WEEK 1: AN OVERVIEW OF FINANCIAL INSTITUTIONS

FINANCIAL SYSTEMS

5 PARTS

1. Money: medium of exchange, unit of account, store of value

2. Financial instruments: legal contracts used to transfer resources and risks between suppliers and
users of funds
3. Financial markets: places to buy/sell FI
4. Financial Institutions: provide services that facilitate flow of funds from savers to investors
5. Central bank: monitor/stabilise economy

2 MAIN ROLES

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1) Channel savings to investments
a) Importance: produces efficient allocation of capital -> higher production and efficiency for overall
economy
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i) e.g. $1000 with no financial markets = no investment opportunities = no interest
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2) Allow economic agents to share risks
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Both related

FUNDS FLOW THROUGH FINANCIAL SYSTEM

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DIRECT FINANCE
Direct Finance: corporations borrow funds directly from households in financial markets by selling them
securities (claims on corporation's future income/assets)

Primary Securities: Claims on corporation's future income or assets sold directly from corporation

Balance Sheet view of Direct Finance

RISK OF DIRECT INVESTMENT IN CORPORATIONS

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1) Information and Monitoring Costs

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a) high cost of information collection before transaction
b) high cost of monitoring after transaction
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a) relative LT nature of corporate E and D & lack of liquid secondary markets where households can sell
securities creates disincentive for household investors to directly invest in corporations
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3) Price Risk
a) Investors face risk of sale price of direct claim being lower than purchase price of claim even with
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financial markets to help liquidity.

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i) small size of household investments do not have scale to diversify price risk
4) Transaction Costs
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a) Prohibitively high transaction costs and small size investments

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THEREFORE WITHOUT FI, HOUSEHOLDS EITHER CONSUME OR SAVE AS CASH.

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INDIRECT FINANCE

Indirect Finance: FI stand between lender and borrower, borrowing from lender and providing funds to
borrower.
- FI can take advantage of economy of scale (pooling savings) to reduce information and monitoring
costs and transaction costs

Primary Securities: FI buys primary securities issued by corporations

Secondary Securities: FI issues to household lenders, backed by primary securities FI holds, claims on FI's
future income/assets not of corporation issuing primary security
- appeals to household, highly liquid, low price risk
e.g. Bank Deposits almost risk free, very short maturity

Asset Transformation: FI transform primary securities into secondary securities, more attractive to
households.

BS VIEW OF INDIRECT FINANCE

RISK TRANSFORMATION

How can FI offer highly liquid low price risk contracts to savers on the liability side of BS while investing in
illiquid higher price risk securities by corporations on other side

 VIA: Risk transformation and Liquidity transformation

o FIs can diversify some portfolio risk (unsystematic risk/firm-specific risk)
 Portfolio return Variance:

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 as N goes to infinity, variance goes to 0.

LIQUIDITY TRANSFORMATION

Liquidity Transformation: exposes modern banks to potential insolvency

e.g.

 if Liab of 1m > bank's ability to satisfy in unlikely event all depositors seek to withdraw
simultaneously, potential failure because loans are illiquid.
o e.g. if $1m deposits came from one depositor and probability of withdrawing all after 1
period p=0.1, $100k reserve? or 1m depositors with $1 deposit each.
  as number of depositors increase, assuming independence, withdrawal of 10%
becomes more predictable; in limit, 10% cash holding will "almost certainly" satisfy
deposit withdrawals.
 Hence: liquidity transformation lies in ability of FIs to diversity source of
funds to accurately predict expected daily withdrawals and set aside cash
without liquidating LT investment at a loss

INFORMATION PROBLEMS IN INVESTING

Asymmetric information: issuers of financial instruments know more about their business prospects and
willingness to work than potential lenders or investors

 lack of information creates problems in FS before the transaction is entered into and after

ADVERSE SELECTION

Adverse selection: problem created by asymmetric information before the transaction occurs

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 occurs when potential borrowers most likely to produce undesirable (adverse) outcome - bad credit

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risk - are the ones who most actively seek out a loan and thus most likely to be selected.
o makes it more likely that loans made to bad credit risks, lenders may decide not to make
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loans even though there are good credit risk in the marketplace
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E.G. 2 FIRMS, ONE SAFE PROJECT, ONE RISKY PROJECT

Lend $1000 to safe firm generating profit $1050, give it all to you as loan repayment
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Lend $1000 to risky firm, project generates $10000 or $0 at 50% - E(r) = $5k
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Suppose you want to lend to safe firm but cannot tell difference:

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If you charge interest of 5% or lower both firms willing to borrow, rate is too low for you if you pick
risky.
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 If you charge interest above 5%, safe firm will not borrow, leaving only risky firm which you don't
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want to lend to.

Therefore you don't have information to distinguish the 2 firms, you decide not to make a loan to either.

SOLUTIONS:

1. Screening: requires lenders be good at collecting/analysing information

a. FIs have advantage over individual
i. they have developed expertise in information collection and screening
ii. take advantage of economy of scale to significantly lower average cost of
information collection
2. Collaterals: if loan is insured in some way, borrower isn't a bad credit risk

MORAL HAZARD

Moral Hazard: created by asymmetric information after transaction occurs

 Risk that borrower might engage in activities undesirable (immoral) from lender's point of view
because they make it less likely loan will be paid back
 o borrower knows more than lender about where borrowed funds will be used and effort that
will go into the project
 Because debt contracts allow owners to keep all profits in excess of loan payments,
they encourage risk taking. Lenders need to make sure borrowers don't take too
much risk

SOLUTIONS:

 Monitoring: FIs can more efficiently monitor than households

FIS FUNCTION AS BROKERS

 FIs involved as agents not principals and usually compensated with fee for performing services
 FIs mainly provide information and transaction services
o perform services more efficiently than individuals : economy of scale

DEPOSITORY INSTITUTIONS

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Depository Institutions (DIs): FI's that accept deposits from individuals and institutions and make loans.

 largest group of FIs by size of BS m

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o e.g.
 US : commercial banks, savings institutions, credit unions
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 AUS: Called Authorised Depository Institutions (ADIs): banks, building societies,

credit unions.
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o Liabilities of DIs are significant component of money supply impacting rate of inflation, DIs
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play key role in transmission of monetary policy from central bank to rest of economy
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FINANCE COMPANIES, MUTUAL FUNDS

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Finance Companies: raise funds by selling commercial paper (ST debt instrument) and issuing stocks and
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bonds.

 Lend funds to consumers who make purchases of home appliances and small businesses
 Some finance companies are organised by a parent corporation to help sell its product

Mutual Funds: raise funds by selling shares to many individuals

 Use proceeds to purchased diversified portfolios of stocks and bonds

 Mutual funds allow SHs to pool resources to lower transaction cost buying large blocks of stocks or
bonds.
 Allow SH to hold more diversified portfolio

INSURANCE COMPANIES

Life Insurance Companies: insure people against financial hazards following death and sell annuities

 acquire funds from premiums that people pay to keep policies

 use funds to buy corporate bonds and mortgages
 can also purchase stocks but restricted in amount they can hold
Property-causality Insurance Companies: insure policy holders against loss from theft, fire and accidents.

 raise funds through premiums from policies but greater possibility of loss of funds if major disasters
occur.
 Use funds to buy more liquid assets than life insurance

SECURITY FIRMS AND INVESTMENT BANKS

Security Firms and Investment Banks: help net suppliers of funds transfer funds to net users of funds at low
cost with maximum degree of efficiency

 Securities firms and IBs DO NOT TRANSFORM SECURITIES ISSUED by net users of funds into claims
more attractive to net suppliers but serve as brokers intermediating between fund suppliers and
users
o Investment Banking: raising D and E securities for corporations or governments
 e.g. origination, underwriting, and placement of securities in money and capital
markets

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o Securities Services: assistance in trading of securities in secondary markets

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 e.g. brokerage services and/or market making
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MAIN DIFFERENCE BETWEEN BROKERS: whether they offer advice
o Full-service brokers: offering advice on buying/selling securities, make recommendations,
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provide research and compile tailored investment plans.
o Non-advisory brokers: No recommendations/advice
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REGULATIONS OF FIS
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 FIs failure can cause economic breakdown (e.g. GFC)

