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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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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1 2 3 4 5 6 7 8 9 0 QPD/QPD 0 9 8 7 ISBN 978-0-07-340514-8
MHID 0-07-340514-0
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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 11 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 51918 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
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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
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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
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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
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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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