How does the fed decide to and then close an institution?

Financial Institutions Management A Risk Management Approach

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Financial Institutions Management A Risk Management Approach Sixth Edition

Anthony Saunders John M. Schiff Professor of Finance Salomon Center Stern School of Business New York University

Marcia Millon Cornett Rehn Professor of Business Southern Illinois University

Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

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FINANCIAL INSTITUTIONS MANAGEMENT: A RISK MANAGEMENT APPROACH

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2008, 2006, 2003, 2000, 1997, 1994 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers out- side the United States.

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Library of Congress Cataloging-in-Publication Data

Saunders, Anthony, 1949– Financial institutions management : a risk management approach / Anthony Saunders, Marcia Millon Cornett.—6th ed. p. cm.— (The McGraw-Hill/Irwin series in finance, insurance, and real estate) Includes index. ISBN-13: 978-0-07-340514-8 (alk. paper) ISBN-10: 0-07-340514-0 (alk. paper) 1. Financial institutions—United States—Management. 2. Risk management—United States. 3. Financial services industry—United States—Management. I. Cornett, Marcia Millon. II. Title. HG181.S33 2008 332.1068--dc22

2007026797

www.mhhe.com

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This book is dedicated to Pat, Nicholas, and Emily and to my mother, Evelyn.

Anthony Saunders

To the Millons and the Cornetts, especially Galen.

Marcia Millon Cornett

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vi

About the Authors Anthony Saunders Anthony Saunders is the John M. Schiff Professor of Finance and Chair of the Department of Finance at the Stern School of Business at New York University. Professor Saunders received his PhD from the London School of Economics and has taught both undergraduate- and graduate-level courses at NYU since 1978. Throughout his academic career, his teaching and research have specialized in fi- nancial institutions and international banking. He has served as a visiting profes- sor all over the world, including INSEAD, the Stockholm School of Economics, and the University of Melbourne. He is currently on the Executive Committee of the Salomon Center for the Study of Financial Institutions, NYU.

Professor Saunders holds positions on the Board of Academic Consultants of the Federal Reserve Board of Governors as well as the Council of Research Ad- visors for the Federal National Mortgage Association. In addition, Dr. Saunders has acted as a visiting scholar at the Comptroller of the Currency and at the Fed- eral Reserve Bank of Philadelphia. He also held a visiting position in the research department of the International Monetary Fund. He is an editor of the Journal of Banking and Finance and the Journal of Financial Markets, Instruments and Institu- tions, as well as the associate editor of eight other journals, including Financial Management and the Journal of Money, Credit and Banking. His research has been published in all the major money and banking and finance journals and in several books. In addition, he has authored or coauthored several professional books, the most recent of which is Credit Risk Measurement: New Approaches to Value at Risk and Other Paradigms, 2nd edition, John Wiley and Sons, New York, 2002.

Marcia Millon Cornett Marcia Millon Cornett is the Rehn Professor of Business at Southern Illinois University at Carbondale. She received her BS degree in Economics from Knox College in Galesburg, Illinois, and her MBA and PhD degrees in Finance from Indiana University in Bloomington, Indiana. Dr. Cornett has written and published several articles in the areas of bank performance, bank regulation, and corporate finance. Articles authored by Dr. Cornett have appeared in such academic journals as the Journal of Finance, the Journal of Money, Credit and Banking, the Journal of Financial Economics, Financial Management, and the Journal of Banking and Finance. She served as an Associate Editor of Financial Management and is currently an Associate Editor for the Journal of Banking and Finance, Journal of Financial Services Research, FMA Online, the Multinational Finance Journal and the Review of Financial Economics. Dr. Cornett is currently a member of the Board of Directors, the Executive Committee, and the Finance Committee of the SIU Credit Union. Dr. Cornett has also taught at the University of Colorado, Boston College, and Southern Methodist University. She is a member of the Financial Management Association, the American Finance Association, and the Western Finance Association.

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vii

Preface The financial services industry continues to undergo dramatic changes. Not only have the boundaries between traditional industry sectors, such as commercial banking and investment banking, broken down but competition is becoming in- creasingly global in nature. Many forces are contributing to this breakdown in in- terindustry and intercountry barriers, including financial innovation, technology, taxation, and regulation. It is in this context that this book is written. Although the traditional nature of each sector's product activity is analyzed, a greater emphasis is placed on new areas of activities such as asset securitization, off-balance-sheet banking, and international banking.

When the first edition of this text was released in 1994, it was the first to analyze modern financial institutions management from a risk perspective. Thus, the title, Financial Institutions Management: A Modern Perspective. At that time, traditional texts presented an overview of the industry sector by sector, concentrating on bal- ance sheet presentations and overlooking management decision making and risk management. Over the last decade other texts have followed this change, such that a risk management approach to analyzing modern financial institutions is now well accepted. Thus, the title: Financial Institutions Management: A Risk Man- agement Approach.

The sixth edition of this text takes the same innovative approach taken in the first five editions and focuses on managing return and risk in modern financial institutions (FIs). Financial Institutions Management ’s central theme is that the risks faced by FI managers and the methods and markets through which these risks are managed are similar whether an institution is chartered as a commercial bank, a savings bank, an investment bank, or an insurance company.

As in any stockholder-owned corporation, the goal of FI managers should al- ways be to maximize the value of the financial intermediary. However, pursuit of value maximization does not mean that risk management can be ignored.

Indeed, modern FIs are in the risk-management business. As we discuss in this book, in a world of perfect and frictionless capital markets, FIs would not exist and individuals would manage their own financial assets and portfolios. But since real-world financial markets are not perfect, FIs provide the positive function of bearing and managing risk on behalf of their customers through the pooling of risks and the sale of their services as risk specialists.

INTENDED AUDIENCE

Financial Institutions Management: A Risk Management Approach is aimed at upper- level undergraduate and MBA audiences. Occasionally there are more technical sections that are marked with a footnote. These sections may be included or dropped from the chapter reading, depending on the rigor of the course, without harming the con- tinuity of the chapters.

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MAIN FEATURES

Throughout the text, special features have been integrated to encourage students' interaction with the text and to aid them in absorbing the material. Some of these features include:

Standard & Poor's Market Insight Questions, which are included in the end- of-chapter questions and problems and which guide the student through this Web site to access data on specific financial institutions or industry sectors. In-chapter Internet Exercises and references, which guide the student to ac- cess the most recent data on the Web. International material highlights, which call out material relating to global is- sues. In-chapter Examples, which provide numerical demonstrations of the analytics described in various chapters. Bold key terms and marginal glossary, which highlight and define the main terms and concepts throughout the chapter. Concept Questions, which allow students to test themselves on the main con- cepts within each major chapter section. Ethical Dilemmas, Industry Perspectives, and Technology in the News boxes, which demonstrate the application of chapter material to real current events.

ORGANIZATION

Since our focus is on return and risk and the sources of that return and risk, this book relates ways in which the managers of modern FIs can expand return with a managed level of risk to achieve the best, or most favorable, return-risk outcome for FI owners.

Chapter 1 introduces the special functions of FIs and takes an analytical look at how financial intermediation benefits today's economy. Chapters 2 through 6 provide an overview describing the key balance sheet and regulatory features of the major sectors of the U.S. financial services industry. We discuss depository institutions in Chapter 2, insurance institutions in Chapter 3, securities firms and investment banks in Chapter 4, mutual funds and hedge funds in Chapter 5, and finance companies in Chapter 6. In Chapter 7 we preview the risk measurement and management sections with an overview of the risks facing a modern FI. We divide the chapters on risk measurement and management into two sections: mea- suring risk and managing risk.

In Chapters 8 and 9 we start the risk-measurement section by investigating the net interest margin as a source of profitability and risk, with a focus on the effects of interest rate volatility and the mismatching of asset and liability durations on FI risk exposure. In Chapter 10 we analyze market risk, a risk that results when FIs actively trade bonds, equities, and foreign currencies.

In Chapter 11 we look at the measurement of credit risk on individual loans and bonds and how this risk adversely impacts an FI's profits through losses and provisions against the loan and debt security portfolio. In Chapter 12 we look at the risk of loan (asset) portfolios and the effects of loan concentrations on risk exposure. Modern FIs do more than generate returns and bear risk through traditional

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maturity mismatching and credit extensions. They also are increasingly engaging in off-balance-sheet activities to generate fee income (Chapter 13) pursuing foreign exchange activities and overseas financial investments (Chapter 15), engaging in sovereign lending and securities activities (Chapter 16), and making technological investments to reduce costs (Chapter 16). Each of these has implications for the size and variability of an FI's profits and/or revenues. In addition, as a by-product of the provision of their interest rate and credit intermediation services, FIs face liquidity risk. We analyze the special nature of this risk in Chapter 17.

In Chapter 18 we begin the risk-management section by looking at ways in which FIs can insulate themselves from liquidity risk. In Chapter 19 we look at the key role deposit insurance and other guaranty schemes play in reducing liquid- ity risk. At the core of FI risk insulation is the size and adequacy of the owners' capital or equity investment in the FI, which is the focus of Chapter 20. Chap- ters 21 and 22 analyze how and why product diversification and geographic di- versification—both domestic and international—can improve an FI's return-risk performance and the impact of regulation on the diversification opportunity set. Chapters 23 through 27 review various new markets and instruments that have been innovated or engineered to allow FIs to better manage three important types of risk: interest rate risk, credit risk, and foreign exchange risk. These markets and instruments and their strategic use by FIs include futures and forwards (Chapter 23); options, caps, floors, and collars (Chapter 24); swaps (Chapter 25); loan sales (Chapter 26); and securitization (Chapter 27).

CHANGES IN THIS EDITION

Each chapter in this edition has been revised thoroughly to reflect the most up-to-date information available. End-of-chapter questions and problem mate- rial have also been expanded and updated to provide a complete selection of testing material.

The following are some of the new features of this revision:

The discussion of hedge funds in Chapter 5 has been expanded and included in the body of Chapter 5. These relatively unregulated investment companies now manage over $2 trillion in assets and have become a major sector of the financial institutions industry. Chapter 6 includes a discussion of the crash in the subprime mortgage market and the impact on finance companies that were deeply involved in this area of mortgage lending. The impact of the devastating hurricane season in 2005, including Hurricane Katrina, on insurance companies has been added to Chapter 3. Integrated Mini Cases have been added to several chapters. These exercises combine the various numerical concepts within a chapter into one overall problem. Additional end-of-chapter problems have been added to many of the chapters. A more detailed look at the interaction of interest rates, inflation, and foreign exchange rates has been added to Chapter 14. Chapters 21 and 22 in the previous edition of the text have been combined so that domestic and international geographic expansion are viewed as part of an overall expansion strategy for financial institutions rather than as independent activities.

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The order of Chapters 14 through 16 has been changed so that client-based risk measures are now all presented first followed by risk measures associated with the internal operations of the financial institution. The growth of the financial services holding company as a corporate form, first allowed under the 1999 Financial Services Modernization Act, is highlighted in several chapters. These entities can combine the various sectors of the financial institutions industry into one holding company that offers a whole variety of financial services. Ethical dilemmas continue to be an issue for financial institutions. In-chapter discussions of the many ethical controversies involving financial institutions (such as those involving commercial banks, investment banks, and mutual funds) have been updated. The latest information pertaining to new capital adequacy rules (or Basel II) that were implemented in 2006 has been highlighted in Chapter 20. The changes, implemented in 2007, to the bank and savings institution insurance fund, de- posit insurance premiums charged to financial institutions, and insurance cov- erage for financial institutions customers are discussed in Chapter 19. The impact of the rise in interest rates in the mid-2000s on financial institutions is highlighted and discussed. Tables and figures in all chapters have been revised to include the most re- cently available data.

We have retained and updated these features:

The risk approach of Financial Institutions Management has been retained, keep- ing the first section of the text as an introduction and the last two sections as a risk measurement and risk management summary, respectively. We again present a detailed look at what is new in each of the different sec- tors of the financial institutions industry in the first six chapters of the text. We have highlighted the continued international coverage with a global issues icon throughout the text. The discussion of how the Financial Services Modernization Act of 1999 contin- ues to affect financial institutions remains in several chapters. Chapter 16 includes material on electronic technology and the Internet's impact on financial services. Technological changes occurring over the last decade have changed the way financial institutions offer services to customers, both domestically and overseas. The effect of technology is also referenced in other chapters where relevant. Coverage of Credit Risk models (including newer models, such as KMV, Cred- itMetrics, and CreditRisk � ) remains in the text. Coverage in the “Product Diversification” chapter and the “Geographic Exp- ansion” chapter explores the increased inroads of banks into the insurance field, the move toward nationwide banking (in the United States), and the rapid growth of foreign banks and other intermediaries in the United States. A Web site has been expanded as a supplement to the text. The Web site, www. mhhe.com/saunders6e , will include information about the book and an instruc- tor's site containing the password-protected Instructor's Manual and Power- Point material. Numerous highlighted in-chapter Examples remain in the chapters.

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Preface xi

Technology in the News boxes on how technology and the Internet are affecting financial institutions as an industry have been updated. Internet references remain throughout each chapter as well as at the end of each chapter, and Internet questions are found after the end-of-chapter questions. An extensive problem set, including S&P Market Insight, Excel, and Internet exercises, can be found at the end of each chapter that allows students to prac- tice a variety of skills using the same data or set of circumstances.

ANCILLARIES

To assist in course preparation, the following ancillaries are offered:

The Online Learning Center at www.mhhe.com/saunders6e includes the following: The Instructor's Manual/Test Bank includes detailed chapter contents, additional examples for use in the classroom, PowerPoint teaching notes, complete solu- tions to end-of-chapter questions and problem material, and additional prob- lems for test material, both in Word and computerized testing format. The PowerPoint Presentation System was created by Kenneth Stanton of the University of Baltimore and is included on the Instructor's Resource CD. It con- tains useful and graphically enhanced outlines, summaries, and exhibits from the text. The slides can be edited, printed, or arranged to fit the needs of your course. Online quizzes are available at www.mhhe.com/saunders6e that provide stu- dents with chapter-specific interactive quizzing for self-evaluation.

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xii

Acknowledgments Finally, we would like to thank the numerous colleagues who assisted with the previous editions of this book. Of great help were the book reviewers whose painstaking comments and advice guided the text through its first, second, third, and fourth revisions.

Jack Aber Boston University Michael H. Anderson Suffolk University Rita Biswas SUNY—Albany M. E. Bond University of Memphis Yen Mow Chen San Francisco State University Jeffrey A. Clark Florida State University Robert A. Clark Butler University S. Steven Cole University of North Texas Douglas Cook University of Mississippi Paul Ellinger University of Illinois David Ely San Diego State University Elyas Elyasiani Temple University James H. Gilkeson University of Central Florida John H. Hand Auburn University Yan He San Francisco State University Alan C. Hess University of Washington—Seattle Kevin Jacques Georgetown University and Office of the Comptroller of the Currency

Julapa Jagtiani Federal Reserve Bank of Chicago Craig G. Johnson California State University—Hayward Nelson J. Lacey University of Massachusetts at Amherst Robert Lamy Wake Forest University Rick LeCompte Wichita State University Patricia C. Matthews Mount Union College Robert McLeod University of Alabama Rose M. Prasad Central Michigan University Tara Rice Boston College Don Sabbarese Kennesaw State University Daniel Singer Towson University Richard Stolz California State University—Fullerton Michael Toyne Northeastern State University Haluk Unal University of Maryland James A. Verbrugge University of Georgia Sonya Williams-Stanton University of Michigan—Ann Arbor

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In addition, we gratefully acknowledge the contributions of the reviewers of the fifth edition:

Mounther Barakat University of Houston–Clear Lake Sreedhar Bharath University of Michigan Kenneth Daniels Virginia Commonwealth University Joseph Finnerty University of Illinios Jack Clark Francis Baruch College–CUNY

Jamie McNutt Rutgers–Camden Roberto Perli University of Maryland Kenneth Rhoda LaSalle University Robert Wolf University of Wisconsin–La Crosse

We very much appreciate the contributions of the book team at McGraw-Hill/ Irwin: Michele Janicek, Executive Editor; Katherine Mau, Editorial Assistant; Julie Phifer, Senior Marketing Manager; Cathy Tepper, Media Project Manager; Mary Conzachi, Project Manager; Debra Sylvester, Production Supervisor; and Mathew Baldwin, Designer. We are also grateful to our secretaries and assistants, Robyn Vanterpool, Ingrid Persaud, Anand Srinivasan, and Sharon Moore.

Anthony Saunders

Marcia Millon Cornett

Acknowledgments xiii

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xiv

Brief Contents PART ONE Introduction 1

1 Why Are Financial Intermediaries Special? 2

2 The Financial Services Industry: Depository Institutions 27

3 The Financial Services Industry: Insurance Companies 66

4 The Financial Services Industry: Securities Firms and Investment Banks 93

5 The Financial Services Industry: Mutual Funds and Hedge Funds 118

6 The Financial Services Industry: Finance Companies 153

7 Risks of Financial Intermediation 168

PART TWO Measuring Risk 189

8 Interest Rate Risk I 190

9 Interest Rate Risk II 221

10 Market Risk 266

11 Credit Risk: Individual Loan Risk 295

12 Credit Risk: Loan Portfolio and Concentration Risk 348

13 Off-Balance-Sheet Risk 372

14 Foreign Exchange Risk 400

15 Sovereign Risk 425

16 Technology and Other Operational Risks 458

17 Liquidity Risk 493

PART THREE Managing Risk 519

18 Liability and Liquidity Management 520

19 Deposit Insurance and Other Liability Guarantees 551

20 Capital Adequacy 586

21 Product Diversification 631

22 Geographic Expansion 656

23 Futures and Forwards 691

24 Options, Caps, Floors, and Collars 728

25 Swaps 769

26 Loan Sales 797

27 Securitization 814

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xv

Contents PART ONE INTRODUCTION 1

Chapter One Why Are Financial Intermediaries Special? 2

Introduction 2 Financial Intermediaries' Specialness 3

FIs Function as Brokers 5 FIs Function as Asset Transformers 5 Information Costs 6 Liquidity and Price Risk 7 Other Special Services 8

Other Aspects of Specialness 9 The Transmission of Monetary Policy 9 Credit Allocation 9 Intergenerational Wealth Transfers or Time Intermediation 9 Payment Services 10 Denomination Intermediation 10

Specialness and Regulation 10 Safety and Soundness Regulation 11 Monetary Policy Regulation 12 Credit Allocation Regulation 13 Consumer Protection Regulation 13 Investor Protection Regulation 14 Entry Regulation 14

The Changing Dynamics of Specialness 15 Trends in the United States 15 Future Trends 18 Global Issues 20

Summary 21 Appendix 1A Monetary Policy Tools 26 (www.mhhe.com/saunders6e)

Chapter Two The Financial Services Industry: Depository Institutions 27

Introduction 27 Commercial Banks 29

Size, Structure, and Composition of the Industry 29

Balance Sheet and Recent Trends 33 Other Fee-Generating Activities 38 Regulation 39 Industry Performance 44

Savings Institutions 47 Size, Structure, and Composition of the Industry 48 Balance Sheet and Recent Trends 50 Regulation 51 Industry Performance 52

Credit Unions 53 Size, Structure, and Composition of the Industry 54 Balance Sheets and Recent Trends 55 Regulation 57 Industry Performance 57

Global Issues: Europe, Japan, and China 58 Summary 60 Appendix 2A Financial Statement Analysis Using a Return on Equity (ROE) Framework 64 (www.mhhe.com/saunders6e) Appendix 2B Depository Institutions and Their Regulators 65 (www.mhhe.com/saunders6e) Appendix 2C Technology in Commercial Banking 65 (www.mhhe.com/saunders6e)

Chapter Three The Financial Services Industry: Insurance Companies 66

Introduction 66 Life Insurance Companies 66

Size, Structure, and Composition of the Industry 66 Balance Sheet and Recent Trends 71 Regulation 73

Property–Casualty Insurance 75 Size, Structure, and Composition of the Industry 75 Balance Sheet and Recent Trends 76 Regulation 85

Global Issues 86 Summary 88

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Chapter Four The Financial Services Industry: Securities Firms and Investment Banks 93

Introduction 93 Size, Structure, and Composition of the Industry 95 Balance Sheet and Recent Trends 103

Recent Trends 103 Balance Sheet 106

Regulation 108 Global Issues 112 Summary 114

Chapter Five The Financial Services Industry: Mutual Funds and Hedge Funds 118

Introduction 118 Size, Structure, and Composition of the Mutual Fund Industry 119

Historical Trends 119 Different Types of Mutual Funds 122 Mutual Fund Objectives 126 Investor Returns from Mutual Fund Ownership 128 Mutual Fund Costs 131

Balance Sheet and Recent Trends for the Mutual Fund Industry 134

Money Market Funds 134 Long-Term Funds 135

Regulation of Mutual Funds 136 Global Issues in the Mutual Fund Industry 141 Hedge Funds 143

Types of Hedge Funds 144 Fees on Hedge Funds 148 Offshore Hedge Funds 148 Regulation of Hedge Funds 148

Summary 150

Chapter Six The Financial Services Industry: Finance Companies 153

Introduction 153 Size, Structure, and Composition of the Industry 154 Balance Sheet and Recent Trends 157

Assets 157 Liabilities and Equity 161

Industry Performance 162 Regulation 163 Global Issues 164 Summary 165

Chapter Seven Risks of Financial Intermediation 168

Introduction 168 Interest Rate Risk 169 Market Risk 171 Credit Risk 173 Off-Balance-Sheet Risk 176 Foreign Exchange Risk 177 Country or Sovereign Risk 179 Technology and Operational Risks 180 Liquidity Risk 181 Insolvency Risk 182 Other Risks and the Interaction of Risks 183 Summary 184 Appendix 7A Commercial Banks' Financial Statements and Analysis 188 (www.mhhe.com/saunders6e)

PART TWO MEASURING RISK 189

Chapter Eight Interest Rate Risk I 190

Introduction 190 The Level and Movement of Interest Rates 191 The Repricing Model 195

Rate-Sensitive Assets 197 Rate-Sensitive Liabilities 198 Equal Changes in Rates on RSAs and RSLs 200 Unequal Changes in Rates on RSAs and RSLs 201

Weaknesses of the Repricing Model 203 Market Value Effects 203 Overaggregation 203 The Problem of Runoffs 204 Cash Flows from Off-Balance-Sheet Activities 205

Summary 205 Appendix 8A The Maturity Model 214 (www.mhhe.com/saunders6e) Appendix 8B Term Structure of Interest Rates 214

xvi Contents

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Chapter Nine Interest Rate Risk II 221

Introduction 221 Duration: A Simple Introduction 222 A General Formula for Duration 224

The Duration of Interest-Bearing Bonds 226 The Duration of a Zero-Coupon Bond 228 The Duration of a Consol Bond (Perpetuities) 228

Features of Duration 229 Duration and Maturity 229 Duration and Yield 229 Duration and Coupon Interest 230

The Economic Meaning of Duration 230 Semiannual Coupon Bonds 233

Duration and Interest Rate Risk 234 Duration and Interest Rate Risk Management on a Single Security 234 Duration and Interest Rate Risk Management on the Whole Balance Sheet of an FI 238

Immunization and Regulatory Considerations 243 Difficulties in Applying the Duration Model 244

Duration Matching Can Be Costly 245 Immunization Is a Dynamic Problem 245 Large Interest Rate Changes and Convexity 246

Summary 248 Appendix 9A The Basics of Bond Valuation 255 (www.mhhe.com/saunders6e) Appendix 9B Incorporating Convexity into the Duration Model 256

Chapter Ten Market Risk 266

Introduction 266 Calculating Market Risk Exposure 267 The RiskMetrics Model 268

The Market Risk of Fixed-Income Securities 269 Foreign Exchange 272 Equities 273 Portfolio Aggregation 274

Historic (Back Simulation) Approach 277 The Historic (Back Simulation) Model versus RiskMetrics 281 The Monte Carlo Simulation Approach 282

Regulatory Models: The BIS Standardized Framework 283

Fixed Income 283 Foreign Exchange 287 Equities 287

The BIS Regulations and Large-Bank Internal Models 288 Summary 290

Chapter Eleven Credit Risk: Individual Loan Risk 295

Introduction 295 Credit Quality Problems 297 Types of Loans 299

Commercial and Industrial Loans 299 Real Estate Loans 301 Individual (Consumer) Loans 303 Other Loans 305

Calculating the Return on a Loan 306 The Contractually Promised Return on a Loan 306 The Expected Return on a Loan 309

Retail versus Wholesale Credit Decisions 310 Retail 310 Wholesale 310

Measurement of Credit Risk 312 Default Risk Models 313

Qualitative Models 313 Credit Scoring Models 316

Newer Models of Credit Risk Measurement and Pricing 320

Term Structure Derivation of Credit Risk 320 Mortality Rate Derivation of Credit Risk 326 RAROC Models 328 Option Models of Default Risk 332

Summary 337 Appendix 11A Credit Analysis 347 (www.mhhe.com/saunders6e) Appendix 11B Black-Scholes Option Pricing Model 347 (www.mhhe.com/saunders6e)

Chapter Twelve Credit Risk: Loan Portfolio and Concentration Risk 348

Introduction 348 Simple Models of Loan Concentration Risk 348 Loan Portfolio Diversification and Modern Portfolio Theory (MPT) 350

KMV Portfolio Manager Model 353 Partial Applications of Portfolio Theory 356

Contents xvii

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Loan Loss Ratio–Based Models 359 Regulatory Models 360

Summary 361 Appendix 12A CreditMetrics 365 Appendix 12B CreditRisk+ 369

Chapter Thirteen Off-Balance-Sheet Risk 372

Introduction 372 Off-Balance-Sheet Activities and FI Solvency 373 Returns and Risks of Off-Balance-Sheet Activities 378

Loan Commitments 380 Commercial Letters of Credit and Standby Letters of Credit 384 Derivative Contracts: Futures, Forwards, Swaps, and Options 386 Forward Purchases and Sales of When-Issued Securities 389 Loans Sold 390

Non–schedule L Off-Balance-Sheet Risks 391 Settlement Risk 391 Affiliate Risk 392

The Role of OBS Activities in Reducing Risk 393 Summary 394 Appendix 13A A Letter of Credit Transaction 399 (www.mhhe.com/saunders6e)

Chapter Fourteen Foreign Exchange Risk 400

Introduction 400 Foreign Exchange Rates and Transactions 400

Foreign Exchange Rates 400 Foreign Exchange Transactions 401

Sources of Foreign Exchange Risk Exposure 403 Foreign Exchange Rate Volatility and FX Exposure 406

Foreign Currency Trading 407 FX Trading Activities 407 The Profitability of Foreign Currency Trading 408

Foreign Asset and Liability Positions 409 The Return and Risk of Foreign Investments 409 Risk and Hedging 411 Multicurrency Foreign Asset–Liability Positions 415

Interaction of Interest Rates, Inflation, and Exchange Rates 417

Purchasing Power Parity 417

Interest Rate Parity Theorem 419 Summary 420

Chapter Fifteen Sovereign Risk 425 Introduction 425 Credit Risk versus Sovereign Risk 428 Debt Repudiation versus Debt Rescheduling 429 Country Risk Evaluation 430

Outside Evaluation Models 431 Internal Evaluation Models 432 Debt Service Ratio (DSR) 434 Import Ratio (IR) 434 Investment Ratio (INVR) 435 Variance of Export Revenue (VAREX) 435 Domestic Money Supply Growth (MG) 436 Using Market Data to Measure Risk: The Secondary Market for LDC Debt 442

Summary 448 Appendix 15A Mechanisms for Dealing with Sovereign Risk Exposure 453

Chapter Sixteen Technology and Other Operational Risks 458 Introduction 458 What Are the Sources of Operational Risk? 459 Technological Innovation and Profitability 459 The Impact of Technology on Wholesale and Retail Financial Service Production 462

Wholesale Financial Services 462 Retail Financial Services 463

The Effect of Technology on Revenues and Costs 465

Technology and Revenues 466 Technology and Costs 467

Testing for Economies of Scale and Economies of Scope 472

The Production Approach 472 The Intermediation Approach 473

Empirical Findings on Cost Economies of Scale and Scope and Implications for Technology Expenditures 473 Economies of Scale and Scope and X-Inefficiencies 473 Technology and the Evolution of the Payments System 475

Risks That Arise in an Electronic Payment System 477 Other Operational Risks 483

xviii Contents

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Regulatory Issues and Technology and Operational Risks 486 Summary 489

Chapter Seventeen Liquidity Risk 493

Introduction 493 Causes of Liquidity Risk 493 Liquidity Risk at Depository Institutions 494

Liability-Side Liquidity Risk 494 Asset-Side Liquidity Risk 498 Measuring a DI's Liquidity Exposure 500 Liquidity Risk, Unexpected Deposit Drains, and Bank Runs 507 Bank Runs, the Discount Window, and Deposit Insurance 509

Liquidity Risk and Life Insurance Companies 510 Liquidity Risk and Property–Casualty Insurers 511 Ivestment Funds 511 Summary 514 Appendix 17A Sources and Uses of Funds Statements, Bank of America, December 2005 518 (www.mhhe.com/saunders6e)

PART THREE MANAGING RISK 519

Chapter Eighteen Liability and Liquidity Management 520

Introduction 520 Liquid Asset Management 520

Monetary Policy Implementation Reasons 521 Taxation Reasons 522

The Composition of the Liquid Asset Portfolio 522 Return-Risk Trade-Off for Liquid Assets 523

The Liquid Asset Reserve Management Problem for U.S. Depository Institutions 523 Undershooting/Overshooting of the Reserve Target 527 Managing Liquid Assets Other than Cash 531

Liability Management 532 Funding Risk and Cost 533

Choice of Liability Structure 533 Demand Deposits 534 Interest-Bearing Checking (NOW) Accounts 535 Passbook Savings 536 Money Market Deposit Accounts (MMDAs) 536

Retail Time Deposits and CDs 537 Wholesale CDs 538 Federal Funds 539 Repurchase Agreements (RPs) 540 Other Borrowings 540

Liquidity and Liability Structures for U.S. Depository Institutions 542 Liability and Liquidity Risk Management in Insurance Companies 544 Liability and Liquidity Risk Management in Other FIs 544 Summary 545 Appendix 18A Federal Reserve Requirement Accounting 550 (www.mhhe.com/saunders6e) Appendix 18B Bankers Acceptances and Commercial Paper as a Source of Financing 550 (www.mhhe.com/saunders6e)

Chapter Nineteen Deposit Insurance and Other Liability Guarantees 551 Introduction 551 Bank and Thrift Guaranty Funds 552 The Causes of the Depository Fund Insolvencies 554

The Financial Environment 554 Moral Hazard 555

Panic Prevention versus Moral Hazard 556 Controlling Depository Institution Risk Taking 557

Stockholder Discipline 557 Depositor Discipline 564 Regulatory Discipline 569

Non-U.S. Deposit Insurance Systems 570 The Discount Window 571

Deposit Insurance versus the Discount Window 571 The Discount Window 571

Other Guaranty Programs 573 National Credit Union Administration 573 Property–Casualty and Life Insurance Companies 574 The Securities Investor Protection Corporation 575 The Pension Benefit Guaranty Corporation 575

Summary 577 Appendix 19A Calculation of Deposit Insurance Premiums 582 Appendix 19B FDIC Press Releases of Bank Failures 585 (www.mhhe.com/saunders6e)

Contents xix

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Appendix 19C Deposit Insurance Schemes for Commercial Banks in Various Countries 585 (www.mhhe.com/saunders6e)

Chapter Twenty Capital Adequacy 586 Introduction 586 Capital and Insolvency Risk 587

Capital 587 The Market Value of Capital 587 The Book Value of Capital 590 The Discrepancy between the Market and Book Values of Equity 592 Arguments against Market Value Accounting 593

Capital Adequacy in the Commercial Banking and Thrift Industry 594

Actual Capital Rules 594 The Capital–Assets Ratio (or Leverage Ratio) 595 Risk–Based Capital Ratios 596 Calculating Risk-Based Capital Ratios 601

Capital Requirements for Other FIs 615 Securities Firms 615 Life Insurance 616 Property–Casualty Insurance 618

Summary 619 Appendix 20A Internal Ratings–Based Approach to Measuring Credit Risk–Adjusted Assets 627

Chapter Twenty-One Product Diversification 631

Introduction 631 Risks of Product Segmentation 631 Segmentation in the U.S. Financial Services Industry 633

Commercial and Investment Banking Activities 633 Banking and Insurance 636 Commercial Banking and Commerce 638 Nonbank Financial Service Firms and Commerce 639

Activity Restrictions in the United States versus Other Countries 640 Issues Involved in the Diversification of Product Offerings 641

Safety and Soundness Concerns 643 Economies of Scale and Scope 645 Conflicts of Interest 647 Deposit Insurance 649 Regulatory Oversight 650 Competition 650

Summary 652

Appendix 21A EU and G-10 Countries: Regulatory Treatment of the Mixing of Banking, Securities, and Insurance Activities and the Mixing of Banking and Commerce 655 (www.mhhe.com/saunders6e)

Chapter Twenty-Two Geographic Expansion 656

Introduction 656 Domestic Expansions 656 Regulatory Factors Impacting Geographic Expansion 657

Insurance Companies 657 Thrifts 657 Commercial Banks 658

Cost and Revenue Synergies Impacting Domestic Geographic Expansion by Merger and Acquisition 664

Cost Synergies 664 Revenue Synergies 667 Merger Guidelines for Acceptability 668

Other Market- and Firm-Specific Factors Impacting Domestic Geographic Expansion Decisions 671 The Success of Domestic Geographic Expansions 672

Investor Reaction 672 Postmerger Performance 673

Global and International Expansions 674 U.S. Banks Abroad 675 Foreign Banks in the United States 679

Advantages and Disadvantages of International Expansion 683

Advantages 684 Disadvantages 685

Summary 686

Chapter Twenty-Three Futures and Forwards 691

Introduction 691 Forward and Futures Contracts 693

Spot Contracts 693 Forward Contracts 693 Futures Contracts 695

Forward Contracts and Hedging Interest Rate Risk 696 Hedging Interest Rate Risk with Futures Contracts 697

Microhedging 697

xx Contents

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Macrohedging 698 Routine Hedging versus Selective Hedging 698 Macrohedging with Futures 699 The Problem of Basis Risk 707

Hedging Foreign Exchange Risk 708 Forwards 709 Futures 709 Estimating the Hedge Ratio 713

Hedging Credit Risk with Futures and Forwards 716

Credit Forward Contracts and Credit Risk Hedging 716 Futures Contracts and Catastrophe Risk 718 Futures and Forward Policies of Regulators 719

Summary 720 Appendix 23A Interest Rate Futures Quotes from The Wall Street Journal Online 726 Appendix 23B Microhedging with Futures 727 (www.mhhe.com/saunders6e)

Chapter Twenty-Four Options, Caps, Floors, and Collars 728

Introduction 728 Basic Features of Options 728

Buying a Call Option on a Bond 729 Writing a Call Option on a Bond 730 Buying a Put Option on a Bond 731 Writing a Put Option on a Bond 732

Writing versus Buying Options 733 Economic Reasons for Not Writing Options 733 Regulatory Reasons 735 Futures versus Options Hedging 735

The Mechanics of Hedging a Bond or Bond Portfolio 736

Hedging with Bond Options Using the Binomial Model 737

Actual Bond Options 740 Using Options to Hedge Interest Rate Risk on the Balance Sheet 743 Using Options to Hedge Foreign Exchange Risk 748 Hedging Credit Risk with Options 794 Hedging Catastrophe Risk with Call Spread Options 751 Caps, Floors, and Collars 751

Caps 752 Floors 755 Collars 756 Caps, Floors, Collars, and Credit Risk 759

Summary 760 Appendix 24A Black-Scholes Option Pricing Model 768 (www.mhhe.com/saunders6e) Appendix 24B Microhedging with Options 768 (www.mhhe.com/saunders6e)

Chapter Twenty-Five Swaps 769

Introduction 769 Swap Markets 769 Interest Rate Swaps 770

Realized Cash Flows on an Interest Rate Swap 774 Macrohedging with Swaps 775

Currency Swaps 778 Fixed-Fixed Currency Swaps 778 Fixed-Floating Currency Swaps 780

Credit Swaps 782 Total Return Swaps 782 Pure Credit Swaps 784

Swaps and Credit Risk Concerns 785 Netting and Swaps 786 Payment Flows Are Interest and Not Principal 786 Standby Letters of Credit 787

Summary 788 Appendix 25A Setting Rates on an Interest Rate Swap 794

Chapter Twenty-Six Loan Sales 797

Introduction 797 The Bank Loan Sales Market 798

Definition of a Loan Sale 798 Types of Loan Sales 799 Types of Loan Sales Contracts 800 Trends in Loan Sales 802 The Buyers and the Sellers 803

Why Banks and Other FIs Sell Loans 808 Reserve Requirements 808 Fee Income 808 Capital Costs 808 Liquidity Risk 808

Factors Affecting Loan Sales Growth 809 Access to the Commercial Paper Market 809 Customer Relationship Effects 809 Legal Concerns 809 BIS Capital Requirements 810 Market Value Accounting 810

Contents xxi

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Asset Brokerage and Loan Trading 810 Government Loan Sales 810 Credit Ratings 810 Purchase and Sale of Foreign Bank Loans 811

Summary 811

Chapter Twenty-Seven Securitization 814

Introduction 814 The Pass-Through Security 814

GNMA 815 FNMA 815 FHLMC 816 The Incentives and Mechanics of Pass-Through Security Creation 816 Prepayment Risk on Pass-Through Securities 821 Prepayment Models 826

Government Sponsorship and Oversight of FNMA and Freddie Mac 833

The Collateralized Mortgage Obligation (CMO) 835

Creation of CMOs 835 Class A, B, and C Bond Buyers 838 Other CMO Classes 838

The Mortgage-Backed Bond (MBB) 840 Innovations in Securitization 841

Mortgage Pass-Through Strips 842 Securitization of Other Assets 844

Can All Assets Be Securitized? 845 Summary 847 Appendix 27A Fannie Mae and Freddie Mac Balance Sheets 852 (www.mhhe.com/saunders6e)

INDEX 853

xxii Contents

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Part One

Introduction

1. Why Are Financial Intermediaries Special? 2

2. The Financial Services Industry: Depository Institutions 27

3. The Financial Services Industry: Insurance Companies 66

4. The Financial Services Industry: Securities Firms and Investment Banks 93

5. The Financial Services Industry: Mutual Funds 118

6. The Financial Services Industry: Finance Companies 153

7. Risks of Financial Intermediation 168

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2

Chapter One

Why Are Financial Intermediaries Special?

INTRODUCTION

Over the last 75 years, the financial services industry has come full cycle. Originally, the banking industry operated as a full-service industry, performing directly or indirectly all financial services (commercial banking, investment banking, stock investing services, insurance providers, etc.). In the early 1930s, the economic and industrial collapse resulted in the separation of some of these activities. In the 1970s and 1980s, new, relatively unregulated financial services industries sprang up (mutual funds, brokerage funds, etc.) that separated financial services func- tions even further. As we enter the 21st century, regulatory barriers, technology, and financial innovation changes are such that a full set of financial services may again be offered by a single financial services firm. Not only are the boundar- ies between traditional industry sectors weakening, but competition is becoming global in nature as well. As the competitive environment changes, attention to profit and, more than ever, risk becomes increasingly important. The major themes of this book are the measurement and management of the risks of financial institu- tions. Financial institutions (e.g., banks, credit unions, insurance companies, and mutual funds), or FIs, perform the essential function of channeling funds from those with surplus funds (suppliers of funds) to those with shortages of funds (users of funds). In 2007, U.S. FIs held assets totaling over $37.46 trillion. In con- trast, the U.S. motor vehicle and parts industry (e.g., General Motors and Ford Motor Corp.) held total assets of $0.47 trillion.

Although we might categorize or group FIs as life insurance companies, banks, finance companies, and so on, they face many common risks. Specifically, all FIs described in this chapter and Chapters 2 through 6 (1) hold some assets that are potentially subject to default or credit risk and (2) tend to mismatch the maturi- ties of their balance sheet assets and liabilities to a greater or lesser extent and are thus exposed to interest rate risk. Moreover, all FIs are exposed to some degree of liability withdrawal or liquidity risk, depending on the type of claims they have sold to liability holders. In addition, most FIs are exposed to some type of underwriting risk, whether through the sale of securities or the issue of various

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Chapter 1 Why Are Financial Intermediaries Special? 3

types of credit guarantees on or off the balance sheet. Finally, all FIs are exposed to operating cost risks because the production of financial services requires the use of real resources and back-office support systems (labor and technology combined to provide services).

Because of these risks and the special role that FIs play in the financial sys- tem, FIs are singled out for special regulatory attention. In this chapter, we first examine questions related to this specialness. In particular, what are the special functions that FIs—both depository institutions (banks, savings institutions, and credit unions) and nondepository institutions (insurance companies, securi- ties firms, investment banks, finance companies, and mutual funds)—provide? These special functions are summarized in Table 1–1 . How do these functions bene fit the economy? Second, we investigate what makes some FIs more special than others. Third, we look at how unique and long-lived the special functions of FIs really are.

FINANCIAL INTERMEDIARIES’ SPECIALNESS

To understand the important economic function of FIs, imagine a simple world in which FIs do not exist. In such a world, households generating excess savings by consuming less than they earn would have the basic choice: They could hold cash as an asset or invest in the securities issued by corporations. In general, cor- porations issue securities to finance their investments in real assets and cover the gap between their investment plans and their internally generated savings such as retained earnings.

TABLE 1–1 Areas of Financial Intermediaries’ Specialness in the Provision of Services

Information costs The aggregation of funds in an FI provides greater incentive to collect information about customers (such as corporations) and to monitor their actions. The relatively large size of the FI allows this collection of information to be accomplished at a lower average cost (so-called economies of scale) than would be the case for individuals.

Liquidity and price risk FIs provide financial claims to household savers with superior liquidity attributes and with lower price risk.

Transaction cost services Similar to economies of scale in information production costs, an FI’s size can result in economies of scale in transaction costs.

Maturity intermediation FIs can better bear the risk of mismatching the maturities of their assets and liabilities.

Transmission of monetary supply Depository institutions are the conduit through which monetary policy actions by the country’s central bank (such as the Federal Reserve) impact the rest of the financial system and the economy.

Credit allocation FIs are often viewed as the major, and sometimes only, source of financing for particular sectors of the economy, such as farming, small business, and residential real estate.

Intergenerational wealth transfers FIs, especially life insurance companies and pension funds, provide savers with the ability to transfer wealth from one generation to the next.

Payment services The efficiency with which depository institutions provide payment services such as check clearing directly benefits the economy.

Denomination intermediation FIs, such as mutual funds, allow small investors to overcome constraints to buying assets imposed by large minimum denomination size.

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4 Part One Introduction

As shown in Figure 1–1 , in such a world, savings would flow from households to corporations; in return, financial claims (equity and debt securities) would flow from corporations to household savers.

In an economy without FIs, the level of fund flows between household savers and the corporate sectors is likely to be quite low. There are several reasons for this. Once they have lent money to a firm by buying its financial claims, households need to monitor, or check, the actions of that firm. They must be sure that the firm’s management neither absconds with nor wastes the funds on any projects with low or negative net present values. Such monitoring actions are extremely costly for any given household because they require considerable time and expense to collect sufficiently high-quality information relative to the size of the average household saver’s investments. Given this, it is likely that each household would prefer to leave the monitoring to others; in the end, little or no monitoring would be done. The resulting lack of monitoring would reduce the attractiveness and increase the risk of investing in corporate debt and equity.

The relatively long-term nature of corporate equity and debt, and the lack of a secondary market in which households can sell these securities, creates a sec- ond disincentive for household investors to hold the direct financial claims issued by corporations. Specifically, given the choice between holding cash and holding long-term securities, households may well choose to hold cash for liquidity rea- sons, especially if they plan to use savings to finance consumption expenditures in the near future.

Finally, even if financial markets existed (without FIs to operate them) to pro- vide liquidity services by allowing households to trade corporate debt and equity securities among themselves, investors also face a price risk on sale of securities, and the secondary market trading of securities involves various transaction costs. That is, the price at which household investors can sell securities on secondary markets such as the New York Stock Exchange may well differ from the price they initially paid for the securities.

Because of (1) monitoring costs, (2) liquidity costs, and (3) price risk, the aver- age household saver may view direct investment in corporate securities as an unattractive proposition and prefer either not to save or to save in the form of cash.

However, the economy has developed an alternative and indirect way to chan- nel household savings to the corporate sector. This is to channel savings via FIs. Because of costs of monitoring, liquidity, and price risk, as well as for some other reasons, explained later, savers often prefer to hold the financial claims issued by FIs rather than those issued by corporations.

Consider Figure 1–2 , which is a closer representation than Figure 1–1 of the world in which we live and the way funds flow in our economy. Notice how financial intermediaries or institutions are standing, or intermediating, between the household and corporate sectors. These intermediaries fulfill two functions; any given FI might specialize in one or the other or might do both simultaneously.

liquidity The ease of convert- ing an asset into cash.

liquidity The ease of convert- ing an asset into cash.

price risk The risk that the sale price of an asset will be lower than the purchase price of that asset.

price risk The risk that the sale price of an asset will be lower than the purchase price of that asset.

FIGURE 1–1 Flow of Funds in a World without FIs

Households (net savers)

Corporations (net borrowers)

Equity and debt claims

Cash

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Chapter 1 Why Are Financial Intermediaries Special? 5

FIs Function as Brokers The first function is the brokerage function. When acting as a pure broker, an FI acts as an agent for the saver by providing information and transaction services. For example, full-service securities firms (e.g., Merrill Lynch) carry out investment research and make investment recommendations for their retail (or household) clients as well as conducting the purchase or sale of securities for commission or fees. Discount brokers (e.g., Charles Schwab) carry out the purchase or sale of securities at better prices and with greater efficiency than household savers could achieve by trading on their own. This efficiency results in reduced costs of trading, or economies of scale (see Chapter 21 for a detailed discussion). Independent insurance brokers identify the best types of insurance policies household savers can buy to fit their savings and retirement plans. In fulfilling a brokerage function, the FI plays an extremely important role by reducing transaction and information costs or imperfections between households and corporations. Thus, the FI encour- ages a higher rate of savings than would otherwise exist. 1

FIs Function as Asset Transformers The second function is the asset-transformation function. In acting as an asset transformer , the FI issues financial claims that are far more attractive to house- hold savers than the claims directly issued by corporations. That is, for many households, the financial claims issued by FIs dominate those issued directly by corporations as a result of lower monitoring costs, lower liquidity costs, and lower price risk. In acting as asset transformers, FIs purchase the financial claims issued by corporations—equities, bonds, and other debt claims called primary securities —and finance these purchases by selling financial claims to household investors and other sectors in the form of deposits, insurance policies, and so on. The financial claims of FIs may be considered secondary securities because these assets are backed by the primary securities issued by commercial corporations that in turn invest in real assets. Specifically, FIs are independent market parties that create financial products whose value added to their clients is the transforma- tion of financial risk.

Simplified balance sheets of a commercial firm and an FI are shown in Table 1–2 . Note that in the real world, FIs hold a small proportion of their assets in the form of real assets such as bank branch buildings. These simplified balance sheets reflect a reasonably accurate characterization of the operational differences between com- mercial firms and FIs.

1 Most recently, with the introduction of new derivative securities markets for financial futures, options, and swaps, financial institutions that participate in the markets reduce transaction and information costs for firms and consumers wanting to hedge their risks. Thus, FIs encourage better risk management than otherwise would exist.

economies of scale The concept that the cost reduction in trading and other transaction services results from increased efficiency when FIs perform these services.

economies of scale The concept that the cost reduction in trading and other transaction services results from increased efficiency when FIs perform these services.

asset transformer An FI issues financial claims that are more attractive to house- hold savers than the claims directly issued by corporations.

asset transformer An FI issues financial claims that are more attractive to house- hold savers than the claims directly issued by corporations.

primary securities Securities issued by corporations and backed by the real assets of those corporations.

primary securities Securities issued by corporations and backed by the real assets of those corporations.

secondary securities Securities issued by FIs and backed by primary securities.

secondary securities Securities issued by FIs and backed by primary securities.

FIGURE 1–2 Flow of Funds in a World with FIs

Households Corporations FI

(brokers)

FI (asset

transformers)

Equity and debt

Cash

Cash

Deposits and insurance policies

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6 Part One Introduction

How can FIs purchase the direct or primary securities issued by corporations and profitably transform them into secondary securities more attractive to house- hold savers? This question strikes at the very heart of what makes FIs special and important to the economy. The answer lies in the ability of FIs to better resolve the three costs facing a saver who chooses to invest directly in corporate securities.

Information Costs One problem faced by an average saver directly investing in a commercial firm’s financial claims is the high cost of information collection. Household savers must monitor the actions of firms in a timely and complete fashion after purchasing securities. Failure to monitor exposes investors to agency costs , that is, the risk that the firm’s owners or managers will take actions with the saver’s money contrary to the promises contained in the covenants of its securities contracts. Monitoring costs are part of overall agency costs. That is, agency costs arise when- ever economic agents enter into contracts in a world of incomplete information and thus costly information collection. The more difficult and costly it is to col- lect information, the more likely it is that contracts will be broken. In this case the saver (the so-called principal) could be harmed by the actions taken by the bor- rowing firm (the so-called agent).

FI’s Role as Delegated Monitor One solution to this problem is for a large number of small savers to place their funds with a single FI. This FI groups these funds together and invests in the direct or primary financial claims issued by firms. This agglomeration of funds resolves a number of problems. First, the large FI now has a much greater incentive to col- lect information and monitor actions of the firm because it has far more at stake than does any small individual household. In a sense, small savers have appointed the FI as a delegated monitor to act on their behalf. 2 Not only does the FI have a greater incentive to collect information, the average cost of collecting information is lower. For example, the cost to a small investor of buying a $100 broker’s report may seem inordinately high for a $10,000 investment. For an FI with $10 million under management, however, the cost seems trivial. Such economies of scale of information production and collection tend to enhance the advantages to savers of using FIs rather than directly investing themselves.

2 For a theoretical modeling of the delegated monitor function, see D. W. Diamond, “Financial Intermedi- aries and Delegated Monitoring,” Review of Economic Studies 51 (1984), pp. 393–414; and A. Winton, “Competition among Financial Intermediaries When Diversification Matters,” Journal of Financial Inter- mediation 6 (1997), pp. 307–46.

agency costs Costs relating to the risk that the own- ers and managers of firms that receive sav- ers’ funds will take actions with those funds contrary to the best interests of the savers.

agency costs Costs relating to the risk that the own- ers and managers of firms that receive sav- ers’ funds will take actions with those funds contrary to the best interests of the savers.

delegated monitor An economic agent appointed to act on behalf of smaller agents in collecting information and/or investing funds on their behalf.

delegated monitor An economic agent appointed to act on behalf of smaller agents in collecting information and/or investing funds on their behalf.

TABLE 1–2 Simplified Balance Sheets for a Commercial Firm and an FI

Commercial Firm Financial Intermediary

Assets Liabilities Assets Liabilities

Real assets Primary securities Primary securities Secondary securities (plant, machinery) (debt, equity) (debt, equity) (deposits, insurance policies)

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Chapter 1 Why Are Financial Intermediaries Special? 7

FI’s Role as Information Producer Second, associated with the greater incentive to monitor and the costs involved in failing to monitor appropriately, FIs may develop new secondary securities that enable them to monitor more effectively. Thus, a richer menu of contracts may improve the monitoring abilities of FIs. Perhaps the classic example of this is the bank loan. Bank loans are generally shorter-term debt contracts than bond con- tracts. This short-term nature allows the FI to exercise more monitoring power and control over the borrower. In particular, the information the FI generates regarding the firm is frequently updated as its loan renewal decisions are made. When bank loan contracts are sufficiently short term, the banker becomes almost like an insider to the firm regarding informational familiarity with its operations and financial conditions. Indeed, this more frequent monitoring often replaces the need for the relatively inflexible and hard-to-enforce covenants found in bond contracts. Thus, by acting as a delegated monitor and producing better and more timely information, FIs reduce the degree of information imperfection and asym- metry between the ultimate suppliers and users of funds in the economy.

Liquidity and Price Risk In addition to improving the flow and quality of information, FIs provide financial or secondary claims to household and other savers. Often, these claims have supe- rior liquidity attributes compared with those of primary securities such as corpo- rate equity and bonds. For example, banks and thrifts issue transaction account deposit contracts with a fixed principal value (and often a guaranteed interest rate) that can be withdrawn immediately on demand by household savers. 3 Money market mutual funds issue shares to household savers that allow those savers to enjoy almost fixed principal (depositlike) contracts while often earning interest rates higher than those on bank deposits. Even life insurance companies allow policyholders to borrow against their policies held with the company at very short notice. The real puzzle is how FIs such as depository institutions can offer highly liquid and low price-risk contracts to savers on the liability side of their balance sheets while investing in relatively illiquid and higher price-risk securities issued by corporations on the asset side. Furthermore, how can FIs be confident enough to guarantee that they can provide liquidity services to investors and savers when they themselves invest in risky asset portfolios? And why should savers and inves- tors believe FIs’ promises regarding the liquidity of their investments?

The answers to these questions lie in the ability of FIs to diversify away some but not all of their portfolio risks. The concept of diversification is familiar to all students of finance: Basically, as long as the returns on different investments are not perfectly positively correlated, by exploiting the benefits of size, FIs diversify away significant amounts of portfolio risk—especially the risk specific to the indi- vidual firm issuing any given security. Indeed, experiments in the United States and the United Kingdom have shown that equal investments in as few as 15 secu- rities can bring significant diversification benefits to FIs and portfolio managers. Further, as the number of securities in an FI’s asset portfolio increases beyond 15 securities, portfolio risk falls, albeit at a diminishing rate. What is really going on here is that FIs exploit the law of large numbers in their investments, achieving a

3 Also, the largest commercial banks in the world make markets for swaps, allowing businesses to hedge various risks (such as interest rate risk and foreign exchange risk) on their balance sheets.

diversify Reducing risk by holding a number of securities in a portfolio.

diversify Reducing risk by holding a number of securities in a portfolio.

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8 Part One Introduction

significant amount of diversification, whereas because of their small size, many household savers are constrained to holding relatively undiversified portfolios. This risk diversification allows an FI to predict more accurately its expected return on its asset portfolio. A domestically and globally diversified FI may be able to generate an almost risk-free return on its assets. As a result, it can credibly fulfill its promise to households to supply highly liquid claims with little price or capital value risk. A good example of this is the ability of a bank to offer highly liquid demand deposits—with a fixed principal value—as liabilities, while at the same time investing in risky loans as assets. As long as an FI is sufficiently large to gain from diversification and monitoring, its financial claims are likely to be viewed as liquid and attractive to small savers compared with direct investments in the capital market.

Other Special Services The preceding discussion has concentrated on three general or special services pro- vided by FIs: reducing household savers’ monitoring costs, increasing their liquid- ity, and reducing their price-risk exposure. Next, we discuss two other special services provided by FIs: reduced transaction costs and maturity intermediation.

Reduced Transaction Costs Just as FIs provide potential economies of scale in information collection, they also provide potential economies of scale in transaction costs. For example, since May 1, 1975, fixed commissions for equity trades on the NYSE have been abolished. As a result, small retail buyers face higher commission charges or transaction costs than do large wholesale buyers. By grouping their assets in FIs that purchase assets in bulk—such as in mutual funds and pension funds— household savers can reduce the transaction costs of their asset purchases. In addi- tion, bid–ask (buy–sell) spreads are normally lower for assets bought and sold in large quantities.

Maturity Intermediation An additional dimension of FIs’ ability to reduce risk by diversification is that they can better bear the risk of mismatching the maturities of their assets and liabilities than can small household savers. Thus, FIs offer maturity intermediation services to the rest of the economy. Specifically, through maturity mismatching, FIs can produce new types of contracts, such as long-term mortgage loans to households, while still raising funds with short-term liability contracts. Further, while such mismatches can subject an FI to interest rate risk (see Chapters 8 and 9), a large FI is better able to manage this risk through its superior access to markets and instru- ments for hedging such as loan sales and securitization (Chapters 26 and 27); futures (Chapter 23); swaps (Chapter 25); and options, caps, floors, and collars (Chapter 24).

What are the three major risks to household savers from direct security purchases? What are two major differences between brokers (such as security brokers) and deposi- tory institutions (such as commercial banks)? What are primary securities and secondary securities? What is the link between asset diversification and the liquidity of deposit contracts?

1. 2.

3. 4.

Concept Questions Concept Questions

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Chapter 1 Why Are Financial Intermediaries Special? 9

OTHER ASPECTS OF SPECIALNESS

The theory of the flow of funds points to three principal reasons for believing that FIs are special, along with two other associated reasons. In reality, academics, policymakers, and regulators identify other areas of specialness relating to certain specific functions of FIs or groups of FIs. We discuss these next.

The Transmission of Monetary Policy The highly liquid nature of bank and thrift (depository institution) deposits has resulted in their acceptance by the public as the most widely used medium of exchange in the economy. Indeed, at the core of the two most commonly used defi- nitions of the money supply—M1 and M2 4 —lie depository institutions’ deposit contracts. Because the liabilities of depository institutions are a significant com- ponent of the money supply that impacts the rate of inflation, they play a key role in the transmission of monetary policy from the central bank to the rest of the economy. That is, depository institutions are the conduit through which mone- tary policy actions impact the rest of the financial sector and the economy in gen- eral. Monetary policy actions include open market operations (the purchase and sale of securities in the U.S. Treasury securities market), setting the discount rate (the rate charged on “lender of last resort” borrowing from the Federal Reserve), and setting reserve requirements (the minimum amount of reserve assets depos- itory institutions must hold to back deposits held as liabilities on their balance sheets). Appendix 1A to the chapter (located at the book’s Web site, www.mhhe. com/saunders6e ) reviews the tools used by the Federal Reserve to implement monetary policy.

Credit Allocation A further reason FIs are often viewed as special is that they are the major and sometimes the only source of financing for a particular sector of the economy pre- identified as being in special need of financing. Policymakers in the United States and a number of other countries, such as the United Kingdom, have identified res- idential real estate as needing special subsidies. This has enhanced the specialness of FIs that most commonly service the needs of that sector. In the United States, savings associations and savings banks have traditionally served the credit needs of the residential real estate sector. In a similar fashion, farming is an especially important area of the economy in terms of the overall social welfare of the popula- tion. The U.S. government has even directly encouraged financial institutions to specialize in financing this area of activity through the creation of Federal Farm Credit Banks.

Intergenerational Wealth Transfers or Time Intermediation The ability of savers to transfer wealth between youth and old age and across gen- erations is also of great importance to the social well-being of a country. Because of

4 M1: ($1,365.7 billion outstanding in January 2007) consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits at all commercial banks other than those owed to depository institutions, the U.S. government, and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs). M2: ($7,021.0 billion outstanding in January 2007) consists of M1 plus (1) savings and small time deposits (time deposits in amounts of less than $100,000) and (2) other nondeposit obligations of depository institutions.

www.federalreserve.gov www.federalreserve.gov

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10 Part One Introduction

this, life insurance and pension funds (see Chapter 3) are often especially encour- aged, via special taxation relief and other subsidy mechanisms, to service and accommodate those needs.

Payment Services Depository institutions such as banks and thrifts (see Chapter 2) are special in that the efficiency with which they provide payment services directly benefits the economy. Two important payment services are check-clearing and wire transfer services. For example, on any given day, trillions of dollars worth of payments are effected through Fedwire and CHIPS, the two large wholesale payment wire networks in the United States (see Chapter 16). Any breakdowns in these systems probably would produce gridlock in the payment system with resulting harmful effects to the economy.

Denomination Intermediation Both money market and debt–equity mutual funds are special because they pro- vide services relating to denomination intermediation (see Chapter 5). Because they are sold in very large denominations, many assets are either out of reach of individual savers or would result in savers’ holding highly undiversified asset portfolios. For example, the minimum size of a negotiable CD is $100,000 and commercial paper (short-term corporate debt) is often sold in minimum pack- ages of $250,000 or more. Individually, a saver may be unable to purchase such instruments. However, by buying shares in a money market mutual fund along with other small investors, household savers overcome the constraints to buying assets imposed by large minimum denomination sizes. Such indirect access to these markets may allow small savers to generate higher returns on their portfo- lios as well.

SPECIALNESS AND REGULATION

In the preceding section, FIs were shown to be special because of the various ser- vices they provide to sectors of the economy. Failure to provide these services or a breakdown in their efficient provision can be costly to both the ultimate sources (households) and users (firms) of savings. The negative externalities 5 affecting firms and households when something goes wrong in the FI sector of the economy make a case for regulation. That is, FIs are regulated to protect against a disruption in the provision of the services discussed above and the costs this would impose on the economy and society at large. For example, bank failures may destroy household savings and at the same time restrict a firm’s access to credit. Insurance company failures may leave households totally exposed in old age to catastrophic illnesses and sudden drops in income on retirement. Further, individual FI failures may create doubts in savers’ minds regarding the stability and solvency of FIs in general and cause panics and even runs on sound institutions. In addition, racial, sexual, age, or other discrimination—such as mortgage redlining —may unfairly exclude some potential financial service consumers from the marketplace. This

5 A good example of a negative externality is the costs faced by small businesses in a one-bank town if the local bank fails. These businesses could find it difficult to get financing elsewhere, and their custom- ers could be similarly disadvantaged. As a result, the failure of the bank may have a negative or conta- gious effect on the economic prospects of the whole community, resulting in lower sales, production, and employment.

negative externalities Action by an econo- mic agent imposing costs on other econo- mic agents.

negative externalities Action by an econo- mic agent imposing costs on other econo- mic agents.

redlining The procedure by which a banker re- fuses to make loans to residents living inside given geographic boundaries.

redlining The procedure by which a banker re- fuses to make loans to residents living inside given geographic boundaries.

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Chapter 1 Why Are Financial Intermediaries Special? 11

type of market failure needs to be corrected by regulation. Although regulation may be socially beneficial, it also imposes private costs, or a regulatory burden, on individual FI owners and managers. For example, regulations prohibit com- mercial banks from making loans to individual borrowers that exceed more than 10 percent of their equity capital even though the loans may have a positive net present value to the bank. Consequently, regulation is an attempt to enhance the social welfare benefits and mitigate the social costs of the provision of FI services. The private costs of regulation relative to its private benefits, for the producers of financial services, is called the net regulatory burden. 6

Six types of regulation seek to enhance the net social welfare benefits of finan- cial intermediaries’ services: (1) safety and soundness regulation, (2) monetary policy regulation, (3) credit allocation regulation, (4) consumer protection regula- tion, (5) investor protection regulation, and (6) entry and chartering regulation. Regulations are imposed differentially on the various types of FIs. For example, depository institutions are the most heavily regulated of the FIs. Finance compa- nies, on the other hand, are subject to much fewer regulations. Regulation can also be imposed at the federal or the state level and occasionally at the international level, as in the case of bank capital requirements (see Chapter 20).

Finally, some of these regulations are functional in nature, covering all FIs that carry out certain functions, such as payment services, while others are institu- tion specific. Because of the historically segmented nature of the U.S. FI system, many regulations in that system are institution-specific, for example, consumer protection legislation imposed on bank credit allocation to local communities. However, these institution-specific regulations are increasingly being liberalized (see Chapter 21).

Safety and Soundness Regulation To protect depositors and borrowers against the risk of FI failure due, for example, to a lack of diversification in asset portfolios, regulators have developed layers of protective mechanisms. These mechanisms are intended to ensure the safety and soundness of the FI and thus to maintain the credibility of the FI in the eyes of its borrowers and lenders. In the first layer of protection are requirements encour- aging FIs to diversify their assets. Thus, banks are required not to make loans exceeding more than 10 percent of their own equity capital funds to any one com- pany or borrower (see Chapter 11). A bank that has 6 percent of its assets funded by its own capital funds (and therefore 94 percent by deposits) can lend no more than 0.6 percent of its assets to any one party.

The second layer of protection concerns the minimum level of capital or equity funds that the owners of an FI need to contribute to the funding of its operations (see Chapter 20). For example, bank, thrift, and insurance regulators are concerned with the minimum ratio of capital to (risk) assets. The higher the proportion of capital contributed by owners, the greater the protection against insolvency risk to outside liability claim holders such as depositors and insurance policyhold- ers. This is because losses on the asset portfolio due, for example, to the lack of diversification are legally borne by the equity holders first, and only after equity is totally wiped out by outside liability holders. 7 Consequently, by varying the required degree of equity capital, FI regulators can directly affect the degree of risk

6 Other regulated firms, such as gas and electric utilities, also face a complex set of regulations imposing a net regulatory burden on their operations. 7 Thus, equity holders are junior claimants and debt holders are senior claimants to an FI’s assets.

net regulatory burden The difference bet ween the private costs of regulations and the private ben- efits for the producers of financial services.

net regulatory burden The difference bet ween the private costs of regulations and the private ben- efits for the producers of financial services.

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12 Part One Introduction

exposure faced by nonequity claim holders in FIs. 8 (See Chapter 20 for more dis- cussion on the role of capital in FIs.)

The third layer of protection is the provision of guaranty funds such as the Deposit Insurance Fund (DIF) for depository institutions, the Security Investors Protection Corporation (SIPC) for securities firms, and the state guaranty funds established (with regulator encouragement) to meet insolvency losses to small claim holders in the life and property–casualty insurance industries (see Chapter 19). By protecting FI claim holders, when an FI fails and owners’ equity or net worth is wiped out, these funds create a demand for regulation of the insured institutions to protect the funds’ resources (see Chapter 19 for more discussion). For example, the FDIC monitors and regulates participants in the DIF.

The fourth layer of regulation is monitoring and surveillance itself. Regulators subject all FIs, whether banks, securities firms, or insurance companies, to varying degrees of monitoring and surveillance. This involves on-site examination as well as an FI’s production of accounting statements and reports on a timely basis for off-site evaluation. Just as savers appoint FIs as delegated monitors to evaluate the behavior and actions of ultimate borrowers, society appoints regulators to moni- tor the behavior and performance of FIs.

Finally, note that regulation is not without costs for those regulated. For exam- ple, society’s regulators may require FIs to have more equity capital than private owners believe is in their own best interests. Similarly, producing the information requested by regulators is costly for FIs because it involves the time of managers, lawyers, and accountants. Again, the socially optimal amount of information may differ from an FI’s privately optimal amount.9

As noted earlier, the differences between the private benefits to an FI from being regulated—such as insurance fund guarantees—and the private costs it faces from adhering to regulation—such as examinations—is called the net regulatory burden. The higher the net regulatory burden on FIs, the more inefficiently they produce any given set of financial services from a private (FI) owner’s perspective.

Monetary Policy Regulation Another motivation for regulation concerns the special role banks play in the transmission of monetary policy from the Federal Reserve (the central bank) to the rest of the economy. The problem is that the central bank directly controls only the quantity of notes and coin in the economy—called outside money —whereas the bulk of the money supply consists of deposits—called inside money . In theory,

8 New capital regulations—so-called Basel II regulations—are being used by commercial banks in Europe. However, implementation of these new regulations has been delayed in the United States for a number of reasons (see Chapter 20 for details). A major issue concerns which banks will be covered by which of the various new rules (the Standardized Approach or the more sophisticated Internal Ratings Based (IRB) Approach). While the Federal Reserve has proposed that the sophisticated IRB Approach be used for the largest 20 banking organizations, they are less sure about imposing the simpler Standardized Approach on the remaining banks. To compound the implementation problem, the four largest U.S. banks have recently argued that because the Federal Reserve will not allow them to immediately enjoy any capital reduction under Basel II’s IRB Approach, but rather calls for phasing any reduction in over time, they will be at a disadvantage compared to European banks (which can take immediate advantage of any capital savings under the IRB sophisticated approach). Indeed, these four banks have argued that they may well prefer the simple standardized model over the Federal Reserve’s proposed handling of capital savings under the IRB Approach. The result is that, as of the end of 2006, the implementation of new capital regulations in the United States has been delayed for at least a year. 9 Also, a social cost rather than social benefit from regulation is the potential risk-increasing behavior (often called moral hazard ) that results if deposit insurance and other guaranty funds provide coverage to FIs and their liability holders at less than the actuarially fair price (see Chapter 19 for further discussion).

www.fdic.gov www.fdic.gov

www.sipc.org www.sipc.org

www.federalreserve.gov www.federalreserve.gov

outside money The part of the money supply directly pro- duced by the govern- ment or central bank, such as notes and coin.

outside money The part of the money supply directly pro- duced by the govern- ment or central bank, such as notes and coin.

inside money The part of the money supply produced by the private banking system.

inside money The part of the money supply produced by the private banking system.

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Chapter 1 Why Are Financial Intermediaries Special? 13

a central bank can vary the quantity of cash or outside money and directly affect a bank’s reserve position as well as the amount of loans and deposits it can cre- ate without formally regulating the bank’s portfolio. In practice, regulators have chosen to impose formal controls (these are described in Appendix 1A, located at the book’s Web site, www.mhhe.com/saunders6e ). 10 In most countries, regu- lators commonly impose a minimum level of required cash reserves to be held against deposits (see Chapter 17). Some argue that imposing such reserve require- ments makes the control of the money supply and its transmission more predict- able. Such reserves also add to an FI’s net regulatory burden if they are more than the institution believes are necessary for its own liquidity purposes. In general, whether banks or insurance companies, all FIs would choose to hold some cash reserves—even non-interest-bearing—to meet the liquidity and transaction needs of their customers directly. For well-managed FIs, however, this optimal level is normally low, especially if the central bank (or other regulatory body) does not pay interest on required reserves. As a result, FIs often view required reserves as similar to a tax and as a positive cost of undertaking intermediation. 11

Credit Allocation Regulation Credit allocation regulation supports the FI’s lending to socially important sectors such as housing and farming. These regulations may require an FI to hold a mini- mum amount of assets in one particular sector of the economy or to set maximum interest rates, prices, or fees to subsidize certain sectors. Examples of asset restric- tions include the qualified thrift lender (QTL) test, which requires thrifts to hold 65 percent of their assets in residential mortgage-related assets to retain a thrift char- ter, and insurance regulations, such as those in New York State that set maximums on the amount of foreign or international assets in which insurance companies can invest. Examples of interest rate restrictions are the usury laws set in many states on the maximum rates that can be charged on mortgages and/or consumer loans and regulations (now abolished) such as the Federal Reserve’s Regulation Q maxi- mums on time and savings deposit interest rates.

Such price and quantity restrictions may have justification on social welfare grounds—especially if society has a preference for strong (and subsidized) hous- ing and farming sectors. However, they can also be harmful to FIs that have to bear the private costs of meeting many of these regulations. To the extent that the net private costs of such restrictions are positive, they add to the costs and reduce the efficiency with which FIs undertake intermediation.

Consumer Protection Regulation Congress passed the Community Reinvestment Act (CRA) and the Home Mortgage Disclosure Act (HMDA) to prevent discrimination in lending. For example, since 1975, the HMDA has assisted the public in determining whether banks and other

10 In classic central banking theory, the quantity of bank deposits ( D ) is determined as the product of 1 over the banking system’s required (or desired) ratio of cash reserves to deposits ( r ) times the quantity of bank reserves ( R ) outstanding, where R comprises notes and coin plus bank deposits held on reserve at the central bank. D � (1/ r ) � R . Thus, by varying R , given a relatively stable reserve ratio ( r ), the central bank can directly affect D , the quantity of deposits or inside money that, as just noted, is a large com- ponent of the money supply. Even if not required to do so by regulation, banks would still tend to hold some cash reserves as a liquidity precaution against the sudden withdrawal of deposits or the sudden arrival of new loan demand. 11 In the United States, bank reserves held with the central bank (the Federal Reserve, or the Fed) are non- interest-bearing. In some other countries, interest is paid on bank reserves, thereby lowering the “regula- tory tax” effect.

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14 Part One Introduction

mortgage-lending institutions are meeting the needs of their local communities. HMDA is especially concerned about discrimination on the basis of age, race, sex, or income. Since 1990, depository institutions have reported to their chief federal regulator on a standardized form the reasons credit was granted or denied. To get some idea of the information production cost of regulatory compliance in this area, consider that the Federal Financial Institutions Examination Council (FFIEC) processed information on as many as 31 million mortgage transactions from over 8,800 institutions in 2006. (The council is a federal supervisory body comprising the members of the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency.) 12 Many analysts believe that community and consumer protection laws are imposing a considerable net regula- tory burden on FIs without providing offsetting social benefits that enhance equal access to mortgage and lending markets. However, as deregulation proceeds and the trend toward consolidation and universal banking (see Chapter 2) continues, it is likely that such laws will be extended beyond banks to other financial ser- vice providers, such as insurance companies, that are not currently subject to CRA community lending requirements.

Investor Protection Regulation A considerable number of laws protect investors who use investment banks directly to purchase securities and/or indirectly to access securities markets through invest- ing in mutual or pension funds. Various laws protect investors against abuses such as insider trading, lack of disclosure, outright malfeasance, and breach of fiduciary responsibilities (see Chapter 4). Important legislation affecting investment banks and mutual funds includes the Securities Acts of 1933 and 1934 and the Investment Company Act of 1940. As with consumer protection legislation, compliance with these acts can impose a net regulatory burden on FIs. 13

Entry Regulation The entry and activities of FIs are also regulated (e.g., new bank chartering regula- tions). Increasing or decreasing the cost of entry into a financial sector affects the profitability of firms already competing in that industry. Thus, the industries heav- ily protected against new entrants by high direct costs (e.g., through required equity or capital contributions) and high indirect costs (e.g., by restricting individuals who can establish FIs) of entry produce bigger profits for existing firms than those in which entry is relatively easy (see Chapter 22). In addition, regulations (such as the Financial Securities Modernization Act of 1999) define the scope of permitted activi- ties under a given charter (see Chapter 21). The broader the set of financial service activities permitted under a given charter, the more valuable that charter is likely to be. Thus, barriers to entry and regulations pertaining to the scope of permitted activities affect the charter value of an FI and the size of its net regulatory burden.

12 The FFIEC also publishes aggregate statistics and analysis of CRA and HMDA data. The Federal Reserve and other regulators also rate bank compliance. For example, in 2006 the Federal Reserve judged 17.0 percent of the banks examined to be outstanding in CRA compliance, 78.6 percent as satisfactory, and 4.4 percent as needing to improve or as being in noncompliance. 13 There have been a number of moves to extend these regulations to hedge funds, which have tradition- ally been outside SEC regulations and the securities acts as long as they have fewer than 100 “sophisti- cated” investors. It has been believed until recently that large sophisticated investors do not need such protections. However, recent scandals and failures relating to hedge funds and their investments—such as the failure of Long-Term Capital Management in 1998 and its subsequent bailout—appear to be changing lawmakers’ and regulators’ perceptions.

www.ffiec.gov www.ffiec.gov

www.federalreserve.gov www.federalreserve.gov

www.fdic.gov www.fdic.gov

www.occ.treas.gov www.occ.treas.gov

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Chapter 1 Why Are Financial Intermediaries Special? 15

Why should more regulation be imposed on FIs than on other types of private corporations? Define the concept of net regulatory burden. What six major types of regulation do FIs face?

THE CHANGING DYNAMICS OF SPECIALNESS

At any moment in time, each FI supplies a set of financial services (brokerage related, asset transformation related, or both) and is subject to a given net regula- tory burden. As the demands for the special features of financial services change as a result of changing preferences and technology, one or more areas of the finan- cial services industry become less profitable. Similarly, changing regulations can increase or decrease the net regulatory burden faced in supplying financial ser- vices in any given area. These demand, cost, and regulatory pressures are reflected in changing market shares in different financial service areas as some contract and others expand. Clearly, an FI seeking to survive and prosper must be flexible enough to move to growing financial service areas and away from those that are contracting. If regulatory activity restrictions inhibit or reduce the flexibility with which FIs can alter their product mix, this will reduce their competitive ability and the efficiency with which financial services are delivered. That is, activity barri- ers within the financial services industry may reduce the ability to diversify and potentially add to the net regulatory burden faced by FIs.

Trends in the United States In Table 1–3 we show the changing shares of total assets in the U.S. financial ser- vices industry from 1860 to 2007. A number of important trends are evident: Most apparent is the decline in the total share of depository institutions since the Second World War. Specifically, the share of commercial banks declined from 55.9 to 26.2 percent between 1948 and 2007, while the share of thrifts (savings banks, savings associations, and credit unions) fell from 12.3 to 7.1 percent over the same period. Similarly, life insurance companies also witnessed a secular decline in their share, from 24.3 to 15.7 percent. Thus, services provided by depository institutions (pay- ment services, transaction costs services, information cost) have become relatively less significant as a portion of all services provided by FIs.

The most dramatically increasing trend is the rising share of investment compa- nies, with investment companies (mutual funds and money market mutual funds) increasing their share from 1.3 to 24.2 percent between 1948 and 2007. Investment companies differ from banks and insurance companies in that they give savers cheaper access to the direct securities markets. They do so by exploiting the com- parative advantages of size and diversification, with the transformation of financial claims, such as maturity transformation, a lesser concern. Thus, open-ended mutual funds buy stocks and bonds directly in financial markets and issue savers shares whose value is linked in a direct pro rata fashion to the value of the mutual fund’s asset portfolio. Similarly, money market mutual funds invest in short-term financial assets such as commercial paper, CDs, and Treasury bills and issue shares linked directly to the value of the underlying portfolio. To the extent that these funds effi- ciently diversify, they also offer price-risk protection and liquidity services.

1.

2. 3.

Concept Questions Concept Questions

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Chapter 1 Why Are Financial Intermediaries Special? 17

The maturity and return characteristics of the financial claims issued by mutual funds closely reflect the maturities of the direct equity and debt securities port- folios in which they invest. In contrast, banks, thrifts, and insurance companies have lower correlations between their asset portfolio maturities and the promised maturity of their liabilities. Thus, banks may partially fund a 10-year commercial loan with demand deposits; a thrift may fund 30-year conventional mortgages with three-month time deposits. 14

To the extent that the financial services market is efficient and these trends reflect the forces of demand and supply, they indicate a current trend: Savers increasingly prefer the denomination intermediation and information services provided by mutual funds. These FIs provide investments that closely mimic diversified investments in the direct securities markets over the transformed financial claims offered by traditional FIs. This trend may also indicate that the net regulatory burden on traditional FIs—such as banks and insurance companies— is higher than that on investment companies. Indeed, traditional FIs are unable to produce their services as cost efficiently as they could previously. Recognizing this changing trend, the U.S. Congress passed the Financial Services Modernization Act, which repealed the 1933 Glass-Steagall barriers between commercial bank- ing, insurance, and investment banking. The act, promoted as the biggest change in the regulation of financial institutions in 70 years, allowed for the creation of “financial services holding companies” that could engage in banking activi- ties, insurance activities, and securities activities. Thus, after 70 years of partial or complete separation between insurance, investment banking, and commercial banking, the Financial Services Modernization Act of 1999 opened the door for the creation of full-service financial institutions in the United States similar to those that existed before 1933 and that exist in many other countries. Thus, while Table 1–3 lists assets of financial institutions by functional area, the financial services holding company (which combines these activities in a single financial institution) has become the dominant form of financial institution in terms of total assets.

In addition to a secular decline in the use of services provided by depository institutions and insurance companies and an increase in the services provided by investment banks and mutual funds during the late 1900s, the early 2000s saw an overall weakening of public trust and confidence in the ethics followed by finan- cial institutions. Specifically, tremendous publicity was generated concerning con- flicts of interest in a number of financial institutions between analysts’ research recommendations on stocks to buy or not buy and whether these firms played a role in underwriting the securities of the firms the analysts were recommend- ing. As a result, several highly publicized securities violations resulted in criminal cases brought against securities law violators by state and federal prosecutors. In particular, the New York State attorney general forced Merrill Lynch to pay a $100 million penalty because of allegations that Merrill Lynch brokers gave inves- tors overly optimistic reports about the stock of its investment banking clients. By year-end 2002, $1.4 billion of fines were assessed against financial institutions as a result of a broad investigation into whether securities firms misled small investors with faulty research and stock recommendations (see the Ethical Dilemmas box).

14 The close links between the performance of their assets and liabilities have led to mutual funds and pension funds being called “transparent” intermediaries. By contrast, the lower correlation between the performance of the assets and liabilities of banks, thrifts, and insurance companies has led to their being called “opaque” intermediaries.

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18

Such allegations of securities law violations led to a loss in public trust and confi- dence in many sectors of the FI industry.

Future Trends The growth of mutual funds coupled with the weakening of public trust and con- fidence (amid a multitude of regulatory investigations into the practices of invest- ment advisors, brokers, and banks), and with investors’ recent focus on direct investments in primary securities, may together signal the beginning of a secu- lar trend away from intermediation as the most efficient mechanism for savers to channel funds to borrowers. While this trend may reflect changed investors’ pref- erences toward risk and return, it may also reflect a decline in the relative costs of direct securities investment versus investment via FIs. This decline in costs has led to many FI products being “commoditized” and sold directly in financial markets; for example, many options initially offered over the counter by FIs eventually migrate to the public option markets as trading volume grows and trading terms become standardized. As Merton has noted, financial markets “tend to be efficient institutional alternatives to intermediaries when the products have standardized terms, can serve a large number of customers and are well-enough understood for transactors to be comfortable in assessing their prices . . . intermediaries are better suited for low volume products.”

STREET BRACES FOR REVELATIONS IN SETTLEMENT

Ten Wall Street securities firms are bracing for a burst of e-mail messages and other documents suggesting that their stock research was tainted by investment-banking goals, as regulators put the finishing touches on the long-awaited $1.4 billion global research settlement, which is expected to be announced early next week. . . . The pact’s firm-by-firm allegations will include e-mails from Goldman telecom-sector ana- lysts James Golob and Frank Governali, in which they candidly discuss how investment- banking considerations influenced how many telecom stocks they were recommending in mid-2000 even as the stocks’ prices were plummeting. Even Morgan Stanley . . . comes in for criticism for allowing some bullish research reports to sit for as long as six months without an update, according to one person familiar with the pact. The findings on Lehman will focus on four or five individuals, including both analysts and managers. . . .

The Smith Barney unit of Citigroup, which is slated to pay a $400 million fine, the largest portion of the settlement, is expected to be subject voluntarily to a separate set of rules separating its research and investment-banking activities that are more strin- gent than for other firms involved in the settlement. Three firms paying the most— Citigroup, Merrill Lynch and the Credit Suisse First Boston (CSFB) unit of Credit Suisse Group—also could be hit with securities-fraud charges.

Merrill and CSFB have agreed to pay $200 million in settlement payments. Other firms are paying between $37.5 million and $125 million. The pact also generally in- cludes rules separating research from investment banking; provision of independent research for individual investors; and more disclosure of research ratings and other data. . . .

Source: Randall Smith, Susanne Craig, and Charles Gasparino, The Wall Street Journal, April 25, 2003, p. C1. Reprinted by permission of The Wall Street Journal. © 2003 Dow Jones & Company, Inc. All rights reserved worldwide. www.wsj.com

Ethical Dilemmas

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Chapter 1 Why Are Financial Intermediaries Special? 19

Recent regulatory changes in the United States, such as the Financial Services Modernization Act of 1999, are also alleviating the net regulatory burden by allow- ing FIs to move across traditional product boundaries and lines (see Chapter 21). The result has been a number of mergers and acquisitions between commercial banks and investment banks, such as Citicorp’s $83 billion merger with Travelers Group (which operated extensive insurance activities and owned Smith Barney and Salomon Brothers) and UBS’s (the Swiss commercial bank) purchase of Paine Webber (the U.S. investment bank). At the same time, banking organiza- tions (such as bank holding companies) are getting bigger via mergers (such as the mergers of J. P. Morgan Chase and Bank One) and other forms of con- solidation. Larger size accommodates this expansion in service offerings while providing an enhanced potential to diversify risk and lower (average) costs (see Chapter 22). 15

As a result, bank profitability in the late 1990s and early 2000s has been con- siderably better than in the early 1990s—despite the effects of a recession, ter- rorist attacks on the World Trade Center and the Pentagon in September 2001, and numerous, highly publicized actions involving conflicts of interest including loans to companies like Enron (the second-largest bankruptcy in U.S. history) (see Chapter 2).