 Negative externalities: Actions by economic agent imposing costs on other economic agents
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 Safety and Soundness regulations

o Diversification requirement, Capital Adequacy Requirement (BASEL II)
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 Investor Protection Regulations

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o Disclosure, Insider Trading

FINANCIAL REGULATORS IN AUSTRALIA

 APRA = Australian Prudential Regulation Authority

o prudential regulation/supervision of financial services industry
 ASIC = Australia Securities and Investments Commission
o Responsible for market integrity and consumer protection across the financial systems
o set standards for financial market behaviour with aim to protect investor and consumer
confidence
o administers Corporate Law to promote honesty and fairness in companies and markets
 RBA = Reserve Bank of Australia
o Responsible for development and implementation of monetary policy and overall financial
stability

LECTURE 2: BANK FINANCIAL STATEMENTS

ASSET ITEMS

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CASH

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2 ITEMS: Literal currency held in bank's vault & deposits at central bank
o deposits are "reserves"
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 Required reserves: amount of reserve that within minimum amount required by

central bank
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INVESTMENT SECURITIES

 e.g. U.S. treasuries, municipal bonds, investment grade corporate bonds, Mortgage backed-securities
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(MBS)
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o earn lower interests than loans

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o more liquid

LOANS: GROSS, NET AND LOAN LOSS RESERVE (LLR)

 Gross Loans: Total mount lent to borrowers

o since some loans default, banks set up account (LLR) that is deducted from gross loans to get
net loans: amount bank expects to be paid
 Loan Loss Reserve (LLR): contra-asset (negative asset) account. Estimate by bank's management of
amount of gross loan not repaid to bank
o when loan actually goes bad it is charged off and leaves BS
 Gross charge-offs/write-offs : dollar value of loans actually written off as
uncollectible during period
 Bank lowers gross loans AND LLR so net loans unaffected by charged off loan

e.g. $5000 Loan Loss and charge off

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COMMERCIAL AND INDUSTRIAL LOANS (C&I)

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 loans to businesses, NOT SECURED by real estate

o made for periods as short as few weeks to 8 years or more.
o illiquid due to asymmetric information

REAL ESTATE LOANS

 Primarily commercial and residential mortgages

 tend to be LT loans.

INDIVIDUAL (CONSUMER) LOANS

 Non-revolving consumer loans

o automobile loans/mobile home loans/fixed-term personal loans
 Revolving consumer loans
o credit card loans: high interest, high adverse selection

MORTGAGES HAVE RISEN TO #1. SECURITIES FALLEN.

LIABILITY ITEMS

TRANSACTION ACCOUNTS

 deposits you can write a check against

 MOST LIQUID deposit and offers close substitute for cash
o e.g. demand deposits and NOW accounts
 demand deposits most liquid: bank must give you funds on demand
 US: bank cannot pay interest on these funds by law since 1930s
 Negotiable Order of Withdrawal (NOW) accounts: checkable deposits that pay
interest and are withdrawable on demand
 NOW vs Demand Deposits: NOW require depositor to maintain minimum
balance to earn interest.
 Since funds in transaction accounts are demandable: Fed Reserve require banks to hold certain % of
funds on reserve at a Fed Reserve Bank

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NON-TRANSACTION ACCOUNTS

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e.g. passbook savings, MMDA(money market deposit accounts, retail CDs, wholesale CDs
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o all pay explicit interest
 Passbook savings account: non-checkable and involve physical presence at DI to withdrawal
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 MMDA (money market deposit accounts): US, checkable

o number of checks written per account per month is restricted
o number of pre-authorised automatic transfers per month is restricted
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o minimum denomination of amount of each check restricted

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o minimum balance requirements

 Retail CDs (certificate of deposit)
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o pay higher interest

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o less liquid than passbook savings and MMDA


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Wholesale CDs
o minimum denomination of $100k+
o negotiable: can be sold by title assignment on secondary market to other investors
 Fed Reserve does not require banks to hold reserves against non-transaction accounts

EQUITY (CAPITAL)

𝐴𝑠𝑠𝑒𝑡𝑠𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = 𝐸𝑞𝑢𝑖𝑡𝑦

 Equity buffer is important to prevent insolvency

OFF-BALANCE SHEET ACTIVITIES

 Many things banks do that generate profits and risks not reported on BS

LOAN COMMITMENTS

 Most C&I (commercial and industrial) loans made by firms take pre-negotiated lines of credit or loan
commitment
 Loan commitment: contractual commitment by bank to lend firm certain maximum amount at given
interest rate terms over certain period of time

 bank may charge up-front fee of commitment size

 may also back-end fee on unused balances in commitment line at end of period

Risk to FI: unused portion of loan commitment is OBS BUT exposes bank to interest rate risk, credit risk
and liquidity risk

LETTERS OF CREDIT

Letters of Credit: guarantees sold by bank to firm for fee to insure third-party that firm will perform a
transaction. e.g. delivering goods/make payment for goods shipped oversees

 Commercial letters of credit (LCs): widely used domestic/international trade

 Standby letters of credit (SLCs): perform insurance function like LCs but cover contingencies more
severe, less predictable or frequent and not always trade related.

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o e.g. default guarantee to back issue of commercial paper to allow issuer to achieve higher

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credit rating and lower funding cost

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Risk to bank: buyer of LC may fail to perform contractual obligation and bank forced to make good on
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guarantee.
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DERIVATIVES

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FIs hold positions in FX (e.g. spot/futures/swaps), financial futures and forwards, interest rate swaps,
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credit default swaps (CDS) and other derivative

 FIs use derivative contracts for hedging or dealers that act as counterparties in trade with customers
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for a fee.
o small banks hold positions to manage risks
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o large banks act as dealers in the market

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Risk to FIs: counterparty to contract may default on payment obligation leaving FI unhedged and have to
replace contract at today's interest rates/prices/exchange rates.

 defaults most likely to occur when counterparty is deep out of money on contract and FI is in the
money on contract
o more serious for forwards than futures
 forward contracts are nonstandard contracts entered bilaterally and all CF required
to be paid at one time (on contract maturity)
 futures contracts are standardised contracts guaranteed by organised exchanges. If
counterparty defaults on futures, exchange assumes defaulting party's position and
the payment obligations
 Option Contracts: can be traded over the counter (OTC) or organised exchanges
o if standardised options traded on exchanges: virtually risk free
o if OTC, some default risk exists
 Swaps: OTC instruments susceptible to counterparty risk
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BANK INCOME STATEMENTS

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INTEREST INCOME AND INTEREST EXPENSES

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NON-INTEREST INCOME AND NON-INTEREST EXPENSES

PROVISION FOR LOAN LOSSES (PLL)

PLL: expense account on Bank's Income Statement

 represents deduction from current income equal to bank's expectation for future losses on its loans
 funds go into LLR, contra-asset account on BS
o when loan actually goes bad, bank writes down gross loans, lowers LLR by same amount so
that net loans don't change
o if banks have unusually large losses that deplete LLR, they will be forced to increase current
loan loss provisions (PLL) to build account back up.
e.g. PLL $50k

Ending balance of LLR

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subsequent recoveries of amounts previously written off decrease amount of the charge for loan

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impairment in income statement
o if in subsequent period, the amount of impairment charge decreases and the decrease can
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be related to an event occurring after impairment was recognised. (e.g. improvement in
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debtor's credit rating), previously recognised impairment charge is reversed by adjusting
provision account(PLL).
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 amount of reversal recognised in Income Statement

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FOUR CATEGORIES OF FINANCIAL ASSETS

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1. Loans and Receivables:

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a. Non-derivative financial assets with fixed/determinable payments not quoted in active

market
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2. Held-to-maturity Securities:
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a. Debt securities a bank has positive intent and ability to hold to maturity
3. Trading Securities:
a. D and E securities bought and held for purpose of selling in near future
4. Available-for-sale Securities:
a. D and E securities not classified as held-to-maturity or trading

RECOGNITION OF FINANCIAL ASSETS

Fair Value of financial instrument: amount which instrument could be exchanged for in a current transaction
between willing parties, other than in a forced or liquidation sale

AT INCEPTION

 Trading Securities: recognised initially at fair value

 All other financial assets: recognised initially at fair value + directly attributable transaction costs.

