Financial institutions management a risk management approach 8th by sauder

Financial institutions management a risk management approach 8th by sauder Financial institutions management a risk management approach 8th by sauder Financial institutions management a risk management approach 8th by sauder Financial institutions management a risk management approach 8th by sauder Financial institutions management a risk management approach 8th by sauder Financial institutions management a risk management approach 8th by sauder

Financial Institutions Management A Risk Management Approach The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor FINANCIAL MANAGEMENT Block, Hirt, and Danielsen Foundations of Financial Management Fifteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Eleventh Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Eighth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Tenth Edition Shefrin Behavioral Corporate Finance: Decisions That Create Value First Edition White Financial Analysis with an Electronic Calculator Sixth Edition INVESTMENTS Brealey, Myers, and Marcus Fundamentals of Corporate Finance Seventh Edition Bodie, Kane, and Marcus Essentials of Investments Ninth Edition 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Skills Fourth Edition Kapoor, Dlabay, and Hughes Personal Finance Tenth Edition Walker and Walker Personal Finance: Building Your Future First Edition Financial Institutions Management A Risk Management Approach Eighth Edition Anthony Saunders John M Schiff Professor of Finance Salomon Center Stern School of Business New York University Marcia Millon Cornett Professor of Finance Bentley University FINANCIAL INSTITUTIONS MANAGEMENT: A RISK MANAGEMENT APPROACH, EIGHTH EDITION Published by McGraw-Hill Education, Penn Plaza, New York, NY 10121 Copyright © 2014 by McGraw-Hill Education All rights reserved Printed in the United States of America Previous editions © 2011, 2008, and 2006 No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning Some ancillaries, including electronic and print components, may not be available to customers outside the United States This book is printed on acid-free paper QVS/QVS ISBN 978-0-07-803480-0 MHID 0-07-803480-9 Senior Vice President, Products & Markets: Kurt L Strand Vice President, Content Production & Technology Services: Kimberly Meriwether David Managing Director: Douglas Reiner Executive Brand Manager: Chuck Synovec Development Editor: Noelle Bathurst Senior Marketing Manager: Melissa Caughlin Director, Content Production: Terri Schiesl Content Project Manager: Judi David Buyer: Susan K Culbertson Cover Image: Eyewire/Getty Images Compositor: Laserwords Private Limited Typeface: 10/12 Palatino Printer: Quad/Graphics All credits appearing on page or at the end of the book are considered to be an extension of the copyright page Library of Congress Cataloging-in-Publication Data Saunders, Anthony, 1949Financial institutions management : a risk management approach/Anthony Saunders, John M Schiff Professor of Finance, Salomon Center, Stern School of Business, New York University, Marcia Millon Cornett, Professor of Finance, Bentley University.—Eighth edition pages cm ISBN 978-0-07-803480-0 (alk paper) Financial institutions—United States—Management Risk management—United States Financial services industry—United States—Management I Cornett, Marcia Millon II Title HG181.S33 2014 332.1068—dc23 2013018782 The Internet addresses listed in the text were accurate at the time of publication The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites www.mhhe.com To all my co-authors over the years Anthony Saunders To my parents, Tom and Sue Marcia Millon Cornett About the Authors Anthony Saunders Anthony Saunders is the John M Schiff Professor of Finance and the former Chair of the Department of Finance at the Stern School of Business at New York University Professor Saunders received his PhD from the London School of Economics and has taught both undergraduate- and graduate-level courses at NYU since 1978 Throughout his academic career, his teaching and research have specialized in financial institutions and international banking He has served as