Checkable Deposits, Nontransaction Deposits, and Borrowings

What are the Liabilities on the Bank Balance Sheet?

Checkable Deposits

• Allows the owner (depositor) to write checks to third parties • Examples include: • Non-interest earning checking accounts • Interest earning negotiable orders of withdrawal (NOW) accounts • Money-market deposit accounts • Lowest cost funds – safe and liquid for depositor, so lowest interest rate offered • Make up about 10% of bank liabilities

Nontransaction Deposits

• Primary source of bank liabilities (50%) • Accounts from which the depositor cannot write checks • Examples include: Savings accounts and Time deposits (Certificates of deposits) • For bank: highest cost of funding, but most stable

Borrowings

• Funds from the Federal Reserve System, other banks, and corporations • Examples include: - Discount loans (from the Fed) - Federal funds (from other banks) - Interbank offshore dollar deposits (from other banks) - Repurchase agreements (a.k.a., “repos”) - Commercial paper and notes • More volatile than other liabilities

Reserves and cash items, Securities, and Loans

What are the Assets on the Bank Balance Sheet?

Reserves and Cash Items

Reserves - Funds held in account with the Fed as well as vault cash - Required reserves + Excess reserves • Cash Items in Process of Collection - Checks deposited at a bank, funds being transferred from other banks • Deposits at Other Banks - Small banks often hold deposits in larger banks ("correspondent banking")

Securities

• U.S. government/agency debt • Municipal debt • Other (non-equity) securities • Short-term Treasury debt is a secondary reserve because of its high liquidity

Loans

• Bank's key income-earning assets • Includes business loans, auto loans, and mortgages • Not very liquid

1. Liquidity Management 2. Asset Management 3. Liability Management 4. Managing Capital Adequacy

What are the banks four primary concerns?

Asset Management

Attempt to earn highest possible return on assets while minimizing risk 1. Attract borrowers with low default risk, 2. Charge high interest rates 3. Buy securities with high return, low risk 4. Diversify 5. Manage liquidity

Liability Management

Managing source of funds (checkable deposits, CDs, borrowings, etc.): • Banks manage both sides of the balance sheet together • In the past, it tended to be more separate • Most banks manage this via the asset-liability management (ALM) committee • Extremely important since assets and liabilities typically have different maturities

1. Loan Sales (secondary loan participation) 2. Fee Income From • Foreign exchange trades for customers • Servicing mortgage-backed securities • Guarantees of debt • Backup lines of credit 3. Trading Activities and Risk Management • Financial futures and options • Foreign exchange trading • Interest rate swaps

What are the Off-Balance-Sheet Activities?

Rogue Traders: Barings Bank

• Nick Leeson engaged in speculative trades on the Nikkea • Personally generated $1.3 billion in losses over a three-year period • Barings had to close!

Rogue Traders: Daiwa Bank

• Toshihide Iguchi racked up $1.1 billion in losses in trading • When he fessed up, the bank decided to hide this from regulators • Bank was eventually fined $340 million and barred from U.S. operations

• Restrictions on asset holdings • Capital requirements • Chartering and examination • Assessment of risk management • Disclosure requirements • Macroprudential regulation

What are the types of financial regulation?

Restrictions on asset holdings

• Regulations limit the type of assets banks may hold as assets • For instance, banks are typically not allowed to buy stocks • Even with regulations in place, the 2007–2009 global financial crisis still occurred

Capital requirements: Types of Capital

Types of Capital • Common Equity Tier 1 (CET1) - "Core Capital" – highest quality, absorbs losses immediately - Includes common stock and surplus, retained earnings, and other comprehensive income • Additional Tier 1 (AT1) – oreferred stock and surplus • Tier 2 (T2) – subordinated debt, loan-loss reserves

Capital requirements

Current requirements: • Ratios scaled capital by bank's risk-adjusted assets • CET1 Ratio > 4.5% • CET1 + AT1 > 6.0% • CET1 + AT1 + T2 > 8.0%

Basel Committee on Banking Supervision

• Created in 1974 by central bank Governors from the G10 countries • Today: 45 institutions from 28 countries (including the Fed BoG and NY Fed)

Basel Capital Accord

• Went into effect in July 1988, required minimum capital ratios (relative to risk-weighted assets) of 8%