CARRYING VALUE

 Loans and Receivables and Held-to-maturity Securities: subsequently carried at amortised cost
 Trading Securities and Available-for-sale Securities: subsequently carried at fair value
FAIR VALUE MEASUREMENT (HIERARCHY)

1. BEST EVIDENCE of fair value: quoted price in active market.

a. wherever possible bank is required to determine fair value of financial instrument based on
quoted price
2. No direct quoted price in active market available: Present value estimates or other market accepted
valuation techniques
a. use of market accepted valuation technique will involve use of valuation model and
appropriate inputs
3. Based on whether inputs to valuation technique are observable or unobservable: accounting
standards specify hierarchy of valuation techniques.
a. observable inputs reflect market data obtained from independent sources
b. unobservable inputs reflect bank's market assumptions
i. LEVEL 1: quoted price for identical instruments in active markets
ii. LEVEL 2: quoted price for similar instruments in active markets
1. similar instruments in inactive market
2. model derived valuation where all significant input are significant value

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drivers observable in active market
iii. LEVEL 3: Valuation derived from valuation techniques where one or more significant
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inputs or significant value drivers are unobservable
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 Hierarchy requires bank to use observable market data to determine fair value
o minimise use of unobservable inputs
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 Financial instrument's categorisation within valuation hierarchy is based on lowest level input that is
significant to fair value measurement (least reliable)
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IMPAIRMENT OF ASSETS CARRIED AT AMORTISED COST

 bank assesses at each balance date whether there is objective evidence that a financial asset/group of
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financial assets is impaired

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 if impaired, impairment charges are recognised if there is objective evidence of impairment as result
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of one or more events that occurred after initial recognition of the asset ("loss event") and that loss
event/s has impact on estimated future CF of financial asset/group that can be reliably estimated
o IF there is evidence that an impairment on Loans and Receivables or Held-to-maturity
Securities, amount of charge is measured as

𝐴𝑠𝑠𝑒𝑡 ′ 𝑠 𝑐𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑎𝑚𝑜𝑢𝑛𝑡 − 𝑃𝑉 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑢𝑡𝑢𝑟𝑒 𝐶𝐹 − 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑟𝑒𝑑𝑖𝑡 𝑙𝑜𝑠𝑠𝑒𝑠

= 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑐𝑕𝑎𝑟𝑔𝑒
1 + 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 ′ 𝑠𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑡

GAINS AND LOSSES ON ASSETS CARRIED AT FAIR VALUE

 Trading Securities
o realised and unrealised gains/losses from changes in fair value of trading securities are
included in INCOME STATEMENT in period they arise
 Available-for-sale Securities
o gains/losses from changes in fair value of available-for-sale securities recognised in "OTHER
COMPREHENSIVE INCOME" until financial asset is derecognised or impaired
 at which time cumulative gain or loss previously recognised in OTHER
COMPREHENSIVE INCOME is recognised in INCOME STATEMENT
MARKET VS BOOK VALUE ACCOUNTING

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MV of Capital: = 𝐴𝑠𝑠𝑒𝑡𝑠𝑀𝑉 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠𝑀𝑉 = 𝑁𝑒𝑡 𝑤𝑜𝑟𝑡𝑕 𝑜𝑓 𝐹𝐼

 MV accounting advocated by academics and analysts because more accurate net worth and ability to
absorb losses before liability holders do
o e.g. if FI were closed by regulators before economic net worth = 0, neither liability holders
nor deposit insurance fund would stand to lose
 difficult to implement when FI hold large amount of non-traded assets
 introduces unnecessary variability (risk) into FI's earnings - therefore capital - because paper
gains/losses on assets are passed through FI's Income Statements
 o in many cases, paper gains/losses never realise when FI hold loans and other assets to
maturity
o regulators may be forced to close banks too early under prompt corrective action(PCA)
requirement imposed by FDICIA
 FIs less willing to accept LT asset exposure under MV accounting
o LT asset more sensitive to interest rate change than ST (interest rate risk)

BV of Capital: = 𝐴𝑠𝑠𝑒𝑡𝑠𝐵𝑉 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠𝐵𝑉

 even though trading assets carried at fair value, significant amount of assets/liabilities carried at
amortised cost
 FIs have greater discretion recognising loan loss on BS both in terms of amount of loss and timing of
recognition
o e.g. if FI were closed by regulators before BV of capital = 0, liability holders and deposit
insurance fund may still suffer a loss

WEEK 3: CAPITAL ADEQUACY

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FUNCTIONS OF CAPITAL


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absorb unanticipated losses with enough margin to inspire confidence and enable FI to continue as
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going concern
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 protect uninsured liability holders: depositors/bondholders/creditors in event of insolvency and

liquidation
 protect FI insurance fund and tax payers
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 protect FI owners against increase in insurance premium

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 fund branch and other real investments necessary to provide financial services
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CAPITAL RATIO
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𝐶𝑎𝑝𝑖𝑡𝑎𝑙
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𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 =
𝑆𝑜𝑚𝑒 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠

THE BASEL AGREEMENT OR ACCORD

 APRA makes/enforces capital adequacy rules for Australian authorised depository institutions (ADIs)
o Prudential Standards apply to all locally incorporated ADIs, including small and medium-sized
commercial banking institutions not internationally active

BASEL I AND II

BASEL I (Jan 1, 1993) : explicitly incorporate different credit risks of assets into capital adequacy measures

 risk weight depend on categories of borrowers (e.g. sovereigns, banks, corporates) - all corporate
loans have risk weight 100%
 both on BS and OBS assets considered in credit risk-weighted assets (RWA)
 market risk incorporated in 1998 revision
o credit risk-based cap ratio is adequate only if DI is not exposed to undue interest rate risk
and market risk
 o since 1998, DI have to add onto 8% risk-based cap ratio to reflect their own exposure to
market risk
 no formal add-on for interest rate risk

BASEL II: used wider differentiation of credit risk weights than BASEL I

 risk weight for sovereign, bank, and corporate loans refined by reference to ratings by external credit
rating agency (e.g. S&P)
 added capital charge for operational risk

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BASEL II AND II PILLARS OF CAPITAL REGULATION

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2006 BASEL II PILLARS: safety and soundness of financial system

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1. PILLAR 1: regulatory minimum capital requirements for credit market, and operational risk
2. PILLAR 2: importance of regulatory supervisory review process as critical complement to minimum
capital requirements.
a. Basel II created process to ensure each DI has sound internal processes to assess adequacy
of its capital and set targets for capital that fit DI's specific risk profile and control
environment
3. PILLAR 3: BIS encourages market discipline by developing requirements on disclosure of capital
structure, risk exposures, band capital adequacy.
a. allow market participants to assess critical information of DIs

WEAKNESS OF BASEL II REVEALED BY GFC

 credit ratings on securities (e.g. default swaps) were conducted by private companies without
supervision/review by official regulatory agencies.
o inflated ratings held partially responsible for crisis
 BASEL II cap adequacy formula for credit risk was procyclical
o as GFC developed, probability of borrower default and loss on default both increased
 therefore regulatory cap requirements increased
 o during GFC, banks unable to raise required capital thus had to turn to central bank for capital
injection and liquidity support
 early stages of GFC many banks had adequate capital but experienced difficulties because they didn't
have adequate liquid capital

BASEL III IMPROVEMENTS

Basel III (2010): raised quality and quantity of capital with focus on common equity

 significantly higher capital requirements for trading and derivatives activities

 substantial strengthening of counterparty credit risk calculations in determining required minimum
capital
 introduced internationally harmonised leverage ratio to serve as backstop to risk-based capital
requirements
 Capital Conservation Buffer: built up in good times
 Countercyclical buffer: built up during periods of excess credit growth
 Minimum global liquidity standards: improve banks' resilience to acute ST stress and improve LT