a visiting professor all over the world, including INSEAD, the Stockholm School of Economics, and the University of Melbourne Professor Saunders has held positions on the Board of Academic Consultants of the Federal Reserve Board of Governors as well as the Council of Research Advisors for the Federal National Mortgage Association In addition, Dr Saunders has acted as a visiting scholar at the Comptroller of the Currency and at the Federal Reserve Banks of Philadelphia and New York Currently, he is an academic consultant for the FDIC He also held a visiting position in the research department of the International Monetary Fund He is editor of Financial Markets, Instruments and Institutions His research has been published in all the major money and banking and finance journals and in several books In addition, he has authored or coauthored several professional books, the most recent of which is Credit Risk Measurement: New Approaches to Value at Risk and Other Paradigms, 3rd edition, John Wiley and Sons, New York, 2010 In 2008, he was ranked as the most published author in the last 50 years in the top seven journals in finance Marcia Millon Cornett Marcia Millon Cornett is a Professor of Finance at Bentley University She received her BS degree in Economics from Knox College in Galesburg, Illinois, and her MBA and PhD degrees in Finance from Indiana University in Bloomington, Indiana Dr Cornett has written and published several articles in the areas of bank performance, bank regulation, and corporate finance Articles authored by Dr Cornett have appeared in such academic journals as the Journal of Finance, the Journal of Money, Credit and Banking, the Journal of Financial Economics, Financial Management, and the Journal of Banking and Finance In 2008, she was ranked as the 124th most published author in the last 50 years in the top seven journals in finance Dr Cornett served as an Associate Editor of Financial Management and is currently an Associate Editor for the Journal of Banking and Finance, Journal of Financial Services Research, FMA Online, the Multinational Finance Journal, and the Review of Financial Economics She has served as a member of the Board of Directors, the Executive Committee, and the Finance Committee of the SIU Credit Union Dr Cornett has also taught at the University of Colorado, Boston College, Southern Methodist University, and Southern Illinois University at Carbondale She is a member of the Financial Management Association, the American Finance Association, and the Western Finance Association vi Preface The last 25 years have been dramatic for the financial services industry In the 1990s and 2000s boundaries between the traditional industry sectors, such as commercial banking and investment banking, broke down, and competition became increasingly global in nature Many forces contributed to this breakdown in interindustry and intercountry barriers, including financial innovation, technology, taxation, and regulation Then in 2008–09, the financial services industry experienced the worst financial crisis since the Great Depression Even into the mid-2010s, the U.S and world economies have not recovered from this crisis It is in this context that this book is written Although the traditional nature of each sector’s product activity is analyzed, a greater emphasis is placed on new areas of activities such as asset securitization, off-balance-sheet banking, international banking, and on changes occurring as a result of the financial crisis When the first edition of this text was released in 1994, it was the first to analyze modern financial institutions management from a risk perspective Thus, the title, Financial Institutions Management: A Modern Perspective At that time, traditional texts presented an overview of the industry sector by sector, concentrating on balance sheet presentations and overlooking management decision making and risk management Over the last 20 years other texts have followed this change, such that a risk management approach to analyzing modern financial institutions is now well accepted Thus, the title: Financial Institutions Management: A Risk Management Approach The eighth edition of