Further, direct financial markets are also evolving fast; because of technological advances, the costs of direct access to financial markets by savers are ever falling and the relative benefits to the individual savers of investing through FIs are nar- rowing. The ability to reduce transaction costs by e-trading on the Internet rather than using a traditional stockbroker and paying brokerage fees has reduced the need for FIs to perform these services. Figure 1–3 shows the increased use of the Internet to conduct equity trades over the period 1998 to 2006. In addition, a num- ber of companies allow investors to buy their stock directly without using a bro- ker. Among well-known companies that have instituted such stock purchase plans are Bell Atlantic, Bell/South, IBM, and Walt Disney. A final example is the private placement market, where securities are sold directly by corporations to investors without underwriters and with a minimum of public disclosure about the issuing

15 The number of banks in the United States dropped from 12,230 in 1990 to 7,450 at the beginning of 2007, a decline of 39 percent. This decline is even more dramatic when it is realized that 2,247 new bank charters were granted over this period.

e-trading Buying and selling shares on the Internet.

e-trading Buying and selling shares on the Internet.

FIGURE 1–3 Equity Trading on the Internet

Source: Investment Company Institute, “Ownership of Mutual Funds and Use of Internet, 2006.” www.ici.org

1998 2006

Internet trade

Non-Internet trade

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20 Part One Introduction

firm. Privately placed bonds and equity have traditionally been the most illiquid of securities, with only the very largest FIs or institutional investors being able or willing to hold them in the absence of a secondary market. In April 1990, the Securities and Exchange Commission amended Regulation 144A. This allowed large investors to begin trading these privately placed securities among them- selves even though, in general, privately placed securities do not satisfy the strin- gent disclosure and informational requirements imposed by the SEC on approved publicly registered issues. While the SEC defined the large investors able to trade privately placed securities as those with assets of $100 million or more—which excludes all but the very wealthiest household savers—it is reasonable to ask how long this size restriction will stay in effect. As they get more sophisticated and the costs of information acquisition fall, smaller savers will increasingly demand access to the private placement market. In such a world, savers would have a choice between not only the secondary securities from FIs and the primary securi- ties publicly offered by corporations but also publicly offered (registered) secu- rities and privately offered (unregistered) securities. Recent trends in the 144A Private Placement market are shown in Table 1–4 .

Global Issues In addition to these domestic trends, U.S. FIs must now compete not only with other domestic FIs but increasingly with foreign FIs that provide services (such as payment services and denomination intermediation) comparable to those of U.S. FIs. For example, Table 1–5 lists the 10 largest banks in the world, measured by total assets at the start of 2007. Notice that only 2 of the top 10 banks are U.S. banks. Table 1–6 lists foreign versus domestic bank offices’ assets held in the United States from 1992 through 2006. Total foreign bank assets over this period increased from $509.3 billion in 1992 to $809.6 billion in 2006. This consistently represents over 10 percent (and has been as high as 17.2 percent) of total assets held in the United States.

www.sec.gov www.sec.gov

£ $ ¥

:

£ $ ¥

:

TABLE1–4 U.S. Private Placements (in billions of dollars)

Source: Investment Dealer’s Digest, various issues; and Thompson Financial Securi- ties Data. www.thomson.com

1990 1995 2000 2005 2006*

144A placements 3.7 71.3 325.5 755.5 487.5 Total private placements 128.6 132.6 483.2 838.6 542.9

*Through June

TABLE 1–5 The 10 Largest Banks in the World (in millions of dollars)

Source: The Banker, February 2007. www.thebanker.com

Total Assets

Barclays Bank (United Kingdom) $1,591.5 United Bank of Switzerland (Switzerland) 1,567.6 Mitsubishi UFJ Financial Group (Japan) 1,508.5 HSBC Holdings (United Kingdom) 1,502.0 Citigroup (United States) 1,494.0 BNP Paribas (France) 1,484.1 Credit Agricole Groupe (France) 1,380.6 Royal Bank of Scotland (United Kingdom) 1,337.5 Bank of America (United States) 1,291.8 Mizuho Financial Group (Japan) 1,226.6

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Chapter 1 Why Are Financial Intermediaries Special? 21

Is the share of bank and thrift assets growing as a proportion of total FI assets in the United States? What are the fastest-growing FIs in the United States? Define privately placed securities. Describe the global challenges facing U.S. FIs in the early 2000s.

Go to the Web site of the Board of Governors of the Federal Reserve, and find the latest information available for foreign bank offices’ assets and liabilities held in the United States using the following steps. Go to the Board of Governors of the Federal Reserve Web site at www.federalreserve.gov. Click on “Economic Research and Data.” Click on “Statistics: Releases and Historical Data.” Under “Quarterly,” click on “Flow of Funds Accounts of the United States: Releases.” Click on the most recent date. Click on “Level Tables.” This will down- load a file to your computer that will contain the most recent information in Table L.111.

Internet Exercise

This chapter described the various factors and forces impacting financial interme- diaries and the specialness of the services they provide. These forces suggest that in the future, FIs that have historically relied on making profits by performing traditional special functions, such as asset transformation and the provision of liquidity services, will need to expand into selling financial services that interface with direct security market transactions, such as asset management, insurance, and underwriting services. This is not to say that specialized or niche FIs cannot survive but rather that only the most efficient FIs will prosper as the competitive value of a specialized FI charter declines.

The major theme of this book is the measurement and management of FI risks. In particular, although we might categorize or group FIs and label them life insur- ance companies, banks, finance companies, and so on, in fact, they face risks that are more common than different. Specifically, all the FIs described in this and the next five chapters (1) hold some assets that are potentially subject to default or credit risk and (2) tend to mismatch the maturities of their balance sheets to a greater or lesser extent and are thus exposed to interest rate risk. Moreover, all are exposed to some degree of saver withdrawal or liquidity risk depending on the type of claims sold to liability holders. And most are exposed to some type of underwriting risk, whether through the sale of securities or by issuing various types of credit guarantees on or off the balance sheet. Finally, all are exposed to operating cost risks because the production of financial services requires the use of real resources and back-office support systems.

1.

2. 3. 4.

Concept Questions Concept Questions

Summary Summary

1992 1994 1996 1998 2000 2005 2006

Foreign Bank Financial Assets $ 509.3 $ 589.7 $ 714.8 $ 806.3 $ 779.9 $ 786.9 $ 809.6

Domestic Bank Financial Assets 2,775.2 3,122.9 3,444.5 4,094.2 4,773.1 6,903.9 7,285.1

TABLE 1–6 Domestic Versus Foreign Bank Offices’ Assets Held in the United States (in billions of dollars)

Source: Federal Reserve Board, “Flow of Fund Accounts,” Statistical Releases, various dates. www.federalreserve.gov

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22 Part One Introduction

In Chapters 7 through 27 of this textbook, we investigate the ways managers of FIs are measuring and managing this inventory of risks to produce the best return risk trade-off for shareholders in an increasingly competitive and contestable mar- ket environment.

What are five risks common to financial institutions? Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial intermediaries. Identify and explain three economic disincentives that probably would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial intermediaries. Identify and explain the two functions in which FIs may specialize that would enable the smooth flow of funds from household savers to corporate users. In what sense are the financial claims of FIs considered secondary securities, while the financial claims of commercial corporations are considered primary securities? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to savers? Explain how financial institutions act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process? What are five general areas of FI specialness that are caused by providing vari- ous services to sectors of the economy? How do FIs solve the information and related agency costs when household savers invest directly in securities issued by corporations? What are agency costs? What is a benefit to lenders, borrowers, and financial markets in general of the solution to the information problem provided by large financial institutions? How do FIs alleviate the problem of liquidity risk faced by investors who wish to invest in the securities of corporations? How do financial institutions help individual savers diversify their portfolio risks? Which type of financial institution is best able to achieve this goal? How can financial institutions invest in high-risk assets with funding pro- vided by low-risk liabilities from savers? How can individual savers use financial institutions to reduce the transaction costs of investing in financial assets? What is maturity intermediation? What are some of the ways the risks of ma- turity intermediation are managed by financial intermediaries? What are five areas of institution-specific FI specialness, and which types of institutions are most likely to be the service providers? How do depository institutions such as commercial banks assist in the imple- mentation and transmission of monetary policy?

1. 2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

16.

Questions and Problems Questions and Problems

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Chapter 1 Why Are Financial Intermediaries Special? 23

What is meant by credit allocation regulation? What social benefit is this type of regulation intended to provide? Which intermediaries best fulfill the intergenerational wealth transfer func- tion? What is this wealth transfer process? What are two of the most important payment services provided by financial institutions? To what extent do these services efficiently provide benefits to the economy? What is denomination intermediation? How do FIs assist in this process? What is negative externality? In what ways do the existence of negative externalities justify the extra regulatory attention received by financial institutions? If financial markets operated perfectly and costlessly, would there be a need for financial intermediaries? What is mortgage redlining? Why are FIs among the most regulated sectors in the world? When is the net regulatory burden positive? What forms of protection and regulation do the regulators of FIs impose to ensure their safety and soundness? In the transmission of monetary policy, what is the difference between inside money and outside money? How does the Federal Reserve Board try to control the amount of inside money? How can this regulatory position create a cost for depository financial institutions? What are some examples of credit allocation regulation? How can this attempt to create social benefits create costs to a private institution? What is the purpose of the Home Mortgage Disclosure Act? What are the so- cial benefits desired from the legislation? How does the implementation of this legislation create a net regulatory burden on financial institutions? What legislation has been passed specifically to protect investors who use in- vestment banks directly or indirectly to purchase securities? Give some ex- amples of the types of abuses for which protection is provided. How do regulations regarding barriers to entry and the scope of permitted activities affect the charter value of financial institutions? What reasons have been given for the growth of pension funds and investment companies at the expense of “traditional” banks and insurance companies? What are some of the methods banking organizations have employed to re- duce the net regulatory burden? What has been the effect on profitability? What characteristics of financial products are necessary for financial markets to become efficient alternatives to financial intermediaries? Give some exam- ples of the commoditization of products which were previously the sole prop- erty of financial institutions? In what way has Regulation 144A of the Securities and Exchange Commission provided an incentive to the process of financial institution disintermediation?

The following questions and problems are based on material in Appendix 1A to the Chapter.

What are the tools used by the Federal Reserve to implement monetary policy?

17.

18.

19.

20. 21.

22.

23. 24.

25.

26.

27.

28.

29.

30.

31.

32.

33.

34.

35.

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24 Part One Introduction

Suppose the Federal Reserve instructs the Trading Desk to purchase $1 billion of securities. Show the result of this transaction on the balance sheets of the Federal Reserve System and commercial banks. Suppose the Federal Reserve instructs the Trading Desk to sell $850 million of securities. Show the result of this transaction on the balance sheets of the Federal Reserve System and commercial banks. Explain how a decrease in the discount rate affects credit availability and the money supply. Why does the Federal Reserve rarely use the discount rate to implement its monetary policy? What changes did the Fed implement to its discount window lending policy in the early 2000s? Bank Three currently has $600 million in transaction deposits on its balance sheet. The Federal Reserve has currently set the reserve requirement at 10 per- cent of transaction deposits.

Suppose the Federal Reserve decreases the reserve requirement to 8 per- cent. Show the balance sheet of Bank Three and the Federal Reserve System just before and after the full effect of the reserve requirement change. As- sume that Bank Three withdraws all excess reserves and gives out loans and that borrowers eventually return all of these funds to Bank Three in the form of transaction deposits. Redo part (a) using a 12 percent reserve requirement.

National Bank currently has $500 million in transaction deposits on its balance sheet. The current reserve requirement is 10 percent, but the Federal Reserve is decreasing this requirement to 8 percent.

Show the balance sheet of the Federal Reserve and National Bank if Na- tional Bank converts all excess reserves to loans but borrowers return only 50 percent of these funds to National Bank as transaction deposits. Show the balance sheet of the Federal Reserve and National Bank if Na- tional Bank converts 75 percent of its excess reserves to loans and borrowers return 60 percent of these funds to National Bank as transaction deposits.

Which of the monetary tools available to the Federal Reserve is most often used? Why? Describe how expansionary activities conducted by the Federal Reserve im- pact credit availability, the money supply, interest rates, and security prices. Do the same for contractionary activities.

Web Questions

Go to the Federal Reserve Board’s Web site at www.federalreserve.gov . Find the latest figures for M1 and M2 using the following steps. Click on “Economic Research and Data.” Click on “Statistics: Releases and Historical Data.” Click on “Money Stock Measures.” Click on the most recent date. This downloads a file onto your computer that contains the relevant data. By what percentage have these measures of the money supply grown over the past year?

36.

37.

38.

39.

40.

41.

a.

b. 42.

a.

b.

43.

44.

45.

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Chapter 1 Why Are Financial Intermediaries Special? 25

Go to the Federal Reserve Board’s Web site at www.federalreserve.gov . Find the latest figures for financial assets outstanding at various types of finan- cial institutions using the following steps. Click on “Economic Research and Data.” Click on “Statistics: Releases and Historical Data.” Click on “Flow of Funds Accounts of the United States.” Click on the most recent date. Click on “Level tables.” This downloads a file onto your computer that contains the rel- evant data. How has the percent of financial assets held by commercial banks changed since that listed in Table 1–3 for 2007?

S&P Questions

Go to the Standard & Poor’s Market Insight Web site at www.mhhe.com/ edumarketinsight . Use the following steps to identify the Industry Description and Industry Constituents for the following industries: Diversified Banks, Investment Banking & Brokerage, Life & Health Insurance, and Property & Casualty Insurance. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Industry.” From the Industry list, select (one at a time) “Diversified Banks,” “Other Diversified Financial Services,” “Investment Banking and Brokerage,” “Life & Health Insurance,” and “Property & Casualty.” Click on “Go!” Click on “Industry Profile” and, separately, “Industry Constituents.” Go to the Standard & Poor’s Market Insight Web site at www.mhhe.com/ edumarketinsight . Use the following steps to identify the Industry Financial Highlights for the following industries: Diversified Banks, Investment Banking & Brokerage, Life & Health Insurance, and Property & Casualty Insurance. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Industry.” From the Industry list, select (one at a time) “Diversified Banks,” “Other Diversified Financial Services,” “Investment Banking and Brokerage,” “Life & Health Insurance,” and “Property & Casualty.” Click on any/all of the items listed under “Industry Financial Highlights.”

Pertinent Web Sites

The Banker www.thebanker.com Board of Governors of the Federal Reserve www.federalreserve.gov Federal Deposit Insurance Corporation www.fdic.gov Federal Financial Institutions Examination Council www.ffiec.gov Investment Company Institute www.ici.org Office of the Comptroller of the Currency www.occ.treas.gov Securities and Exchange Commission www.sec.gov Securities Investors Protection Corporation www.sipc.org The Wall Street Journal www.wsj.com Thompson Financial Securities Data www.thomson.com

46.

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Appendix 1A: Monetary Policy Tools

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26 Part One Introduction

View Appendix 1A at the Web site for this textbook ( www.mhhe.com/ saunders6e ).

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27

Chapter Two

The Financial Services Industry: Depository Institutions

INTRODUCTION

A theme of this book is that the products sold and the risks faced by modern finan- cial institutions are becoming increasingly similar, as are the techniques used to measure and manage those risks. To illustrate this, Tables 2–1A and 2–1B con- trast the products sold by the financial services industry in 1950 with those sold in 2007. In 1999, the U.S. Congress passed the Financial Services Modernization Act (FSMA), which repealed regulations that set barriers between commercial banking, insurance, and investment banking. The bill, promoted as the biggest change in the regulation of financial institutions in nearly 70 years, allowed for the creation of “financial services holding companies” that could engage in bank- ing activities, insurance activities, and securities activities. The bill also allowed large banks to place certian activities, including some securities underwriting, in direct bank subsidiaries. Thus, after nearly 70 years of partial or complete separa- tion between the various functions performed by financial institutions, the FSMA opened the door for the creation of full-service financial institutions in the United States. Accordingly, many FIs operate in more than one of the industries discussed in the next five chapters.

TABLE 2–1A Products Sold by the U.S. Financial Services Industry, 1950

Function

Institution Payment Services

Savings Products

Fiduciary Services

Lending Underwriting Issuance of

Insurance and Risk

Management ProductsBusiness Consumer Equity Debt

Depository institutions X X X X X Insurance companies X * X Finance companies * X Securities firms X X X X Pension funds X Mutual funds X

*Minor involvement.

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28 Part One Introduction

In this chapter we begin by describing three major FI groups—commercial banks, savings institutions, and credit unions—which are also called depository institutions (DIs) because a significant proportion of their funds comes from cus- tomer deposits. Historically, commercial banks have operated as more diversi- fied institutions, having a large concentration of residential mortgage assets but holding commercial loans, corporate bonds, and corporate stock as well. Savings institutions have concentrated primarily on residential mortgages. Finally, credit unions have historically focused on consumer loans funded with member depos- its. In Chapters 3 through 6 other (nondepository) FIs will be described. We focus on four major characteristics of each group: (1) size, structure, and composition of the industry group, (2) balance sheets and recent trends, (3) regulation, and (4) industry performance.

Figure 2–1 presents a very simplified product-based balance sheet for deposi- tory institutions. Notice that DIs offer products to their customers on both sides of their balance sheets (loans on the asset side and deposits on the liability side). This joint-product nature of the DI business creates special challenges for manage- ment as they deal with the many risks facing these institutions. These risks will be discussed later, in Chapters 8 through 27.

Table 2–2 lists the largest U.S. depository institutions in 2007. The ranking is by asset size and reflects the dramatic trend toward consolidation and mergers among financial service firms at the end of the 1990s. The largest bank is Citigroup, created from the merger of Citicorp and Travelers Insurance; the second largest is Bank of America, created by the merger of the old NationsBank BankAmerica, and FleetBoston; and the third largest is J. P. Morgan Chase, created from the merger of J. P. Morgan, Chase Manhattan, and Bank One. Note that Washington Mutual is the largest savings institution in the country—reflecting over 20 mergers and acquisitions by the Seattle-based institution since 1990, including HF Ahmanson, then the nation’s second-largest savings institution.

FIGURE 2–1 A Simple Depository Institution Balance Sheet

Depository Institutions

Assets Liabilities and Equity

Loans Deposits

Other assets Other liabilities and equity

Function

Institution Payment Services

Savings Products

Fiduciary Services

Lending Underwriting Issuance of

Insurance and Risk

Management ProductsBusiness Consumer Equity Debt

Depository institutions X X X X X X X X Insurance companies X X X X X X X X Finance companies X X X X X † † X Securities firms X X X X X X X X Pension funds X X X X Mutual funds X X X X

†Selective involvement via affiliates

TABLE 2–1B Products Sold by the U.S. Financial Services Industry, 2007

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Chapter 2 The Financial Services Industry: Depository Institutions 29

COMMERCIAL BANKS

Commercial banks make up the largest group of depository institutions mea- sured by asset size. They perform functions similar to those of savings institu- tions and credit unions; that is, they accept deposits (liabilities) and make loans (assets). However, they differ in their composition of assets and liabilities, which are much more varied. Commercial bank liabilities usually include several types of nondeposit sources of funds, while their loans are broader in range, including consumer, commercial, and real estate loans. Commercial banking activity is also regulated separately from the activities of savings institutions and credit unions. Within the banking industry the structure and composition of assets and liabilities also vary significantly across banks of different asset sizes. For example, as shown in Figure 2–2 , small banks make proportionately fewer commercial and industrial (C&I) loans and more real estate loans than do big banks.

Size, Structure, and Composition of the Industry At the beginning of 2007 the United States had 7,450 commercial banks. Even though this may seem a large number, in fact, the number of banks has been shrinking. For example, in 1985 there were 14,416 banks, and in 1989 there were 12,744. Figure 2–3 illustrates the number of bank mergers, bank failures, and new

commercial bank A bank that accepts deposits and makes consumer, commer- cial, and real estate loans.

commercial bank A bank that accepts deposits and makes consumer, commer- cial, and real estate loans.

Company Assets

1. Citigroup $1,746.2 2. Bank of America 1,451.6 3. J. P. Morgan Chase 1,338.0 4. Wachovia 559.9 5. Wells Fargo 483.4 6. HSBC North America 473.7 7. Taurus 430.4 8. Washington Mutual 348.9 9. U.S. Bancorp 216.9 10. Countrywide Financial 193.2

TABLE 2–2 Largest Depository Institutions, 2007 (Banks and Savings Institutions Ranked by Total Assets on December 31, 2006, in billions of dollars)

Source: Annual reports, 2006.

FIGURE 2–2 Breakdown of Loan Portfolios

Source: Federal Deposit Insurance Corporation, February 2007. www.fdic.gov

Small Banks Large Banks

C&I 15%

Credit card 1%

Consumer 6%

Other 5%

Real estate 73%

C&I 20%

Credit card 7%

Consumer 9%

Other 11%

Real estate 53%

Note: Small banks are defined as banks with assets less than $1 billion. Large banks are defined as banks with assets of $1 billion or more.

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30 Part One Introduction

charters for the period 1980 through 2006. Notice that much of the change in the size, structure, and composition of this industry is the result of mergers and acqui- sitions. It was not until the 1980s and 1990s that regulators (such as the Federal Reserve or state banking authorities) allowed banks to merge with other banks across state lines (interstate mergers), and it has only been since 1994 that Congress has passed legislation (the Reigle-Neal Act) easing branching by banks across state lines. Indeed, the number of branches at U.S. banks has increased from 43,293 in 1985 to 72,362 at the beginning of 2007. Further, the industry has seen some of the largest mergers and acquisitions ever, such as J. P. Morgan’s acquisition of Chase Manhattan (for $33.6 billion) in September 2000, Norwest’s acquisition of Wells Fargo (for $34.3 billion) in June 1998, Bank of America’s acquisition of FleetBoston Financial (for $49.3 billion) in October 2003, J. P. Morgan Chase’s acquisition of Bank One (for $60.0 billion) in January 2004, and NationsBank’s acquisition of BankAmerica (for $61.6 billion) in April 1998. Thus, while back-office operations are being consolidated, bank customers have an increase in the number of branch locations available to them. Finally, it has only been since 1987 that banks have possessed (limited) powers to underwrite corporate securities. Full authority to enter the investment banking (and insurance) business was received only with the passage of the Financial Services Modernization Act in 1999. Thus, commer- cial banks may now merge with investment banks (and insurance companies). In subsequent chapters, we discuss the impact that changing regulations as well as technological advances have had on the drop in the number of commercial banks (e.g., technology changes [Chapter 14], regulatory changes [Chapters 21 and 22], and competition 1 [Chapter 22]).

A comparison of asset concentration by bank size (see Table 2–3 ) indicates that the consolidations in banking appear to have reduced the asset share of the small- est banks (under $1 billion) from 36.6 percent in 1984 to 12.4 percent in 2007. These

1 In particular, Chapter 22 provides a detailed discussion of the merger wave that swept the commercial banking industry in the 1990s and early 2000s.

FIGURE 2–3 Structural Changes in the Number of Commercial Banks, 1980–2006

Source: Federal Deposit Insurance Corporation, Quarterly Banking Profile, various issues. www.fdic.gov

600 Number

1980 1982 1984 1986 1988 1990 Year

1992 1994 1996 1998 2000 2002 2004 2006

Mergers New charters Failures500

400

300

200

100

0

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Chapter 2 The Financial Services Industry: Depository Institutions 31

smaller or community banks —under $1 billion in asset size—tend to specialize in retail or consumer banking, such as providing residential mortgages and con- sumer loans and accessing the local deposit base. Clearly, this group of banks is decreasing in both number and importance.

The relative asset share of the largest banks (over $1 billion in assets), on the other hand, increased from 63.4 percent in 1984 to 87.6 percent in 2007. The major- ity of banks in the two largest size classes are often either regional or superre- gional banks. They engage in a more complete array of wholesale commercial banking activities, encompassing consumer and residential lending as well as commercial and industrial lending (C&I loans), both regionally and nationally. In addition, the big banks access markets for purchased funds—such as the inter- bank or federal funds market —to finance their lending and investment activities. However, some of the very biggest banks often have the separate title money cen- ter banks. Currently, five banking organizations constitute the money center bank group: Bank of New York, Deutsche Bank (through its U.S. acquisition of Bankers Trust), Citigroup, J. P. Morgan Chase, and HSBC Bank USA (formerly Republic NY Corporation). 2, 3 This number has been declining because of the megamergers, discussed earlier.

It is important to note that asset or lending size does not necessarily make a bank a money center bank. Thus, Bank of America Corporation, with $1,452 billion in assets in 2007 (the second-largest U.S. bank organization), is not a money center bank, while Bank of New York (with only $107 billion in assets) is. What makes a bank a money center bank is partly location and partly its heavy reli- ance on nondeposit or borrowed sources of funds. 4 In fact, because of its exten- sive retail branch network, 5 Bank of America tends to be a net supplier of funds on the interbank market (federal funds market). By contrast, money center banks

2 Bank One’s inclusion results from its acquisition of First Chicago in 1998. J. P. Morgan Chase and Bank One announced a merger in January 2004. Bankers Trust was purchased by Deutsche Bank (a German bank) in 1998. The Bankers Trust name, however, has been retained for U.S. operations. Republic NY Corporation was purchased by HSBC (a British bank) in 1999. Republic NY Bank has been retained for U.S. operations under the name HSBC Bank USA.

3 These banking organizations are mostly holding companies that own and control the shares of a bank or banks.

4 A money center bank normally is headquartered in New York or Chicago. These are the traditional na- tional and regional centers for correspondent banking services offered to smaller community banks.

5 In 2007 Bank of America had over 4,800 branches nationwide.

community banks Banks that specialize in retail or consumer banking.

community banks Banks that specialize in retail or consumer banking.

regional or superregional banks Banks that engage in a complete array of wholesale commercial banking activities.

regional or superregional banks Banks that engage in a complete array of wholesale commercial banking activities.

federal funds market An interbank market for short-term bor- rowing and lending of bank reserves.

federal funds market An interbank market for short-term bor- rowing and lending of bank reserves.

money center banks Banks that have a heavy reliance on nondeposit or bor- rowed sources of funds.

money center banks Banks that have a heavy reliance on nondeposit or bor- rowed sources of funds.

2007 1984

Number Percent of Total Assets*

Percent of Total Number

Percent of Total Assets*

Percent of Total

All FDIC-insured commercial banks

7,450 $9,765.4 14,483 $2,508.9

1. Under $100 million 3,331 44.7% 173.9 1.8% 12,044 83.2% 404.2 16.1% 2. $100 million–$1 billion 3,631 48.7 1,031.9 10.6 2,161 14.9 513.9 20.5 3. $1 billion–$10 billion 401 5.4 1,095.3 11.2 254 1.7 725.9 28.9 4. $10 billion or more 87 1.2 7,464.3 76.4 24 0.2 864.8 34.5

*In billions of dollars.

TABLE 2–3 U.S. Bank Asset Concentration, 1984 versus 2007

Source: FDIC Quarterly Banking Profile, fourth quarter 1984 and first quarter 2007. www.fdic.gov

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32 Part One Introduction

have few retail branches and rely almost entirely on wholesale and borrowed funds as sources of assets or liabilities. Money center banks are also major partici- pants in foreign currency markets and are therefore subject to foreign exchange risk (see Chapter 15).

The bigger banks tend to fund themselves in national markets and lend to larger corporations. This means that their spreads (i.e., the difference between lending and deposit rates) in the past (the mid-1990s) often were narrower than those of smaller regional banks, which were more sheltered from competition in highly localized markets. As a result, the largest banks’ return on assets (ROA) was below that of smaller banks (see Table 2–4 ). However, as the barriers to interstate competition and expansion in banking have fallen in recent years and as large banks have focused more on off-balance-sheet activities to generate income (see below), the largest banks’ ROAs as well as returns on equity (ROEs) have outperformed those of the smallest banks, especially those with assets under $100 million (see Table 2–4 ). Appendix 2A (located at the book’s Web site, www.mhhe.com/ saunders6e ) shows how a bank’s ROE can be decomposed to examine the different underlying sources of profitability. This decomposition of ROE is often referred to as DuPont analysis.

The U.S. banking system is unique in that it consists of not only very big banks but also a large number of relatively small community banks. This unique bank- ing structure is largely the result of a legal framework that until recently restricted banks’ abilities to diversify geographically. Over time, with regulatory change (see below) and financial innovation, large banks have become complex organiza- tions engaged in a wide range of activities worldwide. These large banks provide

spread The difference between lending and deposit rates.

spread The difference between lending and deposit rates.

Percentage Return on Assets (insured commercial banks by consolidated assets)

Year All

Banks $0–$100 Million

$100 Million– $1 Billion

$1 Billion– $10 Billion $10 Billion+

1990 0.49% 0.79% 0.78% 0.76% 0.38% 1995 1.17 1.18 1.25 1.28 1.10 2000 1.19 1.01 1.28 1.29 1.16 2001 1.16 0.91 1.20 1.31 1.13 2002 1.33 1.02 1.26 1.53 1.32 2003 1.40 0.94 1.27 1.46 1.42 2004 1.31 0.99 1.28 1.46 1.30 2005 1.31 1.01 1.32 1.37 1.31 2006 1.37 1.03 1.28 1.35 1.39

Percentage Return on Equity (insured commercial banks by consolidated assets)

Year All Banks $0–$100 Million

$100 Million– $1 Billion

$1 Billion– $10 Billion $10 Billion+

1990 7.64% 9.02% 9.95% 10.25% 6.68% 1995 14.68 11.37 13.48 15.04 15.60 2000 14.07 9.09 13.56 14.57 14.42 2001 13.10 8.07 12.24 13.77 13.43 2002 14.53 9.08 12.85 14.88 15.06 2003 15.31 8.19 12.80 14.00 16.37 2004 13.82 8.46 12.88 13.48 14.24 2005 12.91 8.28 13.03 12.74 13.07 2006 13.36 8.12 12.60 12.01 13.84

TABLE 2–4 ROA and ROE of Banks by Size, 1990–2006

Source: Federal Deposit Insurance Corporation, Vari- ous dates. www.fdic.gov

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Chapter 2 The Financial Services Industry: Depository Institutions 33

a variety of services to their customers, but often rely on factual financial infor- mation, computer models, and centralized decision making as the basis for con- ducting business. Small banks focus more on relationship banking, often basing decisions on personal knowledge of customers’ creditworthiness and an under- standing of business conditions in the communities they serve. As discussed above, with increased merger activity over the last 20 years, the number of com- munity banks (while still large) has declined. Although community banks hold only a small share of the nation’s banking assets, they provide important financial services (such as small-business lending) for which there are few, if any, substi- tutes. Thus, community banks will likely continue to play an important role in the banking industry even as technology and market conditions change.

Balance Sheet and Recent Trends Assets Figure 2–4 shows the broad trends over the 1951–2007 period in the four principal earning asset areas of commercial banks: business loans (or C&I loans), securities, mortgages, and consumer loans. Although business loans were the major asset in bank balance sheets between 1965 and 1990, there has been a drop in their impor- tance (as a proportion of the balance sheet) since 1990. This drop has been mir- rored by an offsetting rise in holdings of securities and mortgages. These trends reflect a number of long-term and temporary influences. One important long-term influence has been the growth of the commercial paper market, which has become an alternative funding source for major corporations. Another has been the secu- ritization of mortgages—the pooling and packaging of mortgage loans for sale in the form of bonds (see Chapter 27). A more temporary influence was the so-called credit crunch and decline in the demand for business loans as a result of the eco- nomic downturn and recession in 1989–92 and 2001–02.

Look at the detailed balance sheet for all U.S. commercial banks as of the end of 2006 ( Table 2–5 ). Total loans amount to $6,210.5 billion, or 63.6 percent of total assets, and fall into four broad classes: business or C&I ($1,117.2 billion); commer- cial and residential real estate ($3,207.1 billion); individual, such as consumer loans

FIGURE 2–4 Portfolio Shift: U.S. Commercial Banks’ Financial Assets

Source: Federal Deposit Insurance Corporation, March 2007. www.fdic.gov

50

Percent of total

Securities

40

30

20

10

1995 2000199019851980197519701965196019551951 0

Business loans

Consumer loans

Mortgages

2005

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34 Part One Introduction

for auto purchases and credit card debt ($846.9 billion); and all other loans, such as less developed country (LDC) loans ($566.3 billion). In the investment security portfolio of $1,632.9 billion, or 16.7 percent of total assets, U.S. government securi- ties, such as Treasury bonds, constitute $1,070.6 billion, with other securities (in particular, municipal securities and investment-grade corporate bonds) making up the rest. 6

A major inference we can draw from this asset structure is that credit or default risk exposure is a major risk faced by modern commercial bank managers (see Chapters 11 and 12). Because commercial banks are highly leveraged and therefore hold little equity (see below) compared with total assets, even a relatively small number of loan defaults can wipe out the equity of a bank, leaving it insolvent. 7

6 The footnotes to commercial bank balance sheets also distinguish between securities held by banks for trading purposes, normally for less than one year, and those held for longer-term investment purposes. The large money center banks are often active in the secondary market trading of government securities, reflecting their important role as primary dealers in government securities at the time of Treasury security auctions.

7 Losses such as those due to defaults are charged off against the equity (stockholders’ stake) in a bank. Additions to the reserve for loan and lease losses account (and, in turn, the expense account “provisions for losses on loans and leases”) to meet expected defaults reduce retained earnings and, thus, reduce equity of the bank. Unexpected defaults (e.g., due to a sudden major recession) are meant to be written off against the remainder of the bank’s equity (e.g., its retained earnings and funds raised from share offerings).

Assets

Loans and securities $7,843.4 Investment securities $1,632.9 U.S. government securities $1,070.6 Other 562.3 Total loans 6,210.5 Interbank loans 544.4 Loans excluding interbank 5,666.1 Commercial and industrial $1,117.2 Real estate 3,207.1 Revolving home equity $447.6 Other 2,759.5 Individual 846.9 All other 566.3 Less: Reserve for loan losses 71.4 Total cash assets 393.0 Other assets 1,529.0

Total assets 9,765.4

Liabilities

Total deposits $6,426.5 Transaction accounts $677.3 Nontransaction accounts 5,749.3 Large time deposits $1,024.1 Other 4,725.2 Borrowings 2,020.7 Other liabilities 306.2 Total liabilities 8,753.4 Residual (assets less liabilities) 1,012.0

TABLE 2–5 Balance Sheet (All U.S. Commercial Banks) as of December 31, 2006 (in billions of dollars)

Source: Federal Deposit Insurance Corporation, December 31, 2006. www. fdic.gov

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Chapter 2 The Financial Services Industry: Depository Institutions 35

Liabilities Commercial banks have two major sources of funds other than the equity pro- vided by owners: deposits and borrowed or other liability funds. A major differ- ence between banks and other firms is banks’ high leverage. For example, banks had an average ratio of equity to assets of 10.36 percent in 2006; this implies that 89.64 percent of their assets were funded by debt, either deposits or borrowed funds.

Note in Table 2–5 , the aggregate balance sheet of U.S. banks, that deposits amounted to $6,426.5 billion, or 65.8 percent of total liabilities and equity, and borrowings and other liabilities were $2,020.7 billion and $306.2 billion, respec- tively. Of the total stock of deposits, transaction accounts constituted 10.5 percent, or $677.2 billion.

Transaction accounts are checkable deposits that bear no interest (demand deposits) or are interest bearing (most commonly called NOW accounts, or negotiable order of withdrawal accounts). Since their introduction in 1980, interest-bearing checking accounts—especially NOW accounts—have dominated the transaction accounts of banks. However, since limitations are imposed on the ability of corporations to hold such accounts and since there are minimum balance requirements for NOW accounts, 8 non-interest-bearing demand deposits are still held. The second major segment of deposits is retail or household savings and time deposits, normally individual account holdings of less than $100,000. Important components of bank retail savings accounts are small nontransaction accounts, which include passbook savings accounts and retail time deposits. Small nontransaction accounts constitute 73.5 percent of total deposits, or $4,725.2 billion. However, this disguises an important trend in the supply of these deposits to banks. Specifically, retail savings and time deposits have been falling in recent years, largely as a result of competition from money market mutual funds. These funds pay a competitive rate of interest based on wholesale money market rates by pooling and investing funds (see Chapter 5) while requiring relatively small-denomination investments by mutual fund investors.

The third major source of deposit funds consists of large time deposits (over $100,000), which amounted to $1,024.1 billion, or approximately 15.9 percent of the stock of deposits, in December 2006. These are primarily negotiable certifi- cates of deposit (deposit claims with promised interest rates and fixed maturities of at least 14 days) that can be resold to outside investors in an organized second- ary market. As such, they are usually distinguished from retail time deposits by their negotiability and secondary market liquidity.

Nondeposit liabilities comprise borrowings and other liabilities that together total 26.6 percent of all bank liabilities, or $2,326.9 billion. These categories include a broad array of instruments, such as purchases of federal funds (bank reserves) on the interbank market and repurchase agreements (temporary swaps of securi- ties for federal funds) at the short end of the maturity spectrum to the issuance of notes and bonds at the longer end. 9

8 In the early 2000s, in an effort to attract new customers, many banks eliminated minimum balance re- quirements on NOW accounts. However, the many (and increased) fees on these accounts (such as over- draft charges) have more than offset the benefits of these new free checking features.

9 These instruments are explained in greater detail in later chapters, especially Chapter 18.

transaction accounts The sum of non- interest-bearing demand deposits and interest-bearing checking accounts.

transaction accounts The sum of non- interest-bearing demand deposits and interest-bearing checking accounts.

NOW accounts Interest-bearing checking accounts.

NOW accounts Interest-bearing checking accounts.

money market mutual funds Specialized mutual funds that offers de- positlike interest bear- ing claims to savers.

money market mutual funds Specialized mutual funds that offers de- positlike interest bear- ing claims to savers.

negotiable CDs Fixed-maturity inter- est-bearing deposits with face values over $100,000 that can be resold in the second- ary market.

negotiable CDs Fixed-maturity inter- est-bearing deposits with face values over $100,000 that can be resold in the second- ary market.

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36 Part One Introduction

Overall, the liability structure of bank balance sheets tends to reflect a shorter maturity structure than does the asset portfolio with relatively more liquid instru- ments such as deposits and interbank borrowings—used to fund less liquid assets such as loans. Thus, maturity mismatch or interest rate risk and liquidity risk are key exposure concerns for bank managers (see Chapters 8, 9, 17, and 18).

Equity Commercial bank equity capital (10.36 percent of total liabilities and equity in 2006) consists mainly of common and preferred stock (listed at par value), sur- plus 10 or additional paid-in capital, and retained earnings. Regulators require banks to hold a minimum level of equity capital to act as a buffer against losses from their on- and off-balance-sheet activities (see Chapter 20). Because of the relatively low cost of deposit funding, banks tend to hold equity close to the mini- mum levels set by regulators. As we discuss in subsequent chapters, this impacts banks’ exposures to risk and their ability to grow—both on and off the balance sheet—over time.

Go to the Federal Deposit Insurance Corporation Web site (www.fdic.gov) and find the lat- est balance sheet information available for commercial banks.

Go to the Federal Deposit Insurance Corporation Web site at www.fdic.gov. Click on “Analysts.” Click on “Statistics on Banking.” Click on “Run Report.” This will download a file onto your computer that will contain the most recent balance sheet information for com- mercial banks.

Internet Exercise

Off-Balance-Sheet Activities The balance sheet itself does not reflect the total scope of bank activities. Banks conduct many fee-related activities off the balance sheet. Off-balance-sheet (OBS) activities are becoming increasingly important, in terms of their dollar value and the income they generate for banks—especially as the ability of banks to attract high-quality loan applicants and deposits becomes ever more difficult. OBS activities include issuing various types of guarantees (such as letters of credit), which often have a strong insurance underwriting element, and making future commitments to lend. Both services generate additional fee income for banks. Off-balance-sheet activities also involve engaging in derivative transactions— futures, forwards, options, and swaps.

Under current accounting standards, such activities are not shown on the cur- rent balance sheet. Rather, an item or activity is an off-balance-sheet asset if, when a contingent event occurs, the item or activity moves onto the asset side of the balance sheet or an income item is realized on the income statement. Conversely, an item or activity is an off-balance-sheet liability if, when a contin- gent event occurs, the item or activity moves onto the liability side of the balance sheet or an expense item is realized on the income statement.

By moving activities off the balance sheet, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business. At the same time, they can avoid regulatory costs or “taxes” since reserve requirements and deposit insurance premiums are not levied on off-balance-sheet

10 Surplus or additional paid-in capital shows the difference between the stock’s par value and what the original stockholders paid when they bought the newly issued shares.

off-balance-sheet asset An item that moves onto the asset side of the balance sheet when a contingent event occurs.

off-balance-sheet asset An item that moves onto the asset side of the balance sheet when a contingent event occurs.

off-balance-sheet liability An item that moves onto the liability side of the balance sheet when a contingent event occurs.

off-balance-sheet liability An item that moves onto the liability side of the balance sheet when a contingent event occurs.

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Chapter 2 The Financial Services Industry: Depository Institutions 37

activities (see Chapter 13). Thus, banks have both earnings and regulatory “tax- avoidance” incentives to undertake activities off their balance sheets.

Off-balance-sheet activities, however, can involve risks that add to the over- all insolvency exposure of an FI. Indeed, the failure of the U.K. investment bank Barings and the bankruptcy of Orange County in California in the 1990s have been linked to FIs’ off-balance-sheet activities in derivatives. More recently, in 2001 Allied Irish Banks incurred a $750 million loss from foreign exchange derivative trades by a rogue trader, and in 2004 unauthorized trading of foreign currency options at National Australian Bank resulted in a loss of $485 million. However, off-balance-sheet activities and instruments have both risk-reducing as well as risk-increasing attributes, and, when used appropriately, they can reduce or hedge an FI’s interest rate, credit, and foreign exchange risks.

We show the notional, or face, value of bank OBS activities, and their distribu- tion and growth, for 1992 to 2006 in Table 2–6 . Notice the relative growth in the notional dollar value of OBS activities in Table 2–6 . By the end of 2006, the notional value of OBS bank activities was $136,205.6 billion compared with the $9,765.4 billion value of on-balance-sheet activities. It should be noted that the notional, or face, value of OBS activities does not accurately reflect the risk to the bank undertaking such activities. The potential for the bank to gain or lose is based on the possible change in the market value over the life of the contract rather than the

1992 1996 2003 2006 Distribution

2006

Commitments to lend $ 1,272.0 $ 2,528.7 $ 5,398.9 $ 6,745.8 5.0% Future and forward contracts (exclude FX) On commodities and equities 26.3 101.6 104.9 323.5 0.2 On interest rates 1,738.1 3,201.2 7,209.8 8,392.7 6.2 Notional amount of credit derivatives 9.6 28.6 1,001.2 7,904.0 5.8 Standby contracts and other option contracts Option contracts on interest rates 1,012.7 3,156.2 12,539.5 20,097.7 14.7 Option contracts on foreign exchange 494.8 1,032.5 1,298.3 3,213.7 2.4 Option contracts on commodities 60.3 203.9 767.5 2,934.6 2.2 Commitments to buy FX (includes $US), spot, and forward 3,015.5 5,000.8 4,351.1 6,682.9 4.9 Standby LCs and foreign office guarantees 162.5 211.0 348.9 519.9 0.4 (amount of these items sold to others via participations) (14.9) (21.8) (60.3) (107.5) Commercial LCs 28.1 30.9 24.2 29.7 0.0 Participations in acceptances 1.0 2.4 0.5 0.1 0.0 Securities borrowed or lent 107.2 233.5 852.0 1,704.6 1.3 Other significant commitments and contingencies 8.7 14.0 53.3 113.0 0.0 Memoranda Notional value of all outstanding swaps 2,122.0 7,069.4 44,082.7 77,543.4 56.9 Total, including memoranda items $10,075.8 $22,814.7 $78,032.8 $136,205.6 100.0% Total assets (on-balance-sheet items) $ 3,476.4 $ 4,578.3 $ 7,602.5 $ 9,765.4

FX = foreign exchange; LC = letter of credit.

TABLE 2–6 Aggregate Volume of Off-Balance-Sheet Commitments and Contingencies by U.S. Commercial Banks, Annual Data as of December (in billions of dollars)

Sources: FDIC, Statistics on Banking, various issues. www.fdic.gov

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38 Part One Introduction

notional, or face, value of the contract, normally less than 3 percent of the notional value of an OBS contract. 11

The use of derivative contracts (futures and forwards, swaps, and options) accelerated during the 1992–2006 period and accounted for much of the growth in OBS activity. Along with the growth in the notional value of OBS activities, banks have seen significant growth in the percentage of their total operating income (interest income plus noninterest income) coming from these non-balance-sheet activities. Indeed, the percentage of noninterest income to total operating income has increased from 22.66 percent in 1979 to 29.42 percent in 2006. As we discuss in detail in Chapters 23 through 25, the significant growth in derivative securities activities by commercial banks has been a direct response to the increased interest rate risk, credit risk, and foreign exchange risk exposures they have faced, both domestically and internationally. In particular, these contracts offer banks a way to hedge these risks without having to make extensive changes on the balance sheet.

Although the simple notional dollar value of OBS items overestimates their risk exposure amounts, the increase in these activities is still nothing short of phe- nomenal. 12 Indeed, this phenomenal increase has pushed regulators into impos- ing capital requirements on such activities and into explicitly recognizing an FI’s solvency risk exposure from pursuing such activities. We describe these capital requirements in Chapter 20.

As noted in Table 2–6 , major types of OBS activities for U.S. banks include the following:

Loan commitments. Standby letters of credit and letters of credit. Derivative contracts: futures, forwards, swaps, and options. When-issued securities.

We discuss each of these and the risks they present in Chapter 13.

Other Fee-Generating Activities Commercial banks engage in other fee-generating activities that cannot easily be identified from analyzing their on- and off-balance-sheet accounts. Two of these are trust services and correspondent banking.

Trust Services The trust department of a commercial bank holds and manages assets for indi- viduals or corporations. Only the largest banks have sufficient staff to offer trust services. Individual trusts represent about one-half of all trust assets managed by commercial banks. These trusts include estate assets and assets delegated to bank trust departments by less financially sophisticated investors. Pension fund assets are the second largest group of assets managed by the trust departments of com- mercial banks. The banks manage the pension funds, act as trustees for any bonds

11 For example, the market value of a swap (today) is the difference between the present value of the cash flows (expected) to be received minus the present value of cash flows expected to be paid (see Chapter 25).

12 This overestimation of risk exposure occurs because the risk exposure from a contingent claim (such as an option) is usually less than its face value (see Chapter 13).

• • • •

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Chapter 2 The Financial Services Industry: Depository Institutions 39

held by the pension funds, and act as transfer and disbursement agents for the pension funds.

Correspondent Banking Correspondent banking is the provision of banking services to other banks that do not have the staff resources to perform the service themselves. These services include check clearing and collection, foreign exchange trading, hedging services, and participation in large loan and security issuances. Correspondent banking services are generally sold as a package of services. Payment for the services is generally in the form of non-interest-bearing deposits held at the bank offering the correspondent services (see Chapter 13).

Regulation The Regulators Unlike banks in countries that have one or sometimes two regulators, U.S. banks may be subject to the supervision and regulations of up to four separate regula- tors. The key regulators are the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Federal Reserve System (FRS), and state bank regulators. Next, we look at the principal roles played by each regulator. Appendix 2B (located at the book’s Web site, www.mhhe.com/ saunders6e ) lists in greater detail the regulators that oversee the various activities of depository institutions. The FDIC Because of the serious social welfare effects that a contagious run on de- pository institutions could have, the Federal Deposit Insurance Corporation (FDIC) has established guarantee programs offering deposit holders varying degrees of insurance protection to deter depositor “runs.” While a run on an unhealthy DI is not necessarily a bad thing, there is a risk that runs on bad DIs can become conta- gious and spread to good or well-run DIs. In a contagious run or panic conditions, liability holders do not bother to distinguish between good and bad DIs but, in- stead, seek to turn their liabilities into cash or safe securities as quickly as possible. Contagious runs can have a major contractionary effect on the supply of credit as well as the money supply regionally, nationally, or even internationally. Moreover, a contagious run on DIs can have serious social welfare effects. For example, a major run on banks can have an adverse effect on the level of savings in all types of FIs and therefore can inhibit the ability of individuals to transfer wealth through time to protect themselves against major risks such as future ill health and falling income in old age. However, if a deposit holder believes a claim is totally secure, even if the DI is in trouble, the holder has no incentive to run. Thus, FDIC deposit insurance deters runs as well as contagious runs and panics.

In exchange for insuring the deposits of member banks, the Federal Deposit Insurance Corporation levies insurance premiums on member banks, manages the deposit insurance fund, and carries out bank examinations. Further, when an insured bank is closed, the FDIC acts as the receiver and liquidator—although the closure decision itself is technically in the hands of the bank chartering or licensing agency, such as the OCC. Because of the problems in the thrift industry and the insolvency of the savings association insurance fund (FSLIC) in 1989, the FDIC managed both the commercial bank insurance fund and the savings associa- tion insurance fund. In 2007, the two funds were combined into one, the Deposit Insurance Fund (DIF). The number of FDIC-insured banks and the division between nationally chartered and state chartered banks is shown in Figure 2–5 .

www.fdic.gov www.fdic.gov

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40 Part One Introduction

Office of the Comptroller of the Currency (OCC) The OCC is the oldest bank regulatory agency; established in 1863, it is a subagency of the U.S. Treasury. Its primary function is to charter so-called national banks as well as to close them. In addition, the OCC examines national banks and has the power to approve or dis- approve their merger applications. However, instead of seeking a national charter, banks can be chartered by any of 50 individual state bank regulatory agencies. The choice of being a nationally chartered or state chartered bank lies at the founda- tion of the dual banking system in the United States. While most large banks, such as Bank of America, choose national charters, this is not always the case. For example, Morgan Guaranty, the money center bank subsidiary of J. P. Morgan Chase, is chartered as a state bank under New York state law. In December 2006, 1,758 banks were nationally chartered and 5,692 were state chartered, with approxi- mately 67 percent and 33 percent of total commercial bank assets, respectively. 13 Federal Reserve System Apart from being concerned with the conduct of mon- etary policy, as this country’s central bank, the Federal Reserve also has regulatory power over some banks and, when relevant, their holding company parents. All the 1,758 nationally chartered banks in Figure 2–5 are automatically members of the Federal Reserve system; 896 state-chartered banks also have chosen to become members. Since 1980, all banks have had to meet the same non-interest-bearing reserve requirements whether they are members of the Federal Reserve System (FRS) or not. The primary advantages of FRS membership are direct access to the federal funds wire transfer network for nationwide interbank borrowing and lending of reserves and to the discount window for lender of last resort borrowing

13 In early 2004 the regulation of banks by federal versus state regulators came under debate. In January 2004 the OCC proclaimed that it alone has the right to draft and enforce rules that govern not only na- tionally chartered bank holding companies, but also the more than 2,000 banks that operate as subsid- iaries of these holding companies. The move outraged state regulators, who claimed the OCC was attempting to preempt states’ authority and grab power. In September 2005, the U.S. Court of Appeals for the Ninth Circuit ruled in favor of the OCC’s authority over these subsidiaries.

www.occ.treas.gov www.occ.treas.gov

dual banking system The coexistence of both nationally chartered and state chartered banks in the United States.

dual banking system The coexistence of both nationally chartered and state chartered banks in the United States.

www.federalreserve.gov www.federalreserve.gov

FIGURE 2–5 Bank Regulators

Source: FDIC (internal fig- ures), December 31, 2006. www.fdic.gov

$9,765.4 billion in assets

Insured Commercial Banks (FDIC-DIF) 2006

7,450 in number

1,758 5,692

Nationally chartered

(OCC)

State-chartered

Members (FRS)

4,796

Nonmembers (FDIC)

896

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Chapter 2 The Financial Services Industry: Depository Institutions 41

of funds. Finally, many banks are often owned and controlled by parent holding companies; for example, Citigroup is the parent holding company of Citibank (a bank). Because the holding company’s management can influence decisions taken by a bank subsidiary and thus influence its risk exposure, the Federal Reserve System regulates and examines bank holding companies as well as banks.

Regulations Because of the inherent special nature of banking and banking contracts (see Chapter 1), commercial banks are among the most regulated firms in the U.S. economy. Regulators have imposed numerous restrictions on their product and geographic activities. Table 2–7 lists the major laws from the McFadden Act of 1927 to the Financial Services Modernization Act of 1999 and briefly describes the key features of each act.

holding companies Parent companies that own a controlling interest in subsidiary banks or other FIs.

holding companies Parent companies that own a controlling interest in subsidiary banks or other FIs.

1927 The McFadden Act

1. Made branching of nationally chartered banks subject to the same branching regulations as state-chartered banks.

2. Liberalized national banks’ securities underwriting activities, which previously had to be conducted through state-chartered affiliates.

1933 The Banking Acts of 1933

1. The Glass-Steagall Act generally prohibited commercial banks from underwriting securities with four exceptions:

a. Municipal general obligation bonds. b. U.S. government bonds. c. Private placements. d. Real estate loans. 2. In addition, the acts established the FDIC to insure bank deposits. 3. The Glass-Steagall Act prohibited banks from paying interest on demand deposits.

1956 The Bank Holding Company Act

1. Restricted the banking and nonbanking acquisition activities of multibank holding companies.

2. Empowered the Federal Reserve to regulate multibank holding companies by: a. Determining permissible activities. b. Exercising supervisory authority. c. Exercising chartering authority. d. Conducting bank examinations.

1970 Amendments to the Bank Holding Company Act of 1956

1. Extended the BHC Act of 1956 to one-bank holding companies. 2. Restricted permissible BHC activities to those “closely related to banking.”

1978 International Banking Act

1. Regulated foreign bank branches and agencies in the United States. 2. Subjected foreign banks to the McFadden and Glass-Steagall Acts. 3. Gave foreign banks access to Fedwire, the discount window, and deposit insurance.

1980 Depository Institutions Deregulation and Monetary Control Act (DIDMCA)

1. Set a six-year phaseout for Regulation Q interest rate ceilings on small time and savings deposits.

2. Authorized NOW accounts nationwide.

TABLE 2–7 Major Bank Laws, Major Features

(continued)

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42 Part One Introduction

TABLE 2–7 (continued)

3. Introduced uniform reserve requirements for state-chartered and nationally chartered banks.

4. Increased the ceiling on deposit insurance coverage from $40,000 to $100,000. 5. Allowed federally chartered thrifts to make consumer and commercial loans (subject to

size restrictions).

1982 Garn–St. Germain Depository Institutions Act (DIA)

1. Introduced money market deposit accounts (MMDAs) and super NOW accounts as interest rate–bearing savings accounts with limited check-writing features.

2. Allowed federally chartered thrifts more extensive lending powers and demand deposit–taking powers.

3. Allowed sound commercial banks to acquire failed savings institutions. 4. Reaffirmed limitations on bank powers to underwrite and distribute insurance.

1987 Competitive Equality in Banking Act (CEBA)

1. Redefined the definition of a bank to limit the growth of nonbank banks. 2. Sought to recapitalize the Federal Savings and Loan Insurance Corporation (FSLIC).

1989 Financial Institutions Reform Recovery and Enforcement Act (FIRREA)

1. Limited savings banks’ investments in nonresidential real estate, required divestiture of junk bond holdings (by 1994), and imposed a restrictive asset test for qualifications as a savings institution (the qualified thrift lender [QTL] test).

2. Equalized the capital requirements of thrifts and banks. 3. Replaced the FSLIC with the FDIC-SAIF. 4. Replaced the Federal Home Loan Bank Board as the charterer of federal savings and

loans with the Office of Thrift Supervision (OTS), an agency of the Treasury. 5. Created the Resolution Trust Corporation (RTC) to resolve failed and failing savings

institutions.

1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA)

1. Introduced prompt corrective action (PCA), requiring mandatory interventions by regulators whenever a bank’s capital falls.

2. Introduced risk-based deposit insurance premiums beginning in 1993. 3. Limited the use of too-big-to-fail bailouts by federal regulators for large banks. 4. Extended federal regulation over foreign bank branches and agencies in the Foreign

Bank Supervision and Enhancement Act (FBSEA).

1994 Riegle-Neal Interstate Banking and Branching Effi ciency Act

1. Permitted bank holding companies to acquire banks in other states, starting September 1995.

2. Invalidated the laws of states that allowed interstate banking only on a regional or reciprocal basis.

3. Beginning in June 1997, bank holding companies were permitted to convert out-of-state subsidiary banks into branches of a single interstate bank.

4. Newly chartered branches also permitted interstate if allowed by state law.

1999 Financial Services Modernization Act

1. Eliminated restrictions on banks, insurance companies, and securities firms entering into each others’ areas of business. Allowed for the creation of a financial services holding company.

2. Provided for state regulation of insurance. 3. Streamlined bank holding company supervision, with the Federal Reserve as the umbrella

holding company supervisor. 4. Prohibited FDIC assistance to affiliates and subsidiaries of banks and savings institutions. 5. Provided for national treatment of foreign banks engaging in activities authorized under

the act.

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Chapter 2 The Financial Services Industry: Depository Institutions 43

Even though we will go into greater detail about these regulations in later chap- ters (e.g., product diversification, Chapter 21; geographic diversification, Chapter 22), we now note the major objectives of each of these laws. The 1927 McFadden Act sought to restrict interstate bank branching, while the 1933 Glass-Steagall Act sought to separate commercial banking from investment banking by limiting the powers of commercial banks to engage in securities activities. Restrictions on the nonbank activities of commercial banks were strengthened by the Bank Holding Company Act of 1956 and its 1970 amendments, which limited the ability of a bank’s parent holding company to engage in commercial, insurance, and other nonbank financial service activities. The 1978 International Banking Act extended federal regulation, such as the McFadden and Glass-Steagall Acts, to foreign branches and agencies in the United States for the first time, thereby seeking to level the competi- tive playing field between domestic and foreign banks. The 1980 DIDMCA and the 1982 DIA are mainly deregulation acts in that they eliminated interest ceilings on deposits and gave banks (and thrifts) new liability and asset powers. 14 As we dis- cuss in the next section on thrifts, this deregulation is blamed in part for the thrift crisis that resulted in widespread failures and the insolvency of the FSLIC in 1989.

The Competitive Equality in Banking Act (CEBA) of 1987 sought to impose controls over a growing number of nonbank banks that were established to get around interstate banking restrictions and restrictions on nonbank ownership of banks imposed under the 1927 McFadden and the 1956 Bank Holding Company Acts. In 1989 Congress responded to the problems of thrift banks and the col- lapse of the FSLIC with the passage of the FIRREA. In 1991 Congress enacted the FDICIA to deal with a large number of bank failures and the threatened insol- vency of the FDIC, the insurance fund for commercial banks. Both the FIRREA and FDICIA sought to pull back from some of the deregulatory elements of the 1980 DIDMCA and the 1982 DIA. In 1994 the Riegle-Neal Act rolled back many of the restrictions on interstate banking imposed by the 1927 McFadden and the 1956 Bank Holding Company Acts. In particular, since June 1997 bank holding com- panies have been permitted to convert their bank subsidiaries in various states into branches, thus making nationwide branching possible for the first time in 70 years. In 1999 the Financial Services Modernization Act repealed Glass-Steagall barriers between commercial banks and investment banks. The act allowed for the creation of a financial services holding company that could engage in banking activities and securities underwriting. In 2006, 462 banks (holding $8.2 trillion in assets) qualified as financial services holding companies. Of these 462 banks, 97 engaged in insurance activities, 46 engaged in securities brokerage, and 26 also operated a thrift subsidiary. This act also allows FI customers to opt out of any pri- vate information sharing an FI may want to pursue. Thus, FI customers have some control over who will see and have access to their private information. 15

14 In particular, Regulation Q ceilings on bank deposit rates were phased out in stages between March 1980 and March 1986.

15 While not specific to commercial banks, after the terrorist attacks on September 11, 2001, the U.S. Congress passed the USA Patriot Act of 2001. The act consists of a number of specific amendments to existing criminal laws designed to streamline early detection and investigation of suspected terrorist activ- ity conducted through banks. Specifically, banks must define their methods for profiling new individual and corporate customers who are opening accounts, as well as for maintaining data on them. Further, the Sarbanes-Oxley Act of 2002 requires public companies to make sure their boards’ audit committees have at least one individual who is familiar with generally accepted accounting principles (GAAP) and has experience with internal auditing controls, preparing or auditing financial statements of “generally comparable issuers,” and applying GAAP guidelines for estimates, accruals, and reserves. Small banks— especially those in rural markets—might find it difficult and expensive to comply with these laws.

nonbank banks Firms that undertake many of the activities of a commercial bank without meeting the legal definition of a bank.

nonbank banks Firms that undertake many of the activities of a commercial bank without meeting the legal definition of a bank.

financial services holding company A financial institution that engages in banking activities and securities under- writing or any other financial activity.

financial services holding company A financial institution that engages in banking activities and securities under- writing or any other financial activity.

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44 Part One Introduction

Industry Performance Table 2–8 presents selected performance ratios for the commercial banking indus- try for various years from 1989 through 2006. With the economic expansion in the U.S. economy and falling interest rates throughout most of the 1990s, U.S. com- mercial banks flourished for most of that period. In 1999 commercial bank earnings were a record $71.6 billion. More than two-thirds of all U.S. banks reported a return on assets (ROA) of 1 percent or higher, and the average ROA for all banks was 1.31 percent, up from 1.19 percent for the year 1998. 16 This, despite continued finan- cial problems (or sovereign risk, see Chapter 16) in Southeast Asia, Russia, and South America. With the economic downturn in the early 2000s, however, bank performance deteriorated slightly. For example, commercial banks’ string of eight consecutive years of record earnings ended in 2000 as their net income fell to $71.2 billion. Banks’ provision for loan losses (or credit risk) rose to $9.5 billion in the fourth quarter of 2000, an increase of $3.4 billion (54.7 percent) from the level of a year earlier. This was the largest quarterly loss provision since the fourth quarter of 1991. Finally, the average ROA was 1.19 in 2000, down from 1.31 percent in 1999.

This downturn was short-lived, however. In 2001, net income of $74.3 billion easily surpassed the old record of $71.6 billion, and net income rose further, to $106.3 billion, in 2003. Moreover, in 2003, both ROA and ROE reached all-time highs of 1.40 percent and 15.34 percent, respectively. The two main sources of earn- ings strength in 2003 were higher noninterest income (up $18.9 billion, 10.3 percent) and lower loan loss provisions (down $14.2 billion, or 27.6 percent). The greatest improvement in profitability occurred at large institutions, whose earnings had been depressed in the early 2000s by credit losses on loans to corporate borrowers and by weakness in market-sensitive noninterest revenue. Only 5.7 percent of all institutions were unprofitable in 2003, the lowest proportion since 1997.

Several explanations have been offered for the strong performance of com- mercial banks during the early 2000s. First, the Federal Reserve cut interest rates 13 times during this period. Lower interest rates made debt cheaper to service

16 ROA is calculated as net income divided by the book value of total assets. It reflects the earnings per dollar of assets for the bank. ROE is calculated as net income divided by common equity of the bank and measures the return to the bank’s common stockholders.

2006 2005 2003 2001 2000 1999 1997 1995 1993 1989

Number of institutions 7,450 7,541 7,769 8,079 8,315 8,580 9,143 9,940 10,958 12,709 Return on assets (%) 1.37 1.33 1.40 1.15 1.19 1.31 1.24 1.17 1.22 0.49 Return on equity (%) 13.36 13.26 15.34 13.09 14.07 15.31 14.71 14.68 15.67 7.71 Provision for loan losses

to total assets (%) 0.25 0.17 0.47 0.67 0.47 0.38 0.39 0.29 0.45 0.94 Net charge-offs to

loans (%) 0.39 0.56 0.89 0.95 0.64 0.61 0.64 0.49 0.85 1.16 Asset growth rate (%) 9.68 7.43 7.42 4.91 8.79 5.37 9.54 7.53 5.72 5.38 Net operating income

growth (%) 12.04 11.92 14.92 –1.89 2.02 20.42 12.48 7.48 35.36 –38.70 Number of failed/

assisted institutions 0 0 3 3 6 7 1 6 42 206

TABLE 2–8 Selected Indicators for U.S. Commercial Banks, 1989 through 2006

Source: FDIC, Quarterly Banking Profile, various issues; and Historical Statistics, 1989. www.fdic.gov

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Chapter 2 The Financial Services Industry: Depository Institutions 45

and kept many households and small firms borrowing. Second, lower interest rates made home purchasing more affordable. Thus, the housing market boomed throughout the period. Third, the development of new financial instruments, such as credit derivatives and mortgage-backed securities, helped banks shift credit risk from their balance sheets to financial markets and other FIs such as insurance companies. Finally, improved information technology has helped banks manage their risk better.

As interest rates rose in the mid-2000s, performance did not deteriorate significantly. Increased loan loss provisions, reduced servicing income, and lower trading revenue kept net income reported by commercial banks from setting a new record in 2006. However, third quarter 2006 earnings represented the second- highest quarterly total ever reported by the industry, and more than half of all banks reported higher earnings in the third quarter of 2006 than in the second quarter. The average ROA declined to 1.37 percent from 1.33 percent in 2005, but more than half of all institutions reported a quarterly ROA of 1 percent or higher. A flat yield curve, growing reliance on interest-sensitive funding sources, and competitive pricing pressures all contributed to downward pressure on net interest margins. Rising funding costs outstripped increases in asset yields for a majority of banks. Further, mortgage delinquencies, particularly on subprime mortgages, surged in the last quarter of 2006 as homeowners who had stretched themselves financially to buy a home or refinance a mortgage in the early 2000s fell behind on their loan payments. Loan losses at banks in Louisiana, Mississippi, and Texas soared as businesses and consumers hit by Hurricanes Katrina and Rita defaulted on loans. Despite these weaknesses, the industry’s core capital ratio increased to 10.36 percent, the highest level since new, risk-based capital ratios were implemented in 1993. Finally, no FDIC-insured banks failed during 2005 or 2006. Both the number and assets of “problem” banks were at historical lows.

The performance of the late 1990s and early and mid-2000s is quite an improve- ment from the recessionary and high interest rate conditions in which the indus- try operated in the late 1980s. As reported in Table 2–8 , the average ROA and return on equity (ROE) for commercial banks in 2006 were 1.37 percent and 13.36 percent, respectively, compared with 1989 when the ROA and ROE aver- aged 0.49 percent and 7.71 percent, respectively. Provision for loan losses (bank management’s expectations of losses on the current loan portfolio) to assets ratio and net charge-offs (actual losses on loans and leases) to loans ratio averaged 0.25 percent and 0.39 percent, respectively, in 2006, versus 0.94 percent and 1.16 percent, respectively, in 1989. Net operating income (income before taxes and extraordinary items) grew at an annualized rate of 12.04 percent in 2006 versus a drop of 38.70 percent in 1989. Finally, note that in 2006 no U.S. commercial banks failed, versus 206 failures in 1989. In response to such massive losses and failures in the industry, several regulations were proposed and enacted to prevent such occurrences from happening again. (We discuss the major changes in regulation and their impact in Chapters 21 and 22.) As a result of these changes and the strong U.S. economy, in the last 15 years or so the commercial banking industry essentially has gone from the brink of failure to a period of unprecedented profit and stability.

Nevertheless, as mentioned in Chapter 1, the early 2000s saw a weakening in public trust and confidence in the ethics followed by financial institutions. A num- ber of commercial banks continue to deal with ethics-related issues. For exam- ple, in March 2004 Bank of America and FleetBoston Financial agreed to pay a

provision for loan losses Bank management’s recognition of expected bad loans for the period.

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 charge-offs Actual losses on loans and leases.

net operating income Income before taxes and extraordinary items.

net operating income Income before taxes and extraordinary items.

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46

combined $675 million to settle civil fraud charges relating to improper mutual fund trading. In July 2003 J. P. Morgan Chase and Citigroup settled with the New York District Attorney over allegations that the banks wrongly helped Enron hide its debt prior to the energy company’s filing for Chapter 11 bankruptcy in December 2001. Related to the issue of ethics are conflicts of interest. A 2003 sur- vey by the Association for Financial Professionals found that management at 56 percent of companies with more than $1 billion in revenues believed that a com- mercial bank had refused to lend funds or changed the terms on which it was willing to lend because the company did not agree to do other business with the bank. In April 2004 Riggs National Bank, which provides banking services to most of Washington’s foreign embassies and to American consulates worldwide, was swept up in controversy over allegations that some of its deposit accounts involved terrorist financing and money laundering. The investigation began as federal officials tried to track funds used by the September 11 hijackers. As the investigation wore on, banking regulators became increasingly alarmed by Riggs’s practices. In July 2003 and again in July 2004, regulators publicly rebuked Riggs for failing to comply with anti–money laundering standards. One congressional report stated that Riggs “turned a blind eye” to evidence of massive corruption involving U.S. oil companies and an African autocrat. As described in the Ethical Dilemmas box, anti–money laundering standards continue to be an issue, even at the country’s biggest banks.

Also certain to affect the future performance of commercial banks (as well as savings institutions and credit unions) is the extent to which banks adopt the newest technology (see Chapter 16), including the extent to which industry par- ticipants embrace the Internet and online banking. Early entrants into Internet

NASD FINES BANK OF AMERICA UNIT $3 MILLION

The National Association of Securities Dealers fined a Bank of America Corp. unit $3 million for allegedly failing to comply with money-laundering rules on accounts held by billionaire brothers Sam and Charles Wyly. The fine, which the NASD said was the largest it has levied against a financial institution for money-laundering violations, comes four months after Bank of America paid $7.5 million to settle a New York City investigation into money laundering.

The NASD said Banc of America Investment Services Inc. failed to obtain customer information on 34 “high risk” accounts and didn’t adequately communicate with its parent company to ensure its suspicious-activity-reporting obligations were met. The failures came despite warnings from the bank’s clearing firm, a senior lawyer for the Charlotte, N.C., bank and its risk committee. The accounts, opened in August 2003, held as much as $93 million and were controlled by entities in the Isle of Man. . . . In August, the Senate’s Permanent Subcommittee on Investigations issued a staff report outlining how wealthy U.S. citizens use offshore jurisdictions to evade between $40 billion and $70 billion in taxes each year. A case study of the Wyly brothers’ offshore accounts and relationship with Bank of America made up more than half the report.

Source: Jamie Levy Pessin and David Enrich, The Wall Street Journal, January 31, 2007, p. C4. Reprinted by permission of The Wall Street Journal. © 2007 Dow Jones & Company, Inc. All rights reserved world- wide. www.wsj.com

Ethical Dilemmas

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Chapter 2 The Financial Services Industry: Depository Institutions 47

banking have been banks that have introduced new technology in markets with demographic and economic characteristics that help ensure customer acceptance, such as urban banks with a strong retail orientation that have tailored their Internet offerings to their retail customers. These early entrants have generally developed their Internet-related products to gain access to noncore, less traditional sources of funds. Appendix 2C (located at the book’s Web site, www.mhhe.com/saunders6e ) provides a short summary of technology-based wholesale and retail services pro- vided by banks and other FIs. The performance of banks that have invested in Internet banking as a complement to their existing services has been similar to the performance of those without Internet banking, despite relatively high initial tech- nology-related expenses. In particular, the banks with Internet banking services generally have higher noninterest income (which offsets any increased technology expenses). Further, the risk of banks offering Internet-related banking products appears to be similar to the risk of those banks without Internet banking.

In addition to the development of Internet banking as a complement to the tra- ditional services offered by commercial banks, a new segment of the industry has arisen that consists of Internet-only banks. That is, these banks have no “brick and mortar” facilities, or are banks without “walls.” In these banks, all business is con- ducted over the Internet. However, Internet-only banks have yet to capture more than a small fraction of the banking market.

What are the major assets held by commercial banks? What are the major sources of funding for commercial banks? Describe the responsibilities of the three federal regulatory agencies in the United States. What are the major regulations that have affected the operations of U.S. commercial banks? What has the trend in ROA and ROE been in the commercial banking industry over the last decade?

SAVINGS INSTITUTIONS

Savings institutions were first created in the early 1800s in response to commercial banks’ concentration on serving the needs of business (commercial) enterprises rather than the needs of individuals requiring borrowed funds to purchase homes. Thus, the first savings institutions pooled individual savings and invested them mainly in mortgages and other securities. Today’s savings institutions, however, generally perform services similar to those of commercial banks.

Savings institutions comprise two different groups of FIs: savings associations (SAs) and savings banks (SBs). They usually are grouped together because they not only provide important mortgage and/or lending services to households but also are important recipients of household savings. Historically, savings associa- tions have concentrated more on residential mortgages, while savings banks have been operated as relatively diversified savings institutions that have a large con- centration of residential mortgage assets but hold commercial loans, corporate bonds, and corporate stock as well. In this section, we review these two groups.

1. 2. 3.

4.

5.

Concept Questions Concept Questions

savings institutions Depository institu- tions that specialize in residential mortgages mostly backed by short-term deposits and other funds.

savings institutions Depository institu- tions that specialize in residential mortgages mostly backed by short-term deposits and other funds.

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48 Part One Introduction

Size, Structure, and Composition of the Industry Savings associations were historically referred to as savings and loans (S&Ls) associations. However, in the 1980s, federally chartered savings banks appeared in the United States. The term savings association has replaced “S&L association” to capture the resulting change in the structure of the industry. 17 These institutions have the same regulators as traditional savings and loans.

The savings association industry prospered throughout most of the 20th cen- tury. These specialized institutions made long-term residential mortgages backed by short-term savings deposits. At the end of the 1970s, slightly fewer than 4,000 savings associations had assets of approximately $0.6 trillion. Over the period October 1979 to October 1982, however, the Federal Reserve’s restrictive monetary policy action led to a sudden and dramatic surge in interest rates, with rates on T-bills rising as high as 16 percent. This increase in short-term rates and the cost of funds had two effects. First, savings associations faced negative interest spreads or net interest margins (i.e., interest income minus interest expense divided by earning assets) in funding much of their fixed-rate long-term residential mortgage portfolios over this period. Second, they had to pay more competitive interest rates on savings deposits to prevent disintermediation and the reinvestment of those funds in money market mutual fund accounts. Their ability to do this was constrained by the Federal Reserve’s Regulation Q ceilings, which limited the rates savings associations could pay on traditional passbook savings account and retail time deposits. 18

In part to overcome the effects of rising rates and disintermediation on the sav- ings association industry, Congress passed two acts, the DIDMCA and the DIA (see Table 2–7 ); these acts expanded the deposit-taking and asset-investment pow- ers of savings associations. For many savings associations, the new powers created safer and more diversified institutions. For a small but significant group whose earnings and shareholders’ capital were being eroded in traditional lines of busi- ness, this created an opportunity to take more risks in an attempt to return to prof- itability. However, in the mid-1980s, real estate and land prices in Texas and the Southwest collapsed. This was followed by economic downturns in the Northeast and in western states of the United States. Many borrowers with mortgage loans issued by savings associations in these areas defaulted. In other words, the credit or lending risks incurred by savings associations in these areas often failed to pay off. This risk-taking, or moral hazard, behavior was accentuated by the policies of the savings association insurer, the FSLIC. Due to a lack of funds, the FSLIC could not close many of the capital-depleted, economically insolvent savings associa- tions (a policy of regulator forbearance ) and maintained deposit insurance pre- mium assessments independent of the risk of the savings institution (see Chapter 19). 19 As a result, there was an increasing number of failures in the 1982–89 period aligned with rapid asset growth of the industry. Thus, while savings associations decreased in number from 4,000 in 1980 to 2,600 in 1989, or by 35 percent, their assets actually doubled from $600 billion to $1.2 trillion over that period.

17 In 1978, the Federal Home Loan Bank Board (FHLBB), at the time the main regulator of savings associa- tions, began chartering federal savings banks insured by the Federal Savings and Loan Insurance Corpora- tion (FSLIC). In 1982, the FHLBB allowed S&Ls to convert to federal savings banks with bank (rather than S&L) names. As more and more S&Ls converted to savings banks, the title associated with this sector of the thrift industry was revised to reflect this change.

18 These Regulation Q ceilings were usually set at rates of 5¼ or 5½ percent.

19 We discuss moral hazard behavior and the empirical evidence regarding such behavior in more detail in Chapter 19.

net interest margin Interest income minus interest expense divided by earning assets.

net interest margin Interest income minus interest expense divided by earning assets.

disintermediation Withdrawal of deposits from savings associations and other depository institu- tions and their rein- vestment elsewhere.

disintermediation Withdrawal of deposits from savings associations and other depository institu- tions and their rein- vestment elsewhere.

Regulation Q ceiling An interest ceiling imposed on small savings and time deposits at banks and thrifts until 1986.

Regulation Q ceiling An interest ceiling imposed on small savings and time deposits at banks and thrifts until 1986.

regulator forbearance A policy of not closing economically insolvent FIs, but allowing them to continue in operation.

regulator forbearance A policy of not closing economically insolvent FIs, but allowing them to continue in operation.

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Chapter 2 The Financial Services Industry: Depository Institutions 49

Traditionally, savings banks were established as mutual organizations (in which the depositors are also legally the owners of the bank) in states that permit- ted such organizations. These states are largely confined to the East Coast—for example, New York, New Jersey, and the New England states. As a result, savings banks (unlike savings associations) were not as affected by the oil-based economic shocks that impacted Texas and the Southwest in the 1980s. Nevertheless, the crash in New England real estate values in 1990–91 presented equally troubling prob- lems for this group. Indeed, many of the failures of savings institutions in the early 1990s were savings banks rather than savings associations. In addition, in recent years, many of these institutions—similar to savings associations—have switched from mutual to stock charters. Further, some (fewer than 20) have switched to fed- eral charters. As a result, savings banks have decreased in both size and number.

Figure 2–6 shows the number of failures, mergers, and new charters of savings institutions from 1984 through 2006. Notice the large number of failures from 1987 through 1992 and the decline in the number of new charters. The large number of savings institution failures, especially in 1988 and 1989, depleted the resources of the FSLIC to such an extent that by 1989 it was massively insolvent (see Chapter 19). The resulting legislation—the FIRREA of 1989—abolished the FSLIC and cre- ated a new insurance fund (SAIF) under the management of the FDIC. In addition, the act created the Resolution Trust Corporation (RTC) to close the most insolvent savings associations. 20

Further, the FIRREA strengthened the capital requirements of savings institu- tions and constrained their non-mortgage-related asset-holding powers under a

20 At the time of its dissolution in 1995, the RTC had resolved or closed more than 700 savings institutions.

mutual organizations Savings banks in which the deposi- tors are also the legal owners of the bank.

mutual organizations Savings banks in which the deposi- tors are also the legal owners of the bank.

FIGURE 2–6 Structural Changes in the Number of Savings Institutions, 1984–2006

Source: Federal Deposit Insurance Corporation, Quarterly Banking Profile, various years. www.fdic.gov

300

250

200

150

100

50

0

Number

Failures

20001984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Mergers New charters

2001 2002 2003 2004 2005 2006

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50 Part One Introduction

newly imposed qualified thrift lender, or QTL, test. In 1991, Congress enacted the FDICIA. FDICIA introduced risk-based deposit insurance premiums (starting in 1993) in an attempt to limit excess risk taking by savings associations and banks. It also introduced a prompt corrective action (PCA) policy, such that regulators could close thrifts and banks faster (see Chapter 20). In particular, if a savings institution’s ratio of its equity capital to its assets falls below 2 percent, it has to be closed down or recapitalized within three months.

As a result of the closing of weak savings institutions and the strengthening of capital requirements, the industry shrunk significantly, both in numbers and in asset size, in the 1990s. Savings institutions decreased in number from 3,677 in 1989 to 2,262 in 1993 (by 38 percent), and assets shrank from $1.427 trillion to $1.001 trillion (by 30 percent) over that same period.

Balance Sheet and Recent Trends Even in its new streamlined state, concerns have been raised about the future viability of the savings institution industry in traditional mortgage lending areas. This is partly due to intense competition for mortgages from other financial insti- tutions, such as commercial banks and specialized mortgage bankers. It is also due to the securitization of mortgages into mortgage-backed security pools by govern- ment-sponsored enterprises, which we discuss further in Chapter 27. 21 In addi- tion, long-term mortgage lending exposes an FI to significant credit, interest rate, and liquidity risks.

Table 2–9 shows the balance sheet of savings institutions in 2006. On this bal- ance sheet, mortgages and mortgage-backed securities (securitized pools of mort- gages) account for 76.54 percent of total assets. This compares with 32.84 percent in commercial banks. As noted earlier, the FDICIA uses the qualified thrift lender (QTL) test to establish a minimum holding of 65 percent in mortgage-related assets for savings institutions. Reflecting the enhanced lending powers established under the 1980 DIDMCA and the 1982 DIA, commercial loans and consumer loans amounted to 3.57 and 5.43 percent of assets, respectively. Finally, savings institu- tions are required to hold cash and investment securities for liquidity risk pur- poses and to meet regulator-imposed reserve requirements. In December 2006, cash and U.S. Treasury securities holdings amounted to 3.77 percent of total assets, compared with 14.99 percent at commercial banks.

On the liability side of the balance sheet, small time and savings deposits are still the predominant source of funds, with total deposits accounting for 57.83 per- cent of total liabilities and net worth. The second most important source of funds consists of borrowings from the Federal Home Loan Banks (FHLBs), of which there are 12; these banks in turn are owned by the savings institutions themselves. Because of their size and government-sponsored status, FHLBs have access to wholesale money markets and the capital market for notes and bonds and can relend the funds borrowed on these markets to savings associations at a small markup over wholesale cost. Other borrowed funds include repurchase agree- ments and direct federal fund borrowings. Finally, net worth, the book value of the equity holders’ capital contribution, amounted to 10.91 percent of total assets in 2006. This compares with 10.36 percent at commercial banks.

21 The major enterprises are GNMA, FNMA, and FHLMC.

QTL test Qualified thrift lender test that sets a floor on the mortgage related assets held by thrifts (currently 65 percent).

QTL test Qualified thrift lender test that sets a floor on the mortgage related assets held by thrifts (currently 65 percent).

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Chapter 2 The Financial Services Industry: Depository Institutions 51

Regulation The main regulators of savings institutions are the Office of Thrift Supervision (OTS) and the FDIC.

The Office of Thrift Supervision Established in 1989 under the FIRREA, this office charters and examines all federal savings institutions. Further, when savings institutions are held by parent holding companies, it supervises the holding companies as well.

The FDIC-DIF Fund Also established in 1989 under the FIRREA and in the wake of the FSLIC insol- vency, the FDIC oversaw and managed the Savings Association Insurance Fund (SAIF). In 1996, as part of a plan to recapitalize the SAIF, commercial banks were required to pay for part of the burden. In return, Congress promised to eventually merge bank and thrift charters (and hence insurance funds) into one. In January 2007, the FDIC merged the SAIF and the Bank Insurance Fund (BIF) to form the Deposit Insurance Fund (DIF). Thus, thrifts now operate under the same regula- tory structure that applies to commercial banks.