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funding
 Additional capital surcharge: for systematically important institutions (the biggest 10)
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4 Capital Ratios
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 Market Risk: Basel II revised standardised approach

o greater reliance placed on expected short fall of capital resulting from major shock rather
than variance in internal-model approach
 PILLAR 2: enhanced incentives for banks to better manage risk and return over LT
o more stress testing and implementation of sound compensation practices
 e.g. compensation should be sensitive to risk outcomes over multi-year horizon
 by arrangements that defer compensation until risk outcomes have been realised
  may include"clawback" provisions: compensation reduced or reversed if employees
generate exposures that cause bank to perform poorly in subsequent years or if
employee has failed to comply with internal policies or legal requirements
 PILLAR 3: enhanced disclosure of risks (e.g. relating to securitisation exposures and sponsorship of
OBS vehicles)

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IMPLEMENTATION OF BASEL III IN AUSTRALIA

 generally consistent but not completely aligned (BASEL 2.9)

o APRA exercised discretion applying Basel framework to ADIs
 more conservative approach than minimum standards
o APRA introduced new standards from 1 Jan 2013 with no phasing in of higher capital
requirements as allowed by BCBS.
 reduce reported capital ratios relative to those reported in other jurisdictions

BASEL III: TIER 1 CAPITAL

COMMON EQUITY TIER 1 CAPITAL (CET1)

CET1:

 common shares and stock surplus

  retained earnings
 accumulated other comprehensive income and other disclosed reserves
 common shares issued by consolidated subsidiaries of bank and held by third parties (e.g. minority
interests)
 LESS GOODWILL: amount DI pays above MV when it acquires other DIs or subsidiaries
o Regulatory adjustments applied in calculation of CET1

𝐶𝐸𝑇1 = 𝐵𝑉 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑀𝑖𝑛𝑜𝑟𝑖𝑡𝑦 𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠 𝑕𝑒𝑙𝑑 𝑏𝑦 𝐷𝐼 𝑖𝑛 𝑠𝑢𝑏𝑠𝑖𝑑𝑖𝑎𝑟𝑖𝑒𝑠 − 𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙

ADDITIONAL TIER 1 CAPITAL

Addition Tier 1: other options to absorb losses of bank beyond common equity

 e.g. noncumulative perpetual preferred stock and related surplus, Tier 1 minority interest not
included in CET1

TIER 1 CAPITAL

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𝑇𝑖𝑒𝑟 1 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝐸𝑇1 + 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑇𝑖𝑒𝑟 1 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
m
Tier 1 Capital: capital available to absorb losses on a "going-concern" basis OR
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 Capital that can be depleted without placing bank into insolvency or liquidation.
Do

 primary capital of DI
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BASEL III: TIER 2 CAPITAL

wa

Tier 2 Capital: secondary "equity-like" capital

ks

 capital that can absorb losses on a "gone-concern" basis

in

 capital that absorbs losses in insolvency prior to depositors losing any money
o convertible and subordinated debt instruments
Th

o allowances for loans and lease losses ≤ 1.25% bank's total credit risk-weighted assets (RWA)
 general LLR held against future, presently unidentified losses are freely available to
meet losses which subsequently materialise and therefore fall in Tier 2
 provisions ascribed to identify losses excluded
o regulatory adjustments applied to calculation of Tier 2 capital

TIER 1 LEVERAGE RATIO

𝑇𝑖𝑒𝑟 1 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝑇𝑖𝑒𝑟 1 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 = ≥ 3%
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑜𝑛 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑠𝑕𝑒𝑒𝑡

 non-risk based leverage ratio of Tier 1 capital to total exposure (on and OBS) to serve as backstop to
risk-based capital ratios

e.g. Risk-based capital ratio usually higher than leverage ratio when many assets receive <100% risk weights
BASEL III CAPITAL REQUIREMENTS

 Capital Conservation Buffer

o Good times: buffer > 2.5% total risk-weighted assets (RWA)
o must be CET1 capital and held separately from minimum risk-based capital requirements


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Countercyclical Capital Buffer

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o 0% to 2.5% total risk-weighted assets (RWA)
o may be declared by country when experiencing excess aggregate credit growth
m
o must be CET1 capital, DIs given 12 months to adjust buffer level
cu
 Globally systematically important banks ( G-SIBs)
o higher loss absorbency capacity
Do

o Additional CET1 capital surcharge of 1% to 3.5% held ABOVE 7% minimum CET1 plus
conservation buffer requirement
p

 4.5% +2.5% = 7%
wa
ks
in
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BASEL III:

4.5% CET1 + 1.5% Additional Tier 1 = 6% Tier 1 Capital

2% Tier 2 capital + 6% Tier 1 Capital = 8% Total Capital

8% Total Capital +2.5% Capital Conservation Buffer + 2.5% Countercyclical buffer + ~2.5% GSIBs surcharge =
15.5% Capital

CREDIT RISK-ADJUSTED ON BALANCE-SHEET ASSETS

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 Cash: Zero risk weight
 Commercial and Consumer Loans: 100% risk weight
 Residential 1-4 family mortgages: m
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o Category 1: traditional, first lien, prudently underwritten products
o Category 2: junior liens and non-traditional mortgage products
Do

 risk weight assigned depends on mortgage's loan-to-value ratio

 Sovereign exposures: determined using OECD risk classifications( CRCs)
o 8 risk categories (0-7)
p

o Categories 0-1: lowest possible risk: risk weight 0%

wa

o Category 7: risk weight 159%

 Foreign Banks: based on CRCs for the bank's home country
ks
in
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Th
in
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 t
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CREDIT RISK-ADJUSTED OBS ASSETS

ks
in

 DI's OBS activities represent contingent NOT actual claims against DI


Th

Regulations require capital be held against amount equivalent to any eventual on-balance-sheet
credit risk these securities might create for a DI. NOT full FV.

CALCULATE CREDIT-RISK ADJUSTED OBS ASSETS

1. Convert into Credit Equivalent Amounts: amounts equivalent to on-balance-sheet item

2. Assign appropriate risk category depending on TYPE of OBS item
a. Contingent guaranty contract (e.g. SLCs, Loan commitment)
i. 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑂𝐵𝑆 𝑔𝑢𝑎𝑟𝑎𝑛𝑡𝑦 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 × 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 =
𝐶𝑟𝑒𝑑𝑖𝑡 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝐴𝑚𝑜𝑢𝑛𝑡
ii. Credit risk weights same as on-balance-sheet credit risk exposures to same party
b. Derivative contract: (e.g. interest rate forward, option and swap contracts)
i. expose DIs to counterparty credit risk: risk that counterpart will default when
suffering large actual or potential losses on its position
1. DI would have to go back to market to replace contract at less favourable
terms
ii. Exchange-traded derivatives vs OTC derivatives
 1. credit risk/default risk of exchange-traded derivatives≈ 0 because when
counterparty defaults, the exchange adopts counterparty's obligations in
full
2. Most OBS futures and options have virtually no capital requirement for DI
iii. CALCULATIONS FOR DERIVATIVES = Potential Exposure + Current Exposure
iv. Potential Exposure: risk if counterparty defaults in FUTURE
1. 𝑛𝑜𝑡𝑖𝑜𝑛𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 × 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑓𝑎𝑐𝑡𝑜𝑟

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v. Current Exposure: cost of replacing contract if counterparty defaults TODAY
1. Out of money = 0
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2. In the money = replacement cost
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vi. BASEL III risk weight for OTC derivatives = 100%
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E.G. CALCULATING CREDIT RWA AND CAPITAL RATIOS

1. On-Balance-Sheet Assets = 0% 8 + 13 + 60 + 50 + 42 + 20% 10 + 10 + 20 + 55 + 10 +

50% 34 + 308 + 75 + 100% 390 + 108 + 22 + 150% 10 = $764.5𝑚𝑖𝑙𝑙𝑖𝑜𝑛
2. OBS Assets:
o Guaranty Contracts = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑂𝐵𝑆 𝑔𝑢𝑎𝑟𝑎𝑛𝑡𝑦 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 × 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 =
𝐶𝑟𝑒𝑑𝑖𝑡 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝐴𝑚𝑜𝑢𝑛𝑡

 80*0.5+10*1+50*0.2=60m
o Derivative Contracts = Current + Potential Exposure

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m
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 3.5+2=5.5m
p