this text takes the same innovative approach taken in the first seven editions and focuses on managing return and risk in modern financial institutions (FIs) Financial Institutions Management’s central theme is that the risks faced by FI managers and the methods and markets through which these risks are managed are similar whether an institution is chartered as a commercial bank, a savings bank, an investment bank, or an insurance company As in any stockholder-owned corporation, the goal of FI managers should always be to maximize the value of the financial institution However, pursuit of value maximization does not mean that risk management can be ignored Indeed, modern FIs are in the risk management business As we discuss in this book, in a world of perfect and frictionless capital markets, FIs would not exist and individuals would manage their own financial assets and portfolios But since real-world financial markets are not perfect, FIs provide the positive function of bearing and managing risk on behalf of their customers through the pooling of risks and the sale of their services as risk specialists INTENDED AUDIENCE Financial Institutions Management: A Risk Management Approach is aimed at upperlevel undergraduate and MBA audiences Occasionally there are more technical sections These sections may be included or dropped from the chapter reading, depending on the rigor of the course, without harming the continuity of the chapters vii viii Preface MAIN FEATURES Throughout the text, special features have been integrated to encourage student interaction with the text and to aid in absorbing the material Some of these features include: • In-chapter Internet Exercises and references, which detail instructions for accessing important recent financial data online • International material highlights, which call out material relating to global issues • In-chapter Examples, which provide numerical demonstrations of the analytics described in various chapters • Bold key terms and marginal glossary, which highlight and define the main terms and concepts throughout the chapter • In-chapter Concept Questions, which allow students to test themselves on the main concepts within each major chapter section • Notable Events from the Financial Crisis, Industry Perspectives, and After the Crisis boxes, which demonstrate the application of chapter material to real current events ORGANIZATION Since our focus is on return and risk and the sources of that return and risk, this book relates ways in which the managers of modern FIs can expand return with a managed level of risk to achieve the best, or most favorable, return-risk outcome for FI owners Chapter introduces the special functions of FIs and takes an analytical look at how financial intermediation benefits today’s economy Chapters through provide an overview describing the key balance sheet and regulatory features of the major sectors of the U.S financial services industry We discuss depository institutions in Chapter 2, finance companies in Chapter 3, securities firms and investment banks in Chapter 4, mutual funds and hedge funds in Chapter 5, and insurance institutions in Chapter In Chapter we preview the risk measurement and management sections with an overview of the risks facing a modern FI We divide the chapters on risk measurement and management into two sections: measuring risk and managing risk In Chapters and 9, we start the risk measurement section by investigating the net interest margin as a source of profitability and risk, with a focus on the effects of interest rate volatility and the mismatching of asset and liability durations on FI risk exposure In Chapter 10, we look at the measurement of credit risk on individual loans and bonds and how this risk adversely affects an FI’s profits through losses and provisions against the loan and debt security portfolio In Chapter 11, we look at the risk of loan (asset) portfolios and the effects of loan concentrations on risk exposure In addition, as a by-product of the provision of their interest rate and credit intermediation services, FIs face liquidity risk We analyze the special nature of this risk in Chapter 12 Modern FIs more