copyright-a.s. cebenoyan1 money, banking, and financial markets professor a. sinan cebenoyan stern...

Copyright-A.S. Cebenoyan 1

Money, Banking, and Financial Markets

Professor A. Sinan Cebenoyan

Stern School of Business - NYU

Set 1


US Depository Institutions

• Incentives, always incentives!

• Commercial Banks

Size, Structure, and Composition

Balance Sheet and Trends-Regulation

• Thrifts

S&L’s and Savings Banks

Credit Unions


Commercial Banks

• 1985----->>> 14,416

• 1989----->>> 12,744

• 1994----->>> 10,384

• 1998----->>> around 9,000

• Why? Failures and M&A

• Community, Regional, Super Regional, and Money Center Banks


Commercial Banks continued

• Assets: Business Loans (C and I)

Securities

Mortgages

Consumer Loans

Other (LDC)



• Liabilities: Deposits

transactions

NOW

Savings and Time

Negotiable CD’s

Borrowings and Other

Exposure Concerns



• Off-Balance Sheet Activities

Fee-related activities

Letters of Credit

Derivatives

Swaps

Exposure Concerns


Regulation

• FDIC

• COC

• The Fed


Thrifts

• Savings and Loans

Long-term mortgages backed by short-term

savings deposits (helped by the yield curve)

after 1979 different Fed targets:

Disintermediation

Regulation Q

DIDMCA, DIA

Regulatory Forbearance


Thrifts continued

• FSLIC in trouble.>>>>FIRREA (1989)

SAIF under FDIC

RTC

strengthen capital requirements

QTL test

Number of S&Ls down sharply

• Balance Sheet and Recent Trends


Thrifts continued

• Savings BanksNew England

mutual to stock

more diversified than S&Ls (assets)

more reliant on deposits >>less borrow

State regulators


Thrifts continued

• Credit Unions65% of assets in small Consumer loans

hold large amount of Government Sec.’s

Residential mortgages very small

lending funded by savings deposits

NCUA and NCUIF


Insurance Companies

• Life Insurance Companiesdeath, illnesses, and retirement

• Property-Casualty Insurancepersonal injury and liability

accidents, theft, fire...


Life Insurance Companies

• Life Insurance

Ordinary Life (Term, Whole, Endowment

Variable, Universal, VariableUniversal) ---- 58%

Group Life --- 40%

Industrial Life ---- 0.2%

Credit Life ------ 2%


• Other Life Insurer Activities

Annuities

Private Pension Funds

Accident and Health Insurance

• Balance Sheet

Assets>>15.9% Gov.Sec., 65% corp. Bonds and stock, 8% mortgs.,

balance policy and other loans

Liabilities>>53% net policy reserves

• Regulation >> McCarran-Ferguson Act ‘45


Property-Casualty Insurance

• PC Insurance

Fire Insurance

Homeowners

Commercial

Marine

Auto liability+ PD, Liability other

Reinsurance


• Balance Sheet and Underwriting Risk

Loss Risk >>>Predictability:

Property(more) vs. liability(less predict.)

Severity vs. Frequency

Long tail(claims later) versus short tail

Product Inflation versus social infl.Loss ratio (Losses/Premiums)

Expense risk

Investment Yield/Return Risk

Regulation


Other Financial Institutions

• Securities Firms and Investment Banks

• Finance Companies

• Mutual Funds


Securities Firms and Investment Banks

• Size, Structure, + Composition of IndustryNumber of firms

Sizes >>>Merrill Lynch to regionals

Activities: Investing, Investment Banking (IPO, PP)

Market Making, Trading (Position Trading,

Pure Arbitrage, Risk Arbitrage, Program

Trading), Back-Office and Other


• Balance Sheet and Recent TrendsCommissions down after crashes, but up mostly in the 90’s. Underwriting and Holdings of Fixed income securities >>> Risk implications

Assets: Long Positions in Securities and Commodities (26%) and Reverse

repurchase agreements (35%).