Other Regulators State-chartered savings institutions (the vast majority) are regulated by state agen- cies. Savings institutions that adopt federal charters are subject to the regulations of the OTS.

www.ots.treas.gov www.ots.treas.gov

www.fdic.gov www.fdic.gov

Millions of Dollars Percent

Cash and due from $ 37,078 1.86% U.S. Treasury securities 38,096 1.91 Mortgage loans 1,250,182 62.75 MBS (includes CMOs, POs, IOs) 274,698 13.79 Bonds, notes, debentures, and other securities 87,147 4.37 Commercial loans 71,102 3.57 Consumer loans 108,178 5.43 Other loans and financing leases 4,536 0.23 Less: Allowance for loan losses and unearned income (8,784) (0.44) Other assets 130,018 6.53

Total assets $1,992,251 100.00% Total deposits $1,152,055 57.83% Borrowings and mortgages warehousing 466,284 23.40% Federal funds and repurchase agreements 99,391 4.99 Other liabilities 57,158 2.87

Total liabilities 1,774,888 89.09 Net worth 217,363 10.91

Total liabilities and net worth $1,992,251 100.00% Number of institutions 1,293

TABLE 2–9 Assets and Liabilities of Savings Institutions, December 31, 2006

Source: FDIC, February 2007. www.fdic.gov

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52 Part One Introduction

Industry Performance Like commercial banks, savings institutions experienced record profits in the mid- to late-1990s as interest rates (and thus the cost of funds to savings institutions) remained low and the U.S. economy expanded. The result was an increase in the spread between interest income and interest expense for savings institutions and consequently an increase in their net income. In 1999, savings institutions reported $10.7 billion in net income and an annualized ROA of 1.00 percent (this compares with an ROA of 1.31 percent over the same period for commercial banks). Only the $10.8 billion of net income reported in 1998 exceeded these results. Asset quality improvements were widespread during 1999, providing the most favorable net operating income that the industry had ever reported. However, as in the com- mercial banking industry, the downturn in the U.S. economy also resulted in a decline in savings institutions’ profitability in 2000. Specifically, their ROA and ROE ratios fell slightly in 2000 to 0.92 percent and 11.14 percent, respectively, from their 1999 levels. Again, as with commercial banks, despite an economic reces- sion, this downturn was short-lived. Both ROA and ROE increased to record levels each year from 2001 through 2003. The industry’s net interest margins rose: the cost of funding earning assets declined by 2.70 percent while the yield on earning assets declined by only 2.35 percent. However, net charge-offs in 2003 were almost twice those in 2000. A flat yield curve and increased funding costs contributed to decreased margins in the mid-2000s. The average ROA declined to 1.15 percent in 2005 and 1.10 percent in 2006, while ROE decreased to 10.40 percent in 2005 and 9.99 percent in 2006. Table 2–10 presents several performance ratios for the indus- try for various years from 1989 through 2006.

Also like commercial banks, savings institutions experienced substantial con- solidation in the 1990s. For example, the 1998 acquisition of H. F. Ahmanson & Co. by Washington Mutual Inc. for almost $10 billion was the fourth-largest bank–thrift merger completed in 1998. 22 Washington Mutual was the third-largest savings institutions in the United States early in 1997, while Ahmanson was the largest savings institution. In 1997, Washington Mutual bought Great Western, to become the largest thrift in the country. Then, in March 1998, Washington Mutual bought Ahmanson to combine the two largest U.S. thrifts. Table 2–11 shows the industry consolidation in number and asset size over the period 1992–2006. Notice

22 Behind Travelers Group–Citigroup ($74 billion), NationsBank–BankAmerica ($67 billion), and BankOne– First Chicago NBD ($30 billion).

2006 2005 2003 2001 2000 1999 1997 1995 1993 1989

Number of institutions 1,293 1,307 1,413 1,535 1,589 1,642 1,780 2,030 2,262 3,677 Return on assets (%) 1.10 1.15 1.28 1.07 0.92 1.00 0.93 0.77 0.71 −0.39 Return on equity (%) 9.99 10.40 13.66 12.33 11.14 11.73 10.84 9.40 9.32 −8.06 Noncurrent assets plus

other real estate owned to assets (%) 0.58 0.57 0.62 0.65 0.56 0.58 0.95 1.20 2.10 2.78

Asset growth rate (%) 10.88 8.64 8.49 8.17 6.41 5.60 −0.21 1.70 −2.85 −11.14 Net operating income

growth (%) 9.79 8.03 23.07 6.64 3.55 16.70 20.07 13.81 21.16 −58.95 Number of failed institutions 0 0 0 1 1 1 0 2 8 331

TABLE 2–10 Selected Indicators for U.S. Savings Institutions, 1989 through 2006

Source: FDIC, Quarterly Banking Profile, various issues, and Historical Statistics, 1989. www.fdic.gov

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Chapter 2 The Financial Services Industry: Depository Institutions 53

that over this period, the biggest savings institutions (over $10 billion in assets) grew in number from 8 to 33 and their control of industry assets grew from 17.8 percent to 69.6 percent.

Are savings institutions likely to be more or less exposed to interest rate risk than are banks? Explain your answer. How do adjustable-rate mortgages help savings institutions? Why should savings institutions with little or no equity capital seek to take more risk than well-capitalized savings institutions? Why could it be argued that the QTL test makes savings institutions more rather than less risky? Describe the recent performance of savings institutions. Describe the ways that profit trends for savings institutions have been similar to those of commercial banks in the 1990s and early 2000s.

CREDIT UNIONS

Credit unions (CUs) are nonprofit depository institutions mutually organized and owned by their members (depositors). Credit unions (CUs) were first established in the United States in the early 1900s as self-help organizations intended to allevi- ate widespread poverty. The first credit unions were organized in the Northeast, initially in Massachusetts. Members paid an entrance fee and invested funds to purchase at least one deposit share in the CU. Members were expected to deposit their savings in the CU, and these funds were lent only to other members.

This limit in the customer base of CUs continues today as, unlike commercial banks and savings institutions, CUs are prohibited from serving the general pub- lic. Rather, in organizing a credit union, members are required to have a com- mon bond of occupation (e.g., police CUs) or association (e.g., university-affiliated CUs), or to cover a well-defined neighborhood, community, or rural district. CUs may, however, have multiple groups with more than one type of membership.

The primary objective of credit unions is to satisfy the depository and lending needs of their members. CU member deposits (shares) are used to provide loans

1.

2. 3.

4.

5. 6.

Concept Questions Concept Questions

credit unions Nonprofit depository institutions, owned by members with a common bond, specializing in small consumer loans.

credit unions Nonprofit depository institutions, owned by members with a common bond, specializing in small consumer loans.

2006 1992

Number Percent of Total Assets*

Percent of Total Number

Percent of Total Assets*

Percent of Total

All FDIC-insured savings institutions 1,293 $1,992.3 2,391 $1,035.2

1. Under $100 million 399 30.9% 20.3 1.0% 1,109 46.4% 55,946 5.4% 2. $100 million—$1 billion 738 57.1 251.6 12.6 1,093 45.7 315,246 30.5 3. $1 billion–$10 billion 123 9.5 333.4 16.8 181 7.6 479,526 46.3 4. $10 billion or more 33 2.5 1,387.0 69.6 8 0.3 184,476 17.8

*In billions of dollars.

TABLE 2–11 U.S. Savings Institution Asset Concentration, 1992 versus 2006

Source: FDIC Quarterly Banking Profile, Fourth Quarter 1992 and Fourth Quarter 2003. www.fdic.gov

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54 Part One Introduction

to other members in need of funds. Any earnings from these loans are used to pay higher rates on member deposits, charge lower rates on member loans, or attract new members to the CU. Because credit unions do not issue common stock, the members are legally the owners of a CU. Also, because credit unions are nonprofit organizations, their net income is not taxed and they are not subject to the local investment requirements established under the 1977 Community Reinvestment Act. This tax-exempt status allows CUs to offer higher rates on deposits, and charge lower rates on some types of loans, than do banks and savings institutions. This is shown in Figure 2–7 for the period 1991–2006.

Size, Structure, and Composition of the Industry Credit unions are the most numerous of the institutions that make up the deposi- tory institutions segment of the FI industry, totaling 8,629 in 2006. Moreover, they were less affected by the crisis that impacted commercial banks and sav- ings institutions in the 1980s 23 because traditionally, more than 40 percent of their assets have been in the form of small consumer loans, often for amounts less than $10,000. In addition, CUs tend to hold large amounts of government securities (16.1 percent of their assets in 2006) and relatively small amounts of residential mortgages. Their lending activities are funded by savings deposits contributed by over 87 million members who share some common thread or bond of association, usually geographic or occupational in nature.

To attract and keep customers, CUs have had to expand their services to com- pete with those of commercial banks and savings institutions. For example, CUs now offer products and services ranging from mortgages and auto loans (their

23 Credit unions have been covered by federal deposit insurance guarantees since 1971 (under the National Credit Union Share Insurance Fund). The depositor coverage cap of $100,000 is the same as that which currently exists for both commercial banks and savings institutions.

FIGURE 2–7 Credit Union versus Bank Interest Rates

Source: Federal Reserve; and National Credit Union Administration, February 2007. www.federalreserve.gov, www.ncua.gov

12%

10

1-Year CDs

New Car Loans

8

6

4

2

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Banks

Banks

Credit unions

Credit unions

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Chapter 2 The Financial Services Industry: Depository Institutions 55

traditional services) to credit lines and automated teller machines. Some credit unions now offer business and commercial loans to their employer groups. For example, in the mid-2000s, C-Plant Federal Credit Union’s (of Paducah, Kentucky 24) business loans represented 9.2 percent of its lending and the CU participated actively in the Small Business Administration loan programs, which enabled it to sell a portion of those loans. Because of their tax-exempt status, CUs can charge lower rates on these loans, providing CUs with a cost advantage over banks and savings institutions that is very attractive to customers.

As CUs have expanded in number, size, and services, bankers have claimed that CUs are unfairly competing with small banks that have historically been the major lenders in small towns. For example, the American Bankers Association has stated that the tax exemption for CUs gives them the equivalent of a $1 billion per year subsidy. The Credit Union National Association’s (CUNA) response is that any cost to taxpayers from CUs’ tax-exempt status is more than made up in ben- efits to members and therefore the social good they create. CUNA estimates that the benefits of CU membership can range from $200 to $500 a year per member or, with over 87 million members, a total benefit of $14 billion to $35 billion per year.

In 1997 the banking industry filed two lawsuits in its push to narrow the widen- ing membership rules governing credit unions that followed a 1982 legal interpre- tation of the original 1934 Federal Credit Union Act’s definition of what constitutes a “group having a common bond of occupation or association.” The first lawsuit (filed by four North Carolina banks and the American Bankers Association) chal- lenged the ability of an occupation-based credit union (the AT&T Family Credit Union based in North Carolina) to accept members from companies unrelated to the firm that originally sponsored the CU. In the second lawsuit, the American Bankers Association asked the courts to bar the federal government from letting occupation-based credit unions convert to community-based charters. Bankers argued in both lawsuits that such actions, broadening the membership of credit unions under other than occupation-based guidelines, would further exploit an unfair advantage allowed by the credit unions’ tax-exempt status. In February 1998 the Supreme Court sided with banks, stating that credit unions could no longer accept members who did not share the common bond of membership. In April 1998, however, the U.S. House of Representatives overwhelmingly passed a bill that allowed all existing members to keep their credit union accounts. The bill was passed by the Senate in July 1998 and signed into law by the president in August 1998. This legislation allowed CUs not only to keep their existing mem- bers but also to accept new groups of members—including small businesses and low income communities—that were not considered part of the “common bond” of membership by the Supreme Court ruling.

Balance Sheet and Recent Trends Table 2–12 shows the assets and liabilities for credit unions in December 31, 2006. In that year 8,629 credit unions had assets of $710.8 billion. This compares with $155 billion in assets in 1987, for a growth rate of over 350 percent over the period 1987–2006. Individually, credit unions tend to be very small, with an average size of $82.4 million in 2006 compared with $1,310.8 million for banks. The total assets

24 C-Plant Federal Credit Union has a community charter, which allows membership to anyone living in or going to school in the western Kentucky counties of Ballard, Graves, Livingston, or McCracken.

www.aba.com www.aba.com

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56 Part One Introduction

of all credit unions are less than half the size of those of the largest U.S. banking organization, Citigroup. 25

Given their emphasis on retail or consumer lending, discussed above, 33.0 percent of CU assets are in the form of small consumer loans and another 38.4 percent are in the form of home mortgages. Together, these member loans constitute 71.4 percent of total assets. Because of the common bond requirement on credit union customers, relatively few business or commercial loans are issued by CUs.

Credit unions also invest heavily in investment securities (19.8 percent of total assets in 2006). Further, 81.2 percent of the investment portfolios of CUs are in U.S. government Treasury securities or federal agency securities, while investments in other FIs (such as deposits of banks) totaled 12.9 percent of CUs’ investment portfolios. Their investment portfolio composition, along with their cash holdings (5.7 percent of total assets), allow credit unions ample liquidity to meet their daily cash needs—such as share (deposit) withdrawals. Some CUs have also increased their off-balance-sheet activities. Specifically, unused loan commitments, includ- ing credit card limits and home equity lines of credit, totaled over $109 billion in 2006.

Credit union funding comes mainly from member deposits (86.6 percent of total funding in 2006). Figure 2–8 presents the distribution of these deposits in

25 Whereas in the United States credit unions account for a relatively small proportion of the financial services industry, in many less developed countries they play an important role in mobilizing savings at the rural level. One very important credit union–type FI, first developed in Bangladesh and extended to other LDCs, has been the Grameen Bank.

Billions of Dollars Percent

Assets

Checkable deposits and currency $ 40.3 5.7% Time and savings deposits 18.2 2.6 Federal funds and security RPs 6.1 0.8 Open market paper 2.3 0.3 U.S. government securities 114.6 16.1 Treasury 8.6 1.2 Agency 106.0 14.9 Home mortgages 272.9 38.4 Consumer credit 234.6 33.0 Credit market instruments 689.0 96.9 Mutual fund shares 2.0 0.3 Miscellaneous assets 19.8 2.8 Total assets $710.8 100.0%

Liabilities and Equity

Checkable $ 74.7 10.5% Small time and savings 476.7 67.1 Large time 64.0 9.0 Shares and deposits 615.4 86.6 Other loans and advances 16.8 2.4 Miscellaneous liabilities 13.0 1.8 Total liabilities 645.2 90.8 Total ownership shares 65.6 9.2

TABLE 2–12 Assets and Liabilities of Credit Unions, December 31, 2006

Source: Federal Reserve Bulletin, March 2007. www.federalreserve.gov

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Chapter 2 The Financial Services Industry: Depository Institutions 57

2006. Regular share draft transaction accounts (similar to NOW accounts at other depository institutions) accounted for 36.8 percent of all CU deposits, followed by certificates of deposit (22.8 percent of deposits) and share accounts—similar to passbook savings accounts at other depository institutions, but so named to designate the deposit holders’ ownership status—(12.5 percent of deposits). Credit unions tend to hold higher levels of equity than other depository institutions. Since CUs are not stockholder owned, this equity is basically the accumulation of past profits from CU activities that are “owned” collectively by member deposi- tors. As will be discussed in Chapters 7 and 20, this equity protects a CU against losses on its loan portfolio as well as against other financial and operating risks. In December 2006, CUs’ capital-to-assets ratio was 9.23 percent compared with 10.91 percent for savings institutions and 10.36 percent for commercial banks.

Regulation Like savings banks and savings institutions, credit unions can be federally or state chartered. As of 2006, 66.4 percent of the 8,629 CUs were federally chartered and subject to National Credit Union Administration (NCUA) regulation, accounting for 56.5 percent of the total credit union membership and 55.2 percent of total assets. In addition, through its insurance fund (the National Credit Union Share Insurance Fund, or NCUSIF), the NCUA provides deposit insurance guarantees of up to $100,000 for insured credit unions. Currently, the NCUSIF covers 98 percent of all credit union deposits.

Industry Performance Like other depository institutions, the credit union industry has grown in asset size in the 1990s and early 2000s. Asset growth from 1999 to 2006 was more than 10 percent annually. In addition, CU membership increased from 75.4 million to over 87.5 million over the 1999–2006 period. Asset growth was especially pro- nounced among the largest CUs (with assets of over $500 million) as their assets increased by over 20 percent annually from 1999 through 2006. Figure 2–9 shows the trend in ROA for CUs from 1993 through 2006. The decrease in ROA over the period is mostly attributed to earnings decreases at the smaller CUs. For example, the largest credit unions experienced an ROA of 0.86 percent in 2006, while for the smallest CUs (with assets of less than $5 million) the ROA was 0.43. ROA for the whole industry was 0.82 percent. Smaller CUs generally have a smaller customer base with which to issue quality loans and have higher overhead expenses per dollar of assets. Thus, their ROAs have been hurt.

www.ncua.gov www.ncua.gov

www.cuna.org www.cuna.org

FIGURE 2–8 Composition of Credit Union Deposits, 2006

Source: National Credit Union Association, Year-End Statistics, 2006. www.ncua.gov

Share drafts 12.5%

IRAs and Koegh accounts 8.8%Money market

shares 19.1%

Regular shares 36.8%

CDs 22.8%

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58 Part One Introduction

Given the mutual-ownership status of this industry, however, growth in ROA (or profits) is not necessarily the primary goal of CUs. Rather, as long as capital or equity levels are sufficient to protect a CU against unexpected losses on its credit portfolio as well as other financial and operational risks, this not-for-profit indus- try has a primary goal of serving the deposit and lending needs of its members. This contrasts with the emphasis placed on profitability by stockholder-owned commercial banks and savings institutions.

How do credit unions differ from commercial banks and savings institutions? Why did credit unions prosper in the 1980s compared with savings institutions? What is the major asset held by credit unions? Why do commercial banks and savings institutions claim that credit unions have an unfair advantage in providing bank services?

GLOBAL ISSUES: EUROPE, JAPAN, AND CHINA

Banks in most regions of the world posted strong performance in the early and mid-2000s. However, net interest margins narrowed, reflecting competitive pres- sures and flattening yield curves. The growth of interest revenue was driven by rapid loan extension compensating for narrower margins. The return on assets changed little, largely as a result of falling operating costs and minimal provi- sions for loan losses. Retail business also contributed to banks’ strong financial performance. In many countries, mortgages dominated loan growth. In France and Spain, the rapid pace of mortgage lending boosted revenue. In addition, asset management and the sale of pension and insurance products contributed to non- interest income. Finally, the continued expansion of the retail business showed few signs of abating and was expected to advance further in countries where per- sonal indebtedness remained relatively low, such as Italy.

1. 2. 3. 4.

Concept Questions Concept Questions

£ $ ¥

:

£ $ ¥

:

FIGURE 2–9 Return on Assets for Credit Unions, 1993 through 2006

Source: National Credit Union Association, Year-End Statistics, 2003. www.ncua.gov

1.4

1.2

1.0

0.8

ROA (%)

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

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Chapter 2 The Financial Services Industry: Depository Institutions 59

Credit growth increased at various speeds in different countries, conveying a mixed overall picture. The euro area’s robust credit growth rate of 11 percent in 2005 included substantial differences among countries. For example, lending in Germany remained almost flat. Diversification across locations and business lines helped banks overcome various challenges including natural disasters, litigation, and the flattening of the yield curve. The number of personal bankruptcies rose worldwide, and with it the arrears and provisions banks recorded for personal loans, including credit cards. But U.K. banks’ profitability, cost efficiency, and diversification allowed them to cope with any deterioration. 26

However, not all countries fared as well. In April 2001, the Japanese govern- ment announced plans for a government-backed purchase of ¥11,000 billion ($90 billion) of shares of Japanese banks as part of an increasingly frantic drive to avert a banking crisis, recover from a 16-year low in the levels of Japanese stock mar- kets, and stem the country’s economic decline. This was the third major attempt to bail out the banking system since 1998. Previous attempts had been unsuccessful. For example, in March 2001, Fitch Investors Service (a major international rating agency) put 19 of the biggest Japanese banks on its credit watch list. The purchase of bank shares was intended to offset losses from writing off bad loans (estimated to be as high as ¥32,000 billion ($260 billion) in bank portfolios. Foreign financial institutions were also solicited in attempts to prevent a complete financial col- lapse in Japan. For instance, in October 2003, Goldman Sachs set up an investment fund to buy as much as ¥1 trillion ($9.1 billion) in nonperforming loans from the Sumitomo Mitsui Banking Corporation. Earlier, in January 2003, Goldman agreed to buy ¥150.3 billion ($1.4 billion) of preferred shares from Sumitomo. Merrill Lynch and Deutsche Bank also bought troubled assets from Japanese banks. These efforts, along with a strengthening Japanese economy, appear to have averted a disaster. By the end of 2003, Japanese banks posted their largest earnings in years. Specifically, as of September 2003, Japan’s eight biggest banking groups all reported positive six-month net profits.

However, the Bank of Japan ended its five-year policy of keeping short-term interest rates near zero only in July 2006 when it raised its rate target to 0.25 per- cent and then to 0.50 percent in February 2007. But the low target rate, combined with rising competition, forced Japanese banks to hold down consumer borrow- ing rates. As a result, Japanese banks reported declines in performance at their core businesses. Mitsubishi UFJ Financial Group Inc., Japan’s largest bank by both market capitalization and assets, said its consolidated net business profit in the third quarter of 2006 dropped 3.8 percent from a year earlier, while Mizuho Financial Group, Japan’s second-largest bank, dropped 12 percent. These results show how difficult it is for Japanese banks to boost earnings even after cleaning up the bad loans that dragged them down for years. To increase profitability, Japanese banks tried to reduce their dependency on the traditional lending business, while expanding into more profitable areas such as wealth management, credit cards, and investment banking.

In China, however, the banking industry deteriorated in the early 2000s. China’s four state-run banks had about $120 billion in nonperforming loans, accounting for about 21 percent of total loans. Private economists put the percentage of nonper- forming loans closer to 50 percent of total loans. Looking to clean up its troubled

26 See Bank for International Settlements, “BIS 76th Annual Report,” June 2006. www.bis.org

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60 Part One Introduction

banking sector, the China Banking Regulatory Commission unveiled a compre- hensive plan to overhaul the country’s banking system, one that included a shift by China from restricting overseas competition to allowing it. The plan gives for- eign banks greater scope to operate. Measures include raising the ceiling on for- eign ownership in Chinese financial institutions from 15 percent to 20 percent for a single investor, expanding the number of cities where foreign branches can do some local currency business, and easing capital requirements for branches.

However, as of 2007, foreign banks had not yet been allowed to reach out to retail customers in China. For example, in 2007, Citigroup operated just 13 branches in six Chinese cities. Its growing network of ATMs, including a new one at the Great Wall, existed mainly to dispense cash to foreign visitors and to publicize its brand. Neither Citigroup nor any other non-Chinese bank could take deposits from individuals or make them loans in China’s currency, the yuan. Citigroup’s own employees, in fact, had to be paid through accounts at Chinese banks.

This chapter provided an overview of the major activities of commercial banks, savings institutions, and credit unions. It also described the agencies that regulate these depository institutions. The Federal Reserve System, the FDIC, the OTS, and the Office of the Comptroller of the Currency, in conjunction with state regulators, are the agencies that oversee the activities of these institutions. Each of these insti- tutions relies heavily on deposits to fund its activities, although borrowed funds are becoming increasingly important for the largest institutions. Historically, commercial banks have concentrated on commercial or business lending and on investing in securities, while savings institutions have concentrated on mortgage lending and credit unions have concentrated on consumer lending. These differ- ences are being eroded as a result of competitive forces, regulation, and changing financial and business technology. Specifically, in the late 1990s and early 2000s, the largest group of assets in commercial bank portfolios were mortgage related, and the largest banking organization, Citigroup, was created out of a merger with an insurance company (Travelers) that owned a major securities firm (Salomon Brothers).

What are the differences between community banks, regional banks, and money center banks? Contrast the business activities, location, and markets of each of these bank groups. Use the data in Table 2–4 for the banks in the two asset size groups (a) $100 million–$1 billion and (b) over $10 billion to answer the following questions.

Why have the ratios for ROA and ROE tended to increase for both groups over the 1990–2006 period? Identify and discuss the primary variables that affect ROA and ROE as they relate to these two size groups. Why is ROA for the smaller banks generally larger than ROA for the large banks? Why is the ratio for ROE consistently larger for the large bank group?

1.

2.

a.

b.

c.

SummarySummary

Questions and Problems Questions and Problems

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Chapter 2 The Financial Services Industry: Depository Institutions 61

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Using the information on ROE decomposition in Appendix 2A, calculate the ratio of equity to total assets for each of the two bank groups for the period 1990–2006. Why has there been such dramatic change in the values over this time period, and why is there a difference in the size of the ratio for the two groups?

What factors have caused the decrease in loan volume relative to other assets on the balance sheets of commercial banks? How has each of these factors been related to the change and development of the financial services industry during the 1990s and early 2000s? What strategic changes have banks imple- mented to deal with changes in the financial services environment? What are the major uses of funds for commercial banks in the United States? What are the primary risks to a bank caused by each use of funds? Which of the risks is most critical to the continuing operation of a bank? What are the major sources of funds for commercial banks in the United States? How is the landscape for these funds changing and why? What are the three major segments of deposit funding? How are these seg- ments changing over time? Why? What strategic impact do these changes have on the profitable operation of a bank? How does the liability maturity structure of a bank’s balance sheet compare with the maturity structure of the asset portfolio? What risks are created or intensified by these differences? The following balance sheet accounts (in millions of dollars) have been taken from the annual report for a U.S. bank. Arrange the accounts in balance sheet order and determine the value of total assets. Based on the balance sheet struc- ture, would you classify this bank as a community bank, regional bank, or money center bank?

What types of activities are normally classified as off-balance-sheet (OBS) activities?

How does an OBS activity move onto the balance sheet as an asset or liability? What are the benefits of OBS activities to a bank? What are the risks of OBS activities to a bank?

Use the data in Table 2–6 to answer the following questions. What was the average annual growth rate in OBS total commitments over the period 1992–2006?

d.

3.

4.

5.

6.

7.

8.

9.

a.

b. c.

10. a.

Premises $ 1,078 Net loans $29,981 Savings deposits 3,292 Short-term borrowing 2,080 Cash 2,660 Other liabilities 778 NOW accounts 12,816 Equity 3,272 Long-term debt 1,191 Investment securities 5,334 Other assets 1,633 Demand deposits 5,939 Intangible assets 758 Certificates of deposit

(under $100,000) 9,853 Other time deposits 2,333 Federal funds sold 110

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62 Part One Introduction

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What categories of contingencies have had the highest annual growth rates? What factors are credited for the significant growth in derivative securities activities by banks?

For each of the following banking organizations, identify which regulatory agencies (OCC, FRB, FDIC, or state banking commission) may have some reg- ulatory supervision responsibility:

State-chartered, nonmember non–holding company bank. State-chartered, nonmember holding company bank. State-chartered member bank. Nationally chartered non–holding company bank. Nationally chartered holding company bank.

What factors normally are given credit for the revitalization of the banking industry during the 1990s? How is Internet banking expected to provide benefits in the future? What factors are given credit for the strong performance of commercial banks in the early 2000s? What are the main features of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994? What major impact on commercial banking activity is expected from this legislation? What happened in 1979 to cause the failure of many savings institutions dur- ing the early 1980s? What was the effect of this change on the operating state- ments of savings institutions? How did two pieces of regulatory legislation—the DIDMCA in 1980 and the DIA in 1982—change the operating profitability of savings institutions in the early 1980s? What impact did these pieces of legislation ultimately have on the risk posture of the savings institutions industry? How did the FSLIC react to this change in operating performance and risk? How do the asset and liability structures of a savings institution compare with the asset and liability structures of a commercial bank? How do these struc- tural differences affect the risks and operating performance of a savings insti- tution? What is the QTL test?

How do savings banks differ from savings institutions? Differentiate in terms of risk, operating performance, balance sheet structure, and regulatory responsibility.

How did the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 reverse some of the key features of earlier legislation?

What is the “common bond” membership qualification under which credit unions have been formed and operated? How does this qualification affect the operational objective of a credit union?

What are the operating advantages of credit unions that have caused concern among commercial bankers? What has been the response of the Credit Union National Association to the banks’ criticism?

b.

c.

11.

a. b. c. d. e.

12.

13.

14.

15.

16.

17.

18.

19.

20.

21.

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Chapter 2 The Financial Services Industry: Depository Institutions 63

How does the asset structure of credit unions compare with the asset structure of commercial banks and savings institutions? Refer to Tables 2–5 , 2–9 , and 2–12 to formulate your answer. Compare and contrast the performance of the U.S. depository institution in- dustry with those of Japan and China.

Web Questions

Go to the FDIC Web site at www.fdic.gov and find the most recent break- down of U.S. bank asset concentrations using the following steps. Click on “Analysts.” From there click On “FDIC Quality Banking Profile” and then click on “Quarterly Banking Profile.” Click on “Commercial Bank Section.” Then click on “TABLE III-A. Full Year 20XX, FDIC-Insured Commercial Banks.” This will bring the files up on your computer that contain the relevant data. How have the number and dollar value of assets held by commercial banks changed since 2006? Go to the Federal Reserve Board’s Web site at www.federalreserve.gov and find the most recent balance sheet information for the credit union industry using the following steps. Click on “Economic Research and Data.” Click on “Statistics: Releases and Historical Data.” Click on “Flow of Funds Accounts of the United States.” Click on the most recent date. Click on “Level tables.” Using information in this file (in Table L.115), update Table 2–12 . How have the assets and liabilities of credit unions changed since December 2006? Go to the National Credit Union Association Web site at www.ncua.gov to collect the most recent information on number of credit unions, assets of credit unions, and membership in credit unions using the following steps. Under “Resources,” click on “Reports, Plans, and Statistics.” Click on “Credit Union Statistics.” Click on the most recent statistical data. This will download a file onto your computer that will contain the necessary data. How have these data changed since 2006?

S&P Questions

Go to the Standard & Poor’s Market Insight Web site at www.mhhe.com/edu- marketinsight. Identify the industry description and industry constituents for banks using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Industry.” From the Industry list, select “Regional Banks.” Click on “Go!” Click on “Industry Profile” and separately, “Industry Constituents.” Go to the Standard & Poor’s Market Insight Web site at www.mhhe.com/ edu- marketinsight. Look up the industry financial highlights for banks as posted by S&P using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Industry.” From

22.

23.

24.

25.

26.

27.

28.

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64 Part One Introduction

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the Industry list, select “Regional Banks.” Click on “Go!” Click on any or all of the items listed under “Industry Financial Highlights.” Go to the Standard & Poor’s Market Insight Web site at www.mhhe. com/ edumarketinsight. Find the most recent balance sheets for Bank of America (BAC) and Suntrust Banks (STI) using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Company.” Enter “BAC” in the “Ticker:” box and click on “Go!” Click on “Excel Analytics.” Click on “FS Ann. Balance Sheet.” This will download the balance sheet for Bank of America, which contains the balances for loans, total assets, and stockholders’ equity. Repeat the process by entering “STI” in the “Ticker:” box to get information on Suntrust Banks. Compare the ratios of loans to total assets and of stockholders’ equity to total assets from these balance sheets with that for the banking industry, as listed in Table 2–5 . Go to the Standard & Poor’s Market Insight Web site at www.mhhe.com/ edumarketinsight. Find the most recent balance sheets for Washington Mutual (WM) and Astoria Financial (AF) using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Company.” Enter “WM” in the “Ticker:” box and click on “Go!” Click on “Excel Analytics.” Click on “FS Ann. Balance Sheet.” This will download the balance sheet for Washington Mutual, which contains the bal- ances for loans, total assets, and stockholders’ equity. Repeat the process by entering “AF” in the “Ticker:” box to get information on Astoria Financial. Compare the ratios of loans to total assets and of stockholders’ equity to total assets from these balance sheets with that for the savings association industry, as listed in Table 2–9 .

Pertinent Web Sites

American Bankers Association www.aba.com Board of Governors of the Federal Reserve www.federalreserve.gov Credit Union National Association www.cuna.org Federal Deposit Insurance Corporation www.fdic.gov National Credit Union Administration www.ncua.gov Offi ce of the Comptroller of the Currency www.occ.treas.gov Offi ce of Thrift Supervision www.ots.treas.gov The Wall Street Journal www.wsj.com

29.

30.

Appendix 2A: Financial Statement Analysis Using a Return on Equity (ROE) Framework

View Appendix 2A at the Web site for this textbook (www.mhhe.com/ saunders6e).

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Chapter 2 The Financial Services Industry: Depository Institutions 65

Appendix 2B: Depository Institutions and Their Regulators

View Appendix 2B at the Web site for this textbook (www.mhhe.com/ saunders6e).

Appendix 2C: Technology in Commercial Banking

View Appendix 2C at the Web site for this textbook (www.mhhe.com/ saunders6e).

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66

Chapter Three

The Financial Services Industry: Insurance Companies

INTRODUCTION

The primary function of insurance companies is to protect individuals and corpo- rations (policyholders) from adverse events. By accepting premiums, insurance companies promise policyholders compensation if certain specified events occur. These policies represent financial liabilities to the insurance company. With the premiums collected, insurance companies invest in financial securities such as corporate bonds and stocks. The industry is classified into two major groups: life and property–casualty. Life insurance provides protection against the possibility of untimely death, illnesses, and retirement. Property insurance protects against personal injury and liability such as accidents, theft, and fire. However, as will become clear, insurance companies also sell a variety of investment products in a similar fashion to other financial service firms, such as mutual funds (Chapter 5) and depository institutions (Chapter 2).

As in Chapter 2, where we discussed banks and thrifts, in this chapter we describe the main features of life insurance and property–casualty insurance com- panies by concentrating on (1) the size, structure, and composition of the industry in which they operate, (2) balance sheets and recent trends, and (3) regulations for each. We also look at global competition and trends in this industry.

LIFE INSURANCE COMPANIES

Life insurance allows individuals and their beneficiaries to protect against losses in income through premature death or retirement. By pooling risks, life insurance transfers income-related uncertainties from the insured individual to a group.

Size, Structure, and Composition of the Industry In the mid-2000s, the United States had approximately 1,300 life insurance com- panies compared with over 2,300 in 1988. The aggregate assets of life insurance companies were $4.5 trillion at the beginning of 2006, compared with $1.12 trillion in 1988. The three largest life insurance companies, in terms of total assets (listed in Table 3–1 ) wrote 20 percent of the industry’s $529.8 billion new life insurance

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Chapter 3 The Financial Services Industry: Insurance Companies 67

premium business in 2005. Interestingly, many of these insurance policies are sold through commercial banks. For example, in 2005 Nationwide sold $33.1 million in life insurance policies through banks, a 45 percent increase over 2004. In 2005 bank sales of all types of insurance contracts increased to $80.1 billion. This is up from $27.7 billion in 1997.

Although not to the extent seen in the banking industry, the life insurance industry has seen some major mergers in recent years (e.g., SunAmerica and AIG and Prudential and Cigna) as competition within the industry and from other FIs has increased. In addition, many of the largest insurance companies, such as Metropolitan and Prudential, have converted to stockholder-controlled companies. In so doing, they gain access to the equity markets in order to realize additional capital for future business expansions and to compete with the rapidly consolidat- ing banking industry. Since a mutual company is owned by its policyholders, the existing capital and reserves (equal to accumulated past profits) have to be distrib- uted to the insurer’s policyholders. Table 3–1 lists the form of ownership for the top 10 life insurers in the United States, while Figure 3–1 illustrates the difference between a mutual insurer and a stock insurance company.

While life insurance may be the core activity area, modern life insurance com- panies also sell annuity contracts, manage pension plans, and provide accident and health insurance ( Figure 3–2 shows the distribution of premiums written for the various lines of insurance in 2005). We discuss these different activity lines in the following sections.

TABLE 3–1 Biggest Life Insurers

Source: Best’s Review, July 2006; and author’s research. www.ambest.com

Rank Insurance Company Form of Ownership Assets (billions)

1 Metropolitan Life Stock $407.8 2 American International Group Stock 341.1 3 Prudential of America Stock 331.0 4 Hartford Life Stock 204.5 5 Teachers Insurance and Annuity Stock 177.9 6 Aegon USA Inc. Mutual 172.5 7 ING Group Stock 169.9 8 New York Life Mutual 166.2 9 Axa Financial Group Stock 133.2

10 Northwestern Mutual Mutual 133.1

FIGURE 3–1 Mutual versus Stock Insurance Companies

Policyholders

Policy and ownership rights

Policy dividends

Accumulated profits owned by policyholders

Mutual Insurance Company

Mutual Insurer Stock Insurer

Policyholders

Stockholders

Policy rights

Accumulated profits owned by stockholders

Stock Insurance Company

Own ershi

p righ ts

Stoc k div

idend s

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68 Part One Introduction

One problem that naturally faces life insurance companies (as well as property– casualty insurers) is the so-called adverse selection problem. Adverse selection is a problem in that customers who apply for insurance policies are more likely to be those most in need of insurance (i.e., someone with chronic health problems is more likely to purchase a life insurance policy than someone in perfect health). Thus, in calculating the probability of having to pay out on an insurance contract and, in turn, determining the insurance premium to charge, insurance companies’ use of health (and other) statistics representing the overall population may not be appropriate (since the insurance company’s pool of customers is more prone to health problems than the overall population). Insurance companies deal with the adverse selection problem by establishing different pools of the population based on health and related characteristics (such as income). By altering the pool used to determine the probability of losses to a particular customer’s health characteristics, the insurance company can more accurately determine the probability of having to pay out on a policy and can adjust the insurance premium accordingly.

As the various types of insurance policies and services offered are described below, notice that some policies (such as universal life policies and annuities) pro- vide not only insurance features but also savings components. For example, uni- versal life policy payouts are a function of the interest earned on the investment of the policyholder’s premiums.

Types of Life Insurance The four basic classes or lines of life insurance are distinguished by the manner in which they are sold or marketed to purchasers. These classes are (1) ordinary life, (2) group life, (3) industrial life, and (4) credit life. Among the life insur- ance policies in force in the United States, ordinary life accounted for approxi- mately 78.1 percent, group life for 20.9 percent, and industrial life and credit life together for less than 1 percent of the $530 billion in contracts written in 2006. Ordinary Life Ordinary life insurance involves policies marketed on an indi- vidual basis, usually in units of $1,000, on which policyholders make periodic premium payments. Despite the enormous variety of contractual forms, there are essentially five basic contractual types. The first three are traditional forms of ordinary life insurance, and the last two are newer contracts that originated in the 1970s and 1980s as a result of increased competition for savings from other seg- ments of the financial services industry. The three traditional contractual forms are term life, whole life, and endowment life. The two newer forms are variable

FIGURE 3–2 Distribution of Premiums Written on Various Life Insurance Lines

Source: Best’s Review, September 2006. www.ambest.com

Ordinary annuities, 30.7%

Other* 0.3%

Group life 5.5%

Group annuities 20.8% Accident

and health 22.2%

Ordinary life

20.5%

*Includes credit life and industrial life

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Chapter 3 The Financial Services Industry: Insurance Companies 69

life and universal life. The key features of each of these contractual forms are as follows:

Term life. A term life policy is the closest to pure life insurance, with no savings element attached. Essentially, the individual receives a payout contingent on death during the coverage period. The term of coverage can vary from as little as 1 year to 40 years or more. Whole life. A whole life policy protects the individual over an entire lifetime. In return for periodic or level premiums, the individual’s beneficiaries receive the face value of the life insurance contract on death. Thus, there is certainty that if the policyholder continues to make premium payments, the insurance com- pany will make a payment—unlike term insurance. As a result, whole life has a savings element as well as a pure insurance element. Endowment life. An endowment life policy combines a pure (term) insurance ele- ment with a savings element. It guarantees a payout to the beneficiaries of the policy if death occurs during some endowment period (e.g., prior to reaching retirement age). An insured person who lives to the endowment date receives the face amount of the policy. Variable life. Unlike traditional policies that promise to pay the insured the fixed or face amount of a policy if a contingency arises, variable life insurance invests fixed premium payments in mutual funds of stocks, bonds, and money mar- ket instruments. Usually, policyholders can choose mutual fund investments to reflect their risk preferences. Thus, variable life provides an alternative way to build savings compared with the more traditional policies such as whole life because the value of the policy increases or decreases with the asset returns of the mutual fund in which the premiums are invested. Universal life and variable universal life. Universal life allows both the premium amounts and the maturity of the life contract to be changed by the insured, unlike traditional policies that maintain premiums at a given level over a fixed contract period. In addition, for some contracts, insurers invest premiums in money, equity, or bond mutual funds—as in variable life insurance—so that the savings or investment component of the contract reflects market returns. In this case, the policy is called variable universal life.

Group Life Insurance Group life insurance covers a large number of insured per- sons under a single policy. Usually issued to corporate employers, these policies may be either contributory (where both the employer and employee cover a share of the employee’s cost of the insurance) or noncontributory (where the employee does not contribute to the cost of the insurance) for the employees. Cost economies represent the principal advantage of group life over ordinary life policies. Cost economies result from mass administration of plans, lower costs for evaluating individuals through medical screening and other rating systems, and reduced sell- ing and commission costs. Industrial Life Industrial life insurance currently represents a very small area of coverage. Industrial life usually involves weekly payments directly collected by representatives of the companies. To a large extent, the growth of group life insur- ance has led to the demise of industrial life as a major activity class. Credit Life Credit life insurance is sold to protect lenders against a borrower’s death prior to the repayment of a debt contract such as a mortgage or car loan. Usually, the face amount of the insurance policy reflects the outstanding principal and interest on the loan.

•

•

•

•

•

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70 Part One Introduction

Other Life Insurer Activities Three other major activities of life insurance companies involve the sale of annui- ties, private pension plans, and accident and health insurance. Annuities Annuities represent the reverse of life insurance activities. Whereas life insurance involves different contractual methods of building up a fund, annui- ties involve different methods of liquidating a fund, such as paying out a fund’s proceeds. As with life insurance contracts, many different types of annuity con- tracts have been developed. Specifically, they can be sold to an individual or a group and on a fixed or a variable basis by being linked to the return on some underlying investment portfolio. Individuals can purchase annuities with a single payment or with payments spread over a number of years. The annuity builds up a fund whose returns are tax deferred; that is, they are not subject to capital gains taxes on their investments. Payments may be structured to start immediately, or they can be deferred (at which time taxes are paid based on the income tax rate of the annuity receiver). These payments may cease on death or continue to be paid to beneficiaries for a number of years after death. Annuity sales in 2005 topped $272 billion ($162.8 billion of which were ordinary annuities), compared with $26 billion in 1996. 1 Growth has been large despite the 1997 reduction in the capital gains tax rate from 28 percent to 20 percent.

The year 2004 saw the first action against an insurance company involving alleged unethical practices. In a sweeping investigation of variable annuity sales, federal and state regulators prepared a case against Conseco, asserting that the insurer provided advantages to big investors that could increase profits but hurt small investors. Until recently, many variable annuities permitted almost unlim- ited movement of money among asset pools in which annuity funds were invested. Regulators assert that in the early 2000s, companies had increasingly imposed lim- its on asset pool movements by smaller investors (annuity holders). Regulators were also investigating a number of other insurance companies and brokerage companies for similar practices. Private Pension Funds Insurance companies offer many alternative pension plans to private employers in an effort to attract this business from other financial service companies, such as commercial banks and security firms. Some of their in- novative pension plans are based on guaranteed investment contracts (GICs). This means the insurer guarantees not only the rate of interest credited to a pension plan over a given period—for example, five years—but also the annuity rates on beneficiaries’ contracts. Other plans include immediate participation and separate account plans that follow more aggressive investment strategies than traditional life insurance, such as investing premiums in special-purpose equity mutual funds. In the mid-2000s, life insurance companies were managing over $2.3 tril- lion in pension fund assets, equal to approximately 45 percent of all private pen- sion plans. Accident and Health Insurance While life insurance protects against mortality risk, accident and health insurance protect against morbidity, or ill health, risk. Over $117.8 billion in premiums were written by life and health companies in the accident–health area in the mid-2000s. The major activity line is group insurance, providing health insurance coverage to corporate employees. Life insurance companies write more than 50 percent of all health insurance premiums.

1 As discussed in Chapter 21, life insurers are facing increasingly intense competition from banks in the annuity product market.

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Chapter 3 The Financial Services Industry: Insurance Companies 71

However, the growth in health maintenance organizations (HMOs) (nonregulated providers of health insurance) in the late 1990s has cut into this line of business. For example, a 1998 survey of 11 major life insurance companies, conducted by A. M. Best, 2 reported that from 1996 to 1997 the number of enrollees in life insurance company– sponsored health insurance plans dropped by more than 8 percent and more than 25 percent of the companies’ existing policies were dropped. Overall, premiums dropped nearly 7 percent. In contrast, HMO enrollment increased more than 7 percent from 1996 to 1997. 3 Other coverages include credit health plans by which individuals have their debt repayments insured against unexpected health contingencies and various types of renewable, nonrenewable, and guaranteed health and accident plans for individuals. In many respects, the loss exposures faced by insurers in accident and health lines are more similar to those faced under property–casualty insurance than to those faced under traditional life insurance (see section on page 75 on property–casualty insurance).

Balance Sheet and Recent Trends

Assets Because of the long-term nature of their liabilities (as a result of the long-term nature of life insurance policyholders’ claims) and the need to generate com- petitive returns on the savings elements of life insurance products, life insurance companies concentrate their asset investments at the longer end of the maturity spectrum (e.g., bonds, equities, and government securities). Look at Table 3–2 , where we show the distribution of life insurance companies’ assets.

2 A. M. Best is a leading source of information on the insurance industry. The company provides quantita- tive and qualitative data on the performance of individual insurance companies as well as the industry as a whole.

3 A. M. Best’s Supplemental Rating Questionnaire, 1998.

TABLE 3–2 Distribution of Assets of U.S. Life Insurance Companies Source: American Council of Life Insurance, Life Insurance Fact Book, 1994; Best’s Review, October 1996; and Federal Reserve Bulletin, various issues. www.federalreserve.gov

Year Total Assets

(millions) Government

Securities

Corporate Securities

Bonds Stocks Mortgages Policy Loans

Miscellaneous U.S. Assets

1917 $ 5,941 9.6% 33.2% 1.4% 34.0% 13.6% 5.2% 1920 7,320 18.4 26.7 1.0 33.4 11.7 6.5 1930 18,880 8.0 26.0 2.8 40.2 14.9 5.2 1940 30,802 27.5 28.1 2.0 19.4 10.0 6.3 1950 64,020 25.2 36.3 3.3 25.1 3.8 4.1 1960 119,576 9.9 39.1 4.2 34.9 4.4 4.4 1970 207,254 5.3 35.3 7.4 35.9 7.8 5.3 1980 479,210 6.9 37.5 9.9 27.4 8.6 6.6 1990 1,408,208 15.0 41.4 9.1 19.2 4.4 7.8 1995 2,131,900 18.6 41.4 17.4 9.9 4.5 6.3 2000 3,133,900 9.3 39.1 31.5 7.5 3.2 9.4 2005 4,350,700 10.6 44.0 29.2 6.6 2.5 7.1 2006 4,577,900 10.3 43.1 30.8 6.5 2.4 6.9

Note: Beginning with 1962, these data include the assets of separate accounts.

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72 Part One Introduction

As you can see, in 2006, 10.3 percent of assets were invested in government securities, 73.9 percent in corporate bonds and stocks, and 6.5 percent in mortgages, with other loans—including policy loans (loans made to policyholders using their policies as collateral)—making up the balance. While commercial banks are the major issuers of new mortgages (sometimes keeping the mortgages on their books and sometimes selling them to secondary market investors), insurance companies hold mortgages as investment securities. That is, they purchase many mortgages in the secondary markets (see Chapters 26 and 27). The major trends have been a long-term increase in the proportion of bonds and equities 4 and a decline in the proportion of mortgages in the balance sheet (see below). Thus, insurance com- pany managers must be able to measure and manage the credit risk, interest rate risk, and other risks associated with these securities.

Liabilities The aggregate balance sheet for the life insurance industry at the beginning of 2006 is shown in Table 3–3 . Looking at the liability side of the balance sheet, we see that $2.069 trillion, or 46.3 percent, of total liabilities and capital are net policy reserves (the expected payment commitment on existing policy contracts). These reserves are based on actuarial assumptions regarding the insurers’ expected future liability commitments to pay out on present contracts, including death benefits, matured endowments (lump sum or otherwise), and the cash surrender values of poli- cies (the cash value paid to the policyholder if the policy is surrendered before it matures). Even though the actuarial assumptions underlying policy reserves are normally very conservative, unexpected fluctuations in future required payouts can occur; thus, underwriting life insurance is risky. For example, mortality rates— and life insurance payouts—might unexpectedly increase above those defined by historically based mortality tables as a result of a catastrophic epidemic illness such as AIDS. To meet unexpected future losses, the life insurer holds a capital and surplus reserve fund with which to meet such losses (and reduce insolvency risk). The capital and surplus reserves of life insurers in 2006 were $250 billion, or 5.6 percent of total assets. 5 Separate account business represented 32.9 percent of total liabilities and capital in 2006. A separate account is a fund established and held separately from the insurance company’s other funds. These funds may be invested without regard to the usual diversification restrictions; that is, they may be invested in all stocks, all bonds, and so forth. Note that these assets are also listed separately on the asset side of the balance sheet. Separate account assets are 33 percent of total assets. The payoff on the life insurance policy thus depends on the return on the funds in the separate account. Another important life insurer liability, GICs (7.3 percent of total liabilities and capital), are short- and medium- term debt instruments sold by insurance companies to fund their pension plan business (see deposit-type contracts in Table 3–3 ).

Recent Trends The life insurance industry was very profitable in the early and mid-2000s, with over $500 billion in premiums and annuities recorded in 2004 through 2006. Net income topped $34 billion in 2006, up 6.5 percent from 2005. The credit markets

4 The bull market of the 1980s and 1990s probably constitutes a major reason for the large percentage of assets invested in equities.

5 An additional line of defense against unexpected underwriting losses is the insurer’s investment income from its asset portfolio plus any new premium income flows.

policy loans Loans made by an insurance company to its policyholders using their policies as collateral.

policy loans Loans made by an insurance company to its policyholders using their policies as collateral.

policy reserves A liability item for insurers that reflects their expected pay- ment commitment on existing policy contracts.

policy reserves A liability item for insurers that reflects their expected pay- ment commitment on existing policy contracts.

surrender value of a policy The cash value of a policy received from the insurer if a policy- holder surrenders the policy before maturity. The cash surrender value is normally only a portion of the contract’s face value.

surrender value of a policy The cash value of a policy received from the insurer if a policy- holder surrenders the policy before maturity. The cash surrender value is normally only a portion of the contract’s face value.

separate accounts Annuity programs sponsored by life insurance companies in which the payoff on the policy is linked to the assets in which policy premiums are invested.

separate accounts Annuity programs sponsored by life insurance companies in which the payoff on the policy is linked to the assets in which policy premiums are invested.

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Chapter 3 The Financial Services Industry: Insurance Companies 73

continued to be strong, and capital levels for the industry remained strong. However, events could adversely impact the industry’s financial strength. These include potential effects from a pandemic, another terrorist attack, or a significant correction in the stock markets. Other risks to the industry are net outflows for some large variable annuity writers, competition from banks and mutual funds, and a prolonged inverted yield curve.

Regulation The most important legislation affecting the regulation of life insurance compa- nies is the McCarran-Ferguson Act of 1945, which confirms the primacy of state over federal regulation of insurance companies. Thus, unlike the depository insti- tutions we discussed in Chapter 2, which can be chartered either at the federal or the state level, chartering of life insurers is done entirely at the state level. In addi- tion to chartering, state insurance commissions supervise and examine insurance companies by using a coordinated examination system developed by the National Association of Insurance Commissioners (NAIC).

In early 2004 the prospect of the federal government’s gaining a role in the reg- ulation of the insurance industry gained momentum. The chairman of the House Committee on Financial Services spelled out plans for 2004 legislation that would create a council of federal and state officials to oversee insurance (life as well as property–casualty) nationally, with a presidential appointee as its head. The leg- islation would force states to adopt uniform standards and permit the market to determine insurance prices rather than have them determined by state regula- tors, as is generally the case. For several years state regulators have been trying to

McCarran-Ferguson Act of 1945 Legislation confirming the primacy of state over federal regulation of insurance companies.

McCarran-Ferguson Act of 1945 Legislation confirming the primacy of state over federal regulation of insurance companies.

www.naic.org www.naic.org

Assets Percent of

Total Assets

Bonds $2,204,770 49.3% Preferred stock 26,070 0.6 Common stock 72,411 1.6 Mortgage loans 284,652 6.4 Real estate 19,344 0.4 Contract loans 108,748 2.4 Cash and short-term investments 65,219 1.5 Other invested assets 75,812 1.7 Premiums due 22,482 0.5 Accrued investment income 31,457 0.7 Separate account assets 1,476,009 33.0 Other assets 84,335 1.9

Total assets $4,471,309 100.0%

Liabilities and Capital/Surplus

Net policy reserves $2,069,106 46.3% Deposit-type contracts 325,012 7.3 Policy claims 36,585 0.8 Other liabilities 318,167 7.1 Separate account business 1,472,612 32.9 Total capital and surplus 249,826 5.6

Total liabilities and capital/surplus $4,471,309 100.0%

TABLE 3–3 Life Insurance Industry Balance Sheet, 2006 (in millions of dollars)

Source: Reprinted with per- mission from Best’s Aggre- gates & Averages, Life-Health, 2006, p. 2. www.ambest.com

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74 Part One Introduction

simplify and speed their procedures on rates, conditions of coverage, and approval of new insurance products. But progress has been slow. The results have been complaints that cumbersome and costly state regulation was failing to meet the needs of both insurance companies and their customers. Many of the nation’s big- gest insurers have been campaigning for a dual system, which would create a federal regulator but also permit companies to choose whether to be regulated at the federal level or the state level. The proposal has met resistance from the states, consumer groups, and some members of Congress.

Other than supervision and examination, states promote life insurance guar- antee funds . Unlike banks and thrifts, life insurers have no access to a federal guarantee fund. These state guarantee funds differ in a number of important ways from deposit insurance. First, although these programs are sponsored by state insurance regulators, they are actually run and administered by the (private) insurance companies themselves.

Second, unlike DIF, in which the FDIC has established a permanent reserve fund by requiring banks to pay annual premiums in excess of payouts to resolve failures (see Chapter 19), no such permanent guarantee fund exists for the insur- ance industry—with the sole exception of the PC and life guarantee funds in the state of New York. This means that contributions are paid into the guarantee fund by surviving firms in a state only after an insurance company has actually failed.

Third, the size of the required contributions that surviving insurers make to protect policyholders in failed insurance companies differs widely from state to state. In those states that have guarantee funds, each surviving insurer is normally levied a pro rata amount, according to the size of its statewide premium income. This amount either helps pay off small policyholders after the assets of the failed insurer have been liquidated or acts as a cash injection to make the acquisition of a failed insurer attractive. The definition of small policyholders varies among states in the range of holding policies from $100,000 to $500,000.

Finally, because no permanent fund exists and the annual pro rata payments to meet payouts to failed insurer policyholders are often legally capped, a delay usu- ally occurs before small policyholders receive the cash surrender values of their policies or other payment obligations from the guarantee fund. This contrasts with deposit insurance, which normally provides insured depositors immediate cover- age of their claims up to $100,000.

As discussed in Chapter 21, a piece of legislation that will have a major impact on state regulation of the insurance (both life insurance and property–casualty insurance) industry in the future is the Financial Services Modernization Act of 1999. This legislation allows insurance companies and depository institutions (as well as investment banks) to engage in each other’s businesses.

What is the difference between a life insurance contract and an annuity contract? Describe the different forms of ordinary life insurance. Why do life insurance companies invest in long-term assets? What is the major source of life insurance underwriting risk? Who are the main regulators of the life insurance industry? Why is traditional life insurance in decline?

1. 2. 3. 4. 5. 6.

Concept Questions Concept Questions

insurance guarantee funds Funds consisting of required contribu- tions from withinstate insurance companies to compensate insurance company policyholders if there is a failure.

insurance guarantee funds Funds consisting of required contribu- tions from withinstate insurance companies to compensate insurance company policyholders if there is a failure.

www.ins.state.ny.us www.ins.state.ny.us

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Chapter 3 The Financial Services Industry: Insurance Companies 75

PROPERTY–CASUALTY INSURANCE

Property insurance involves insurance coverages related to the loss of real and personal property. Casualty—or, perhaps more accurately, liability—insurance concerns protection against legal liability exposures. However, the distinctions between the two broad areas of property and liability insurance are increasingly becoming blurred. This is due to the tendency of PC insurers to offer multiple- activity line coverages combining features of property and liability insurance into single policy packages, for example, homeowners multiple-peril insurance.

Size, Structure, and Composition of the Industry Currently, some 2,700 companies sell property–casualty (PC) insurance, with approximately half of these firms writing PC business in all or most of the United States. The U.S. PC insurance industry is quite concentrated. Collectively, the top 10 firms have a 48 percent share of the overall PC market measured by premiums written, and the top 100 firms made up over 87 percent of the industry premiums written. In 2005, the top firm (State Farm) wrote 10.9 percent of all PC insurance premiums, while the second-ranked insurer AIG wrote 7.3 percent (i.e., a joint total of 18.2 percent of premiums written). In contrast, in 1985, these top two firms wrote 14.5 percent of the total industry insurance premiums. Thus, the industry leaders appear to be increasing their domination of this financial service sector. As with banks, much of this consolidation is coming through mergers and acquisitions. For example, in late 2003 St. Paul Companies acquired Travelers Property Casualty Corporation in a $16.4 billion stock swap to create St. Paul Travelers. The acqui- sition moved the combined companies into the number three position (based on total assets) among all PC insurers. The total assets of the PC industry in 2006 were $1,406 billion, or approximately 30 percent of the life insurance industry’s assets.

Types of Property–Casualty Insurance In this section we describe the key features of the main PC lines. Note, however, that some PC activity lines are marketed as different products to both individu- als and commercial firms (e.g., auto insurance) while other lines are marketed to one specific group (e.g., boiler and machinery insurance targeted at commer- cial purchasers). To understand the importance of each line in terms of premium income and losses incurred, look at Table 3–4 . The following data show the chang- ing composition in net premiums written (NPW) (the entire amount of premi- ums on insurance contracts written) for major PC lines over the 1960–2005 period. Important PC lines include the following:

Fire insurance and allied lines. Protects against the perils of fire, lightning, and removal of property damaged in a fire (3.7 percent of all premiums written in 2005; 16.6 percent in 1960). Homeowners multiple-peril (MP) insurance. Protects against multiple perils of damage to a personal dwelling and personal property as well as providing lia- bility coverage against the financial consequences of legal liability due to injury done to others. Thus, it combines features of both property and liability insur- ance (12.2 percent of all premiums written in 2005; 5.2 percent in 1960). Commercial multiple-peril insurance. Protects commercial firms against perils; similar to homeowners multiple-peril insurance (6.8 percent of all premiums written in 2005; 0.4 percent in 1960).

•

•

•

net premiums written The entire amount of premiums on insurance contracts written.

net premiums written The entire amount of premiums on insurance contracts written.

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76 Part One Introduction

Automobile liability and physical damage (PD) insurance. Provides protection against (1) losses resulting from legal liability due to the ownership or use of the vehicle (auto liability) and (2) theft of or damage to vehicles (auto physical damage) (42.8 percent of all premiums written in 2005; 43.0 percent in 1960). Liability insurance (other than auto). Provides either individuals or commercial firms with protection against non-automobile-related legal liability. For com- mercial firms, this includes protection against liabilities relating to their busi- ness operations (other than personal injury to employees covered by workers’ compensation insurance) and product liability hazards (23.7 percent of all pre- miums written in 2005; 6.6 percent in 1960).

Balance Sheet and Recent Trends The Balance Sheet and Underwriting Risk The balance sheet of PC firms at the beginning of 2006 is shown in Table 3–5 . Similar to life insurance companies, PC insurers invest the majority of their assets in long-term securities, thus subjecting them to credit and interest rate risks. Bonds ($798.7 billion), preferred stock ($9.2 billion), and common stock ($151.8 billion) constituted 68.3 percent of total assets in 2006. PC insurers hold mainly long-term securities for two reasons. First, PC insurers, like life insurers, hold long-term assets to match the maturity of their longer-term contractual liabilities. Second,

•

•

Net Premiums Written* Losses Incurred†

Fire $ 7,933,899 1.8% Allied lines 8,191,576 1.9 Farm owners multiple peril (MP) 2,266,571 0.5 Homeowners MP 53,013,230 12.2 Commercial MP 29,668,133 6.8 Mortgage guaranty 4,454,711 1.0 Ocean marine 2,946,374 0.7 Inland marine 8,246,499 1.9 Financial guaranty 2,097,489 0.5 Medical malpractice 9,734,417 2.2 Earthquake 1,106,653 0.2 Accident and health 9,577,392 2.2 Workers’ compensation 39,734,079 9.1 Other liability 39,103,126 9.0 Products liability 3,561,119 0.8 Private passenger auto liability 94,645,760 21.7 Commercial auto liability 19,832,301 4.6 Private passenger auto physical damage (PD) 64,922,222 14.9 Commercial auto PD 6,946,014 1.6 Aircraft 1,985,858 0.5 Fidelity 1,216,803 0.3 Surety 3,819,541 0.9 Reinsurance 6,589,802 1.5 Burglary and theft 120,188 0.0 Boiler and machinery 1,582,965 0.4 Credit 936,108 0.2 Other lines 11,339,905 2.6

Total 435,572,735 100.0%

*In thousands of dollars. † To premiums earned.

TABLE 3–4 Property and Casualty Insurance Industry Underwriting by Lines, 2005

Source: BestWeek, November 2006.

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Chapter 3 The Financial Services Industry: Insurance Companies 77

PC insurers, unlike life insurers, have more uncertain payouts on their insurance contracts (i.e., they incur greater levels of liquidity risk). Thus, their asset structure includes many assets with relatively fixed returns that can be liquidated easily and at low cost. Looking at their liabilities, we can see the major component is the loss reserve and loss adjustment expenses ($541.6 billion) set aside to meet expected losses from underwriting and administrative expenses associated with the PC lines just described. This item constitutes 38.5 percent of total liabilities and capital. Unearned premiums (a reserve set-aside that contains the portion of a premium that has been paid before insurance coverage has been provided) are also a major liability, representing 14 percent of total liabilities and capital.

To understand how and why a loss reserve on the liability side of the balance sheet is established, we need to understand the risks of underwriting PC insur- ance. In particular, PC underwriting risk results when the premiums generated on a given insurance line are insufficient to cover (1) the claims (losses) incurred insuring against the peril and (2) the administrative expenses of providing that insurance (legal expenses, commissions, taxes, etc.) after taking into account (3) the investment income generated between the time premiums are received and the time claims are paid. Thus, underwriting risk may result from (1) unexpected increases in loss rates, (2) unexpected increases in expenses, and/or (3) unexpected

unearned premiums Reserve set-aside that contains the portion of a premium that has been paid before in- surance coverage has been provided.

unearned premiums Reserve set-aside that contains the portion of a premium that has been paid before in- surance coverage has been provided.

TABLE 3–5 Balance Sheet for the Property–Casualty Industry, 2006 (in millions of dollars)

Source: Reprinted with permission from A.M. Best’s Aggregates and Averages, property–casualty, 2006, p. 1. www.ambest.com

Assets Percent of

Total Assets

Unaffiliated investments $ 1,097,396 78.1% Bonds 798,738 56.8% Preferred stocks 9,172 0.7 Common stocks 151,789 10.8 Real estate investments 1,471 0.1 Cash and short-term investments 92,695 6.6 Other invested assets 43,531 3.1 Investments in affiliates 64,660 4.6 Real estate, office 8,080 0.6 Premium balances 116,355 8.3 Accrued interest 10,336 0.7 Other assets 109,004 7.7

Total assets $ 1,405,831 100.0%

Liabilities and Capital/Surplus

Loss reserve and loss adjustment expenses

$ 541,578 38.5%

Unearned premiums 196,753 14.0 Conditional reserve funds 25,052 1.8 Other liabilities 203,718 14.5

Total liabilities $ 967,101 68.8% Policy holders surplus $ 438,730 31.2% Capital and assigned surplus $179,034 12.7 Surplus notes 11,109 0.8 Unassigned surplus 248,587 17.7

Total liabilities and capital/surplus $ 1,405,831 100.0%

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78 Part One Introduction

decreases in investment yields or returns. Next, we look more carefully at each of these three areas of PC underwriting risk. Loss Risk The key feature of claims loss exposure is the actuarial predictability of losses relative to premiums earned. This predictability depends on a number of characteristics or features of the perils insured, specifically:

Property versus liability. In general, the maximum levels of losses are more pre- dictable for property lines than for liability lines. For example, the monetary value of the loss of, or damage to, an auto is relatively easy to calculate, while the upper limit to the losses an insurer might be exposed to in a product liability line—for example, asbestos damage to workers’ health under other liability insurance— may be diffi cult, if not impossible, to estimate.

Severity versus frequency. In general, loss rates are more predictable on low severity, high-frequency lines than they are on high-severity, low-frequency lines. For example, losses in fi re, auto, and homeowners peril lines tend to involve events expected to occur with a high frequency and to be independently distrib- uted across any pool of the insured. Furthermore, the dollar loss on each event in the insured pool tends to be relatively small. Applying the law of large numbers, insurers can estimate the expected loss potential of such lines—the frequency of loss times the size of the loss ( severity of loss )—within quite small probability bounds. Other lines, such as earthquake, hurricane, and fi nancial guaranty insur- ance, tend to insure very low-probability (frequency) events. Here the probabilities are not always stationary, the individual risks in the insured pool are not indepen- dent, and the severity of the loss could be enormous. This means that estimating expected loss rates (frequency times severity) is extremely diffi cult in these cover- age areas. For example, even with the new federal terrorism insurance program introduced in 2002, coverage for high-profi le buildings in big cities, as well as other properties considered potential targets, remains expensive. Under the 2002 federal program, the government is responsible for 90 percent of insurance industry losses that arise from any future terrorist incidents that exceed a minimum amount. The government’s losses are capped at $100 billion per year. Each insurer has a maxi- mum amount it would pay before federal aid kicks in. In 2005, the amount was 15 percent of each company’s commercial property–casualty premiums. The result is that in some cases, the cost of terrorism insurance has been reduced signifi cantly since the new law took effect. But those buildings viewed as target risks will con- tinue to have much higher premiums than properties outside of major cities. This higher uncertainty of losses forces PC fi rms to invest in more short-term assets and hold a larger percentage of capital and reserves than life insurance fi rms hold.

Long tail versus short tail. Some liability lines suffer from a long-tail risk exposure phenomenon that makes the estimation of expected losses diffi cult. This long-tail loss arises in policies in which the insured event occurs during a coverage period but a claim is not fi led or reported until many years later. The delay in fi ling of a claim is in accordance with the terms of the insurance contract and often occurs because the detrimental consequences of the event are not known for a period of time after the event actually occurs. Losses incurred but not reported have caused insurers signifi cant problems in lines such as medical malpractice and other liability insurance where product damage suits (e.g., the Dalkon shield case and asbes- tos cases) have mushroomed many years after the event occurred and the cover- age period expired. 6 For example, in 2002 Halliburton, a major U.S. corporation,

6 In some product liability cases, such as those involving asbestos, the nature of the risk being covered was not fully understood at the time many of the policies were written.

•

•

•

frequency of loss The probability that a loss will occur.

severity of loss The size of the loss.

frequency of loss The probability that a loss will occur.

severity of loss The size of the loss.

long-tail loss A claim that is made some time after a policy was written.

long-tail loss A claim that is made some time after a policy was written.

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Chapter 3 The Financial Services Industry: Insurance Companies 79

agreed to pay $4 billion in cash and stock, and to seek bankruptcy protection for a subsidiary, to settle more than 300,000 asbestos claims. To resolve its growing asbestos liability, Halliburton considered a novel step that put one of its biggest subsidiaries into bankruptcy courts, while allowing Halliburton to hold on to the rest of its businesses. Questions still remain about how much insurance companies will be required to reimburse Halliburton for the cost of asbestos case settlements and when. The company had only $1.6 billion of expected insurance on its books for asbestos claims. If Halliburton is successful in putting just one of its subsidiar- ies (and not the entire fi rm) into bankruptcy, it could set a precedent for many companies, such as Honeywell International and Dow Chemical, which were also trying to contain their asbestos risk in subsidiaries.

Product infl ation versus social infl ation. Loss rates on all PC property policies are adversely affected by unexpected increases in infl ation. Such increases were trig- gered, for example, by the oil price shocks of 1973, 1978, and potentially, 2003–04. However, in addition to a systematic unexpected infl ation risk in each line, there may be line-specifi c infl ation risks. The infl ation risk of property lines is likely to refl ect the approximate underlying infl ation risk of the economy. Liability lines may be subject to social infl ation, as refl ected in juries’ willingness to award puni- tive and other liability damages at rates far above the underlying rate of infl ation. Such social infl ation has been particularly prevalent in commercial liability and medical malpractice insurance and has been directly attributed by some analysts to faults in the U.S. civil litigation system.

Reinsurance An alternative to managing risk on a PC insurer’s balance sheet is to purchase reinsurance from a reinsurance company. Reinsurance is essentially insur- ance for insurance companies. Note from Table 3–4 that reinsurance represented 1.5 percent of all premiums written in 2005. It is a way for primary insurance com- panies to protect against unforeseen or extraordinary losses. Depending on the contract, reinsurance can enable the insurer to improve its capital position, expand its business, limit losses, and stabilize cash flows, among other things. In addi- tion, the reinsurer, drawing information from many primary insurers, will usually have a far larger pool of data for assessing risks. Reinsurance takes a variety of forms. It may represent a layer of risk, such as losses within certain limits, say, $5 million to $10 million, that will be paid by the reinsurer to the primary insurance company for which a premium is paid, or a sharing of both losses and profits for certain types of business. Reinsurance is an international business. About 75 percent of the reinsurance business that comes from U.S. insurance companies is written by non-U.S. reinsurers such as Munich Re. Some investment banks are now setting up reinsurers as part of a move to develop alternative risk financ- ing deals such as catastrophe bonds. Insurers and reinsurers also typically issue catastrophe bonds. The bonds pay high interest rates and diversify an investor’s portfolio because natural disasters occur randomly and are not associated with (independent of) economic factors. Depending on how the bond is structured, if losses reach the threshold specified in the bond offering, the investor may lose all or part of the principal or interest. For example, a deep-discount or zero-coupon catastrophe bond would pay 100(1 � � ) on maturity, where � is the loss rate due to the catastrophe. Thus, Munich Re issued a $250 million catastrophe bond in 2001 where � (the loss rate) reflected losses incurred on all reinsurer policies over a 24-hour period should an event (such as a flood or hurricane) occur and losses ex- ceed a certain threshold. The required yield on these bonds reflected the risk-free rate plus a premium reflecting investors’ expectations regarding the probability of the event’s occurring.

•

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80 Part One Introduction

Measuring Loss Risk The loss ratio measures the actual losses incurred on a line. It measures the ratio of losses incurred to premiums earned (premiums received and earned on insurance contracts because time has passed with no claim being filed). Thus, a loss ratio less than 100 means that premiums earned were sufficient to cover losses incurred on that line. Aggregate loss ratios for the period 1951–2006 are shown in Table 3–6 . Notice the steady increase in indus- try loss ratios over the period, increasing from the 60 percent range in the 1950s to the 70 and 80 percent range in the 1980s and 1990s. For example, in 2006, the aggregate loss ratio on all PC lines was 73.2. This includes, however, loss adjust- ment expenses (LAE)—see below—as well as (pure) losses. The (pure) loss ratio, net of LAE, in 2006 was 52.7. Expense Risk The two major sources of expense risk to PC insurers are (1) loss adjustment expenses (LAE) and (2) commissions and other expenses. Loss adjustment expenses relate to the costs surrounding the loss settlement pro- cess; for example, many PC insurers employ adjusters who determine the li- ability of the insurer and the size of the adjustment or settlement to be made. The other major area of expense occurs in the commission costs paid to in- surance brokers and sales agents and other expenses related to the acquisi- tion of business. As mentioned above, the loss ratio reported in Table 3–6 includes LAE. The expense ratio reported in Table 3–6 reflects commissions and other (non-LAE) expenses for PC insurers over the 1951–2006 period. In contrast to the increasing trend in the loss ratio, the expense ratio gener- ally decreased over the period shown. Expense can account for significant portions of the overall costs of operations. In 2006, for example, expenses— other than LAE—amounted to 25.4 percent of premiums written. Clearly, sharp rises in insurance broker commissions and other operating costs can

loss ratio Ratio that measures pure losses incurred to premiums earned.

loss ratio Ratio that measures pure losses incurred to premiums earned.

premiums earned Premiums received and earned on insur- ance contracts be- cause time has passed with no claim being filed.

premiums earned Premiums received and earned on insur- ance contracts be- cause time has passed with no claim being filed.

TABLE 3–6 Industry Underwriting Ratios

Source: Best’s Review, various issues. www.ambest.com

Year Loss Ratio* Expense Ratio†

Combined Ratio

Dividends to Policyholders‡

Combined Ratio after Dividends

1951 60.3 34.0 94.3 2.6 96.9 1960 63.8 32.2 96.0 2.2 98.1 1965 70.3 30.4 100.7 1.9 102.6 1970 70.8 27.6 98.4 1.7 100.1 1975 79.3 27.3 106.6 1.3 107.9 1980 74.9 26.5 101.4 1.7 103.1 1985 88.7 25.9 114.6 1.6 116.3 1990 82.3 26.0 108.3 1.2 109.6 1995 78.8 26.2 105.0 1.4 106.4 1997 72.8 27.1 99.9 1.7 101.6 2000 81.4 27.8 109.2 1.3 110.5 2001 88.4 26.9 115.3 0.7 116.0 2002 81.1 25.6 106.7 0.5 107.2 2003 74.7 24.9 99.6 0.5 100.1 2004 74.8 25.0 99.8 0.4 98.7 2005 74.8 25.5 100.3 0.6 100.9 2006 73.2 25.4 92.6 0.6 93.2

*Losses and adjustment expenses incurred to premiums earned. †Expenses incurred (before federal income taxes) to premiums written. ‡Dividends to policyholders to premiums earned.

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Chapter 3 The Financial Services Industry: Insurance Companies 81

rapidly render an insurance line unprofitable. Indeed, one of the reasons for the secular decline in the expense ratio has been the switch in the way PC insurance has been distributed. Specifically, rather than relying on independent brokers to sell policies (the American agency method of distribution), large insurance companies are increasingly selling insurance to the public directly through their own brokers (the direct writer method of distribution). A number of researchers 7 have found that the costs of the American agency distribution system are much higher than those of the direct writer distribution system.

A common measure of the overall underwriting profitability of a line, which includes both loss and expense experience, is the combined ratio . Technically, the combined ratio is equal to the loss ratio plus the ratios of LAE to premiums earned, commissions and other acquisition costs and general expense costs to premiums written, plus any dividends paid to policyholders as a proportion of premiums earned. The combined ratio after dividends adds any dividends paid to policyholders as a proportion of premiums earned to the combined ratio. If the combined ratio is less than 100, premiums alone are sufficient to cover both losses and expenses related to the line.

If premiums are insufficient and the combined ratio exceeds 100, the PC insurer must rely on investment income earned on premiums for overall profitability. For example, in 2001 the combined ratio before dividend payments was 116.0, indicat- ing that premiums alone were insufficient to cover the costs of both losses and expenses related to writing PC insurance. Table 3–6 presents the combined ratio and its components for the PC industry for the years 1951–2006. We see that the trend over this period is toward decreased profitability. The industry’s premiums generally covered losses and expenses until the 1980s. Since then premiums have been unable to cover losses and expenses (i.e., combined ratios have generally been greater than 100). Investment Yield/Return Risk As discussed above, when the combined ratio is more than 100, overall profitability can be ensured only by a sufficient investment return on premiums earned. That is, PC firms invest premiums in assets between the time they are received and the time they are paid out to meet claims. For ex- ample, in 2005 net investment income to premiums earned (or the PC insurers’ investment yield) was 11.6 percent. As a result, the overall average profitability (or operating ratio ) of PC insurers was 89.3. It was equal to the combined ratio after dividends (100.9) minus the investment yield (11.6). Since the operating ratio was less than 100, PC insurers were profitable in 2005. However, lower net returns on investments (e.g., 0.5 percent rather than 11.6 percent) would have meant that underwriting PC insurance was marginally unprofitable (i.e., the operating ratio of insurers in this case would have been 100.4). Thus, the effect of interest rates and default rates on PC insurers’ investments is crucial to PC insurers’ overall profitability. That is, measuring and managing credit and interest rate risk are key concerns of PC managers.

Consider the following example. Suppose an insurance company’s projected loss ratio is 79.8 percent, its expense ratio is 27.9 percent, and it pays 2 percent of its premiums earned to policyholders as dividends. The combined ratio (after dividends) for this insurance company is equal to:

7 See, for example, N. D. Chidambaran, T. A. Pugel, and A. Saunders, “An Investigation of the Perfor- mance of the U.S. Property–Casualty Insurance Industry,” Journal of Risk and Insurance 64 (June 1997), pp. 371–82.

combined ratio Ratio that measures the overall underwrit- ing profitability of a line; it is equal to the loss ratio plus the ratios of loss adjust- ment expenses to premiums earned and commission and other acquisition costs to premiums written plus any dividends paid to policyhold- ers as a proportion of premiums earned.

combined ratio Ratio that measures the overall underwrit- ing profitability of a line; it is equal to the loss ratio plus the ratios of loss adjust- ment expenses to premiums earned and commission and other acquisition costs to premiums written plus any dividends paid to policyhold- ers as a proportion of premiums earned.

operating ratio A measure of the overall profitability of a PC insurer; it equals the combined ratio minus the investment yield.

operating ratio A measure of the overall profitability of a PC insurer; it equals the combined ratio minus the investment yield.

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82 Part One Introduction

Loss ratio Expense ratio Dividend ratio Com� � � bbined ratio after dividends 79.8 27.9 2.0 1� � � 009.7

Thus, expected losses on all PC lines, expenses, and dividends exceeded premi- ums earned by 9.7 percent.

If the company’s investment portfolio, however, yielded 12 percent, the operat- ing ratio and overall profitability of the PC insurer would be:

Operating ratio Combined ratio after divide� nnds Investment yield 109.7 12.0

�

� �

� 97.7 percent and

Overall profitability 100 Operating ratio

1

� �

� 000 97.7 2.3 percent

�

�

As can be seen, the high investment returns (12 percent) make the PC insurer prof- itable overall.

Given the importance of investment returns to PC insurers’ profitability, we can see from the balance sheet in Table 3–5 that bonds—both Treasury and cor- porate—dominated the asset portfolios of PC insurers. Bonds constituted 56.8 percent of total assets and 72.8 percent of financial assets (so-called unaffiliated investments) in 2006.

Finally, if losses, expenses, and other costs are higher and investment yields are lower than expected so that operating losses are incurred, PC insurers carry a significant amount of surplus reserves (policyholder surplus) to reduce the risk of insolvency. In 2006, the ratio of policyholder surplus to assets was 31.2 percent.

Recent Trends While catastrophes should be random, the period 1987–2006 was characterized by a number of catastrophes of historically high severity, as shown in Figure 3–3 . As a result, the period 1987–2006 was not very profitable for the PC industry. In particular, the combined ratio (the measure of loss plus expense risk) increased from 104.6 in 1987 to 115.7 in 1992. (Remember that a combined ratio higher than 100 is bad in that it means that losses, expenses, and dividends totaled more than premiums earned.) The major reason for this rise was a succession of catastrophes from Hurricane Hugo in 1989, the San Francisco earthquake in 1991, the Oakland fires of 1991, and the almost $20 billion in losses incurred in Florida as a result of Hurricane Andrew in 1991. In the terminology of PC insurers, the industry was in the trough of an underwriting cycle, or underwriting conditions were hard. These cycles are characterized by periods of rising premiums leading to increased profitability. Following a period of solid but not spectacular rates of returns, the industry enters a down phase in which premiums soften as the sup- ply of insurance products increases. Most analysts agree that a cycle that affects all lines simultaneously is unlikely. However, variations in premiums and profit- ability among individual lines and sectors will continue. As an example of how

underwriting cycle The tendency of prof- its in the PC industry to follow a cyclical pattern.

underwriting cycle The tendency of prof- its in the PC industry to follow a cyclical pattern.

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Chapter 3 The Financial Services Industry: Insurance Companies 83

bad things can be in this industry, after 20 years of profits, Lloyd’s of London (arguably one of the world’s most well known and respected insurers) posted a £510 million loss in 1991. 8

In 1993 the industry showed signs of improvement, with the combined ratio falling to 106.9. However, in 1994 that ratio rose again to 108.4, partly as a result of the Northridge earthquake with estimated losses of $7 billion to $10 billion. The industry ratio fell back down to 101.6 in 1997. However, major losses associ- ated with El Niño (e.g., Hurricane Georges and Midwest storms) drove the com- bined ratio back up to 105.6 in 1998. The combined ratio increased even further to 107.9 in 1999 and 110.5 in 2000. Part of these increases is attributable to an increase in amounts paid on asbestos claims. In 1999, $3.4 billion was paid out on these claims, the largest payouts ever. The Insurance Services Office, Inc., estimates that the combined ratio for 1999, 107.9, would have been one percentage point lower without these claims. Also affecting the profitability of the insurance industry (both life and health and PC) has been the introduction of technology and insur- ance services offered on the Internet. In 2000, insurers spent more than $12 billion on technological investments, equal to about 4 percent of premiums written and 16 percent of their controllable expenses. The investment in technology was intended to both manage customer relations and reduce operating costs (by some estimates as much as 70 percent).

The year 2001 saw yet another blow to the insurance industry and the world with the terrorist attacks on the World Trade Center and the Pentagon. Early esti- mates of the costs of these attacks to insurance companies were as high as $40 bil- lion. It was estimated that only 10 percent of the September 11 losses were reported in 2001, and yet the losses attributed to the terrorist attacks added an estimated 4 percentage points to the combined ratio after dividends of 116.0. Because of the tremendous impact these attacks had on the health of the U.S. insurance industry, the Bush administration proposed that the U.S. government pay the majority of the losses of the insurance industry due to the attacks. The proposal capped insur- ers’ 2002 liabilities at $12 billion, 2003 liabilities at $23 billion, and 2004 liabilities at $36 billion. Despite this bailout of the industry, many insurers did not survive and those that did were forced to increase premiums significantly.

The traditional reaction to losses or poor profit results has been the exit from the industry—through failure or acquisition—of less profitable firms and a rapid increase in premiums among the remaining firms. Historically, this has resulted in a fall in the combined ratio as premiums rise and an improvement occurs in the operating ratio and PC industry profitability. In the late 1990s and early 2000s, the PC industry was in a phase of firm exit and consolidation consistent with the initial upward phase of the profitability cycle.