than domestic maturity mismatching and credit extensions They also are increasingly engaging in foreign exchange activities and overseas financial investments (Chapter 13) and engaging in sovereign lending and securities activities (Chapter 14) In Chapter 15, we analyze market risk, a Preface ix risk incurred by FIs in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices In addition, modern FIs more than generate returns and bear risk through traditional maturity mismatching and credit extensions They also are increasingly engaging in off-balance-sheet activities to generate fee income (Chapter 16) and making technological investments to reduce costs (Chapter 17) Each of these has implications for the size and variability of an FI’s profits and/or revenues In Chapter 18 we begin the risk management section by looking at ways in which FIs can insulate themselves from liquidity risk In Chapter 19 we look at the key role deposit insurance and other guaranty schemes play in reducing liquidity risk At the core of FI risk insulation is the size and adequacy of the owners’ capital or equity investment in the FI, which is the focus of Chapter 20 Chapter 21 analyzes how and why product and geographic diversification—both domestic and international—can improve an FI’s return-risk performance and the impact of regulation on the diversification opportunity set Chapters 22 through 26 review various new markets and instruments that have been innovated or engineered to allow FIs to better manage three important types of risk: interest rate risk, credit risk, and foreign exchange risk These markets and instruments and their strategic use by FIs include futures and forwards (Chapter 22); options, caps, floors, and collars (Chapter 23); swaps (Chapter 24); loan sales (Chapter 25); and securitization (Chapter 26) CHANGES IN THIS EDITION Each chapter in this edition has been revised thoroughly to reflect the most upto-date information available End-of-chapter questions and problem material have also been expanded and updated to provide a complete selection of testing material The following are some of the new features of this revision: • Tables and figures in all chapters have been revised to include the most recently available data • New boxes highlighting significant events occurring “After the Crisis” have been added to chapters throughout the book • Integrated Minicases have been added to Chapters 9, 13, 16, and 24 • Updates on the major changes proposed for the regulation of financial institutions are included where appropriate throughout the book • Discussion of how financial institutions continue to recover from the financial crisis has been added throughout the book Virtually every chapter includes new material detailing how the financial crisis has affected risk management in financial institutions • Chapters 2, 7, and 14 include discussions of the European debt crisis as it affects the risk and return of financial institutions • Chapter includes a discussion of Bank Transfer Day, as well as a summary of the new stress tests imposed on large depository institutions • A section on venture capital services has been added to Chapter Also, the chapter includes a discussion of the LIBOR scandal that broke in late 2012 • Chapter includes a new section on index funds and expanded discussion of ETFs Further, the chapter includes an update on the regulation of hedge funds Index 873 in financial crisis of late 2000s, 61, 62, 174, 413 insurance companies, 169 investment ratio (INVR), 423 ITT Financial, 803 J Jackson, W E III, 678, 678n Jagtiani, J A., 678, 678n Japan accounting standards, 685 commercial banks, 586, 660 deposit insurance system, 586 finance companies, 82 in financial crisis of late 2000s, 61, 400, 586 insurance companies, 169–170 largest banks, 20, 61 mutual fund market, 136 nationwide banking, 670 wire transfer systems, 524 Japan Post Bank, 20 Japan Post Holdings, 169 Jayhawk Acceptance Corp., 75 J.P Morgan (JPM), 27, 29, 87, 89, 90, 95, 345, 345n., 412, 430n., 441, 441n., 448n., 655, 671, 766, 799, 801 J.P Morgan Asset Management, 137 J.P Morgan Chase, 2, 11–12, 20, 26, 27, 29, 30, 38, 40, 54, 57, 72, 86, 88, 102, 184, 188, 274, 