Liabilities: Repurchase agreements (47%)

securities and comm. sold short +loans+equity

• Regulation: SEC, NYSE, NASD, SIPC


Finance Companies

• 2 Major Types:

1) Installment (auto) loans to consumers

2) Consumer+corporate loans, Factoring

• Commercial Paper used in Financing

• No Deposits -->>> Not much regulation


Mutual Funds

• Diversification

• Lower Transaction Costs

• First in Boston, 1924,

360 in 1970

about 8,000 today ($5 trillion managed)

after last couple of weeks maybe $4 trillion!


Mutual Funds continued

• Short-term fundsTaxable or tax-exempt

Money market mutual funds

• Long Term FundsBond, income, and equity funds

Returns: income and dividends,

capital gains when sold, capital

appreciationMarked-to-Market daily

NAV

open versus closed-end

• Load Funds, REITs

• 12b-1 fees

• Balance Sheets:• MMMF 75% in short

term securities (foreign and domestic deposits, RP’s, CP, US gov.secs)

• Long term Funds 63% in stocks, US Treasuries and muni. bonds 23%.

• Regulated by the SEC, and States.


Overview of the Federal Reserve System

• Today, Fed’s duties are:• Conducting the nation’s monetary policy…in

pursuit of full employment and stable prices

• Supervising and regulating Financial Inst.s…safety and soundness…credit rights of consumers

• Maintaining the stability of the fin’l system ...containing systemic risk

• Providing certain fin’l services…major role in operating the nation’s payment system


Background• History of failures.

• December 23, 1913 Wilson signs into law the Federal Reserve Act

• To provide for the establishment of Federal Reserve Banks, to furnish an elastic currency,…,effective supervision…

• Other Acts followed to fill in other needs

Structure of the System•Board of Governors, Washington, D.C.

•12 Regional Federal Reserve Banks

•Federal Open Market Committee (FOMC)

•Board + President of NY Fed+ 4 rotating other presidents


Three Major Tools Fed uses to conduct Monetary policy:

•Open Market Operations - FOMC

•Reserve Requirements - Board has sole authority

•The Discount Rate - Board approves any change by a Fed bank

Banking Supervision

•shared with OCC + FDIC

•All member banks + BHCs + Foreign activities of member banks, US activities of foreign banks, Edge Act corporations


Federal Reserve Banks•12 regional feds with 25 branches: Operate the nationwide payments system, distribute the nation’s currency and coin, supervise, regulate member banks and BHCs, and serve as Banker to the US Treasury.


Monetary Policy

• Goals of Monetary Policy– maximum employment

– stable prices

– moderate long-term interest rates

• Reserves Market– Demand for Reserves

» Required reserves and excess reserves

– Supply of Reserves

» (Borrowed Reserves) Discount Window and (Nonborrowed Reserves) Open Market Operations

– Federal Funds Rate


Open Market Operations• Buying and selling of Securities by the Fed

– Purchase adds to nonborrowed reserves, a sale reduces them

– When fed buys securities, it pays by issuing a check on itself, when the seller deposits the check in her bank, the bank presents the check to the Fed for payment, and the Fed increases the reserve account of the seller’s bank at the federal reserve bank. The reserves of the seller’s bank rise with no offsetting decline elsewhere; consequently, the total volume of reserves increases.

– This dollar for dollar change in the reserves makes Open M. Ops. The most powerful, flexible, and precise tool of monetary policy.


• Other factors Influencing Nonborrowed Reserves (Technical factors):– Amount of currency in circulation

– Size of Treasury Balances at the Fed

– Volume of Federal reserve Float

• Techniques of Open Market Operations– Outright Purchases and Sales

• through auctions with dealers

– Repurchase agreements

• for temporary adjustments, buy from dealers who will repurchase by a fixed date at a fixed price.

