a good measure
Credit-equivalent exposure is the sum
of
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1. Bilaterally netted current credit exposure
2. Future exposure
Glossary (Box 14-4, p, 493)
Data (Table 14-7, 14-8, 14-9, pp. 494497)
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Transparency and Disclosure
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Bank loans and OTC derivatives share
three common characteristics:
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1. Customized
2. Privately negotiated
3. Often lack liquidity and transparency
Result: They are more difficult to value
and manage
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The Regulatory Dialectic
(Struggle Model)
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Thesis: Derivatives and securitization
Antithesis: Risk-based capital
requirements for these activities
Synthesis: Regulatory capital arbitrage
seeks ways to circumvent requirements
Chapter 14
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Chapter Summary


Asset securitization and derivatives
activities capture two of the traits of
modern banking
Although the world of derivatives is
dominated by large banks,
securitization has a much broader
appeal
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