277, 282, 286, 345, 373, 387, 391, 392, 412–413, 417, 438, 439, 441–450, 453–454, 461–462, 468, 476, 477, 479, 488, 491, 495, 585, 616, 630, 652, 660, 664, 665, 666, 673–675, 678–680, 773, 803, 830, 847, 848 J.P Morgan Chase Bank, 692 J.P Morgan Chase & Co., 2, 87, 104, 107 J.P Morgan Insurance Agency, J.P Morgan Securities, Julis, Mitchell, 140 Junk bonds, 276, 802 K Kansas City Board of Trade, 695n Kensington Global Strategies Fund, 140 Keogh plans, 581 Kerviel, Jerome, 476 Keybank National Association, 692 KeyCorp, 391, 468, 616 KMV Corporation, 310, 310n., 331 Knight Capital Group, Inc., 88, 99, 504 Kolatch, Jonathan, 140 KPMG Information Security Survey, 532 Kroszner, Randall, 16n Kuchne, B J., 306n Kuhn, Steve, 141 Kuwait, in financial crisis of late 2000s, 61 L LaBranche & Co., 88 Lagged reserve accounting system, 544 Lang, W., 521n Late trading abuses, 131, 133 Latin America See names of specific countries Lazard Ltd., 88, 95 Least-cost resolution (LCR) strategy, 582–584 Leeson, Nicholas, 476 Legal issues See also Regulation of financial institutions loan sales growth and, 808 Lehman Brothers Inc., 2, 26, 80, 86, 87, 102, 117, 128–129, 184, 373, 415, 438–439, 476, 491, 572–573, 589, 592, 593, 594, 655, 766 Lender of last resort, Lender-specific default risk factors, 428–429 Less developed countries (LDCs) See also Emerging markets and names of specific countries secondary market for debt, 429–433 sovereign risk and, 412–429 Letters of credit (LCs), 185, 475, 478, 485–487 commercial, 485–486, 487 electronic initiation, 509 risks associated with, 487 standby, 485, 486–487, 786 Leverage as borrower-specific default risk factor, 293 highly leveraged transactions (HLTs), 798–799, 800–801, 802, 803, 808, 809 Leverage adjusted duration gap, 246 Leveraged buyouts (LBOs), 800–801 Leverage ratio, 630–631, 635–636 Liabilities See also Balance sheet; Liability management commercial bank, 34–35, 36 finance company, 77–78 investment banking market risk, 183–184 life insurance company, 154–155 off-balance-sheet (OBS), 36–38, 475–478 rate-sensitive liabilities (RSL), 199–200, 202–208, 209 securities firm/investment bank, 99–100 Liability insurance, 159 Liability management, 550–563 See also Guaranty programs depository institution (DI), 552–561 insurance company, 562 other fiduciary institutions, 562–563 Liability-side liquidity risk, 352–356 Liability withdrawal risk See Liquidity risk Liberty Mutual, 158 LIBOR (London Interbank Offered Rate), 769–771 as base lending rate, 285 in duration models, 271–272 interest rate manipulation, 106– 107, 285, 286, 484, 505 liquidity risk and, 351 Life insurance companies, 148–157 accident and health insurance, 152–153 annuities, 149, 152 balance sheet, 153–155 capital adequacy, 636–638 credit (default) risk, 176–178 guaranty programs, 569, 590–591 in financial crisis of late 2000s and, 155–156 industry characteristics, 149–153 international issues, 168–170 874 Index LIBOR—Cont largest, 148, 149, 169 liquidity risk, 7, 370 mutual versus stock insurance companies, 149–150 off-balance-sheet (OBS) risks, 494 price risk, private pension funds, 152 regulation, 156–157, 339 surrender value of policy, 370, 370n trends, 155–156 types of life insurance, 150–152 Limited-purpose finance companies, 18 Lincoln National, 155 Linear discriminant credit scoring model, 296–298 Linear probability credit scoring model, 295–296 Lipper Analytical Services, 125 Liquid asset management, 538–550 See also Guaranty programs; Liquidity risk bank runs/panics, 39, 355n., 368–369, 538, 568–569, 574, 582, 589–590 depository institution management problem, 541–545 insurance company, 562 liability structure for depository institutions, 560–561 liquid asset portfolio composition, 540 monetary policy, 539–540 non-cash liquid assets, 549–550 other fiduciary institutions, 562–563 overshooting reserve target, 546, 547–549 reasons, 538–540 return-risk trade-off, 541–550 taxation, 539–540 technology and, 508–509 undershooting reserve target, 545–547 Liquid assets ratio, 540 Liquidity costs, 4–5 Liquidity coverage ratio, 362–363, 364 Liquidity index, 360–361, 538–539 Liquidity premium theory, 222–223 Liquidity risk, 3, 4, 7–8, 173, 178– 180, 