After several tumultuous years, 2003 saw profitability in the PC industry improve. The combined ratio after dividends was 100.1, down sharply from 107.2 in 2002, and much better than most analysts and industry experts expected. The 2003 results were the best since 1979, when the combined ratio was 100.6. However, 2004 saw an increase in losses for the PC industry as Florida and the East coast were hit with several major hurricanes including Hurricanes Charley,

8 As explained by Lloyd’s management, the loss was a result of four years of unprecedented disaster claims. As a result of their losses, a group of Lloyd’s investors sued the company for negligence in their business operations (some of these cases were still working their way through the legal system in the late 1990s).

www.iso.com www.iso.com

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84 Part One Introduction

Catastrophe

Hurricane Katrina Terrorist attacks on WTC and Pentagon Florida Hurricanes Hurricane Andrew Hurricane Wilma Northridge earthquake Hurricane Rita Hurricane Hugo Midwest tornadoes Hurricane Georges Hurricane Betsy Hurricane Opal Blizzard of 1996 Hurricane Iniki Blizzard of 1993 Hurricane Floyd Hurricane Fran

Year

2005

2001 2004 1992 2005 1994 2005 1989 2003 1998 1965 1995 1996 1992 1993 1999 1995

$40,600

40,000 25,000 19,900 10,300

7,200 5,627 4,939 3,100 2,900 2,346 2,100 2,000 1,646 1,625 1,600 1,600

Amount ($ millions) Catastrophe

Hurricane Frederic Wind, hail, tornadoes Minnesota storms Freeze Oakland fire Hurricane Cecelia Wind California earthquake Midwest drought Texas hailstorm Midwest storms Hurricane Isabel Hurricane Alicia L.A. riots

Year

1979 1974 1998 1983 1991 1970 1950 1989 2000 1995 1998 2003 1983 1992

$1,575 1,395 1,300 1,280 1,273 1,169 1,136 1,130 1,100 1,100 1,000 1,000

983 797

Amount ($ millions)

$15

$10

$5

$0 1949 20021956 1961 1966 1969 1973 1975 1977 1979 1980 1982 1984 1986 1988 1989 1991 1992 1994 1995 1996 1998 2000 2001 2004 2005 20062003

Year

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FIGURE 3–3 U.S. Catastrophes, 1949–2006 Source: Richard L.sandor,Center Financial Products, 1949-1994; author’s reserch,1995-2006

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Chapter 3 The Financial Services Industry: Insurance Companies 85

Frances, Ivan, and Jeanne. The estimated losses from these four hurricanes were $25 billion. In 2005 the PC industry reported a combined ratio of 100.9. The losses resulted from $57.7 billion in catastrophe losses primarily resulting from the record-breaking hurricane season, which included losses from Hurricanes Katrina, Wilma, and Rita. These losses added an estimated 8 points to the indus- try’s combined ratio. If catastrophe losses are excluded, the combined ratios for 2005 and 2004 would have been 92.9 and 94.5, respectively. Losses from the record 2005 hurricane season prompted both Allstate and State Farm to stop writing new homeowner policies and drop some existing customers altogether. Finally, in 2006 a small level of catastrophic losses, combined with a strong performance in vir- tually all other major lines of PC insurance, resulted in a combined ratio of 93.2, the best underwriting performance since 1936. While the 2006 results are up sub- stantially from 2005, insurer profits remain highly volatile. It was just five years earlier, in 2001, that the PC industry suffered its worst year ever with a combined ratio of 116.0.

The federal government has gradually increased the role of providing compen- sation and reconstruction assistance following a variety of natural disasters such as the terrorist attacks of 9/11. Although the insurance industry has been stressed by major catastrophes, it has argued that government involvement in the market for catastrophe insurance should be minimized to avoid crowding out more effi- cient private market solutions, such as catastrophe bonds.

Regulation As with life insurance companies, PC insurers are chartered by states and regu- lated by state commissions. In addition, state guaranty funds provide some pro- tection to policyholders if an insurance company fails. The National Association of Insurance Commissioners (NAIC) also provides various services to state regu- latory commissions. These services include a standardized examination system called IRIS (Insurance Regulatory Information System) to identify insurers with loss, combined, and other ratios outside the normal ranges.

An additional burden that PC insurers face in some activity lines—especially auto insurance and workers’ compensation insurance—is rate regulation. That is, given the public utility nature of some insurance lines, state commissioners set ceilings on premiums and premium increases, usually based on specific cost of capital and line risk exposure formulas for the insurance suppliers. This had led some insurers to leave states such as New Jersey, Florida, and California, which have the most restrictive regulations.

More recently, as was the case with other sectors of the FI industry, PC insur- ance companies came under scrutiny for alleged inconsistencies in fees paid to brokers and consultants for arranging certain policies (see the Ethical Dilemmas box). The inconsistencies became public when the New York Attorney General’s Office sent subpoenas to several PC insurance brokers instructing them to save all relevant documents.

Further, the industry came under attack for the way it handled homeowners’ claims associated with Hurricane Katrina. Homeowners policies excluded dam- age caused by flooding. Insurers insisted the storm surge from Hurricane Katrina was classified as a flood and that damage therefore was excluded from coverage under policy forms that had been reviewed by regulators in each state and in force for years. Lawyers for policyholders of State Farm Insurance Company claimed

www.naic.org www.naic.org

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86 Part One Introduction

that insurers were trying to avoid paying out on their homeowners policies by claiming the cause was a flood when it was a combination of hurricane winds and a storm surge. They claimed that the storm surge was not a flood but a direct result of the hurricane’s winds, which is a covered risk. Policyholders claimed that State Farm and other insurance companies used “deceptive” sales practices to sell those hurricane policies and collected extra premiums from them. A verdict in January 2007 not only held State Farm responsible for policy limits that totaled more than $220,000 on a loss deemed to be due to storm-surge flooding but also held the company liable for punitive damages.

Why do PC insurers hold more capital and reserves than do life insurers? Why are life insurers’ assets, on average, longer in maturity than those of PC insurers? Describe the main lines of insurance offered by PC insurers. What are the components of the combined ratio? How does the operating ratio differ from the combined ratio? Why does the combined ratio tend to behave cyclically?

GLOBAL ISSUES

Like the other sectors of the financial institutions industry, the insurance sector is becoming increasingly global. Table 3–7 lists the top 10 countries in terms of total premiums written in 2005 (in U.S. dollars) and their percentage share of the world market. Panel A lists the data for life insurers, while panel B lists the data for PC insurers. Table 3–8 lists the top 10 insurance companies worldwide by total revenues. While North America, Japan, and Western Europe dominate the global market, all regions are engaged in the insurance business and many insurers are engaged internationally.

Globalization has certainly affected the U.S. insurance market. In the mid- 2000s, insurers headquartered outside the United States accounted for over 10 percent of all premiums written in the United States. Because of lax regula- tions, such as lower capital regulations, many insurance companies have set up offices in the Cayman Islands and the Bahamas. Indeed, it has been esti- mated that 44 percent of the insurance companies selling life insurance in the Caribbean are from outside the region. The pressure of the global economy, the inability of local insurers to serve all domestic customers, and the domestic demand for better economic performance have caused governments around the world to introduce and accelerate insurance market reform. This includes improving insurance and insurance supervision by formulating common prin- ciples and practices across nations. One consequence of these changes is that there have been a number of mergers of insurance companies across country borders, such as the Dutch ING Group’s 2000 acquisition of the U.S. Aetna for $7.75 billion.

As with commercial banks, Japanese non–life insurance companies suffered severe losses in the early 2000s. Six of the nine major non–life insurance groups that announced earnings (for the April through December 2003 period) saw their net premiums drop relative to the prior year. The main factor in the decline was the sluggish performance of automobile insurance, which accounts for roughly half

1. 2. 3. 4. 5. 6.

Concept Questions Concept Questions

£ $ ¥

:

£ $ ¥

:

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Chapter 3 The Financial Services Industry: Insurance Companies 87

Rank Country Premiums Written

(US$ billions) Share of

World Market

Panel A: Life Insurers

1 United States $517.1 26.2% 2 Japan 376.0 19.1 3 United Kingdom 199.6 10.1 4 France 154.1 7.8 5 Italy 91.7 4.6 6 Germany 90.2 4.6 7 South Korea 58.8 3.0 8 China 39.6 2.0 9 Taiwan 38.8 2.0

10 Canada 34.5 1.8

Panel B: Property–Casualty Insurers

1 United States $625.8 43.1% 2 Germany 100.7 6.9 3 United Kingdom 100.6 6.9 4 Japan 100.5 6.9 5 France 68.2 4.7 6 Italy 47.5 3.3 7 Canada 44.3 3.1 8 Spain 34.8 2.4 9 Netherlands 29.2 2.0

10 Australia 24.3 1.7

TABLE 3–7 The World’s Top Countries in Terms of Insurance Premiums Written

Source: Swiss Re, sigma No 3/2006.

Rank Company Revenues

(US$ millions) Home Country

Panel A: Life Insurers

1 ING Group $138,235 Netherlands 2 AXA Group 129,839 France 3 Assicurazioni Generali 101,404 Italy 4 Aviva 92,579 United Kingdom 5 Prudential 74,745 United Kingdom 6 Nippon Life Insurance 61,158 Japan 7 Legal General Corp. 56,385 United Kingdom 8 CNP Assurances 48,475 France 9 MetLife 46,983 United States

10 Dai-Ichi Mutual Life 44,598 Japan

Panel B: Property–Casualty Insurers

1 Allianz $121,406 Germany 2 American International Group 108,905 United States 3 Berkshire Hathaway 81,663 United States 4 Zurich Financial Services 67,186 Switzerland 5 Munich Re Group 60,256 Germany 6 State Farm Insurance 59,224 United States 7 Allstate 35,383 United States 8 Millea Holdings 30,030 Japan 9 Swiss Reinsurance 28,093 Switzerland

10 Hartford Financial Services 27,083 United States

TABLE 3–8 World’s Largest Insurance Companies by Total Revenues

Source: Insurance Informa- tion Institute Web site, 2007. www.iii.org

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88

the revenue for these firms. The total net premiums of the nine groups declined 0.5 percent on the year to ¥4.9 trillion (US$46.4 billion). Life insurers did not fare much better. In 2004, many Japanese life insurers took steps to boost reserves and repair their capital bases after two very difficult years. By the mid-2000s, however, Japanese insurers increased their solvency margins as premium income rose, the number of policy cancelations declined, and the rising stock markets generated unrealized capital gains.

This chapter examined the activities and regulation of insurance companies. The first part of the chapter described the various classes of life insurance and recent trends. The second part covered property–casualty companies. The various lines that make up property–casualty insurance are becoming increasingly blurred as multiple-activity line coverages are offered. Both life and property–casualty insur- ance companies are regulated at the state rather than the federal level. In addition, both are coming under threat from other financial service firms that offer similar or competitive products.

Summary Summary

SPITZER STUDIES NEW CONFLICTS ON INSURANCE

Insurance companies routinely pay fees to brokers and consultants who advise employers on where to buy policies for workers, a little-noticed potential conflict that appears to fall within the scope of New York Attorney General Eliot Spitzer’s investigation of the industry. Since Mr. Spitzer’s inquiry became public last month, most attention has focused on insurance companies paying brokers and consultants for arranging certain property-and-casualty insurance policies, not employee life-insurance and health ben- efit plans. At issue is whether these fees compromise the independence of the bro- kers and consultants, who are supposed to provide unbiased advice to their corporate clients on where to get the best insurance deal. The fees typically reward brokers and consultants for bringing volume business to a carrier. . . .

Critics say these fees can compromise a broker’s independence, particularly when they aren’t fully disclosed. As agents of the insurance buyer, brokers and consultants are supposed to represent a client’s best interests: undisclosed payment directly from an insurance carrier could provide reasons to place business with a particular carrier at variance with the client’s best interest. . . . Undisclosed fees from arranging employee benefits mean workers themselves could be the ultimate loser, the critics say. That is because many group-benefit programs let employees buy additional coverage with their own money. Additional payments from an insurer to consultants and brokers would likely be built into the premium structures that these employees must pay.

There are concerns for employers as well: Under federal law, they have a fiduciary responsibility to their employees for the benefits they provide. “If there are silent deals out there or secret deals, those have a direct impact to employees’ costs,” said Terry Havens, managing partner of Havensure, a Cincinnati employee-benefits consult- ing firm. . . . “That’s real damage to real people,” Mr. Havens said. But many employers may not be aware of the payments, current and former consultants say. “Most of the time it’s not disclosed. . . .” A former consultant who now manages a corporation’s employee benefits from in-house explained that such payments may not show up in the typical disclosures to employers because they don’t stem from any single client, but rather from the total business that a consultant places with the insurer. . . .

Source: Theo Francis, The Wall Street Journal, May 5, 2004, p. C1, Reprinted by permission of The Wall Street Journal. © 2004 Dow Jones & Company, Inc. All rights reserved worldwide. www.wsj.com

Ethical Dilemmas

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Chapter 3 The Financial Services Industry: Insurance Companies 89

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What is the primary function of an insurance company? How does this function compare with the primary function of a depository institution? What is the adverse selection problem? How does adverse selection affect the profitable management of an insurance company? What are the similarities and differences among the four basic lines of life insur- ance products? Explain how annuity activities represent the reverse of life insurance activities. Explain how life insurance and annuity products can be used to create a steady stream of cash disbursements and payments to avoid paying or receiving a sin- gle lump-sum cash amount. a. Calculate the annual cash flows of a $1 million, 20-year fixed-payment annu-

ity earning a guaranteed 10 percent per year if payments are to begin at the end of the current year. Calculate the annual cash flows of a $1 million, 20-year fixed-payment annuity earning a guaranteed 10 percent per year if payments are to begin at the end of year 5. What is the amount of the annuity purchase required if you wish to receive a fixed payment of $200,000 for 20 years? Assume that the annuity will earn 10 percent per year.

You deposit $10,000 annually into a life insurance fund for the next 10 years, after which time you plan to retire.

If the deposits are made at the beginning of the year and earn an interest rate of 8 percent, what will be the amount of retirement funds at the end of year 10? Instead of a lump sum, you wish to receive annuities for the next 20 years (years 11 through 30). What is the constant annual payment you expect to re- ceive at the beginning of each year if you assume an interest rate of 8 percent during the distribution period? Repeat parts (a) and (b) above assuming earning rates of 7 percent and 9 percent during the deposit period and earning rates of 7 percent and 9 percent during the distribution period. During which period does the change in the earning rate have the greatest impact?

a. Suppose a 65-year-old person wants to purchase an annuity from an insur- ance company that would pay $20,000 per year until the end of that person’s life. The insurance company expects this person to live for 15 more years and would be willing to pay 6 percent on the annuity. How much should the insurance company ask this person to pay for the annuity? A second 65-year-old person wants the same $20,000 annuity, but this person is much healthier and is expected to live for 20 years. If the same 6 percent interest rate applies, how much should this healthier person be charged for the annuity? In each case, what is the difference in the purchase price of the annuity if the distribution payments are made at the beginning of the year?

Contrast the balance sheet of a life insurance company with the balance sheet of a commercial bank and with that of a savings institution. Explain the balance sheet differences in terms of the differences in the primary functions of the three organizations.

1.

2.

3.

4. 5.

6.

b.

c.

7.

a.

b.

c.

8.

b.

c.

9.

Questions and Problems Questions and Problems

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90 Part One Introduction

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Using the data in Table 3–2 , how has the composition of assets of U.S. life insurance companies changed over time? How do life insurance companies earn a profit? How would the balance sheet of a life insurance company change if it offered to run a private pension fund for another company? How does the regulation of insurance companies differ from the regulation of depository institutions? What are the major pieces of life insurance regulatory legislation? How do state guarantee funds for life insurance companies compare with deposit insurance for commercial banks and thrifts? What are the two major activity lines of property–casualty insurance firms? How have the product lines of property–casualty insurance companies changed over time? Contrast the balance sheet of a property–casualty insurance company with the balance sheet of a commercial bank. Explain the balance sheet differences in terms of the differences in the primary functions of the two organizations. What are the three sources of underwriting risk in the property–casualty insurance industry? How do unexpected increases in inflation affect property–casualty insurers? Identify the four characteristics or features of the perils insured against by property–casualty insurance. Rank the features in terms of actuarial predict- ability and total loss potential. Insurance companies will charge a higher premium for which of the insurance lines listed below? Why?

Low-severity, high-frequency lines versus high-severity, low-frequency lines. Long-tail lines versus short-tail lines.

What does the loss ratio measure? What has been the long-term trend of the loss ratio? Why? What does the expense ratio measure? Identify and explain the two major sources of expense risk to a property–casualty insurer. Why has the long-term trend in this ratio been decreasing? How is the combined ratio defined? What does it measure? What is the investment yield on premiums earned? Why has this ratio become so important to property–casualty insurers? Consider the data in Table 3–6 . Since 1980, what has been the necessary invest- ment yield for the industry to enable the operating ratio to be less than 100 in each year? How is this requirement related to the interest rate risk and credit risk faced by a property–casualty insurer? An insurance company’s projected loss ratio is 77.5 percent, and its loss ad- justment expense ratio is 12.9 percent. The company estimates that commis- sion payments and dividends to policyholders will be 16 percent. What must be the minimum yield on investments to achieve a positive operating ratio? a. What is the combined ratio for a property insurer that has a loss ratio of 73

percent, a loss adjustment expense of 12.5 percent, and a ratio of commis- sions and other acquisition expenses of 18 percent? What is the combined ratio adjusted for investment yield if the company earns an investment yield of 8 percent?

10.

11. 12.

13.

14.

15. 16.

17.

18.

19. 20.

21.

a.

b. 22.

23.

24. 25.

26.

27.

28.

b.

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Chapter 3 The Financial Services Industry: Insurance Companies 91

An insurance company collected $3.6 million in premiums and disbursed $1.96 million in losses. Loss adjustment expenses amounted to 6.6 percent, and dividends paid to policyholders totaled 1.2 percent. The total income gen- erated from the company’s investments was $170,000 after all expenses were paid. What is the net profitability in dollars?

Go to the FDIC Web site at www.federalreserve.gov and find the most recent distribution of life insurance industry assets for Table 3–2 . Click on “Economic Research and Data.” Click on “Statistics: Releases and Historical Data.” Click on “Flow of Fund Accounts of the United States,” “Releases.” Click on the most recent date. Click on “Level tables.” This will bring the file (Table L.117) onto your computer that contains the relevant data. How have the values of government securities, corporate securities, mortgages, and policy loans changed since 2006? Go to the Insurance Information Institute’s Web site at www.iii.org and use the following steps to find the most recent data on the largest life insurance companies by total revenue. Click on “Facts and Statistics.” Click on “Financial Services.” Click on “ www.financialservicesfacts.org .” Click on “Life/Health: Financial.” This will bring the file onto your computer that contains the rel- evant data. What are total revenues and assets of the top 10 life insurance companies?

S&P Questions

Go to the Standard & Poor’s Market Insight Web site at www.mhhe.com/ edumarketinsight and identify the industry description and industry con- stituents for life and health insurance and property–casualty insurance using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Industry.” From the industry list, select “Life & Health Insurance.” Click on “Go!” Click on “GICS Sub-Industry Profile” and separately, “GICS Sub-Industry Constituents.” Repeat these steps selecting “Property & Casualty” from the industry list. Go to the Standard & Poor’s Market Insight Web site at www.mhhe.com/edu- marketinsight and find the most recent balance sheets for Allstate Corporation (ALL) and Cigna (CI) using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Company.” Enter “ALL” in the “Ticker:” box and click on “Go!” Click on “Excel Analytics.” Click on “FS Ann. Balance Sheet.” This will download the balance sheet for Allstate, which contains the balances for total equity and total assets. Repeat the process by entering “CI” in the “Ticker:” box to get in- formation on Cigna. Compare the equity ratio for these companies from their balance sheets with that for the property–casualty insurance industry, as listed in Table 3–5 .

29.

30.

31.

32.

33.

Web QuestionsWeb Questions

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92 Part One Introduction

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A. M. Best www.ambest.com Board of Governors of the Federal Reserve www.federalreserve.gov Insurance Information Institute www.iii.org Insurance Services Offices, Inc. www.iso.com National Association of Insurance Commissioners www.naic.org State of New York Insurance Guaranty Fund www.ins.state.ny.us The Wall Street Journal www.wsj.com

Pertinent Web SitesPertinent Web Sites

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93

Chapter Four

The Financial Services Industry: Securities Firms and Investment Banks

INTRODUCTION

Investment banking involves the raising of debt and equity securities for corpora- tions or governments. This includes the origination, underwriting, and placement of securities in money and capital markets for corporate or government issuers. Securities services involve assistance in the trading of securities in the second- ary markets (brokerage services and/or market making). Together these services are performed by the securities firms and investment banking industry. The larg- est companies in this industry perform both sets of services (i.e., underwriting and brokerage services). These full-line firms (e.g., Merrill Lynch) are generally called investment banks. Many other firms concentrate their services in one area only (either securities trading or securities underwriting). That is, some firms in the industry specialize in the purchase, sale, and brokerage of existing securities (the retail side of the business) and are called securities firms, while other firms spe- cialize in originating, underwriting, and distributing issues of new securities (the commercial side of the business) and are called investment banks.

Investment banking also includes corporate finance activities such as advising on mergers and acquisitions (M&As), as well as advising on the restructuring of existing corporations. Figure 4–1 reports merger activity for the period 1990–2006. Total dollar volume (measured by transaction value) of domestic M&As increased from less than $200 billion in 1990 to $1.83 trillion in 2000 (reflecting 10,864 deals). This merger wave was not restricted to the United States. For example, in 2000 there were over 36,700 merger and acquisition deals globally, valued at over $3.49 trillion. However, reflecting the downturn in the U.S. economy, M&A transac- tions fell 53 percent in 2001 to $819 billion on only 7,525 deals (the first time since 1995 there were fewer than 10,000 deals). Similarly, worldwide M&As fell to $1.74 trillion in 2001. Domestic M&A activity bottomed out at $458 billion in 2002 (while worldwide activity fell to $1.2 trillion) before recovering (along with the

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94 Part One Introduction

economy), topping $1.3 trillion in the United States (and $2.9 trillion worldwide) in 2006.

In this chapter we present an overview of (1) the size, structure, and composi- tion of the industry, (2) the balance sheet and recent trends, and (3) the regulation of the industry. After studying the chapter, the reader should have a basic under- standing of the services provided by securities firms and investment banks, as well as the major trends in the industry.

1990 1992 1994 1996 1998

$ 2,000 billion

1,900

1,800

1,700

1,600

1,500

1,400

1,300

1,200

1,100

1,000

900

800

700

600

500

400

300

200

100

0

2000 2002 2004 2006

Total value of mergers and acquisitions in the United States (in billions of dollars)

FIGURE 4–1 Attracting Partners

Source: Thomson Financial Securities Data, 2007. www.thomson.com

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 95

SIZE, STRUCTURE, AND COMPOSITION OF THE INDUSTRY

Because of the emphasis on securities trading and underwriting, the size of the industry is usually measured by the equity capital of the firms participat- ing in the industry. Securities trading and underwriting is a financial service that requires no investment in assets or liability funding (such as the issuance of loans funded through deposits or payments on insurance contracts funded through insurance premiums). Rather, securities trading and underwriting is a profit-generating activity that does not require FIs to actually hold or invest in the securities they trade or issue for their customers, except for very short periods either as part of their trading inventory or during the underwriting period for new issues. Accordingly, asset value is not traditionally a measure of the size of a firm in this industry. Instead, the equity or capital of the FI is used as the most common benchmark of relative size. Equity capital in this industry amounted to $164.1 billion at the beginning of 2006, supporting total assets of $5.22 trillion.

Beginning in 1980 and extending up to the stock market crash of October 19, 1987, the number of firms in the industry expanded dramatically from 5,248 to 9,515. The aftermath of the crash saw a major shakeout, with the number of firms declining to 6,016 by 2006, a decline of 37 percent since 1987. Concentration of business among the largest firms over this period has increased dramatically. The largest investment bank in 1987, Salomon Brothers, held capital of $3.21 bil- lion. By 2006 the largest investment banks, Merrill Lynch and Morgan Stanley, held capital of $35.5 billion and $35.4 billion, respectively. Some of the significant growth in size has come through M&As among the top ranked firms. Table 4–1 lists major U.S. securities industry M&A transactions, many of which involve repeated ownership changes of the same company. Notice from this table that most of the major mergers occurred in 1997 through 2000. Notice too how many recent mergers and acquisitions have been interindustry mergers (i.e., insur- ance companies and investment banks). Recent regulatory changes such as the Financial Services Modernization Act of 1999 (discussed in Chapter 2 and described in more detail in Chapter 21) are a primary cause for such mergers. In fact, note in Table 4–1 that a majority of the securities’ industry mergers and acquisitions occurring in the 2000s include securities firms that are a part of a financial services holding company.

The firms in the industry can be divided along a number of dimensions. First are the largest firms, the so-called national full-line firms, which service both retail customers (especially in acting as broker–dealers, thus assisting in the trading of existing securities) and corporate customers (such as underwriting, thus assist- ing in the issue of new securities). The major (ranked by capital) national full- line firms are Merrill Lynch and Morgan Stanley. In 1997 Morgan Stanley, ranked sixth in size of capital, and Dean Witter Discover, ranked fifth in capital size, merged to create one of the largest investment banks in the world. Second are the national full-line firms that specialize more in corporate business with cus- tomers and are highly active in trading securities. Examples are Goldman Sachs and Salomon Brothers/Smith Barney, the investment banking arm of Citigroup

broker–dealers Assist in the trading of existing securities.

broker–dealers Assist in the trading of existing securities.

broker–dealers Assist in the trading of existing securities.

broker–dealers Assist in the trading of existing securities.

underwriting Assisting in the issue of new securities.

underwriting Assisting in the issue of new securities.

underwriting Assisting in the issue of new securities.

underwriting Assisting in the issue of new securities.

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96 Part One Introduction

(created from the merger of Travelers and Citicorp in 1998). Third, the rest of the industry comprises:

Specialized investment bank subsidiaries of commercial bank holding compa- nies (such as J. P. Morgan Chase). 1 Specialized discount brokers that effect trades for customers on- or offline without offering investment advice or tips (such as Charles Schwab). 2 Regional securities firms that are often subdivided into large, medium, and small categories and concentrate on servicing customers in a particular region, e.g., New York or California (such as Deutsche Bank Alex Brown, Inc.). Specialized electronic trading securities firms (such as E*trade) that provide a platform for customers to trade without the use of a broker. Rather, trades are enacted on a computer via the Internet.

1 These so-called Section 20 subsidiaries are discussed in more detail in Chapter 21. Since 1987 bank holding companies have been allowed to establish special investment bank subsidiaries (Section 20 subsidiaries) that can underwrite corporate debt and equity on the same terms as investment banks (since 1999). Section 20 subsidiaries are rapidly being phased out as banking organizations became full-service universal banks by es- tablishing financial service holding companies under the 1999 Financial Services Modernization Act.

2 Discount brokers usually charge lower commissions than do full-service brokers such as Merrill Lynch.

1.

2.

3.

4.

discount brokers Stockbrokers that conduct trades for customers but do not offer investment advice.

discount brokers Stockbrokers that conduct trades for customers but do not offer investment advice.

discount brokers Stockbrokers that conduct trades for customers but do not offer investment advice.

discount brokers Stockbrokers that conduct trades for customers but do not offer investment advice.

Rank Deal Price ($ billions) Year

1 Citicorp merges with Travelers (which owns Smith Barney and Salomon). $83.0 1998

2 Bank of America acquires FleetBoston.* 49.3 2003 3 J. P. Morgan acquires Bank One.* 60.0 2004 4 Chase acquires J. P. Morgan.* 35.0 2000 5 Bank of America acquires MBNA.* 35.0 2005 6 Wachovia acquires Golden West Financial.* 25.5 2006 7 Wachovia acquires Southtrust.* 14.3 2004 8 UBS acquires Paine Webber Group. 12.0 2000 9 Credit Suisse First Boston acquires Donaldson

Lufkin Jenrette. 11.5 2000 10 Dean Witter merges with Morgan Stanley.† 10.2 1997 11 Deutsche Bank acquires Bankers Trust.* 10.1 1998 12 Travelers acquires Salomon Inc. 9.0 1997 13 Region’s Financial acquires AmSouth.* 10.0 2006 14 Goldman Sachs acquires Spear, Leeds & Kellogg. 6.5 2000 15 Sears spins off Dean Witter, Discover. 5.0 1993 16 Bankers Trust acquires Alex Brown. 2.1 1997 17 Mellon Bank acquires Dreyfus. 1.8 1993 18 American Express spins off Lehman Bros. Holdings. 1.6 1994 19 Fleet Financial acquires Quick and Reilly. 1.6 1997 20 Chase acquires Hambrecht & Quist. 1.3 1998 21 Primerica acquires Shearson. 1.2 1993 22 NationsBank acquires Montgomery Securities. 1.2 1997 23 First Union acquires Everen Capital. 1.2 1999

* These organizations own Section 20 securities subsidiaries and/or are established financial service holding companies un- der the 1999 Financial Services Modernization Act.

† Value of Dean Witter, Discover shares to be exchanged for Morgan Stanley stock, based on closing price of $40.625 on Febru- ary 5, 1997.

TABLE 4–1 Major U.S. Securities Industry Merger and Acquisition Transactions

Source: Thomson Financial Securities Data; The Wall Street Journal; and author’s figures.

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 97

Venture capital firms that pool money from individual investors and other FIs (e.g., hedge funds, pension funds, and insurance companies) to fund relatively small and new businesses (e.g., in biotechnology). 3 Securities firms and investment banks engage in as many as seven key activity

areas. Note that while each activity is available to a firm’s customers indepen- dently, many of these activities can be and are conducted simultaneously, such as mergers and acquisitions financed by new issues of debt and equity underwritten by the M&A advising firm.

1. Investing Investing involves managing not only pools of assets such as closed- and open end mutual funds but also pension funds in competition with life insurance com- panies. Securities firms can manage such funds either as agents for other investors or as principals for themselves. The objective in funds management is to choose asset allocations to beat some return-risk performance benchmark such as the S&P 500 index. 4 Since this business generates fees that are based on the size of the pool of assets managed, it tends to produce a more stable flow of income than does either investment banking or trading (discussed next).

2. Investment Banking Investment banking refers to activities related to underwriting and distributing new issues of debt and equity. New issues can be either primary, the first-time issues of companies (sometimes called IPOs [initial public offerings]), or secondary issues (the new issues of seasoned firms whose debt or equity is already trading). In recent years public confidence in the integrity of the IPO process has eroded significantly. Investigations have revealed that certain underwriters of IPOs have engaged in conduct contrary to the best interests of investors and the markets. Among the most harmful practices that have given rise to public concerns are spinning (in which certain underwriters allocate “hot” IPO issues to directors and/or executives of potential investment banking clients in exchange for invest- ment banking business) and biased recommendations by research analysts (due to their compensation being tied to the success of their firms’ investment banking business). We discuss these issues and some of the legal proceedings resulting from these practices below. 5

Table 4–2 lists the top five underwriters of global debt and equity for 2006 and 2005. The top five common stock underwriters represented 33.3 percent of the industry total, suggesting that the industry is dominated by a handful of top- tier underwriting firms. Top-tier rating and the implied reputation this brings has a huge effect in this business. At times, investment banks have refused to participate in an issue because their name would not be placed where they desired it on the “tombstone” advertisement announcing the issue and its major underwriters.

3 Venture capital firms generally play an active management role in the firms in which they invest, often including a seat on the board of directors, and hold significant equity stakes. This differentiates them from traditional banking and securities firms.

4 Or the “securities market line” given the fund’s “beta.”

5 R. Aggarwal, N. R. Prabhala, and M. Puri, in “Institutional Allocation in Initial Public Offerings: Empirical Evidence,” The Journal of Finance, June 2002, pp. 1421–42, document a positive relationship between institutional allocation and day-one IPO returns. The result is partly explained by the practice of giving institutions more shares in IPOs with strong premarket demand.

5.

IPO An initial, or first time, public offering of debt or equity by a corporation.

IPO An initial, or first time, public offering of debt or equity by a corporation.

IPO An initial, or first time, public offering of debt or equity by a corporation.

IPO An initial, or first time, public offering of debt or equity by a corporation.

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98 Part One Introduction

Securities underwritings can be undertaken through either public offerings or private offerings. In a private offering, the investment banker acts as a private placement agent for a fee, placing the securities with one or a few large institu- tional investors such as life insurance companies. In a public offering, the securi- ties may be underwritten on a best-efforts or a firm commitment basis, and the securities may be offered to the public at large. With best-efforts underwriting, investment bankers act as agents on a fee basis related to their success in plac- ing the issue. In firm commitment underwriting, the investment banker acts as a principal, purchasing the securities from the issuer at one price and seeking to place them with public investors at a slightly higher price. Finally, in addition to investment banking operations in the corporate securities markets, the investment banker may participate as an underwriter (primary dealer) in government, munic- ipal, and asset-backed securities. Table 4–3 shows the top-ranked underwriters for 2006 and 2005 in the different areas of securities underwriting.

An investment banker agrees to underwrite an issue of 20 million shares of stock for Mur- ray Construction Corp. on a firm commitment basis. The investment banker pays $15.50 per share to Murray Construction Corp. for the 20 million shares of stock. It then sells those shares to the public for $16.35 per share. How much money does Murray Construction Corp. receive? What is the profit to the investment banker? If the investment bank can sell the shares for only $14.75, how much money does Murray Construction Corp. receive? What is the profit to the investment banker?

If the investment bank sells the stock for $16.35 per share, Murray Construction Corp. receives $15.50 � 20,000,000 shares = $310,000,000. The profit to the investment bank is ($16.35 � $15.50) � 20,000,000 shares = $17,000,000. The stock price of Murray Construc- tion Corp. is $16.35 since that is what the public agrees to pay. From the perspective of Murray Construction Corp., the $17 million represents the commission that it must pay to issue the stock.

If the investment bank sells the stock for $14.75 per share, Murray Construction Corp. still receives $15.50 � 20,000,000 shares = $310,000,000. The profit to the investment bank is ($14.75 � $15.50) � 20,000,000 shares = �$15,000,000. The stock price of Murray Con- struction Corp. is $14.75 since that is what the public agrees to pay. From the perspective of the investment company, the �$15 million represents a loss for the firm commitment it made to Murray Construction Corp. to issue the stock.

Suppose, instead, that the investment banker agrees to underwrite the 20 million shares on a best-efforts basis. The investment banker is able to sell 18 million shares for $15.50 per

EXAMPLE 4–1 Best Efforts versus Firm Commitment Securities Offering

private placement A securities issue placed with one or a few large institutional investors.

private placement A securities issue placed with one or a few large institutional investors.

private placement A securities issue placed with one or a few large institutional investors.

private placement A securities issue placed with one or a few large institutional investors.

Full Year 2006 Full Year 2005

Manager Amount (billions)

Market Share

Amount (billions) Rank

Market Share

Salomon Smith Barney* $ 666.8 8.7% $ 575.7 1 8.7% J. P. Morgan 506.1 6.6 436.7 2 6.6 Deutsche Bank 475.0 6.2 436.6 3 6.6 Morgan Stanley 454.6 6.0 390.4 5 5.9 Lehman Brothers 446.5 5.8 434.1 4 6.6 Top five $ 2,549.0 33.3% $ 2,273.5 34.4% Industry total $ 7,643.0 100.0% $ 6,616.8 100.0%

*Part of Citigroup.

TABLE 4–2 Top Underwriters of Global Debt and Equity

Source: Reprinted with permission of Thomson Fi- nancial Securities Data, 2007. www.thomson.com

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 99

share, and it charges Murray Construction Corp. $0.375 per share sold. How much money does Murray Construction Corp. receive? What is the profit to the investment banker? If the investment bank can sell the shares for only $14.75, how much money does Murray Con- struction Corp. receive? What is the profit to the investment banker?

If the investment bank sells the stock for $15.50 per share, Murray Construction Corp. receives ($15.50 � $0.375) � 18,400,000 shares = $278,300,000, the investment banker’s profit is $0.375 � 18,400,000 shares = $6,900,000, and the stock price is $15.50 per share since that is what the public pays.

If the investment bank sells the stock for $14.75 per share, Murray Construction Corp. receives ($14.75 � $0.375) � 18,400,000 shares = $264,500,000, the investment banker’s profit is still $0.375 � 18,400,000 shares = $6,900,000, and the stock price is $14.75 per share since that is what the public pays.

Go to the Thomson Financial Investment Banking/Capital Markets group Web site (www. thomson.com/solutions/financials) and find the latest information available for top under- writers of various securities using the following steps. Go to the Thomson Financial Invest- ment Banking/Capital Markets group Web site at www.thomson.com/solutions/financials. Under “xx Quarter League Tables,” click on “VIEW NOW.” Click on “Debt & Equity.” Under the most recent date, click on “Debt Capital Markets Review.” This will download a file onto your computer that will contain the most recent information on top underwriters for various securities.

Internet Exercise

3. Market Making Market making involves creating a secondary market in an asset by a securities firm or investment bank. Thus, in addition to being primary dealers in government securities and underwriters of corporate bonds and equities, investment bankers make a secondary market in these instruments. Market making can involve either agency or principal transactions. Agency transactions are two-way transactions on behalf of customers, for example, acting as a stockbroker or dealer for a fee or

Full Year 2006 Full Year 2005

Type Amount (billions)

Top-Ranked Manager

Amount (billions)

Top-Ranked Manager

Total debt $ 6,948.0 Citigroup $ 6,090.2 Citigroup Convertible debt 120.7 Citigroup 70.4 J. P. Morgan Investment-grade debt 918.9 Citigroup 672.0 Citigroup Mortgage-backed securities 1,403.6 Royal Bank of Scotland 1,225.8 Lehman Brothers Asset-backed securities 1,042.3 Citigroup 1,148.9 Lehman Brothers Common stock 574.1 Goldman Sachs 456.2 Citigroup IPOs 257.3 UBS 164.8 Credit Suisse Syndicated loans 3,881.3 J. P. Morgan 3,508.8 J. P. Morgan

TABLE 4–3 Who Is the Lead Underwriter in Each Market?

Source: Reprinted with permission of Thomson Financial Securities Data, 2007. www.thomson.com

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100 Part One Introduction

commission. On the NYSE, a market maker in a stock such as IBM may, upon the placement of orders by its customers, buy the stock at $78 from one customer and immediately resell it at $79 to another customer. The $1 difference between the buy and sell price is usually called the bid–ask spread and represents a large portion of the market maker’s profit. Many securities firms and investment banks offer online trading services to their customers as well as direct access to a client repre- sentative (stockbroker). Thus, customers may now conduct trading activities from their homes and offices through their accounts at securities firms at a lower cost in terms of fees and commissions. In the mid-2000s, there were also more than 100 purely electronic securities trading firms in existence. These firms, where at least $5,000 is generally required to open an account, offer investors (day traders) a desk and a computer with high-speed access to the stock markets. An estimated 10 mil- lion people used the facilities offered by electronic trading firms in the mid-2000s. Unfortunately, computer access to accounts has not been without its problems. For example, in September 2004 one-third of Wachovia Securities’ brokers, sales assistants, and other employees were blocked from logging on to their comput- ers. As the week wore on, the technology breakdowns escalated, with many frus- trated brokers unable to view clients’ accounts, place trades, or wire funds from their computers without using a backup system. Accordingly, technology risk is an increasingly important issue for these FIs (see Chapter 16).

In principal transactions, the market maker seeks to profit on the price move- ments of securities and takes either long or short inventory positions for its own account. (Or an inventory position may be taken to stabilize the market in the securities.) 6 In the example above, the market maker would buy the IBM stock at $78 and hold it in its own portfolio in expectation of a price increase later on. Normally, market making can be a fairly profitable business; however, in periods of market stress or high volatility, these profits can rapidly disappear. For exam- ple, on the NYSE, market makers, in return for having monopoly power in market making for individual stocks (e.g., IBM), have an affirmative obligation to buy stocks from sellers even when the market is crashing. This caused a number of actual and near bankruptcies for NYSE market makers at the time of the October 1987 market crash. On NASDAQ, which has a system of competing market mak- ers, liquidity was significantly impaired at the time of the crash and a number of firms had to withdraw from market making. Finally, the recent moves toward decimalization of equities markets in the United States (i.e., expressing quotes in integers of 1 cent [e.g., $50.32] rather than rounding to eighths [e.g., 503/8]) has cut into traders’ profits, as has competition from Internet-based or electronic-based exchanges such as The Island ECN and GlobeNet ECN.

4. Trading Trading is closely related to the market-making activities just described, where a trader takes an active net position in an underlying instrument or asset. There are at least four types of trading activities:

Position trading involves purchasing large blocks of securities on the expectation of a favorable price move. Such positions also facilitate the smooth functioning of the secondary markets in such securities. In most cases, these trades are held in inventory for a period of time, either after or prior to the trade.

6 In general, full-service investment banks can become market makers in stocks on the NASDAQ, but they have been prevented until recently from acting as market-making specialists on the NYSE.

1.

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 101

Pure arbitrage entails buying an asset in one market at one price and selling it immediately in another market at a higher price. Pure arbitrage “locks in” profits that are available in the market. This profit position usually occurs with no equity investment, the use of only very short-term borrowed funds, and re- duced transaction costs for securities firms. Risk arbitrage involves buying blocks of securities in anticipation of some in- formation release, such as a merger or takeover announcement or a Federal Reserve interest rate announcement. 7 Program trading is defined by the NYSE as the simultaneous buying and sell- ing of a portfolio of at least 15 different stocks valued at more than $1 million, using computer programs to initiate such trades. Program trading is often as- sociated with seeking a risk arbitrage between a cash market price (e.g., the Standard & Poor’s 500 Stock Market Index) and the futures market price of that instrument. 8

As with many activities of securities firms, such trading can be conducted on behalf of a customer as an agent (or broker), or on behalf of the firm as a principal.

5. Cash Management Investment banks offer bank deposit–like cash management accounts (CMAs) to individual investors and since the 1999 Financial Services Modernization Act, deposit accounts themselves (Merrill Lynch was the first investment bank to offer a direct deposit account in June 2000, via the two banks it owns). Most of these CMAs allow customers to write checks against some type of mutual fund account (e.g., money market mutual fund). These accounts, when issued in association with commercial banks and thrifts, can even be covered by federal deposit insur- ance from the FDIC. CMAs were adopted by other security firms under various names (e.g., house account) and spread rapidly. Many of these accounts offer ATM services and debit cards. As a result of CMAs, the distinction between commercial banks and investment banks became blurred. However, the advantage of broker- age firm CMAs over commercial bank deposit accounts is that they make is eas- ier to buy and sell securities. The broker can take funds out of the CMA account when an investor buys a security and deposit funds back into the CMA when the investor sells securities. CMAs were instrumental in the securities industry’s efforts to provide commercial banking services prior to the 1999 Financial Services Modernization Act. Since the passage of this regulation, securities firms are allowed to make loans, offer credit and debit cards, provide ATM services, and, most importantly, sell securities.

6. Mergers and Acquisitions Investment banks are frequently involved in providing advice or assisting in mergers and acquisitions. For example, they will assist in finding merger partners, underwriting new securities to be issued by the merged firms, assessing the value of target firms, recommending terms of the merger agreement, and even helping

7 It is termed risk arbitrage because if the event does not actually occur—for example, if a merger does not take place or the Federal Reserve does not change interest rates—the trader stands to lose money.

8 An example would be buying the cash S&P index and selling futures contracts on the S&P index. Since stocks and futures contracts trade in different markets, their prices are not always equal. Moreover, pro- gram trading can occur between futures and cash markets in other assets, for example, commodities.

2.

3.

4.

cash management accounts Money market mu- tual funds sold by in- vestment banks; most CMAs offer check- writing privileges.

cash management accounts Money market mu- tual funds sold by in- vestment banks; most CMAs offer check- writing privileges.

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102 Part One Introduction

target firms prevent a merger (for example, seeing that poison-pill provisions are written into a potential target firm’s securities contracts). As noted in the intro- duction to this chapter, U.S. merger and acquisition activity stood at $1.3 trillion in 2006. Panel A of Table 4–4 lists the top 10 investment bank merger advisors ranked by dollar volume of the mergers in which they were involved. 9 Panel B of Table 4–4 lists the top 10 investment banks ranked by dollar volume of worldwide M&A activity. Notice that many of the top U.S.-ranked investment banks reported in panel A of Table 4–4 are also top-ranked for worldwide activity in panel B.

9 Often, in addition to providing M&A advisory services, an investment banker will be involved in under- writing new securities that help finance an M&A. See L. Allen, J. Jagtiani, S. Peristiani and A. Saunders, “The Role of Financial Advisors in Mergers and Acquisitions,” Journal of Money, Credit, and Banking 36 , no. 2 (April 2004), pp. 197–224. A. Saunders and A. Srinivasan, in “Investment Banking Relationships and Merger Fees,” 2002, Working Paper, New York University, find that acquiring firms perceive benefits of retaining merger advisors with whom they have had a prior relationship (even at a cost of higher fees) and/or they face some other (higher) costs of switching to new bank advisors. Finally, V. Ivashina, V. Nair, A. Saunders, N. Massoud, and R. Stover, in “The Role of Banks in Takeovers,” 2004, Working Paper, New York University, show that banks use the information generated in lending to increase the probability of takeovers.

Panel A: Mergers Completed in U.S.

Rank Investment Bank Value

($ billions) Number of Deals

1 Goldman Sachs $ 496.0 152 2 J. P. Morgan 417.1 155 3 Morgan Stanley 379.6 132 4 Citigroup 358.9 127 5 Lehman Brothers 356.8 113 6 Merrill Lynch 266.1 114 7 Credit Suisse First Boston 219.7 125 8 UBS 217.8 131 9 Bear Stearns 217.5 57

10 Lazard 188.9 59 Industry total $1,308.7 8,086

Panel B: Worldwide Mergers

Rank Investment Bank Credit Lent ($ billions)

Number of Deals

1 Goldman Sachs $ 950.8 376 2 Morgan Stanley 719.9 323 3 Citigroup 694.6 312 4 J. P. Morgan 692.1 331 5 Merrill Lynch 529.0 253 6 UBS 523.8 326 7 Lehman Brothers 468.5 198 8 Credit Suisse 424.2 273 9 Deutsche Bank 394.9 209

10 Lazard 310.5 191 Industry total $2,859.4 24,590

TABLE 4–4 Ten Largest Merger and Acquisition Firms Ranked by Value of Mergers, 2006

Source: Thomson Financial Securities Data Company, 2007. www.thomson.com

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 103

7. Back-Office and Other Service Functions These functions include custody and escrow services, clearance and settlement services, and research and other advisory services—for example, giving advice on divestitures and asset sales. In addition, investment banks are making increas- ing inroads into traditional bank service areas such as small business lending and the trading of loans (see Chapter 21). In performing these functions, a securities firm normally acts as an agent for a fee. As mentioned above, fees charged are often based on the total bundle of services performed for the client by the firm. The portion of the fee or commission allocated to research and advisory services is called soft dollars. When one area in the firm, such as an investment advisor, uses client commissions to buy research from another area in the firm, it receives a benefit because it is relieved from the need to produce and pay for the research itself. Thus, the advisor using soft dollars faces a conflict of interest between the need to obtain research and the client’s interest in paying the lowest commission rate available. Because of the conflict of interest that exists, the SEC (the primary regulator of investment banks and securities firms) requires these firms to disclose soft dollar arrangements to their clients.

Nevertheless, in 2001 tremendous publicity was generated concerning con- flicts of interest in a number of securities firms between analysts’ research recom- mendations on stocks to buy or not buy and whether the firm played a role in underwriting the securities of the firm the analysts were recommending. After an investigation by the New York State Attorney General, Merrill Lynch agreed to pay a fine of $100 million and to follow procedures more clearly separating ana- lysts’ recommendations (and their compensation) from the underwriting activities of the firm. A number of other major Wall Street firms were also placed under investigation (see page 109). The investigation was triggered by the dramatic col- lapse of many new technology stocks while analysts were still making recommen- dations to buy or hold them.

Describe the difference between brokerage services and underwriting services. What are the key areas of activities for securities firms? Describe the difference between a best-efforts offering and a firm commitment offering. What are the trading activities performed by securities firms?

1. 2. 3.

4.

Concept Questions Concept Questions

BALANCE SHEET AND RECENT TRENDS

Recent Trends In this section, we look at the balance sheet and trends in the securities firm and investment banking industry. Trends in this industry depend heavily on the state of the stock market. For example, a major effect of the 1987 stock market crash was a sharp decline in stock market trading volume and thus in brokerage commissions earned by securities firms over the 1987–91 period. Commission income began to recover only after 1992, with record equity trading volumes being achieved in 1995–2000 when the Dow Jones and S&P indexes hit new highs. As stock market values plummeted in 2001 and 2002, so did commission income. However, improvements in the U.S. economy in the mid-2000s resulted in an increase in stock market values

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104 Part One Introduction

and trading and thus commission income. The overall decline in brokerage com- missions actually began over 25 years ago, in 1977, and is reflective of a long- term fall in the importance of commission income, as a percentage of revenues, for securities firms as a result of the abolition of fixed commissions on secu- rities trades by the Securities and Exchange Commission (SEC) in May 1975 and the fierce competition for wholesale commissions and trades that followed (see Figure 4–2 ).

Also affecting the profitability of the securities industry was the decline in new equity issues over the 1987–90 period as well as a decline in bond and equity underwriting in general (see Table 4–5 ). This was due partly to the stock market crash, partly to a decline in mergers and acquisitions, partly to a general economic recession, and partly to investor concerns about the high-risk junk-bond market, which crashed during this period.

Between 1991 and 2001, however, the securities industry showed a resurgence in profitability. 10 For example, domestic underwriting activity over the 1991–2001 period grew from $192.7 billion in 1990 to $1,623.9 billion in 2001 (see Table 4–5 ). The principal reasons for this were enhanced trading profits and increased growth in new issue underwritings. In particular, corporate debt issues became highly attractive to corporate treasurers because of relatively low long-term interest rates. Moreover, growth in the asset-backed securities market as a result of increased securitization of mortgages (and growth of mortgage debt) added to the value of underwriting. 11

10 Pretax return on equity for broker–dealers rose from 2.2 percent in 1990 to 20.9 and 25.1 percent in 1995 and 2000, respectively. The ratio fell to as low as 8.34 percent in 2002 before recovering to 18.6 percent in 2003 and 11.9 percent in 2006.

11 Another sign of the resurgence in this industry during the 1990s appears in employment figures. An- nual U.S. securities industry employment increased by 72 percent (from 486,000 jobs in 1992 to 837,000 in 2000 [peaking at 840,900 in March 2001]). Employment leveled off at around 800,000 jobs through the mid-2000s.

15

1977 1980 1985 1990 1995

20

25

30

35

40

45%

2000 2005

FIGURE 4–2 Commission Income as a Percentage of Total Revenues

Source: Securities and Exchange Commission, Standard & Poor’s Industry Surveys, and Securities Industry and Financial Markets Association.

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 105

As a result of enhanced trading profits and growth in new issue underwriting, pretax net income for the industry topped $9 billion each year over the 1996–2000 period (see Figure 4–3 ). This is despite the collapse of the Russian ruble and bond markets, economic turmoil in Asia, and political uncertainty in Washington dur- ing this period. Possibly more surprising is that despite a downturn in the U.S. economy toward the end of 2000, pretax profits soared to an all-time high of $21 billion in 2000. The continued slowdown of the U.S. economy in 2001 and the terrorist attacks on the World Trade Center in September 2001, however, brought an end to these record profits. Industry pretax profits for the year 2001 fell 24 percent, to $16 billion. The Bank of New York alone estimated costs associated with the terrorist attacks were $125 million. Citigroup estimated it lost $100–$200 million in business from branches that were closed and because of the four days the stock market did not trade. Morgan Stanley, the largest commercial tenant in the World Trade Center, said the cost of property damage and relocation of its employees was $150 million.

The slow rate of recovery of the U.S. economy (along with the decline in stock market trading and the fall in M&As and related activities) hampered the ability of the industry to generate profit growth in 2002. As a result, 2002 pretax profits for securities firms were $12.1 billion. Further, employment declined to a two-year low of 793,700 jobs in May 2003 (a decline of 5.6 percent from the high in March 2001). Moreover, the securities industry was rocked by several allegations of secu- rities law violations as well as a loss of investor confidence in Wall Street and corporate America as a result of a number of corporate governance failures and accounting scandals involving Enron, Merck, WorldCom, and other major U.S. corporations.

Straight Corporate

Debt

Con- vertible

Debt

Asset- Backed Debt

Non agency

MBS Total Debt

Common Stock

Preferred Stock

Total Equity All IPOs

Total Under- writing

1986 134.9 9.8 10.0 62.2 216.9 43.2 13.9 57.1 22.3 274.0

1987 108.5 10.3 8.9 83.3 211.0 41.5 11.4 52.9 24.0 263.9

1988 99.2 4.1 14.3 83.5 201.1 29.7 7.6 37.3 23.6 239.4

1989 101.1 5.8 22.2 35.1 164.2 22.9 7.7 30.6 13.7 194.8

1990 76.5 5.5 43.6 43.2 168.8 19.2 4.7 23.9 10.1 192.7

1995 279.8 12.0 113.1 36.5 441.4 82.0 15.1 97.1 30.2 538.5

2000 587.5 49.6 337.0 102.1 1,076.2 189.1 15.4 204.5 76.1 1,280.7

2001 776.1 78.3 383.3 216.5 1,454.2 128.4 41.3 169.7 40.8 1,623.9

2002 635.4 30.5 496.2 263.9 1,399.0 116.4 37.6 154.0 41.2 1,553.0

2003 775.1 72.7 600.2 345.3 1,793.3 118.5 37.8 156.3 43.7 1,949.6

2004 779.9 32.5 869.8 403.8 2,086.0 169.6 33.2 202.7 72.8 2,288.7

2005 750.8 30.1 1,172.1 645.7 2,598.7 160.5 29.9 190.4 62.6 2,789.1

2006 1,054.4 63.1 1,249.6 770.6 3,137.7 154.9 33.1 188.0 55.7 3,325.7

% Change 40.4% (2005 to 2006)

109.6% 6.6% 19.3% 20.7% �3.5% 10.7% �1.3% �11.0% 19.2%

TABLE 4–5 U.S. Corporate Underwriting Activity (in billions of dollars)

Source: Securities Industry and Financial Markets Association, 2007. www.sia.com

Note: High-yield bonds represent a subset of straight corporate debt. IPOs are a subset of common stock; true and closed-end fund IPOs are subsets of all IPOs.

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106 Part One Introduction

However, with the recovery of the U.S. economy in the mid-2000s, the U.S. securities industry again earned record profits as revenue growth strengthened and became more broadly based. Domestic underwriting surged to $3,325.7 billion in 2006, from $1,553.0 billion in 2002 (see Table 4–5 ). Further, the industry maintained its profitability mainly through deep cuts in expenses. Total expenses fell 10.4 percent from 2002 levels, largely due to lower interest expenses. Interest expense fell an estimated 22.5 percent from $48.4 billion in 2002 to $37.5 billion in 2003. Operating expenses excluding interest expense fell 4.1 percent in 2003, reflecting the success of cost controls and continued high rates of productivity growth in the securities industry. The results for 2003 were record pretax profits of $24.1 billion (see Figure 4–3 ). As interest rates increased in 2005 and 2006, so did interest expense incurred by the securities industry. Specifically, interest expense increased from $43.3 billion in 2003 to $136.1 billion in 2005 and $153.6 billion for the first nine months of 2006. The result was that, while gross revenues remained high, the increased interest expense caused pretax profits to fall to $17.6 billion in 2005. A surge in revenues caused pretax profits to bounce back to $22.3 billion for just the first nine months of 2006.

Balance Sheet The consolidated balance sheet for the industry is shown in Table 4–6 . Note the current importance of securities trading and underwriting in the consolidated bal- ance sheet of all securities firms. Looking at the asset portfolio, we can see that long positions in securities and commodities accounted for 24.6 percent of assets,

$24

22

20

18

16

14

12

10

8

6

4

2

0

�2

Billions

1990

�.16

5.8

1991

6.2

1992

8.6

1993

1.1

1994

7.4

1995

11.3

1996

12.2

1997 1998

9.8

1999

16.3

2000

21.0

24.1

20.7

17.6

2003 2004 2005

12.1

2002

16.0

2001

FIGURE 4–3 Securities Industry Pretax Profits, 1990–2005

Source: Securities Industry and Financial Markets Association, 2007. www.sia.com

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 107

while reverse repurchase agreements—securities purchased under agreements to resell (i.e., the broker gives a short-term loan to the repurchase agreement seller)— accounted for 24.8 percent of assets. Because of the extent to which this industry’s balance sheet consists of financial market securities, the industry is subjected to particularly high levels of market risk (see Chapter 10) and interest rate risk (see Chapters 8 and 9). Further, to the extent that many of these securities are foreign issued securities, FI managers must also be concerned with foreign exchange risk (see Chapter 14) and sovereign risk (see Chapter 15).

With respect to liabilities, repurchase agreements were the major source of funds; these are securities temporarily lent in exchange for cash received. Repurchase agreements—securities sold under agreements to repurchase—amounted to 40.8 percent of total liabilities and equity. The other major sources of funds were secu- rities and commodities sold short for future delivery and broker-call loans from banks. Equity capital amounted to only 3.1 percent of total assets, while total capi- tal (equity capital plus subordinated liabilities) accounted for 5.0 percent of total assets. These levels are well below those we saw for depository institutions in Chapter 2 (10.36 percent for commercial banks, 10.91 percent for savings insti- tutions, and 9.23 percent for credit unions). One reason for lower capital levels is that securities firms’ balance sheets contain mostly tradable (liquid) securities

Assets Percent of

Total Assets

Cash $ 60,745.0 1.2% Receivables from other broker–dealers 2,081,173.4 39.9 Receivables from customers 202,277.6 3.9 Receivables from noncustomers 29,022.0 0.6 Long positions in securities and commodities 1,281,868.4 24.6 Securities and investments not readily marketable 14,815.5 0.3 Securities purchased under agreements to resell 1,291,245.2 24.7 Exchange membership 1,322.3 0.0 Other assets 252,603.4 4.8 Total assets $5,215,073.0 100.0%

Liabilities

Bank loans payable $ 98,785.7 1.9% Payables to other broker–dealers 1,140,399.7 21.9 Payables to noncustomers 67,420.0 1.3 Payables to customers 508,374.7 9.7 Short positions in securities and commodities 584,561.5 11.2 Securities sold under repurchase agreements 2,126,253.1 40.8 Other nonsubordinated liabilities 426,259.8 8.2 Subordinated liabilities 98,912.6 1.9 Total liabilities $5,050,966.9 96.9%

Capital

Equity capital $ 164,106.1 Total capital $ 263,018.6 3.1% Number of firms 6,016 5.0%

TABLE 4–6 Assets and Liabilities of Broker–Dealers as of the Beginning of 2006 (in millions of dollars)

Source: Focus Report, Office of Economic Analysis, U.S. Securities and Exchange Commission, 2007. www. sec.gov

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108 Part One Introduction

compared with the relatively illiquid loans that constitute a significant proportion of banks’ asset portfolios. Securities firms are required to maintain a net worth (capital) to assets ratio in excess of 2 percent (see Chapter 20).

Describe the trend in profitability in the securities industry over the last 10 years. What are the major assets held by broker–dealers? Why do broker–dealers tend to hold less equity capital than do commercial banks and thrifts?

1. 2. 3.

Concept Questions Concept Questions

REGULATION

The primary regulator of the securities industry is the Securities and Exchange Commission (SEC), established in 1934 largely in response to abuses by securities firms that many at the time felt were partly responsible for the economic prob- lems in the United States. The primary role of the SEC includes administration of securities laws, review and evaluation of registrations of new securities offerings (ensuring that all relevant information is revealed to potential investors), review and evaluation of annual and semiannual reports summarizing the financial status of all publicly held corporations, and the prohibition of any form of security mar- ket manipulation. The National Securities Markets Improvement Act (NSMIA) of 1996 reaffirmed the significance of the SEC as the primary regulator of securities firms. According to the NSMIA, states are no longer allowed to require federally registered securities firms to be registered in a state as well. States are also now prohibited from requiring registration of securities firms’ transactions and from imposing substantive requirements on private placements. Prior to the NSMIA, most securities firms were subject to regulation from the SEC and from each state in which they operated. While the NSMIA provides that states may still require securities firms to pay fees and file documents to be submitted to the SEC, most of the regulatory burden imposed by states has been removed. Thus, the NSMIA effectively gives the SEC the exclusive regulatory jurisdiction over securities firms. However, the early 2000s saw a reversal of this trend toward the dominance of the SEC with states—especially their attorneys general—increasingly intervening through securities-related investigations. As noted earlier, several highly publi- cized securities violations resulted in criminal cases brought against securities law violators by state and federal prosecutors. In particular, the New York State attor- ney general forced Merrill Lynch to pay a $100 million penalty because of allega- tions that Merrill Lynch brokers gave investors overly optimistic reports about the stock of its investment banking clients.

Subsequent to these investigations, the SEC instituted rules requiring Wall Street analysts to vouch that their stock picks are not influenced by investment banking colleagues and that analysts disclose details of their compensation that would flag investors to any possible conflicts. If evidence surfaces that analysts have falsely attested to the independence of their work, it could be used to bring enforcement actions. Violators could face a wide array of sanctions, including fines and other penalties, such as a suspension or a bar from the securities industry. In addition, the SEC proposed that top officials from all public companies sign off on financial statements.

www.sec.govwww.sec.gov

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 109

In the spring of 2003 the issue culminated in an agreement between regula- tors and 10 of the nation’s largest securities firms to pay a record $1.4 billion in penalties to settle charges involving investor abuse. The long-awaited settlement centered on civil charges that securities firms routinely issued overly optimis- tic stock research to investors in order to gain favor with corporate clients and win their investment banking business. The agreement also settled charges that at least two big firms, Citigroup and Credit Suisse First Boston, improperly allo- cated IPO shares to corporate executives to win banking business from their firms. The SEC and other regulators, including the NASD, the NYSE, and state regula- tors, unveiled multiple examples of how Wall Street stock analysts tailored their research reports and ratings to win investment banking business. The Wall Street firms agreed to the settlement without admitting or denying any wrongdoing. The agreement forced brokerage companies to make structural changes in the way they handle research—preventing analysts, for example, from attending certain investment banking meetings with bankers. The agreement also required securi- ties firms to have separate reporting and supervisory structures for their research and banking operations. Additionally, it required that analysts’ pay be tied to the quality and accuracy of their research, rather than the amount of investment bank- ing business they generate. Table 4–7 lists the 10 firms involved in the settlement and the penalties assessed.

Unfortunately, this did not deter the alleged illegal and unethical activities of investment banks. Within days of this agreement, Bear Stearns, one of the 10 firms, was accused of using its analysts to promote new stock offerings. In November 2005, the NYSE fined Lehman Brothers $500,000 for failing to supervise a trading strategy pegged to the closing price of a stock that gave a profit to the invest- ment bank while potentially harming its customers. In December 2005, the NASD fined Merrill Lynch $14 million and Wells Fargo $3 million for directing inves- tors into mutual fund share classes that cost the clients more than necessary and reduced returns while providing brokers with higher commissions. In March 2006, the NASD fined Merrill Lynch $5 million when the firm transferred thousands of clients from individual stockbrokers into call centers and subsequently put many of these customers into unsuitable mutual funds that yielded bigger commissions for the firm. In November 2006, the SEC began an investigation into whether UBS and Credit Suisse Group improperly manipulated Treasury securities prices. In February 2007, the SEC began an investigation of potential insider trading, focus- ing mainly on the passing of inside information within a brokerage firm, as well

www.nasd.comwww.nasd.com

www.nyse.comwww.nyse.com

Firm Penalty ($ millions)

Citigroup $400 Credit Suisse First Boston 200 Merrill Lynch 200 Morgan Stanley 125 Goldman Sachs 110 Bear Stearns 80 J. P. Morgan Chase 80 Lehman Brothers 80 UBS Warburg 80 Piper Jaffray 32

TABLE 4–7 Securities Firm Penalties Assessed for Trading Abuses

Source: Authors’ research, 2004.

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110

NASD TO SUE MORGAN STANLEY OVER E-MAIL ISSUE

Morgan Stanley used 9/11 as an excuse for failing to produce millions of e-mails in hundreds of arbitration claims, even though it turned out not to be the case, the National Association of Securities Dealers charged yesterday. . . . In its complaint, the NASD alleges that the brokerage arm of Morgan Stanley falsely claimed millions of its e-mails were destroyed in the Sept. 11, 2001, terrorist attacks on the World Trade Center, where Morgan Stanley had a large brokerage operation. The complaint alleges that the firm recovered most of those e-mails within days of the attacks. . . .

According to people familiar with Morgan Stanley’s position on the matter, the firm was willing to compensate some investors whose claims might have been af- fected had the e-mails been produced. They said the NASD wanted the firm to com- pensate upward of 1,000 investors who filed arbitration claims between October 2001 and March 2005, even if those claims were without merit altogether, or didn’t involve e-mail at all. . . .

Morgan Stanley’s brokerage-unit e-mail servers were kept in its World Trade Center offices at the time of the terrorist attacks on lower Manhattan. Although the serv- ers were destroyed, the NASD’s complaint says, the firm was able to restore mil- lions of e-mails by using backup tapes. Despite restoring the e-mails, the NASD alleges, Morgan Stanley repeatedly told regulators and investors involved in arbitration claims that all e-mails had been destroyed. The complaint also says that when Morgan Stanley discovered that backup copies of e-mails still existed, “it made the affirmative determination not to preserve the restored messages or the tapes used to restore them to the servers.” According to the NASD’s complaint, many arbitration proceedings were concluded between October 2001 and March 2005 “without the benefit of potentially valuable evidence that [the firm] possessed but falsely denied having.” . . .

Since Sept. 11, 2001, Morgan Stanley has been involved in scores of arbitration cases, regulatory settlements and legal judgments in which it said it couldn’t pro- duce e-mail evidence. Morgan Stanley told one Kansas City investor her files were destroyed even though there were no trades in her account until October 2001. The firm blamed a “simple and honest mistake,” apologized and agreed to settle. But last year, the firm informed regulators and lawyers for individual investors that it had discovered e-mail sources thought to have been destroyed in the World Trade Center. The e-mail sources were discovered as part of an internal review of e-mail retention related to another case. . . .

Source: Jamie Levy Pessin, The Wall Street Journal, December 20, 2006, p. A3. Reprinted by permission of The Wall Street Journal. © Dow Jones & Company, Inc. All rights reserved worldwide. www.wsj.com

Ethical Dilemmas

as between firms. The instances involved traders passing information about large pending trades before they were public across the firms. As described in the Ethical Dilemmas box, Morgan Stanley was investigated by NASD for falsely claiming that the firm lost requested e-mails during the terrorist attacks of September 2001. Thus, regulators continue to be diligent in their pursuit of violations of securities regulations.

Along with changes instituted by the SEC, the U.S. Congress passed the Sarbanes-Oxley Act in July 2002. This act created an independent auditing over- sight board under the SEC, increased penalties for corporate wrongdoers, forced faster and more extensive financial disclosure, and created avenues of recourse for aggrieved shareholders. The goal of the legislation was to prevent deceptive accounting and management practices and to bring stability to jittery stock markets

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 111

battered in the summer of 2002 by corporate governance scandals of Enron, Global Crossings, Tyco, WorldCom, and others.

In addition to investigating and prosecuting securities law violations, the SEC also sets rules governing securities firms’ underwriting and trading activities. For example, SEC Rule 415 on shelf-offerings allows larger corporations to register their new issues with the SEC up to two years in advance. 12 Similarly, SEC Rule 144A defines the boundaries between public offerings of securities and private placements of securities. In a private placement, a corporation or municipality, sometimes with the help of an investment bank, seeks to find a large institutional buyer or group of buyers (usually fewer than 10) to purchase the whole issue. Unlike publicly traded security issues that must be registered with the SEC, private placements can be unregistered and can be resold only to large, financially sophisticated investors. These large investors supposedly possess the resources and expertise to analyze a security’s risk. In April 1990, however, the SEC amended its Regulation 144A to allow large investors to begin trading these privately placed securities among themselves even though, in general, such securities do not satisfy the stringent disclosure and informational requirements that the SEC imposes on approved publicly registered issues. Of the total $1.25 trillion in private debt and equity placements in 2006, $1.15 trillion (92 percent) were Rule 144A placements. Citigroup was the lead underwriter of Rule 144A placements in 2006 (underwriting $112.7 million, 9.8 percent of the total 144A placements).

While the SEC sets the overall regulatory standards for the industry, two self regulatory organizations are involved in the day-to-day regulation of trading prac- tices. These are the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD)—the latter is responsible for trading in the over- the-counter markets such as NASDAQ. The NYSE and NASD monitor trading abuses (such as insider trading) trading rule violations, and securities firms’ capi- tal (solvency) positions. For example, in July 2003, the NYSE fined a veteran floor trader at Fleet Specialist Inc. $25,000 for allegedly mishandling customer orders in General Motors stock when they fell sharply on June 27, 2002, after rumors circu- lated that the automaker had accounting problems. Instead of buying the stock, the trader sold 10,000 shares from Fleet’s own account when there was another known seller on the floor.

Securities firms and investment banks have historically been strongly support- ive of efforts to combat money laundering, and the industry has been subject to federal laws that impose extensive reporting and record-keeping requirements. However, the USA Patriot Act, passed in response to the September 11 terrorist attacks, included additional provisions that financial services firms must imple- ment. The new rules, which took effect on October 1, 2003, imposed three require- ments on firms in the industry. First, firms must verify the identity of any person seeking to open an account. Second, firms must maintain records of the informa- tion used to verify the person’s identity. Third, firms must determine whether a person opening an account appears on any list of known or suspected terrorists or terrorist organizations. The new rules are intended to deter money laundering without imposing undue burdens that would constrain the ability of firms to serve their customers.

12 They are called shelf-offerings because after registering the issue with the SEC, the firm can take the issue “off the shelf” and sell it to the market when conditions are the most favorable, for example, in the case of debt issues, when interest rates are low.

shelf-offering An arrangement that allows firms that plan to offer multiple is- sues of stock over a two-year period to submit one registra- tion statement sum- marizing the firm’s financing plans for the period.

shelf-offering An arrangement that allows firms that plan to offer multiple is- sues of stock over a two-year period to submit one registra- tion statement sum- marizing the firm’s financing plans for the period.

shelf-offering An arrangement that allows firms that plan to offer multiple is- sues of stock over a two-year period to submit one registra- tion statement sum- marizing the firm’s financing plans for the period.

shelf-offering An arrangement that allows firms that plan to offer multiple is- sues of stock over a two-year period to submit one registra- tion statement sum- marizing the firm’s financing plans for the period.

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112 Part One Introduction

Finally, the Securities Investor Protection Corporation (SIPC) protects investors against losses of up to $500,000 caused by securities firm failures. This guaranty fund was created after the passage of the Securities Investor Protection Act in 1970 and is based on premium contributions from member firms. The fund protects investor accounts against the possibility of the member broker–dealer’s not being able to meet its financial obligations to customers. The fund does not, however, protect against losses on a customer’s account due to poor investment choices that reduce the value of a portfolio.

While not a primary regulator of securities firms and investment banks, the Federal Reserve, as overseer of the financial system as a whole, also comments on rules and regulations governing the industry and suggests changes to be made. For example, in late 2000, the Federal Reserve called for the securities industry to shorten the time it takes to complete stock trades. Federal Reserve Chairman Alan Greenspan stated that rising volumes of stock trading were straining the capacity of brokerage firms to settle trades in a timely fashion. Delays between the purchase of a stock to completion of the paperwork increase risk to the finan- cial system. The Fed worried that when stock prices plunge, large banks may be vulnerable if investors to whom banks have lent money are unable to come up with more collateral for these loans. A shorter time for the completion of stock sales would lower the risk of defaults on any one trade. Mr. Greenspan noted that the Securities Industry Association, an industry trade group, had been working to shorten the settlement time to one day after the stock sale instead of the current three days.

What is the major result of the NSMIA? What two organizations monitor trading abuses?

1. 2.

Concept Questions Concept Questions

GLOBAL ISSUES

Much more so than other sectors of the financial institutions industry, securi- ties firms and investment banks operate globally. This can be seen in Table 4–1 , where many recent mergers (such as Deutsche Bank’s acquisition of Bankers Trust) involve non-U.S. securities firms. Also, Table 4–3 shows that Royal Bank of Scotland, a U.K.-based investment bank, was the top underwriter of mortgage- backed securities in the United States. Accordingly, as domestic securities trading and underwriting have grown in the 1990s, so have foreign securities trading and underwriting. Tables 4–8 and 4–9 show the foreign transactions in U.S. securities and U.S. transactions in foreign securities from 1991–2006. For example, foreign investors’ transactions involving U.S. stocks increased from $211.2 billion in 1991 to $6,157.3 billion in 2006, an increase of 2,815 percent. Similarly, U.S. investors’ transactions involving stocks listed on foreign exchanges grew from $152.6 billion in 1991 to $2,427.1 billion in 2006, an increase of 1,490 percent.

Table 4–10 reports the total dollar value of international security offerings from 1995–2006. Over this period, despite a worldwide economic slowdown, total offer- ings increased from $570.5 billion to $4,143.8 billion in 2005 and $3,684.2 billion in just the first nine months of 2006. Of the amounts in 2006, U.S. security issuers

www.sipc.orgwww.sipc.org

£ $ ¥

:

£ $ ¥

:

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 113

Year Corporate Stock Transactions Corporate Bond Transactions

1991 $ 211.2 $ 85.9 1995 451.7 168.1 2000 3,605.2 479.5 2001 3,051.4 741.0 2002 3,209.8 820.7 2003 3,104.2 979.9 2004 3,862.0 1,171.4 2005 4,740.7 1,277.0 2006 6,157.3 1,578.5

TABLE 4–8 Foreign Transactions in U.S. Securities Markets (in billions of dollars)

Source: Treasury Bulletin, U.S. Treasury, various dates. www.ustreas.gov

Year Corporate Stock Transactions Corporate Bond Transactions

1991 $ 152.6 $ 345.1 1995 395.8 927.9 2000 1,815.3 963.0 2001 1,447.8 1,128.8 2002 1,343.7 1,269.3 2003 1,425.2 1,393.2 2004 1,526.9 1,749.0 2005 1,505.0 2,367.4 2006 2,427.1 3,197.9

TABLE 4–9 U.S. Transactions in Foreign Securities Markets (in billions of dollars)

Source: Treasury Bulletin, U.S. Treasury, various dates. www.ustreas.gov

TABLE 4–10 Value of International Security Offerings (in billions of dollars)

Source: Quarterly Review: International Banking and Financial Market Develop- ments, Bank for International Settlements, various issues. www.bis.org

1995 2001 2002 2005 2006*

Total International Offerings

Floating-rate debt $103.0 $ 642.7 $ 603.3 $1,470.7 $1,388.8 Straight debt 394.8 1,590.3 1,454.6 2,323.9 2,014.3 Convertible debt 18.1 72.2 42.7 41.7 37.1 Equity 54.6 149.4 102.3 307.5 244.0 Total offerings $570.5 $2,454.6 $2,202.9 $4,143.8 $3,684.2

International Offerings by U.S. Issuers

Floating-rate debt $ 50.9 $ 262.3 $ 214.4 $ 602.4 $ 477.3 Straight debt 115.3 836.1 755.0 1,454.0 869.9 Convertible debt 8.5 32.9 16.5 42.8 13.1 Equity 10.0 24.8 1.2 5.7 12.0 Total offerings $184.7 $1,156.1 987.1 $2,104.9 $1,372.3

*Through three quarters.

offered $1,372.3 billion in international markets, up from $184.7 billion in 1995. Nevertheless, concerns about U.S. accounting practices as a result of recent scan- dals, the burdensome nature of reporting accounting figures using U.S. account- ing standards as well as local accounting standards, the decline in the U.S. stock market, and the fall in the value of the U.S. dollar against the euro and yen were all working to weaken the attractiveness of U.S. markets to foreign investors and issuers in the early and mid-2000s.

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114 Part One Introduction

What have been the trends in foreign transactions in U.S. securities and U.S. transac- tions in foreign securities in the 1990s and early 2000s? What have been the trends in international securities offerings in the late 1990s and early 2000s? Why do foreign banks operating in the United States compete with both U.S. com- mercial banks and investment banks?

1.

2.

3.

Concept Questions Concept Questions

This chapter presented an overview of security firms (which offer largely retail services to investors) and investment banking firms (which offer largely wholesale services to corporate customers). Firms in this industry assist in getting new issues of debt and equity to the markets. Additionally, this industry facilitates trading and market making of securities after they are issued as well as corporate mergers and restructurings. We looked at the structure of the industry and changes in the degree of concentration in firm size in the industry over the last decade. We also analyzed balance sheet information which highlighted the major assets and liabili- ties of firms in the industry. Overall, the industry is in a period of consolidation and globalization as the array and scope of its activities expand.

Explain how securities firms differ from investment banks. In what ways are they financial intermediaries? In what ways have changes in the investment banking industry mirrored changes in the commercial banking industry? What are the different types of firms in the securities industry, and how does each type differ from the others? What are the key activity areas for securities firms? How does each activity area assist in the generation of profits, and what are the major risks for each area? What is the difference between an IPO and a secondary issue? What is the difference between a private placement and a public offering? What are the risk implications to an investment banker from underwriting on a best-efforts basis versus a firm commitment basis? If you operated a com- pany issuing stock for the first time, which type of underwriting would you prefer? Why? What factors might cause you to choose the alternative? How do agency transactions differ from principal transactions for market makers? An investment banker agrees to underwrite a $500 million, 10-year, 8 percent semiannual bond issue for KDO Corporation on a firm commitment basis. The investment banker pays KDO on Thursday and plans to begin a public sale on Friday. What type of interest rate movement does the investment bank fear while holding these securities? If interest rates rise 0.05 percent, or five basis points, overnight, what will be the impact on the profits of the invest- ment banker? What if the market interest rate falls five basis points?

1.

2.

3.

4.

5. 6. 7.

8.

9.

SummarySummary

Questions and Problems Questions and Problems

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 115

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An investment banker pays $23.50 per share for 4 million shares of JCN Company. It then sells those shares to the public for $25 per share. How much money does JCN receive? What is the profit to the investment banker? What is the stock price of JCN? XYZ, Inc., has issued 10 million new shares of stock. An investment banker agrees to underwrite these shares on a best-efforts basis. The investment banker is able to sell 8 million shares for $27 per share, and it charges XYZ $0.675 per share sold. How much money does XYZ receive? What is the profit to the investment banker? What is the stock price of XYZ? One of the major activity areas of securities firms is trading.

What is the difference between pure arbitrage and risk arbitrage? What is the difference between position trading and program trading?

If an investor observes that the price of a stock trading in one exchange is different from the price in another exchange, what form of arbitrage is appli- cable, and how can the investor participate in that arbitrage? An investor notices that an ounce of gold is priced at $318 in London and $325 in New York.

What action could the investor take to try to profit from the price discrepancy? Under which of the four trading activities would this action be classified? If the investor is correct in identifying the discrepancy, what pattern should the two prices take in the short-term future? What may be some impediments to the success of this transaction?

What three factors are given credit for the steady decline in brokerage com- missions as a percentage of total revenues over the period beginning in 1977 and ending in 1991? What factors are given credit for the resurgence of profitability in the securi- ties industry beginning in 1991? Are firms that trade in fixed-income securities more or less likely to have volatile profits? Why? Using Table 4–5 , which type of security accounts for most underwriting in the United States? Which is likely to be more costly to underwrite: corporate debt or equity? Why? How do the operating activities, and thus the balance sheet structures, of secu- rities firms differ from the operating activities of depository institutions such as commercial banks and insurance firms? How are the balance sheet struc- tures of securities firms similar to those of other financial intermediaries? Based on the data in Table 4–6 , what were the second-largest single asset and the largest single liability of securities firms in 2006? Are these asset and liabil- ity categories related? Exactly how does a repurchase agreement work? How did the National Securities Markets Improvement Act of 1996 (NSMIA) change the regulatory structure of the securities industry? Identify the major regulatory organizations that are involved in the daily op- erations of the investment securities industry, and explain their role in provid- ing smoothly operating markets. What are the three requirements of the USA Patriot Act that financial service firms must implement after October 1, 2003?

10.

11.

12. a. b.

13.

14.

a.

b. c.

d. 15.

16.

17.

18.

19.

20.

21.

22.

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116 Part One Introduction

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Web Questions

Go to the Thomson Financial Securities Data Web site at www.thomson.com /solutions/financials and find the most recent data on merger and acquisition volume and number of deals using the following steps. Under “xx Quarter League Tables,” click on “VIEW NOW.” Click on “Mergers & Acquisitions.” Click on “Global M&A Financial Advisory Review.” This will download a file onto your computer that will contain the most recent information on top un- derwriters for various securities. How has the dollar volume and number of deals changed since 2006, as reported in Figure 4–1 ? Go to the U.S. Treasury Web site at www.ustreas.gov and find the most recent data on foreign transactions in U.S. securities and U.S. transactions in foreign securities using the following steps. Click on “Bureaus.” Click on “Financial Management Services (FMS).” Under “Publications”, click on “Treasury Bulletin.” Click on “Capital Movements Tables (Section IV).” This will down- load a file onto your computer that will contain the most recent information on foreign transactions. How have these number changed since 2006, as re- ported in Tables 4–8 and 4–9 ?

S&P Questions

Go to the Standard & Poor’s Market Insight Web site at www.mhhe.com/ edumarketinsight and identify the industry description and industry con- stituents for investment banking and brokerage using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Industry.” From the industry list, select “Investment Banking & Brokerage.” Click on “Go!” Click on “Industry Profile” and sepa- rately, “Industry Constituents.” Go to the Standard & Poor’s Market Insight Web site at www.mhhe.com/ edumarketinsight and look up the industry financial highlights as posted by S&P for investment banking and brokerage using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Industry.” From the industry list, select “Investment Banking & Brokerage.” Click on “Go!” Click on any/all of the items listed under “Industry Financial Highlights.” Go to the Standard & Poor’s Market Insight Web site at www.mhhe.com/edu- marketinsight and look up the most recent balance sheets for Merrill Lynch (MER) and Morgan Stanley Dean Witter (MWD) using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Company.” Enter “MER” in the “Ticker:” box and click on “Go!” Click on “Excel Analytics.” Click on “FS Ann. Balance Sheet.” This will download the Balance Sheet for Merrill Lynch which contains the balances for total equity and total assets. Repeat the process by entering “MWD” in the “Ticker:” box to get information on Morgan Stanley Dean Witter. Compare the equity ratios for these firms with that for the broker–dealer industry listed in Table 4–6 .

23.

24.

25.

26.

27.

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Chapter 4 The Financial Services Industry: Securities Firms and Investment Banks 117

Bank for Inter

Pertinent Web Sites

national Settlements www.bis.org Board of Governors of the Federal Reserve www.federalreserve.gov National Association of Securities Dealers www.nasd.com New York Stock Exchange www.nyse.com Securities and Exchange Commission www.sec.gov Securities Industry and Financial Markets Association www.sia.com Securities Investor Protection Corporation www.sipc.org Thomson Financial Securities Data Company www.thomson.com U.S. Treasury www.ustreas.gov The Wall Street Journal www.wsj.com

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118

Chapter Five

The Financial Services Industry: Mutual Funds and Hedge Funds

INTRODUCTION

Mutual funds and hedge funds are financial intermediaries that pool the finan- cial resources of individuals and companies and invest in diversified portfolios of assets. An open-ended mutual fund (the major type of mutual fund) continuously stands ready to sell new shares to investors and to redeem outstanding shares on demand at their fair market value. Thus, these funds provide opportunities for small investors to invest in financial securities and diversify risk. Mutual funds are also able to generate greater economies of scale by incurring lower transaction costs and commissions than are incurred when individual investors buy securi- ties directly. As a result of the tremendous increase in the market value of finan- cial assets, such as equities, in the 1990s (for example, the S&P 500 index saw a return of over 25 percent in 1997 and 1998) and the relatively low-cost opportunity mutual funds provide to investors (particularly small investors) who want to hold such assets (through either direct mutual fund purchases or contributions to retire- ment funds sponsored by employers and managed by mutual funds), the mutual fund industry boomed in size and customers in the 1990s. 1 The early 2000s and a slowdown in the U.S. economy brought an end to such a rapid pace of growth. Further, allegations of trading abuses resulted in a loss of confidence in several mutual fund managers. Despite these issues, in 2007 almost 7,100 different stock and bond mutual companies held total assets of $8.21 trillion. If we add money market mutual funds, the number of funds rises close to 8,125 and the 2007 value of assets under management rises to $10.57 trillion. 2

Hedge funds are a type of investment pool that solicit funds from (wealthy) individuals and other investors (e.g., commercial banks) and invest these funds on their behalf. Hedge funds are similar to mutual funds in that they are pooled

1 Shareholder services offered by mutual funds include free exchanges of investments between a mutual fund company’s funds, automatic investing, check-writing privileges on many money market funds and some bond funds, automatic reinvestment of dividends, and automatic withdrawals.

2 See The Investment Company Institute, Trends in Mutual Fund Investing, January 2007. www.ici.org .

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 119

investment vehicles that accept investors’ money and generally invest it on a col- lective basis. Hedge funds, however, are not required to register with the SEC.