Basel III

• In response to financial crisis, new guidelines issued in 2010, implemented between 2013 and 2019 • Includes stricter capital definitions, leverage and liquidity requirements

Basel II

• Passed in June 2004, sought to develop and expand standardized rules set out in 1988 Accord • Supervisory review of institution's capital adequacy and internal assessment process • Effective use of disclosure as a lever to strengthen market discipline and encourage sound banking practices

Additional Capital Requirements: Larger Banks ($100+ Billion)

• Minimum CET1 = 4.5% • Stress Capital Buffer (SCB) requirement, determined by supervisory stress tests and is at least 2.5% • Capital surcharge for global systemically important banks (G-SIBs), which is at least 1.0%

Chartering and Examination

• Reduces adverse selection problem of crooks owning banks • Periodic reporting and frequent examinations • Examinations assign CAMELS ratings to banks - Capital adequacy, Asset management, Management quality, Earnings, Liquidity, Sensitivity - Used to justify cease and desist orders for risky activities • If examiners aren’t happy, bank can be subject to more frequent examinations

Assessment of Risk Management

• Regulators have adopted guidelines for dealing with interest-rate risk • Particularly important is the implementation of stress testing • Involves calculating Value at Risk (VaR) - Measures potential losses of a group of investments - Can adjust for current market conditions, specific periods of time • Critical when dealing with fluctuations in interest rates and, subsequently, loan and bond values (i.e., bank's assets)

Disclosure Requirements

• Better information reduces moral hazard and adverse selection • Requirements constantly updated, often in response to financial market frictions • For example, Sarbanes-Oxley (SOX) in 2002 was in response to corporate accounting scandals (Enron) - Established Public Company Accounting Oversight Board - Required CEO and CFO to certify financial statements

Macroprudential Regulation

• Micro regulation focuses on individual banks • Macro regulation looks at the banking system as a whole • Financial crisis showed micro regulation alone is not enough • Macro regulation needed, can take many forms - leverage cycle, which feeds asset bubbles by increasing lending, can be damped - higher net stable funding ratio, the % of short-term funding to total funding

Federal Reserve Act (1913)

Created the Federal Reserve System

McFadden Act of 1927

• Effectively prohibited banks from branching across state lines • Put national and state banks on equal footing regarding branching

Banking Acts of 1933 (Glass-Steagall) and 1935

• Created the FDIC • Separated banking from the securities industry • Prohibited interest on checkable deposits and restricted such deposits to commercial banks • Put interest-rate ceilings on other deposits • Essentially created investment banks • Before, investment banking activities were part of large commercial banks

Securities Act of 1933 and Securities Exchange Act of 1934

• Required that investors receive financial information on securities offered for public sale • Prohibited misrepresentations and fraud in the sale of securities • Created the Securities and Exchange Commission (SEC)

Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

• Overturned prohibition of interstate banking • Allowed branching across state lines - Overturned McFadden Act

Gramm-Leach-Bliley Financial Services Modernization Act of 1999

• Legislation to eliminate Glass-Steagall • States retain insurance regulation • SEC oversees securities activities • OCC regulates subsidiaries that underwrite securities • Fed still oversees bank holding companies

Sarbanes-Oxley Act of 2002

• Created Public Company Accounting Oversight Board (PCAOB) • Prohibited certain conflicts of interest • Required certification by CEO and CFO of financial statements and independence of audit committee

Federal Deposit Insurance Reform Act of 2005

• Increased deposit insurance on individual accounts to $250,000 per account • Authorized FDIC to revise its system of risk-based premiums

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

• Created Consumer Financial Protection Bureau to regulate mortgages and other financial products • Required routine derivatives to be cleared through central clearinghouses and exchanges • Provided new government resolution authority to allow government takeovers of financial holding companies that pose risk to financial system • Created Financial Stability Oversight Council to regulate systemically important financial institutions • Volcker Rule banned banks from proprietary trading and owning large percentage of hedge funds

• Response to Changes in Demand • Response to Changes in Supply • Avoidance of Existing Regulation

What are the three types of changes or financial innovations?

• Bank credit and debit cards • Electronic banking (e.g., ATMs, virtual banking) • Junk bonds • Commercial paper (unsecured short-term debt)

What are some major financial innovations?