351–374, 815–816 See also Guaranty programs; Liquid asset management asset-side, 352, 356–358, 821 Bank for International Settlements (BIS) measures, 362–368 bank runs/panics, 39, 368–369, 538, 568–569, 574, 582, 589–590 causes, 352 deposit drains, 368–369 depository institution (DI), 7, 351–369 financial crisis of late 2000s, 351, 371, 373 financing gap, 361 financing requirement, 361 hedge fund, 373 insolvency risk, 351 insurance company, 7, 370–371 liability management, 550–563 liability-side, 352–356 liquid asset management, 538–550, 560–563 liquidity index, 360–361, 538–539 loan sales, 807 market risk and, 357–358 measuring liquidity exposure, 358–368 measuring liquidity exposure, 358–368 mutual fund, 7, 128–129, 371–373 net stable funding ratio (NSFR), 363–365, 366 peer group ratio comparisons, 359–360 required stable funding (RSF), 365, 366–367 sources and uses of liquidity, 358–359 Lloyds Banking Group, 286, 630 Lloyds TSB, 82 Load funds, 125–126 Loan commitment (line of credit), 279, 475, 478, 481–485 Loan commitment agreement, 481–485 Loan concentration risk, 274, 328–339 CreditMetrics model, 326, 329n., 345–348, 610 CreditRisk+ model, 326, 348–350 Moody’s Analytics Portfolio Manager model, 326, 331–335 partial applications of portfolio theory, 335–339 regulatory models, 339 simple models, 326–328 Loan loss ratios, 338–339 Loan loss reserves, 412 Loan migration matrix (transition matrix), 327 Loan origination fees, 285 Loan Pricing Corporation, 335, 800–801 Loan purchases, 802–803, 809–810 Loan sales, 796–810 bank loan sales, 797–810 buyers, 801–803 contract types, 799–800 factors affecting growth, 807–810 foreign bank, 805, 809–810 reasons, 806–807 sellers, 803–806 trends, 800–801 types, 797–799 Loan sharks, 75 Loans sold, 475, 493 Loan-to-value ratio, 282, 635 Loan volume-based models, 335–338 Loeb, Daniel, 141 Logit model, 295–296 Lombard, 82 London Interbank Offered Rate (LIBOR) See LIBOR (London Interbank Offered Rate) London International Financial Futures Exchange (LIFFE), 695n Long positions, net long in a currency, 388 Long-tail losses, 161 Long-Term Capital Management (LTCM), 137, 141–142, 142n., 476 Long-term mutual funds, 130 Loss adjustment expenses (LEA), 162, 163–164 Loss ratio, 162 Loss risk, 160–162 Lower of cost or current market value (LOCOM) accounting, 226n Loyalty programs, 511 Index 875 Luxembourg in financial crisis of late 2000s, 61 offshore hedge funds, 143 regulatory risk and, 683 M M1, 8–9, 9n M2, 8–9, 9n Macaulay’s duration, 229–234 See also Duration Macro hedge funds, 138 Macrohedging, 697–706 nature of, 697–698 off-balance-sheet effects, 704, 705, 706, 775 on-balance-sheet effects, 704, 705, 706 risk-minimizing futures position, 700–703 short hedge, 703–706 with futures, 698–708 with put options, 745, 746 with swaps, 773–775 Macy’s, 798–799 Madoff, Bernard, 144, 505, 591, 592 Madoff Investment Securities, 112, 137, 144, 505, 591, 592, 593 Maine, interstate banking pacts, 670 Management fees, mutual fund, 126 Man Group, 137, 141 Manulife Financial, 149 Marathon Asset Management, 141 Marginal default probability, 302 Marginal mortality rate (MMR), 305–306 Marino, Kevin, 530 Market benchmarks, 335–338 Market making, 92, 392 Market neutral-arbitrage hedge funds, 139 Market neutral-securities hedge funds, 139 Market Reform Act of 1990, 131 Market risk, 173, 183–184, 438–468, 532 Basel III (2010), 631–632 benefits of market risk measurement (MRM), 440, 441 BIS regulations, 461–468 calculating, 440–461 capital adequacy and, 631–632 See also Capital adequacy expected shortfall (ES) approach, 458–461, 463, 467 financial crisis of late 2000s, 183– 184, 438–440, 454, 466–468, 631–632 historic (back simulation) approach, 450–454 large-bank internal models, 466–468 liquidity risk and, 357–358 marking-to-market, 122, 226, 607, 609, 610, 693, 694–695, 719 Monte Carlo simulation approach, 454–458 RiskMetrics model, 345, 441–450, 453–454 standardized framework, 461–465 Market risk measurement (MRM), 440, 441 Market segmentation theory, 223–224 Market-specific default risk factors, 293–294 Market timing abuses, 131, 132–133 Market timing hedge funds, 138–139 Market value arguments against market value