In this chapter we first provide an overview of the services offered by mutual funds and highlight their rapid growth over the last decade. We look at the size, structure, and composition of the industry. This section highlights historical trends in the industry, the different types of mutual funds, mutual fund objectives, inves- tor returns from mutual fund ownership, and mutual fund costs. We also look at the industry’s balance sheets and recent trends, the regulations and regulators governing the industry, and global issues for this industry. We then discuss invest- ment pools organized as hedge funds. Because hedge funds limit investors to only the wealthiest individuals and are generally unregulated, they are examined sepa- rately from mutual funds discussed elsewhere in the chapter that are regulated by the Securities and Exchange Commission.

SIZE, STRUCTURE, AND COMPOSITION OF THE MUTUAL FUND INDUSTRY

Historical Trends The first mutual fund was founded in Boston in 1924. The industry grew very slowly at first; by 1970, 360 funds held about $50 billion in assets. Since then the number of mutual funds and the asset size of the industry have increased dramati- cally. This growth is attributed to the advent of money market mutual funds in 1972 (as investors looked for ways to earn market rates on short-term funds when bank deposit rates were constrained by regulatory ceilings), to tax-exempt money market mutual funds first established in 1979, and to an explosion of special- purpose equity, bond, emerging market, and derivative funds (as capital market

Year Total Net

Assets (billions) Gross Sales

(billions) Redemptions

(billions) Net Sales (billions)

Accounts (thousands)

Number of Funds

2006 $10,413.6 $17,534.7 $16,875.1 $659.6 289,977 8,120 2005 8,904.8 14,042.5 13,648.4 394.1 275,479 7,975 2004 8,106.9 12,270.0 12,117.5 92.5 269,468 8,041 2003 7,414.4 12,452.6 12,415.6 47.0 260,701 8,126 2002 6,390.4 13,195.8 13,038.8 157.0 251,125 8,244 2001 6,974.9 12,866.2 12,242.3 623.9 248,701 8,305 2000 6,964.6 11,109.4 10,586.6 522.8 244,706 8,155 1995 2,811.3 3,600.6 3,314.9 285.7 131,219 5,725 1990 1,065.2 1,564.8 1,470.8 94.0 61,948 3,079 1980 134.8 247.4 216.1 31.3 12,088 564 1970 47.6 4.6 3.0 1.6 10,690 361 1960 17.0 2.1 0.8 1.3 4,898 161 1950 2.5 0.5 0.3 0.2 939 98 1940 0.5 N/A N/A N/A 296 68

*Data include money market funds. Institute “gross sales” figures include the proceeds of initial fund underwritings prior to 1970.

TABLE 5–1 Growth of Mutual Fund Industry, 1940–2006

Source: Investment Company Institute, 2006 Investment Company Fact Book (Washington, DC: Investment Company Institute, May 2006) and Trends in Mutual Fund Investing, January 2007. www.ici.org

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120 Part One Introduction

values soared in the 1990s). Table 5–1 documents the tremendous increase from 1940 though 2006 of mutual funds. For example, total assets invested in mutual funds grew from $0.5 billion in 1940 to $10,413.6 billion in 2006. In addition, the number of mutual fund accounts increased from 296,000 in 1940 to 290.0 million in 2006 and the number of mutual funds increased from 68 in 1940 to 8,120 in 2006. The majority of this growth occurred during the bull market run in the 1990s (total assets in 1990 were $1,065.2 billion). Table 5–2 lists the net new investment in equity mutual funds and the return on the New York Stock Exchange (NYSE) composite index from 1985 through 2006. Notice that the net new cash flows into equity mutual funds has been strongly related to the NYSE stock index. Only in 1988 and 2002, as stock markets faltered along with the U.S. economy, did the total net assets invested in mutual funds fall.

Additionally, growth has been the result of the rise in retirement funds under management by mutual funds. The retirement fund market has increased from $4 trillion in 1990 to over $15 trillion in 2006. Mutual funds manage approximately one-quarter of this market and have experienced the growth along with it. Many of these retirement funds are institutional funds. Institutional funds are mutual funds that manage retirement plans for an institution’s employees. Institutions arrange these retirement (mutual) funds for the benefit of their members. Wealthy individuals also often use institutional funds. In total, about 80 percent of all retire- ment plan investments are in institutional funds. Institutional funds are managed

Net New Cash Flows to Equity Mutual Funds*

Return on NYSE Composite

Index

2006 $157.9 17.86% 2005 135.6 6.95 2004 177.8 12.57 2003 152.3 28.81 2002 �27.6 �19.83 2001 32.0 �10.21 2000 309.4 1.01 1999 187.6 9.15 1998 156.9 16.55 1997 227.1 30.31 1996 216.9 19.06 1995 124.4 31.31 1994 114.5 �3.14 1993 127.3 7.86 1992 79.0 4.69 1991 39.9 27.12 1990 12.9 �7.46 1989 6.8 24.82 1988 �14.9 13.00 1987 19.2 �0.25 1986 20.4 13.97 1985 6.6 26.80

*In billions of dollars.

TABLE 5–2 Net New Cash Flows to Equity Mutual Funds versus Annual Returns on the NYSE Composite Index

Source for the Net New Cash Flows to Equity Mutual Funds: Investment Company Institute, 2006 Investment Company Fact Book (Washing- ton, DC: Investment Com- pany Institute, May 2006). Reprinted by permission of the Investment Company Institute. www.ici.org

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 121

by the same companies that help run mutual funds: banks, insurance companies, brokers, and mutual fund advisory companies. Costs of institutional funds are very low because there are no additional distribution fees and because the retire- ment plan can use its bargaining power to get the best deals. Unlike the case with traditional mutual funds, retirement plan sponsors can set out how much risk an institutional fund can take in trying to beat the market.

As can be seen in Figure 5–1 , in terms of asset size, the mutual fund industry is larger than the life insurance industry but smaller than the commercial bank- ing industry. This makes mutual funds the second most important FI group in the United States as measured by asset size. The tremendous growth in this area of FI services has not gone unnoticed by commercial banks as they have sought to directly compete by either buying existing mutual fund groups or managing mutual fund assets for a fee. Banks’ share of all mutual fund assets managed was

9.4

10.2

Mutual FundsMutual FundsMutual Funds Pention Fund Commercial

banks

5

4

3

3.3

1.1

1.6

5.6

2

1

0 Finance

companies

0.5

1.9

Mutual funds

Private pension funds

Life insurance companies

Thrift institutions

1.4

4.7 1990

2006

0.9

3.0

1.61.7

State and local government

pension funds

7

6

8

9

10

FIGURE 5–1 Assets of Major Financial Intermediaries, 1990 and 2006 (in trillions of dollars)

Source: Federal Reserve Board, “Flow of Fund Accounts,” various years. www.federalreserve.gov

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122 Part One Introduction

about 11 percent in 2006. Much of this growth has occurred through banks buy- ing mutual fund companies, for example, Mellon buying Dreyfus, as well as con- verting internally managed trust funds into open-end mutual funds. Insurance companies are also beginning to enter this booming industry. In March 2001, for example, State Farm began offering a family of 10 mutual funds nationwide. The funds are available from more than 9,000 registered State Farm agents, on the Internet, or by application sent in response to phone requests made to a toll-free number. As of 2006, insurance companies managed 10 percent of the mutual fund industry’s assets.

Low barriers to entry in the U.S. mutual fund industry has allowed new entrants to offer funds to compete for investor attention and has kept the indus- try from being increasingly concentrated. As a result, the share of industry assets held by the largest mutual fund sponsors has changed little since 1990. For exam- ple, the largest 25 companies that sponsor mutual funds managed 71 percent of the industry’s assets in 2006, compared to 75 percent of the industry’s assets in 1990. The composition of the list of the 25 largest fund sponsors, however, has changed, with seven of the largest fund companies in 2006 not among the largest in 1990.

Different Types of Mutual Funds The mutual fund industry is usually divided into two sectors: short-term funds and long-term funds. Long-term funds include bond funds (comprised of fixed- income securities with a maturity of over one year), equity funds (comprised of common and preferred stock securities), and hybrid funds (comprised of both bond and stock securities). Short-term funds include taxable money market mutual funds (MMMFs) and tax-exempt money market mutual funds. Table 5–3 shows how the mix of stock, bond, hybrid, and money market fund assets changed between 1980 and 2006. As can be seen, there was a strong trend toward investing in stock mutual funds, reflecting the rise in share values during the 1990s. As a result, in 1999, 74.3 percent of all mutual fund assets were in longterm funds while the remaining funds, or 25.7 percent, were in money market mutual funds. As you can see in Table 5–3 , the proportion invested in long-term ver- sus short-term funds can vary considerably over time. For example, the share of money market funds was 44.8 percent in 1990 compared to 25.7 percent in 1999. The decline in the growth rate of short-term funds and the increase in the growth rate of long-term funds reflect the increase in equity returns during the period 1992–1999 and the generally low level of short-term interest rates over the period. Notice that in the early 2000, as interest rates rose, the U.S. economy declined, and equity returns fell, the growth in money market funds outpaced the growth in long-term funds. In 2002, the share of long-term funds fell to 62.1 percent and money market funds grew to 37.9 percent. However, in the mid-2000s, as the U.S. economy grew and stock values increased, the share of long-term funds grew (to 75.4 percent of all funds in 2006), while money market funds decreased (to 24.6 percent in 2006).

Money market mutual funds provide an alternative investment to interest- bearing deposits at commercial banks, which may explain the growth in MMMFs in the 1980s and late 1990s, when the spread earned on MMMF investments rela- tive to deposits was mostly positive (see Figure 5–2 ). Both investments are rela- tively safe and earn short-term returns. The major difference between the two is

bond funds Funds that con- tain fixed-income capital market debt securities.

bond funds Funds that con- tain fixed-income capital market debt securities.

equity funds Funds that contain common and pre- ferred stock securities.

equity funds Funds that contain common and pre- ferred stock securities.

hybrid funds Funds that contain bond and stock securities.

hybrid funds Funds that contain bond and stock securities.

money market mutual funds Funds that contain various mixtures of money market securities.

money market mutual funds Funds that contain various mixtures of money market securities.

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 123

that interest-bearing deposits (below $100,000 in size) are fully insured but due to bank regulatory costs (such as reserve requirements, capital requirements, and deposit insurance premiums) generally offer lower returns than do noninsured MMMFs. 3 Thus, the net gain in switching to MMMFs is higher returns in exchange for the loss of deposit insurance coverage. Many investors appeared willing to give up insurance coverage to obtain additional returns in the 1980s and late

3 Some mutual funds are covered by private insurance and/or by implicit or explicit guarantees from mu- tual fund management companies.

1980 1990 1995 1997 1999 2000 2002 2004 2006

Panel A: Equity, Hybrid, and Bond Mutual Funds

Holdings at market value

$61.8 $608.4 $1,852.8 $2,989.4 $4,538.5 $4,433.1 $3,638.4 $5,436.3 $7,093.4

Household sector 52.1 511.6 1,313.6 2,059.6 3,067.1 2,856.2 2,420.5 3,610.8 4,962.8 Nonfinancial

corporate business 1.5 9.7 45.7 75.0 127.0 121.9 94.6 139.8 182.0

State and local governments

0.0 4.8 35.0 33.6 33.4 30.8 24.3 27.3 29.8

Commercial banking 0.0 1.9 2.3 8.1 12.4 15.0 19.6 18.0 24.5 Credit unions 0.0 1.4 2.8 2.4 2.5 2.2 3.5 3.1 2.1 Life insurance

companies 1.1 30.7 33.5 57.2 98.7 97.0 76.6 114.4 119.6

Private pension funds 7.1 40.5 357.0 660.1 1,056.5 1,131.7 831.9 1,292.3 1,507.1 State and local

government retirement funds

0.0 7.8 62.9 93.4 140.9 178.3 167.4 230.6 265.5

Panel B: Money Market Mutual Funds

Total assets $76.4 $493.3 $ 741.3 $1,042.5 $1,579.6 $1,812.1 $2,223.9 $1,879.8 $2,312.5 Household sector 64.3 391.6 477.5 608.9 816.0 959.8 1,070.0 903.4 1,109.6 Nonfinancial

corporate business 7.0 19.7 60.0 87.8 154.9 191.4 329.7 319.0 444.1

Nonfarm noncorporate business

0.0 6.7 17.0 22.9 40.7 49.4 61.3 61.5 77.9

State and local governments

0.0 0.0 10.7 15.6 51.2 53.9 58.7 66.1 72.1

Life insurance companies

1.9 18.1 22.8 92.9 131.8 142.3 159.8 120.7 162.3

Private pension funds 2.6 17.8 37.9 62.5 76.9 81.1 84.5 84.9 90.2 State and local

government retirement funds

0.0 2.8 5.9 9.6 11.8 13.2 15.5 9.6 10.2

Funding corporations 0.6 36.6 109.5 142.3 296.3 321.1 444.4 314.6 346.1

TABLE 5–3 Growth in Long-Term versus Short-Term Mutual Funds, 1980–2006 (in billions of dollars)

Source: Federal Reserve Bulletin, “Flow of Fund Accounts,” various issues. www.federalreserve.gov

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124 Part One Introduction

1990s (through 2001). Despite this growth, the decline in the relative importance of short-term funds and the increase in the relative importance of long-term funds in the 1990s reflect the dramatic rise in equity returns over the 1990–2000 period even though MMMF interest spreads over bank deposits were mostly positive. However, a period of low interest rates that began in 2001 and persisted through 2005 resulted in a large relative drop in investments in MMMFs. Many individual and institutional investors moved assets from MMMFs to bank and thrift deposits and open market securities. Indeed, with short-term rates on MMMF too low to cover fund fees, in the early 2000s some MMMFs lowered fees in order to maintain net asset values (discussed below).

Year Equity Hybrid Bond

Taxable Money Market

Tax-Exempt Money Market Total

1980* 288 N/A 170 96 10 564 1990 1,099 193 1,046 506 235 3,079 2000 4,385 523 2,208 703 336 8,155 2002 4,747 473 2,035 679 310 8,244 2004 4,547 510 2,041 639 304 8,041 2006 4,768 508 1,993 576 273 8,118 2007 4,784 501 1,993 574 273 8,125

*The definition of equity, hybrid, and bond funds was reclassified in 1984. Thus, 1980 data are not directly comparable to data for other years.

TABLE 5–4 Number of Mutual Funds, 1980–2007

Source: Investment Com- pany Institute, 2006 Invest- ment Company Fact Book (Washington DC: Investment Company Institute, May 2006) and Trends in Mutual Fund Investing, January 2007. Reprinted by permission of the Investment Company Institute. www.ici.org

FIGURE 5–2 Interest Rate Spread and Net New Cash Flow to Retail Money Market Funds, 1985–2006 (percent)

Source: Investment Company Institute, Investment Company Fact Book (Washington, DC: Investment Company Institute, various issues). www.ici.org

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Interest rate spread

Net new cash flow

Percent of total assets Percent

4

3

2

1

0

−1

−2

4

3

2

1

0

−1

−2

Note: Net new cash flow is a percentage of retail money market fund assets and is shown as a six-month moving average. The interest rate spread is the dif- ference between the taxable money market fund yield and the average interest rate on savings deposits; the series is plotted with a six-month lag.

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 125

Table 5–4 reports the growth in this industry based on the number of mutual funds from 1980 through 2007. All categories of funds have increased in num- ber in this time period, from a total of 564 in 1980 to 8,125 in 2007. Tax- exempt money market funds first became available in 1979. This was the major reason for their relatively small number (10 funds) in 1980. Also, the number of equity funds has boomed, mainly in the 1990s: Equity funds numbered 4,784 in 2007, up from 1,099 in 1990, while bond funds numbered 1,993 in 2007, up from 1,046 in 1990.

Notice that in Table 5–3 households (i.e., small investors) own the majority of both long- and short-term funds: 70 percent for long-term mutual funds and 48 percent for short-term mutual funds at year-end 2006. This is to be expected, given that the rationale for the existence of mutual funds is to achieve superior diversification through fund and risk pooling compared to what individual small investors can achieve on their own. Consider that wholesale CDs sell in minimum denominations of $100,000 each and often pay higher interest rates than passbook savings accounts or small time deposits offered by depository institutions. By pooling funds in a money market mutual fund, small investors can gain access to wholesale money markets and instruments and, therefore, to potentially higher interest rates and returns.

Go to the Federal Reserve Board’s Web site at www.federalreserve.gov. Find the latest figures for the dollar value of money market and long-term mutual funds and the distribution of mu- tual fund investment by ownership using the following steps. Click on “Economic Research and Data.” Click on “Statistics: Releases and Historical Data.” Click on “Flow of Funds Accounts of the United States.” Click on the most recent date. Click on “Level tables.” This downloads a file onto your computer that contains the relevant data, in Tables L.206 and L.214.

Internet Exercise

As of 2006, 54.9 million (48 percent of) U.S. households owned mutual funds. This was down from 56.3 million (52 percent) in 2001. Table 5–5 lists some char- acteristics of household mutual fund owners as of 2006. Most are long-term own- ers, with 50 percent making their first purchases before 1990. While mutual fund investors come from all age groups, ownership is concentrated among individu- als in their prime saving and investing years. Two-thirds of households owning mutual funds in 2006 were headed by individuals between the ages of 35 and 64. Interestingly, the number of families headed by a person with less than a college degree investing in mutual funds is 44 percent. In 70 percent of married house- holds owning mutual funds, the spouse also worked full- or part-time. The bull markets of the 1990s, the low transaction costs of purchasing mutual funds shares, as well as the diversification benefits achievable through mutual fund investments are again the likely reasons for these trends. The typical fund-owning household had $48,000 invested in a median number of four mutual funds. Finally, 23 percent of investors who conducted equity fund transactions used the Internet for some or all of these transactions. This compares to 6 percent in 1998.

Notice, from Table 5–5 , that compared to 1995, 2006 has seen an increase in the median age of mutual fund holders (from 44 to 51 years) and a large increase in median household financial assets owned (from $50,000 to $125,000) and median mutual fund assets owned (from $18,000 to $48,000). Further, holdings of equity funds have increased from 73 to 80 percent of all households.

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126 Part One Introduction

Mutual Fund Objectives Regulations require that mutual fund managers specify the investment objectives of their funds in a prospectus available to potential investors. This prospectus should include a list of the securities that the fund holds. However, many “large” company funds, aiming to diversify across company size, held stocks of relatively “small” companies in the late 1990s, contrary to their stated objectives. Some fund managers justified the inclusion of seemingly “smaller” companies by changing their definition of what a large company was. For example, one fund manager stated the definition of a small company that he used is one that has less than $1 billion in equity capital, in contrast to a large company that has more than $1 bil- lion (the median size of equity capital of firms in the S&P 500 index is $28 billion). The point here is that investors need to read a prospectus carefully before making an investment.

Go to the Vanguard Group’s Web site at www.vanguard.com. Find the latest prospectus for the Vanguard 500 Index Fund using the following steps. Click on “Prospectuses.” Click on “Prospectus & reports.” In the line for “500 Index Fund Inv,” click on “View and Print.” Click on “I Accept.” This downloads a file onto your computer that contains the prospectus. What is listed as the primary investment objective for this fund?

Internet Exercise

2006 1995

Demographic Characteristics:

Median age 51 years 44 years Median household income $ 65,000 $ 60,000 Median household financial assets $125,000 $ 50,000

Percent:

Married or living with a partner 70.0 71.0 Employed 70.0 80.0 Four-year college degree or more 56.0 58.0 Household financial assets invested in

mutual funds 20.3 11.7

Owning fund inside employer-sponsored retirement funds

33.5 17.0

Owning fund outside employer-sponsored retirement funds

35.5 28.3

Mutual Fund Ownership Characteristics:

Median mutual fund assets $ 48,000 $ 18,000 Median number of funds owned 4 3

Fund Types Owned (percent):

Equity 80 73 Bond 33 49 Hybrid 65 N/A Money market 43 52

*Characteristics of primary financial decision maker in the household.

TABLE 5–5 Selected Characteristics of Household Owners of Mutual Funds*

Source: Investment Com- pany Institute, Equity Owner- ship in America, 2006 and 1996 Mutual Fund Fact Book (Washington, DC: Invest- ment Company Institute, 2006 and 1996). Reprinted by permission of the Investment Company Institute. www. ici.org

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 127

The aggregate figures for long-term equity, bond, and hybrid funds tend to obscure the fact that there are many different funds in these groups. Every mutual fund sponsor offers multiple funds of each type (e.g., long-term equity), differentiated by the securities held in the particular mutual fund as defined by the fund’s objective. Table 5–6 classifies 12 major categories of investment objec- tives (or classifications) for mutual funds. These objectives are shown along with the assets allocated to each major category. A fund objective provides general information about the types of securities a mutual fund will hold as assets. For example, “capital appreciation” funds hold securities (mainly equities) of high- growth, high-risk firms. Again, within each of these 12 categories of mutual funds are a multitude of different funds offered by mutual fund companies (see also the mutual fund quote section below). Historically, mutual funds have had to send out lengthy prospectuses describing their objectives and investments. In 1998, the SEC adopted a new procedure in which key sections of all funds’ prospectuses must be written in “plain” English instead of legal boilerplate. The idea is to increase the ability of investors to understand the risks related to the investment objectives or profile of a fund.

Table 5–7 lists the largest (in total assets held) 20 mutual funds available in March 2007, including the fund’s objective; 12-month, 5-year, and 10-year returns; net asset value (discussed below); and any initial fees (discussed below). American Funds’ Growth Fund of America Class A Shares (which seeks to invest primarily in common stocks of companies that appear to offer superior opportunities for growth of capital) was the largest fund at the time. American Funds, Vanguard, and Fidelity offered 18 of the top 20 funds measured by asset size. Many of the top funds list either growth or growth and income as the fund objective, and all of the top 20 funds performed well as the stock market saw high returns in the

www.americanfunds.comwww.americanfunds.com

www.vanguard.comwww.vanguard.com

www.fidelity.comwww.fidelity.com

Classification of Fund

Combined Assets

($ billions) Percent of Total

Total net assets $ 8,905.18 100.0%

Capital appreciation 2,376.65 26.7% World equity 919.58 10.3 Total return 1,643.80 18.5 Total equity funds $ 4,940.03 55.5%

Total hybrid funds $ 567.30 6.4%

Corporate bond 239.79 2.7% High-yield bond 143.99 1.6 World bond 45.36 0.5 Government bond 207.16 2.3 Strategic income 382.26 4.3 State municipal 148.14 1.7 National municipal 190.61 2.1 Total bond funds $ 1,357.31 15.2%

Taxable money market funds 1,706.54 19.2% Tax-exempt money market funds 334.00 3.7 Total money market funds $ 2,040.54 22.9%

TABLE 5–6 Total Net Asset Value of Equity, Hybrid, and Bond Funds by Investment Classification

Source: Investment Com- pany Institute, 2006 Invest- ment Company Fact Book (Washington, DC: Invest- ment Company Institute, 2004). Reprinted by permis- sion of the Investment Com- pany Institute. www.ici.org

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128 Part One Introduction

mid-2000s. Despite a downturn in the U.S. economy and a general drop in stock market values from 2001 through 2002, most of the top 20 funds earned strong positive returns over the period 1996–2006. At least half of the funds earned double-digit annual returns for each time period (12 months, 5 years, and 10 years). Fidelity’s Magellan Fund was the worst performer, with a return of 2.04 percent, 3.02 percent, and 6.53 percent for the three time periods, respectively. Over the same periods (12 months, 5 years, and 10 years), the S&P 500 index saw annual returns of 6.85 percent, 3.88 percent, and 7.55 percent, respectively. Of the top mutual funds, 17 outperformed the S&P 500 index over the 12-month period, and 19 outperformed it over the 5-year period; 15 of the 18 funds in existence over the 10-year period outperformed the S&P 500 index. It should be noted that the risk of returns [e.g., the fund’s total return risk or even its “beta” (or system- atic risk)] is rarely mentioned in prospectuses or advertisements. In 1998, the SEC adopted an initiative requiring mutual funds to disclose more information about their return risk as well as the returns themselves. The SEC’s rule was intended to better enable investors to compare return-risk trade-offs from investing in dif- ferent mutual funds.

Investor Returns from Mutual Fund Ownership The return an investor gets from investing in mutual fund shares reflects three aspects of the underlying portfolio of mutual fund assets. First, income and divi- dends are earned on those assets; second, capital gains occur when assets are

Name of Fund Objective Total Assets ($ millions)

Total Return

12 Month 5 Year 10 Year NAV Initial Fees

American Funds Growth; A Growth $83,868 5.75% 7.72% 12.18% $32.48 5.75% American Funds InvCoA Growth/Income 73,616 9.32 7.12 9.61 33.01 5.75 Vanguard 500 Index: Inv Growth/Income 70,112 8.12 5.29 7.36 128.21 0.00 Fidelity Invest: Contra Growth 68,135 6.14 10.65 10.58 63.81 0.00 American Funds WshMut Growth/Income 67,816 10.11 6.18 8.97 34.31 5.75 Dodge & Cox Stock Growth/Income 67,561 11.55 11.62 13.53 153.07 0.00 American Funds CIB;A Income 65,661 15.35 12.09 10.76 60.59 5.75 American Funds CWGI;A International 64,474 13.77 15.26 13.10 41.10 5.75 American Funds Inc;A Income 61,807 13.52 10.18 9.63 20.15 5.75 American Funds Eupac International 56,229 13.23 14.53 10.83 46.08 5.75 Fidelity Diversified Intl International 48,309 12.37 16.43 12.78 36.67 0.00 Vanguard 500 Index; Adm Growth/Income 47,280 8.22 5.37 NA 128.23 0.00 Vangaurd Instl Indx:Inst Balanced 45,197 8.26 5.42 7.49 127.26 0.00 Fidelity Magellan Growth 43,812 2.04 3.02 6.53 89.19 0.00 American Funds NPer;A International 43,296 12.22 10.90 11.16 31.22 5.75 Vanguard Tot Stk Inx;Inv Growth/Income 40,862 8.21 6.70 7.83 33.68 0.00 Fidelity Lw-Prcd Stock Smallcap 39,255 8.52 14.10 14.89 43.24 0.00 Dodge & Cox Intl Stock International 35,831 19.48 19.26 NA 44.15 0.00 American Funds Bal;A Balanced 35,399 7.36 6.68 9.10 18.79 5.75 American Funds FInv;A Growth/Income 33,000 11.04 9.74 10.40 39.64 5.75

TABLE 5–7 Largest Mutual Funds by Assets Managed

Source: The Wall Street Journal Online, March 16, 2007, and author’s research. Reprinted by permission of The Wall Street Journal, © 2007 Dow Jones & Com- pany, Inc. All rights reserved worldwide www.wsj.com

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 129

sold by a mutual fund at prices higher than the purchase price; third, capital appreciation in the underlying values of the assets held in a fund’s portfolio add to the value of mutual fund shares. With respect to capital appreciation, mutual fund assets are normally marked-to-market daily. This means that the managers of the fund calculate the current value of each mutual fund share by computing the daily market value of the fund’s total asset portfolio and then dividing this amount by the number of mutual fund shares outstanding. The resulting value is called the net asset value (NAV) of the fund. This is the price the investor gets when selling shares back to the fund that day or buying any new shares in the fund on that day.

Suppose a mutual fund contains 1,000 shares of Sears, Roebuck currently trading at $37.75, 2,000 shares of Exxon/Mobil currently trading at $43.70, and 1,500 shares of Citigroup cur- rently trading at $46.67. The mutual fund currently has 15,000 shares outstanding held by investors. Thus, today, the NAV of the fund is calculated as:

NAV � � � � � �[( , $ . ) ( , $ . ) ( , $1 000 37 75 2 000 43 70 1 500 446 67 15 000 13 01. )] , $ .� �

If next month Sears shares increase to $45, Exxon/Mobil shares increase to $48, and Citi- group shares increase to $50, the NAV (assuming the same number of shares outstanding) would increase to:

NAV � � � � � � �[( , $ ) ( , $ ) ( , $ )]1 000 45 2 000 48 1 500 50 155 000 14 40, $ .�

EXAMPLE 5–1 Impact of Capital Appreciation on NAV

Most mutual funds are open-end in that the number of shares outstanding fluctuates up and down daily with the amount of share redemptions and new purchases. With open-end mutual funds, investors buy and sell shares from and to the mutual fund company. Thus, the demand for shares determines the number outstanding and the NAV of shares is determined solely by the market value of the underlying securities held in the mutual fund divided by the number of share- holders outstanding.

Consider the mutual fund in Example 5–1, but suppose that today 1,000 additional investors buy into the mutual fund at the current NAV of $13.01. This means that the fund manager now has $13,010 in additional funds to invest. Suppose the fund manager decides to use these additional funds to buy additional shares in Sears. At today’s market price he or she can buy $13,010 � $37.75 = 344 additional shares of Sears. Thus, the mutual fund’s new portfolio of shares would be 1,344 in Sears, 2,000 in Exxon/Mobil, and 1,500 in Citigroup. At the end of the month the NAV of the portfolio would be:

NAV � � � � � � �[( , $ ) ( , $ ) ( , $ )]1 344 45 2 000 48 1 500 50 166 000 14 47, $ .�

given the appreciation in value of all three stocks over the month. Note that the fund’s value changed over the month due to both capital appreciation and

investment size. A comparison of the NAV in Example 5–1 with the one in this example in- dicates that the additional shares alone enabled the fund to gain a slightly higher NAV than had the number of shares remained static ($14.47 versus $14.40).

EXAMPLE 5–2 Impact of Investment Size on NAV

marked-to-market Adjusting asset and balance sheet values to reflect current mar- ket prices.

marked-to-market Adjusting asset and balance sheet values to reflect current mar- ket prices.

NAV The net asset value of a mutual fund; equal to the market value of the assets in the mu- tual fund portfolio di- vided by the number of shares outstanding.

NAV The net asset value of a mutual fund; equal to the market value of the assets in the mu- tual fund portfolio di- vided by the number of shares outstanding.

open-end mutual fund The supply of shares in the fund is not fixed but can increase or decrease daily with purchases and re- demptions of shares.

open-end mutual fund The supply of shares in the fund is not fixed but can increase or decrease daily with purchases and re- demptions of shares.

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130 Part One Introduction

Open-end mutual funds can be compared to most regular corporations traded on stock exchanges and to closed-end investment companies , both of which have a fixed number of shares outstanding at any given time. For example, real estate investment trusts (REITs) are closed-end investment companies that spe- cialize in investment in real estate company shares and/or in buying mortgages. 4 With closed-end funds, investors must buy and sell the investment company’s shares on a stock exchange similar to the trading of corporate stock. Since the number of shares available for purchase at any moment in time is fixed, the NAV of the fund’s shares is determined not only by the value of the underlying shares but also by the demand for the investment company’s shares themselves. When demand is high, the shares can trade at more than the NAV of the securities held in the fund. In this case, the fund is said to be trading at a premium, that is, at more than the fair market value of the securities held. When the value of the closed-end fund’s shares are less than the NAV of its assets, its shares are said to be trading at a discount, that is, at less than the fair market value of the securities held.

Because of high demand for a closed-end investment company’s shares, the 50 shares (NS) are trading at $20 per share (PS). The market value of the equity-type securities in the fund’s asset portfolio, however, is $800, or $16 ($800 � 50) per share. The market value balance sheet of the fund is shown below:

Assets Liabilities and Equity

Market value of asset portfolio $800 Market value of closed-end fund shares (PS � NS) $1,000

Premium $200

The fund’s shares are trading at a premium of $4(200 � 50) per share. Because of low demand for a second closed-end fund, the 100 shares outstanding are

trading at $25 per share. The market value of the securities in this fund’s portfolio is $3,000, or each share has a NAV of $30 per share. The market value balance sheet of this fund is:

Assets Liabilities and Equity

Market value of asset portfolio $3,000 Market value of closed-end fund shares (100 � $25) $2,500

Discount �$500

EXAMPLE 5–3 Market Value of Closed-End Mutual Fund Shares

Similar to closed-end funds in that a fixed number of shares are outstanding at any point in time, an exchange-traded fund (ETF) is an investment company with shares that trade intraday on stock exchanges at market-determined prices.

4 Many closed-end funds are specialized funds that invest in shares in countries such as Argentina, Brazil, and Mexico. The shares of these closed-end funds are traded on the NYSE or the over-the-counter mar- ket. The total market value of funds invested in closed-end funds was $298.3 billion at the end of 2006. This compares to $10,413.7 billion invested in open-end funds at that time.

closed-end investment companies Specialized invest- ment companies that invest in securities and assets of other firms but have a fixed supply of shares out- standing themselves.

closed-end investment companies Specialized invest- ment companies that invest in securities and assets of other firms but have a fixed supply of shares out- standing themselves.

REIT A real estate invest- ment trust. A closed- end investment company that special- izes in investing in mortgages, property, or real estate company shares.

REIT A real estate invest- ment trust. A closed- end investment company that special- izes in investing in mortgages, property, or real estate company shares.

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 131

ETFs may be bought or sold through a broker or in a brokerage account, like trading shares of any publicly traded company. While ETFs are registered with the SEC as investment companies, they differ from traditional mutual funds both in how their shares are issued and redeemed and in how their shares or units are traded. Specifically, ETF shares are created by an institutional inves- tor’s depositing of a specified block of securities with the ETF. In return for this deposit, the institutional investor receives a fixed amount of ETF shares, some or all of which may then be sold on a stock exchange. The institutional inves- tor may obtain its deposited securities by redeeming the same number of ETF shares it received from the ETF. Individual investors can buy and sell the ETF shares only when they are listed on an exchange. Unlike an institutional inves- tor, a retail investor cannot purchase or redeem shares directly from the ETF, as with a traditional mutual fund. As of 2007, 407 domestic ETFs traded, with assets of $431 billion.

Mutual fund investors can get information on the performance of mutual funds from several places. For example, for a comprehensive analysis of mutual funds, Morningstar, Inc., offers information on over 10,000 open-end and closed-end funds. Morningstar does not own, operate, or hold an interest in any mutual fund. Thus, it is recognized as the leading provider of unbiased data and performance analysis (e.g., of returns) for the industry.

Mutual Fund Costs Mutual funds charge shareholders a price or fee for the services they provide (i.e., management of a diversified portfolio of financial securities). Two types of fees are incurred by investors: sales loads and fund operating expenses. We discuss these next. The total cost to the shareholder of investing in a mutual fund is the sum of the annualized sales load and other fees charged.

Load versus No-Load Funds An investor who buys a mutual fund share may be subject to a sales charge, some- times as high as 8.5 percent. In this case, the fund is called a load fund. 5 Other funds that directly market shares to investors do not use sales agents working for commissions and have no up-front commission charges; these are called no-load funds.

The argument in favor of load funds is that their managers provide inves- tors with more personal attention and advice than managers of no-load funds. However, the cost of this increased attention may not be worthwhile. For example, the last column in Table 5–7 lists initial fees for the largest U.S. stock funds in 2007. Notice that only American Funds group assesses a load fee on mutual fund share purchases. After adjusting for this fee, the 12-month returns on the 10 American Funds mutual funds fall from 19.48 percent to 5.75 percent (among the highest returns earned by the largest funds) to 13.73 percent to 0.00 percent (among the lowest of the returns on these funds). As Figure 5–3 indicates, investors increas- ingly recognized this cost disadvantage for load funds in the 1990s as stock market values increased broadly and dramatically. In 1985, load funds represented almost 70 percent of equity mutual fund sales, and no-load funds represented just over 30 percent. By 1998 new sales of no-load mutual fund shares exceeded that of

5 Another kind of load, called a back-end load, is sometimes charged when mutual fund shares are sold by investors. Back-end loads, also referred to as deferred sales charges, are an alternative way to com- pensate the fund managers or sales force for their services.

www.morningstar.comwww.morningstar.com

no-load fund A mutual fund that does not charge up- front fees or commis- sion charges on the sale of mutual fund shares to investors.

no-load fund A mutual fund that does not charge up- front fees or commis- sion charges on the sale of mutual fund shares to investors.

load fund A mutual fund with an up-front sales or commission charge that has to be paid by the investor.

load fund A mutual fund with an up-front sales or commission charge that has to be paid by the investor.

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132 Part One Introduction

load fund shares, and by 2005 total assets invested in no-load funds far exceeded those invested in load funds. Of course, because the load fee is a one-time charge, it must be converted to an annualized charge incurred by the shareholder over the life of the investment. If the shareholder’s investment horizon is long term, the annualized load fee can end up being quite small. If the investment horizon is short, however, the load fee can leave the shareholder with little profit.

The demand for no-load funds by mutual fund investors has not gone unno- ticed. Many companies, particularly discount brokers, now offer mutual fund supermarkets through which investors can buy and sell mutual fund shares, offered by several different mutual fund sponsors, through a single broker. The most important feature of a fund supermarket is its non–transaction fee program, whereby an investor may purchase mutual funds with no transaction fees from a large number of fund companies. The broker is generally paid for services from the fund’s 12b–1 fees (see below). The non–transaction fee offerings at a discount broker often number in the thousands, providing an investor the convenience of purchasing no-load funds from different families at a single location.

Fund Operating Expenses In contrast to one-time up-front load charges on the initial investment in a mutual fund, annual fees are charged to cover all fund level expenses experienced as a percent of the fund assets. One type of fee (called a management fee ) is charged to meet operating costs (such as administration and shareholder services). In addi- tion, mutual funds generally require a small percentage (or fee) of investable funds to meet fund level marketing and distribution costs. Such annual fees are known as 12b–1 fees after the SEC rule covering such charges. 6 Because these

6 12b–1 fees are limited to a maximum of 0.25 percent on no-load funds.

12b–1 Fees Fees relating to the distribution and other operating costs of mutual fund shares.

12b–1 Fees Fees relating to the distribution and other operating costs of mutual fund shares.

FIGURE 5–3 Load versus No-Load Fund Assets as a Share of Fund Assets (percent)

Source: Investment Company Institute, Investment Company Fact Book (Washington, DC: Investment Company Institute, various issues). Reprinted by permission of the Investment Company Institute. www.ici.org

80

70

60

50

40

30

20

10

0

Equity funds (%)

1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Load

No-load

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 133

fees, charged to cover fund operating expenses, are paid out of the fund’s assets, investors indirectly bear these expenses.

EXAMPLE 5–4 Calculation of Mutual Fund Costs

The cost of mutual fund investing to the shareholder includes both the one-time sales load and any annual fees charged. Because the sales load is a one-time charge, it must be con- verted to an annualized payment incurred by the shareholder over the life of his or her invest- ment. With this conversion, the total shareholder cost of investing in a fund is the sum of the annualized sales load plus any annual fees.

For example, suppose an investor purchases fund shares with a 4 percent front-end load and expects to hold the shares for 10 years. The annualized sales load 7 incurred by the inves- tor is:

4 10%/ years .4% per year�

Further, suppose the fund has a total fund expense ratio (including 12b–1 fees) of 1 per-

cent per year. The annual total shareholder cost for this fund is calculated as

. % % . %4 1 1 4� � per year

Funds sold through financial professionals such as brokers have recently

adopted alternative payment methods. These typically include an annual 12b–1 fee based on asset values that also may be combined with a front-end or back-end sales charge. In many cases, funds offer several different share classes (all of which invest in the same underlying portfolio of assets), but each share class may offer investors different methods of paying for broker services. Indeed, in 2006, over half of all mutual funds had two or more share classes, compared to 1980 when all funds had only one share class. Most funds sold in multiple classes offer investors three payment plans through three share classes (A, B, and C), each having different mixes of sales loads and management and 12b–1 fees.

Class A shares represent the traditional means for paying for investment advice. That is, class A shares carry a front-end load that is charged at the time of purchase as a percent of the sales price. The front-end load on class A shares is charged on new sales and is not generally incurred when class A shares are exchanged for another mutual fund within the same fund family. In addition to the front-end load, class A shares usually have annual management and 12b–1 fees that are used to compensate brokers and sales professionals for ongoing assistance and service provided to fund shareholders. The management and 12b–1 fees for class A shares are typically between 25 and 35 basis points of the portfolio’s assets.

Unlike class A shares, class B shares are offered for sale at the NAV without a front-end load. Class B share investors pay for advice and assistance from brokers through a combination of annual management and 12b–1 fees (usually 1 percent) and a back-end load. The back-end load is charged when shares are redeemed (sold) and is typically based on the lesser of the original cost of the shares or the market value at the time of sale. After six to eight years, class B shares typically

7 Convention in the industry is to annualize the sales load without adjusting for the time value of money.

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134 Part One Introduction

convert to class A shares, lowering the level of the annual management and 12b–1 fees from 1 percent to that of A shares.

Class C shares are offered at the NAV with no front-end load, and they typi- cally recover distribution costs through a combination of annual management and 12b–1 fees of 1 percent and a back-end load, set at 1 percent in the first year of purchase. After the first year, no back-end load is charged on redemp- tion. Class C shares usually do not convert to class A shares, and thus the annual 1 percent payment to the broker continues throughout the period of time that the shares are held.

As discussed below, the lack of complete disclosure and the inability of most mutual fund investors to understand the different fees charged for various classes of mutual fund shares came under scrutiny in the early 2000s. Indeed, the poten- tial for overcharging fees to various classes of mutual fund shareholders led to the SEC creating new rules pertaining to these charges. Possibly as a result of these scandals and new rules, more than 850 mutual funds decreased their management fees in 2005, and over 700 lowered their fees in 2006. In 2005, the average fees and expenses paid by mutual fund investors fell to their lowest level in more than 25 years. Investors paid 1.13 percent on the average stock fund in 2005, down 0.04 percent from 2004. Bond fund investors paid an average of 0.90 percent, down 0.02 percent, and money market fund investors paid an average of 0.41 percent, down 0.01 percent from 2004.

Where do mutual funds rank in terms of asset size among all FI industries? Describe the difference between short-term and long-term mutual funds. What have been the trends in the number of mutual funds since 1980? What are the three biggest mutual fund companies? How have their funds performed in recent years? Describe the difference between open-end and closed-end mutual funds.

1. 2. 3. 4.

5.

Concept Questions Concept Questions

BALANCE SHEET AND RECENT TRENDS FOR THE MUTUAL FUND INDUSTRY

Money Market Funds Look at the distribution of assets of money market mutual funds from 1990 through 2006 shown in Table 5–8 . As you can see, in 2006, $1,514.9 billion (65.5 percent of total assets) was invested in short-term financial securities such as foreign depos- its, domestic checkable deposits and currency, time and savings deposits, repur- chase agreements (RPs), open market paper (mostly commercial paper), and U.S. government securities. Managers of these funds are particularly subject to credit risk, interest rate risk, foreign exchange risk, and market risk. Short-maturity asset holdings reflect the objective of these funds to retain the depositlike nature of the share liabilities they issue. In fact, most money market mutual fund shares have their values fixed at $1. Asset value fluctuations due to interest rate changes and capital gains or losses on assets are adjusted for by increasing or reducing the number of $1 shares owned by the investor.

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 135

Due to a drop in interest rates, the market value of the assets held by a particular MMMF increases from $100 to $110. The market value balance sheet for the mutual fund before and after the drop in interest rates is:

Assets Liabilities and Equity

(a) Before the interest rate drop: Market value of MMMF assets $100

Market value of MMMF fund shares (100 shares � $1) $100

(b) After the interest rate drop: Market value of MMMF assets 110

Market value of MMMF fund shares (110 shares � $1) 110

The interest rate drop results in 10 (110 � 100) new equity-type shares that are held by inves- tors in the MMMF, reflecting the increase in the market value of the MMMF’s assets of $10 (i.e., 10 new shares of $1 each).

EXAMPLE 5–5 Calculation of Number of Shares Outstanding in a Money Market Mutual Fund

Long-Term Funds Note the asset composition of long-term mutual funds shown in Table 5–9 . As might be expected, it reflects the popularity of different types of bond or equity funds at that time. Underscoring the attractiveness of equity funds in 2006 was the fact that stocks comprised over 70.7 percent of total long-term mutual fund asset portfolios. Credit market instruments were the next most popular assets (27.2 percent of the asset portfolio). In contrast, look at the distribution of assets in 1990, when the equity markets were not doing so well. Equities made up only 38.3 percent of the long-term mutual fund portfolios. Credit market instruments were the largest asset group, at 59.2 percent of total assets.

1990 1995 2000 2005 2006 Percent of Total, 2006

Total financial assets $493.3 $745.3 $1,812.1 $2,006.9 $2,312.5 100.0% Foreign deposits 26.7 19.7 91.1 94.7 84.2 3.6 Checkable deposits and currency 11.2 �3.5 2.2 �0.9 6.6 0.3 Time and savings deposits 21.9 52.3 142.4 183.0 206.7 8.9 Security RPs 58.2 87.8 183.0 346.0 394.9 17.1 Credit market instruments 371.3 545.5 1,290.9 1,340.8 1,561.0 67.5 Open market paper 204.0 235.5 608.6 492.2 608.4 26.3 U.S. government securities 81.3 160.8 275.6 248.7 214.1 9.3 Treasury 44.9 70.0 90.4 88.6 82.7 3.6 Agency 36.4 90.8 185.2 160.1 131.4 5.7 Municipal securities 84.0 127.7 244.7 336.7 370.2 16.0 Corporate and foreign bonds 2.0 21.5 161.9 263.2 368.3 15.9 Miscellaneous assets 4.0 43.4 102.5 43.3 59.1 2.6

TABLE 5–8 Distribution of Assets in Money Market Mutual Funds, 1990–2006 (in billions of dollars)

Source: Federal Reserve Board, “Flow of Fund Accounts,” various issues. www.federalreserve.gov

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136 Part One Introduction

Describe the major assets held by mutual funds in the 1990s and through the mid-2000s. How does the asset distribution differ between money market mutual funds and long-term mutual funds?

1.

2.

Concept Questions Concept Questions

REGULATION OF MUTUAL FUNDS

Because mutual funds manage and invest small investors’ savings, this industry is heavily regulated. Indeed, many regulations have been enacted to protect inves- tors against possible abuses by managers of mutual funds. The SEC is the pri- mary regulator of mutual funds. Specifically, the Securities Act of 1933 requires a mutual fund to file a registration statement with the SEC and sets rules and proce- dures regarding the fund’s prospectus sent to investors. In addition, the Securities Exchange Act of 1934 makes the purchase and sale of mutual fund shares subject to various antifraud provisions. This regulation requires that a mutual fund fur- nish full and accurate information on all financial and corporate matters to pro- spective fund purchasers. The 1934 act also appointed the National Association of Securities Dealers (NASD) to supervise mutual fund share distributions.

In 1940 Congress passed the Investment Advisers Act and the Investment Company Act. The Investment Advisers Act regulates the activities of mutual fund advisers. The Investment Company Act sets out rules to prevent conflicts of interest, fraud, and excessive fees or charges for fund shares.

In recent years, the passage of the Insider Trading and Securities Fraud Enforcement Act of 1988 has required mutual funds to develop mechanisms and procedures to avoid insider trading abuses. In addition, the ability of mutual funds to conduct their business is affected by the Market Reform Act of 1990, which was passed in the wake of the 1987 stock market crash. This act allows the SEC to intro- duce circuit breakers to halt trading on exchanges and to restrict program trading

www.sec.govwww.sec.gov

www.nasd.comwww.nasd.com

1990 1995 2000 2005 2006 Percent of Total, 2006

Total financial assets $608.4 $1,852.8 $4,434.6 6,048.9 $7,093.4 100.0% Security RPs 6.1 50.2 106.4 115.4 132.3 1.9 Credit market instruments 360.1 771.3 1,097.8 1,747.1 1,927.3 27.2 Open market paper 28.5 50.2 106.4 97.1 114.1 1.6 U.S. government securities 159.7 315.1 399.0 639.1 656.5 9.3 Treasury 111.1 205.3 123.7 155.7 159.9 2.3 Agency 48.6 109.9 275.3 483.4 496.6 7.0 Municipal securities 112.6 210.2 230.5 311.7 343.0 4.8 Corporate and foreign bonds 59.3 195.7 361.9 699.2 813.7 11.5 Corporate equities 233.2 1,024.9 3,226.9 4,175.7 5,018.4 70.7 Miscellaneous assets 8.9 6.3 3.5 10.7 15.4 0.2

TABLE 5–9 Distribution of Assets in Bond, Income, and Equity Market Mutual Funds, 1990–2006 (in billions of dollars)

Source: Federal Reserve Board, “Flow of Fund Accounts,” various issues. www.federalreserve.gov

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 137

when it deems necessary. Finally, the National Securities Markets Improvement Act (NSMIA) of 1996 also applies to mutual fund companies. Specifically, the NSMIA exempts mutual fund sellers from oversight by state securities regulators, thus reducing their regulatory burden.

Despite the many regulations imposed on mutual fund companies, several allegations of trading abuses and improper assignment of fees were revealed and prosecuted in the early 2000s. The abusive activities fell into four general catego- ries: market timing, late trading, directed brokerage, and improper assessment of fees to investors.

Market timing involves short-term trading of mutual funds that seeks to take advantage of short-term discrepancies between the price of a mutual fund’s shares and out-of-date values on the securities in the fund’s portfolio. It is especially common in international funds as traders can exploit differences in time zones. Typically, market timers hold a fund for only a few days. For example, when Asian markets close with losses, but are expected to rebound the following day, market timers can buy a U.S. mutual fund, investing in Asian securities after the loss on that day and then sell the shares for a profit the next day. This single-day invest- ment dilutes the profits of the fund’s long-term investors, while market timers profit without much risk.

Late trading allegations involved cases in which some investors were able to buy or sell mutual fund shares long after the price had been set at 4 pm eastern time each day (i.e., after the close of the NYSE and NASDAQ). Under existing rules, investors had to place an order with their broker or another FI by 4 pm. But the mutual fund company may not have received the order until much later, sometimes as late as 9 pm. However, because of this time delay, some large inves- tors had been able to call their broker back after the market closed and alter or cancel their order.

Directed brokerage involves arrangements between mutual fund companies and brokerage houses and whether those agreements improperly influenced which funds brokers recommended to investors. The investigation examined whether some mutual fund companies agreed to direct orders for stock and bond pur- chases and sales to brokerage houses that agreed to promote sales of the mutual fund company’s products.

Finally, regulators claimed that the disclosure of 12b–1 fees allowed some brokers to trick investors into believing they were buying no-load funds. Before 12b–1 fees, all funds sold through brokers carried front-end load fees. As dis- cussed above, with 12b–1 fees, fund companies introduced share classes, some of which carried back-end loads that declined over time and others that charged annual fees of up to 1 percent of asset values. Funds classes that charged annual 12b–1 fees would see performance decrease by that amount and thus not per- form as well as an identical fund that carried a lower 12b–1 fee. The shareholder, however, saw only the fund’s raw return (before annual fees) and not the dollar amount of the fee paid. Further, regulators discovered in late 2002 that brokers often overcharged customers by failing to provide discounts to fund investors who qualified to receive them. Since discount policies differ from fund to fund, brokers did not always realize which customers qualified for them. Table 5–10 lists some of the mutual fund companies at the center of these abuses, the abuses they were accused of, and outcomes of some of the investigations.

The result of these illegal and abusive activities was new rules and regulations imposed (in 2004) on mutual fund companies. The rules were intended to give

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138 Part One Introduction

investors more information about conflicts of interest, improve fund governance, and close legal loopholes that some fund managers had abused. Many of these new rules involve changes to the way mutual funds operate, including require- ments that funds have an independent board headed by an independent chair- man. Specifically, the SEC required an increase in the percentage of independent board members to 75 percent from the previous level of 50 percent and required mutual fund companies to have independent board chairs (a move that would displace the sitting chairmen at about 80 percent of the nations mutual funds). The SEC saw independent directors as those who better serve as watchdogs guard- ing investors’ interests. Further, the Sarbanes-Oxley Act of 2002 requires public companies, including mutual fund companies, to make sure their boards’ audit committees have at least one individual who is familiar with generally accepted

Company Charge Results

Alliance Capital Market timing $250 million settlement; 2 employees fired Bank of America Market timing/

late trading $515 million settlement; 3 employees

fired; several more employees resigned Bank One Market timing 2 managers resigned Bear Stearns Market timing 6 employees fired Canary Capital Market timing/

late trading $40 million settlement

Charles Schwab Late trading 2 employees fired Citigroup Market timing/

late trading 5 employees fired

Federated Investors Market timing Actions pending Fred Alger & Co. Market timing/

late trading Vice chairman convicted of felony and

fined $400,000; 2 employees fired Janus Capital Market timing $226 million settlement; CEO and others

resign; fee reductions of $125 million Merrill Lynch Market timing 3 employees fired MFS Investment

Management Market timing $225 million settlement; fee reductions

of $125 million Millennium Partners Late trading Fund trader pleads guilty and sentenced to up

to 4 years in prison Morgan Stanley Directed brokerage/

improper fees $50 million settlement

PBHG Funds Market timing Co-founders resign Pilgrim, Baxter &

Associates Market timing 2 founders resign

Prudential Securities Market timing 12 employees fired; 7 employees facing charges Putnam Investments Market timing/

improper fees $110 million settlement; CEO resigns; 6 fund

managers resign Security Trust Market timing Company closed; CEO, president, and head of trading

operations charged with grand larceny and fraud Strong Capital

Management Market timing $140 million settlement; chairman of mutual fund unit

resigns; fee reductions of $35 million

TABLE 5–10 Mutual Fund Investigations in the Early 2000s

Source: Author’s research.

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 139

accounting principles and has experience with internal auditing controls, prepar- ing or auditing financial statements of “generally comparable issuers,” and apply- ing GAAP principles for estimates, accruals, and reserves.

The SEC also took steps to close a loophole that allowed improper trading to go unnoticed at some mutual funds. Prior to the new rules, the SEC required that funds report trading by senior employees in individual stocks but not in shares of mutual funds they manage. The SEC now requires portfolio managers to report trading in funds they manage. Investment advisors also have to protect informa- tion about stock selections and client holding and transactions. The SEC and other regulators had found that advisory personnel revealed confidential information about fund portfolio holdings so that others could exploit the funds.

To address the problem of market timing, the SEC now requires funds to pro- vide expanded disclosure of the risks of frequent trading in fund shares and of their policies and procedures regarding such activities. Mutual funds also now have to be more open about their use of fair value pricing (a practice of estimating the value of rarely traded securities or updating the values of non-U.S. securities that last traded many hours before U.S. funds calculate their share prices each day) to guard against stale share prices that could produce profits for market tim- ers. The market timing provisions also require mutual funds to explain when they use fair value pricing. Fair value pricing is one of the most effective ways of com- bating the market timing that was most common in some mutual funds holding non-U.S. stocks. Many mutual funds had rarely used fair value pricing. Further, new SEC rules require brokers to tell investors about any payments, compensa- tion, or other incentives they receive from fund companies including whether they were paid more to sell a certain fund. Conflicts would have to be disclosed before the sale is completed. Finally, the SEC required that any profits earned by market timers be returned to investors in the mutual funds hurt by the timing. The Ethical Dilemmas box illustrates, however, that even after the new rules were in effect, not all mutual funds acted accordingly.

To ensure that the required rule changes take place, starting October 5, 2004, the SEC required that mutual funds hire chief compliance officers to monitor whether the mutual fund company follows the rules. The chief compliance officer will report directly to mutual fund directors, and not to executives of the fund management company. To further insulate the chief compliance officer from being bullied into keeping quiet about improper behavior, only the fund board can fire the compliance officer. Duties of the compliance officer include policing personal trading by fund managers, ensuring accuracy of information provided to regula- tors and investors, reviewing fund business practices such as allocating trading commissions, and reporting any wrongdoing directly to fund directors.

Finally, the new SEC rules call for shareholder reports to include the fees share- holders paid during any period covered, as well as management’s discussion of the fund’s performance over that period. As of September 1, 2004, mutual fund companies must provide clear information to investors on brokerage commissions and discounts, including improved disclosure on up-front sales charges for broker- sold mutual funds. Investors now get a document showing the amount they paid for a fund, the amount their broker was paid, and how the fund compares with industry averages based on fees, sales loads, and brokerage commissions. As of December 2004, mutual funds must provide to investors summary information in a fund prospectus on eligibility for breakpoint discounts and explain what records investors may need to show brokers to demonstrate they qualify for discounts.

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The SEC also proposed that mutual funds or their agents receive all trading orders by 4 pm eastern time, when the fund’s daily price is calculated. This “hard closing,” which would require fund orders to be in the hands of the mutual fund companies by 4 pm, is intended to halt late trading abuses. This proposal has not yet been passed because some argued that the change would cause significant problems for investors who buy funds through brokers. The move requires dead- lines several hours earlier at intermediaries such as brokerage firms, forcing them to place orders as early as 10 am so their requests are processed on the same day. Thus, mutual fund investors using brokers for their trades would have less flex- ibility than direct mutual fund investors.

Despite these scandals, and possibly as a result of the corrective actions by regulators, the Investment Company Institute reported in 2006 that mutual fund investors’ impressions of mutual funds improved for the third consecutive year. More than 75 percent of mutual fund shareholders had a “very” or “some- what” favorable impression of mutual fund companies. However, the survey

JEFFERIES SETTLES PROBE OF LAVISH GIFTS, BUT FIDELITY ISN’T OUT OF THE WOODS YET

Brokerage firm Jefferies Group Inc. has agreed to pay more than $10 million to settle allegations that a former star trader doled out gifts and entertainment, including ex- pensive wine and private jet flights, to Fidelity Investments to win mutual fund trading business. The National Association of Securities Dealers, which spearheaded the inves- tigation, imposed a $5.5 million penalty on Jefferies, and the Securities and Exchange Commission ordered Jefferies to return nearly $4.8 million of trading gains. The firm, which settled charges without admitting or denying guilt, has been ordered to hire a monitor to review travel, entertainment and gift policies.

Former Jefferies trader Kevin Quinn, whom Jefferies armed with a big expense ac- count to lure Fidelity business, was fined $468,000, and Scott Jones, a Jefferies board member who was Mr. Quinn’s immediate supervisor, was fined $50,000. . . . Mutual funds are supposed to send their stock trades to whichever firm offers them—and their customers—the best price and service, and such decisions aren’t supposed to be based on gifts a fund manager may have received from a broker. . . .

In 2002, the company hired Mr. Quinn, agreeing to pay him $4 million a year. The firm armed the trader with a $1.5 million expense account that Mr. Quinn used to curry favor with a select group of Fidelity traders. He spared little expense, doling out gifts valued at more than $600,000 and entertainment that totaled more than $1 million, regulators estimated. The NASD bars gifts valued at more than $100 and allows “ordinary and usual business entertainment” so long as it is “neither so fre- quent nor so extensive as to raise any question of propriety.” Mr. Quinn bought tickets to concerts and tennis matches at Wimbledon and the U.S. Open, often making avail- able a private plane so traders could travel in style to the events, regulators said. In 2004, Jefferies paid more than $125,000 for a weekend trip to the Super Bowl that featured parties hosted by Maxim and Playboy magazines. Regulators said the broker- age firm also bought traders numerous bottles of wine, including six bottles of 1998 Pous One for a total of more than $2,600. . . . As the probe unfolded, some traders said they reimbursed Jefferies for some of the gifts. Still, regulators said any money paid to Jefferies didn’t come close to covering the amount that was spent.

Source: Susanne Craig and Jennifer Levitz, The Wall Street Journal, December 5, 2006, p. C1. Reprinted by permission of the Wall Street Journal, © 2006 Dow Jones & Company, Inc. All rights reserved worldwide.

Ethical Dilemmas

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 141

also found that fund performance is the main factor that affects investor sen- timent regarding mutual funds. Nearly 50 percent of all fund investors listed fund performance as the most important factor in determining their opinion of the mutual fund industry. The S&P 500 index and mutual fund investor ratings both peaked in 2000, fell between 2001 and 2003, and increased each year since 2004. Thus, despite the problems and scandals experienced in the early 2000s, it is fund performance that has the biggest impact on mutual fund investors’ opin- ions of the industry. 8

Who is the primary regulator of mutual fund companies? How did the NSMIA affect mutual funds?

1. 2.

Concept Questions Concept Questions

GLOBAL ISSUES IN THE MUTUAL FUND INDUSTRY

As discussed throughout the chapter, mutual funds have been the fastest-growing sector in the U.S. financial institutions industry throughout the 1990s and into the 2000s. Worldwide investment in mutual funds is shown in Table 5–11 . While not as striking as the growth in U.S. funds, worldwide (other than in the United States) investments in mutual funds have increased over 307 percent, from $2.575 trillion in 1996 to $10.490 trillion in 2006. This compares to growth of over 176 percent in U.S. funds. The relatively large returns on U.S. stocks are the most likely reason for this growth in U.S. funds relative to other countries. In contrast, as this industry developed in countries throughout the world, the number of mutual funds world- wide (other than in the United States) increased over 100 percent, from 25,534 in 1996 to 51,707 in 2006. Much more established in the United States, the number of U.S. mutual funds increased 29 percent over this period. In 2006, of the total amount invested in mutual funds outside the United States, 41.9 percent was in equity funds, 23.2 percent in bond funds, 15.1 percent in hybrid funds, and 19.8 percent in money market funds.

As may be expected, the worldwide mutual fund market is most active in those countries with the most sophisticated securities markets (e.g., Japan, France, Australia, and the United Kingdom). However, in the late 1990s and early 2000s, the faltering Japanese economy resulted in a decrease in both the assets invested in and the number of mutual funds. Assets invested in Japanese mutual funds fell from $502.7 billion in 1999 to $432.0 billion in 2000 (a drop of 14.1 percent) and the number of funds fell from 3,444 to 2,884 (16.3 percent) over the period. Some U.S. FIs saw this decline in the Japanese market as an opportunity. U.S. FIs such as Paine Webber Group (teaming up with Yasuda Life Insurance Co.) and Merrill Lynch (buying the assets of failed Japanese brokerage firm Yamaichi Securities) entered the Japanese mutual fund market in the late 1990s. The U.S. FIs saw Japan as a profitable market for mutual fund sales, noting that about 60 percent of Japan’s savings was in low-yielding bank deposits or government-run

8 See “Shareholder Sentiment about the Mutual Fund Industry, 2006,” Research Fundamentals, Invest- ment Company Institute, December 2006. www.ici.org

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142 Part One Introduction

Non-U.S. Countries 1999 2000 2002 2005 2006†

Argentina $ 6,990 $ 7,425 $ 1,021 $ 3,626 $ 4,811 Australia N/A 341,955 356,304 700,068 777,254 Austria 56,254 56,549 66,877 109,002 120,132 Belgium 65,461 70,313 74,983 115,314 129,328 Brazil 117,758 148,538 96,729 302,927 394,613 Canada 269,825 279,511 248,979 490,518 545,602 Chile 4,091 4,597 6,705 13,969 16,671 Costa Rica N/A N/A 1,738 804 1,069 Czech Republic 1,473 1,990 3,297 5,331 5,952 Denmark‡ 27,558 32,485 40,153 75,199 86,588 Finland 10,318 12,698 16,516 45,415 58,987 France 656,132 721,973 845,147 1,362,671 1,658,966 Germany 237,312 238,029 209,168 296,787 320,916 Greece 36,397 29,154 26,621 32,011 26,457 Hong Kong 182,265 195,924 164,322 460,517 567,008 Hungary 1,725 1,953 3,992 6,068 6,362 India 13,065 13,507 20,364 40,546 52,874 Ireland 95,174 137,024 250,116 546,242 726,697 Italy 475,661 424,014 378,259 450,514 442,706 Japan 502,752 431,996 303,191 470,044 527,179 Korea 167,177 110,613 149,544 198,994 241,937 Liechtenstein N/A N/A 3,847 13,970 16,404 Luxembourg 661,084 747,117 803,869 1,635,785 1,988,166 Mexico 19,468 18,488 30,759 47,253 58,753 Netherlands 94,539 93,580 84,211 94,357 102,478 New Zealand 8,502 7,802 7,505 10,332 11,659 Norway 15,107 16,228 15,471 40,122 45,441 Pakistan N/A N/A N/A N/A 2,146 Philippines 117 108 474 1,449 1,272 Poland 762 1,546 5,468 17,652 23,138 Portugal 19,704 16,588 19,969 28,801 30,005 Romania N/A 8 27 109 191 Russia 177 177 372 2,417 4,334 Slovakia N/A N/A N/A 3,035 2,765 South Africa 18,235 16,921 20,983 65,594 63,896 Spain 207,603 172,438 179,133 316,864 356,208 Sweden 83,250 78,085 57,992 119,059 153,351 Switzerland 82,512 83,059 82,622 116,669 147,198 Taiwan 31,153 32,074 62,153 57,301 53,870 Turkey N/A N/A 6,002 21,761 15,505 United Kingdom 375,199 361,008 288,887 547,103 701,478

Total non-U.S. $ 4,544,799 $ 4,906,394 $ 4,933,771 $ 8,866,203 $ 10,490,370

Total U.S. $ 6,846,339 $ 6,964,667 $ 6,390,360 $ 8,904,822 $ 9,727,758 Total world $11,391,138 $11,871,061 $11,324,131 $ 17,771,025 $ 20,218,128

*Funds of funds are not included. Data include home-domiciled funds, except for Hong Kong, Korea, and New Zealand. †As of end of the third quarter. ‡Before 2003, data include special funds reserved for institutional investors. Note: Components may not add to total because of rounding.

TABLE 5–11 Worldwide Assets of Open-End Investment Companies* (in million of dollars)

Source: Investment Company Institute, Investment Company Fact Book (Washington, DC: Investment Company Institute, various issues). Reprinted by permis- sion of the Investment Company Institute. www.ici.org

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 143

institutions. 9 The worldwide economic downturn in 2001–2002 also affected the global mutual fund industry. Assets invested in non-U.S. mutual funds fell from $ 4.91 trillion in 1999 to $4.68 trillion in 2001. As the worldwide economic situation improved in the mid-2000s, so did assets invested in mutual funds, rising to $10.49 trillion by 2006.

Although U.S. mutual fund companies sponsor funds abroad, barriers to entry overseas are typically higher than in the United States. The U.S. mutual fund indus- try has worked to lower the barriers that prevent U.S. mutual fund firms from marketing their services more widely and to improve competition in the oftendi- verse fund markets around the world. The U.S. mutual fund industry, for example, has worked to achieve a true cross-border market for mutual fund companies in Europe and to ensure that publicly offered mutual fund companies can be used as funding vehicles in the retirement fund market in Europe and Japan. The industry also has sought to reduce barriers for U.S. mutual fund sponsors seeking to offer mutual fund company products in China and other Asian countries.

What have been the trends in the assets invested in worldwide mutual funds from the 1990s through the mid-2000s?

1.Concept Question Concept Question

HEDGE FUNDS

Hedge funds are a type of investment pool that solicits funds from (wealthy) individuals and other investors (e.g., commercial banks) and invests these funds on their behalf. Hedge funds are similar to mutual funds in that they are pooled investment vehicles that accept investors’ money and generally invest it on a col- lective basis. Hedge funds, however, are not required to register with the SEC. Thus, they are subject to virtually no regulatory oversight (e.g., by the SEC under the Securities Act and Investment Advisors Act) and generally take significant risk. Hedge funds are also not subject to the numerous regulations that apply to mutual funds for the protection of individuals, such as regulations requiring a cer- tain degree of liquidity, regulations requiring that mutual fund shares be redeem- able at any time, regulations protecting against conflicts of interest, regulations to ensure fairness in the pricing of funds shares, disclosure regulations, and regula- tions limiting the use of leverage. Further, hedge funds do not have to disclose their activities to third parties. Thus, they offer a high degree of privacy for their investors. Hedge funds offered in the United States avoid regulations by limiting the number of investors to less than 100 individuals (below that required for SEC registration), who must be deemed “accredited investors.” To be accredited, an investor must have a net worth of over $1 million or have an annual income of at least $200,000 ($300,000 if married). These stiff financial requirements allow hedge funds to avoid regulation under the theory that individuals with such wealth should be able to evaluate the risk and return on their investments. According to the SEC, these types of investors should be expected to make more informed deci- sions and take on higher levels of risk.

9 It might be noted that as many European countries move away from state-sponsored pension plans to privately funded pension plans and retirement vehicles, the rate of growth in mutual funds in these coun- tries is likely to accelerate rapidly.

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144 Part One Introduction

Because hedge funds are exempt from many of the rules and regulations govern- ing mutual funds, they can use aggressive strategies that are unavailable to mutual funds, including short selling, leveraging, program trading, arbitrage, and deriva- tives trading. Further, since hedge funds do not register with the SEC, their actual data cannot be independently tracked. Therefore, hedge fund data are self-reported. It is estimated that in 2007 there were over 9,000 hedge funds in the United States, with managed assets estimated at $2.1 trillion. Estimates of new assets flowing into hedge funds in the mid-2000s exceeded $25 billion annually. Table 5–12 lists the estimated 10 largest hedge funds by total assets managed in 2006.

Hedge funds grew in popularity in the 1990s as investors saw returns of over 40 percent after management fees (often more than 25 percent of the fund’s profits). They came to the forefront of the news in the late 1990s when one large hedge fund, Long-Term Capital Management (LTCM), nearly collapsed. The near collapse of LTCM not only hurt its investors, but arguably came close to damaging the world’s financial system. So great was the potential impact of the failure of LTCM that the Federal Reserve felt it was necessary to intervene by brokering a $3.6 billion bail- out of LTCM by a consortium of some of the world’s largest financial institutions.

Some hedge funds take positions (using sophisticated computer models) specu- lating that some prices will rise faster than others. For example, a hedge fund may buy (take a long position in) a bond expecting that its price will rise. At the same time the fund will borrow (taking a short position) in another bond and sell it, promising to return the borrowed bond in the future. Generally, bond prices tend to move up and down together. Thus, if prices go up as expected, the hedge fund will gain on the bond it purchased while losing money on the bond it borrowed. The hedge fund will make a profit if the gain on the bond it purchased is larger than the loss on the bond it borrowed. If, contrary to expectations, bond prices fall, the hedge fund will make a profit if the gains on the bond it borrowed are greater than the losses on the bond it bought. Thus, regardless of the change in prices, the simultaneous long and short positions in bonds will minimize the risk of overall losses for the hedge fund.

Types of Hedge Funds Most hedge funds are highly specialized, relying on the specific expertise of the fund manager(s) to produce a profit. Hedge fund managers follow a variety of investment strategies, some of which use leverage and derivatives, while oth- ers use more conservative strategies and involve little or no leverage. Generally,

Name of Fund Country Total Assets

(billions)

Goldman Sachs Hedge Funds Strategies United States $29.0 D. E. Shaw & Company United States 26.0 Union Bancaire Privée Switzerland 20.8 HSBC Private Bank Switzerland 20.2 Och-Ziff United States 19.8 Permal Asset Management United States 18.8 Crédit Agricole Alternative Investment Products France 18.5 Société Générale France 15.9 Quellos Capital Management United States 15.0 Ivy Asset Management United States 14.9

TABLE 5–12 Largest Hedge Funds by Assets Managed

Source: Institutional Investor Magazine, December 2006. www.institutionalinvestor .com

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 145

hedge funds are set up with specific parameters so that investors can forecast a risk-return profile. Figure 5–4 shows the general categories of hedge funds by risk classification.

More risky funds are the most aggressive and may produce profits in many types of market environments. Funds in this group are classified by objectives such as aggressive growth, emerging markets, macro, market timing, and short selling. Aggressive growth funds invest in equities expected to experience acceleration in growth of earnings per share. Generally, high price-to-earnings ratio, low or no dividend companies are included. These funds hedge by shorting equities where earnings disappointment is expected or by shorting stock indexes. Emerging mar- ket funds invest in equity or debt securities of emerging markets, which tend to have higher inflation and volatile growth. Macro funds aim to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates. These funds include investments in equities, bonds, curren- cies, and commodities. They use leverage and derivatives to accentuate the impact of market moves. Market timing funds allocate assets among different asset classes depending on the manager’s view of the economic or market outlook. Thus, port- folio emphasis may swing widely between asset classes. The unpredictability of market movements and the difficulty of timing entry and exit from markets add significant risk to this strategy. Short-selling funds sell securities in anticipation of being able to buy them back in the future at a lower price based on the manager’s assessment of the overvaluation of the securities or in anticipation of earnings disappointments.

Moderate risk funds are more traditional funds, similar to mutual funds, with only a portion of the portfolio being hedged. Funds in this group are classified by objectives such as distressed securities, fund of funds, opportunistic, multistrat- egy, and special situations. Distressed securities funds buy equity, debt, or trade claims, at deep discounts, of companies in or facing bankruptcy or reorganization. Profit opportunities come from the market’s lack of understanding of the true value of these deep-discount securities and from the fact that the majority of insti- tutional investors cannot own below-investment-grade securities. Funds of funds mix hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns and risk can be controlled by

More Risky Market directional—These funds seek high returns using leverage, typically investing based on anticipated events.

Market neutral or value orientation—These funds have moderate exposure to market risk, typically favoring a longer-term investment strategy.

Market neutral—These funds strive for moderate, consistent returns with low risk.

Moderate Risk

Risk Avoidance

FIGURE 5–4 Classification of Hedge Funds

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146 Part One Introduction

the mix of underlying strategies and funds. Capital preservation is generally an important consideration for these funds. Opportunistic funds change their invest- ment strategy as opportunities arise to profit from events such as IPOs, sudden price changes resulting from a disappointing earnings announcement, and hostile takeover bids. These funds may utilize several investing styles at any point in time and are not restricted to any particular investment approach or asset class. Multistrategy funds take a diversified investment approach by implementing var- ious strategies simultaneously to realize short- and long-term gains. This style of investment allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Special-situation funds invest in event-driven situations such as mergers, hostile takeovers, reorganiza- tions, or leveraged buyouts. These funds may undertake the simultaneous pur- chase of stock in a company being acquired and sale of stock in its bidder, hoping to profit from the spread between the current market price and the final purchase price of the company.

Risk-avoidance funds are more traditional funds, emphasizing consistent but moderate returns while avoiding risk. Funds in this group are classified by objec- tives such as income, market neutral–arbitrage, market neutral–securities hedging, and value. Income funds invest with the primary focus on yield or current income rather than solely on capital gains. These funds use leverage to buy bonds and some fixed-income derivatives, profiting from principal appreciation and interest income. Market neutral–arbitrage funds attempt to hedge market risk by taking offsetting positions, often in different securities of the same issuer, for example, long convertible bonds and short the firm’s equity. Their focus is on obtaining returns with low or no correlation to both equity and bond markets. Market neutral–securities hedging funds invest equally in long and short equity portfolios in particular market sectors. Market risk is reduced, but effective stock analysis is critical to obtaining a profit. These funds use leverage to magnify their returns. They also sometimes use market index futures to hedge systematic risk. Value funds invest in securities perceived to be selling at deep discounts relative to their intrinsic values. Securities include those that may be out of favor or underfollowed by analysts.

Using traditional risk-adjusted measures of performance (such as Sharpe ratios), the performance of hedge funds has been very strong compared to that of traditional financial investments like stocks and bonds. 10 Many hedge funds posted strong returns during the early 2000s even as stock returns were plum- meting. Table 5–13 lists the top hedge fund managers and their hedge fund com- pany by 2005 earnings. Total assets managed by hedge funds increased by almost 6 percent in the last quarter of 2006 and by 22 percent in the first quarter of 2007. Funds of hedge funds grew by 22 percent to $953 billion, equity-focused hedge funds increased 30 percent to $743 billion, emerging market equity-focused funds increased by 58 percent, and energy sector funds grew by 52 percent to $79.3 bil- lion. Note that while mutual fund performance is generally measured by returns relative to some benchmark (and therefore can perform “well” even by losing

10 However, data deficiencies in the reporting and collection of hedge fund returns somewhat reduce confidence in all measures of hedge fund performance. Further, the inability to explain returns of individ- ual hedge funds with standard multifactor risk models leaves open the possibility that it is not possible to properly measure the risk associated with at least some hedge fund strategies. If so, risk-adjusted returns earned by hedge funds may be overstated.

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 147

10 percent if the benchmark loses 10.5 percent), performance of hedge funds is measured by the growth in total assets managed.

Despite their name, hedge funds do not always “hedge” their investments to protect the fund and its investors against market price declines and other risks. For example, while bond prices generally move in the same direction, the risk in hedge funds is that bond prices may unexpectedly move faster in some markets than others. For example, in 1997 and 1998 computer models used by LTCM detected a price discrepancy between U.S. Treasury markets and other bonds (including high yield corporate bonds, mortgaged-backed securities, and European government bonds). LTCM consequently shorted U.S. Treasury securities (betting their prices would fall) and took long positions in other types of bonds (betting their prices would rise). However, unexpectedly, in 1998 large drops in many foreign stock markets caused money to pour into the U.S. Treasury markets, driving Treasury security prices up and yields down. This drop in U.S. Treasury yields drove rates on mortgages down, which pushed down the prices of many mortgage-backed securities. Further, the flight to U.S. Treasury security markets meant a drop in funds flowing into European bond markets and high-yield corporate bond mar- kets. With all of their positions going wrong, LTCM experienced huge losses. 11

In recent years, hedge funds have played an even bigger role in terms of global capital flows. During the early 2000s, riskier securities around the globe became popular investments for hedge funds eagerly searching for higher returns in a low– interest rate environment. In early 2004 emerging market bond yields started to rise far more rapidly than those on U.S. Treasury bonds, increasing the gap in yields between the two as investors moved out of the riskier emerging country bond mar- ket. As a result, as rising interest rates negatively impacted emerging market hedge fund investments, many hedge funds saw decreases in returns. Consequently, there are fears that hedge funds may see a repeat of 1998. This time, however, no one fund is likely to pose a systemic risk since, after LTCM, the amount of borrow- ing banks extend to any one hedge fund client is far more carefully monitored. But given the copycat nature of hedge fund management, there is concern that similar fund strategies by many hedge funds are combining to create potential systematic

11 A major reason for LTCM’s large loss was that it was so highly leveraged compared to other funds. LTCM was two to four times more leveraged than the typical fund.

Fund Manager Fund Company Asset Growth

(billions)

T. Boone Pickens BP Capital Management $1.50 Steven A. Cohen SAC Capital Advisors 1.00� James H. Simons Renaissance Technologies 0.90–1.00 Paul Tudor Jones Tudor Investment Corp. 0.80–0.90 Stephen Feinberg Cerberus Capital Management 0.50–0.60 Bruce Kovner Caxton Associates 0.50–0.60 Eddie Lampert ESL Investments 0.50–0.60 David E. Shaw D. E. Shaw & Co. 0.40–0.50 Jeffrey Gendell Tontine Partners 0.30–0.35 Louis Bacon Moore Capital Management 0.30–0.35 Stephen Mandel Lone Pine Capital 0.30–0.35

TABLE 5–13 Largest Hedge Funds by Fund Earnings

Source: Institutional Investor Magazine, December 2006. www.institutionalinvestor .com

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148 Part One Introduction

LTCM-type problems. Along with the use of similar investment strategies, many hedge funds are using the same risk models. These models are often historically based and are subject to similar errors in predicting the future.

Fees on Hedge Funds Hedge fund managers generally charge two type of fees: management fees and performance fees. As with mutual funds, the management fee is computed as a percentage of the total assets under management and typically runs between 1.5 and 2.0 percent. Performance fees are unique to hedge funds. Performance fees give the fund manager a share of any positive returns on a hedge fund. The aver- age performance fee on hedge funds is approximately 20 percent but varies widely. For example, Steven Cohen’s SAC Capital Partners charges a performance fee of 50 percent. Performance fees are paid to the hedge fund manager before returns are paid to the fund investors. Hedge funds often specify a hurdle rate, which is a minimum annualized performance benchmark that must be realized before a per- formance fee can be assessed. Further, a high-water mark is usually used for hedge funds in which the manager does not receive a performance fee unless the value of the fund exceeds the highest net asset value it has previously achieved. High-water marks are used to link the fund manager’s incentives more closely to those of the fund investors and to reduce the manager’s incentive to increase the risk of trades.

Offshore Hedge Funds Hedge funds that are organized in the United States are designated as domes- tic hedge funds. These funds require investors to pay income taxes on all earn- ings from the hedge fund. Funds located outside the United States and structured under foreign laws are designated as offshore hedge funds. Many offshore finan- cial centers encourage hedge funds to locate in their countries. The major centers include the Cayman Islands, Bermuda, Dublin, and Luxembourg. The Cayman Islands is estimated to be the location of approximately 75 percent of all hedge funds. Offshore hedge funds are regulated in that they must obey the rules of the host country. However, the rules in most of these countries are not generally bur- densome and provide anonymity to fund investors. Further, offshore hedge funds are not subject to U.S. income taxes on distributions of profit or to U.S. estate taxes on fund shares. Europe is the fastest-growing area for offshore hedge funds, with total assets managed of $743 billion.

When compared to domestic hedge funds, offshore hedge funds have been found to trade more intensely, due to the low or zero capital gains tax for offshore funds. Further, offshore hedge funds tend to engage less often in positive feedback trading (rushing to buy when the market is booming and rushing to sell when the market is declining) than domestic hedge funds. Finally, offshore hedge funds have been found to herd (mimic each other’s behavior when trading while ignor- ing information about the fundamentals of valuation) less than domestic hedge funds. Many hedge fund managers maintain both domestic and offshore hedge funds. Given the needs of their client investors, hedge fund managers want to have both types of funds to attract all types of investors.

Regulation of Hedge Funds While mutual funds are very highly regulated, hedge funds are generally unregu- lated. Mutual funds in the United States are required to be registered with the SEC. Although hedge funds fall within the same statutory category as mutual

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 149

funds, they operate under two exemptions from registration requirements as set forth in the Investment Company Act of 1940. First, funds are exempt if they have less than 100 investors; second, funds are exempt if the investors are “accredited.” To comply with SEC exemptions, hedge funds are also sold only via private place- ments. Thus, hedge funds may not be offered or advertised to the general invest- ing public.

Nevertheless, hedge funds are prohibited from abusive trading practices and a number got mixed up in the scandals plaguing the mutual fund indus- try in the early 2000s. For example, Canary Capital Partners and its managers agreed to pay $30 million from its illicit profits as well as a $10 million penalty to the SEC to settle allegations that it engaged in illegal trading practices with mutual fund companies, including making deals after the market had closed and promising to make substantial investments in various funds managed by the mutual funds. More recently, in March 2007, the SEC charged 14 defendants in a scheme involving insiders at UBS Securities, Morgan Stanley, and several hedge funds and hedge fund managers. The SEC claimed that the defendants made $15 million in illicit profits through thousands of illegal trades, using inside information misappropriated from UBS. Just two months prior to this announcement, regulators announced an investigation of UBS and other banks that leased office space to hedge fund traders. Regulators stated a concern about the relationship between the banks and their hedge fund “hotel guests,” look- ing at whether the banks might be using the real estate relationships as a way to entice hedge funds to do business with them, possibly at the expense of the funds’ investors. Specifically, there was an investigation into whether hedge funds located in bank buildings were paying higher than normal trading fees to banks to compensate them for the office space and failing to disclose this expense to investors.

Further, in 2006 regulators found it necessary to examine circumstances sur- rounding the multibillion-dollar losses of Amaranth Advisors, a Connecticut- based hedge fund. The fund lost $6.4 billion in September 2006, and its assets were down 65 to 70 percent for the month and 55 to 60 percent for the year. Amaranth started 2006 with $7.5 billion and rose to $9.2 billion before plummeting to less than $3 billion in October. Amaranth’s energy desk, run by a young trader, Brian Hunter, bet aggressively on natural gas. When certain prices fell in September 2006, the fund found itself in positions too big to liquidate. Ultimately, it was forced to sell its energy holdings at a loss of $560 million when some of its counterparties threatened to cut off its credit. Once this news got to the markets, and faced with large margin calls and no ability to borrow, Amaranth was forced to sell additional positions, resulting in even bigger losses. In October 2006, the fund announced it would close by the end of the year.