– Matched Sale-Purchase transactions


• The Discount Window• Complements Op. Mkt. Ops…and implementation

of longer-term monetary policy goals

• Facilitates B/S adjustments of individual banks that face temporary changes in asset-liability structure

• Uniform Discount rate across all Reserve Banks

• If holding deposits subject to reserve requirements then eligible for discount window access.

• Borrowing either done as discounting paper, or as an advance secured by collateral

• Adjustment Credit: for short-term liquidity needs– Fed provides credit at its own discretion

– Borrowing must be for appropriate reason

– other sources must be sought first


• Seasonal Credit helps small institutions lacking access to national money markets, e.g. agricultural banks

• Extended Credit: provided when exceptional circumstances or practices adversely affect an institution.

• Emergency Credit: “unusual and exigent” circumstances, not used since the 1930s

• Reserve Requirements:– Since the MCA of 1980 all depository institutions, regardless of

membership in the Fed, are subject to reserve requirements

– 8-14 percent on transaction deposits, 0-9 percent on nonpersonal time deposits

– The MCA broadened the reserve base and improved the predictability of the link between reserves and M1

– In 1982 switch to Contemporaneous reserve requirement scheme tightened the real-time link between M1 and reserves.

– 1984 focus shifts to M2, as M1 becomes highly sensitive to interest rates


• Consumer Protection– Federal reserve writes regulations to implement Consumer

protection laws enacted by Congress

– Federal reserve enforces state-chartered member banks

– staff examiners regularly evaluate banks

• The Fed and the Payments System – The Fed is an active intermediary in clearing and settling interbank

payments, as they maintain reserve or clearing accounts for the majority of depository institutions.

– Cash Services:Currency and Coin…ensure enough in circulation to meet public’s demand. Notes issued by the Feds, coin by the Treasury.

– Noncash-Transaction Services• Check processing

• Electronic Funds transfer: Fedwire for large ACH for small-dollar payments


• Fiscal Agency Functions– Maintaining the Treasury’s funds account

– Clearing Treasury checks drawn on that account

– Conducting nationwide auctions of Treasury securities

– Issuing, servicing, and redeeming Treasury securities

• International Services


Why are Financial Intermediaries Special?

• Flow of Funds in a world without FI’s

Householdsnet savers

Corporationsnet borrowers

Cash

Equity and debt claims

•Monitoring costs (covenants)

•Liquidity

•Price Risk


• Flow of funds in a world with FI’s

HouseholdsFI

(brokers)

-----------FI

(asset-transformers)

Corporations

Cash

Deposits and insurance policies

Cash

Equity + Debt

… …

•Brokerage Function reduce transaction costs, imperfections etc..

•Asset transformer: purchase Primary Securities and sell deposits, insurance policies,etc.(Secondary securities)


• Information Costs

FI does the monitoring to reduce agency costs

hence a delegated monitor

economies of scale

frequent monitoring in Bank Loans allows the FI to gather information constantly (insider?)

Reduction of imperfections and information asymmetries

• Liquidity and price risk

Through diversification, FI’s offer highly liquid and

low price -risk contracts on the liability side of their

B/S while investing in relatively illiquid and higher

price-risk securities of corporations on the asset side.


• Reduced Transaction Costs

Bulk asset purchases reduce costs (mutual funds and pension funds)

Bid-ask spreads are lower in large quantity purchases

• Maturity Intermediation

Other Aspects• Transmission of Monetary Policy• Credit Allocation (residential mortgages, farming loans…)

• Intergenerational Wealth Transfers (Time Intermediation)

• Payment Services

check clearing and wire transfers

• Denomination Intermediation


Specialness and Regulation

Negative externalities - Runs - RedliningNet regulatory burden (Difference between the private benefits to

an FI from being regulated (guaranties) and the private costs of regulations (examinations)).