Securitization

• Involves transforming illiquid assets into marketable securities • Almost any type of private debt can be securitized • Includes mortgages, credit card debt, student loans, car loans, etc. • Fundamental building block of the shadow banking system…

Loan origination -> Servicing ->Bundling -> Distribution • Fees are earned at each step

What is the Securitization Process?

Shadow Banking

• Financial intermediaries not subject to common financial regulations • In traditional banking, one financial institution engages in the process of asset transformation • Securitization, on the other hand, involves several institutions

Shadow Banking Example

• Mortgage broker (loan originator) arranges residential mortgage, funded by loan servicer • Bundler purchases mortgages to create portfolio that has claim on monthly mortgage payments • Distributor (investment bank) divides portfolio into standardized amounts

Shadow Banking and the Financial Crisis

• Subprime mortgage market developed in the 2000s • Market for residential mortgages given to borrowers with poor credit records • As risk analysis techniques improved, bundling these mortgages into securities became possible • Provided a new source of funding for these mortgages • Subprime mortgages were key factor that led to the global financial crisis

Bank Holding Companies

• Branching restrictions (McFadden Act of 1927) were anti-competitive • Response to branching restrictions: Bank Holding Companies - Allowed purchases of banks outside state - Fed allows wider scope of activities • Today, BHCs are dominant form of corporate structure for banks • For example, JPMorgan Chase & Co. is the BHC that owns JPMorgan Chase Bank (a commercial bank) as well as JPMorgan Securities (a broker-dealer)

Bank Consolidation: Why has number of banks decreased from 14,000 to 4,500?

Economies of scale • Increased with the web and computer technology • Scope economies also present in using data for pricing, new products, etc. • Birth of large, complex banking organizations Riegle-Neal Act of 1994 • Allowed full interstate branching • Promoted further consolidation

• Community banks will survive • Increase competition and efficiency • Increased diversification of bank loan portfolios (lessens likelihood of failures)

Bank Consolidation Pros

• Fear of decline of small business lending • Rush to consolidation may increase risk taking • Too big to fail?

Bank Consolidation Cons

Credit Unions

• Not-for-profit deposit institutions owned by members • In contrast, commercial banks earn profits for shareholders • Typically smaller institutions that specialize in short-term consumer loans • National Credit Union Administration (NCUA) issues federal charters • National Credit Union Share Insurance Fund (NCUSIF) provides deposit insurance

Foreign Banks in the US are set up as: 1. Agency office of a foreign bank (fewer regulations) 2. Subsidiary of a US bank (same regulations as US banks) US bank (same regs as a U.S. bank 3. Branch of a foreign bank (may create Edge Act corporations and International Banking Facilities)

What are foreign banks in the U.S. set up as?

International Banking

- Foreign Banks in the US hold more than 25% of total US bank assets. - Responsible for around 20% of lending to US corporations - Eurodollar Market

Mutual Funds

Pools resources of many investors: 1. Mutual fund buys securities 2. Investors by shares of mutual fund 3. Mutual fund manager retains voting rights of equity • Increases access to diversification

Mutual Fund Structure

• Investment companies usually offer many types of mutual funds • Funds often have a specific strategy (high growth, high payout, etc.) • Investors can usually move retirement savings among these funds without penalty • Can only be bought and sold at the end of the trading day

Open-End-Fund

Investors may buy or redeem shares at any point, where the price is determined by the net asset value (NAV) of the fund

Closed-End-Fund

Fixed number of nonredeemable shares sold through initial offering, share price determined by forces of supply and demand (i.e., price can differ from NAV)

Types of Mutual Funds

1. Stock (equity) funds 2. Bond funds 3. Hybrid funds 4. Money market funds

Stock Funds

Other than investing in common equity, stated objective can vary dramatically

Stock Fund Examples

• Capital Appreciation Funds seek rapid increase in share price • Income Funds seek high shareholder payouts (e.g., dividends) • Total Return Funds seek a balance of dividends and capital appreciation • World Equity Funds invest primarily in foreign firms. • Other types in Value, Growth, a particular industry, etc.