Possibly as a result of the trading abuses and scandals, the SEC began scru- tinizing the hedge fund industry more closely. Specifically, in 2003 the SEC rec- ommended that large hedge funds register as investment advisors with the SEC, subjecting them to periodic audits and inspections. Only about 25 percent of hedge funds were registered with the SEC at the time. In 2007, after years of examina- tion and reflection, a committee of U.S. financial system regulators concluded that current regulations on hedge funds were sufficient to prevent hedge funds from threatening the financial system’s stability. The report, compiled by the heads of the U.S. Treasury, Federal Reserve, SEC, and Commodity Futures Trading Commission (the President’s Working Group on Financial Markets), concluded that while hedge

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150 Part One Introduction

funds present challenges for market participants and policymakers, their risks can be maintained through a combination of market discipline and limiting access to the private pools of capital to wealthy investors.

What is the difference between a mutual fund and a hedge fund? What are the performance fees charged by hedge funds? How is the regulatory status of hedge funds changing?

1. 2. 3.

Concept Questions Concept Questions

This chapter provided an overview of the mutual fund and hedge fund industries. Mutual funds and hedge funds pool funds from individuals and corporations and invest in diversified asset portfolios. Given the tremendous growth in the market values of financial assets—such as equities—in the 1990s and the cost-effective way in which these funds allow investors to participate in these markets, mutual funds and hedge funds have grown tremendously in size, number of funds, and number of shareholders.

What is a mutual fund? In what sense is it a financial intermediary? What are money market mutual funds? In what assets do these funds typi- cally invest? What factors have caused the strong growth in this type of fund since the late 1970s? What are long-term mutual funds? In what assets do these funds usually in- vest? What factors caused the strong growth in this type of fund during the 1990s and early 2000s? Using the data in Table 5–3 , discuss the growth and ownership holding over the last 26 years of long-term funds versus short-term funds. Why did the proportion of equities in long-term funds increase from 38.3 per- cent in 1990 to over 70 percent by 2000 and then decrease to 62 percent in 2002? How might an investor’s preference for a mutual funds objective change over time? How does the risk of short-term funds differ from the risk of long-term funds? What are the economic reasons for the existence of mutual funds; that is, what benefits do mutual funds provide for investors? Why do individuals rather than corporations hold most mutual funds shares? What are the principal demographics of household owners who own mutual funds? What are the primary reasons why household owners invest in mutual funds? What change in regulatory guidelines occurred in 1998 that had the primary purpose of giving investors a better understanding of the risks and objectives of a fund? What are the three possible components reflected in the return an investor receives from a mutual fund?

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SummarySummary

Questions and Problems Questions and Problems

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Chapter 5 The Financial Services Industry: Mutual Funds and Hedge Funds 151

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How is the net asset value (NAV) of a mutual fund determined? What is meant by the term marked-to-market daily? A mutual fund owns 400 shares of Fiat, Inc., currently trading at $7, and 400 shares of Microsoft, Inc., currently trading at $70. The fund has 100 shares outstanding.

What is the net asset value (NAV) of the fund? If investors expect the price of Fiat shares to increase to $9 and the price of Microsoft shares to decrease to $55 by the end of the year, what is the ex- pected NAV at the end of the year? Assume that the expected price of the Fiat shares is realized at $9. What is the maximum price decrease that can occur to the Microsoft shares to real- ize an end-of-year NAV equal to the NAV estimated in (a)?

What is the difference between open-end and closed-end mutual funds? Which type of fund tends to be more specialized in asset selection? How does a closed-end fund provide another source of return from which an investor may either gain or lose? Open-end fund A owns 100 shares of AT&T valued at $100 each and 50 shares of Toro valued at $50 each. Closed-end fund B owns 75 shares of AT&T and 100 shares of Toro. Each fund has 100 shares of stock outstanding.

What are the NAVs of both funds using these prices? Assume that in one month the price of AT&T stock has increased to $105 and the price of Toro stock has decreased to $45. How do these changes impact the NAV of both funds? If the funds were purchased at the NAV prices in (a) and sold at month end, what would be the realized returns on the investments? Assume that another 100 shares of AT&T are added to fund A. What is the effect on fund A’s NAV if the stock prices remain unchanged from the original prices?

What is the difference between a load fund and a no-load fund? Is the argu- ment that load funds are more closely managed and therefore have higher returns supported by the evidence presented in Table 5–7 ? What is a 12b–1 fee? Suppose you have a choice between a load fund with no annual 12b–1 fee and a no-load fund with a maximum 12b–1 fee. How would the length of your expected investment horizon, or holding period, influence your choice between these two funds? Suppose an individual invests $10,000 in a load mutual fund for two years. The load fee entails an up-front commission charge of 4 percent of the amount invested and is deducted from the original funds invested. In addition, annual fund operating expenses (or 12b–1 fees) are 0.85 percent. The annual fees are charged on the average net asset value invested in the fund and are recorded at the end of each year. Investments in the fund return 5 percent each year paid on the last day of the year. If the investor reinvests the annual returns paid on the investment, calculate the annual return on the mutual fund over the two-year investment period. Who are the primary regulators of the mutual fund industry? How do their regulatory goals differ from those of other types of financial institutions? What is a hedge fund, and how is it different from a mutual fund? What are the different categories of hedge funds?

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152 Part One Introduction

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What types of fees do mutual funds charge? What is the difference between domestic hedge funds and offshore hedge funds? Describe the advantages of offshore hedge funds over domestic hedge funds.

Web Questions Go to the Fidelity Investments Web site and look up the annual 1-, 5-, and 10- year returns on Fidelity Select Biotechnology Fund using the following steps. The Web site is www.fidelity.com . Click on “Investment Products.” Click on “Mutual Funds.” Click on “Fidelity Mutual Funds.” Click on “Browse Fidelity Funds.” Click on “s.” Click on “Select Biotechnology Portfolio.” This will bring the file onto your computer that contains the relevant data. Go to the Investment Company Institute Web site and look up the most re- cent data on the asset values and number of short-term and long-term mutual funds using the following steps. The Web site is www.ici.org . Under “Statistics & Research,” click on “Mutual Fund Statistics.” Click on “Mutual Fund Fact Book.” Click on the most recent year for “XXXX Investment Company Fact Book.” Go to “Data Tables.” This section contains the relevant data. The data on asset values and number of mutual funds are among the first few pages. How have these values increased since those for 2006 reported in Table 5–1 ?

Pertinent Web Sites

American Funds www.americanfunds.com Board of Governors of the Federal Reserve www.federalreserve.gov Fidelity Investments www.fidelity.com Institutional Investor www.institutionalinvestor.com Investment Company Institute www.ici.org Morningstar, Inc. www.morningstar.com National Association of Securities Dealers www.nasd.com Securities and Exchange Commission www.sec.gov Vanguard www.vanguard.com The Wall Street Journal www.wsj.com

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153

Chapter Six

The Financial Services Industry: Finance Companies

INTRODUCTION

The primary function of finance companies is to make loans to both individu- als and corporations. The services provided by finance companies include con- sumer lending, business lending, and mortgage financing. Some of their loans are similar to commercial bank loans, such as consumer and auto loans, but oth- ers are more specialized. Finance companies differ from banks in that they do not accept deposits but instead rely on short- and long-term debt as a source of funds. Additionally, finance companies often lend to customers commercial banks find too risky. This difference can lead to losses and even failure if the high risk does not pay off. For example, New Century Financial, once the second-biggest lender of home loans for buyers with less than perfect credit (subprime borrow- ers), built a billion-dollar business by selling risky loans to buyers and then selling them to investment banks, using the proceeds to continue funding new loans for homebuyers. That worked during the housing boom years, but rising defaults coupled with the market’s downturn in 2006 prompted New Century’s creditors to demand that the company buy back the bad loans. The company disclosed in early 2007 that it failed to accurately record loan losses, that it would be unable to repay its creditors, and that it would have to restate financial results for 2006. The company was on the brink of bankruptcy as creditors cut off funding, many demanding that the company buy back billions in mortgage loans. On March 13, 2007, the NYSE suspended trading on the company’s stock and began steps to delist the company, stating the securities were no longer suitable for continued listing on the NYSE.

In this chapter we look at the services provided by this industry and the com- petitive and financial situation facing these firms. We discuss the size, structure, and composition of the industry; the services the industry provides; its competi- tive and financial position; and its regulation. We conclude the chapter with a look at some global issues. From this chapter, the reader should obtain a basic under- standing of services provided by finance companies, their performance, and the degree to which they are regulated.

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154 Part One Introduction

SIZE, STRUCTURE, AND COMPOSITION OF THE INDUSTRY

The first major finance company was originated during the Depression, when General Electric Corp. created General Electric Capital Corp. (GECC) as a means of financing appliance sales to cash-constrained customers who were unable to get installment credit from banks. Installment credit is a loan that is paid back to the lender with periodic payments (installments) consisting of varying amounts of interest and principal (e.g., auto loans, home mortgages, and student loans). By the late 1950s banks were more willing to make installment loans, and so finance companies began looking outside their parent companies for business. A look at GECC’s loan and lease portfolio today shows leases for almost 10,000 locomotive railcars, 1,419 aircraft, almost $4 billion in financing of mergers and acquisitions, and $157 billion in a mortgage servicing portfolio (see below), along with over $9.1 billion in loans to General Electric customers. 1

Because of the attractive rates they offer on some loans (such as new car loans, see below), their willingness to lend to riskier borrowers than commercial banks, their often direct affiliation with manufacturing firms, and the relatively limited amount of regulation imposed on these firms, finance companies have been among the fastest growing FI groups in recent years. In 2006 their assets stood at $2,119.9 billion (see Table 6–1 ). Comparing this to assets at the end of 1977 (reported in Table 6–2 ) of $104.3 billion, this industry has experienced growth of almost 1,933 percent in the last 29 years. GMAC Commercial Mortgage Corp. (GMACCM), originally a subsidiary of General Motors Acceptance Corp. (GMAC), is one of the largest commercial mortgage lenders in the United States, with a mortgage portfolio over $370 billion in place. The company announced in the late 1990s that it had plans to expand its product mix to create one of the

1 See GECC’s Web site, www.gecapital.com .

www.gecapital.com www.gecapital.com

www.gmacfs.com www.gmacfs.com

Billions of Dollars

Percent of Total Assets

Assets

Accounts receivable gross $ 1,711.1 80.7% Consumer 629.8 29.7 Business 489.6 23.1 Real estate 591.7 27.9 Less reserves for unearned income (48.4) (2.3) Less reserves for losses (24.7) (1.1) Accounts receivable net $ 1,638.0 77.3% All other 481.9 22.7 Total assets $ 2,119.9 100.0%

Liabilities and Capital

Bank loans $ 132.4 6.3% Commercial paper 164.0 7.7 Debt due to parent 335.8 15.9 Debt not elsewhere classified 825.3 38.9 All other liabilities 420.0 19.8 Capital, surplus, and undivided profits 242.4 11.4 Total liabilities and capital $ 2,119.9 100.0%

TABLE 6–1 Assets and Liabilities of U.S. Finance Companies, 2006

Source: Federal Reserve Bulletin, February 2007. www.federalreserve.gov

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Chapter 6 The Financial Services Industry: Finance Companies 155

world’s leading “onestop” commercial finance companies. In November 2006, General Motors sold a 51 percent interest in GMAC to a consortium of investors led by hedge fund Cerberus Capital Management and subsidiaries of Citigroup, Aozora Bank, and PNC Financial. GMAC’s existing management team remained in place, but the finance company assumed a separate and independent credit profile and independent governance by a new board of directors. Under terms of the transaction, General Motors and GMAC entered into a 10-year agreement under which GMAC remains the exclusive provider of GM-sponsored auto finance programs.

The three major types of finance companies are (1) sales finance institutions, (2) personal credit institutions, and (3) business credit institutions. Sales finance institutions (e.g., Ford Motor Credit and Sears Roebuck Acceptance Corp.) spe- cialize in making loans to the customers of a particular retailer or manufacturer. Because sales finance institutions can frequently process loans faster and more conveniently (generally at the location of purchase) than depository institutions, this sector of the industry competes directly with depository institutions for con- sumer loans. Personal credit institutions (e.g., HSBC Finance and AIG American General) specialize in making installment and other loans to consumers. Personal credit institutions will make loans to customers that depository institutions find too risky to lend to (due to low income or a bad credit history). These institutions compensate for the additional risk by charging higher interest rates than deposi- tory institutions and/or accepting collateral (e.g., used cars) that depository insti- tutions do not find acceptable. Business credit institutions (e.g., CIT Group and FleetBoston Financial) are companies that provide financing to corporations, espe- cially through equipment leasing and factoring, in which the finance company purchases accounts receivable from corporate customers. These accounts are pur- chased at a discount from their face value, and the finance company specializes in

sales finance institutions Institutions that specialize in making loans to the customers of a particular retailer or manufacturer.

sales finance institutions Institutions that specialize in making loans to the customers of a particular retailer or manufacturer.

personal credit institutions Institutions that specialize in making installment and other loans to consumers.

personal credit institutions Institutions that specialize in making installment and other loans to consumers.

business credit institutions Institutions that specialize in making business loans.

business credit institutions Institutions that specialize in making business loans.

factoring The process of purchasing accounts receivable from corporations (often at a discount), usually with no recourse to the seller if the receivables go bad.

factoring The process of purchasing accounts receivable from corporations (often at a discount), usually with no recourse to the seller if the receivables go bad.

TABLE 6–2 Assets and Liabilities of U.S. Finance Companies on December 31, 1977

Source: Federal Reserve Bulletin, June 1978, p. A39. www.federalreserve.gov

Billions of Dollars

Percent of Total Assets

Assets

Accounts receivable gross $ 99.2 95.1% Consumer 44.0 42.2 Business 55.2 52.9 Less reserves for unearned income and losses (12.7) (12.2) Accounts receivable net $ 86.5 82.9% Cash and bank deposit 2.6 2.5 Securities 0.9 0.9 All others 14.3 13.7 Total assets $104.3 100.0%

Liabilities and Capital

Bank loans $ 5.9 5.7% Commercial paper 29.6 28.4 Debt Short-term 6.2 5.9 Long-term 36.0 34.5 Other 11.5 11.0 Capital, surplus, and undivided profits 15.1 14.5 Total liabilities and capital $104.3 100.0%

www.fordcredit.com www.hfc.com

www.aigag.com www.citgroup.com

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156 Part One Introduction

and assumes the responsibility for collecting the accounts receivable. As a result, the corporate customer no longer has the worry of whether the accounts receiv- able may or may not be delayed and thus receives cash for sales faster than the time it takes customers to pay their bills. Many finance companies perform more than one of these three services (e.g., GMAC).

The industry is quite concentrated, with the largest 20 firms accounting for more than 65 percent of its assets. In addition, many of the largest finance compa- nies, such as Ford Motor Credit Corp., tend to be wholly owned or captive sub- sidiaries of major manufacturing companies. A major role of a captive finance company is to provide financing for the purchase of products manufactured by the parent, as Ford Motor Credit Corp. does for cars. In turn, the parent company is often a major source of debt finance for the captive finance company. A benefit of the captive finance subsidiary to the parent company is diversification in rev- enue streams. For example, as the auto industry suffered from a lack of sales in the mid-2000s, Ford Motor Credit Corp. was producing record profits, as much as 80 percent of the overall profits of Ford Motor Corporation.

Table 6–3 lists the top 10 finance companies (in terms of total receivables) as of 2006. GECC is the largest with receivables totaling $333.8 billion. In late 2000, Associates First Capital, then the fourth largest finance company and the larg- est consumer finance company, was acquired by Citigroup for $31.1 billion. The acquisition resulted in Citigroup becoming the industry’s second-largest receiv- ables financer, with receivables of $164.2 billion in 2006. Indeed, it should be noted that many finance companies are subsidiaries of financial services holding compa- nies such as Citigroup. Thus, while Citibank cannot make high-risk, high-interest rate loans due to bank regulations that restrict credit risk, Citigroup can indirectly make these loans through its finance company subsidiary. Note from Table 6–3

captive finance company A finance company that is wholly owned by a parent corporation.

captive finance company A finance company that is wholly owned by a parent corporation.

Company Name

Total receivables ($ millions)

Type of Finance Company Ownership

General Electric Capital Corporation $333,780 Sales finance and business credit

Captive of GE

Citigroup (credit card business) 164,205 Personal credit Part of Citigroup General Motors Acceptance Corp. 154,764 Sales finance Owned by consortium of

investors including Cerberus Capital Management, Citigroup, PNC Financial, and GM

Ford Motor Credit Company 153,000 Sales finance Captive of Ford J. P. Morgan Chase (credit card business) 144,835 Personal credit Part of J. P. Morgan Chase SLM Corp. 124,024 Personal credit NYSE-listed independent Capital One Financial 92,923 Personal credit NYSE-listed independent that

also owns Capital One Bank American Express 88,500 Personal credit NYSE-listed independent that

also owns American Express Bank HSBC Finance Corp. 62,973 Personal credit Subsidiary of HSBC Holdings Bank of America (credit card business) 61,179 Personal credit Part of Bank of America

TABLE 6–3 The Largest Finance Companies

Source: Insurance Information Institute and authors research.

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Chapter 6 The Financial Services Industry: Finance Companies 157

that 6 of the top 10 finance companies are subsidiaries of financial services holding companies.

What are the three major types of finance companies? What types of customers does each serve? What is a captive finance company?

BALANCE SHEET AND RECENT TRENDS Assets As mentioned above, finance companies provide three basic lending services: cus- tomer lending, consumer lending, and business lending. In Table 6–1 we show the balance sheet of finance companies in 2006. As you can see, business and con- sumer loans (called accounts receivable ) are major assets held by finance companies, accounting for 52.8 percent of total assets, while real estate loans are 27.9 percent of total assets. Comparing the figures in Table 6–1 to those in Table 6–2 for 1977, we see that 95.1 percent of total assets were consumer and business loans in 1977, yet no real estate loans were listed. Over the last 26 years, finance companies have replaced consumer and business loans with increasing amounts of real estate loans and other assets, although these loans have not become dominant, as is the case with depository institutions. However, like commercial banks, these activities cre- ate credit risk, interest rate risk, and liquidity risk that finance company managers must evaluate and manage.

Table 6–4 shows the breakdown of the industry’s loans from 1995 through 2006 for consumer, real estate, and business lending. In recent years, the fastest-growing areas of asset business have been in the nonconsumer finance areas, especially leas- ing and business lending. In December 2006 consumer loans constituted 40.9 per- cent of all finance company loans, mortgages represented 30.3 percent, and business loans comprised 28.8 percent.

Consumer Loans Consumer loans consist of motor vehicle loans and leases, other consumer loans, and securitized loans from each category. Motor vehicle loans and leases are tra- ditionally the major type of consumer loan (58.8 percent of the consumer loan portfolio in December 2006). As can be seen from Table 6–5 , finance companies historically charged higher rates for automobile loans than did commercial banks. In 1995 and 1996, auto finance companies charged interest rates 1.62 to 0.79 per- cent, respectively, higher than those of commercial banks. Nevertheless, some- times these rates get lowered dramatically. For example, because new car sales by U.S. firms in the late 1990s were lower than normal, auto finance companies owned by the major auto manufacturers slashed interest rates on new car loans (some to as low as 0.9 percent). Moreover, after the terrorist attacks in September 2001, the major auto manufacturers lowered rates on many new car loans to 0 percent in an attempt to boost sales. Some of these 0 percent rates continued to be offered into 2005 as the U.S. economy struggled to recover and the general level of interest rates remained low. Notice that the difference between new car loans at commercial banks and finance companies continued to widen throughout the

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Concept Questions Concept Questions

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158 Part One Introduction

early 2000s. By 2003 finance companies were charging over 3.5 percent less on new car loans than commercial banks, mainly due to the zero interest rates offered by the major auto manufacturers’ captive finance company loans to new car buyers. However, other than for new car loans, these types of low rates are fairly rare.

The higher rates finance companies charge for consumer loans are mostly due to the fact that finance companies attract riskier customers than commercial banks.

1995 Percent of Total, 1995 2006

Percent of Total, 2006

Consumer $ 285.8 $ 41.5% $ 830.4 40.9% Motor vehicle loans 81.1 11.8 259.9 12.8 Motor vehicle leases 80.8 11.7 106.0 5.2 Revolving2 28.5 4.1 78.2 3.9 Other3 42.6 6.2 195.5 9.6 Securitized assets Motor vehicle loans 34.8 5.1 118.5 5.8 Motor vehicle leases 3.5 0.5 3.6 0.2 Revolving n.a. n.a. 15.9 0.8 Other 14.7 2.1 52.8 2.6 Real estate 72.4 10.5% 616.0 30.3% One- to four-family n.a. n.a. 539.2 26.5 Other n.a. n.a. 56.3 2.8 Securitized real estate assets4

One- to four-family n.a. n.a. 16.8 0.8 Other n.a. n.a. 3.7 0.2 Business 331.2 48.0% 586.0 28.8% Motor vehicles 66.5 9.6 105.1 5.2 Retail loans 21.8 3.1 17.1 0.8 Wholesale loans5 36.6 5.3 55.7 2.8 Leases 8.0 1.2 32.3 1.6 Equipment 188.0 27.3 299.5 14.7 Loans 58.6 8.5 102.4 5.0 Leases 129.4 18.8 197.1 9.7 Other business receivables6 47.2 6.8 93.5 4.6 Securitized assets4

Motor vehicles 20.6 3.0 38.0 1.8 Retail loans 1.8 0.3 3.0 0.1 Wholesale loans 18.8 2.7 34.9 1.7 Leases n.a. n.a. 0.1 0.0 Equipment 8.1 1.2 15.4 0.8 Loans 5.3 0.8 9.9 0.5 Leases 2.8 0.4 5.5 0.3 Other business receivables6 0.8 0.1 34.6 1.7 Total $ 689.5 $100.0% $2,032.3 100.0%

1 Owned receivables are those carried on the balance sheet of the institution. Managed receivables are outstanding balances of pools upon which securities have been issued; these balances are no longer carried on the balance sheets of the loan originator. 2 Excludes revolving credit reported as held by depository institutions that are subsidiaries of finance companies. 3 Includes personal cash loans, mobile home loans, and loans to purchase other types of consumer goods, such as appliances, apparel, boats, and recreation vehicles. 4 Outstanding balances of pools on which securities have been issued; these balances are no longer carried on the balance sheets of the loan originator. 5 Credit arising from transactions between manufacturers and dealers, that is, floor plan financing. 6 Includes loans on commercial accounts receivable, factored commercial accounts, and receivable dealer capital; small loans used primarily for business or farm purposes; and wholesale and lease paper for mobile homes, campers, and travel trailers.

TABLE 6–4 Finance Company Loans Outstanding, 1995–2006 1 (in billions of dollars)

Source: Federal Reserve Board, “Flow of Fund Accounts,” various issues. www.federalreserve.gov

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Chapter 6 The Financial Services Industry: Finance Companies 159

In fact, customers who seek individual (or business) loans from finance compa- nies are often those judged too risky to obtain loans from commercial banks or thrifts. 2 It is, in fact, possible for individuals to get a loan from a subprime lender finance company (a finance company that lends to high-risk customers) even with a bankruptcy on their records. For example, in 1997 Jayhawk Acceptance Corp., one of a group of finance companies that lent money to used-car buyers with poor or no credit, began marketing loans for tummy tucks, hair transplants, and other procedures that are not usually covered by health insurance. Jayhawk entered into contracts with doctors to lend money to their patients who were seeking cos- metic surgery or some types of dental procedures. Borrowers who paid the loans within a year paid an annual rate of 9.9 percent, while those who repaid within the maximum of two years paid 13.9 percent per year. Left unanswered, however, was what Jayhawk could repossess if a borrower defaulted on a loan. Jayhawk declared bankruptcy in late 1997. Banks would rarely do this. Most finance com- panies that offer these types of loans charge rates commensurate with the higher risk, and there are a few loan shark companies that prey on desperate consumers, charging exorbitant rates as high as 30 percent per annum or more.

Another case of a subprime lender is the payday lender. Payday lenders pro- vide short-term cash advances that are often due when borrowers receive their next paycheck. The payday lending industry originated from check cashing out- lets in the early 1990s and has exploded in recent years as demand for short-term loans has risen. Payday lenders generate approximately $40 billion in loans annu- ally and earned about $6 billion in revenue in 2006. The number of storefronts more than doubled between 2000 and 2007, to roughly 25,000 nationwide. A typi- cal borrower takes out a two-week loan and pays $15 for every $100 borrowed, or the equivalent of a 390 percent annual interest rate. The typical customer earns between $25,000 and $50,000 per year. Critics claim that rates are exorbitant and often trap financially strapped borrowers in a cycle of paying additional fees to renew the same amount of principal. Lenders argue that the high rates are neces- sary to cover costs, offset higher default rates, and still earn a profit. The payday loan industry is regulated at the state level. As of 2007, 13 states had effectively banned payday lending. But the demand for small, short-term loans has grown tremendously, and all states are debating whether the accessibility and compara- tive ease of payday loans outweigh the risk for consumers of falling further into debt. As of 2007, the National Conference of State Legislatures said that at least 52 payday loan bills had been introduced at the state level. 3

2 We look at the analysis of borrower (credit) risk in Chapter 11.

3 A study by A. Morse (“Payday Lenders: Heroes or Villains?” University of Michigan Working Paper, November 2006) shows that payday loans add social welfare value, based on the empirical outcomes from natural disasters in California. Morse shows that areas with a large concentration of payday lenders had a lower rate of death and higher birth rates (both measures of social welfare).

subprime lender A finance company that lends to high-risk customers.

subprime lender A finance company that lends to high-risk customers.

loan sharks Subprime lenders that charge unfairly exorbitant rates to desperate subprime borrowers.

loan sharks Subprime lenders that charge unfairly exorbitant rates to desperate subprime borrowers.

Type 1995 1996 1997 2000 2002 2003 2004 2006

Commercial bank new car 9.57% 9.05% 9.02% 9.34% 7.62% 6.93% 6.60% 7.92% Auto finance company new car 11.19 9.84 7.12 6.61 4.29 3.40 4.36 5.52 Difference in commercial bank

versus finance company rate 1.62 0.79 �1.90 �2.73 �3.33 �3.53 �2.24 �2.42

TABLE 6–5 Consumer Credit Interest Rates, 1995–2006

Source: Federal Reserve Board, “Flow of Fund Accounts,” various dates. www.federalreserve.gov

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160 Part One Introduction

Other consumer loans include personal cash loans, mobile home loans, and pri- vate-label credit card loans (e.g., Discover card) to purchase other types of con- sumer goods, such as appliances, apparel, general merchandise, and recreational vehicles. In 2006 other consumer loans made up 41.2 percent of the consumer loan portfolio of finance companies.

Mortgages Residential and commercial mortgages have become a major component in finance company portfolios, although, referring again to Table 6–2 , they did not generally deal in mortgages in 1977. However, since finance companies are not subject to as extensive regulations as are banks, they are often willing to issue mortgages to riskier borrowers than commercial banks. They compensate for this additional risk by charging higher interest rates and fees. Mortgages include all loans secured by liens on any type of real estate. Mortgages can be made either directly or as securitized mortgage assets . Securitization of mortgages involves the pooling of a group of mortgages with similar characteristics, the removal of these mort- gages from the balance sheet, and the subsequent sale of interests in the pool to secondary market investors. Securitization of mortgages results in the creation of mortgage-backed securities (e.g., government agency securities, collateralized mortgage obligations), which can be traded in secondary mortgage markets. 4, 5 While removed from its balance sheet, the finance company that originates the mortgage may still service the mortgage portfolio for a fee.

The mortgages in the loan portfolio can be first mortgages or second mortgages in the form of home equity loans. Home equity loans allow customers to borrow on a line of credit secured with a second mortgage on their home. Home equity loans have become very profitable for finance companies since the Tax Reform Act of 1986 was passed, disallowing the tax deductibility of consumers’ interest payments other than those on home mortgages. Specifically, interest on (first and second) mortgages secured by residential real estate is tax deductible. Interest on other types of individual loans—such as consumer (e.g., credit card) loans—is not eligible for a tax deduction. Also, the bad debt expense and administrative costs on home equity loans are lower than those on other finance company loans. For example, a study by the Consumer Bankers Association found that in 1997–1998 more than 4.2 million households converted $26 billion in credit card debt to home equity loans. Further, in 2006, the average outstanding balance on home equity loans was $82,872, up from $26,627 in 1999. As discussed below, in 2007 a sharp rise in late payments and defaults by subprime and even relatively strong credit mortgage and home equity loan borrowers caused large losses for mortgage lend- ers and mortgage-backed securities investors.

Business Loans Business loans represent the largest portion of the loan portfolio of finance com- panies. Finance companies have several advantages over commercial banks in offering services to small business customers. First, as mentioned earlier, they are not subject to regulations that restrict the types of products and services they can

4 We discuss the securitization of mortgages in more detail in Chapter 27.

5 Mortgage servicing is a fee-related business whereby, after mortgages are securitized, the flow of mort- gage repayments (interest and principal) has to be collected and passed on (by the mortgage servicer) to investors in either whole mortgage loan packages or securitization vehicles such as pass-through securi- ties (see Chapter 27). In undertaking this intermediation activity, the servicer charges a fee.

securitized mortgage assets Mortgages packaged and used as assets backing secondary market securities.

securitized mortgage assets Mortgages packaged and used as assets backing secondary market securities.

home equity loans Loans that let customers borrow on a line of credit secured with a second mortgage on their home.

home equity loans Loans that let customers borrow on a line of credit secured with a second mortgage on their home.

www.cbanet.org www.cbanet.org

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Chapter 6 The Financial Services Industry: Finance Companies 161

offer. Second, because finance companies do not accept deposits, they have no bank-type regulators looking directly over their shoulders. 6 Third, being in many cases subsidiaries of corporate-sector holding companies, finance companies often have substantial industry and product expertise. Fourth, as mentioned in regard to consumer loans, finance companies are more willing to accept risky customers than are commercial banks. Fifth, finance companies generally have lower over- heads than banks have; for example, they do not need tellers or branches for tak- ing deposits.

The major subcategories of business loans are retail and wholesale motor vehi- cle loans and leases (17.9 percent of all business loans in 2006), equipment loans (51.1 percent), other business loans (16.0 percent), and securitized business assets (15.0 percent). Motor vehicle loans consist of retail loans that assist in transactions between the retail seller of the product and the ultimate consumer (i.e., passenger car fleets and commercial land vehicles for which licenses are required). Wholesale loans are loan agreements between parties other than the companies’ consumers. For example, Ford Motor Credit Corp. (FMCC) provides wholesale financing to Ford dealers for inventory floor plans in which FMCC pays for Ford dealers’ auto inventory received from Ford. FMCC puts a lien on each car on the showroom floor. While the dealer pays periodic interest on the floor plan loan, it is not until the car is sold that the dealer pays for the car. These activities extend to retail and wholesale leasing of motor vehicles as well.

Business-lending activities of finance companies also include equipment loans, with the finance company either owning or leasing the equipment directly to its industrial customer or providing the financial backing for a leveraged lease, a working capital loan, or a loan to purchase or remodel the customer’s facility. Finance companies often prefer to lease equipment rather than sell and finance the purchase of equipment. One reason for this is that repossession of the equip- ment in the event of default is less complicated when the finance company retains its title (by leasing). Further a lease agreement generally requires no down pay- ment, making a lease more attractive to the business customer. Finally, when the finance company retains ownership of the equipment (by leasing), it receives a tax deduction in the form of depreciation expense on the equipment. Other business loans include loans to businesses to finance accounts receivable, factored commer- cial accounts, small farm loans, and wholesale and lease paper for mobile homes, campers, and trailers.

Liabilities and Equity To finance asset growth, finance companies have relied primarily on short-term commercial paper and other debt (longer-term notes and bonds). Thus, manage- ment of liquidity risk is quite different from that in commercial banks that mostly rely on deposits (see Chapter 2). As reported in Table 6–1 , in 2006 commercial paper amounted to $164.0 billion (7.7 percent of total assets), while other debt (debt due to parents and debt not elsewhere classified) totaled $1,161.1 billion (54.8 percent) and bank loans totaled $132.4 billion (6.3 percent). Debt due to parent includes all short- and long-term debt owed to the parent company of the finance company, for example, debt Ford Motor Credit Corp. owes to Ford Motor Corp. Debt not elsewhere classified includes all short- and long-term debt (loans, notes, certifi- cates, negotiable paper, or other) owed to external lenders not listed above. If the

6 Finance companies do, of course, have market participants looking over their shoulders and monitoring their activities.

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162 Part One Introduction

finance company subsidiary has a bad year and cannot make promised payments on its debt, the parent company would be less likely than external fund providers to initiate legal proceedings against the finance company. However, given their large percentage funding, the parent to a finance company is susceptible to large losses of its own if the finance company subsidiary has a bad year.

Comparing these figures with those for 1977 (in Table 6–2 ), commercial paper was used more in 1977 (28.4 percent of total liabilities and capital), while other debt (short- and long-term) was less significant as a source of financing (40.4 per- cent). Finance companies also now rely less heavily on bank loans for financing. In 1977, bank loans accounted for 5.7 percent of total financing. Much of the change in funding sources is due to the strong economy and low interest rates in the U.S. long-term debt markets in the early 2000s. Finally, in 2006 finance companies’ cap- ital-to-assets ratio was 11.4 percent, higher than the 14.5 percent in 1977.

As discussed above, unlike banks and thrifts, finance companies cannot issue deposits. Rather, to finance assets, finance companies rely heavily on short-term commercial paper, with many having direct sale programs in which commercial paper is sold directly to mutual funds and other institutional investors on a continu- ous day-by-day basis. Indeed, finance companies are now the largest issuers in the short-term commercial paper market. Most commercial paper issues have maturities of 30 days or less, although they can be issued with maturities of up to 270 days. 7

INDUSTRY PERFORMANCE

In the early 2000s, the outlook for the industry as a whole was bright. Interest rates were at historical lows. Mortgage refinancing grew, and loan demand among lower- and middle-income consumers was strong. Because many of their potential borrow- ers had very low savings, no major slowdown in the demand for finance company services is expected. The largest finance companies—those that lend to less risky individual and business customers and with few subprime borrowers (e.g., HSBC Finance)—experienced strong profits and loan growth. (The industry’s assets as a whole grew at a rate of almost 8 percent in the early 2000s.) As such, the most successful finance companies became takeover targets for other financial service as well as industrial firms. For example, as discussed earlier, Citigroup acquired Associates First Capital to create the largest full-service financial institution in the country. In May 2001 American General (the then 13th-largest finance company) was acquired by American International Group (AIG), one of the country’s largest life insurance companies. Finally, in 2003 Household International was acquired by British commercial bank HSBC Holdings for $14.9 billion. This acquisition was one of the largest M&As of any kind in 2003. These are just other examples of integra- tion and consolidation among firms in the financial services sector.

Nevertheless, in the mid-2000s problems for industry participants who spe- cialize in loans to relatively lower-quality customers created large losses in the industry and possibly a very big problem for the U.S. economy as a whole. As home prices fell in 2005 and 2006 and borrowers faced rising interest rates, more people defaulted on their mortgages. At the end of 2006, the percentage of sub- prime mortgage loans on which payments were at least 60 days late was 14 per- cent, up from 6 percent in early 2005, and forecasts estimated that 19 percent of subprime mortgages originated in 2005 and 2006 would end in foreclosure.

7 Commercial paper issued with a maturity longer than 270 days has to be registered with the SEC (i.e., it is treated the same as publicly placed bonds).

www.hfc.com www.hfc.com

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Chapter 6 The Financial Services Industry: Finance Companies 163

With delinquencies and defaults by borrowers rising, finance companies started a sharp pullback in subprime lending. Originations of subprime mortgages were expected to decline 30 to 35 percent in 2007 from 2006, when they totaled approx- imately $600 billion, or about one-fifth of the entire mortgage market. In addition, bank regulators proposed tougher lending standards and regulations. The results were sharply lower values for finance companies. For example, shares of New Century Financial, the number-two subprime lender, plunged nearly 79 percent in early March 2007 after the company said it was facing a criminal probe of its practices by the Justice Department and its outside auditor said it believed there was substantial doubt about New Century’s ability to continue as a going con- cern. On March 13, 2007, the NYSE suspended trading on the company’s stock and began steps to delist the company. Fremont General Corp. lost one-third of its value after it announced it would exit the subprime sector due to demands of regulators and market conditions. Other leaders in the subprime mortgage lend- ing market were units of some of the nation’s biggest financial services holding companies, including HSBC (the number-one subprime mortgage lender, which took a $10.6 million charge for bad loans in 2006), General Electric, Wells Fargo, and Washington Mutual.

This crash in the subprime mortgage market was feared to create serious prob- lems in the U.S. economy as a whole. The housing boom of the early 2000s held defaults to very low levels because borrowers who fell behind on payments could easily sell their homes or refinance into a loan with easier terms. Further, rightly two-thirds of mortgages were packaged into securities and sold to investors world- wide. That and other innovations made credit cheaper and more available, help- ing more people to afford a home. But as home prices flattened and even dropped in many parts of the country, more borrowers fell behind on their mortgage pay- ments. Many also wondered how well investors in mortgage-backed securities would cope as delinquencies rose. For example, as losses in the subprime mort- gage market soared, major banks such as Merrill Lynch and J. P. Morgan Chase were trying to force mortgage originators to buy back many of the high-risk loans they had bought in 2005 and 2006.

How have the major assets held by finance companies changed in the last 25 years? How do subprime lender finance company customers differ from consumer loan custom- ers at banks? What advantages do finance companies offer over commercial banks to small business customers?

REGULATION

The Federal Reserve defines a finance company as a firm (other than a deposi- tory institution) whose primary assets are loans to individuals and businesses. 8 Finance companies, like depository institutions, are financial intermediaries that borrow funds for relending, making a profit on the difference between the interest rate on borrowed funds and the rate charged on the loans. Also like depository institutions, finance companies are subject to any state-imposed usury ceilings on

8 Whereas a bank is defined as an institution that both accepts deposits and makes loans.

1. 2.

3.

Concept Questions Concept Questions

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164 Part One Introduction

the maximum loan rate assigned to any individual customer and are regulated as to the extent to which they can collect on delinquent loans (e.g., legal mechanisms to be followed). However, because finance companies do not accept deposits, they are not subject to extensive oversight by any specific federal or state regulators as are banks or thrifts—even though they offer services that compete directly with those of depository institutions (e.g., consumer installment loans and mortgages). 9 The lack of regulatory oversight for these companies enables them to offer a wide scope of “bank-like” services and yet avoid the expense of regulatory compli- ance, such as that imposed on banks and thrifts by the Community Reinvestment Act of 1977, which requires these institutions to keep and file extensive reports showing that they are not discriminating in their lending practices in their local communities.

Further since finance companies are heavy borrowers in the capital markets and do not enjoy the same regulatory “safety net” as banks, they need to signal their solvency and safety to investors. 10 Signals of solvency and safety are usually sent by holding higher equity or capital–asset ratios—and therefore lower lever- age ratios—than banks hold. For example, in 2006 the aggregate balance sheet ( Table 6–1 ) shows a capital–assets ratio of 11.4 percent for finance companies. This can be compared to the capital–asset ratio for commercial banks of 10.4 percent reported in Table 2–5 for commercial banks. Larger, captive finance companies also use default protection guarantees from their parent companies and/or guarantees such as letters of credit or lines of credit purchased for a fee from high-quality commercial or investment banks as additional protection against insolvency risk and as a device to increase their ability to raise additional funds in the capital and money markets. Thus, this group will tend to operate with lower capital-to-asset ratios than smaller finance companies. Given that there is little regulatory over- sight of this industry, having sufficient capital and access to financial guarantees are critical to their continued ability to raise funds. Thus, finance companies oper- ate more like nonfinancial, nonregulated companies than other types of financial institutions examined in this text.

Since finance companies seem to compete in the same lending markets as banks, why aren’t they subject to the same regulations as banks? How do finance companies signal solvency and safety to investors?

GLOBAL ISSUES

While commercial banks are the most important source of credit supply in many foreign countries, particularly emerging market economies, nonbank financial institutions (finance companies, credit unions, and building societies) account for a substantial part of the outstanding credit by all financial institutions and their relative importance has been increasing over the past decade. For example, from 1994 to 2004, the percentage of aggregate credit issued by nonbank financial insti- tutions increased from 22 to 32 percent in Latin America and from 4 to 17 percent in central Europe. In Thailand, nonbank financial institutions, particularly those

9 Like any corporation, they are subject to SEC disclosure rules.

10 That is, they have no access to the deposit insurance fund or to the Federal Reserve discount window (see Chapters 17 and 19). On the other hand, they do not have to pay deposit insurance premiums or meet regulatory imposed minimum capital standards.

1.

2.

Concept Questions Concept Questions

£ $ ¥

:

£ $ ¥

:

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Chapter 6 The Financial Services Industry: Finance Companies 165

specializing in credit card lending, gained market share. This trend also occurred in Mexico, where specialized mortgage institutions now dominate low-income mortgage lending. In central Europe, leasing and factoring business by nonbank financial institutions is particularly increasing.

Because regulations in most foreign countries are not as restrictive as those in the United States, finance companies in foreign countries are generally subsidiar- ies of commercial banks or industrial firms. For those finance companies owned by commercial banks, as the bank goes, so does the finance company. For example, the economic recession in Japan in the late 1990s and early 2000s and the result- ing huge volume of nonperforming property loans in Japanese commercial banks depleted the banks’ capital and restricted their ability to lend to finance company subsidiaries. The result has been some attractive opportunities for others. For example, in January 1999 GE Capital Corporation (GECC) agreed to buy (for $7 billion) Japan Leasing Corporation (JLC), the Japanese lending unit of Long-Term Credit Bank of Japan, in the biggest acquisition ever involving a Japanese com- pany. GECC bought only the healthy assets of JLC shortly after its parent, Long- Term Credit Bank, was declared insolvent and nationalized because of its huge problems with nonperforming property loans. Historically, assets of companies such as JLC would never have been acquired by a foreign investor like GECC, but the extreme size of nonperforming property loans at Japan’s biggest banks restricted their ability to undertake any rescue missions like that of JLC.

This chapter provided an overview of the finance company industry. This indus- try competes directly with depository institutions for its high-quality (prime) loan customers by specializing in consumer loans, real estate loans, and business loans. The industry also services subprime (high-risk) borrowers deemed too risky for most depository institutions. However, because firms in this industry do not accept deposits, they are not regulated to the same extent as are depository institutions. Because they do not have access to deposits for their funding, finance companies rely heavily on short- and long-term debt, especially commercial paper. Currently, the industry is generally growing and profitable, although the subprime lending sector of the industry is experiencing some financial problems as consumer default rates on loans and credit cards rise (see Chapter 11).

SummarySummary

What is the primary function of finance companies? How do finance companies differ from commercial banks? What are the three major types of finance companies? To which market seg- ments do each of these types of companies provide service? What have been the major changes in the accounts receivable balances of fi- nance companies over the 29-year period 1977–2006? What are the major types of consumer loans? Why are the rates charged by con- sumer finance companies typically higher than those charged by commercial banks? Why have home equity loans become popular? What are securitized mortgage assets? What advantages do finance companies have over commercial banks in offer- ing services to small business customers? What are the major subcategories of business loans? Which category is the largest?

1.

2.

3.

4.

5.

6.

Questions and Problems Questions and Problems

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166 Part One Introduction

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What have been the primary sources of financing for finance companies? How do finance companies make money? What risks does this process entail? How do these risks differ for a finance company versus a commercial bank? Compare Tables 6–1 and 4–6. Which firms have higher ratios of capital to total assets: finance companies or securities firms? What does this comparison indi- cate about the relative strengths of these two types of firms? How does the amount of equity as a percentage of total assets compare for finance companies and commercial banks? What accounts for this difference? Why do finance companies face less regulation than do commercial banks? How does this advantage translate into performance advantages? What is the major performance disadvantage?

Web Question

Go to the Federal Reserve’s Web site at www.federalreserve.gov and get the latest information on finance company consumer, real estate, and business lending using the following steps. Click on “Economic Research and Data.” Click on “Statistics: Releases and Historical Data.” Under “Business Finance,” click on “Finance Companies.” Click on the most recent date. This downloads a file onto your computer that contains the relevant data. How have these numbers changed since 2006, reported in Table 6–4 ?

S&P Questions

Go to Standard & Poor’s Market Insight Web site at www.mhhe.com/edu- marketinsight and identify the industry constituents for Capital One Financial Corp. through the related links using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Company.” Enter “COF” in the “Ticker:” box and click on “Go!” This will take you to the information on Capital One Financial Corp. Click on “Related Links.” Click on “Consumer Finance.” Click on “GICS Sub- Industry Constituents.” This will download the list of industry constituents for Capital One Financial Corp. Go to Standard & Poor’s Market Insight Web site at www.mhhe.com/edu- marketinsight and find the most recent balance sheet for Capital One Financial Corp (COF) and American Express (AXP) using the following steps. Click on “Educational Version of Market Insight.” Enter your site ID and click on “Login.” Click on “Company.” Enter “COF” in the “Ticker:” box and click on “Go!” Click on “Excel Analytics.” Click on “FS Ann. Balance Sheet.” This will download the balance sheet for Capital One Financial Corp., which con- tains the balances for consumer loans, commercial loans, mortgage loans, and total assets. Repeat the process by entering “AXP” in the “Ticker:” box to get information on American Express. Compare the ratios of consumer loans to

7. 8.

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Chapter 6 The Financial Services Industry: Finance Companies 167

total assets, business (commercial) loans to total assets, and real estate (mort- gage) loans to total assets from these balance sheets with those for the finance company industry listed in Table 6–1.

Pertinent Web Sites

AIG American General Finance www.aigag.com Board of Governors of the Federal Reserve www.federalreserve.gov CIT Group www.citgroup.com Citigroup www.citigroup.com Consumer Bankers Association www.cbanet.org Ford Motor Credit Corp. www.fordcredit.com General Electric Capital Corp. www.gecapital.com General Motors Acceptance Corp. www.gmacfs.com HSBC Finance www.hfc.com

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168

Chapter Seven

Risks of Financial Intermediation

INTRODUCTION

A major objective of FI management is to increase the FI’s returns for its owners. This often comes, however, at the cost of increased risk. This chapter introduces the various risks facing FIs: interest rate risk, market risk, credit risk, off- balance-sheet risk, technology and operational risk, foreign exchange risk, country or sovereign risk, liquidity risk, and insolvency risk. Table 7–1 presents a brief definition of each of these risks. In general, risk measurement and management are quantitative subjects. Before we get into the rigorous quantitative methods, in this chapter we provide a basic description of each type of risk. By the end of this chapter, students new to the study of financial institutions will have a

TABLE 7–1 Risks Faced by Financial Intermediaries

Interest rate risk The risk incurred by an FI when the maturities of its assets and liabilities are mismatched.

Market risk The risk incurred from assets and liabilities in an FI’s trading book due to changes in interest rates, exchange rates, and other prices.

Credit risk The risk that promised cash flows from loans and securities held by FIs may not be paid in full.

Off-balance-sheet risk The risk incurred by an FI as the result of activities related to its contingent assets and liabilities held off the balance sheet.

Foreign exchange risk The risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in nondomestic currencies.

Country or sovereign risk The risk that repayments to foreign lenders or investors may be interrupted because of restrictions, intervention, or interference from foreign governments.

Technology risk The risk incurred by an FI when its technological investments do not produce anticipated cost savings.

Operational risk The risk that existing technology, auditing, monitoring, and other support systems may malfunction or break down.

Liquidity risk The risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at less than fair market prices.

Insolvency risk The risk that an FI may not have enough capital to offset a sudden decline in the value of its assets.

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Chapter 7 Risks of Financial Intermediation 169

basic understanding of the variety and complexity of risks facing managers of modern FIs. In the remaining chapters of the text, we look at the quantitative measurement and management of these risks in more detail. As will become clear throughout the rest of the textbook, the effective management of these risks is central to an FI’s performance. 1 Indeed, it can be argued that the main business of FIs is to manage these risks. 2

INTEREST RATE RISK

Chapter 1 discussed asset transformation as a key special function of FIs. Asset transformation involves an FI’s buying primary securities or assets and issuing secondary securities or liabilities to fund asset purchases. The primary securities purchased by FIs often have maturity and liquidity characteristics different from those of the secondary securities FIs sell. In mismatching the maturities of assets and liabilities as part of their asset-transformation function, FIs potentially expose themselves to interest rate risk.

1 These risks are not necessarily unique to financial institutions. Every global, nonfinancial corporation faces these risks as well, and managers of these firms must deal with these risks just as do managers of FIs. 2 Appendix 7A at the book’s Web site ( www.mhhe.com/saunders6e ) contains an overview of the evalu- ation of FI performance and risk exposure (“Commercial Banks’ Financial Statements and Analysis”). Included are several accounting ratio–based measures of risk.

interest rate risk The risk incurred by an FI when the maturities of its assets and liabilities are mismatched.

interest rate risk The risk incurred by an FI when the maturities of its assets and liabilities are mismatched.

Consider an FI that issues $100 million of liabilities of one-year maturity to finance the pur- chase of $100 million of assets with a two-year maturity. We show this situation in the fol- lowing time lines:

Liabilities 10

0 21 Assets

($100 million)

($100 million)

In these time lines the FI can be viewed as being “short-funded.” That is, the maturity of its liabilities is less than the maturity of its assets.

Suppose the cost of funds (liabilities) for an FI is 9 percent per annum and the return on assets is 10 percent per annum. Over the first year the FI can lock in a profit spread of 1 per- cent (10 percent – 9 percent) times $100 million by borrowing short term (for one year) and lending long term (for two years). Thus, its profit is $1 million (.01 × $100 m).

However, its profits for the second year are uncertain. If the level of interest rates does not change, the FI can refinance its liabilities at 9 percent and lock in a 1 percent, or $1 mil- lion, profit for the second year as well. There is always a risk, however, that interest rates will change between years 1 and 2. If interest rates were to rise and the FI can borrow new one- year liabilities only at 11 percent in the second year, its profit spread in the second year would actually be negative; that is, 10 percent – 11 percent = –1 percent, or the FI’s loss is $1 million (–.01 × $100 m). The positive spread earned in the first year by the FI from holding assets

EXAMPLE 7–1 Impact of an Interest Rate Increase on an FI’s Profits When the Maturity of Its Assets Exceeds the Maturity of Its Liabilities

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170 Part One Introduction

In addition to a potential refinancing or reinvestment risk that occurs when interest rates change, an FI faces market value risk as well. Remember that the mar- ket (or fair) value of an asset or liability is conceptually equal to the present value of current and future cash flows from that asset or liability. Therefore, rising inter- est rates increase the discount rate on those cash flows and reduce the market value of that asset or liability. Conversely, falling interest rates increase the mar- ket values of assets and liabilities. Moreover, mismatching maturities by holding longer-term assets than liabilities means that when interest rates rise, the market value of the FI’s assets falls by a greater amount than its liabilities. This exposes the FI to the risk of economic loss and, potentially, the risk of insolvency.

with a longer maturity than its liabilities would be offset by a negative spread in the second year. Note that if interest rates were to rise by more than 1 percent in the second year, the FI would stand to take losses over the two-year period as a whole. As a result, when an FI holds longer-term assets relative to liabilities, it potentially exposes itself to refinancing risk. This is the risk that the cost of rolling over or reborrowing funds could be more than the return earned on asset investments. The classic example of this type of mismatch was demonstrated by U.S. savings institutions during the 1980s (see Chapter 2).

refinancing risk The risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments.

refinancing risk The risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments.

An alternative balance sheet structure would have the FI borrowing $100 million for a longer term than the $100 million of assets in which it invests. In the time lines below the FI is “long- funded.” The maturity of its liabilities is longer than the maturity of its assets. Using a similar example, suppose the FI borrowed funds at 9 percent per annum for two years and invested the funds in assets that yield 10 percent for one year. This situation is shown as follows:

Liabilities

10

0 21

Assets

($100 million)

($100 million)

In this case, the FI is also exposed to an interest rate risk; by holding shorter-term assets relative to liabilities, it faces uncertainty about the interest rate at which it can reinvest funds in the second period. As before, the FI locks in a one-year profit spread of 1 percent, or $1 million. At the end of the first year, the asset matures and the funds that have been bor- rowed for two years have to be reinvested. Suppose interest rates fall between the first and second years so that in the second year the return on $100 million invested in new one-year assets is 8 percent. The FI would face a loss, or negative spread, in the second year of 1 per- cent (that is, 8 percent asset return minus 9 percent cost of funds), or the FI loses $1 million (–.01 × $100 m). The positive spread earned in the first year by the FI from holding assets with a shorter maturity than its liabilities is offset by a negative spread in the second year. Thus, the FI is exposed to reinvestment risk; by holding shorter-term assets relative to liabili- ties, it faces uncertainty about the interest rate at which it could reinvest funds borrowed for a longer period. As interest rates fell in the early 2000s, good examples of this exposure were provided by banks that borrowed fixed-rate deposits while investing in floating-rate loans, that is, loans whose interest rates changed or adjusted frequently.

reinvestment risk The risk that the re- turns on funds to be reinvested will fall be- low the cost of funds.

reinvestment risk The risk that the re- turns on funds to be reinvested will fall be- low the cost of funds.

EXAMPLE 7–2 Impact of an Interest Rate Decrease When the Maturity of an FI’s Liabilities Exceeds the Maturity of Its Assets

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Chapter 7 Risks of Financial Intermediation 171

If holding assets and liabilities with mismatched maturities exposes FIs to rein- vestment (or refinancing) and market value risks, FIs can seek to hedge, or protect against, interest rate risk by matching the maturity of their assets and liabilities. 3 This has resulted in the general philosophy that matching maturities is somehow the best policy to hedge interest rate risk for FIs that are averse to risk. Note, how- ever, that matching maturities is not necessarily consistent with an active asset- transformation function for FIs. That is, FIs cannot be asset transformers (e.g., transforming short-term deposits into long-term loans) and direct balance sheet matchers or hedgers at the same time. While reducing exposure to interest rate risk, matching maturities may also reduce the FI’s profitability because returns from act- ing as specialized risk-bearing asset transformers are reduced. As a result, some FIs emphasize asset–liability maturity mismatching more than others. For example, banks and thrifts traditionally hold longer-term assets than liabilities, whereas life insurance companies tend to match the long-term nature of their liabilities with long-term assets. Finally, matching maturities hedges interest rate risk only in a very approximate rather than complete fashion. The reasons for this are technical, relating to the difference between the average life (or duration) and maturity of an asset or liability and whether the FI partly funds its assets with equity capital as well as debt liabilities. In the preceding simple examples, the FI financed its assets completely with borrowed funds. In the real world, FIs use a mix of debt liabilities and stockholders’ equity to finance asset purchases. When assets and debt liabili- ties are not equal, hedging risk (i.e., insulating FI’s stockholder’s equity values) may be achieved by not exactly matching the maturities (or average lives) of assets and liabilities. We discuss the causes of interest rate risk and methods used to mea- sure interest rate risk in detail in Chapters 8 and 9. We discuss the methods and instruments used to hedge interest rate risk in Chapters 23 through 25. 4

What is refinancing risk? What type of FI best illustrated this concept in the 1980s? Why does a rise in the level of interest rates adversely affect the market value of both assets and liabilities? Explain the concept of maturity matching.

1. 2.

3.

Concept Questions Concept Questions

MARKET RISK

Market risk arises when FIs actively trade assets and liabilities (and derivatives) rather than hold them for longer-term investment, funding, or hedging purposes.

3 This assumes that FIs can directly “control” the maturities of their assets and liabilities. As interest rates fall, many mortgage borrowers seek to “prepay” their existing loans and refinance at a lower rate. This prepayment risk—which is directly related to interest rate movements—can be viewed as a further inter- est rate–related risk. Prepayment risk is discussed in detail in Chapter 27. 4 We assumed in our examples that interest payments are paid only at the end of each year and could be changed only then. In reality, many loan and deposit rates adjust frequently or float as market rates change. For example, suppose a bank makes a one-year loan whose interest rate and interest rate pay- ments are adjusted each quarter while fully funding the loan with a one-year CD that pays principal and interest at the end of the year. Even though the maturities of the loan and CD are equal to a year, the FI would not be fully hedged in a cash flow sense against interest rate risk since changes in interest rates over the year affect the cash flows (interest payments) on the loan but not those on deposits. In particu- lar, if interest rates were to fall, the FI might lose on the loan in terms of net interest income (interest revenue minus interest expense). The reason for this loss is that the average life of the loan in a cash flow sense is less than that of the deposit because cash flows on the loan are received, on average, earlier than are those paid on the deposit.

market risk The risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices.

market risk The risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices.

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172 Part One Introduction

Market risk is closely related to interest rate, equity return, and foreign exchange risk in that as these risks increase or decrease, the overall risk of the FI is affected. However, market risk adds another dimension resulting from its trading activity. Market risk is the incremental risk incurred by an FI when interest rate, foreign exchange, and equity return risks are combined with an active trading strategy, especially one that involves short trading horizons such as a day. Conceptually, an FI’s trading portfolio can be differentiated from its investment portfolio on the basis of time horizon and secondary market liquidity. The trading portfolio contains assets, liabilities, and derivative contracts that can be quickly bought or sold on organized financial markets. The investment portfolio (or in the case of banks, the so-called banking book) contains assets and liabilities that are rela- tively illiquid and held for longer holding periods. Table 7–2 shows a hypotheti- cal breakdown between banking book and trading book assets and liabilities. As can be seen, the banking book contains the majority of loans and deposits plus other illiquid assets. The trading book contains long and short positions in instruments such as bonds, commodities, foreign exchange (FX), equities, and derivatives.

With the increasing securitization of bank loans (e.g., mortgages), more and more assets have become liquid and tradable. Of course, with time, every asset and liability can be sold. While bank regulators have normally viewed tradable assets as those being held for horizons of less than one year, private FIs take an even shorter-term view. In particular, FIs are concerned about the fluctuation in value—or value at risk (VAR)—of their trading account assets and liabilities for periods as short as one day—so-called daily earnings at risk (DEAR)—especially if such fluctuations pose a threat to their solvency.

To see an extreme case of the type of risk involved in active trading, consider Barings, the 200-year-old British merchant bank that failed as a result of trading losses in February 1995. In this case, the bank (or, more specifically, one trader, Nick Leeson) was betting that the Japanese Nikkei Stock Market Index would rise by buying futures on that index (some $8 billion worth). However, for a number of reasons—including the Kobe earthquake—the index actually fell. As a result, over a period of one month, the bank lost over $1.2 billion on its trading posi- tions, rendering the bank insolvent. 5 That is, the losses on its futures positions exceeded the bank’s own equity capital resources. Of course, if the Nikkei Index

5 In 1995 Barings was acquired as a subsidiary of ING, a Dutch bank, and was fully integrated into ING in 2000.

Assets Liabilities

Banking book Cash Loans Premises and equipment Other illiquid assets

Deposits Other illiquid borrowed funds Capital

Trading book Bonds (long) Commodities (long) FX (long) Equities (long)

Bonds (short) Commodities (short) FX (short) Equities (short)

Derivatives* (long) Derivatives* (short)

*Derivatives are off-balance-sheet items (as discussed in Chapter 13).

TABLE 7–2 The Investment (Banking) Book and Trading Book of a Commercial Bank

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Chapter 7 Risks of Financial Intermediation 173

had actually risen, the bank would have made very large profits and might still be in business. Another good example involves market risk incurred by commercial banks, investment banks, mutual funds, and other FIs as U.S. equity markets fell dramatically in value in July 2002. For instance, in a two-week period (from July 9, 2002, to July 20, 2002) the Dow Jones Industrial Average sank 1,255.64 points, 13.54 percent, from 9,274.90 to 8,019.26.

As the above examples illustrate, market, or trading, risk is present whenever an FI takes an open or unhedged long (buy) or sell (short) position in bonds, equi- ties, and foreign exchange (as well as in commodities and derivative products), and prices change in a direction opposite to that expected. As a result, the more volatile are asset prices in the markets in which these instruments trade, the greater are the market risks faced by FIs that adopt open trading positions. This requires FI management (and regulators) to establish controls to limit positions taken by traders as well as to develop models to measure the market risk exposure of an FI on a day-to-day basis. These market risk measurement models are discussed in Chapter 10.

What is market, or trading, risk? What modern conditions have led to an increase in this particular type of risk for FIs?

1. 2.

Concept Questions Concept Questions

CREDIT RISK

Credit risk arises because of the possibility that promised cash flows on financial claims held by FIs, such as loans or bonds, will not be paid in full. Virtually all types of FIs face this risk. However, in general, FIs that make loans or buy bonds with long maturities are more exposed than are FIs that make loans or buy bonds with short maturities. This means, for example, that banks, thrifts, and life insur- ance companies are more exposed to credit risk than are money market mutual funds and property–casualty insurance companies. If the principal on all finan- cial claims held by FIs was paid in full on maturity and interest payments were made on the promised dates, FIs would always receive back the original principal lent plus an interest return. That is, they would face no credit risk. If a borrower defaults, however, both the principal loaned and the interest payments expected to be received are at risk. As a result, many financial claims issued by corporations and held by FIs promise a limited or fixed upside return (principal and interest payments to the lender) with a high probability and a large downside risk (loss of loan principal and promised interest) with a much smaller probability. Good examples of financial claims issued with these return-risk trade-offs are fixed- income coupon bonds issued by corporations and bank loans. In both cases, an FI holding these claims as assets earns the coupon on the bond or the interest prom- ised on the loan if no borrower default occurs. In the event of default, however, the FI earns zero interest on the asset and may lose all or part of the principal lent, depending on its ability to lay claim to some of the borrower’s assets through legal bankruptcy and insolvency proceedings. Accordingly, a key role of FIs involves screening and monitoring loan applicants to ensure that FI managers fund the most creditworthy loans (see Chapter 11).

credit risk The risk that the promised cash flows from loans and secu- rities held by FIs may not be paid in full.

credit risk The risk that the promised cash flows from loans and secu- rities held by FIs may not be paid in full.

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174 Part One Introduction

The effects of credit risk are evident in Figure 7–1 , which shows commercial bank charge-off (or write-off) rates for various types of loans. Notice, in particular, the high rate of charge-offs experienced on credit card loans in the 1980s, most of the 1990s, and the early 2000s. Indeed, credit card charge-offs by commercial banks increased persistently from the mid-1980s until 1993 and again from 1995 through early 1998. By 1998, charge-offs leveled off, and they even declined after 1998. However, a weak economy and change in bankruptcy laws 6 resulted in a surge in credit card charge-offs in the early 2000s. Despite these losses, credit card loans extended by commercial banks (including unused balances) continue to grow, from $1.856 trillion in March 1997 to $4.066 trillion in June 2006.

Figure 7–2 presents the probability distribution of dollar returns for an FI invest- ing in risky loans or bonds. The distribution indicates a high probability (but less than 1) of repayment of principal and promised interest in full (point A ). Problems with a borrower’s cash flows can result in varying degrees of default risk. These range from partial or complete default on interest payments—the range between point A and point B in Figure 7–2 —and partial or complete default on the princi- pal lent, the range between point B and point C . Notice, too, that the probability of a complete default on principal and interest (point C ) is often small. Nevertheless, because the probability of partial or complete default on bond and loan interest and principal exists, an FI must estimate expected default risk on these assets and demand risk premiums commensurate with the perceived risk exposure. For example, when a business customer applies for a loan, the loan officer must deter- mine whether the default risk is sufficiently low enough to grant the loan and, if so, the interest rate to charge for this risk.

6 In the early 2000s, the U.S. Congress considered and passed legislation that made it more difficult for individuals to declare bankruptcy. This congressional activity brought about a rise in bankruptcy filings before changes took effect.

9.0

8.0

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0

Net charge-off rate (%)

03 04 05 0685 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 0284

C&I loans Real estate loans Credit card loans

FIGURE 7–1 Charge-Off Rates for Commercial Bank Lending Activities, 1984–2006

Source: FDIC, Quarterly Banking Profile, various issues. www.fdic.gov

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Chapter 7 Risks of Financial Intermediation 175

The potential loss an FI can experience from lending suggests that FIs need to monitor and collect information about borrowers whose assets are in their portfo- lios and to monitor those borrowers over time. Thus, managerial monitoring effi- ciency and credit risk management strategies directly affect the return and risks of the loan portfolio. Moreover, the credit risk distribution in Figure 7–2 is for an investment in a single asset exposed to default risk. One of the advantages FIs have over individual household investors is the ability to diversify some credit risk away by exploiting the law of large numbers in their asset investment portfo- lios (see Chapter 1). In the framework of Figure 7–2 , diversification across assets, such as loans exposed to credit risk, reduces the overall credit risk in the asset portfolio and thus increases the probability of partial or full repayment of princi- pal and/or interest, that is, moderates the long-tailed downside risk of the return distribution.

FIs earn the maximum dollar return when all bonds and loans pay off inter- est and principal in full. In reality, some loans or bonds default on interest pay- ments, principal payments, or both. Thus, the mean return on the asset portfolio would be less than the maximum possible. The effect of risk diversification is to truncate or limit the probabilities of the bad outcomes in the portfolio. In effect, diversification reduces individual firm-specific credit risk , such as the risk spe- cific to holding the bonds or loans of Enron or WorldCom, while leaving the FI still exposed to systematic credit risk , such as factors that simultaneously increase the default risk of all firms in the economy (e.g., an economic recession). We describe methods to measure the default risk of individual corporate claims such as bonds and loans in Chapter 11. In Chapter 12, we investigate methods of measuring the risk in portfolios of such claims. Chapter 26 discusses various methods—for example, loan sales, reschedulings, and a good bank–bad bank structure—to manage and control credit risk exposures better, while Chapters 23 to 25 discuss the role of the recently innovated credit derivative markets in hedging credit risk.

Why does credit risk exist for FIs? How does diversification affect an FI’s credit risk exposure?

1. 2.

firm-specific credit risk The risk of default of the borrowing firm associated with the specific types of proj- ect risk taken by that firm.

firm-specific credit risk The risk of default of the borrowing firm associated with the specific types of proj- ect risk taken by that firm.

systematic credit risk The risk of default associated with gen- eral economywide or macro conditions af- fecting all borrowers.

systematic credit risk The risk of default associated with gen- eral economywide or macro conditions af- fecting all borrowers.

Concept Questions Concept Questions

FIGURE 7–2 The Probability Distribution of Dollar Returns on Risky Debt (Loans/ Bonds)

Probability (p) p = 1

0 Principal

B

C

A

Principal and interest

$ return

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176 Part One Introduction

OFF-BALANCE-SHEET RISK

One of the most striking trends for many modern FIs has been the growth in their off-balance-sheet activities and thus their off-balance-sheet risk . While all FIs to some extent engage in off-balance-sheet activities, most attention has been drawn to the activities of banks, especially large banks. By contrast, off-balance- sheet activities have been less of a concern to smaller depository institutions and many insurance companies. An off-balance-sheet activity, by definition, does not appear on an FI’s current balance sheet since it does not involve holding a cur- rent primary claim (asset) or the issuance of a current secondary claim (liability). Instead, off-balance-sheet activities affect the future shape of an FI’s balance sheet in that they involve the creation of contingent assets and liabilities that give rise to their potential (future) placement on the balance sheet. Thus, accountants place them “below the bottom line” of an FI’s asset and liability balance sheet. A good example of an off-balance-sheet activity is the issuance of standby letter of credit guarantees by insurance companies and banks to back the issuance of municipal bonds. Many state and local governments could not issue such securities with- out bank or insurance company letter of credit guarantees that promise principal and interest payments to investors should the municipality default on its future obligations. Thus, the letter of credit guarantees payment should a municipal government (e.g., New York State) face financial problems in paying the prom- ised interest payments and/or the principal on the bonds it issues. If a munici- pal government’s cash flow is sufficiently strong so as to pay off the principal and interest on the debt it issues, the letter of credit guarantee issued by the FI expires unused. Nothing appears on the FI’s balance sheet today or in the future. However, the fee earned for issuing the letter of credit guarantee appears on the FI’s income statement.

As a result, the ability to earn fee income while not loading up or expanding the balance sheet has become an important motivation for FIs to pursue off-balance- sheet business. Unfortunately, this activity is not risk free. Suppose the municipal government defaults on its bond interest and principal payments. Then the con- tingent liability or guaranty the FI issued becomes an actual liability that appears on the FI’s balance sheet. That is, the FI has to use its own equity to compensate investors in municipal bonds. Indeed, significant losses in off-balance-sheet activi- ties can cause an FI to fail, just as major losses due to balance sheet default and interest rate risks can cause an FI to fail.

Letters of credit are just one example of off-balance-sheet activities. Others include loan commitments by banks, mortgage servicing contracts by thrifts, and positions in forwards, futures, swaps, and other derivative securities by almost all large FIs. While some of these activities are structured to reduce an FI’s exposure to credit, interest rate, or foreign exchange risks, mismanagement or speculative use of these instruments can result in major losses to FIs. We detail the specific nature of the risks of off-balance-sheet activities more fully in Chapter 13.

Why are letter of credit guarantees an off-balance-sheet item? Why are FIs motivated to pursue off-balance-sheet business? What are the risks?

1. 2.

off-balance-sheet risk The risk incurred by an FI due to activities related to contingent assets and liabilities.

off-balance-sheet risk The risk incurred by an FI due to activities related to contingent assets and liabilities.

letter of credit A credit guarantee issued by an FI for a fee on which pay- ment is contingent on some future event occurring.

letter of credit A credit guarantee issued by an FI for a fee on which pay- ment is contingent on some future event occurring.

Concept Questions Concept Questions

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Chapter 7 Risks of Financial Intermediation 177

FOREIGN EXCHANGE RISK

Increasingly, FIs have recognized that both direct foreign investment and foreign portfolio investments can extend the operational and financial benefits available from purely domestic investments. Thus, U.S. pension funds that held approxi- mately 5 percent of their assets in foreign securities in the early 1990s now hold close to 10 percent of their assets in foreign securities. Japanese pension funds currently hold more than 30 percent of their assets in foreign securities plus an additional 10 percent in foreign currency deposits. At the same time, many large U.S. banks, investment banks, and mutual funds have become more global in their orientation. To the extent that the returns on domestic and foreign investments are imperfectly correlated, there are potential gains for an FI that expands its asset holdings and liability funding beyond the domestic borders.

The returns on domestic and foreign direct investing and portfolio invest- ments are not perfectly correlated for two reasons. The first is that the underly- ing technologies of various economies differ, as do the firms in those economies. For example, one economy may be based on agriculture while another is industry based. Given different economic infrastructures, one economy could be expanding while another is contracting. In the early 2000s, for example, the U.S. economy was rapidly expanding while the European economy was stagnant. The second reason is that exchange rate changes are not perfectly correlated across countries. This means the dollar–euro exchange rate may be appreciating while the dollar–yen exchange rate may be falling.

One potential benefit from an FI’s becoming increasingly global in its outlook is an ability to expand abroad directly through branching or acquisitions or by devel- oping a financial asset portfolio that includes foreign securities as well as domestic securities. Even so, foreign investment exposes an FI to foreign exchange risk . Foreign exchange risk is the risk that exchange rate changes can adversely affect the value of an FI’s assets and liabilities denominated in foreign currencies.

To understand how foreign exchange risk arises, suppose that a U.S. FI makes a loan to a British company in pounds sterling (£). Should the British pound depreciate in value relative to the U.S. dollar, the principal and interest payments received by U.S. investors would be devalued in dollar terms. Indeed, were the British pound to fall far enough over the investment period, when cash flows are converted back into dollars, the overall return could be negative. That is, on the conversion of principal and interest payments from pounds into dollars, foreign exchange losses can offset the promised value of local currency interest payments at the original exchange rate at which the investment occurred.

In general, an FI can hold assets denominated in a foreign currency and/or issue foreign liabilities. Consider a U.S. FI that holds £100 million in pound loans as assets and funds £80 million of them with pound certificates of deposit. The difference between the £100 million in pound loans and £80 million in pound CDs is funded by dollar CDs (i.e., £20 million worth of dollar CDs). See Figure 7–3 . In this case, the U.S. FI is net long £20 million in pound assets; that is, it holds more foreign assets than liabilities. The U.S. FI suffers losses if the exchange rate for pounds falls or depreciates against the dollar over this period. In dollar terms, the value of the pound loan assets falls or decreases in value by more than the pound CD liabilities do. That is, the FI is exposed to the risk that its net foreign assets may have to be liquidated at an exchange rate lower than the one that existed when the FI entered into the foreign asset–liability position.

£ $ ¥

:

£ $ ¥

:

foreign exchange risk The risk that ex- change rate changes can affect the value of an FI’s assets and li- abilities denominated in foreign currencies.

foreign exchange risk The risk that ex- change rate changes can affect the value of an FI’s assets and li- abilities denominated in foreign currencies.

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178 Part One Introduction

Instead, the FI could have £20 million more pound liabilities than assets; in this case, it would be holding a net short position in pound assets, as shown in Figure 7–4 . Under this circumstance, the FI is exposed to foreign exchange risk if the pound appreciates against the dollar over the investment period. This occurs because the value of its pound liabilities in dollar terms rose faster than the return on its pound assets. Consequently, to be approximately hedged, the FI must match its assets and liabilities in each foreign currency.

Note that the FI is fully hedged only if we assume that it holds foreign assets and liabilities of exactly the same maturity. 7 Consider what happens if the FI matches the size of its foreign currency book (pound assets = pound liabilities = £100 mil- lion in that currency) but mismatches the maturities so that the pound assets are of six-month maturity and the liabilities are of three-month maturity. The FI would then be exposed to foreign interest rate risk—the risk that British interest rates would rise when it has to roll over its £100 million in pound CD liabilities at the end of the third month. Consequently, an FI that matches both the size and maturi- ties of its exposure in assets and liabilities of a given currency is hedged, or immu- nized, against foreign currency and foreign interest rate risk. To the extent that FIs mismatch their portfolio and maturity exposures in different currency assets and liabilities, they face both foreign currency and foreign interest rate risks. As already noted, if foreign exchange rate and interest rate changes are not perfectly correlated across countries, an FI can diversify away part, if not all, of its foreign currency risk. We discuss the measurement and evaluation of an FI’s foreign cur- rency risk exposure in depth in Chapter 14.

Explain why the returns on domestic and foreign portfolio investments are not, in gen- eral, perfectly correlated. A U.S. bank is net long in European assets. If the euro appreciates against the dollar, will the bank gain or lose? A U.S. bank is net short in European assets. If the euro appreciates against the dollar, will the bank gain or lose?

7 Technically speaking, hedging requires matching the durations (average lives of assets and liabilities) rather than simple maturities (see Chapter 9)

1.

2.

3.

Concept Questions Concept Questions

0 Foreign assets £100 million

0 Foreign liabilities £80 million

FIGURE 7–3 The Foreign Asset and Liability Position: Net Long Asset Position in Pounds

FIGURE 7–4 The Foreign Asset and Liability Position: Net Short Asset Position in Pounds

0 Foreign assets £80 million

0 Foreign liabilities £100 million

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Chapter 7 Risks of Financial Intermediation 179

COUNTRY OR SOVEREIGN RISK

As we noted in the previous section, a globally oriented FI that mismatches the size and maturities of its foreign assets and liabilities is exposed to foreign currency and foreign interest rate risks. Even beyond these risks, and even when investing in dollars, holding assets in a foreign country can expose an FI to an additional type of foreign investment risk called country or sovereign risk . Country or sov- ereign risk is a different type of credit risk that is faced by an FI that purchases assets such as the bonds and loans of foreign corporations. For example, when a domestic corporation is unable or unwilling to repay a loan, an FI usually has recourse to the domestic bankruptcy courts and eventually may recoup at least a portion of its original investment when the assets of the defaulted firm are liq- uidated or restructured. By comparison, a foreign corporation may be unable to repay the principal or interest on a loan even if it would like to. Most commonly, the government of the country in which the corporation is headquartered may prohibit or limit debt payments because of foreign currency shortages and adverse political reasons.

For example U.S., European, and Japanese banks had enhanced sovereign risk exposures to countries such as Argentina, Russia, Thailand, South Korea, Malaysia, and Indonesia. Financial support given to these countries by the International Monetary Fund (IMF), the World Bank, and the U.S., Japanese, and European gov- ernments enabled the banks to avoid the full extent of the losses that were pos- sible. Nevertheless, Indonesia had to declare a moratorium on some of its debt repayments, while Russia defaulted on payments on its short-term government bonds. In 1999, some banks agreed to settle their claims with the Russian gov- ernment, receiving less than five cents for every dollar owed them. In 2001, the government of Argentina, which had pegged its peso to the dollar on a one-to-one basis since the early 1990s, had to default on its government debt largely because of an overvalued peso and the adverse effect this had on its exports and foreign currency earnings. In December 2001, Argentina ended up defaulting on $130 bil- lion in government-issued debt and, in 2002, passed legislation that led to defaults on $30 billion of corporate debt owed to foreign creditors. Argentina’s economic problems continued into 2003; in September 2003 it defaulted on a $3 billion loan repayment to the IMF.

In the event of such restrictions, reschedulings, or outright prohibitions on the payment of debt obligations by sovereign governments, the FI claimholder has little, if any, recourse to the local bankruptcy courts or an international civil claims court. The major leverage available to an FI to ensure or increase repayment prob- abilities and amounts is its control over the future supply of loans or funds to the country concerned. However, such leverage may be very weak in the face of a country’s collapsing currency and government. Chapter 15 discusses how country or sovereign risk is measured and considers possible financial market solutions to the country risk exposure problems of a globally oriented FI.

Can a bank be subject to sovereign risk if it lends only to the highest-quality foreign corporations? What is one major way an FI can discipline a country that threatens not to repay its loans?

1.

2.

£ $ ¥

:

£ $ ¥

:

country or sovereign risk The risk that repay- ments from foreign borrowers may be interrupted because of interference from foreign governments.

country or sovereign risk The risk that repay- ments from foreign borrowers may be interrupted because of interference from foreign governments.

Concept Questions Concept Questions

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180 Part One Introduction

TECHNOLOGY AND OPERATIONAL RISKS

Technology and operational risks are closely related and in recent years have caused great concern to FI managers and regulators alike. The Bank for International Settlements (BIS), the principal organization of central banks in the major economies of the world, defines operational risk (inclusive of technological risk) as “the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.” 8 A number of FIs add reputational risk and strategic risk (e.g., due to a failed merger) as part of a broader definition of operational risk.

Technological innovation has been a major growth area of FIs in recent years. In the 1990s and 2000s, banks, insurance companies, and investment companies all sought to improve operational efficiency with major investments in internal and external communications, computers, and an expanded technological infra- structure. For example, most banks provide depositors with the capabilities to check account balances, transfer funds between accounts, manage finances, pay bills, and perform other functions from their home personal computers. At the wholesale level, electronic transfer of funds through automated clearing houses (ACH) and wire transfer payment networks such as the Clearing House Interbank Payments Systems (CHIPS) have been developed. Indeed, the global financial ser- vices firm Citigroup has operations in more than 100 countries connected in real time by a proprietary-owned satellite system.

The major objectives of technological expansion are to lower operating costs, increase profits, and capture new markets for the FI. In current terminology, the objective is to allow the FI to exploit, to the fullest extent possible, better potential economies of scale and economies of scope in selling its products. Economies of scale refer to an FI’s ability to lower its average costs of operations by expanding its output of financial services. Economies of scope refer to an FI’s ability to gen- erate cost synergies by producing more than one output with the same inputs. For example, an FI could use the same information on the quality of customers stored in its computers to expand the sale of both loan products and insurance products. That is, the same information (e.g., age, job, size of family, income) can identify both potential loan and life insurance customers. Indeed, the attempt to better exploit such economies of scope lies behind megamergers such as that of Citicorp with Travelers to create Citigroup, an FI that services over 100 million customers in areas such as banking, securities, and insurance.

Technology risk occurs when technological investments do not produce the anticipated cost savings in the form of economies of either scale or scope. Diseconomies of scale, for example, arise because of excess capacity, redundant technology, and/or organizational and bureaucratic inefficiencies (red tape) that become worse as an FI grows in size. Diseconomies of scope arise when an FI fails to generate perceived synergies or cost savings through major new technology investments. We describe the measurement and evidence of economies of scale and scope in FIs in Chapter 16. Technological risk can result in major losses in the competitive efficiency of an FI and, ultimately, in its long-term failure. Similarly, gains from technological investments can produce performance superior to an FI’s rivals as well as allow it to develop new and innovative products, enhancing its long-term survival chances. 8 See Basel Committee on Bank Supervision, “Sound Practices for the Management and Supervision of Operational Risk,” July 2002, p. 2, Basel, Switzerland.

www.bis.org www.bis.org

economies of scale The degree to which an FI’s average unit costs of producing fi- nancial services fall as its outputs of services increase.

economies of scale The degree to which an FI’s average unit costs of producing fi- nancial services fall as its outputs of services increase.

economies of scope The degree to which an FI can generate cost synergies by producing mul- tiple financial service products.

economies of scope The degree to which an FI can generate cost synergies by producing mul- tiple financial service products.

technology risk The risk incurred by an FI when technolog- ical investments do not produce the cost savings anticipated.

technology risk The risk incurred by an FI when technolog- ical investments do not produce the cost savings anticipated.

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Chapter 7 Risks of Financial Intermediation 181

Operational risk is partly related to technology risk and can arise whenever existing technology malfunctions or back-office support systems break down. For example, a failure of a back-office system occurred in September 2001 when Citibank’s (a subsidiary of Citigroup) ATM system crashed for an extended period of time. Citibank’s 2,000 nationwide ATMs, its debit card system, and its online banking functions went down for almost two business days. More recently, in February 2005 Bank of America announced that it had lost computer backup tapes containing personal information such as names and Social Security numbers on about 1.2 million federal government employee charge cards as the tapes were being transported to a data-storage facility for safe keeping. Bank of America could not rule out the possibility of unauthorized purchases using lost data, but it said the account numbers, addresses, and other tape contents were not easily accessible without highly sophisticated equipment and technological expertise. Even though such computer breakdowns are rare, their occurrence can cause major dislocations in the FIs involved and potentially disrupt the financial system in general.

Operational risk is not exclusively the result of technological failure. For exam- ple, employee fraud and errors constitute a type of operational risk that often negatively affects the reputation of an FI (see Chapter 16). For instance, as noted in Chapters 1 and 4, several highly publicized securities violations by employees of major investment banks resulted in criminal cases brought against securities law violators by state and federal prosecutors. In particular, after several years of investigation, in August 2006 the U.S. Justice Department agreed to a fine of $600 million for Prudential Financial to settle allegations that former Prudential brokers helped favored clients make improper mutual fund trades. In another instance, a federal judge threw money manager Alan Bond in jail after he was convicted on charges of allocating winning trades to his own brokerage account and saddling his clients with losers. These fraudulent activities by employees of FIs resulted in an overall loss of reputation and, in turn, business for the FI employers.

What is the difference between economies of scale and economies of scope? How is operational risk related to technology risk? How does technological expansion help an FI better exploit economies of scale and economies of scope? When might technology risk interfere with these goals?

LIQUIDITY RISK

Liquidity risk arises when an FI’s liability holders, such as depositors or insur- ance policyholders, demand immediate cash for the financial claims they hold with an FI or when holders of off-balance-sheet loan commitments (or credit lines) suddenly exercise their right to borrow (draw down their loan commitments). In recent years, the Federal Reserve has expressed concerns about both liability-side and asset-side (loan commitment) liquidity risks. 9 When liability holders demand cash immediacy—that is, “put” their financial claims back to the FI—the FI must

9 See, for example, “Regulators Press for Safeguards” and “Years of Living Dangerously Set to Haunt Banks,” Financial Times, June 4, 2001.

1. 2. 3.

operational risk The risk that existing technology or sup- port systems may malfunction or break down.

operational risk The risk that existing technology or sup- port systems may malfunction or break down.

Concept Questions Concept Questions

liquidity risk The risk that a sudden surge in liability with- drawals may leave an FI in a position of having to liquidate assets in a very short period of time and at low prices.

liquidity risk The risk that a sudden surge in liability with- drawals may leave an FI in a position of having to liquidate assets in a very short period of time and at low prices.