• Safety and Soundness RegulationDiversification (no more than 15% of own equity capital can be lent to any one company or borrower

Capital requirements

Guaranty funds

Examinations


• Monetary Policy Regulation

Outside Money

Inside Money

Reserve Requirements• Credit Allocation Regulation

QTL• Consumer Protection Regulation

CRA, HMDA• Investor Protection Regulation

Securities Act of ‘33, Investment Co. Act ‘40• Entry Regulation


Changing Dynamics

• Table 4.3 1997 figures:Commercial banks 36%

Thrifts 11

Insurance companies19

Investment Companies 14

Pension Funds 12

Finance companies 6

Securities brokers/dealers 1.5

Mortgage Companies 0.3

REIT’s 0.2


Risks of Financial Intermediation• Interest Rate Risk: The risk incurred by an FI when the

maturity of its assets and liabilities are mismatched.

0 Liabilities 1

0 1 2

Assets

Suppose the cost of Funds (liabilities) is 9 %, and interest return on

assets is 10%. Profit spread of 1%. But there is 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 returns on funds to be reinvested will fall below the cost of funds

01

2 Liabilities

0 1 Assets

FI borrows at 9%, and invests in an asset yielding 10%. But at what rate will reinvestment take place?

Market Value Risk: As interest rates rise market value of assets or liabilities will fall. Moreover, mismatching maturities by holding longer term assets than liabilities implies when rates rise asset MVs fall more than liabilities. This could lead to economic loss and insolvency.


• Market Risk - The Risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices.

– Barings Bank lost $1.2 billion on its trading position (buying Futures on the Nikkei index and betting the index would rise)

• Credit Risk - The risk that the promised cash flows from loans and securities held by FIs may not be paid in full.

Virtually, all types of FIs face this risk. However, those that make loans or buy bonds with long-maturities are more exposed (banks, thrifts, and life insurance co.s). Default of a borrower puts both the principal and the interest payments at risk. – Diversification helps. Firm Specific Credit Risk is reduced, while

the FI is still exposed to Systematic Credit Risk


• Off-Balance-Sheet Risk - The Risk incurred by an FI due to activities related to contingent assets. While all FIs, to some extent, engage in Off-Balance-Sheet activities, mostly larger banks have drawn attention.– For example: A letter of Credit which is a guaranty issued by an FI

for a fee (makes it attractive) on which payment is contingent on the default of the agent that purchases the letter of credit. Nothing appears on the B/S but the fee appears on the income statement.

• Technology and Operational Risk– Purpose of technology is to lower operating costs, increase profits

and capture new markets for the FI.– Economies of Scale: The degree to which an FI’s average unit costs

of producing financial services fall as its output of services increase– Economies of Scope:The degree to which an FI can generate cost

synergies by producing multiple financial service products.– Technology Risk occurs when technological investments do not

produce the anticipated cost savings.


- Operational Risk : The risk that existing technology or support systems may malfunction or break down.

•Foreign Exchange Risk: The risk that exchange rate changes can affect the value of an FI’s assets and liabilities located abroad. If a U.S. FI is net long in foreign currency denominated assets, any depreciation of the foreign currency against the US dollar would lead to a loss for the U.S. FI . If a net short position prevails, then an appreciation of the foreign currency would lead to a loss.

- Even if we match the amounts of the assets and liabilities, we would still not be fully hedged if we have exposure to foreign interest rate risk from a maturity mismatch (simple maturity matching does not lead to a good hedge either, we need to match durations, but more on that later).

•Country or Sovereign Risk: The risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments.

•Liquidity Risk : The risk that a sudden surge in liability withdrawals may leave an FI in a position of having to liquidate assets in a very short period of time and at low prices. ( Fire-Sale ) (RUNRUN!)

•Insolvency Risk: Not having enough capital to offset a decline in asset values.

copyright-a.s. cebenoyan1 money, banking, and financial markets professor a. sinan cebenoyan stern...

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