3. TOTAL Credit RWA 764.5 + 60 + 5.5 = $830 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

wa

4. CAPITAL RATIOS
o 𝐶𝐸𝑇1 =
ks

𝐵𝑉 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑀𝑖𝑛𝑜𝑟𝑖𝑡𝑦 𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠 𝑕𝑒𝑙𝑑 𝑏𝑦 𝐷𝐼 𝑖𝑛 𝑠𝑢𝑏𝑠𝑖𝑑𝑖𝑎𝑟𝑖𝑒𝑠 −

in

𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙 = > Retained Earnings + Common Stock = 40+30=70m

o TIER 1 CAP = CET1 + Noncumulative Perpetual Preferred Stock = 70+10 = 80m
Th

o Tier 2 Cap = Convertible Debt + Subordinated Debt + Non-qualifying perpetual preferred

stock + LLR = 10 + 10 + 5 + 10 = 35m
o Total Assets = 1215m (given)
70
 CET 1 CAPITAL RATIO = CET1/CRWA = = 8.43% > 4.5%
830
70+10
 TIER 1 CAPITAL RATIO = TIER 1/CRWA = = 9.64% > 6%
830
70+10+35
 TOTAL CAP RATIO = T1+T2/CRWA = = 13.68% > 8%
830
70+10
 LEVERAGE RATIO = TIER 1/Total Assets = = 6.58% > 3%
1,215

PROMPT CORRECTIVE ACTIONS (PCA) IN THE US

 DI's capital adequacy also monitored based on its place in one of 5 capital target zones under FDIC
Improvement Act (FDICIA) 1991
 FDICIA requires regulators take prompt corrective actions when DI falls outside zone 1 (well-
capitalised category)
 Receiver must be appointed when DIs tangible equity
𝑇1+𝑁𝑜𝑛𝑇 1 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘
( ≤ 2%)
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
 idea of PCA is to limit ability of regulators to show tolerance to worst capitalised DIs

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WEEK 4: LIQUIDITY RISK AND LIABILITY MANAGEMENT

LIQUIDITY RISK

Liquidity Risk: manage liquidity to meet demand for daily withdrawals. Extreme cases -> insolvency risk

 Meet liquidity demand by :

1. Run down cash assets
2. Sell off other liquid assets
3. Borrow additional funds
 When all above fail, FI has to liquidate illiquid asset at fire-sale prices for immediate sale
 Then insolvency risk begins

E.G. IMPACT OF LIQUIDTY RISK ON FI'S EQUITY VALUE

 FI forced to liquidate $10m illiquid assets at $5m loss to meet withdrawal demand

t
 Equity drops by $5m

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 If there is another $5million demand, FI would incur at least another $5m in losses and become
insolvent
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LIQUIDITY RISK'S 2 REASONS

Th

1. Liability-side liquidity risk: not enough cash to meet withdrawal

2. Asset-side liquidity risk:
a. not enough cash to fund exercise of loan commitment or other lending commitments
b. value of FI's investment portfolio fallen unexpectedly
i. although loss can be absorbed by equity, FI still needs to fund loss so it has enough
liquid assets to meet loan requests and unexpected deposit withdrawals

Like maturity mismatch, liquidity risk is inherent in FI's asset transformation function

 DI uses large amount of ST liabilities to finance LT assets

LIABILITY-SIDE LIQUIDITY RISK

 liquidity risk inherent in DI's asset transformation: duration mismatch

o DIs use large amount of ST liabilities to finance LT assets
 DI knows only small proportion of deposits will be withdrawn on a given day
o parts of withdrawals offset by inflow of new deposits
o Net Deposit Drain: Deposit withdrawals - deposit additions
 Over time DI can predit probability of net deposit drain
  Most demand deposits act as consumer core deposits on a day-by-day basis, providing relatively
stable/LT source of funds for DI

MANAGINGDEPOSIT DRAINS USING PURCHASED LIQUIDITY MANAGEMENT

AKA BORROWING ADDITIONAL FUNDS by:

1. Borrowing on market for purchased funds

a. e.g. Federal Funds Market/Repurchase Agreement Market
2. Issuing wholesale CDs (certificates of deposit)
3. Sell notes and bonds

Benefit: insulates size and composition of ASSET side of balance sheet from normal deposit drain

COST:

 expensive for DI: pay higher market rates for funds in wholesale money market to offset net drains on

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low-interest-bearing deposits
1. availability of funds can be limited when lenders are concerned about DI solvency

e.g. DI borrowed $5m to meet deposit drain

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MANAGING DEPOSIT DRAINS USING STORED LIQUIDITY MANAGEMENT

AKA SELL OFF LIQUID ASSETS by:

 DI can utilise stored liquidity to meet positive net deposit drains

1. Run down cash assets
2. Sell Liquid assets

Benefit: does not rely on availability of funds on market

COST:
 1. Decreased asset size
2. Must hold excess low-rate assets
a. forgo returns from investing in higher-income-earning assets

Federal Reserve sets minimum reserve requirements DI must hold: DI hold cash in excess to meet liquidity
drains

e.g. $5m run down cash to meet withdraw demand. BS shrinks by $5m

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MANAGING ASSET-SIDE LIQUIDITY RISK

wa

 can use both purchased and stored liquidity management

ks

e.g.
in
Th
MEASURES OF LIQUIDITY RISK

NET LIQUIDITY STATEM ENT

Net Liquidity Statement: lists sources and uses of liquidity 0 provides measure of DI's liquidity position

DI can obtain liquid funds in 3 ways:

1. SELL Liquid asset with little price risk and low transaction cost
2. BORROW funds in money/purchased funds market up to maximum amount.
a. market would impose limit based on DI's debt capacity
3. USE excess cash reserve over and above amount held to meet regulatory imposed reserve
requirements

e.g. Net Liquidity Statement

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PEER GROUP RATIO COMPARISONS

ks

 Compare key ratios and BS features of DI with DI of similar size and geographic location
in

1. Loan to Deposit Ratio

 high ratio means DI relies heavily on ST money market rather than core deposits to
Th

funds loans (risky)

2. Borrowed Funds to Total Assets
3. Commitment to lend to Total Assets
 Funding from ST money market less reliable core deposits
1. e.g. GFC: banks stopped lending to each other at anything but high overnight rates.
Commercial paper market also frozen

LIQUIDITY INDEX

 Liquidity Index: measures potential losses from fire-sale disposal of assets vs. amount it would
receive at fair market value (which takes lengthy period : careful research and bidding process)
 e.g. DI has 2 assets
1. 50% 1 month T-bills
2. 50% real estate loans
If DI must liquidate
T-bills today: it receives $99/$100 FV
T-Bills 1 month later: $100/$100 FV
RE Loan today: $85/100 FV
RE Loan 1 month later: $ 92/100FV
 𝑂𝑛𝑒 − 𝑚𝑜𝑛𝑡𝑕 𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑖𝑛𝑑𝑒𝑥:
−𝐼 = (50% ∗ 99 100 + 50% 85 92 = 0.957

Suppose RE market can only liquidate real estate at $65/100 FV

−𝐼 = (50% ∗ 99 100 + 50% 65 92 = 0.848

FINANCING GAP AND THE FINANCING REQUIREMENT

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 Most depositors do not withdraw demand deposits in normal conditions
o Demand deposits stay for long periods (e.g. 2years +)
 Therefore core source of funding m
cu
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝐺𝑎𝑝 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑙𝑜𝑎𝑛𝑠 − 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑒𝑝𝑜𝑠𝑖𝑡𝑠
Do

 Positive Financing gap: funded by running down cash and liquid ssets/borrowing on market
o 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑔𝑎𝑝 = −𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝐹𝑢𝑛𝑑𝑠
p

o 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝐺𝑎𝑝 + 𝐿𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 = 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡

wa

 The larger a DIs financing gap and liquid asset holdings, the larger the amount of funds it needs to
borrow in money market and greater exposure to liquidity problems.
ks

e.g.
in
Th

𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒏𝒈 𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒎𝒆𝒏𝒕 = 𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 $5𝑚 + 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝐺𝑎𝑝 $5𝑚 = $10𝑚

 Widening finance gap: warn of future liquidity problems: indicate increased deposit withdrawals and
increasing loans due to increased exercise of loan commitment
 if DI doesn't reduce liquid assets, manager must borrow more
o sophisticated lenders will be concerned about creditworthiness
 react by imposing higher risk premiums on borrowed funds/establishing stricter
credit limits by not rolling over funds
 if DI exceeds limits it becomes insolvent.