accounting, 609–611 book value versus, 609–611 credit risk and, 607–608 loan sale accounting, 808–809 marking-to-market, 122, 226, 607, 609, 610, 693, 694–695, 719 of capital, 607–608, 609–611 Market value accounting, 196–197, 208 marking-to-market, 122, 226, 607, 609, 610, 693, 694–695, 719 maturity/duration gap model, 208, 226–256 Market value effects, repricing/ funding gap model, 208, 226 Market value risk, 175–176 Marking-to-market, 122, 226, 607, 609, 610, 693, 694–695, 719 Markit, 783 Marshall, C., 531n Marshalls, 187 MasterCard, 282 Maturity, duration versus, 234–235 Maturity/duration gap model, 226–256, 264–273 duration and interest rate risk, 241–251 See also Duration credit (default) risk, 271 flat term structure, 269–271 floating-rate loans and bonds, 271–272 market value accounting in, 196–197, 208, 226 single security, 241–244 whole balance sheet of FI, 244–251 Maturity intermediation, 3, 8, 174–176 Maturity premium (MP), 219 MBNA, 87 McCarran-Ferguson Act of 1945, 156 McCulley, Paul, 658n McFadden Act of 1927, 41, 43, 670, 683 McNulty, J E., 520n Medium-term notes, 559 Megamergers, 671, 673 Meiji Yasuda Life, 169 Mellon Bank, 803–805 Mellon Financial, 29, 113–114 Merck, 98 Merger bid premiums, 678 Mergers and acquisitions commercial banks/banking, 2, 5, 11–12, 27, 29, 30, 54n., 79, 651, 654, 657, 665, 671–677 cost, 673–674 Herfindahl-Hirschman Index (HHI), 675–677 highly leveraged transactions (HLTs), 798–799, 800–801, 802, 803, 808, 809 largest firms, 95, 671, 673, 801 life insurance companies, 149 revenue, 674 savings institutions, 2, 10, 11–12, 27, 53, 54 securities firm/investment banking activities, 84–86, 87, 94, 95, 105 synergies, 672–677 Meridian, 671 Merkel, Angela, 62 Merrill Lynch, 5, 84, 86–90, 93–96, 101, 102, 104, 136, 184, 430n., 438, 476, 491, 654–655, 766, 805 876 Index Merton, R C., 310, 310n., 312n., 736n Message centers, 511–512 Mester, L J., 521n Metacapital Management, 141 MetLife, 148, 149, 169, 514, 616 Mexico debt moratorium, 412, 429 debt rescheduling, 417 finance companies, 82 NAFTA (North American Free Trade Agreement), 681 sovereign debt, 432 MF Global Holdings, 99, 476 Microhedging, 697 Midland Bank, 476 Migration analysis, 327 Milacron, 594 Milbourn, T T., 520n Miller, S M., 520n Minimum risk portfolio, 330–331 Mitsubishi UFJ Financial Group, 20, 105–106, 630, 652 Mizuho FG, 630 Mobile devices, 47–48, 510–512 Mobile home loans, 282 Model Act, 339 Moderate risk hedge funds, 138, 139 Modern Portfolio Theory (MPT) correlation coefficient, 329, 329n., 333–335 efficient portfolio composition, 337–338 expected return, 328 loan allocation deviation models, 336–338 loan loss ratio-based models, 338–339 loan portfolio diversification, 328–339 minimum risk portfolio, 330–331 Moody’s Analytics Portfolio Manager model, 326, 331–335 partial applications, 335–339 variance of returns (risk), 328–329 Modified duration, 238, 744 Molyneux, P., 521n Monetary policy contractionary, 197 discount window operations, 359, 369, 547, 559, 587–590 expansionary, 197 financial crisis of late 2000s and, 196, 197–199 liquid asset management and, 539–549 open market operations, 197– 199, 369 regulation of, 11, 13 transmission of, 3, 8–9 Money center banks, 30, 30n., 40, 803 Money laundering, 104, 527, 680, 683 Money market deposit accounts (MMDAs) costs, 555 withdrawal risk, 554–555 Money market mutual funds (MMMFs), 18, 18n., 115–117, 118, 120, 128–129, 555 cash management accounts (CMAs) and, 94, 654–655 commercial paper market and, 279–280 competition with commercial banks, 34 competition with savings institutions, 49 in financial crisis of late 2000s, 117, 128–129, 373, 592 liquidity risk, 7, 373 price risk, product diversification, 652 Temporary Guarantee Program of U.S Treasury, 117, 129, 373, 592 trends in U.S., 15–17, 129, 130, 133–134 Money supply components, 8–9, 9n domestic money supply growth (MG), 423–424, 428 inside money, 13 Monitoring costs, 4–5, 12, 685 Monte Carlo simulation approach, 454–458 Moody’s Analytics Credit Monitor, 310, 331, 333 Moody’s Analytics Enterprise Risk Solutions, 310, 313–315 Moody’s Analytics Option Model, 310, 313–315, 577 Moody’s Analytics Portfolio Manager model, 326, 331–335 Moody’s Investors Service ratings, 62, 276, 302n., 327, 345, 489–490 Moon, C.