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182 Part One Introduction

either borrow additional funds or sell assets to meet the demand for the with- drawal of funds. The most liquid asset of all is cash, which FIs can use to directly meet liability holders’ demands to withdraw funds. Although FIs limit their cash asset holdings because cash earns no interest, low cash holdings are usually not a problem. Day-to-day withdrawals by liability holders are generally predictable, and FIs can normally expect to borrow additional funds to meet any sudden short- falls of cash on the money and financial markets.

However, there are times when an FI can face a liquidity crisis. Because of a lack of confidence by liability holders in the FI or some unexpected need for cash, lia- bility holders may demand larger withdrawals than normal. When all, or many, FIs face abnormally large cash demands, the cost of additional purchased or borrowed funds rises and the supply of such funds becomes restricted. As a consequence, FIs may have to sell some of their less liquid assets to meet the withdrawal demands of liability holders. This results in a more serious liquidity risk, especially as some assets with “thin” markets generate lower prices when the asset sale is immedi- ate than when the FI has more time to negotiate the sale of an asset. As a result, the liquidation of some assets at low or fire-sale prices (the price an FI receives if an asset must be liquidated immediately at less than its fair market value) could threaten an FI’s profitability and solvency. Good examples of such illiquid assets are bank loans to small firms. Such serious liquidity problems may eventually result in a run in which all liability claim holders seek to withdraw their funds simultaneously from the FI because they fear that it will be unable to meet their demands for cash in the near future. This turns the FI’s liquidity problem into a solvency problem and can cause it to fail. 10

We examine the nature of normal, abnormal, and run-type liquidity risks and their impact on banks, thrifts, insurance companies, and other FIs in more detail in Chapter 17. In addition, we look at ways an FI can better manage liquidity and lia- bility risk exposures in Chapter 18. Chapter 19 discusses the roles of deposit insur- ance and other liability guarantee schemes in deterring deposit (liability) runs.

Why might an FI face a sudden liquidity crisis? What circumstances might lead an FI to liquidate assets at fire-sale prices?

INSOLVENCY RISK

Insolvency risk is a consequence or outcome of one or more of the risks described above: interest rate, market, credit, off-balance-sheet, technology, foreign exchange, sovereign, and liquidity risks. Technically, insolvency occurs when the capital or 10 The situation of several Ohio savings institutions in 1985 is an extreme example of liquidity risk. A group of 70 Ohio savings institutions was insured by a private fund, the Ohio Deposit Guarantee Fund (ODGF). One of these savings banks, Home State Savings Bank (HSSB), had invested heavily in a Florida- based government securities dealer, EMS Government Securities, Inc., which eventually defaulted on its debts to HSSB (note the interaction between credit risk and liquidity risk). This in turn made it difficult for HSSB to meet deposit withdrawals of its customers. HSSB’s losses from the ESM default were, in fact, so large that the ODGF could not cover them. Not only was HSSB unable to cover the deposit withdrawals, but other Ohio savings institutions insured by ODGF were inundated with deposit withdrawals to the extent that they could not cover them as well. As a result, ODGF-insured institutions were temporarily closed and the Ohio state legislature had to step in to cover depositors’ claims.

1. 2.

Concept Questions Concept Questions

insolvency risk The risk that an FI may not have enough capital to offset a sudden decline in the value of its assets rel- ative to its liabilities.

insolvency risk The risk that an FI may not have enough capital to offset a sudden decline in the value of its assets rel- ative to its liabilities.

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Chapter 7 Risks of Financial Intermediation 183

equity resources of an FI’s owners are driven to, or near to, zero because of losses incurred as the result of one or more of the risks described above. Consider the case of the 1984 failure of Continental Illinois National Bank and Trust Company, still the biggest bank failure in U.S. history. Continental’s strategy in the late 1970s and early 1980s had been to pursue asset growth through aggressive lending, especially to the oil and gas sector. Continental’s loan portfolio grew at an average rate of 19.8 percent per year from 1977 to 1981. The downturn in the U.S. economy at the beginning of the 1980s resulted in the default of many of these loans (credit risk). In addition, Continental had a very small core deposit base, relying instead on purchased and borrowed funds such as fed funds, RPs, and Eurodollar depos- its. The increasing number of defaults in Continental’s loan portfolio fueled con- cerns about the bank’s ability to meet its liability payments, resulting in the refusal by a number of major lenders to renew or roll over the short-term funds they had lent to Continental (liquidity risk). The substantial defaults on Continental’s loans combined with its inability to obtain new or retain existing funds resulted in the rapid deterioration of Continental’s capital position (insolvency risk). Continental was unable to survive, and federal regulators assumed control in 1984.

In general, the more equity capital to borrowed funds an FI has—that is, the lower its leverage—the better able it is to withstand losses, whether due to adverse interest rate changes, unexpected credit losses, or other reasons. Thus, both man- agement and regulators of FIs focus on an FI’s capital (and adequacy) as a key measure of its ability to remain solvent and grow in the face of a multitude of risk exposures. The issue of what is an adequate level of capital to manage an FI’s overall risk exposure is discussed in Chapter 20.

When does insolvency risk occur? How is insolvency risk related to the other risks discussed in this chapter?

OTHER RISKS AND THE INTERACTION OF RISKS

In this chapter we have concentrated on ten major risks continuously impacting an FI manager’s decision-making process and risk management strategies. These risks were interest rate risk, market risk, credit risk, off-balance-sheet risk, technol- ogy and operational risk, foreign exchange risk, country or sovereign risk, liquid- ity risk, and insolvency risk. Even though the discussion generally described each independently, in reality, these risks are often interdependent. For example, when interest rates rise, corporations and consumers find maintaining promised pay- ments on their debt more difficult. 11 Thus, over some range of interest rate move- ments, credit, interest rate, and off-balance-sheet risks are positively correlated. Furthermore, the FI may have been counting on the funds from promised pay- ments on its loans for liquidity management purposes. Thus, liquidity risk is also correlated with interest rate and credit risks. The inability of a customer to make promised payments also affects the FI’s income and profits and, consequently, its equity or capital position. Thus, each risk and its interaction with other risks

11 Rising interest rates may also negatively impact derivative contract holders, who may then be inclined to default. This credit risk on derivatives is often called counterparty risk.

1. 2.

Concept Questions Concept Questions

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184 Part One Introduction

ultimately affects insolvency risk. Similarly, foreign exchange rate changes and interest rate changes are also highly correlated. When the Federal Reserve changes a key interest rate (such as the Fed funds rate) through its monetary policy actions, exchange rates are also likely to change.

Various other risks, often of a more discrete or event type, also impact an FI’s profitability and risk exposure, although, as noted earlier, many view discrete or event risks as part of operational risks. Discrete risks might include events exter- nal to the FI, such as a sudden change in regulation policy. These include lifting the regulatory barriers to lending or to entry or on products offered (see Chapter 21). The 1994 regulatory change allowing interstate branching after 1997 is one example, as is the 1999 Financial Services Modernization Act. Other discrete or event risks involve sudden and unexpected changes in financial market condi- tions due to war, revolution, or sudden market collapse, such as the 1929 and 1987 stock market crashes or the September 2001 terrorist attacks in the United States. These can have a major impact on an FI’s risk exposure. Other event risks include fraud, theft, earthquakes, storms, malfeasance, and breach of fiduciary trust; all of these can ultimately cause an FI to fail or be severely harmed. Yet each is difficult to model and predict.

Finally, more general macroeconomic or systematic risks, such as increased inflation, inflation volatility, and unemployment, can directly and indirectly impact an FI’s level of interest rate, credit, and liquidity risk exposure. For exam- ple, inflation was very volatile in the 1979–82 period in the United States. Interest rates reflected this volatility. During periods in which FIs face high and volatile inflation and interest rates, interest rate risk exposure from mismatching balance sheet maturities tends to rise. Credit risk exposure also rises because borrowing firms with fixed-price product contracts often find it difficult to keep up their loan payments when inflation and interest rates rise abruptly.

What is meant by the term event risk ? What are some examples of event and general macroeconomic risks that impact FIs?

This chapter provided an introductory view of ten major risks faced by modern FIs. They face interest rate risk when their assets and liabilities maturities are mis- matched. They incur market risk on their trading assets and liabilities if there are adverse movements in interest rates, exchange rates, or other asset prices. They face credit risk or default risk if their clients default on their loans and other obli- gations. Modern-day FIs also engage in a significant number of off-balance-sheet activities that expose them to off-balance-sheet risks: contingent asset and liability risks. The advent of sophisticated technology and automation exposes FIs to both technological risk and operational risk. If FIs conduct foreign business, they are sub- ject to additional risks, namely foreign exchange and sovereign risks. Liquidity risk is a result of a serious run on an FI because of excessive withdrawals or problems in refinancing. Finally, insolvency risk occurs when an FI’s capital is insufficient to withstand a decline in the value of assets relative to liabilities. The effective management of these risks determines the success or failure of a modern FI. The chapters that follow analyze each of these risks in greater detail.

1. 2.

Concept Questions Concept Questions

Summary Summary

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Chapter 7 Risks of Financial Intermediation 185

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What is the process of asset transformation performed by a financial institution? Why does this process often lead to the creation of interest rate risk? What is interest rate risk? What is refinancing risk? How is refinancing risk part of interest rate risk? If an FI funds long-term assets with short-term liabilities, what will be the im- pact on earnings of an increase in the rate of interest? A decrease in the rate of interest? What is reinvestment risk? How is reinvestment risk part of interest rate risk? If an FI funds short-term assets with long-term liabilities, what will be the impact on earnings of a decrease in the rate of interest? An increase in the rate of interest? The sales literature of a mutual fund claims that the fund has no risk exposure since it invests exclusively in federal government securities which are free of default risk. Is this claim true? Explain why or why not. How can interest rate risk adversely affect the economic or market value of an FI? A financial institution has the following market value balance sheet structure:

Assets Liabilities and Equity

Cash $ 1,000 Certificate of deposit $10,000 Bond 10,000 Equity 1,000

Total assets $ 11,000 Total liabilities and equity $11,000

The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a 1-year maturity and a 6 percent fixed rate of interest. The FI expects no additional asset growth. What will be the net interest income at the end of the first year? Note: Net interest income equals interest income minus interest expense. If at the end of year 1, market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Is this result caused by reinvestment risk or refinancing risk? Assuming that market interest rates increase 1 percent, the bond will have a value of $9,446 at the end of year 1. What will be the market value of equity for the FI? Assume that all of the NII in part (a) is used to cover operating expenses or dividends. If market interest rates had decreased 100 basis points by the end of year 1, would the market value of equity be higher or lower than $1,000? Why? What factors have caused the changes in operating performance and mar- ket value for this firm?

How does a policy of matching the maturities of assets and liabilities work (a) to minimize interest rate risk and (b) against the asset-transformation function of FIs? Corporate bonds usually pay interest semiannually. If a company decided to change from semiannual to annual interest payments, how would this affect the bond’s interest rate risk?

1.

2.

3.

4.

5.

6.

a.

b.

c.

d.

e.

7.

8.

Questions and Problems Questions and Problems

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186 Part One Introduction

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Two 10-year bonds are being considered for an investment that may have to be liquidated before the maturity of the bonds. The first bond is a 10-year premium bond with a coupon rate higher than its required rate of return, and the second bond is a zero-coupon bond that pays only a lump-sum payment after 10 years with no interest over its life. Which bond would have more interest rate risk? That is, which bond’s price would change by a larger amount for a given change in interest rates? Explain your answer. Consider again the two bonds in problem 9. If the investment goal is to leave the assets untouched until maturity, such as for a child’s education or for one’s retirement, which of the two bonds has more interest rate risk? What is the source of this risk? A money market mutual fund bought $1 million of two-year Treasury notes six months ago. During this time, the value of the securities has increased, but for tax reasons the mutual fund wants to postpone any sale for two more months. What type of risk does the mutual fund face for the next two months? A bank invested $50 million in a two-year asset paying 10 percent interest per annum and simultaneously issued a $50 million, one-year liability paying 8 percent interest per annum. The liability will be rolled over after one year at the current market rate. What will be the impact on the bank’s net interest in- come if at the end of the first year all interest rates have increased by 1 percent (100 basis points)? What is market risk? How does this risk affect the operating performance of financial institutions? What actions can be taken by an FI’s management to minimize the effects of this risk? What is credit risk? Which types of FIs are more susceptible to this type of risk? Why? What is the difference between firm-specific credit risk and systematic credit risk? How can an FI alleviate firm-specific credit risk? Many banks and savings institutions that failed in the 1980s had made loans to oil companies in Louisiana, Texas, and Oklahoma. When oil prices fell, these companies, the regional economy, and the banks and savings institutions all experienced financial problems. What types of risk were inherent in the loans that were made by these banks and savings institutions? What is the nature of an off-balance-sheet activity? How does an FI benefit from such activities? Identify the various risks that these activities generate for an FI, and explain how these risks can create varying degrees of financial stress for the FI at a later time. What two factors provide potential benefits to FIs that expand their asset hold- ings and liability funding sources beyond their domestic borders? What is foreign exchange risk? What does it mean for an FI to be net long in foreign assets? What does it mean for an FI to be net short in foreign assets? In each case, what must happen to the foreign exchange rate to cause the FI to suffer losses? If the Swiss franc is expected to depreciate in the near future, would a U.S.-based FI in Bern City prefer to be net long or net short in its asset positions? Discuss. If international capital markets are well integrated and operate efficiently, will FIs be exposed to foreign exchange risk? What are the sources of foreign exchange risk for FIs? If an FI has the same amount of foreign assets and foreign liabilities in the same currency, has that FI necessarily reduced the risk involved in these inter- national transactions to zero? Explain.

9.

10.

11.

12.

13.

14.

15.

16.

17.

18.

19.

20.

21.

22.

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Chapter 7 Risks of Financial Intermediation 187

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A U.S. insurance company invests $1,000,000 in a private placement of British bonds. Each bond pays £300 in interest per year for 20 years. If the current exchange rate is £1.7612/$, what is the nature of the insurance company’s ex- change rate risk? Specifically, what type of exchange rate movement concerns this insurance company? Assume that a bank has assets located in London that are worth £150 million on which it earns an average of 8 percent per year. The bank has £100 million in liabilities on which it pays an average of 6 percent per year. The current spot exchange rate is £1.50/$.

If the exchange rate at the end of the year is £2.00/$, will the dollar have appreciated or depreciated against the pound? Given the change in the exchange rate, what is the effect in dollars on the net interest income from the foreign assets and liabilities? Note: The net in- terest income is interest income minus interest expense. What is the effect of the exchange rate change on the value of assets and liabilities in dollars?

Six months ago, Qualitybank, LTD., issued a $100 million, one-year maturity CD denominated in euros. On the same date, $60 million was invested in a :-denominated loan and $40 million was invested in a U.S. Treasury bill. The exchange rate on this date was :1.7382/$. Assume no repayment of principal and an exchange rate today of :1.3905/$.

What is the current value of the CD principal (in dollars and euros)? What is the current value of the euro-denominated loan principal (in dol- lars and euros)? What is the current value of the U.S. Treasury bill (in dollars and euros)? What is Qualitybank’s profit/loss from this transaction (in dollars and euros)?

Suppose you purchase a 10-year, AAA-rated Swiss bond for par that is paying an annual coupon of 6 percent. The bond has a face value of 1,000 Swiss francs (SF). The spot rate at the time of purchase is SF1.50/$. At the end of the year, the bond is downgraded to AA and the yield increases to 8 percent. In addi- tion, the SF appreciates to SF1.35/$.

What is the loss or gain to a Swiss investor who holds this bond for a year? What portion of this loss or gain is due to foreign exchange risk? What por- tion is due to interest rate risk? What is the loss or gain to a U.S. investor who holds this bond for a year? What portion of this loss or gain is due to foreign exchange risk? What por- tion is due to interest rate risk?

What is country or sovereign risk? What remedy does an FI realistically have in the event of a collapsing country or currency? What is technology risk? What is the difference between economies of scale and economies of scope? How can these economies create benefits for an FI? How can these economies prove harmful to an FI? What is the difference between technology risk and operational risk? How does internationalizing the payments system among banks increase operational risk? Characterize the risk exposure(s) of the following FI transactions by choosing one or more of the risk types listed below:

Interest rate risk Credit risk

23.

24.

a.

b.

c.

25.

a. b.

c. d.

26.

a.

b.

27.

28.

29.

30.

a. b.

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188 Part One Introduction

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Off-balance-sheet risk Technology risk Foreign exchange risk Country or sovereign risk (1) A bank finances a $10 million, six-year fixed-rate commercial loan by

selling one-year certificates of deposit. (2) An insurance company invests its policy premiums in a long-term mu-

nicipal bond portfolio. (3) A French bank sells two-year fixed-rate notes to finance a two-year

fixed-rate loan to a British entrepreneur. (4) A Japanese bank acquires an Austrian bank to facilitate clearing

operations. (5) A mutual fund completely hedges its interest rate risk exposure by us-

ing forward contingent contracts. (6) A bond dealer uses his own equity to buy Mexican debt on the less de-

veloped country (LDC) bond market. (7) A securities firm sells a package of mortgage loans as mortgage-backed

securities. Consider these four types of risks: credit, foreign exchange, market, and sov- ereign. These risks can be separated into two pairs of risk types in which each pair consists of two related risk types, with one being a subset of the other. How would you pair off the risk types, and which risk type could be consid- ered a subset of the other type in the pair? What is liquidity risk? What routine operating factors allow FIs to deal with this risk in times of normal economic activity? What market reality can create severe financial difficulty for an FI in times of extreme liquidity crises? Why can insolvency risk be classified as a consequence or outcome of any or all of the other types of risks? Discuss the interrelationships among the different sources of FI risk exposure. Why would the construction of an FI risk management model to measure and manage only one type of risk be incomplete?

Pertinent Web Sites

Bank for International Settlements www.bis.org Federal Deposit Insurance Corporation www.fdic.gov

Appendix 7A: Commercial Banks’ Financial Statements and Analysis

c. d. e. f.

31.

32.

33.

34.

View Appendix 7A at the Web site for this textbook ( www.mhhe.com/ saunders6e ).

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Part Two

Measuring Risk 8. Interest Rate Risk I 189

9. Interest Rate Risk II 221

10. Market Risk 266

11. Credit Risk: Individual Loan Risk 295

12. Credit Risk: Loan Portfolio and Concentration Risk 348

13. Off-Balance-Sheet Risk 372

14. Foreign Exchange Risk 400

15. Sovereign Risk 425

16. Technology and Other Operational Risks 458

17. Liquidity Risk 493

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190

Chapter Eight

Interest Rate Risk I INTRODUCTION

In Chapter 7 we established that while performing their asset-transformation func- tions, FIs often mismatch the maturities of their assets and liabilities. In so doing, they expose themselves to interest rate risk. For example, in the 1980s a large num- ber of thrifts suffered economic insolvency (i.e., the net worth or equity of their owners was eradicated) when interest rates unexpectedly increased. All FIs tend to mismatch their balance sheet maturities to some degree. However, measuring interest rate risk exposure by looking only at the size of the maturity mismatch can be misleading. The next two chapters present techniques used by FIs to measure their interest rate risk exposures.

This chapter begins with a discussion of the Federal Reserve’s monetary pol- icy, which is a key determinant of interest rate risk. The chapter also analyzes the simpler method used to measure an FI’s interest rate risk: the repricing model . The repricing, or funding gap, model concentrates on the impact of interest rate changes on an FI’s net interest income (NII), which is the difference between an FI’s interest income and interest expense. Because of its simplicity, smaller deposi- tory institutions (the vast majority of DIs) still use this model as their primary measure of interest rate risk. Appendix 8A, at the book’s Web site ( www.mhhe .com/saunders6e ), compares and contrasts this model with the market value– based maturity model, which includes the impact of interest rate changes on the overall market value of an FI’s assets and liabilities and, ultimately, its net worth. Until recently, U.S. bank regulators had been content to base their evaluations of bank interest rate risk exposures on the repricing model. As explained later in this chapter, however, the repricing model has some serious weaknesses. Recently, the Bank for International Settlements (the organization of the world’s major Central Banks) issued a consultative document 1 suggesting a standardized model to be used by regulators in evaluating a bank’s interest rate risk exposure. Rather than being based on the repricing model, the approach suggested is firmly based on market value accounting and the duration model (see Chapter 9). As regulators move to adopt these models, bigger banks (which hold the vast majority of total assets in the banking industry) have adopted them as their primary measure of interest rate risk. Moreover, where relevant, banks may be allowed to use their own value-at-risk models (see Chapter 10) to assess the interest rate risk of the banking book. 2

1 See Basel Committee on Banking Supervision, “Principles for the Management and Supervision of Inter- est Rate Risk,” Bank for International Settlements, Basel, Switzerland, January 2001. 2 In this case, a longer horizon (e.g., one year) would be taken compared with that used to measure inter- est rate risk in the trading book (e.g., one day).

net worth The value of an FI to its owners; this is equal to the difference between the market value of assets and that of liabilities.

net worth The value of an FI to its owners; this is equal to the difference between the market value of assets and that of liabilities.

www.federalreserve.govwww.federalreserve.gov

www.bis.org www.bis.org

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Chapter 8 Interest Rate Risk I 191

Appendix 8B, at the end of this chapter, looks at the term structure of interest rates that compares the market yields or interest rate on securities, assuming that all characteristics except maturity are the same. This topic is generally covered in introductory finance courses. For students needing a review, appendix 8B is encouraged introductory reading.

THE LEVEL AND MOVEMENT OF INTEREST RATES

Given the impact a change in interest rates has on net income and the market value of the firm, financial institution managers spend much time and effort try- ing to identify factors that determine the level of interest rates at any moment in time, as well as what causes interest rate movements over time. One model that is commonly used to explain interest rates and interest rate movements is the loanable funds theory. The loanable funds theory of interest rate determina- tion views the level of interest rates in financial markets as resulting from factors that affect the supply and demand for loanable funds. This is similar to the way that the prices for goods and services in general are viewed as being the result of the forces of supply and demand for those goods and services. As illustrated in Figure 8–1 , the aggregate quantity of funds supplied is positively related to inter- est rates, while the aggregate quantity of funds demanded is inversely related to interest rates. As long as competitive forces are allowed to operate freely in a financial system, the interest rate that equates the aggregate quantity of loanable funds supplied with the aggregate quantity of loanable funds demanded for a financial security, Q * , is the equilibrium interest rate for that security, i * , point E in Figure 8–1 .

The equilibrium interest rate (point E in Figure 8–1 ) is only a temporary equi- librium. Changes in underlying factors that determine the demand and supply of loanable funds can cause continuous shifts in the supply and/or demand curve for loanable funds. Market forces will react to the resulting disequilibrium with a change in the equilibrium interest rate and quantity of funds traded in that market.

loanable funds theory A theory of interest rate determination that views equilib- rium interest rates in financial markets as a result of the supply and demand for loan- able funds.

loanable funds theory A theory of interest rate determination that views equilib- rium interest rates in financial markets as a result of the supply and demand for loan- able funds.

Interest rate D

i H

i L

i *

Q*

D

E

Quantity of loanable funds supplied and demanded

S

S

FIGURE 8–1 Determination of Equilibrium Interest Rates

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192 Part Two Measuring Risk

Figure 8–2(a) shows the effects of an increase in the supply curve for loanable funds, from SS to SS " (and the resulting decrease in the equilibrium interest rate , from i * to i * "), while Figure 8–2(b) shows the effects of an increase in the demand curve for loanable funds, from DD to DD " (and the resulting increase in the equilibrium inter- est rate , from i * to i * ").

While many factors influence the level and movement of interest rates, it is the central bank’s monetary policy strategy that most directly underlies the level and movement of interest rates that, in turn, affect an FI’s cost of funds and return on assets. The central bank in the United States is the Federal Reserve (the Fed). Through its daily open market operations, such as buying and selling Treasury bonds and Treasury bills, the Fed seeks to influence the money supply, inflation,

www.federalreserve.govwww.federalreserve.gov

FIGURE 8–2 The Effect on Interest Rates from a Shift in the Demand Curve for or Supply Curve of Loanable Funds

Interest rate

Interest rate

(a) Increase in the Supply of Loanable Funds

(b) Increase in the Demand of Loanable Funds

DD

DD

DD

DD

DD″

DD″

SS

SS

SS

SS

SS″

SS″

E″

E″

E

E

i*

i*″

i*

i*″

Q*

Q*

Q*″

Q*″

Quantity of funds supplied

Quantity of funds demanded

sau05140_ch08_189-220.indd 192sau05140_ch08_189-220.indd 192 8/28/07 11:28:28 AM8/28/07 11:28:28 AM

Chapter 8 Interest Rate Risk I 193

and the level of interest rates (particularly short-term interest rates). In turn, chang- ing interest rates impact economic decisions, such as whether to consume or save. When the Fed finds it necessary to slow down the economy, it tightens monetary policy by raising interest rates. The normal result is a decrease in business and household spending (especially that financed by credit or borrowing). Conversely, if business and household spending declines to the extent that the Fed finds it necessary to stimulate the economy, it allows interest rates to fall (an expansion- ary monetary policy). The drop in rates promotes borrowing and spending. For example, in 2001, as the U.S. economy showed initial signs of weakness, the Fed began lowering interest rates aggressively. As the economy slid into a recession in 2001 and after the terrorist attacks on the World Trade Center and the Pentagon in September 2001, the Fed continued its aggressive actions, lowering interest rates 11 times during the year. Even as the economy began to recover in the summer of 2003, the Fed kept interest rates at these low levels. By the summer of 2004 the economy was growing rapidly, and the fed’s top concern turned to curbing inflation. Between June 2004 and August 2006 the Fed increased interest rates 17 consecutive times (by 0.25 percent each time). The Industry Perspectives box dis- cusses how these increases in interest rates affected banks’ cost of funds. Figure 8–3 shows the interest rate on U.S. three-month T-bills for the period 1965–2006. While Federal Reserve actions are targeted mostly at short-term rates (especially the federal funds rate), changes in short-term rates usually feed through to the whole term structure of interest rates. The linkages between short-term rates and long-term rates and theories of the term structure of interest rates are discussed in Appendix A to this chapter.

BANKS DANGLE HIGH TEASER RATES With the Federal Reserve expected soon to end its string of interest rate increases, banks are aggres- sively courting new deposits with introductory rates that could be among the highest that consumers will see for some time. Many of the banks’ new teaser rates are being offered by online banks, which are able to offer higher rates because they don’t have the fixed expenses of maintaining networks of branches. . . . Traditional brick-and-mortar banks also are introducing special deals. For consumers who bring in new deposits and open up a check- ing account, Citigroup Inc.’s Citibank is promoting a 4.25% rate on a six-month certificate of deposit, ex- ceeding even the bank’s long-term rates on one-year and three-year CDs. . . .

The Federal Reserve raised short-term rates for the 14th straight time yesterday, bringing the fed- eral funds rate to 4.5%. But the Fed also gave its

strongest hint yet that the end of rate increases is in sight, and analysts say this likely means short-term market rates are at or near a plateau. . . .

Tantalizing rate offers have long been one of the most reliable asset-gathering mechanisms for financial institutions and some banks are now rais- ing their rates to combat a slowdown in deposit growth. . . .The reasons: A slowdown in the nation’s housing markets has left consumers with less cash than they previously had available through mort- gage refinancings and home-equity loans. What’s more, higher-yielding alternatives such as money market mutual funds, which aren’t federally insured, are taking a bigger share of consumers’ cash. . . .

Source: Jane J. Kim, The Wall Street Journal , February 1, 2006, p. D1. Reprinted by permission of The Wall Street Journal . © 2006 Dow Jones & Company, Inc. All rights reserved worldwide. www.wsj.com

Industry Perspectives

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194 Part Two Measuring Risk

Go to the Federal Reserve Board’s Web site and find the latest information available on three- month CD rates versus the prime rate using the following steps. Go to the Federal Reserve’s Web site at www.federalreserve.gov. Click on “Economic Research and Data.” Click on “Statistics: Releases and Historical Data.” Under “Interest Rates,” click on “Selected Interest Rates—H15 weekly.” Click on the most recent date. This will download the data onto your computer that will contain the most recent information on three-month CD rates and the prime rate.

Internet Exercise

In addition to the Fed’s impact on interest rates via its monetary policy strat- egy, the increased level of financial market integration over the last decade has also affected interest rates. Financial market integration increases the speed with which interest rate changes and associated volatility are transmitted among coun- tries, making the control of U.S. interest rates by the Federal Reserve more difficult and less certain than before. The increased globalization of financial market flows in recent years has made the measurement and management of interest rate risk a prominent concern facing many modern FI managers. For example, investors across the world carefully evaluate the statements made by Ben Bernanke (chair- man of the Federal Reserve Board of Governors) before Congress. Even hints of increased U.S. interest rates may have a major effect on world interest rates (as well as foreign exchange rates and stock prices).

FIGURE 8–3 Interest Rate on U.S. 91-Day Treasury Bills, 1965–2007

Source: Federal Reserve Board Web site, various dates. www.federalreserve.gov 1/

1/ 65

1/ 1/

67

1/ 1/

69

1/ 1/

71

1/ 1/

73

1/ 1/

75

1/ 1/

77

1/ 1/

79

1/ 1/

81

1/ 1/

83

1/ 1/

85

1/ 1/

87

1/ 1/

89

1/ 1/

91

1/ 1/

93

1/ 1/

95

1/ 1/

97

1/ 1/

99

1/ 1/

01

1/ 1/

03

1/ 1/

05

1/ 1/

07 Year

0

1

2

3

4

5

6

7

8

9

10

11

12

13

T-bill

14

15

16

17 Interest

rate (%)

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Chapter 8 Interest Rate Risk I 195

The level and volatility of interest rates and the increase in worldwide finan- cial market integration make the measurement and management of interest rate risk one of the key issues facing FI managers. Further, the Bank for International Settlements has called for regulations that require depository institutions (DIs) to have interest rate risk measurement systems that assess the effects of interest rate changes on both earnings and economic value. These systems should pro- vide meaningful measures of a DI’s current levels of interest rate risk exposure and should be capable of identifying any excessive exposures that might arise (see Chapter 20). In this chapter and in Chapter 9, we analyze the different ways an FI might measure the exposure it faces in running a mismatched maturity book (or gap) between its assets and its liabilities in a world of interest rate volatility.

In particular, we concentrate on three ways, or models, of measuring the asset– liability gap exposure of an FI:

The repricing (or funding gap) model. The maturity model. The duration model.

What is the loanable funds theory? How is the Federal Reserve’s monetary policy linked to the degree of interest rate uncer- tainty faced by FIs? How has financial market integration affected interest rate movements?

THE REPRICING MODEL

The repricing, or funding gap, model is a simple model used by small (thus most) DIs in the United States. This model is essentially a book value accounting cash flow analysis of the repricing gap between the interest income earned on an FI’s assets and the interest expense paid on its liabilities (or its net interest income) over a particular period of time. This contrasts with the market value–based matu- rity and duration models discussed later in this chapter and in Chapter 9.

In recent years, the Federal Reserve has required commercial banks to report quarterly on their call reports the repricing gaps for assets and liabilities with these maturities:

One day. More than one day to three months. More than three months to six months. More than six months to twelve months. More than one year to five years. More than five years.

Under the repricing gap approach, a bank reports the gaps in each maturity bucket by calculating the rate sensitivity of each asset (RSA) and each liability (RSL) on its balance sheet. Rate sensitivity here means that the asset or liability is repriced at or near current market interest rates within a certain time horizon (or maturity bucket). Repricing can be the result of a rollover of an asset or liability (e.g., a loan is paid off at or prior to maturity and the funds are used to issue a

1. 2.

3.

1. 2. 3. 4. 5. 6.

Concept Questions Concept Questions

repricing gap The difference be- tween assets whose interest rates will be repriced or changed over some future period (rate-sensitive assets) and liabilities whose interest rates will be repriced or changed over some future period (rate- sensitive liabilities).

repricing gap The difference be- tween assets whose interest rates will be repriced or changed over some future period (rate-sensitive assets) and liabilities whose interest rates will be repriced or changed over some future period (rate- sensitive liabilities).

rate-sensitive asset or liability An asset or liability that is repriced at or near current market interest rates within a maturity bucket.

rate-sensitive asset or liability An asset or liability that is repriced at or near current market interest rates within a maturity bucket.

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196 Part Two Measuring Risk

new loan at current market rates), or it can occur because the asset or liability is a variable-rate instrument (e.g., a variable-rate mortgage whose interest rate is reset every quarter based on movements in a prime rate).

Table 8–1 shows the asset and liability repricing gaps of an FI, categorized into each of the six previously defined maturity buckets. Although the cumula- tive repricing gap over the whole balance sheet must, by definition, be zero [see Table 8–1 , column (4)], the advantage of the repricing model lies in its information value and its simplicity in pointing to an FI’s net interest income exposure (or profit exposure) to interest rate changes in different maturity buckets. 3

For example, suppose that an FI has a negative $10 million difference between its assets and liabilities being repriced in one day (one-day bucket). Assets and lia- bilities that are repriced each day are likely to be interbank borrowings on the fed- eral funds or repurchase agreement market (see Chapter 2). Thus, a negative gap (RSA < RSL) exposes the FI to refinancing risk, in that a rise in these short-term rates would lower the FI’s net interest income since the FI has more rate-sensitive liabilities than assets in this bucket. In other words, assuming equal changes in interest rates on RSAs and RSLs, interest expense will increase by more than inter- est revenue. Conversely, if the FI has a positive $20 million difference between its assets and liabilities being repriced in 6 months to 12 months, it has a positive gap (RSA > RSL) for this period and is exposed to reinvestment risk, in that a drop in rates over this period would lower the FI’s net interest income; that is, interest income will decrease by more than interest expense. Specifically, let:

Then:

In this first bucket, if the gap is negative $10 million and short-term interest rates (such as fed fund and/or repo rates) rise 1 percent, the annualized change in the FI’s future net interest income is: 4

That is, the negative gap and associated refinancing risk resulted in a loss of $100,000 in net interest income for the FI.

This approach is very simple and intuitive. Remember, however, from Chapter 7 and our overview of interest rate risk that capital or market value losses also occur when rates rise. The capital loss effect that is measured by both the maturity and duration models developed in the appendix to this chapter and in Chapter 9 is not accounted for in the repricing model. The reason is that in the book value accounting world of the repricing model, assets and liability values are reported at

3 If we include equity capital as a long-term (over five years) liability.

4 One can also calculate an “average” gap. If it is assumed that assets and liabilities reprice on average halfway through the period, the one-year gap measure calculated above will be divided by 2.

refinancing risk The risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments.

refinancing risk The risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments.

reinvestment risk The risk that the re- turns on funds to be reinvested will fall below the cost of the funds.

reinvestment risk The risk that the re- turns on funds to be reinvested will fall below the cost of the funds. �NIIi � Change in net interest income in the iith bucket

Dollar size of the gap betwGAPi � eeen the book value of rate-sensitive assetss and rate-sensitive liabilities in maturitty bucket Change in the level of inte

i �Ri � rrest rates impacting assets and liabilitiess in

the th bucketi

�NIIi � Change in net interest income in the iith bucket Dollar size of the gap betwGAPi � eeen the book value of rate-sensitive assetss and rate-sensitive liabilities in maturitty bucket Change in the level of inte

i �Ri � rrest rates impacting assets and liabilitiess in

the th bucketi

� � �NII GAP R RSA RSL Ri i i i i i� � �( ) ( )� � �NII GAP R RSA RSL Ri i i i i i� � �( ) ( )

�NIIi � � � � �( $ ) . $ ,10 01 100 000million�NIIi � � � � �( $ ) . $ ,10 01 100 000million

sau05140_ch08_189-220.indd 196sau05140_ch08_189-220.indd 196 7/25/07 6:42:12 PM7/25/07 6:42:12 PM

Chapter 8 Interest Rate Risk I 197

their historic values or costs. Thus, interest rate changes affect only current interest income or interest expense—that is, net interest income on the FI’s income state- ment—rather than the market value of assets and liabilities on the balance sheet. 5

The FI manager can also estimate cumulative gaps (CGAPs) over various repric- ing categories or buckets. A common cumulative gap of interest is the one-year repricing gap estimated from Table 8–1 as:

If � R i is the average interest rate change affecting assets and liabilities that can be repriced within a year, the cumulative effect on the bank’s net interest income is: 6

(1)

We can now look at how an FI manager would calculate the cumulative one-year gap from a balance sheet. Remember that the manager asks: Will or can this asset or liability have its interest rate changed within the next year? If the answer is yes, it is a rate-sensitive asset or liability; if the answer is no, it is not rate sensitive.

Consider the simplified balance sheet facing the FI manager in Table 8–2 . Instead of the original maturities, the maturities are those remaining on different assets and liabilities at the time the repricing gap is estimated.

Rate-Sensitive Assets Looking down the asset side of the balance sheet in Table 8–2 , we see the follow- ing one-year rate-sensitive assets (RSAs):

Short-term consumer loans: $50 million. These are repriced at the end of the year and just make the one-year cutoff. Three-month T-bills: $30 million. These are repriced on maturity (rollover) every three months. Six-month T-notes: $35 million. These are repriced on maturity (rollover) every six months.

5 For example, a 30-year bond purchased 10 years ago when rates were 13 percent would be reported as having the same book (accounting) value as when rates are 7 percent. Using market value, gains and losses to asset and liability values would be reflected in the balance sheet as rates changed. 6 Note that a change in the dollar value and mix of rate-sensitive assets and liabilities (or a change in CGAP) also affects the FI’s net income.

1.

2.

3.

CGAP � � � � � � � � �( $ ) ( $ ) ( $ ) $ $10 10 15 20 15 millionCGAP � � � � � � � � �( $ ) ( $ ) ( $ ) $ $10 10 15 20 15 million

� �NII CGAP Ri i�

� � � �

( )

( $ ) (. ) $ ,15 01 150 0million 000

� �NII CGAP Ri i�

� � � �

( )

( $ ) (. ) $ ,15 01 150 0million 000

(1) (2) (3) (4)

Assets Liabilities Gaps Cumulative

Gap

1. One day $ 20 $ 30 $�10 $�10 2. More than one day–three months 30 40 �10 �20 3. More than three months–six months 70 85 �15 �35 4. More than six months–twelve months 90 70 �20 �15 5. More than one year–five years 40 30 �10 �5 6. Over five years 10 5 �5 0

$260 $ 260 0

TABLE 8–1 Repricing Gap (in millions of dollars)

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198 Part Two Measuring Risk

30-year floating-rate mortgages: $40 million. These are repriced (i.e., the mortgage rate is reset) every nine months. Thus, these long-term assets are rate-sensitive assets in the context of the repricing model with a one-year repricing horizon.

Summing these four items produces total one-year rate-sensitive assets (RSAs) of $155 million. The remaining $115 million of assets are not rate sensitive over the one-year repricing horizon—that is, a change in the level of interest rates will not affect the size of the interest revenue generated by these assets over the next year. 7

Although the $115 million in long-term consumer loans, 3-year Treasury bonds, and 10-year, fixed-rate mortgages generate interest revenue, the size of revenue generated will not change over the next year, since the interest rates on these assets are not expected to change (i.e., they are fixed over the next year).

Rate-Sensitive Liabilities Looking down the liability side of the balance sheet in Table 8–2 , we see the fol- lowing liability items clearly fit the one-year rate or repricing sensitivity test:

Three-month CDs: $40 million. These mature in three months and are repriced on rollover. Three-month bankers acceptances: $20 million. These also mature in three months and are repriced on rollover. Six-month commercial paper: $60 million. These mature and are repriced every six months. One-year time deposits: $20 million. These get repriced right at the end of the one- year gap horizon.

Summing these four items produces one-year rate-sensitive liabilities (RSLs) of $140 million. The remaining $130 million is not rate sensitive over the one-year period. The $20 million in equity capital and $40 million in demand deposits (see the following discussion) do not pay interest and are therefore classified as non- interest-paying. The $30 million in passbook savings (see the following discussion) and $40 million in two-year time deposits generate interest expense over the next year, but the level of the interest expense generated will not change if the general

7 We are assuming that the assets are noncallable over the year and that there will be no prepayments (runoffs, see below) on the mortgages within a year.

4.

1.

2.

3.

4.

TABLE 8–2 Simple FI Balance Sheet (in millions of dollars)

Assets Liabilities

1. Short-term consumer loans (one-year maturity)

$ 50 1. Equity capital (fixed) $ 20

2. Long-term consumer loans (two-year maturity)

25 2. Demand deposits 40

3. Three-month Treasury bills 30 3. Passbook savings 30 4. Six-month Treasury notes 35 4. Three-month CDs 40 5. Three-year Treasury bonds 70 5. Three-month bankers acceptances 20 6. 10-year, fixed-rate mortgages 20 6. Six-month commercial paper 60 7. 30-year, floating-rate mortgages

(rate adjusted every nine months) 40 7. One-year time deposits 20 8. Two-year time deposits 40

$270 $270

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Chapter 8 Interest Rate Risk I 199

level of interest rates changes. Thus, we classify these items as rate-insensitive liabilities.

Note that demand deposits (or transaction accounts in general) were not included as RSLs. We can make strong arguments for and against their inclusion as rate-sensitive liabilities.

Against Inclusion The explicit interest rate on demand deposits is zero by regulation. Further, although explicit interest is paid on transaction accounts such as NOW accounts, the rates paid by FIs do not fluctuate directly with changes in the general level of interest rates (particularly when the general level of rates is rising). Moreover, many demand deposits act as core deposits for FIs, meaning they are a long-term source of funds.

For Inclusion Even though they pay no explicit interest rates, demand deposits pay implicit interest because FIs do not charge fees that fully cover their costs for checking services. Further, if interest rates rise, individuals draw down (or run off) their demand deposits, forcing the bank to replace them with higher-yielding, interest- bearing, rate-sensitive funds. This is most likely to occur when the interest rates on alternative instruments are high. In such an environment, the opportunity cost of holding funds in demand deposit accounts is likely to be larger than it is in a low–interest rate environment.

Similar arguments for and against inclusion of retail passbook savings accounts can be made. Although Federal Reserve Regulation Q ceilings on the maximum rates to be charged for these accounts were abolished in March 1986, banks still adjust these rates only infrequently. However, savers tend to withdraw funds from these accounts when rates rise, forcing banks into more expensive fund substitutions. 8

The four repriced liabilities ($40 + $20 + $60 + $20) sum to $140 million, and the four repriced assets ($50 + $30 + $35 + $40) sum to $155 million. Given this, the cumulative one-year repricing gap (CGAP) for the bank is:

Often DIs express interest rate sensitivity as a percentage of assets ( A ) (typically called the gap ratio ):

Expressing the repricing gap in this way is useful since it tells us (1) the direction of the interest rate exposure (positive or negative CGAP) and (2) the scale of that

8 The Federal Reserve’s repricing report has traditionally viewed transaction accounts and passbook sav- ings accounts as rate- in sensitive liabilities, as we have done in this example. However, with the growth of the Internet and competition from money market mutual funds, the mobility of these funds is highly sensitive to (relative) rates paid by banks versus other nonbank FIs (such as money market mutual funds). See “Regulators Press for Safeguards,” Financial Times, June 4, 2001, p. 24.

core deposits Those deposits that act as an FI’s long- term sources of funds.

core deposits Those deposits that act as an FI’s long- term sources of funds.

CGAP � �One-year rate-sensitive assets One-yearr rate-sensitive liabilities

RSA RSL $155

� �

� � $$140 $15 million�

CGAP � �One-year rate-sensitive assets One-yearr rate-sensitive liabilities

RSA RSL $155

� �

� � $$140 $15 million�

CGAP A

� � � $

. . % 15

056 5 6 million

$270 million CGAP

A � � �

$ . . %

15 056 5 6

million $270 million

sau05140_ch08_189-220.indd 199sau05140_ch08_189-220.indd 199 7/25/07 6:42:13 PM7/25/07 6:42:13 PM

200 Part Two Measuring Risk

exposure as indicated by dividing the gap by the asset size of the institution. In our example the bank has 5.6 percent more RSAs than RSLs in one-year-and-less buckets as a percentage of total assets.

Equal Changes in Rates on RSAs and RSLs The CGAP provides a measure of an FI’s interest rate sensitivity. Table 8–3 high- lights the relation between CGAP and changes in NII when interest rate changes for RSAs are equal to interest rate changes for RSLs. For example, when CGAP (or the gap ratio) is positive (or the FI has more RSAs than RSLs), NII will rise when interest rates rise (row 1, Table 8–3 ), since interest revenue increases more than interest expense does.

Suppose that interest rates rise by 1 percent on both RSAs and RSLs. The CGAP would project the expected annual change in net interest income (∆NII) of the bank as approximately:

� �NII CGAP R� �

� �

�

($ ) .

$ ,

15 01

150 000

million

Similarly, if interest rates fall equally for RSAs and RSLs (row 2, Table 8–3), NII will fall when CGAP is positive. As rates fall, interest revenue falls by more than interest expense. Thus, NII falls. Suppose that for our FI, rates fall by 1 percent. The CGAP predicts that NII will fall by approximately:

� �NII CGAP R�

� � �

� �

× ($ ) .

$ ,

15 01

150 000

million

EXAMPLE 8–1 Impact of Rate Changes on Net Interest Income When CGAP Is Positive

It is evident from this equation that the larger the absolute value of CGAP , the larger the expected change in NII (i.e., the larger the increase or decrease in the FI’s interest revenue relative to interest expense). In general, when CGAP is positive, the change in NII is positively related to the change in interest rates. Conversely, when CGAP (or the gap ratio) is negative, if interest rates rise by equal amounts for RSAs and RSLs (row 3, Table 8–3 ), NII will fall (since the FI has more RSLs than RSAs). Thus, an FI would want its CGAP to be positive when interest rates are expected to rise. Similarly, if interest rates fall equally for RSAs and RSLs (row 4, Table 8–3 ), NII will increase when CGAP is negative. As rates fall, interest expense decreases by more than interest revenue. In general then, when CGAP is negative,

Row CGAP

Change in Interest Rates

Change in Interest Revenue

Change in Interest Expense

Change in NII

1 >0 ⇑ ⇑ > ⇑ ⇑ 2 >0 ⇓ ⇓ > ⇓ ⇓ 3 <0 ⇑ ⇑ < ⇑ ⇓ 4 <0 ⇓ ⇓ < ⇓ ⇑

TABLE 8–3 Impact of CGAP on the Relation between Changes in Interest Rates and Changes in Net Interest Income, Assuming Rate Changes for RSAs Equal Rate Changes for RSLs

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Chapter 8 Interest Rate Risk I 201

the change in NII is negatively related to the change in interest rates. Thus, an FI would want its CGAP to be negative when interest rates are expected to fall. We refer to these relationships as CGAP effects.

Unequal Changes in Rates on RSAs and RSLs The previous section considered changes in net interest income as interest rates changed, assuming that the change in rates on RSAs was exactly equal to the change in rates on RSLs (in other words, assuming the interest rate spread between rates on RSAs and RSLs remained unchanged). This is not often the case; rather, rate changes on RSAs generally differ from those on RSLs (i.e., the spread between interest rates on assets and liabilities changes along with the levels of these rates). See Figure 8–4 , which plots quarterly CD rates (liabilities) and prime lending rates (assets) for the period 1990–2006. Notice that although the rates generally move in the same direc- tion, they are not perfectly correlated. In this case, as we consider the impact of rate changes on NII, we have a spread effect in addition to the CGAP effects. 9

To understand spread effect, assume for a moment that RSAs equal RSLs equal $155 million. Suppose that rates rise by 1.2 percent on RSAs and by 1 percent on RSLs (i.e., the spread between the rates on RSAs and RSLs increases by 1.2 percent − 1 percent = 0.2 percent). The resulting change in NII is calculated as:

(2)

� � �

�

NII RSA R RSL RRSA RSL� � � �

�

( ) ( )

Interest revennue Interest expense

($155 million 1.2%)

�

� � �

�

(($155 million 1.0%)

$155 million (1.2% 1.0

�

� � %%)

$310,000�

� � �

�

NII RSA R RSL RRSA RSL� � � �

�

( ) ( )

Interest revennue Interest expense

($155 million 1.2%)

�

� � �

�

(($155 million 1.0%)

$155 million (1.2% 1.0

�

� � %%)

$310,000�

EXAMPLE 8–2 Impact of Spread Effect on Net Interest Income

9 The spread effect therefore presents a type of basis risk for the FI. The FI’s net interest income varies as the difference (basis) between interest rates on RSAs and interest rates on RSLs varies. We discuss basis risk in detail in Chapter 23.

CGAP effects The relations between changes in interest rates and changes in net interest income.

CGAP effects The relations between changes in interest rates and changes in net interest income.

FIGURE 8–4 Three-Month CD Rates versus Prime Rates for 1990–2006

Source: Federal Reserve Bulletin, various issues. www. federalreserve.gov

12

10

8

6

4

2

0 Year

Prime (RSA)

CD (RSL)

Ja n-

90

Ja n-

92

Ja n-

94

Ja n-

96

Ja n-

98

Ja n-

00

Ja n-

02

Ja n-

04

Ja n-

06

Yield (%)

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202 Part Two Measuring Risk

If the spread between the rate on RSAs and RSLs increases, when interest rates rise (fall), interest revenue increases (decreases) by more (less) than interest expense. The result is an increase in NII. Conversely, if the spread between the rates on RSAs and RSLs decreases, when interest rates rise (fall), interest revenue increases (decreases) less (more) than interest expense, and NII decreases. In gen- eral, the spread effect is such that, regardless of the direction of the change in interest rates, a positive relation occurs between changes in the spread (between rates on RSAs and RSLs) and changes in NII. Whenever the spread increases (decreases), NII increases (decreases).

See Table 8–4 for various combinations of CGAP and spread changes and their effects on NII. The first four rows in Table 8–4 consider an FI with a positive CGAP; the last four rows consider an FI with a negative CGAP. Notice in Table 8–4 that both the CGAP and spread effects can have the same effect on NII. For example, in row 6 of Table 8–4 , if CGAP is negative and interest rates increase, the CGAP effect says NII will decrease. If, at the same time, the spread between RSAs and RSLs decreases as interest rates increase, the spread effect also says NII will decrease. In these cases, FI managers can accurately predict the direction of the change in NII as interest rates change. When the two work in opposite directions, however, the change in NII cannot be predicted without knowing the size of the CGAP and expected change in the spread. For example, in row 5 of Table 8–4 , if CGAP is neg- ative and interest rates increase, the CGAP effect says NII will decrease. If, at the same time, the spread between RSAs and RSLs increases as interest rates increase, the spread effect says NII will decrease.

Some FIs accept quite large interest rate exposures relative to their asset sizes. For example, the average one-year repricing gap ratio of Macatawa Bank Corporation (Grand Rapids, Michigan) was �5.23 percent at the end of 2005 (i.e., it had considerably more RSLs than RSAs). As interest rates rose from January through July 2006, Macatawa was exposed to significant net interest income losses due to the cost of refinancing its large amount of RSLs (relative to RSAs) at higher rates. Commercial banks have recently paid much closer attention to interest rate risk exposure, significantly reducing the gaps between RSAs and RSLs.

The repricing gap is the measure of interest rate risk historically used by FIs, and it is still the main measure of interest rate risk used by small community banks and thrifts. In contrast to the market value–based models of interest rate risk dis- cussed in the Appendix to this chapter and in Chapter 9, the repricing gap model is conceptually easy to understand and can easily be used to forecast changes in profitability for a given change in interest rates. The repricing gap can be used to

spread effect The effect that a change in the spread between rates on RSAs and RSLs has on net interest in- come as interest rates change.

spread effect The effect that a change in the spread between rates on RSAs and RSLs has on net interest in- come as interest rates change.

Row CGAP Change in

Interest Rates Change in

Spread NII

1 >0 ⇑ ⇑ ⇑ 2 >0 ⇑ ⇓ ⇑⇓ 3 >0 ⇓ ⇑ ⇑⇓ 4 >0 ⇓ ⇓ ⇓ 5 <0 ⇑ ⇑ ⇑⇓ 6 <0 ⇑ ⇓ ⇓ 7 <0 ⇓ ⇑ ⇑ 8 <0 ⇓ ⇓ ⇑⇓

TABLE 8–4 Impact of CGAP on the Relation between Changes in Interest Rates and Changes in Net Interest Income, Allowing for Different Rate Changes for RSAs and RSLs

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Chapter 8 Interest Rate Risk I 203

allow an FI to structure its assets and liabilities or to go off the balance sheet to take advantage of a projected interest rate change. However, the repricing gap model has some major weaknesses that have resulted in regulators’ calling for the use of more comprehensive models (e.g. , the duration gap model) to measure interest rate risk. We next discuss some of the major weaknesses of the repricing model.

Why is it useful to express the repricing gap in terms of a percentage of assets? What specific information does this provide? How can banks change the size and the direction of their repricing gap? Summarize the case for and against the inclusion of demand deposits as a rate- sensitive liability.

1.

2. 3.

Concept Questions

WEAKNESSES OF THE REPRICING MODEL

Despite the fact that this model of interest rate risk is used by the vast major- ity of depository institutions in the United States, the repricing model has four major shortcomings: (1) It ignores market value effects of interest rate changes, (2) it is overaggregative, (3) it fails to deal with the problem of rate-insensitive asset and liability runoffs and prepayments, and (4) it ignores cash flows from off- balance-sheet activities. In this section we discuss each of these weaknesses in more detail.

Market Value Effects As was discussed in the overview of FI risks (Chapter 7), interest rate changes have a market value effect in addition to an income effect on asset and liability val- ues. That is, the present value of the cash flows on assets and liabilities changes, in addition to the immediate interest received or paid on them, as interest rates change. In fact, the present values (and where relevant, the market prices) of vir- tually all assets and liabilities on an FI’s balance sheet change as interest rates change. The repricing model ignores the market value effect—implicitly assuming a book value accounting approach. As such, the repricing gap is only a partial mea- sure of the true interest rate exposure of an FI. As we discuss the market value– based measures of interest rate risk (below and in Chapter 9), we will highlight the impact that ignoring the market value effect has on the ability to accurately measure the overall interest rate risk of an FI.

Overaggregation The problem of defining buckets over a range of maturities ignores information regarding the distribution of assets and liabilities within those buckets. For exam- ple, the dollar values of RSAs and RSLs within any maturity bucket range may be equal; however, on average, liabilities may be repriced toward the end of the bucket’s range, while assets may be repriced toward the beginning, in which case a change in interest rates will have an effect on asset and liability cash flows that will not be accurately measured by the repricing gap approach.

Look at the simple example for the three-month to six-month bucket in Figure 8–5 . Note that $50 million more RSAs than RSLs are repriced between

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204 Part Two Measuring Risk

months 3 and 4, while $50 million more RSLs than RSAs are repriced between months 5 and 6. The bank in its call report would show a zero repricing gap for the three-month to six-month bucket [�50 � (�50) � 0]. But as you can easily see, the bank’s assets and liabilities are mismatched within the bucket. Clearly, the shorter the range over which bucket gaps are calculated, the smaller this problem is. If an FI manager calculated one-day bucket gaps out into the future, this would give a more accurate picture of the net interest income exposure to rate changes. Reportedly, many large banks have internal systems that indicate their repricing gaps on any given day in the future (252 days’ time, 1,329 days’ time, etc.). This suggests that although regulators require the reporting of repricing gaps over only relatively wide maturity bucket ranges, FI managers could set in place inter- nal information systems to report the daily future patterns of such gaps.

The Problem of Runoffs In the simple repricing model discussed above, we assumed that all consumer loans matured in 1 year or that all conventional mortgages matured in 30 years. In reality, the FI continuously originates and retires consumer and mortgage loans as it creates and retires deposits. For example, today, some 30-year original matu- rity mortgages may have only 1 year left before they mature; that is, they are in their 29th year. In addition, these loans may be listed as 30-year mortgages (and included as not rate sensitive), yet they will sometimes be prepaid early as mortgage holders refinance their mortgages and/or sell their houses. Thus, the resulting proceeds will be reinvested at current market rates within the year. In addition, even if an asset or liability is rate insensitive, virtually all assets and liabilities (e.g., long-term mortgages) pay some principal and/or interest back to the FI in any given year. As a result, the FI receives a runoff cash flow from its rate-insensitive portfolio that can be reinvested at current market rates; that is, this runoff cash flow component of a rate-insensitive asset or liability is itself rate sensitive. The FI manager can deal easily with this in the repricing model by iden- tifying for each asset and liability item the estimated dollar cash flow that will run off within the next year and adding these amounts to the value of rate sensitive assets and liabilities.

runoff Periodic cash flow of interest and principal amortization pay- ments on long-term assets, such as con- ventional mortgages, that can be reinvested at market rates.

runoff Periodic cash flow of interest and principal amortization pay- ments on long-term assets, such as con- ventional mortgages, that can be reinvested at market rates.

FIGURE 8–5 The Overaggregation Problem: The Three-Month to Six- Month Bucket

RSA-RSL

RSA-RSL

1 2 3 4 7 8 9 10 Months

�50

0

�50

5 6

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Chapter 8 Interest Rate Risk I 205

How do the supply of and demand for loanable funds, together, determine in- terest rates? How do monetary policy actions made by the Federal Reserve impact interest rates? How has the increased level of financial market integration affected interest rates? What is the repricing gap? In using this model to evaluate interest rate risk, what is meant by rate sensitivity? On what financial performance variable does the repricing model focus? Explain. What is a maturity bucket in the repricing model? Why is the length of time selected for repricing assets and liabilities important in using the repricing model? What is the CGAP effect? According to the CGAP effect, what is the relation be- tween changes in interest rates and changes in net interest income when CGAP is positive? When CGAP is negative? If a bank manager was quite certain that interest rates were going to rise within the next six months, how should the bank manager adjust the bank’s six-month repricing gap to take advantage of this anticipated rise? What if the manager believed rates would fall in the next six months. Consider the following balance sheet positions for a financial institution:

Rate-sensitive assets = $200 million Rate-sensitive liabilities = $100 million

1.

2.

3.

4.

5.

6.

7.

8. •

Questions and Problems Questions and Problems

Cash Flows from Off-Balance-Sheet Activities The RSAs and RSLs used in the repricing model generally include only the assets and liabilities listed on the balance sheet. Changes in interest rates will affect the cash flows on many off-balance-sheet instruments as well. For example, an FI might have hedged its interest rate risk with an interest rate futures contract (see Chapter 23). As interest rates change, these futures contracts—as part of the marking-to-market process—produce a daily cash flow (either positive or nega- tive) for the FI that may offset any on-balance-sheet gap exposure. These offsetting cash flows from futures contracts are ignored by the simple repricing model and should (and could) be included in the model.

What are four major weaknesses of the repricing model? What does runoff mean?

This chapter introduced a method of measuring an FI’s interest rate risk exposure: the repricing model. The repricing model looks at the difference, or gap, between an FI’s rate-sensitive assets and rate-sensitive liabilities to measure interest rate risk. The chapter showed that the repricing model has difficulty in accurately mea- suring the interest rate risk of an FI. In particular, the repricing model ignores the market value effects of interest rate changes. More complete and accurate mea- sures of an FI’s exposure are duration and the duration gap, which are explained in the next chapter.

1. 2.

Concept Questions Concept Questions

SummarySummary

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206 Part Two Measuring Risk

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Rate-sensitive assets = $100 million Rate-sensitive liabilities = $150 million Rate-sensitive assets = $150 million Rate-sensitive liabilities = $140 million Calculate the repricing gap and the impact on net interest income of a 1 percent increase in interest rates for each position. Calculate the impact on net interest income of each of the above situations, assuming a 1 percent decrease in interest rates. What conclusion can you draw about the repricing model from these results?

What are the reasons for not including demand deposits as rate-sensitive li- abilities in the repricing analysis for a commercial bank? What is the subtle but potentially strong reason for including demand deposits in the total of rate sensitive liabilities? Can the same argument be made for passbook sav- ings accounts?

What is the gap ratio? What is the value of this ratio to interest rate risk man- agers and regulators?

Which of the following assets or liabilities fit the one-year rate or repricing sensitivity test? 3-month U.S. Treasury bills 1-year U.S. Treasury notes 20-year U.S. Treasury bonds 20-year floating-rate corporate bonds with annual repricing 30-year floating-rate mortgages with repricing every two years 30-year floating-rate mortgages with repricing every six months Overnight fed funds 9-month fixed-rate CDs 1-year fixed-rate CDs 5-year floating-rate CDs with annual repricing Common stock

What is the spread effect?

A bank manager is quite certain that interest rates are going to fall within the next six months. How should the bank manager adjust the bank’s six-month repricing gap and spread to take advantage of this anticipated rise? What if the manger believed rates would rise in the next six months.

Consider the following balance sheet for WatchoverU Savings, Inc. (in millions):

•

•

a.

b.

c.

9.

10.

11.

12.

13.

14.

Assets Liabilities and Equity

Floating-rate mortgages (currently 10% annually) $ 50

1-year time deposits (currently 6% annually) $ 70

30-year fixed-rate loans (currently 7% annually) 50

3-year time deposits (currently 7% annually) 20

Equity 10 Total assets $100 Total liabilities and equity $100

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Chapter 8 Interest Rate Risk I 207

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What is WatchoverU’s expected net interest income at year-end? What will net interest income be at year-end if interest rates rise 2 percent? Using the cumulative repricing gap model, what is the expected net inter- est income for a 2 percent increase in interest rates? What will net interest income be at year-end if interest rates on RSAs in- crease by 2 percent but interest rates on RSLs increase by 1 percent? Is it reasonable for changes in interest rates on RSAs and RSLs to differ? Why?

Use the following information about a hypothetical government security dealer named M. P. Jorgan. Market yields are in parentheses, and amounts are in millions.

What is the repricing gap if the planning period is 30 days? 3 months? 2 years? Recall that cash is a non-interest-earning asset. What is the impact over the next 30 days on net interest income if interest rates increase 50 basis points? Decrease 75 basis points? The following one-year runoffs are expected: $10 million for two-year T- notes and $20 million for eight-year T-notes. What is the one-year repricing gap? If runoffs are considered, what is the effect on net interest income at year- end if interest rates increase 50 basis points? Decrease 75 basis points?

A bank has the following balance sheet:

Suppose interest rates fall such that the average yield on rate-sensitive assets increases by 45 basis points and the average yield on rate-sensitive liabilities increases by 35 basis points.

Calculate the bank’s CGAP and gap ratio. Assuming the bank does not change the composition of its balance sheet, calculate the resulting change in the bank’s interest income, interest ex- pense, and net interest income. Explain how the CGAP and spread effects influenced this increase in net interest income.

a. b. c.

d.

15.

a.

b.

c.

d.

16.

a. b.

c.

Assets Liabilities and Equity

Cash $ 10 Overnight repos $170 1-month T-bills (7.05%) 75 Subordinated debt 150 3-month T-bills (7.25%) 75 7-year fixed rate (8.55%) 2-year T-notes (7.50%) 50 8-year T-notes (8.96%) 100 5-year munis (floating rate)

(8.20% reset every 6 months) 25 Equity 15 Total assets $335 Total liabilities and equity $335

Assets Avg. Rate Liabilities/Equity Avg. Rate

Rate sensitive $ 550,000 7.75% Rate sensitive $ 375,000 6.25% Fixed rate 755,000 8.75 Fixed rate 805,000 7.50 Nonearning 265,000 Nonpaying 390,000 Total $1,570,000 Total $1,570,000

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208 Part Two Measuring Risk

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A bank has the following balance sheet:

Suppose interest rates fall such that the average yield on rate-sensitive assets decreases by 15 basis points and the average yield on rate-sensitive liabilities decreases by 5 basis points.

Calculate the bank’s CGAP and gap ratio. Assuming the bank does not change the composition of its balance sheet, calculate the resulting change in the bank’s interest income, interest ex- pense, and net interest income. The bank’s CGAP is negative and interest rates decreased, yet net interest income decreased. Explain how the CGAP and spread effects influenced this decrease in net interest income.

The balance sheet of A. G. Fredwards, a government security dealer, is listed below. Market yields are in parentheses, and amounts are in millions.

What is the repricing gap if the planning period is 30 days? 3 months? 2 years? What is the impact over the next three months on net interest income if in- terest rates on RSAs increase 50 basis points and on RSLs increase 75 basis points? What is the impact over the next two years on net interest income if inter- est rates on RSAs increase 50 basis points and on RSLs increase 75 basis points? Explain the difference in your answers to parts (b) and (c). Why is one an- swer a negative change in NII, while the other is positive?

A bank has the following balance sheet:

17.

a. b.

c.

18.

a.

b.

c.

d.

19.

Assets Avg. Rate Liabilities/Equity Avg. Rate

Rate sensitive $ 550,000 7.75% Rate sensitive $ 575,000 6.25% Fixed rate 755,000 8.75 Fixed rate 605,000 7.50 Nonearning 265,000 Nonpaying 390,000 Total $1,570,000 Total $1,570,000

Assets Liabilities and Equity

Cash $ 20 Overnight repos $340 1-month T-bills (7.05%) 150 Subordinated debt 3-month T-bills (7.25%) 150 7-year fixed rate (8.55%) 300 2-year T-notes (7.50%) 100 8-year T-notes (8.96%) 200 5-year munis (floating rate) (8.20% reset every 6 months) 50 Equity 30 Total assets $670 Total liabilities and equity $670

Assets Avg. Rate Liabilities/Equity Avg. Rate

Rate sensitive $225,000 6.35% Rate sensitive $300,000 4.25% Fixed rate 550,000 7.55 Fixed rate 505,000 6.15 Nonearning 120,000 Nonpaying 90,000 Total $895,000 Total $895,000

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Chapter 8 Interest Rate Risk I 209

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Suppose interest rates rise such that the average yield on rate-sensitive assets increases by 45 basis points and the average yield on rate-sensitive liabilities increases by 35 basis points.

Calculate the bank’s repricing GAP. Assuming the bank does not change the composition of its balance sheet, calculate the net interest income for the bank before and after the interest rate changes. What is the resulting change in net interest income? Explain how the CGAP and spread effects influenced this increase in net interest income.

What are some of the weaknesses of the repricing model? How have large banks solved the problem of choosing the optimal time period for repricing? What is runoff cash flow, and how does this amount affect the repricing mod- el’s analysis?

The following questions and problems are based on material in Appendix 8A, located on the Web site (www.mhhe.com/saunders6e).

What is a maturity gap? How can the maturity model be used to immunize an FI’s portfolio? What is the critical requirement that allows maturity matching to have some success in immunizing the balance sheet of an FI?

Nearby Bank has the following balance sheet (in millions):

What is the maturity gap for Nearby Bank? Is Nearby Bank more exposed to an increase or a decrease in interest rates? Explain why. County Bank has the following market value balance sheet (in millions, all interest at annual rates). All securities are selling at par equal to book value.

What is the maturity gap for County Bank? What will be the maturity gap if the interest rates on all assets and liabili- ties increase 1 percent? What will happen to the market value of the equity?

If a bank manager is certain that interest rates are going to increase within the next six months, how should the bank manager adjust the bank’s matu- rity gap to take advantage of this anticipated increase? What if the manager

a. b.

c.

20.

21.

22.

23.

a. b.

c. 24.

Assets Liabilities and Equity

Cash $ 60 Demand deposits $140 5-year Treasury notes 60 1-year certificates of deposit 160 30-year mortgages 200 Equity 20 Total assets $320 Total liabilities and equity $320

Assets Liabilities and Equity

Cash $ 20 Demand deposits $100 15-year commercial loan

at 10% interest, balloon payment 160

5-year CDs at 6% interest, balloon payment 210

30-year mortgages at 8% interest, balloon payment 300

20-year debentures at 7% interest 120

Equity 50 Total assets $480 Total liabilities and equity $480

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210 Part Two Measuring Risk

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believed rates would fall? Would your suggested adjustments be difficult or easy to achieve? Consumer Bank has $20 million in cash and a $180 million loan portfolio. The assets are funded with demand deposits of $18 million, a $162 million CD, and $20 million in equity. The loan portfolio has a maturity of two years, earns in- terest at an annual rate of 7 percent, and is amortized monthly. The bank pays 7 percent annual interest on the CD, but the interest will not be paid until the CD matures at the end of two years.

What is the maturity gap for Consumer Bank? Is Consumer Bank immunized, or protected, against changes in interest rates? Why or why not? Does Consumer Bank face interest rate risk? That is, if market interest rates increase or decrease 1 percent, what happens to the value of the equity? How can a decrease in interest rates create interest rate risk?

FI International holds seven-year Acme International bonds and two-year Beta Corporation bonds. The Acme bonds are yielding 12 percent and the Beta bonds are yielding 14 percent under current market conditions.

What is the weighted-average maturity of FI’s bond portfolio if 40 percent is in Acme bonds and 60 percent is in Beta bonds? What proportion of Acme and Beta bonds should be held to have a weighted-average yield of 13.5 percent? What will be the weighted-average maturity of the bond portfolio if the weighted-average yield is realized?

An insurance company has invested in the following fixed-income securities: (a) $10,000,000 of five-year Treasury notes paying 5 percent interest and selling at par value, (b) $5,800,000 of 10-year bonds paying 7 percent interest with a par value of $6,000,000, and (c) $6,200,000 of 20-year subordinated debentures paying 9 percent interest with a par value of $6,000,000.

What is the weighted-average maturity of this portfolio of assets? If interest rates change so that the yields on all the securities decrease 1 per- cent, how does the weighted-average maturity of the portfolio change? Explain the changes in the maturity values if the yields increase 1 percent. Assume that the insurance company has no other assets. What will be the effect on the market value of the company’s equity if the interest rate changes in (b) and (c) occur?

The following is a simplified FI balance sheet:

The average maturity of loans is four years, and the average maturity of de- posits is two years. Assume that loan and deposit balances are reported as book value, zero-coupon items.

Assume that the interest rate on both loans and deposits is 9 percent. What is the market value of equity?

25.

a. b.

c.

d. 26.

a.

b.

c.

27.

a. b.

c. d.

28.

a.

Assets Liabilities and Equity

Loans $1,000 Deposits $ 850 Equity 150

Total assets $1,000 Total liabilities and equity $1,000

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Chapter 8 Interest Rate Risk I 211

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What must be the interest rate on deposits to force the market value of eq- uity to be zero? What economic market conditions must exist to make this situation possible? Assume that the interest rate on both loans and deposits is 9 percent. What must be the average maturity of deposits for the market value of equity to be zero?

Gunnison Insurance has reported the following balance sheet (in thousands) :

All securities are selling at par equal to book value. The two-year notes are yielding 5 percent, and the 15-year munis are yielding 9 percent. The one-year commercial paper pays 4.5 percent, and the five-year notes pay 8 percent. All instruments pay interest annually.

What is the weighted-average maturity of the assets for Gunnison? What is the weighted-average maturity of the liabilities for Gunnison? What is the maturity gap for Gunnison? What does your answer to part (c) imply about the interest rate exposure of Gunnison Insurance? Calculate the values of all four securities of Gunnison Insurance’s balance sheet assuming that all interest rates increase 2 percent. What is the dollar change in the total asset and total liability values? What is the percentage change in these values? What is the dollar impact on the market value of equity for Gunnison? What is the percentage change in the value of the equity? What would be the impact on Gunnison’s market value of equity if the li- abilities paid interest semiannually instead of annually?

Scandia Bank has issued a one-year, $1 million CD paying 5.75 percent to fund a one-year loan paying an interest rate of 6 percent. The principal of the loan will be paid in two installments: $500,000 in six months and the balance at the end of the year.

What is the maturity gap of Scandia Bank? According to the maturity model, what does this maturity gap imply about the interest rate risk expo- sure faced by Scandia Bank? What is the expected net interest income at the end of the year? What would be the effect on annual net interest income of a 2 percent inter- est rate increase that occurred immediately after the loan was made? What would be the effect of a 2 percent decrease in rates? What do these results indicate about the ability of the maturity model to immunize portfolios against interest rate exposure?

EDF Bank has a very simple balance sheet. Assets consist of a two-year, $1 million loan that pays an interest rate of LIBOR plus 4 percent annually. The loan is funded with a two-year deposit on which the bank pays LIBOR plus

b.

c.

29.

a. b. c. d.

e.

f.

g.

30.

a.

b. c.

d.

31.

Assets Liabilities and Equity

2-year Treasury note $175 1-year commercial paper $135 15-year munis 165 5-year note 160

Equity 45 Total assets $340 Total liabilities and equity $340

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212 Part Two Measuring Risk

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3.5 percent interest annually. LIBOR currently is 4 percent, and both the loan and the deposit principal will be paid at maturity.

What is the maturity gap of this balance sheet? What is the expected net interest income in year 1 and year 2? Immediately prior to the beginning of year 2, LIBOR rates increase to 6 per- cent. What is the expected net interest income in year 2? What would be the effect on net interest income of a 2 percent decrease in LIBOR?

What are the weaknesses of the maturity model? The following questions and problems are based on material in Appendix 8B to

the chapter. The current one-year Treasury bill rate is 5.2 percent, and the expected one- year rate 12 months from now is 5.8 percent. According to the unbiased ex- pectations theory, what should be the current rate for a two-year Treasury security? Suppose that the current one-year rate (one-year spot rate) and expected one- year T-bill rates over the following three years (i.e., years 2, 3, and 4, respec- tively) are as follows:

Using the unbiased expectations theory, calculate the current (long-term) rates for one-, two-, three-, and four-year-maturity Treasury securities. Plot the re- sulting yield curve. A recent edition of The Wall Street Journal reported interest rates of 6 percent, 6.35 percent, 6.65 percent, and 6.75 percent for three-year, four-year, five-year, and six-year Treasury notes, respectively. According to the unbiased expecta- tions theory, what are the expected one-year rates for years 4, 5, and 6? The Wall Street Journal reports that the rate on three-year Treasury securities is 5.60 percent and the rate on four-year Treasury securities is 5.65 percent. According to the unbiased expectations hypothesis, what does the market ex- pect the one-year Treasury rate to be three years from today, E ( 3 r 1 )? How does the liquidity premium theory of the term structure of interest rates differ from the unbiased expectations theory? In a normal economic environ- ment, that is, an upward-sloping yield curve, what is the relationship of li- quidity premiums for successive years into the future? Why? Based on economists’ forecasts and analysis, one-year Treasury bill rates and liquidity premiums for the next four years are expected to be as follows:

Using the liquidity premium hypothesis, plot the current yield curve. Make sure you label the axes on the graph and identify the four annual rates on the curve both on the axes and on the yield curve itself.

a. b. c.

32.

33.

34.

35.

36.

37.

38.

1 1 2 1 3 1 4 16 7 7 5 7 85R E r E r E r� � � �% ( ) % ( ) . % ( ) . %1 1 2 1 3 1 4 16 7 7 5 7 85R E r E r E r� � � �% ( ) % ( ) . % ( ) . %

R

E r L

E r L

1

2 1 2

3 1 3

5 65 6 75 0 05 6 85

�

� �

� �

. % ( ) . % . % ( ) . % 00 10

7 15 0 124 1 4

. % ( ) . % . %E r L� �

R

E r L

E r L

1

2 1 2

3 1 3

5 65 6 75 0 05 6 85

�

� �

� �

. % ( ) . % . % ( ) . % 00 10

7 15 0 124 1 4

. % ( ) . % . %E r L� �

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Chapter 8 Interest Rate Risk I 213

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The Wall Street Journal reports that the rate on three-year Treasury securities is 5.25 percent and the rate on four-year Treasury securities is 5.50 percent. The one-year interest rate expected in three years is E ( 3 r 1 ), 6.10 percent. According to the liquidity premium hypothesis, what is the liquidity premium on the four-year Treasury security, L 4 ? You note the following yield curve in The Wall Street Journal . According to the unbiased expectations hypothesis, what is the one-year forward rate for the period beginning two years from today, 2 f 1 ?

Maturity Yield

One day 2.00% One year 5.50 Two years 6.50 Three years 9.00

39.

40.

Assets Liabilities and Equity

Cash Fed funds (5.05%) 3-month T-bills (5.25%) 2-year T-notes (6.50%) 8-year T-notes (7.50%) 5-year munis (floating rate) (8.20%, repriced

@ 6 months) 6-month consumer loans (6%) 1-year consumer loans (5.8%) 5-year car loans (7%) 7-month C&I loans (5.8%) 2-year C&I loans (floating rate) (5.15%, repriced

@ 6 months) 15-year variable-rate mortgages (5.8%, repriced

@ 6 months) 15-year variable-rate mortgages (6.1%, repriced

@ year) 15-year fixed-rate mortgages (7.85%) 30-year variable-rate mortgages (6.3%, repriced

@ quarter) 30-year variable-rate mortgages (6.4%, repriced

@ month) 30-year fixed-rate mortgages (8.2%) Premises and equipment Total assets

$ 20 Demand deposits Savings accounts (1.5%) MMDAs (4.5%) (no minimum

balance requirement) 3-month CDs (4.2%) 6-month CDs (4.3%) 1-year CDs (4.5%) 2-year CDs (5%) 4-year CDs (5.5%) 5-year CDs (6%) Fed funds (5%) Overnight repos (5%) 6-month commercial paper (5.05%) Subordinate notes: 3-year fixed rate (6.55%) Subordinated debt: 7-year fixed rate (7.25%) Total liabilities

$ 250 150 20 150 340 100 150 200 120

50 220 375

250 425 300 330 350 200 200 225

275 290 300

200 200

400 100 300 $3,545

225

355 400

20 Equity 400 $3,945 Total liabilities and equity $3,945

CALCULATING INTEREST RATES State Bank’s balance sheet is listed below. Market yields are in parentheses, and amounts are in millions.

Integrated Mini Case:

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214 Part Two Measuring Risk

View Appendix 8A at the Web site for this textbook ( www.mhhe.com/ saunders6e ).

What is the repricing gap if the planning pe- riod is 30 days? 6 months? 1 year? 2 years? 5 years? What is the impact over the next six months on net interest income if interest rates on RSAs in- crease 60 basis points and on RSLs increase 40 basis points?

1.

2.

What is the impact over the next year on net in- terest income if interest rates on RSAs increase 60 basis points and on RSLs increase 40 basis points?

3.

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Appendix 8B

Term Structure of Interest Rates

Pertinent Web Sites

Bank for International Settlements www.bis.org Board of Governors of the Federal Reserve www.federalreserve.gov The Wall Street Journal www.wsj.com

Chapter Notation

View the Chapter Notation at the Web site for this textbook ( www.mhhe.com/ saunders6e )

Appendix 8A: The Maturity Model

̀ To explain the process of estimating the impact of an unexpected shock in short-term inter- est rates on the entire term structure of interest rates, FIs use the theory of the term structure of interest rates or the yield curve. The term struc- ture of interest rates compares the market yields or interest rates on securities, assuming that all characteristics (default risk, coupon rate, etc.) except maturity are the same. The change in

required interest rates as the maturity of a secu- rity changes is called the maturity premium (MP). The MP, or the difference between the required yield on long- and short-term securities of the same characteristics except maturity, can be positive, negative, or zero. The yield curve for U.S. Treasury securities is the most commonly reported and analyzed yield curve. The shape of the yield curve on Treasury securities has

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Chapter 8 Interest Rate Risk I 215

taken many forms over the years, but the three most common shapes are shown in Figure 8B–1 . In graph (a), the yield curve on August 12, 2004, yields rise steadily with maturity when the yield curve is upward sloping. This is the most common yield curve, so on average the MP is positive. Graph (b) shows an inverted

or downward-sloping yield curve, reported on November 27, 2000, for which yields decline as maturity increases. Inverted yield curves do not generally last very long. Finally, graph (c) shows a flat yield curve, reported on August 31, 2006, in which the yield to maturity is virtually unaf- fected by the term to maturity.

FIGURE 8B–1 Treasury Yield Curves

Source: U.S. Treasury, “Daily Treasury Rates.” www.ustreas.gov

Time to

maturity

3 month

5.00

6.00

7.00

6 month 1 year 2 year 3 year 5 year 7 year 10 year 20 year 30 year

Time to

maturity

Yield to

maturity

(b) Yield Curve, November 27, 2000

1.00

2.00

3.00

4.00

5.00

6.00

1 month 3 month 6 month 1 year 2 year 3 year 5 year 7 year 10 year 20 year

Yield to

maturity

(a) Yield Curve, August 12, 2004

Time to

maturity

3 month

4.00

4.50

5.00

5.50

6 month 1 year 2 year 3 year 5 year 7 year 10 year 20 year 30 year

Yield to

maturity

(c) Yield Curve, August 31, 2006

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216 Part Two Measuring Risk

Note that these yield curves may reflect factors other than investors’ preferences for the maturity of a security, since in reality there may be liquid- ity differences among the securities traded at dif- ferent points along the yield curve. For example, newly issued 20-year Treasury bonds offer a rate of return less than (seasoned issues) 10-year Treasury bonds if investors prefer new (“on the run”) securities to previously issued (“off the run”) securities. Specifically, since the Treasury (historically) issues new 10-year notes and 20-year bonds only at the long end of the maturity spec- trum, an existing 10-year Treasury bond would have to have been issued 10 years previously (i.e., it was originally a 20-year bond when it was issued 10 years previously). The increased demand for the newly issued “liquid” 20-year Treasury bonds relative to the less liquid 10-year Treasury bonds can be large enough to push the equilibrium interest rate on the 20-year Treasury bonds below that on the 10-year Treasury bonds and even below short-term rates. Explanations for the shape of the yield curve fall predominantly into three theories: the unbiased expectations the- ory, the liquidity premium theory, and the market segmentation theory.

UNBIASED EXPECTATIONS THEORY According to the unbiased expectations theory for the term structure of interest rates, at a given point in time the yield curve reflects the market’s current expectations of future short-term rates. Thus, an upward-sloping yield curve reflects the market’s expectation that short-term rates will rise throughout the relevant time period (e.g., the Federal Reserve is expected to tighten mon- etary policy in the future). Similarly, a flat yield curve reflects the expectation that short-term

rates will remain constant over the relevant time period.

As illustrated in Figure 8B–2 , the intuition behind the unbiased expectations theory is that if investors have a 4-year investment horizon, they either could buy a current 4-year bond and earn the current yield on a 4-year bond ( R 4, if held to maturity) each year or could invest in 4 successive one-year bonds (of which they know only the cur- rent one-year rate, R 1 , but form expectations of the unknown future one-year rates). In equilibrium, the return to holding a 4-year bond to maturity should equal the expected return to investing in 4 successive one-year bonds. Similarly, the return on a 3-year bond should equal the expected return on investing in 3 successive one-year bonds. If future one-year rates are expected to rise each successive year into the future, then the yield curve will slope upward. Specifically, the cur- rent 4-year T-bond rate or return will exceed the 3-year bond rate, which will exceed the 2-year bond rate, and so on. Similarly, if future one-year rates are expected to remain constant each succes- sive year into the future, then the 4-year bond rate will be equal to the 3-year bond rate; that is, the term structure of interest rates will remain con- stant over the relevant time period. Specifically, the unbiased expectations theory posits that long- term rates are a geometric average of current and expected short-term interest rates. That is, the interest rate that equates the return on a series of short-term security investments with the return on a longterm security with an equivalent matu- rity reflects the market’s forecast of future inter- est rates. The mathematical equation representing this relationship is:

( ) ( ) [ ( )] [ ( )]1 1 1 11 1 1 2 1 1� � � � �R R E r E rN

N N�

FIGURE 8B–2 Unbiased Expectations Theory of the Term Structure of Interest Rates

Buy a four-year bond

0 1 2 3 4 Year

(1 + 1R4)4

Buy 4 one-year bonds(1+1R1) [1+E(2r1)] [1+E(3r1)] [1+E(4r1)]

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Chapter 8 Interest Rate Risk I 217

where

1

1 1

1

R

N

R

E r

NN

t

�

�

�

�( )

Actual -period rate Term too maturity Current one-year rate Expected onee-year (forward) yield during period t

Notice that uppercase interest rate terms 1 R t are the actual current interest rates on securi- ties purchased today with a maturity of t years. Lowercase interest rate terms t r 1 are estimates of future one-year interest rates starting t years into the future. For example, suppose the cur- rent one-year spot rate and expected one-year Treasury bill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:

1 1 2 1

3 1 4 1

2 94 4 00

4 74 5 1

R E r

E r E r

� �

� �

. % ( ) . %

( ) . % ( ) . 00%

This would be consistent with the market’s expect- ing the Federal Reserve to increasingly tighten monetary policy. With the unbiased expectations theory, current long-term rates for one-, two-, three-, and four-year maturity Treasury securities should be:

1 1

1 2 1 2

2 940

1 0294 1 04 1 3 469

R

R

�

� � � � �

. %

[( . )( . )] ./ %%

[( . )( . )( . )] /1 3 1 31 0294 1 04 1 0474 1R � � � � �

� 33 891 1 0294 1 04 1 0474

1 05 1 4

. % [( . )( . )( . )

( .