BANK RUNS, DEPOSIT INSURANCE AND DISCOUNT WINDOW

BANK RUNS

Bank Run: sudden and unexpected increase in deposit withdrawals from DI

Reasons:

1. DI's solvency relative to other DIs

2. Failure of related DI leading to heightened concerns about solvency of other DIs
3. Sudden changes in investor preference regarding holding nonbank financial assets( e.g. mutual funds)
relative to deposits

E.G. 2008 RUN ON WASHINGTON MUTUAL (WAMU)

 July 2008 $9.4 billion run

o FDIC seized IndyMac
o Sept 11 2008, Moody's downgraded WaMu's debt to junk status
 rated financial strength D+ and issued negative outlook citing asset quality and

t
potential for future losses (another $600m pullout)

en
 Other rating agencies followed ($2.3b pullout)
o Sept 25 2008, WaMu seized by OTS.
m
 JP Morgan to pay $1.9b to government for WaMu's banking operations and assume
cu
loan portfolio of thrift, which has $307b in assets.
Do

DEMAND DEPOSIT CONTRACTS AND BANK RUNS

p

 Demand Deposit Contracts: first-come, first-served

wa

o Depositor either gets paid in full or nothing

o when DI's value of assets < deposits
ks

 only certain proportion of depositors will be paid in full and depositor's place in line
determines amount withdrawable from DI
in

 incentive for depositor to run first and ask questions later creates fundamental instability in banking
Th

system that an otherwise sound DI can be pushed into insolvency by unexpected large depositor
drains and liquidity demands
 regulators recognise inherent instability of banking system and put 2 mechanisms:
1. Deposit Insurance
2. Discount Window

DEPOSIT INSURANCE

 If deposit holder believes claim is totally secure, even if DI is in trouble holder has no incentive to run
 FDIC deposit insurance: covers depositors of failed FDIC insured depository institution dollar-for-
dollar
o principal + interest accrued/due to depositor
o through the date of default
o up to at least $250k/depositor per FDIC insured bank per ownership category
 AUS: Financial Claims Scheme: provides guarantee on bank deposits up to $250k/customer/institution

COSTS OF DEPOSIT INSURANCE: knowing deposit holders less likely to run even in insolvency creates
situation that DI are more likely to increase liquidity risk on BS
DISCOUNT WINDOW

Discount Window Loans: provide temporary liquidity for inherently solvent DIs, NOT PERMANENT, LT support
for insolvent DIs

 to borrow from discount window:

o DI need high quality liquid assets to pledge as collateral
 Discount rate: interest charged on loans set by central bank
 US: Fed set discount rate below market rate and required borrowers to prove they couldn't get funds
from private sector
o stigma on discount window borrowing
o Jan 2003, Fed lends to all banks but subsidy is gone
 3 lending programs offered through Fed's discount window
1. Primary Credit: generally sound DIs on VERY ST basis (overnight) at rate above Federal Funds rate
a. may be used for any purposes
2. Secondary Credit: for DIs not eligible for primary credit. Extended on very ST basis at rate above
primary credit rate

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en
a. use consistent with timely return to reliance on market sources of funding or orderly
resolution of a troubled institution
3. m
Fed's Seasonal Credit Program: small DIs to manage significant seasonal swings in loans and deposits
cu
a. usually located in agriculture
Do

LIQUIDITY RISK IN INVESTMENT FUNDS

 Open-end funds: issue unlimited supply of shares to investors and stand ready to buy back previously
p

issued shares from investors at current market price for fund shares
wa

o most investment funds are open-end funds

 Net Asset Value (NAV) : price at which open-end fund stands ready to sell new shares or redeem
ks

existing shares
in

o NAV calculated at close of market every day

 Investment funds exposed to similar liquidity problems as banks: if investors become nervous about
Th

NAV
 DIFFERENCE: the way investment fund contracts are valued vs DI deposit contracts mitigates
incentives for fund SHs to engage in runs

e.g. Beginning of Day: $1m assets, $0 liabilities, 10k Shares outstanding

𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 1𝑚
𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 = = = $100
𝑆𝑕𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 10𝑘

During the day asset value falls to $500k, outflow of 5k shares (5k sell)

500𝑘
𝑁𝐴𝑉 = = $50
10𝑘

Shares redeemed at $50/share.

Shares Outstanding drops to 5k

Assets remaining = 500k - NAV*Shares sold = 500k- 50*5 = 250k

 ALL INVESTMENTS/REDEMPTIONS DURING DAY PRICED AT CLOSING NAV

LIABILITY MANAGEMENT

LIQUID ASSET AND LIABILITY MANAGEMENT

 DI manager can optimise liquid assets AND liability structures to insulate DI against liquidity risk
o on one hand, DI needs to build up prudential level of liquid assets while minimising
opportunity costs of funds.
 Optimal mix of lower-yielding, liquid assets and higher-yielding, less liquid assets
 holding too many liquid assets penalises earnings
 holding too few exposes FI to liquidity crises
o on other hand, DI needs to structure liabilities
 need for large amount of liquid assets is reduced
 trading off funding risk and funding costs.
 DI must trade benefits of attracting low funding cost liability with high withdrawal VS high funding
cost liability and low liquidity

t
en
m
cu
Do
p
wa
ks
in
Th

DEMAND DEPOSIT, NOW ACCOUNTS, PASSBOOK SAVINGS, MMDAS

Demand Deposit:

 high withdrawal risk

 zero explicit interest but not costless fund because DI provide whole set of associated services with
absorb real resources
o DI pay implicit interest on accounts and use implicit interest to control withdrawal risk

Interest Bearing Checking (NOW) Accounts:

 Negotiable Order of Withdrawal(NOW) Account: checkable deposits that pay interest and can be
withdrawn on demand
 required to maintain minimum balance to earn interest
 DIs can influence withdrawal risk: adjusting explicit interest, minimum balance requirement and
implicit interest
Passbook Savings:

 non-checkable and require physical presence at DI to withdrawal

 DI has legal power to delay payment/withdrawal requests for up to 1 month
 principal cost: explicit interest payments on account

Money Market Deposit Accounts (MMDAs)

 control risk of funds' disintermediating from DIs and flowing into money market mutual funds
(MMMFs)
 US: don't require DIs to hold reserves against MMDA's -> dI pay higher rate on MMDA than NOW
 Major cost: explicit interest paid to depositors
o managers can use spread of MMMF-MMDA accounts to influence net withdrawal rates on
MMDAs
 rate MMMFs pay on shares directly reflect rate earned on underlying money market
assets: rates on MMDA NOT based directly on any underlying portfolio of money
market assets

t
 MMDA insured by FDIC

en
 MMMFS are NOT insured

Retail CDs m
cu
 fixed maturity instruments: FV under $100k
Do

 regulation lets DI impose penalties on early withdrawals of time deposits or CDs

o does not stop withdrawals when depositors see DI as insolvent
 under normal conditions: low withdrawal risk
p

 Major cost: explicit interest payments

wa

Wholesale CDs
ks

 minimum denomination $100k+

in

 unique feature: negotiable: can be sold by title assignment on secondary market to other investors
Th

 depositor can sell relatively liquid wholesale CD without causing withdrawal risk exposure
o only if CDs are not rolled over and reinvested by holder of deposit claim on maturity
o rate paid on instruments competitive with other wholesale money market rates: e.g. t-bills
o required yield on CDs reflect investor's perception of depth of secondary market for CDs
o only first $250k(per investor per institution) invested in CDs covered by deposit insurance