Mutual Fund Fees

• Load funds charge an upfront fee for buying shares • No-load funds do not charge a fee to buy shares • Deferred load funds charge a fee when the shares are redeemed • Other fees charges by mutual funds include: - Contingent deferred sales charge: backend fee that may disappear after specific period - Exchange fee: a fee (usually low) for transferring money between funds in the same family - Account maintenance fee: charges if the account balance is too low - 12b-1 fee: pays expenses related to marketing, advertising, and commissions

Mutual Fund Regulation

Mutual funds are regulated by four primary laws: 1. Securities Act of 1933: specifies disclosure requirements 2. Securities Exchange Act of 1934: details antifraud rules 3. Investment Company Act of 1940: requires registration and minimal operatingstandards 4. Investment Advisors Act of 1940: regulates fund advisors

Hedge Funds

Many similarities with mutual funds, but significant differences as well: • High minimum investment, averaging around $1 million • Typically requires long-term commitment of funds • High fees: typically 1% of assets plus 20% of profits • Highly levered • Little regulation

Exchange Traded Funds (ETFs)

Many similarities with mutual funds, but again significant differences: • Trade throughout the day • Passively managed (automatically track an index or strategy) • Significantly lower fees

Insurance premium

Specifically, they assume the risk of their clients in return for a fee

Insurance Companies

Financial intermediary involved in risk management

Insurance Fundamentals

Seven basic principles all insurance companies are subject to: 1. Insured and beneficiary must have relationship, and beneficiary would suffer if it weren’t for the insurance 2. Insured must provide full and accurate information to insurance company 3. Insured is not to profit because of insurance coverage 4. If a third party compensates the insured for a loss, the insurance company’s obligation is reduced by the amount of the compensation 5. Insurance company must have large number of insured so that risk can be spread out among many different policies 6. Loss must be quantifiable (e.g., oil company could not buy a policy on an unexplored oil field) 7. Insurance company must be able to compute the probability of a loss occurring

Adverse Selection

Raises issue of which policies an insurance company should accept: • Those most likely to suffer loss are most likely to apply for insurance • In the extreme, insurance companies should turn away anyone who applies! Insurance companies have found solutions to deal with this problem: • Health insurance policies require a physical exam • Preexisting conditions may be excluded from the policy

Moral Hazard

Insured party fails to take proper precautions or takes on excess risk • "Who cares, insurance will cover it!" How do insurance companies control this problem? • Deductibles

Organization of Insurance Companies

Insurance companies may be organized in two different ways: • Stock company – owned by shareholders, has a profit motive • Mutual insurance company – owned by policyholders, attempts to provide the lowest cost insurance

Types of Insurance

Classified by type of event that is covered: • Health Insurance • Life Insurance • Property and Casualty Insurance

Life Insurance

Comes in many forms, including: • Term Life: the insured is covered while the policy is in effect (usually 10 – 20 years) • Whole Life: portion of premium funds cash value, rest funds benefits (lasts entire life) • Universal Life: similar to whole, but premium and benefits can vary over life of policy • Annuities: pays a benefit to the insured until death (funds retirement years)

Property Insurance

Protects from the risk associated with ownership

Open-peril policy

Insures against losses except from perils named in policy

Named-peril policy

Insures against losses only from perils named in policy

Casualty (liability) Insurance

Protects against financial losses related to negligence

Terrorism Risk Insurance Act of 2002 (post 9/11)

• Limits amount insurance firms required to pay out in the event of future attacks • Government will pay 90% of losses, up to $100 billion

Insurance Regulation

• McCarran-Ferguson Act of 1945 exempts insurance companies from federal regulation • As a result, insurance companies are regulated at the state-level

Regulations typically have one of two purposes: 1. Protect policyholders from losses 2. Expand insurance coverage in the state

What are the purposes of insurance regulations?

Monoline Insurance

Monoline insurance companies specialize in credit insurance • Guarantees timely repayment of bond principal and interest when a debt issuer defaults - Lowers interest rates by providing credit enhancement (debt has "credit wrap") - Only insurance companies allowed to offer this insurance • Monoline insurers insured debt securities backed by subprime mortgages during 2007-08 Financial Crisis - Defaults on these mortgages resulted in credit downgrades for the insurers - Weakened the value of their guarantees, which spilled over into municipal bond market - Investors reduced value of insurance, so municipalities had to pay higher interest rates - Resulted in lower spending on roads, schools, etc.