R � � � �

� 11 1 4 1921 4)] . %/ � � And the yield curve should look like this:

Yield to maturity (%)

4.192

3.891

3.469

2.940

0 1 2 3 4

Term to maturity (years)

Thus, the upward-sloping yield curve reflects the market’s expectation of consistently rising one- year (short-term) interest rates in the future. 1 10

LIQUIDITY PREMIUM THEORY The unbiased expectations theory has the short- coming that it neglects to recognize that forward rates are not perfect predictors of future interest rates. If forward rates were perfect predictors of future interest rates, future prices of Treasury secu- rities would be known with certainty. The return over any investment period would be certain and independent of the maturity of the instrument initially purchased and of the time at which the investor needs to liquidate the security. However, with uncertainty about future interest rates (and future monetary policy actions) and hence about future security prices, these instruments become risky in the sense that the return over a future investment period is unknown. In other words, because of future uncertainty of return, there is a risk in holding long-term securities, and that risk increases with the security’s maturity.

The liquidity premium theory of the term structure of interest rates allows for this future uncertainty. It is based on the idea that investors will hold long-term maturities only if they are offered a premium to compensate for the future uncertainty in a security’s value, which increases with an asset’s maturity. Specifically, in a world of uncertainty, short-term securities provide greater marketability (due to their more active secondary market) and have less price risk (due to smaller price fluctuations for a given change in interest rates) than long-term securities. As a result, inves- tors prefer to hold shorter-term securities because they can be converted into cash with little risk of a capital loss, that is, a fall in the price of the secu- rity below its original purchase price. Thus, inves- tors must be offered a liquidity premium to buy longer-term securities that have a higher risk of capital losses. This difference in price or liquidity risk can be directly related to the fact that longer- term securities are more sensitive to interest rate changes in the market than are shorter-term secu- rities—see Appendix 9A for a discussion on bond interest rate sensitivity and the link to a bond’s

1 That is E ( 4 r 1 ) > E ( 3 r 1 ) > E ( 2 r 1 ).

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218 Part Two Measuring Risk

maturity. Because the longer the maturity on a security the greater its risk, the liquidity premium increases as maturity increases.

The liquidity premium theory states that long- term rates are equal to the geometric average of current and expected short-term rates (as with the unbiased expectations theory) plus a liquidity or risk premium that increases with the maturity of the security. Figure 8B–3 illustrates the differ- ence in the shape of the yield curve under the unbiased expectations theory versus the liquid- ity premium theory. For example, according to the liquidity premium theory, an upward-sloping yield curve may reflect the investor’s expectations that future short-term rates will rise, be flat, or fall, but because the liquidity premium increases with maturity, the yield curve will nevertheless increase with the term to maturity. The liquidity premium theory may be mathematically represented as:

1 1 1 2 1 2 1 1

1 1 1R R E r L E r

L N N

N

� � � � �

�

{( )[ ( ) ] [ ( )

]} / �

NN � 1

where L t = liquidity premium for a period t and

L 2 < L 3 < … < L N . For example, suppose that the current one-year

rate (one-year spot rate) and expected one-year

T-bond rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:

1 1 2 1

3 1

4 1

2 94 4 00

4 74

5 1

R E r

E r

E r

� �

�

�

. % ( ) . %

( ) . %

( ) . 00% In addition, investors charge a liquidity premium on longer-term securities such that:

L L L2 3 40 10 0 20 0 30� � �. % . % . %

Using the liquidity premium theory, current rates for one-, two-, three-, and four-year-maturity Treasury securities should be:

1

1

R

R

1

2

2 94

1 0294 1 04 001 1 3 1

2

�

� � � � � �

. %

[( . )( . . )] .552

1 0294 1 04 001 1 0474

002 3

%

[( . )( . . )( .

. 1R � � � � �

� ))] . % [( . )( . . )(

/1 3

4

1 3 99 1 0294 1 04 001 1

� �

� � � � �1R ..

. )( . . )] . %/ 0474

002 1 051 003 1 4 341 4� � � � � and the current yield to maturity curve will be upward sloping as shown:

(a) Upward-sloping yield to maturity

Time to maturity

LPT

UET

(b) Inverted or downward-sloping yield to maturity

Time to maturity

LPT

UET

(c) Flat yield to maturity

Time to maturity

LPT

UET

FIGURE 8B–3 Yield Curve under the Unbiased Expectations Theory (UET) versus the Liquidity Premium Theory (LPT)

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Chapter 8 Interest Rate Risk I 219

Yield to maturity (%)

4.34 3.99

3.52

2.94

1 2 3 4

Term to maturity (years)0

Comparing the yield curves in the example above (using the unbiased expectations hypothesis) and here, notice that the liquidity premium in year 2 ( L 2 = 0.10%) produces a 0.05 percent premium on the yield to maturity on a two-year T-note, the liquidity premium for year 3 ( L 3 = 0.20%) produces a 0.10 percent premium on the yield to maturity on the three-year T-note, and the liquid- ity premium for year 4 ( L 4 = 0.30%) produces a 0.15 percent premium on the yield to maturity on the four-year T-note.

MARKET SEGMENTATION THEORY Market segmentation theory argues that individ- ual investors have specific maturity preferences. Accordingly, securities with different maturities

are not seen as perfect substitutes under the market segmentation theory. Instead, individual investors have preferred investment horizons dictated by the nature of the assets and liabili- ties they hold. For example, banks might prefer to hold relatively short-term U.S. Treasury bills because of the short-term nature of their deposit liabilities, while insurance companies might pre- fer to hold long-term U.S. Treasury bonds because of the long-term nature of their life insurance contractual liabilities. As a result, interest rates are determined by distinct supply and demand conditions within a particular maturity bucket or market segment (e.g., the short end and the long end of the market). The market segmentation the- ory assumes that neither investors nor borrowers are willing to shift from one maturity sector to another to take advantage of opportunities arising from changes in yields. Figure 8B–4 demonstrates how changes in the supply curve for short-versus long-term bonds result in changes in the shape of the yield curve. Such a change may occur if the U.S. Treasury decides to issue fewer short-term bonds and more long-term bonds (i.e., to lengthen the average maturity of government debt out- standing). Specifically in Figure 8B–4 , the higher

FIGURE 8B–4 Market Segmentation and Determination of the Slope of the Yield Curve

Yield percent

Short-term securities

rS SS

DS

Yield percent

Long-term securities

rL SL

DL

Yield percent

Time to maturity

Yield curve

S L

Yield percent

Short-term securities

rS SS

DS

Yield percent

Long-term securities

rL SL

DL

Yield percent

Time to maturity

Yield curve

S L

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220 Part Two Measuring Risk

the yield on securities, the higher the demand for them. 211

Thus, as the supply of securities decreases in the short-term market and increases in the long- term market, the slope of the yield curve becomes steeper. If the supply of short-term securities had increased while the supply of long-term securi- ties had decreased, the yield curve would have become flatter (and may even have sloped down- ward). Indeed, the large-scale repurchases of long- term Treasury bonds (i.e., reductions in supply) by the U.S. Treasury in 2000 have been viewed as the major cause of the inverted yield curve that appeared in 2000.

FORECASTING INTEREST RATES As interest rates change, so do the values of finan- cial securities. Accordingly, the ability to predict or forecast interest rates is critical to the profitability of FIs. For example, if interest rates rise, the value of investment portfolios of FIs will fall, resulting in a loss of wealth. Thus, interest rate forecasts are extremely important for the financial wealth of FIs. The discussion of the unbiased expecta- tions theory above indicated that the shape of the yield curve is determined by the market’s current expectations of future short-term interest rates. For example, an upward-sloping yield curve sug- gests that the market expects future short-term interest rates to increase. Given that the yield curve represents the market’s current expectations of future short-term interest rates, the unbiased expectations theory can be used to forecast (short- term) interest rates in the future (i.e., forward one- year interest rates). A forward rate is an expected or implied rate on a short-term security that is to be originated at some point in the future. With the equations representing unbiased expectations the- ory, the market’s expectation of forward rates can

2 In general, the price and yield on a bond are inversely related. Thus, as the price of a bond falls (becomes cheaper), the de- mand for the bond will rise. This is the same as saying that as the yield on a bond rises, the bond becomes cheaper and the demand for it increases. See Appendix 9A.

be derived directly from existing or actual rates on securities currently traded in the spot market.

To find an implied forward rate on a one-year security to be issued one year from today, we can rewrite the unbiased expectation theory equation as follows:

1 1 2R R f2 1 11 1 1 1

2� � � �{( )[ ( )]} where

2 Expected one-year rate for year 2, or tf1 � hhe implied forward one-year rate for next yeaar

Therefore, 2 f 1 is the market’s estimate of the expected one-year rate for year 2. Solving for 2 f 1 , we get:

2 1 1f R R1 2 2

11 1 1� � � �{( ) / [ ( )]} In general, we can find the one-year forward rate for any year, N years into the future, using the fol- lowing equation:

N N N

N Nf R R1 1

11 1 1� � � �� �{( ) / [ ( )] }1 1

For example, on August 31, 2006, the existing or current (spot) one-year, two-year, three-year, and four-year zero-coupon Treasury security rates were as follows:

1 1

1 1

R R

R R 1 2

3 4

5 00 4 75

4 69 4 69

� �

� �

. % . %

. % . % With the unbiased expectations theory, one-year forward rates on zero-coupon Treasury bonds for years 2, 3, and 4 as of August 31, 2006, were:

2 1 2

3 1

1 0475 1 0500 1 4 501

1 04

f

f

� � �

�

[( . ) / ( . )] . %

[( . 669 1 0475 1 4 570

1 0469 1

3 2

4 1 4

) / ( . ) ] . %

[( . ) / ( .

� �

�f 00469 1 4 6903) ] . %� � Thus, the expected one-year rate one year into the future was 4.501 percent; the expected one-year rate two years into the future was 4.570 percent; and the expected one-year rate three years into the future was 4.690 percent.

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221

Chapter Nine

Interest Rate Risk II INTRODUCTION

As mentioned in Chapter 8, a weakness of the repricing model is its reliance on book values rather than market values of assets and liabilities. Indeed, in most countries, FIs report their balance sheets by using book value accounting. This method records the historic values of securities purchased, loans made, and liabili- ties sold. For example, for U.S. banks, investment assets (i.e., those expected to be held to maturity) are recorded at book values, while those assets expected to be used for trading (trading securities or available-for-sale securities) are reported according to market value.1 The recording of market values means that assets and liabilities are revalued to reflect current market conditions. Thus, if a fixed-coupon bond had been purchased at $100 per $100 of face value in a low-interest rate envi- ronment, a rise in current market rates reduces the present value of the cash flows from the bond to the investor. Such a rise also reduces the price—say to $97—at which the bond could be sold in the secondary market today. That is, the market value accounting approach reflects economic reality, or the true values of assets and liabilities if the FI’s portfolio were to be liquidated at today’s securities prices rather than at the prices when the assets and liabilities were originally purchased or sold. This practice of valuing securities at their market value is referred to as marking to market. We discuss book value versus market value accounting and the impact that the use of the alternate methods has in measuring the value of an FI in more detail in Chapter 20. Appendix 9A, located at the book’s Web site (www.mhhe.com/saunders6e), presents a review of bond pricing and price vola- tility. This topic is generally covered in introductory finance courses. For students needing a review, Appendix 9A is encouraged reading.

In this second chapter on measuring interest rate risk, we present a market value–based model of managing interest rate risk: the duration model. We explain the concept of duration and see that duration and the duration gap are more accurate measures of an FI’s interest rate risk exposure than is the repricing model described in Chapter 8. Unlike the repricing model, duration gap considers market values and the maturity distributions of an FI’s assets and liabilities. Further, duration gap considers the degree of leverage on an FI’s balance sheet as well as the timing of the payment or arrival of cash flows of assets and liabilities. Thus, duration gap is a more comprehensive measure of an FI’s interest rate risk.

1 More accurately, they are reported at the lower of cost or current market value (LOCOM). However, both the SEC and the Financial Accounting Standards Board (FASB) have strongly advocated that FIs switch to full market value accounting in the near future. Currently, FASB 115 requires FIs to value certain bonds at market prices but not loans.

book value accounting Accounting method in which the assets and liabilities of the FI are recorded at his- toric values.

book value accounting Accounting method in which the assets and liabilities of the FI are recorded at his- toric values.

market value accounting Accounting method in which the assets and liabilities of the FI are revalued ac- cording to the current level of interest rates.

market value accounting Accounting method in which the assets and liabilities of the FI are revalued ac- cording to the current level of interest rates.

marking to market Valuing securities at their current market price.

marking to market Valuing securities at their current market price.

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222 Part Two Measuring Risk

As a result, regulators are increasingly focusing on this model in determining an appropriate level of capital reserves for an FI exposed to interest rate risk (see Chapter 20). We begin the chapter by presenting the basic arithmetic needed to calculate the duration of an asset or liability. Then we analyze the economic meaning of the number we calculate for duration. This number, which measures the average life of an asset or liability, also has economic meaning as the interest sensitivity (or interest elasticity) of that asset or liability’s value. Next, we show how the duration measure can be used to protect an FI against interest rate risk. Finally, we examine some problems in applying the duration measure to real-world FIs’ balance sheets. The more advanced issues associated with these problems are presented in Appendix 9B at the end of the chapter.

DURATION: A SIMPLE INTRODUCTION

Duration is a more complete measure of an asset or liability’s interest rate sensi- tivity than is maturity because duration takes into account the time of arrival (or payment) of all cash flows as well as the asset’s (or liability’s) maturity. Consider a loan with a 15 percent interest rate and required repayment of half the $100 in principal at the end of six months and the other half at the end of the year. The loan is financed with a one-year CD paying 15 percent interest per year. The promised cash flows (CF) received by the FI from the loan at the end of one-half year and at the end of the year appear in Figure 9–1.

CF1/2 is the $50 promised repayment of principal plus the $7.50 promised inter- est payment ($100 × ½ × 15%) received after six months. CF1 is the promised cash flow at the end of the year and is equal to the second $50 promised principal repay- ment plus $3.75 promised interest ($50 × ½ × 15%). To compare the relative sizes of these two cash flows, we should put them in the same dimensions. This is the case because $1 of principal or interest received at the end of a year is worth less to the FI in terms of the time value of money than $1 of principal or interest received at the end of six months. Assuming that the current required interest rates are 15 percent per annum, we calculate the present values (PV) of the two cash flows (CF) shown in Figure 9–2 as:

CF PV

CF 1/2 1/2

1

$57.50 $57.5/(1.075) $53.49� � �

$53.75 $53.75/(1.075) $46.512

1/2

� � �

�

PV

CF CF 1

11 � � �$111.25 $100.001/2 1PV PV

Note that since CF1/2, the cash flows received at the end of one-half year, are received earlier, they are discounted at (1 + ½R), where R is the current annual interest rate on the loan. This is smaller than the discount rate on the cash flow

1/2 year0 1 year

CF1/2 = $57.50 CF 1 = $53.75FIGURE 9–1 Promised Cash Flows on the One- Year Loan

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Chapter 9 Interest Rate Risk II 223

received at the end of the year (1 + ½R)2. Figure 9–2 summarizes the PVs of the cash flows from the loan.2

Technically speaking, duration is the weighted-average time to maturity on the loan using the relative present values of the cash flows as weights. On a time value of money basis, duration measures the period of time required to recover the initial investment on the loan. Any cash flows received prior to the loan’s duration reflect recovery of the initial investment, while cash flows received after the period of the loan’s duration and before its maturity are the profits, or return, earned by the FI. As Figure 9–2 shows, the FI receives some cash flows at one-half year and some at one year. Duration analysis weights the time at which cash flows are received by the relative importance in present value terms of the cash flows arriving at each point in time. In present value terms, the relative importance of the cash flows arriving at time t = ½ year and time t = 1 year are as follows:

That is, in present value terms, the FI receives 53.49 percent of cash flows on the loan with the first payment at the end of six months (t = ½) and 46.51 percent with the second payment at the end of the year (t = 1). By definition, the sum of the (present value) cash flow weights must equal 1:

X X1/2 1

.5349 .4651 1

� �

� �

1

We can now calculate the duration (D), or the weighted-average time to matu- rity, of the loan using the present value of its cash flows as weights:

D X X1 � �

� � �

1/2 1

2 1

1 2

( ) (1)

.5349( ) .4651(1) .7326 yyears

Thus, while the maturity of the loan is one year, its duration, or average life in a cash flow sense, is only .7326 years. On a time value of money basis, the initial

2 We use here the Treasury formula for calculating the present values of cash flows on a security that pays cash flows semiannually. This approach is more accurate, since it reflects the semiannual payment and compounding of interest on the loan.

duration The weighted-average time to maturity on an investment.

duration The weighted-average time to maturity on an investment.

Time (t) Weight (x)

1/2 year

1 year X

PV

PV PV1 1

1 2 1

46 51 100 00

4651 46 51� �

� � � /

. .

. . %

1.0 100 %

X PV

PV PV1 2 1 2

1 2 1

53 49 100 00

5349 53 49/ /

/

. .

. .� �

� � � %%X PV

PV PV1 2 1 2

1 2 1

53 49 100 00

5349 53 49/ /

/

. .

. .� �

� � � %%

Time (t) Weight (x)

1/2 year

1 year X

PV

PV PV1 1

1 2 1

46 51 100 00

4651 46 51� �

� � � /

. .

. . %

1.0 100 %

X PV

PV PV1 2 1 2

1 2 1

53 49 100 00

5349 53 49/ /

/

. .

. .� �

� � � %%X PV

PV PV1 2 1 2

1 2 1

53 49 100 00

5349 53 49/ /

/

. .

. .� �

� � � %%

1/2 year0 1 year

CF1/2 = $57.50 PV1 = $46.51 PV1/2 = $53.49

CF1 = $53.75FIGURE 9–2 PV of the Cash Flows from the Loan

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224 Part Two Measuring Risk

investment in the loan is recovered (albeit not realized) after .7326 years. After that time the FI earns a profit, or return, on the loan. The duration is less than the maturity of the loan because in present value terms 53.49 percent of the cash flows are received at the end of one-half year. Note that duration is measured in years since we weight the time (t) at which cash flows are received by the relative pres- ent value importance of cash flows (X1/2, X1, etc.).

We next calculate the duration of the one-year, $100, 15 percent interest certifi- cate of deposit. The FI promises to make only one cash payment to depositors at the end of the year; that is, CF1 = $115, which is the promised principal ($100) and interest repayment ($15) to the depositor. Since weights are calculated in present value terms:3

CF PV1 1� � �$115, and $115/1.15 $100

We show this in Figure 9–3. Because all cash flows are received in one payment at the end of the year, X1 = PV1/PV1 = 1, the duration of the deposit is:

D X

D D

D

� �

� � �

1 (1)

1 (1) 1 year

Thus, only when all cash flows are limited to one payment at the end of the period with no intervening cash flows does duration equal maturity. This example also illustrates that while the maturities on the loan and the deposit are both one year (and thus the difference or gap in maturities is zero), the duration gap is negative:

M M

D D L D

L D

� � � �

� � � � �

1 1 0

.7326 1 .2674 years

As will become clearer, to measure and to hedge interest rate risk, the FI needs to manage its duration gap rather than its maturity gap.

Why is duration considered a more complete measure of an asset or liability’s interest rate sensitivity than maturity? When is the duration of an asset equal to its maturity?

1.

2.

Concept Questions

A GENERAL FORMULA FOR DURATION

You can calculate the duration (or Macauley’s duration4) for any fixed-income security that pays interest annually using the following general formula:

3 Since the CD is like an annual coupon bond, the annual discount rate is 1/(1 + R ) = 1/1.15.

4 Named after an economist who was among the first to develop the duration concept.

0 1 year

CF1 = $115PV1 = $100FIGURE 9–3 PV of the Cash Flows of the Deposit

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Chapter 9 Interest Rate Risk II 225

D CF DF t

CF DF

PV t

PV

t t t

N

t t t

N

t t

N

t t

�

� �

�

� �

�

�1

1

1 ∑

∑

∑ =

��1

N

∑

(1)

where

D = Duration measured in years CFt = Cash flow received on the security at end of period t

N = Last period in which the cash flow is received DFt = Discount factor = 1/(1 + R)t, where R is the annual yield or current level

of interest rates in the market

t

N

� 1 ∑ = Summation sign for addition of all terms from t = 1 to t = N

PVt = Present value of the cash flow at the end of the period t, which equals CFt × DFt

For bonds that pay interest semiannually, the duration equation becomes:5

D

CF t

R

CF

R

t t

t

N

t t

t

N �

�

�

�

�

�

( )

( )

1 2

1 2

2 1 2

2 1 2

∑

∑

(2)

where t = ½, 1, 1½, . . . , N. A key assumption of the simple Macauley duration model is that the yield curve

or the term structure of interest rates is flat and that when rates change, the yield curve shifts in a parallel fashion. Further, the simple duration equation assumes that the issuer of a security or the borrower of a loan pays the interest and princi- pal as promised, that is, the equation assumes no default risk. As we go through the theory and analysis of the duration model and interest rate risk in the body of the chapter, we use the simple Macauley duration model and these assumptions. In Appendix 9B, we relax these assumptions, allowing for something other than a flat yield curve and default risk. Relaxing these assumptions changes the formu- las in the body of the chapter slightly. However, the intuition and general trends remain the same as those seen in the body of the chapter.

Notice that the denominator of the duration equation is the present value of the cash flows on the security (which in an efficient market will be equal to the cur- rent market price). The numerator is the present value of each cash flow received on the security multiplied or weighted by the length of time required to receive the cash flow. To help you fully understand this formula, we next look at some examples. Table 9–1 summarizes duration and its features, which we illustrate in the examples.

5 In general, the duration equation is written as:

D

CF t

R m CF

R m

t mt

t m

N

t mt

t m

N �

�

�

�

�

�

( / )

( / )

/

/

1

1

1

1

∑

∑

where m = number of times per year interest is paid.

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226 Part Two Measuring Risk

The Duration of Interest-Bearing Bonds

Defi nition of Duration

1. The weighted-average time to maturity on a security. 2. The interest elasticity of a security’s price to small interest rate changes.

Features of Duration

1. Duration increases with the maturity of a fixed-income security, but at a decreasing rate.

2. Duration decreases as the yield on a security increases. 3. Duration decreases as the coupon or interest payment increases.

Risk Management with Duration

1. Duration is equal to the maturity of an immunized security. 2. Duration gap is used by FIs to measure and manage the interest rate risk

of an overall balance sheet.

TABLE 9–1 Duration: Definition and Features

t CFt DFt CFt × DFt CFt × DFt × t

1 2 3 4 5 6

80 80 80 80 80

1,080

0.9259 0.8573 0.7938 0.7350 0.6806 0.6302

74.07 68.59 63.51 58.80 54.45

680.58

74.07 137.18 190.53 235.20 272.25

4,083.48

1,000.00 4,992.71

D � � 4,992.71 1,000

4.993 years

TABLE 9–2 The Duration of a Six-Year Eurobond with 8 Percent Coupon and Yield

t CFt DFt CFt × DFt CFt × DFt × t

½ 1 1½ 2

40 40 40

1,040

.9434

.8900

.8396

.7921

37.74 35.60 33.58

823.78

18.87 35.60 50.37

1,647.56

930.70 1,752.40

D � � 1,752.40 930.70

1.883 years

TABLE 9–3 The Duration of a Two-Year U.S. Treasury Bond with 8 Percent Coupon and 12 Percent Yield

Eurobonds pay coupons annually. Suppose the annual coupon is 8 percent, the face value of the bond is $1,000, and the current yield to maturity (R) is also 8 percent. We show the calculation of its duration in Table 9–2.

As the calculation indicates, the duration or weighted-average time to maturity on this bond is 4.993 years. In other words, on a time value of money basis, the initial investment of $1,000 is recovered after 4.993 years. Between 4.993 years and maturity (6 years), the bond produces a profit or return to the investor.

EXAMPLE 9–1 The Duration of a Six-Year Eurobond

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Chapter 9 Interest Rate Risk II 227

U.S. Treasury bonds pay coupon interest semiannually. Suppose the annual coupon rate is 8 percent, the face value is $1,000, and the annual yield to maturity (R) is 12 percent. See Table 9–3 for the calculation of the duration of this bond.6 As the calculation indicates, the duration, or weighted-average time to maturity, on this bond is 1.883 years. Table 9–4 shows that if the annual coupon rate is lowered to 6 percent, duration rises to 1.909 years. Since 6 percent coupon payments are lower than 8 percent, it takes longer to recover the initial investment in the bond. In Table 9–5 duration is calculated for the original 8 percent bond, assuming that the yield to maturity increases to 16 percent. Now duration falls from 1.883 years (in Table 9–3) to 1.878 years. The higher the yield to maturity on the bond, the more the investor earns on reinvested coupons and the shorter the time needed to recover the initial investment. Finally, when the maturity on a bond decreases to 1 year (see Table 9–6), its duration falls to 0.980 year. Thus, the shorter the maturity on the bond, the more quickly the initial investment is recovered.

Next, we look at two other types of bonds that are useful in understanding duration.

6 Here we use the Treasury formula for discounting bonds with semiannual coupons: (1 + R /2) x where x is the number of semiannual coupon payments. Thus, at t = 1/2, the discount rate is (1.06), at t = 1 the discount rate is (1.06) 2 , and so on.

EXAMPLE 9–2 The Duration of a Two-Year U.S. Treasury Bond

t CFt DFt CFt × DFt CFt × DFt × t

½ 1 1½ 2

40 40 40

1,040

0.9259 0.8573 0.7938 0.7350

37.04 34.29 31.75

764.43

18.52 34.29 47.63

1,528.86

867.51 1,629.30

D � � 1,629.30 867.51

1.878 years

TABLE 9–5 Duration of a Two- Year U.S. Treasury Bond with 8 Percent Coupon and 16 Percent Yield

t CFt DFt CFt × DFt CFt × DFt × t

½ 1

40 1,040

0.9434 0.8900

37.74 925.60

18.87 925.60

963.34 944.47

D � � 944.47 963.34

0.980 year

TABLE 9–6 Duration of a One- Year U.S. Treasury Bond with 8 Percent Coupon and 12 Percent Yield

t CFt DFt CFt × DFt CFt × DFt × t

½ 1 1½ 2

30 30 30

1,030

0.9434 0.8900 0.8396 0.7921

28.30 26.70 25.19

815.86

14.15 26.70 37.78

1,631.71

896.05 1,710.34

D � � 1,710.34 896.05

1.909 years

TABLE 9–4 Duration of a Two- Year U.S. Treasury Bond with 6 Percent Coupon and 12 Percent Yield

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228 Part Two Measuring Risk

The Duration of a Zero-Coupon Bond The U.S. Treasury has created zero-coupon bonds that allow securities firms and other investors to strip individual coupons and the principal from regular Treasury bonds and sell them to investors as separate securities. Elsewhere, such as in the Eurobond markets, corporations have issued discount or zero-coupon bonds directly. U.S. T-bills and commercial paper usually are issued on a discount basis and are additional examples of discount bonds. These bonds sell at a discount from face value on issue, pay the face value (e.g., $1,000) on maturity, and have no intervening cash flows, such as coupon payments, between issue and maturity. The current price an investor is willing to pay for such a bond is equal to the pres- ent value of the single, fixed (face value) payment on the bond that is received on maturity (here, $1,000), or:

P R N

� �

1,000 (1 )

where R is the required annually compounded yield to maturity, N is the number of years to maturity, and P is the price. Because there are no intervening cash flows such as coupons between issue and maturity, the following must be true:

D MB B�

That is, the duration of a zero-coupon bond equals its maturity. Note that only for zero-coupon bonds are duration and maturity equal. Indeed, for any bond that pays some cash flows prior to maturity, its duration will always be less than its maturity.

The Duration of a Consol Bond (Perpetuities) Although consol bonds have yet to be issued in the United States, they are of theoretical interest in exploring the differences between maturity and duration. A consol bond pays a fixed coupon each year. The novel feature of this bond is that it never matures; that is, it is a perpetuity:

Mc � �

In fact, consol bonds that were issued by the British government in the 1890s to finance the Boer Wars in South Africa are still outstanding. However, while its maturity is theoretically infinity, the formula for the duration of a consol bond is:7

D Rc

� �1 1

where R is the required yield to maturity. Suppose that the yield curve implies R = 5 percent annually; then the duration of the consol bond would be:

Dc � � �1 1 05

21 .

years

7 For reasons of space, we do not provide a formal proof here. Interested readers might refer to G. Hawawini, “Controlling the Interest Rate Risk of Bonds: An Introduction to Duration Analysis and Immunization Strategies,” Financial Markets and Portfolio Management 1 (1986–87), pp. 8–18.

consol bond A bond that pays a fixed coupon each year forever.

consol bond A bond that pays a fixed coupon each year forever.

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Chapter 9 Interest Rate Risk II 229

Thus, while maturity is infinite, duration is finite. Specifically, on the basis of the time value of money, recovery of the initial investment on this perpetual bond takes 21 years. After 21 years, the bond produces profit for the bondholder. Moreover, as interest rates rise, the duration of the consol bond falls. Consider the 1979–82 period, when some yields rose to around 20 percent on long-term govern- ment bonds. Then:

Dc � � �1 1 2

6 .

years

What does the denominator of the duration equation measure? What does the numerator of the duration equation measure? Calculate the duration of a one-year, 8 percent coupon, 10 percent yield bond that pays coupons quarterly. What is the duration of a zero-coupon bond? What feature is unique about a consol bond compared with other bonds?

FEATURES OF DURATION

From the preceding examples, we derive three important features of duration relating to the maturity, yield, and coupon interest of the security being analyzed.

Duration and Maturity A comparison of Tables 9–6, 9–3, and 9–7 indicates that duration increases with the maturity of a fixed-income asset or liability, but at a decreasing rate:8

∂ ∂

∂ ∂

D M

D M

� �0 0 2

2

To see this, look at Figure 9–4, where we plot duration against maturity for a three- year, a two-year, and a one-year U.S. Treasury bond using the same yield of 12 per- cent for all three and assuming an annual coupon of 8 percent (with semiannual payments of 4 percent) on each bond. As the maturity of the bond increases from one year to two years (Tables 9–6 and 9–3), duration increases by 0.903 year, from 0.980 year to 1.883 years. Increasing maturity an additional year, from two years to three years (Tables 9–3 and 9–7), increases duration by 0.826, from 1.883 years to 2.709 years.

Duration and Yield A comparison of Tables 9–3 and 9–5 indicates that duration decreases as yield increases:

∂ ∂ D R

� 0

As the yield on the Treasury bond increased from 12 percent to 16 percent (Tables 9–3 and 9–5), the duration on the bond decreased from 1.883 years to 1.878 years. This makes sense intuitively because higher yields discount later cash flows more heavily and the relative importance, or weights, of those later cash flows decline when compared with earlier cash flows on an asset or liability.

8 This is the case for the vast majority of securities. It needs to be noted, however, that for bonds selling below par, duration increases at a decreasing rate up to a point. At long maturities (e.g., 50 years) dura- tion starts to decline. Few bonds in the market have a maturity long enough to see this decline.

1. 2. 3.

4. 5.

Concept Questions Concept Questions

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230 Part Two Measuring Risk

Duration and Coupon Interest A comparison of Tables 9–4 and 9–3 indicates that the higher the coupon or prom- ised interest payment on the security, the lower its duration:

∂ ∂ D C

� 0

As the coupon rate on the U.S. Treasury bond increased from 6 percent to 8 per- cent in Tables 9–4 and 9–3, the duration on the bond decreased from 1.909 years to 1.883 years. This is due to the fact that the larger the coupons or promised interest payments, the more quickly cash flows are received by investors and the higher are the present value weights of those cash flows in the duration calculation. On a time value of money basis, the investor recoups the initial investment faster when coupon payments are larger.

Which has the longest duration, a 30-year, 8 percent, zero-coupon or discount bond or an 8 percent infinite maturity consol bond? What is the relationship between duration and yield to maturity on a financial security? Do high-coupon bonds have high or low durations?

THE ECONOMIC MEANING OF DURATION

So far we have calculated duration for a number of different fixed-income assets and liabilities. Now we are ready to make the direct link between the number measured in years we call duration and the interest rate sensitivity of an asset or liability or of an FI’s entire portfolio.

1.

2. 3.

Concept Questions Concept Questions

t CFt DFt CFt × DFt CFt × DFt × t

½ 1 1½ 2 2½ 3

40 40 40 40 40

1,040

0.9434 0.8900 0.8396 0.7921 0.7473 0.7050

37.74 35.60 33.58 31.68 29.89

733.16

18.87 35.60 50.37 63.36 74.72

2,199.48

901.65 2,442.40

D � � 2,442.40 901.65

2.709 years

TABLE 9–7 Duration of a Three-Year U.S. Treasury Bond with 8 Percent Coupon and 12 Percent Yield (Coupon Interest Paid Semiannually)

Duration

2.709 years

1.883 years

0.980 year

1 year 2 years 3 years Maturity ∞

FIGURE 9–4 Duration versus Maturity

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Chapter 9 Interest Rate Risk II 231

In addition to being a measure of the average life, in a cash flow sense, of an asset or liability, duration is also a direct measure of the interest rate sensitivity, or elasticity, of an asset or liability. In other words, the larger the numerical value of D, the more sensitive the price of that asset or liability is to changes or shocks in interest rates.

Consider the following equation showing that the current price of a bond that pays interest annually is equal to the present value of the coupons and principal payment on the bond:

P

C R

C R

C F R N

� �

� �

� � �

�( ) ( ) ( )1 1 12 �

(3)

where P = Price on the bond C = Coupon or interest payment (annual) R = Yield to maturity N = Number of periods to maturity F = Face value of the bond

We want to find out how the price of the bond (P) changes when yields (R) rise. We know that bond prices fall, but we want to derive a direct measure of the size of this fall (i.e., its degree of price sensitivity).

Taking the derivative of the bond’s price (P) with respect to the yield to matu- rity (R), we can show that:9

9 The first derivative of the bond’s price in equation (3) with respect to the yield to maturity ( R ) is:

dP dR

C

R

C

R

N C F

R N �

�

� �

�

� � �

� �

� �( ) ( )

( )

( )1

2

1 12 3 1 �

By rearranging, we get:

dP dR R

C R

C

R

N C F

R N � �

� � �

� � �

�

�

1 1 1

2

1 12( ) ( )

( )

( ) �



 



 

(A)

We have shown that duration ( D ) is the weighted-average time to maturity using the present value of cash flows as weights; that is, by definition:

D

C R

C

R N

C F

R C

R

N

�

� �

� � �

� � � �

�

� �

1 1

2 1 1

1

2( ) ( )

( )

( )

( )

�

CC

R

C F

R N( )

( )

( )1 12� � �

�

� �

Since the denominator of the duration equation is simply the price ( P ) of the bond that is equal to the present value of the cash flows on the bond, then:

D

C R

C

R N

C F

R P

N

�

� �

� � �

� � � �

� 1

1 2

1 12( ) ( )

( )

( ) �

Multiplying both sides of this equation by P , we get:

P D

C R

C

R N

C F

R N � � �

� � �

� � � �

�

� 1

1 2

1 12( ) ( ) ( ) �

(B)

The term on the right side of equation (B) is the same term as that in square brackets in equation (A). Substituting equation (B) into equation (A), we get:

dP dR R

P D� � �

� 1

1 [ ]

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232 Part Two Measuring Risk

dP dR R

P D� � �

� 1

1 ( )

By cross multiplying: dP dR

R P

D� �

� � 1

or, alternatively, and recognizing that interest rate changes tend to be discrete:10

�

�

P P R

R

D

( )1 �

� �

(4)

The economic interpretation of equation (4) is that the number D is the interest elasticity, or sensitivity, of the security’s price to small interest rate changes. That is, D describes the percentage price fall of the bond (�P/P) for any given (present value) increase in required interest rates or yields (�R/(1 + R)).

Equation (4) can be rearranged in another useful way for interpretation regard- ing interest sensitivity. That is, the percentage change in the price of a bond for a change in interest rates can be written as:

� �P P

D R

R � �

�1  

 

(5)

Equation (5) and Figure 9–5, its graphic representation, show that for small changes in interest rates, bond prices move in an inversely proportional fashion according to the size of D. Clearly, for any given change in interest rates, long duration securities suffer a larger capital loss (or receive a higher capital gain) should interest rates rise (fall) than do short-duration securities. By implication, gains and losses under the duration model are symmetric. That is, if we repeated the above examples but allowed interest rates to decrease by one basis point annu- ally (or 1/2 basis point semiannually), the percentage increase in the price of the bond (�P/P) would be proportionate with D. Further, the capital gains would be a mirror image of the capital losses for an equal (small) increase in interest rates.

The duration equation can be rearranged, combining D and (1 + R) into a single variable D/(1 + R), to produce what practitioners call modified duration (MD). For annual compounding of interest:

�P P

MD dR� �

where

MD D

R �

�1

This form is more intuitive because we multiply MD by the simple change in inter- est rates rather than the discounted change in interest rates as in the general dura- tion equation. Next, we use duration to measure the interest sensitivity of an asset or liability.

10 In what follows, we use the � (change) notation instead of d (derivative notation) to recognize that in- terest rate changes tend to be discrete rather than infinitesimally small. For example, in real-world finan- cial markets, the smallest observed rate change is usually one basis point, or 1/100th of 1 percent.

interest elasticity The percentage change in the price of a bond for any given change in interest rates.

interest elasticity The percentage change in the price of a bond for any given change in interest rates.

modified duration Duration divided by 1 plus the interest rate.

modified duration Duration divided by 1 plus the interest rate.

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Chapter 9 Interest Rate Risk II 233

EXAMPLE 9–3 The Six-Year Eurobond

Consider Example 9–1 for the six-year Eurobond with an 8 percent coupon and 8 percent yield. We determined in Table 9–2 that its duration was approximately D = 4.993 years. Suppose that yields were to rise by one basis point (1/100th of 1 percent) from 8 to 8.01 percent. Then:

�P P

� �

� � �

( . ) .

.

.

4 993 0001 1 08

000462

 

 

or 0.04462%

The bond price had been $1,000, which was the present value of a six-year bond with 8 percent coupons and 8 percent yield. However, the duration model predicts that the price of the bond would fall to $999.538 after the increase in yield by one basis point. That is, the price would fall by .0462 percent, or by $0.462.11

Consider a consol bond with an 8 percent coupon paid annually, an 8 percent yield, and a calculated duration of 13.5 years (Dc � 1 � 1/.08 � 13.5). Thus, for a one-basis-point change in the yield (from 8 percent to 8.01 percent):

�P P

� �

� � �

( . ) .

.

.

13 5 0001 1 08

00125

 

 

or 0.1255%

EXAMPLE 9–4 The Consol Bond

As you can see, for any given change in yields, long-duration securities suffer a greater capital loss or receive a greater capital gain than do short-duration securities.

Semiannual Coupon Bonds For fixed-income assets or liabilities whose interest payments are received semi- annually or more frequently than annually, the formula in equation (5) has to be modified slightly. For semiannual payments the percentage change in the price of a bond for a change in interest rates is:

� �P P

D R

R � �

�1 12



 



 

(6)

The only difference between equation (6) and equation (5) is the introduction of a ½ in the discount rate term 1 + ½R to take into account the semiannual payments of interest.

11 To calculate the dollar change in value, we can rewrite the equation as �P = ( P )(– D )[�R /( 1 + R )] = ($1,000)(–4.993)(.0001/1.08) = –$0.462.

–D

Price changes

dP P

Yield changes [dR /(1+R )]

FIGURE 9–5 Proportional Relationship between Price Changes and Yield Changes on a Bond Implied by the Duration Model

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234 Part Two Measuring Risk

EXAMPLE 9–5 Semiannual Coupon, Two- Year Maturity Treasury Bonds

Recall from Example 9–2 the two-year T-bond with semiannual coupons whose duration we derived in Table 9–3 as 1.883 years when annual yields were 12 percent. A one-basis-point rise in interest rates would have the following predicted effect on its price:

�P P

� �

� �

1 883 0001 1 06

000178

. .

.

.

 

 

or the price of the bond would fall by 0.0178 percent from $930.70 to $930.53. That is, a price fall of 0.0178 percent in this case translates into a dollar fall of $0.17.12

What is the relation between the duration of a bond and the interest elasticity of a bond? How would the formula in equation (6) have to be modified to take into account quar- terly coupon payments and monthly coupon payments?

DURATION AND INTEREST RATE RISK

So far, you have learned how to calculate duration and you understand that the duration measure has economic meaning because it indicates the interest sensitiv- ity, or elasticity, of an asset or liability’s value. For FIs, the major relevance of dura- tion is as a measure for managing interest rate risk exposure. Also important is the role of duration in allowing the FI to reduce and even eliminate interest rate risk on its balance sheet or some subset of that balance sheet. In the following sections we consider two examples of how FIs can use the duration measure to manage interest rate risk. The first is its use by insurance company and pension fund man- agers to help meet promised cash flow payments to policyholders or beneficiaries at a particular time in the future. The second is its use to reduce or immunize the whole balance sheet of an FI against interest rate risk.

Duration and Interest Rate Risk Management on a Single Security Frequently, pension fund and life insurance company managers face the problem of structuring their asset investments so they can pay out a given cash amount to policyholders in some future period. The classic example of this is an insurance policy that pays the holder some lump sum on reaching retirement age. The risk to the life insurance company manager is that interest rates on the funds generated from investing the holder’s premiums could fall. Thus, the accumulated returns on the premiums invested could not meet the target or promised amount. In effect, the insurance company would be forced to draw down its reserves and net worth to meet its payout commitments. (See Chapter 3 for a discussion of this risk.)

Suppose that we are in 2010 and the insurer has to make a guaranteed payment to a policyholder in five years, 2015. For simplicity, we assume that this target guaranteed payment is $1,469, a lump-sum policy payout on retirement, equivalent to investing $1,000 at an annually compounded rate of 8 percent over

12 To calculate the dollar change in value, we can rewrite the equation as � P = ( P )(− D )[� R /(1 + R /2)] = ($930.70)(−1.883)(.0001/1.06) = −$0.17.

1.

2.

Concept Questions Concept Questions

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Chapter 9 Interest Rate Risk II 235

EXAMPLE 9–6 Interest Rates Remain at 8 Percent

five years. Of course, realistically, this payment would be much larger, but the underlying principles of the example do not change by scaling up or down the payout amount.

To immunize, or protect, itself against interest rate risk, the insurer needs to determine which investments would produce a cash flow of exactly $1,469 in five years regardless of what happens to interest rates in the immediate future. The FI investing either in a five-year maturity and duration zero-coupon bond or in a coupon bond with a five-year duration would produce a $1,469 cash flow in five years no matter what happened to interest rates in the immediate future. Next, we consider the two strategies: buying five-year maturity (and duration) deep- discount bonds and buying five-year duration coupon bonds.

Buy Five-Year Maturity Discount Bonds Given a $1,000 face value and an 8 percent yield and assuming annual compound- ing, the current price per five-year discount bond would be $680.58 per bond:

P � �680.58 1,000

(1.08)5

If the insurer bought 1.469 of these bonds at a total cost of $1,000 in 2010, these investments would produce exactly $1,469 on maturity in five years ($1,000 � (1.08)5 = $1,469). The reason is that the duration of this bond portfolio exactly matches the target horizon for the insurer’s future liability to its policyholder. Intuitively, since no intervening cash flows or coupons are paid by the issuer of the zero-coupon discount bonds, future changes in interest rates have no reinvest- ment income effect. Thus, the return would be unaffected by intervening interest rate changes.

Suppose no five-year discount bonds exist. Then the portfolio manager may seek to invest in appropriate duration coupon bonds to hedge interest rate risk. In this example the appropriate investment would be in five-year duration coupon bearing bonds.

Buy a Five-Year Duration Coupon Bond We demonstrated earlier in Table 9–2 that a six-year maturity Eurobond paying 8 percent coupons with an 8 percent yield to maturity had a duration of 4.993 years, or approximately five years. If we buy this six-year maturity, five-year duration bond in 2010 and hold it for five years, until 2015, the term exactly matches the target horizon of the insurer. The cash flows generated at the end of five years will be $1,469 whether interest rates stay at 8 percent or instantaneously (immediately) rise to 9 percent or fall to 7 percent. Thus, buying a coupon bond whose duration exactly matches the time horizon of the insurer also immunizes the insurer against interest rate changes.

The cash flows received by the insurer on the bond if interest rates stay at 8 percent through- out the five years would be

Coupons, 5 × $80 $ 400 Reinvestment income 69 Proceeds from sale of bond at end of fifth year 1,000 $1,469

(continued)

1. 2. 3.

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236 Part Two Measuring Risk

We EXAMPLE 9–6 (continued)

calculate each of the three components of the insurer’s income from the bond investment as follows:

Coupons. The $400 from coupons is simply the annual coupon of $80 received in each of the five years. Reinvestment income. Because the coupons are received annually, they can be reinvested at 8 percent as they are received, generating an additional cash flow of $69.13

Bond sale proceeds. The proceeds from the sale are calculated by recognizing that the six year bond has just one year left to maturity when it is sold by the insurance company at the end of the fifth year. That is:

What fair market price can the insurer expect to get when selling the bond at the end of the fifth year with one year left to maturity? A buyer would be willing to pay the present value of the $1,080—final coupon plus face value—to be received at the end of the one remaining year (i.e., in 2016), or:

P5 1080 1 08

1000� � , .

$ ,

Thus, the insurer would be able to sell the one remaining cash flow of $1,080, to be received in the bond’s final year, for $1,000.

Next, we show that since this bond has a duration of five years, matching the insurer’s target period, even if interest rates were to instantaneously fall to 7 per- cent or rise to 9 percent, the expected cash flows from the bond would still exactly sum to $1,469. That is, the coupons + reinvestment income + principal at the end of the fifth year would be immunized. In other words, the cash flows on the bond are protected against interest rate changes.

13 Receiving annual coupons of $80 is equivalent to receiving an annuity of $80. There are tables and formulas that help us calculate the value of $1 received each year over a given number of years that can be reinvested at a given interest rate. The appropriate terminal value of receiving $1 a year for five years and reinvesting at 8 percent can be determined from the Future Value of an Annuity Factor (FVAF) Tables, whose general formula is:

FVAF

R Rn R

n

,

( ) �

� �1 1

 



 

In our example:

FVAF5

51 08 1 08

5 867, ( . )

. .8% �

� � �



 



 

Thus, the reinvestment income for $80 of coupons per year is:

Reinvestment income (80 5.867) 400 469 400� � � � � � 669

Note that we take away $400 since we have already counted the simple coupon income (5 × $80).

1.

2.

3.

↓ Sell

Year 5 (2015)

Year 6 (2016)

$1,080↓ Sell

Year 5 (2015)

Year 6 (2016)

$1,080

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Chapter 9 Interest Rate Risk II 237

EXAMPLE 9–7 Interest Rates Fall to 7 Percent

In this example with falling interest rates, the cash flows over the five years would be:

Coupons, 5 × $80 $ 400 Reinvestment income 60 Bond sale proceeds 1,009 $1,469

The total proceeds over the five years are unchanged from what they were when interest rates were 8 percent. To see why this occurs, consider what happens to the three parts of the cash flow when rates fall to 7 percent:

Coupons. Are unchanged since the insurer still gets five annual coupons of $80 � $400. Reinvestment income. The coupons can now be reinvested only at the lower rate of 7 percent. Reinvestment income is only $60.14

Bond sale proceeds. When the six-year maturity bond is sold at the end of the fifth year with one cash flow of $1,080 remaining, investors are now willing to pay more:

P5 � � 1,080 1.07

1,009

That is, the bond can be sold for $9 more than it could have when rates were 8 percent. The reason for this is that investors can get only 7 percent on newly issued bonds, while this older bond was issued with a higher coupon of 8 percent.

A comparison of reinvestment income with bond sale proceeds indicates that the fall in rates has produced a gain on the bond sale proceeds of $9. This exactly offsets the loss of reinvestment income of $9 due to reinvesting at a lower interest rate. Thus, total cash flows remain unchanged at $1,469.

In this example with rising interest rates, the proceeds from the bond investment are:

Coupons, 5 × $80 $ 400 Reinvestment income [(5.985 × 80) − 400] 78 Bond sale proceeds (1,080/1.09) 991

$1,469

Notice that the rise in interest rates from 8 percent to 9 percent leaves the final terminal cash flow unaffected at $1,469. The rise in rates has generated $9 extra reinvestment income ($78 – $69), but the price at which the bond can be sold at the end of the fifth year has declined from $1,000 to $991, equal to a capital loss of $9. Thus, the gain in reinvestment income is exactly offset by the capital loss on the sale of the bond.

1. 2. 3.

EXAMPLE 9–8 Interest Rates Rise to 9 Percent

14 This reinvestment income is calculated as follows.

FVAF5 1

07 5 751, . .7%

5(1 .07) �

� � �



 



 

Reinvestment income = (5.751 × 80) − 400 = 60, which is $9 less than it was when rates were 8 percent.

1. 2. 3.

1. 2.

3.

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238 Part Two Measuring Risk

These examples demonstrate that matching the duration of a coupon bond— or any other fixed–interest rate instrument, such as a loan or mortgage—to the FI’s target or investment horizon immunizes the FI against instantaneous shocks to interest rates. The gains or losses on reinvestment income that result from an interest rate change are exactly offset by losses or gains from the bond proceeds on sale.

Duration and Interest Rate Risk Management on the Whole Balance Sheet of an FI So far we have looked at the durations of individual instruments and ways to select individual fixed-income securities to protect FIs such as life insurance com- panies and pensions funds with precommitted liabilities such as future pension plan payouts. The duration model can also evaluate the overall interest rate expo- sure for an FI, that is, measure the duration gap on its balance sheet.

The Duration Gap for a Financial Institution To estimate the overall duration gap of an FI, we determine first the duration of an FI’s asset portfolio (A) and the duration of its liability portfolio (L). These can be calculated as:

D X D X D X DA A A

A A

nA n A� � � �1 1 2 2 �

and

D X D X D X DL L L

L L

nL n L� � � �1 1 2 2 �

where

X X X j A Lj j nj1 2 1� � � � �� and ,

The Xij’s in the equation are the market value proportions of each asset or liability held in the respective asset and liability portfolios. Thus, if new 30-year Treasury bonds were 1 percent of a life insurer’s portfolio and DA1

(the duration of those bonds) was equal to 9.25 years, then X DA

A 1 1 = .01(9.25) = 0.0925. More

simply, the duration of a portfolio of assets or liabilities is a market value weighted average of the individual durations of the assets or liabilities on the FI’s balance sheet.15

Consider an FI’s simplified market value balance sheet:

Assets ($) Liabilities ($)

A = 100 L = 90

E = 10

100 100

15 This derivation of an FI’s duration gap closely follows G. Kaufman, “Measuring and Managing Interest Rate Risk: A Primer,” Federal Reserve Bank of Chicago, Economic Perspectives, 1984, pp. 16–29.

duration gap A measure of overall interest rate risk expo- sure for an FI.

duration gap A measure of overall interest rate risk expo- sure for an FI.

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Chapter 9 Interest Rate Risk II 239

From the balance sheet:

A L E� �

and

� � �A L E� �

or

� � �E A L� �

That is, when interest rates change, the change in the FI’s equity or net worth (E) is equal to the difference between the change in the market values of assets and liabilities on each side of the balance sheet.

Since �E = �A � �L, we need to determine how �A and �L—the changes in the market values of assets and liabilities on the balance sheet—are related to duration.

From the duration model (assuming annual compounding of interest):

� �

� �

A A

D R

R L

L D

R R

A

L

� � �

� � �

( )

( )

1

1

Here we have simply substituted �A/A or �L/L, the percentage change in the market values of assets or liabilities, for �P/P, the percentage change in any single bond’s price and DA or DL , the duration of the FI’s asset or liability portfolio, for Di , the duration on any given bond, deposit, or loan. The term �R/(1 + R) reflects the shock to interest rates as before.16 These equations can be rewritten to show the dollar changes in assets and liabilities on an FI’s balance sheet:

�

� A D A

R RA

� � � � �( )1

(7)

and

�

� L D L

R RL

� � � � �( )1

(8)

16 We assume that the level of rates and the expected shock to interest rates are the same for both assets and liabilities, which means that the FI’s spread (the difference between the rate on earning assets and interest-bearing liabilities) is zero. However, as long as the FI has more earning assets than interest bear- ing liabilities, it will have a positive level for net interest income. This assumption is standard in Macauley duration analysis. While restrictive, this assumption can be relaxed. However, if this is done, the duration measure changes, as is discussed later in Appendix 9B to this chapter.

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240 Part Two Measuring Risk

We can substitute these two expressions into the equation �E = �A− �L. Rearranging and combining this equation17 results in a measure of the change in the market value of equity on an FI’s balance sheet for a change in interest rates:

�

� E D D k A

R RA L

� � � � � �

[ ] 1

(9)

where k = L/A is a measure of the FI’s leverage, that is, the amount of borrowed funds or liabilities rather than owners’ equity used to fund its asset portfolio. The effect of interest rate changes on the market value of an FI’s equity or net worth (�E) breaks down into three effects:

The leverage adjusted duration gap = [DA − DLk]. This gap is measured in years and reflects the degree of duration mismatch in an FI’s balance sheet. Specifi- cally, the larger this gap is in absolute terms, the more exposed the FI is to interest rate shocks. The size of the FI. The term A measures the size of the FI’s assets. The larger the scale of the FI, the larger the dollar size of the potential net worth exposure from any given interest rate shock. The size of the interest rate shock = �R/(1 + R). The larger the shock, the greater the FI’s exposure.

Given this, we express the exposure of the net worth of the FI as:

�E � � �[Leverage adjusted duration gap] Asset size Interest rate shock�

Interest rate shocks are largely external to the FI and often result from changes in the Federal Reserve’s monetary policy (as discussed in the first section of Chapter 8). The size of the duration gap and the size of the FI, however, are under the control of management. The Industry Perspectives box highlights how Fannie Mae lowered its duration gap to near zero in August 2006 as the Federal Reserve left interest rates unchanged for the first time in two years.18

Equation (9) and the duration model provide an FI manager with a benchmark measure of the FI’s performance for various interest rate changes and therefore the

17 We do this as follows:

�

� � E D A

R R

D L R RA L

� � � � �

� � � � �( ) ( )1 1

 

 

 

 

Assuming that the level of rates and the expected shock to interest rates are the same for both assets and liabilities:

�

� E D A D L

R RA L

� � � �

[ ] ( )1

or

�

� E D A D L

R RA L

� � � �

[ ] ( )1

To rearrange the equation in a slightly more intuitive fashion, we multiply and divide both D A A and D L L by A (assets):

� �

�

E D A A

D L A

A R R

E D D k

A L

A L

� � � � � �

� � �

 

  ( )

[ ]

1

or �� � �

A R R

�

( )1 18 We discuss the role of Fannie Mae on the U.S. economy and, specifically, the mortgage markets in Chapter 26. Very simply, Fannie Mae and Freddie Mac are government-sponsored agencies that have been critical for the smooth and liquid operations of the secondary mortgage markets.

1.

2.

3.

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Chapter 9 Interest Rate Risk II 241

extent to which the FI is exposed to interest rate risk. If, for an expected change in interest rates, managers find the change in equity will be small or negative, the duration model can be used to identify changes needed on or off the FI’s bal- ance sheet to reduce or even immunize the FI against interest rate risk. Using an example, the next section explains how a manager can use information on an FI’s duration gap to restructure the balance sheet to limit losses in even immunize stockholders’ net worth against interest rate risk (i.e., to set the balance sheet up before a change in interest rates, so that �E is nonnegative for an expected change in interest rates). Chapters 23 through 25 look at ways a manager can use the dura- tion gap to take off-balance-sheet positions in derivative securities to reduce or immunize the FI against interest rate risk.

EXAMPLE 9–9 Duration Gap Measurement and Exposure

Suppose the FI manager calculates that: D

D A

L

�

�

5 years

3 years

Then the manager learns from an economic forecasting unit that rates are expected to rise from 10 percent to 11 percent in the immediate future; that is:

�R

R

� �

� �

1 01

1 1 10

% .

.

The FI’s initial balance sheet is assumed to be:

Assets ($ millions) Liabilities ($ millions)

A = 100 L = 90

E = 10

100 100

The FI’s manager calculates the potential loss to equity holders’ net worth (E) if the forecast of rising rates proves true as follows:

� �

E D kD A R RA L

� � � � � �

� � � �

( ) ( )

( (. )( )) $

1

5 9 3 100 milllion .01 1.1

million� � �$ .2 09

The FI could lose $2.09 million in net worth if rates rise 1 percent. Since the FI started with $10 million in equity, the loss of $2.09 million is almost 21 percent of its initial net worth. The market value balance sheet after the rise in rates by 1 percent would look like this:19

Assets ($ millions) Liabilities ($ millions)

A = 95.45 L = 87.54 E = 7.91

95.45 95.45

19 These values are calculated as follows:

�A A � � � � � �

� �

5 01 1 1 04545 4 545

100 04545

(. . ) . . %

( . )1100 95 45� . and

�L L � � � � � �

� �

3 011 1 02727 2 727

90 02727 9

(. . ) . . %

( . ) 00 87 54� .

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242 Part Two Measuring Risk

Even though the rise in interest rates would not push the FI into economic insol- vency, it reduces the FI’s net worth-to-assets ratio from 10 (10/100) to 8.29 percent (7.91/95.45). To counter this effect, the manager might reduce the FI’s adjusted duration gap. In an extreme case, the gap might be reduced to zero:

� �E A R R� � � � � �[ ] ( )0 1 0

To do this, the FI should not directly set DA = DL , which ignores the fact that the FI’s assets (A) do not equal its borrowed liabilities (L) and that k (which reflects the ratio L/A) is not equal to 1. To see the importance of factoring in leverage, suppose the manager increased the duration of the FI’s liabilities to five years, the same as DA. Then:

�E � � � � � � �[ (. )( )] $5 9 5 100 million (.01/1.1) $0.445 million

The FI is still exposed to a loss of $0.45 million if rates rise by 1 percent. An appro- priate strategy would involve changing DL until:

D kDA L� � 5 years

For example,

�E � � � � � �[5 (.9)5.55] $100 million (.01/1.1) 0

In this case the FI manager sets DL = 5.55 years, or slightly longer than DA = 5 years, to compensate for the fact that only 90 percent of assets are funded by borrowed liabilities, with the other 10 percent funded by equity. Note that the

Industry Perspectives

MUDD DEFENDS PORTFOLIO ROLE Fannie Mae CEO Daniel Mudd strongly defended the company’s retained portfolio business in a con- ference call last week, saying that interest rate risk is low and the portfolio helps stabilize the U.S. mort- gage market. He said Fannie Mae’s duration gap, a key measure of interest rate risk exposure in the portfolio, was currently at zero months. He said the duration gap has remained in the range of plus or minus one month so far during his tenure at the mortgage secondary market giant. “I don’t expect duration to remain this low forever,” he added dur- ing a conference call hosted by UBS.

Mr. Mudd said Fannie Mae’s work to keep inter- est rate risk low, “is not an accident,” adding that

both the company’s board and its regulator con- stantly monitor its risk exposure. . . . He said Fannie Mae’s portfolio business helps add stability and li- quidity to the housing finance system, since it allows Fannie Mae to step into the market and purchase mortgages when demand from other investors slows down. “I’m pleased that our fixed-income securities remain strong. Both U.S. and foreign investors con- tinue to invest their funds in the U.S. housing mar- ket,” he said. “It’s knowing that the capital is there in bad times as well as good times that gives the U.S. mortgage market its stability.”

Source: Mortgage Servicing News, August 2006, p. 17.

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Chapter 9 Interest Rate Risk II 243

FI manager has at least three other ways to reduce the adjusted duration gap to zero:

Reduce DA. Reduce DA from 5 years to 2.7 years (equal to kDL or (.9)3) such that:

[ ] [ . (. )( )]D kDA L� � � �2 7 9 3 0

Reduce DA and increase DL. Shorten the duration of assets and lengthen the dura- tion of liabilities at the same time. One possibility would be to reduce DA to 4 years and to increase DL to 4.44 years such that:

[ ] [4 (.9)(4.44)] 0D kDA L� � � �

Change k and DL. Increase k (leverage) from .9 to .95 and increase DL from 3 years to 5.26 years such that:

[ ] [5 (.95)(5.26)] 0D kDA L� � � �

Refer to the example of the insurer in Examples 9–6 through 9–8. Suppose rates fell to 6 percent. Would the FI’s portfolio still be immunized? What if rates rose to 10 percent? How is the overall duration gap for an FI calculated? How can a manager use information on an FI’s duration gap to restructure, and thereby immunize, the balance sheet against interest rate risk? Suppose DA = 3 years, DL = 6 years, k = .8, and A = $100million. What is the effect on owners’ net worth if �R/(1 + R) rises 1 percent? (�E = $1,800,000)

IMMUNIZATION AND REGULATORY CONSIDERATIONS

In the above section we assumed that the FI manager wants to structure the duration of assets and liabilities to immunize the equity or net worth stake (E) of the FI’s equity owners from interest rate shocks. However, regulators peri- odically monitor the solvency or capital position of FIs. As we discuss in greater detail in Chapter 20 on capital adequacy, regulators set minimum target ratios for an FI’s capital (or net worth) to assets. The simplest is the ratio of FI capital to its assets, or:

E A

� Capital (net worth) ratio

While this target has normally been formulated in book value accounting terms for depository institutions, it is evaluated in a market value context for investment banks. Also, the SEC has long advocated a capital ratio based on market value accounting for U.S. depository institutions.

Given these regulations imposed on the minimum level of the capital ratio, if an FI’s asset levels change significantly through time, FI managers may be most inter- ested in immunizing against changes in the capital ratio (�(E/A)) due to interest

1.

2.

3.

1.

2. 3.

4.

Concept Questions Concept Questions

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244 Part Two Measuring Risk

rate risk rather than changes in the level of capital (�E). For example, suppose the FI manager is close to the minimum regulatory required E/A (or capital) ratio (e.g., 4 percent for depository institutions) and wants to immunize the FI against any fall in this ratio if interest rates rise.20 That is, the immunization target is no longer �E = 0 when rates change but �(E/A) = 0.

Obviously, immunizing �E against interest rate risk cannot result in the same management strategy as immunizing �(E/A). A portfolio constructed to immu- nize �E would have a different duration match from that required to immunize �(E/A). Or, more simply, the manager could satisfy either the FI’s stockholders or the regulators but not both simultaneously. More specifically, when the objective is to immunize equity capital against interest rate risk, that is, to set �E = 0, the FI manager should structure the balance sheet so that the leverage adjusted duration gap is zero:

�E D kDA L� � �0

or set

D kDA L�

By comparison, to immunize the capital ratio, that is, to set �(E/A) = 0 the manager needs to set:21

D DA L�

In this scenario, the leverage adjustment effect (k) drops out. If DA = 5, then immu- nizing the capital ratio would require setting DL = 5.

What minimum target ratio is typically used by regulators to measure a bank’s net worth relative to its assets? Is immunizing a bank’s net worth the same as immunizing its net worth–assets ratio? If not, why not?

In the next section, we analyze weaknesses of the duration model. Specifically, there are several practical problems in estimating duration and duration gaps for real-world FIs.

DIFFICULTIES IN APPLYING THE DURATION MODEL

Critics of the duration model have often claimed that it is difficult to apply in realworld situations. However, duration measures and immunization strategies are useful in most real-world situations. In fact, the model used by the Bank for International Settlements to monitor bank interest rate risk taking is based heav- ily on the duration model. In this section, we look at the various criticisms of the duration model and discuss ways a modern FI manager would deal with them in practice. In Appendix 9B to the chapter, we present some of the more advanced issues associated with these weaknesses. 20 In actuality, depository institutions face three required minimum capital ratios. The 4 percent rule used in this example is for the leverage ratio (see Chapter 20 for more details).

21 See Kaufman, “Measuring and Managing Interest Rate Risk: A Primer,” for a proof.

1.

2.

Concept Questions Concept Questions

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Chapter 9 Interest Rate Risk II 245

Duration Matching Can Be Costly Critics charge that although in principle an FI manager can change DA and DL to immunize the FI against interest rate risk, restructuring the balance sheet of a large and complex FI can be both time-consuming and costly. While this argument may have been true historically, the growth of purchased funds, asset securitiza- tion, and loan sales markets has considerably eased the speed and lowered the transaction costs of major balance sheet restructurings. (See Chapters 26 and 27 for a discussion of these strategies.) Moreover, an FI manager could still manage risk exposure using the duration model by employing techniques other than direct portfolio rebalancing to immunize against interest rate risk. Managers can get many of the same results of direct duration matching by taking hedging positions in the markets for derivative securities, such as futures and forwards (Chapter 23); options, caps, floors, and collars (Chapter 24); and swaps (Chapter 25).22

Immunization Is a Dynamic Problem Immunization is an aspect of the duration model that is not well understood. Let’s go back to the earlier immunization example in which an insurer sought to buy bonds to provide an accumulated cash flow of $1,469 in five years no matter what hap- pened to interest rates. We showed that buying a six-year maturity, 8 percent cou- pon bond with a five-year duration immunizes the insurer against an instantaneous change in interest rates. The word instantaneous is very important here; it means a change in interest rates immediately after purchasing the bond. However, interest rates can change at any time over the holding period. Further, the duration of a bond changes as time passes, that is, as it approaches maturity or the target horizon date. In addition, duration changes at a different rate than does real or calendar time.

To understand this time effect, consider the initially hedged position in which the insurer bought the five-year duration (six-year maturity), 8 percent coupon bond in 2010 to match its cash flow target of $1,469 in 2015. Suppose the FI man- ager puts the bond in the bottom drawer of a desk and does not think about it for a year, believing that the insurance company’s position is fully hedged. After one year has passed (in 2011), suppose interest rates (yields) have fallen from 8 percent to 7 percent and the manager opens the drawer of the desk and finds the bond. Knowing the target date is now only four years away, the manager recalculates the duration of the bond. Imagine the manager’s shock on finding that the same 8 percent coupon bond with a 7 percent yield and only five years left to maturity has a duration of 4.33 years. This means the insurance company is no longer hedged; the 4.33-year duration of this bond portfolio exceeds the investment horizon of four years. As a result, the manager has to restructure the bond portfolio to remain immunized. One way to do this is to sell some of the five-year bonds (4.33-year duration) and buy some bonds of shorter duration so that the overall duration of the investment portfolio is four years.

For example, suppose the insurer sold 50 percent of the five-year bonds with a 4.33-year duration and invested the proceeds in 3.67-year duration and matu- rity zero-coupon bonds. Because duration and maturity are the same for discount bonds, the duration of the asset portfolio is:

DA � � � � �[4.33 .5] [3.67 .5] 4 years

22 In particular, instead of direct immunization of a positive duration gap ( D A > D L ), an FI manager could sell futures (forwards), take the fixed-rate side of an interest rate swap, buy put options on bonds, and/or buy an interest rate cap.

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246 Part Two Measuring Risk

This simple example demonstrates that immunization based on duration is a dynamic strategy. In theory, the strategy requires the portfolio manager to rebal- ance the portfolio continuously to ensure that the duration of the investment portfolio exactly matches the investment horizon (i.e., the duration of liabilities). Because continuous rebalancing may not be easy to do and involves costly trans- action fees, most portfolio managers seek to be only approximately dynamically immunized against interest rate changes by rebalancing at discrete intervals, such as quarterly. That is, there is a trade-off between being perfectly immunized and the transaction costs of maintaining an immunized balance sheet dynamically.

Large Interest Rate Changes and Convexity Duration accurately measures the price sensitivity of fixed-income securities for small changes in interest rates of the order of one basis point. But suppose inter- est rate shocks are much larger, of the order of 2 percent, or 200 basis points. Then duration becomes a less accurate predictor of how much the prices of securi- ties will change and therefore a less accurate measure of interest rate sensitivity. Looking at Figure 9–6, you can see the reason for this. Note first the change in a bond’s price due to yield changes according to the duration model and second, the true relationship, as calculated directly, using the exact present value calculation for bond valuation.

The duration model predicts that the relationship between interest rate shocks and bond price changes will be proportional to D (duration). However, by pre- cisely calculating the true change in bond prices, we would find that for large interest rate increases, duration overpredicts the fall in bond prices, while for large interest rate decreases, it underpredicts the increase in bond prices. That is, the duration model predicts symmetric effects for rate increases and decreases on bond prices. As Figure 9–6 shows, in actuality, for rate increases, the capital loss effect tends to be smaller than the capital gain effect is for rate decreases. This is the result of the bond price–yield relationship exhibiting a property called convexity rather than linearity, as assumed by the basic duration model.

Note that convexity is a desirable feature for an FI manager to capture in a portfolio of assets. Buying a bond or a portfolio of assets that exhibits a lot of convexity, or curvature, in the price–yield curve relationship is similar to buy- ing partial interest rate risk insurance. Specifically, high convexity means that for equally large changes of interest rates up and down (e.g., plus or minus 2 percent), the capital gain effect of a rate decrease more than offsets the capital loss effect of a

convexity The degree of curva- ture of the price–yield curve around some interest rate level.

convexity The degree of curva- ture of the price–yield curve around some interest rate level.

∆P P

∆R 1 + R

–D

Error

True relationship

Error Duration model

FIGURE 9–6 Duration versus True Relationship

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Chapter 9 Interest Rate Risk II 247

rate increase. As we show in Appendix 9B to the chapter, all fixed-income assets or liabilities exhibit some convexity in their price–yield relationships.23

To see the importance of accounting for the effects of convexity in assess- ing the impact of large rate changes on an FI’s portfolio, consider the six-year Eurobond with an 8 percent coupon and yield. According to Table 9–2, its dura- tion is 4.993 years and its current price P0 is $1,000 at a yield of 8 percent:

P0 2 3

4

80 1 08

80 1 08

80 1 08

80 1 08

8

� � �

� �

( . ) ( . ) ( . )

( . ) 00

1 08 1 080 1 08

1 000 5 6( . )

, ( . )

$ ,� �

This is point A on the price–yield curve in Figure 9–7. If rates rise from 8 to 10 percent, the duration model predicts that the bond

price will fall by 9.2463 percent; that is:

�P P

� � � �4 993 02

1 08 9 2463.

. .

. %  

 

or, from a price of $1,000 to $907.537 (see point B in Figure 9–7). However, calculat- ing the exact change in the bond’s price after a rise in yield to 10 percent, we find that its true value is:

P0 2 3

4

80 1 1

80 1 1

80 1 1

80 1 1

80 1

� � �

� �

( . ) ( . ) ( . )

( . ) ( .11 1 080 1 1

912 895 5 6)

, ( . )

$ .� �

23 To be more precise, fixed-income securities without special option features such as callable bonds and mortgage-backed securities exhibit convexity. A callable bond tends to exhibit negative convexity (or con- cavity), as do some mortgage-backed securities.

FIGURE 9–7 The Price–Yield Curve for the Six- Year Eurobond

Price (P )

1,098.347

1,092.463

1,000

912.895

907.537

6% 8% 10% Yield (R )

C

B Error

A

E

D

Error

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248 Part Two Measuring Risk

This is point C in Figure 9–7. As you can see, the true or actual fall in price is less than the predicted fall by $5.358. This means that there is over a 0.5 percent error using the duration model. The reason for this is the natural convexity to the price–yield curve as yields rise.

Reversing the experiment reveals that the duration model would predict the bond’s price to rise by 9.2463 percent if yields fell from 8 to 6 percent, resulting in a predicted price of $1,092.463 (see point D in Figure 9–7). By comparison, the true or actual change in price can be computed as $1,098.347 by estimating the present value of the bond’s coupons and its face value with a 6 percent yield (see point E in Figure 9–7). The duration model has underpredicted the bond price increase by $5.884, or by over 0.5 percent of the true price increase.

An important question for the FI manager is whether a 0.5 percent error is big enough to be concerned about. This depends on the size of the interest rate change and the size of the portfolio under management. Clearly, 0.5 percent of a large number will still be a large number!

This chapter analyzed the duration model approach to measuring interest rate risk. The duration model is superior to the simple repricing model in that it incor- porates the timing of cash flows as well as maturity effects into a simple measure of interest rate risk. The duration measure could be used to immunize a particular liability as well as the whole FI balance sheet. However, as the concluding section of the chapter indicates, a number of potential problems exist in applying the dura- tion model in real-world scenarios. Despite these weaknesses, the duration model is fairly robust and can deal with a large number of real-world complexities, such as credit risk, convexity, floating interest rates, and uncertain maturities.

What is the difference between book value accounting and market value ac- counting? How do interest rate changes affect the value of bank assets and liabilities under the two methods? What is marking to market? What are the two different general interpretations of the concept of duration, and what is the technical definition of this term? How does duration differ from maturity? Two bonds are available for purchase in the financial markets. The first bond is a two-year, $1,000 bond that pays an annual coupon of 10 percent. The sec- ond bond is a two-year, $1,000 zero-coupon bond.

What is the duration of the coupon bond if the current yield to maturity (YTM) is 8 percent? 10 percent? 12 percent? (Hint: You may wish to create a spreadsheet program to assist in the calculations.) How does the change in the yield to maturity affect the duration of this coupon bond? Calculate the duration of the zero-coupon bond with a yield to maturity of 8 percent, 10 percent, and 12 percent. How does the change in the yield to maturity affect the duration of the zero coupon bond? Why does the change in the yield to maturity affect the coupon bond differ- ently than it affects the zero-coupon bond?

1.

2.

3.

a.

b.

c.

d.

e.

SummarySummary

Questions and Problems Questions and Problems

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Chapter 9 Interest Rate Risk II 249

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A one-year, $100,000 loan carries a coupon rate and a market interest rate of 12 percent. The loan requires payment of accrued interest and one-half of the principal at the end of six months. The remaining principal and the accrued interest are due at the end of the year.

What will be the cash flows at the end of six months and at the end of the year? What is the present value of each cash flow discounted at the market rate? What is the total present value? What proportion of the total present value of cash flows occurs at the end of six months? What proportion occurs at the end of the year? What is the duration of this loan?

What is the duration of a five-year, $1,000 Treasury bond with a 10 percent semiannual coupon selling at par? Selling with a yield to maturity of 12 per- cent? 14 percent? What can you conclude about the relationship between du- ration and yield to maturity? Plot the relationship. Why does this relationship exist? Consider three Treasury bonds each of which has a 10 percent semiannual coupon and trades at par.

Calculate the duration for a bond that has a maturity of four years, three years, and two years. What conclusions can you reach about the relationship between duration and the time to maturity? Plot the relationship.

A six-year, $10,000 CD pays 6 percent interest annually and has a 6 percent yield to maturity. What is the duration of the CD? What would be the duration if interest were paid semiannually? What is the relationship of duration to the relative frequency of interest payments? What is a consol bond? What is the duration of a consol bond that sells at a yield to maturity of 8 percent? 10 percent? 12 percent? Would a consol trad- ing at a yield to maturity of 10 percent have a greater duration than a 20-year zero-coupon bond trading at the same yield to maturity? Why? Maximum Pension Fund is attempting to balance one of the bond portfolios under its management. The fund has identified three bonds that have five year maturities and trade at a yield to maturity of 9 percent. The bonds differ only in that the coupons are 7 percent, 9 percent, and 11 percent.

What is the duration for each bond? What is the relationship between duration and the amount of coupon inter- est that is paid? Plot the relationship.

An insurance company is analyzing three bonds and is using duration as the measure of interest rate risk. All three bonds trade at a yield to maturity of 10 percent, have $10,000 par values, and have five years to maturity. The bonds differ only in the amount of annual coupon interest they pay: 8, 10, and 12 percent.

What is the duration for each five-year bond? What is the relationship between duration and the amount of coupon inter- est that is paid?

You can obtain a loan for $100,000 at a rate of 10 percent for two years. You have a choice of paying the principal at the end of the second year or amortizing the

4.

a.

b.

c.

d. 5.

6.

a.

b.

7.

8.

9.

a. b.

10.

a. b.

11.

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250 Part Two Measuring Risk

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loan, that is, paying interest (10 percent) and principal in equal payments each year. The loan is priced at par.

What is the duration of the loan under both methods of payment? Explain the difference in the two results.

How is duration related to the interest elasticity of a fixed-income security? What is the relationship between duration and the price of the fixed-income security? You have discovered that the price of a bond rose from $975 to $995 when the yield to maturity fell from 9.75 percent to 9.25 percent. What is the duration of the bond? Calculate the duration of a two-year, $1,000 bond that pays an annual cou- pon of 10 percent and trades at a yield of 14 percent. What is the expected change in the price of the bond if interest rates decline by 0.50 percent (50 basis points)? The duration of an 11-year, $1,000 Treasury bond paying a 10 percent semian- nual coupon and selling at par has been estimated at 6.9 years.

What is the modified duration of the bond? What will be the estimated price change on the bond if interest rates in- crease 0.10 percent (10 basis points)? If rates decrease 0.20 percent (20 basis points)? What would the actual price of the bond be under each rate change situa- tion in part (b) using the traditional present value bond pricing techniques? What is the amount of error in each case?

Suppose you purchase a five-year, 15 percent coupon bond (paid annually) that is priced to yield 9 percent. The face value of the bond is $1,000.

Show that the duration of this bond is equal to four years. Show that if interest rates rise to 10 percent within the next year and your investment horizon is four years from today, you will still earn a 9 percent yield on your investment. Show that a 9 percent yield also will be earned if interest rates fall next year to 8 percent.

Consider the case in which an investor holds a bond for a period of time lon- ger than the duration of the bond, that is, longer than the original investment horizon.

If interest rates rise, will the return that is earned exceed or fall short of the original required rate of return? Explain. What will happen to the realized return if interest rates decrease? Explain. Recalculate parts (b) and (c) of problem 16 above, assuming that the bond is held for all five years, to verify your answers to parts (a) and (b) of this problem. If either calculation in part (c) is greater than the original required rate of return, why would an investor ever try to match the duration of an asset with his or her investment horizon?

Two banks are being examined by the regulators to determine the interest rate sensitivity of their balance sheets. Bank A has assets composed solely of a 10-year $1 million loan with a coupon rate and yield of 12 percent. The loan is financed with a 10-year $1 million CD with a coupon rate and yield of

a. b.

12.

13.

14.

15.

a. b.

c.

16.

a. b.

c.

17.

a.

b. c.

d.

18.

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Chapter 9 Interest Rate Risk II 251

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10 percent. Bank B has assets composed solely of a 7-year, 12 percent zero- coupon bond with a current (market) value of $894,006.20 and a maturity (principal) value of $1,976,362.88. The bond is financed with a 10-year, 8.275 percent coupon $1,000,000 face value CD with a yield to maturity of 10 percent. The loan and the CDs pay interest annually, with principal due at maturity.

If market interest rates increase 1 percent (100 basis points), how do the market values of the assets and liabilities of each bank change? That is, what will be the net effect on the market value of the equity for each bank? What accounts for the differences in the changes in the market value of eq- uity between the two banks? Verify your results above by calculating the duration for the assets and liabilities of each bank, and estimate the changes in value for the expected change in interest rates. Summarize your results.

If you use only duration to immunize your portfolio, what three factors affect changes in the net worth of a financial institution when interest rates change? Financial Institution XY has assets of $1 million invested in a 30-year, 10 percent semiannual coupon Treasury bond selling at par. The duration of this bond has been estimated at 9.94 years. The assets are financed with equity and a $900,000, two-year, 7.25 percent semiannual coupon capital note selling at par.

What is the leverage adjusted duration gap of Financial Institution XY? What is the impact on equity value if the relative change in all market inter- est rates is a decrease of 20 basis points? Note: The relative change in inter- est rates is �R/(1 + R/2) = -0.0020. Using the information in parts (a) and (b), what can be said about the de- sired duration gap for a financial institution if interest rates are expected to increase or decrease. Verify your answer to part (c) by calculating the change in the market value of equity assuming that the relative change in all market interest rates is an increase of 30 basis points. What would the duration of the assets need to be to immunize the equity from changes in market interest rates?

The balance sheet for Gotbucks Bank, Inc. (GBI), is presented below ($ millions).

Assets Liabilities and Equity

Cash Federal funds Loans (floating) Loans (fixed)

$ 30 20

105 65

Core deposits Federal funds Euro CDs Equity

$ 20 50

130 20

Total assets $220 Total liabilities and equity $220

Notes to the balance sheet: The fed funds rate is 8.5 percent, the floating loan rate is LIBOR + 4 per- cent, and currently LIBOR is 11 percent. Fixed-rate loans have five-year maturities, are priced at par, and pay 12 percent annual interest. The principal is repaid at maturity Core deposits are fixed rate for two years at 8 percent paid annually. The principal is repaid at maturity Euros currently yield 9 percent.

What is the duration of the fixed-rate loan portfolio of Gotbucks Bank? If the duration of the floating-rate loans and fed funds is 0.36 year, what is the duration of GBI’s assets?

a.

b.

c.

19.

20.

a. b.

c.

d.

e.

21.

a. b.

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252 Part Two Measuring Risk

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What is the duration of the core deposits if they are priced at par? If the duration of the Euro CDs and fed funds liabilities is 0.401 year, what is the duration of GBI’s liabilities? What is GBI’s duration gap? What is its interest rate risk exposure? What is the impact on the market value of equity if the relative change in all interest rates is an increase of 1 percent (100 basis points)? Note that the relative change in interest rates is �R/(1 � R) = 0.01. What is the impact on the market value of equity if the relative change in all interest rates is a decrease of 0.5 percent (�50 basis points)? What variables are available to GBI to immunize the bank? How much would each variable need to change to get DGAP to equal zero?

Hands Insurance Company issued a $90 million, one-year zero-coupon note at 8 percent add-on annual interest (paying one coupon at the end of the year) or with an 8 percent yield. The proceeds were used to fund a $100 million, two- year commercial loan with a 10 percent coupon rate and a 10 percent yield. Immediately after these transactions were simultaneously closed, all market interest rates increased 1.5 percent (150 basis points).

What is the true market value of the loan investment and the liability after the change in interest rates? What impact did these changes in market value have on the market value of the FI’s equity? What was the duration of the loan investment and the liability at the time of issuance? Use these duration values to calculate the expected change in the value of the loan and the liability for the predicted increase of 1.5 percent in interest rates. What was the duration gap of Hands Insurance Company after the issu- ance of the asset and note? What was the change in equity value forecasted by this duration gap for the predicted increase in interest rates of 1.5 percent? If the interest rate prediction had been available during the time period in which the loan and the liability were being negotiated, what suggestions would you have offered to reduce the possible effect on the equity of the company? What are the difficulties in implementing your ideas?

The following balance sheet information is available (amounts in thousands of dollars and duration in years) for a financial institution:

Amount Duration

T-bills T-notes T-bonds Loans Deposits Federal funds Equity

$ 90 55

176 2,724 2,092

238 715

0.50 0.90

x 7.00 1.00 0.01

c. d.

e. f.

g.

h.

22.

a.

b.

c.

d.

e.

f.

g.

23.

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Chapter 9 Interest Rate Risk II 253

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