FEDERAL FUNDS

 besides issuing deposits, DIs can borrow for purchased funds

o funds generated from purchases are NOT deposits -> not subject to reserve requirement nor
deposit insurance premium payments to FDIC
 Largest market: Federal Funds Market: interbank market for excess cash reserves where DI with
excess can lend surplus to DIs in need of reserve balance
 Federal Funds: ST uncollateralized loans made by one DI to another
o 90%+ transaction maturity: 1 day
o uncollateralized: institutions selling fed funds impose MAXIMUM bilateral limit (credipt caps)
on borrowing institutions
 MAJOR COST: Federal Funds Rate: interest at which DI lend reserve to each other overnight
  RISK OF FUNDING BY FEDERAL FUNDS: fed funds not rolled over by lending bank the next day if
rollover is desired by borrowing DI: only in periods of extreme crisis (GFC)

REPURCHASE AGREEMENT

FED FUNDS vs REPURCHASE AGREEMENT

Fed Funds can be entered into at any time in business day

Difficult to transact RP late in day since DI sending fed funds must be satisfied with type/quality of securities
collateral proposed by borrower

Negotiations over collateral delay RP: difficult to arrange than FED FUND

Repurchase Agreement (RP): sale of securities coupled with agreement to repurchase same securities at
higher price on later date

 Selling-Buying price = interest payment on borrowing

t


en
maturity date is fixed or extended on day-to-day basis

m
Interest rate (repo rate): depend on quality of collateral/identity of borrower
cu
Repos renewed with same dealer or replaced by new repos with other dealers
Do

REPO: Collateralized loan: cash provider receives repo rate

IF collateral provider (borrower) default on obligation to repay, cash provider( lender) entitled to sell pledged
p

securities
wa

IF cash provider fails to return securities, collateral provider keeps cash

ks

Reverse Repo: same repurchase agreement from buyer's viewpoint: seller calls it repo, buyer calls it reverse
in

repo
Th

E.G.

A borrows $10m overnight at repo 3%pa selling securities to mutual fund and agreeing to repurchase next day

Repurchase price:
COMMERCIAL PAPERS

Commercial Paper: unsecured ST promissory note issued by corporation to raise ST cash

 one of LARGEST money market instruments

o strong credit rating can borrow money at lower interest by issuing commercial paper than
directly borrowing from commercial banks
o maturity<270days
 DI subsidiary itself cannot issue commercial paper, ONLY PARENT company.
o provides DI owned subsidiaries by holding companies with additional funding source

MEDIUM-TERM NOTES AND DISCOUNT WINDOW LOANS

 DIs search of STABLE FUNDS with LOW WITHDRAWAL RISK: medium-term notes: 5-7 yr
o neither reserve requirement OR deposit insurance premium
 DI facing temporary liquidity crunch can borrow from central bank's discount window at discount rate

t
en
LECTURE 5: INTEREST RATE RISK (PART 1)

INTEREST RATE RISK OF FIS

m
cu
ASSET TRANSFORMATION: mismatch in asset/liability maturities
Do

 if interest constant over time and deposits can be rolled over at same rate, no risk to bank
o interest spread locked in
p


wa

IF interest changes over time, bank exposed to interest rate risk

o Net Interest Income(NII) affected
 Repricing Model
ks

o Net Worth (MV equity) affected

in

 Duration Model
Th

Refinancing Risk

 cost of funds: 9%/yr (interest), ROA: 10%

 1st year, FI locks profit spread 1%
o profit 2nd year uncertain
o IF interest rises to 11%, profit spread is -1%
 FI loses 1%*100m = 1m in 2nd year

REINVESTMENT RISK
  interest: 9%, ROA 10%/year.
 1st year profit spread 1%, profits for second year uncertain
o if INTEREST FALLS, FI can only invest in NEW 1 year asset at 8% second year, profit spread = -
1%
 FI lose 1%*100m = 1m in 2nd year

REPRICING MODEL

t
Repricing Gap: DIFFERENCE between assets and liabilities whose interest rates will be REPRICED over some

en
future period

 assets: RISK SENSITIVE ASSETS (RSA) m

cu
 liabilities: RISK SENSITIVE LIABILITIES (RSL)
o REPRICING GAP measures: FI's NET INTEREST INCOME EXPOSURE to interest rate change in
Do

different maturity buckets

o Assume qual change in interest on RSA and RSL
∆𝑵𝑰𝑰𝒊 = 𝑮𝑨𝑷 ∆𝑹
p
wa

= (𝑹𝑺𝑨 − 𝑹𝑺𝑳)∆𝑹
 ∆𝑵𝑰𝑰 = 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑵𝑰𝑰 𝒊𝒏 𝒎𝒂𝒕𝒖𝒓𝒊𝒕𝒚 𝒃𝒖𝒄𝒌𝒆𝒕 𝒊
ks

 ∆𝑹 = 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒊𝒎𝒑𝒂𝒄𝒕𝒊𝒏𝒈 𝒂𝒔𝒔𝒆𝒕𝒔 𝒂𝒏𝒅 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 𝒊𝒏 𝒃𝒖𝒄𝒌𝒆𝒕 𝒊


in

GAP = REPRICING GAP in maturity bucket i

o NEGATIVE REPRICING GAP (RSL>RSA) : REFINANCING RISK:
Th

 Rise in interest = Fall in NII

o POSITIVE REPRICING GAP (RSA>RSL): REINVESTMENT RISL
 drop in interest = FALL IN NII

REPRICING due to:

 rollover of asset/liability
o e.g. loan paid off prior to maturity and funds used to issue new loan at CURRENT market rate
 asset/liability is variable rate instrument
o e.g. variable rate mortgage interest reset every quarter based on movements in prime rate

FI can restructure assets/liabilities, on or OBS to benefit from projected interest change

 if projected increase interest, POSITIVE REPRICING GAP

 if projected decrease interest, NEGATIVE REPRICING GAP

CUMULATIVE GAP
Cumulative Gap: Repricing gap for several consecutive repricing intervals: repricing gap over broader interval
can be calculated by summing repricing gap over narrower interval.

APPLYING REPRICING MODEL

t
en
1. identifying RSA and RSL over maturity bucket
a. e.g. interest rise 1% in next 3 months: annualised change in NII?
m
cu
Do

b.
c. interest rate is p.a., repricing model calculates annualised change in NII
p

i. assumes RSA and RSL repriced at BEGINNING of repricing interval

wa
ks
in
Th

d.
i. Demand Deposits and Passbook Savings are rate INSENSITIVE (core deposits)
1. explicit interest on demand deposit = 0
2. although NOW account pay explicit interest, rate paid by FI don't fluctuate
with changes in interest
ii. ARGUMENT FOR RSA INCLUSION
1. when interest rise, individual may draw down demand deposit or savings to
move money to higher interest instruments, forcing bank to replace with
more expensive fund substitutions
ALTERNATIVE EXPRESSIONS OF REPRICING GAP

 INTEREST RATE SENSITIVITY: % OF ASSETS TELLS US:

𝐶𝐺𝐴𝑃
𝐴𝑆𝑆𝐸𝑇𝑆
o Direction of interest rate exposure
o Scale of Exposure
 OR gap ratio as RSA/RSL

𝑅𝑆𝐴
𝑅𝑆𝐿

 RATIO<1 (RSL>RSA): REFINANCING RISK

 RATIO>1(RSA>RSL): REINVESTMENT RISK

UNEQUAL CHANGES IN RSA AND RSL

IF UNEQUAL, CHANGE IN NII =

t
en
∆𝑁𝐼𝐼 = 𝑅𝑆𝐴 ∗ ∆𝑅𝑟𝑠𝑎 − (𝑅𝑆𝐿 ∗ ∆𝑅𝑟𝑠𝑙 )

DECOMPOSED INTO CGAP effect and SPREAD effect m

cu
Do
p
wa
ks
in
Th

When interest on RSA and RSL are unequal, there is ADDITIONAL spread effect on GAP effect.

Spread effect: Change in spread always POSITIVELY RELATED to

When CGAP and Spread are opposite, cannot be predicted without knowing CGAP size and change
in spread.