Credit Default Swaps

• Form of insurance – protects against default, usually on some kind of securitized bond • Market essentially non-existent before 1995, around $62 trillion by 2008! • Allows speculators to bet on the health of a company (or entire market sector) • Can buy CDS without owning underlying security (called a "naked" CDS) • Key factor in 2007-08 Financial Crisis - Banks sold CDS that insured debt backed by subprime mortgages - When mortgages defaulted, banks were liable for losses

Investment Banks

Financial institutions that perform variety of crucial functions in financial markets: • Underwrite the initial sale of stocks and bonds • Serve as securities brokers and dealers • Facilitate mergers and acquisitions

• Underwriting Stocks and Bonds • Securities Brokers and Dealers • Facilitating Mergers and Acquisitions

What are the three primary roles of Investment Banks?

Underwriting Stocks and Bonds

Firm selects investment bank to help with issuing stocks or bonds • Can involve an underwriting "syndicate" of several investment banks Investment bank conducts due diligence and risk analysis of firm Investment bank helps firm determine structure of issuance: • Type of security (bonds or stock) - High interest rates, rates expected to fall? Issue equity - Undervalued stock price, avoid negative signal? Issue debt - Capital Structure concerns (i.e., increase debt or equity level)? • Total amount to issue (what is use of proceeds?) • Price of security (what is intrinsic value?)

• Firm Commitment • Best Efforts • Private Placements

What are the types of underwriting?

Private Placements

entire issue is sold to a small group of investors (rare for stock)

Best Efforts

Investment bank makes “best effort” to sell entire issue

Firm Commitment

Investment bank commits to buy entire offer (most common)

Underwriting Stocks and Bonds: SEC registration

• Required for issues greater than $1.5 million and with a maturity greater than 270 days • Portion known as the prospectus is made available to the public

Underwriting Stocks and Bonds: Roadshow

• Preliminary prospectus is filed with SEC • Investment bank markets issuance to institutional investors • Large investors (pension funds, hedge funds, other investment banks, etc.) often pre-commit to buy securities • Success or failure of roadshow influences final prospectus

Securities Broker

• Buys and sells securities on behalf of client • Full-Service broker offers research and investment advice (usually charges higher commission) • Discount broker provides facilities to buy/sell securities but offers no advice

Securities Dealer

• Holds inventories of securities on their own account • Provides liquidity to the market by standing ready to buy or sell securities (market maker) • Especially important for thinly traded securities

Mergers and Acquisitions

Investment banks can assist both acquiring firms and potential targets

Hostile takeover

Target does not wish to be acquired

Investment bankers will assist in all areas, including: • Payment type (stock vs. cash) • Financing options (leveraged buyouts) • Legal issues (monopoly concerns) • Valuations (firm, synergies)

What are the areas investment banker's assist in?

Private Equity

Alternative to investing in publicly-traded firms Private equity typically takes one of two forms: 1. Venture Capital 2. Capital Buyouts

Venture Capital

Provide funds for start-up companies VC firms: • Require large equity stakes • Typically formed as a limited partnership • Often become extremely involved with firm management • Usually provide expertise Examples of VC-backed firms: Apple, Cisco, Starbucks

Venture Capital Life Cycle

1. Pre-Seed/Accelerator-Stage Capital – helps initial development • Often involves business incubators, founders' own funds 2. Seed-Stage Capital – funds R&D, creation of early-stage product 3. Early-Stage Capital – supports product development, marketing, etc. • Series A and Series B rounds 4. Later-Stage Capital – provided after business generates significant revenue • Series C round, bridge capital, and mezzanine financing 5. Exit – usually through an IPO or acquisition

Capital Buyouts

A publicly-traded company is taken private • PE firm identifies public company that would benefit from going private • Makes offer to buy all shares, usually at premium over current market value • Shareholders must approve – easy if PE firm owns >50% of shares!

1. Leveraged Buyout • PE firm borrows capital, uses proceeds to acquire firm • Target firm's assets often used as collateral for debt 2. Management Buyout • Firm's current management team buys firm • PE firm will assist for small stake

What are the two main types of capital buyouts?

• Avoid SEC regulation, accounting requirements such as Sarbanes-Oxley • Greater flexibility by avoiding public scrutiny of earnings • Management no longer interested in life of a public-company CEO • Tax advantages and high compensation for partners

Why go private?

Net Interest Margin = ?

(Interest Income – Interest Expenses) / Total Assets

Return on Assets (ROA) = ?

Net Profits / Total Assets

Return on Equity (ROE) = ?

Net Profits / Equity Capital