REPRICING MODEL WEAKNESS

1. ignores MV effects of interest rate change

a. PV of CF on asset/liabilities change as well as interest received/paid as interest changes
b. repricing model ignores MV effect: IMPLICITLY assuming BV approach
c. repricing gap is only partial measure of true interest rate risk
2. ignores distribution of assets/liabilities within maturity bucket
a. assets/liabilities repriced at different time within bucket
b. shorter the range over which bucket gaps are calculated, the smaller the problem
3. Ignores runoff CF
a. FI continuously create/retires assets as it creates new liabilities
 b. even if asset/liability is rate insensitive, virtually ALL assets/liability pay some
principal/interest to FI in any given year
i. FI receive runoff CF from rate insensitive portfolio that can be reinvested at current
market rates
1. IDENTIY each asset/liability ESTIMATED dollar CF run off and add amount
to RSA/RSL
4. Ignores CF from OBS
a. e.g. FI hedged interest rate risk with futures
i. mark-to-market could produce daily CF for FI that may offset on BS gap exposure

MARKET VALUE EFFECTS OF CHANGES IN INTEREST RATES

 Moderate interest rate increase -> insolvency of bank

o mismatch of asset/liabilities: when interest rise
 LT assets fall MORE than ST liabilities
 Maturity Model: effect of interest changes on FI's net worth: weighted average maturity gap between
Assets and Liabilities: 𝑀𝐴 − 𝑀𝐿

t
en
 𝑀𝐴 − 𝑀𝐿 = 0 𝑚𝑎𝑡𝑐𝑕𝑒𝑑 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑑𝑜𝑒𝑠 𝑛𝑜𝑡 𝑖𝑚𝑚𝑢𝑛𝑖𝑠𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑟𝑖𝑠𝑘
o timing of intermittent CF can still be different
m
 even if CF timing same, amount of assets/liabilities different due to leverage
cu
DURATION MODEL
Do

Duration: %change in Price to small change in R

p
wa
ks
in

 MV effect of interest rate changes

Th

DURATION = weighted average time to maturity using PV of CF as weights.

DURATION OF COUPON BOND ALWAYS LESS THAN MATURITY

DURATION OF ZCB = MATURITY

DURATION: LIABILITY

Calculate change in P for small change in R

WEEK 6: INTEREST RATE RISK (PART II)

MULTIPLE TIMES OF COMPOUNDING PER PERIOD & MODIFIED DURATION

When compounding frequency = M times per period

t
en
m
cu
Do

Modified Duration: %change in P to change in interest rate.

p
wa
ks
in
Th

FEATURES OF DURATION

DURATION

1. Increases with maturity at decreasing rate

a. BUT bonds selling BELOW par: duration increases with maturity up to a point
b. LONG maturities (e.g. 50 years) duration start to decline but few bonds have maturity this
long to see the decline
2. DECREASES with yield

3. DECREASES with coupon rate

IMMUNISING SINGLE SECURITY

 insurance company and pension fund managers face risk of INTEREST FALL -> returns on investment
insufficient to meet promised payment
o e.g. 2016 guarantee for 2021
o payment:$1469 lump sum -> $1000 annually compounded at 8% over 5 years
o IMMUNIZE: investment to produce CF of EXACLTY $1469 in 5 years REGARDLESS of interest
 BUY 5 YEAR MATURITY DISCOUNT BOND
 5 year discount bond FV$1000, Yield = 8%p.a.
 Price = FV/1.08^5 = $680.58
 BUY1.469bonds to pay $1469 in 5 years
 SINCE no intervening CF or coupon paid by bonds, future change in interest
rate have no reinvestment income effect ->IMMUNISED
 IF COUPON BOND: match duration not maturity
 e.g. 6 year maturity bond: 8% coupon, 8% YTM, FV $1000, Duration = 4.993 (almost
5)

t
en
m
cu
Do
p
wa
ks
in

If insurer buys this bond and holds for 5 years, reinvests all coupon at market rate, CF at end of 5 years will be
Th

$1469 regardless of interest rate

if interest rate stays 8%

Interest rises to 9%

Interest falls to 7%
Always adds up to $1469

DURATION OF PORTFOLIO OF ASSETS

t
Xi is MV proportion of asset i

en
DURATION OF ASSET AND LIABILITY PORTFOLIO OF AN FI m
cu
Do
p
wa
ks
in

IMMUNISING WHOLE BALANCE SHEET

Th

ASSETS = LIABILITIES + EQUITY

EQUITY is NET WORTH

FI is insolvent if EQUITY < 0

Change in INTEREST causes CHANGE in NET WORTH

IMMUNISE EQUITY AGAINST CHANGE:

k = LEVERAGE = LIABILITIES/ASSETS

Leverage Adjusted Duration Gap:

TO IMMUNISE: Leverage Adjusted Duration Gap = 0 ->

t
en
ASSET DURATION equalling LIABILITY DURATION does not immunise equity because A>L

m
Traditional Bank: Leverage Adjusted Duration Gap > 0 because of POSITIVE LEVERAGE.
cu
As Interest Rises, Equity Falls
Do

As Interest Falls, Equity Rises

p
wa

E.G.
ks

DA = 5yrs
in

DL = 3yrs
Th

∆R = +1%, MV Asset = $100m, MV Liab = $90m

90 0.01
∆E = − 5 − 3 ∗ ∗ 100 ∗ = −$2.09 m
100 1.1

FI loses 2.09m with 1% interest increase

TO IMMUNISE:

REDUCE D Asset ->2.7

Increase D Liability ...etc.

IMMUNIZATION AND REGULATORY CONSIDERATIONS

  regulators set minimum target ratio for capital to asset

o managers may immunise change in CAPITAL ratio rather than equity

 TO IMMUNISE:
 Equity/Assets = 1 - Liab/Assets = 0


o CANNOT IMMUNISE Equity and Capital ratio simultaneously

DURATION MODEL DIFFICULTIES

1. Duration matching costly and time-consuming

a. restructuring BS of large FI time-consuming

t
i. growth of purchased funds/asset securitization/loan sales market has eased speed

en
and lower transaction costs

2. IMMUNIZATION IS DYNAMIC: everchanging

m
ii. OR take hedging position for derivative securities
cu
3. LARGE INTEREST RATE CHANGES: Convexity problems ( Duration measure much less than actual
Do

Duration)
4. DURATION changes as time passes at different rate to real time
5. DURATION changes with INTEREST
p

a. fall in interest -> Duration increase

wa

b. no longer immunised
ks

E.G.
in

interest falls to 7% at end of year 1, Duration ->4.33 years > 4 year horizon
Th

SELL 5 year coupon bond and invest proceeds in 4 year ZCB

 coupon year 1 = $80, 5 year bond sold for $1041 (7% annual yield)
 Investing 80+1041 in 4 year ZCB -> $1469 in 4 years

OR sell 50% of 5 year bond and invest proceeds in 3.67 year duration ZCB

CONTINUOUS REBALANCING: transaction fees -> only approximately dynamically immunised by rebalancing at
discrete intervals

TRADE OFF: PERFECTLY IMMUNISED: TRANSACTION COST OF IMMUNIZATION

LARGE INTEREST RATE CHANGE AND CONVEXITY

LARGE RATE INCREASE: Duration OVERPREDICTS fall in bond price

LARGE RATE DECREASE: UNDERPREDICTS increase in bond price

 CONVEXITY BENEFIT: capital gain effect of rate decrease > capital loss effect of rate increase of same
magnitude
o buying bond/portfolio of assets with a LOT of convexity is similar to buying PARTIAL
INTEREST RATE RISK INSURANCE
o HIGH CONVEXITY: for equally large changes in interest rate, capital gain effect MORE THAN
offsets capital loss effect of rate increase

t
en
First term is simple duration model, second term is curvature adjustment
m
cu
PROPERTIES OF CONVEXITY
Do

1. INCREASES WITH bond maturity

2. SAME MATURITY: Coupon bonds have LESS CONVEXITY than ZCB
3. SAME DURATION: Coupon bonds have MORE CONVEXITY than ZCB
p
wa

E.G.CAPTURING DESIRED EFFECT OF CONVEXITY

ks

15 year horizon IMMUNIZATION

in

15 year bond duration

Th

STRATEGY 2> 1 : GREATER CONVEXITY, SAME DURATION

PROBLEM WITH FLAT TERM STRUCTURE (MACAULAY DURATION)

ASSUMED FLAT YIELD CURVE: Macaulay Duration