-G., 521n Moral hazard, 573–585 controlling depository institution risk taking, 575–585 depositor discipline, 580–584 nature of, 12n., 573 panic prevention versus, 574 regulatory discipline, 585 stockholder discipline, 575–580 Morbidity risk, 638 More risky hedge funds, 138–139 Morgan Guaranty, 40 Morgan Stanley, 26, 29, 81, 86–88, 90, 95, 98, 102, 105–106, 144, 477, 616, 630, 655–656, 680 Morgan Stanley Bank NA, 692 Morningstar, Inc., 121–122, 125 Mortality rate derivation of credit risk, 305–306 Mortality risk, 638 Mortgage(s), 280–282 adjustable-rate mortgages (ARMs), 19, 271–272, 281–282 defaults, 19–20, 79, 184, 275 finance company loans, 74, 76 fully amortized, 772–773, 822 housing boom of early 2000s, 19, 79 in maturity/duration gap model, 273 Internet and, 514 life insurance company investments, 153–154 loan-to-value ratio, 282, 635 mortgage servicing, 76n risk weights, 620 securitized mortgage assets, 76 See also Asset securitization subprime market, 19–20, 46, 60, 79, 96, 99, 142, 148, 275–277, 281–282, 438, 490–491, 784 “teaser” interest rates, 19 “toxic,” 37–38 Mortgage-backed securities, 36, 50–51, 103 See also Passthrough securities conflicts of interest, 664 in maturity/duration gap model, 273 mortgage (asset)-backed bonds (MBB), 842–844 Index 877 Mortgagebot, 514 Mortgage coupons, 819 Mortgage pass-through strips, 844–847 IO/PO strips, 845, 847 IO strips, 845–846 PO strips, 846–847 Motor vehicle loans and leases, 73, 74 MS&AD Insurance Group, 169 MSCI, 441n Mukherjee, K., 520n Multibank holding companies (MBHCs), 495, 670–671 Multichannel business information, 511 Multistrategy hedge funds, 139 Multiyear restructuring agreements (MYRAs), 415 Munich Re Group, 162, 169 Mutual funds, 111–136 See also Securities firms balance sheet and recent trends, 128–130 bond funds, 115, 116, 118, 120, 130 cash management accounts (CMAs), 94, 654–655 closed-end, 123n., 123–124, 371, 802–803 costs, 125–128 “flash crash” of 2010, 504 historical trends, 112–115 in financial crisis of late 2000s, 111, 112, 115, 117, 128–130, 134, 373, 592 industry characteristics, 112–128, 140 international issues, 134–136 investing activities, 94 investor characteristics, 118–119 largest, 120–122 liquidity risk, 7, 128–129, 371–373 loan purchases, 802–803, 809–810 money market funds (MMMFs) See Money market mutual funds (MMMFs) net asset value (NAV), 122–123, 371–372 objectives, 119–120 open-end, 123, 135, 371, 802–803 performance/investor returns, 121–125, 140 problems, 111, 117, 128–129, 131–134, 144 regulation, 11, 14, 120, 122, 128, 131–134, 143 trends in U.S., 15–17, 25–26, 113–119, 129, 130, 134 types, 115–119, 123–125 variable life investments in, 151 Mutual fund supermarkets, 126 Mutual organizations, 49 N NAFTA (North American Free Trade Agreement), 681 Naive hedges, 695–696 Naked options, 734 Narula, Deepak, 141 NASDAQ, market making, 92 National Asset Bank, 803 National Association of Insurance Commissioners (NAIC), 156, 168, 326, 339, 637, 638 National Association of Securities Dealers (NASD), 131 National Bank Supervisor, 44 National Credit Union Administration (NCUA), 59, 67, 590, 785 National Credit Union Share Insurance Fund (NCUSIF), 590 National Credit Union Share Insurance Fund (NCUSIF), 55n., 59 Nationalization, 686 National Loan Bank, 803 National Securities Markets Improvement Act (NSMIA) of 1996, 101, 131 National treatment, 683 NationsBank, 27, 54n., 671 NatWest Bank, 476 Negative duration, 846 Negative externalities, 10, 10n Negotiable certificates of deposit, 34 Negotiable instruments, 556 Net asset value (NAV), 122–123, 371–372 Net charge-offs, 46–47 Net deposit drains, 353–354 Net exposure, 387–389 Netherlands in financial crisis of late 2000s, 60–61 insurance companies, 169 wire transfer systems, 523–524 Net interest income (NII), in repricing/funding gap model, 196, 199–210, 219–225 Net interest margin (NIM), 47 Net liquidity statement, 358–359 Net long (short) in a currency, 388 Net operating income, 46 Net premiums written (NPW), 158–159 Net regulatory burden, 11, 12, 14 Net stable funding ratio (NSFR), 363–365, 366 Netting by novation, 786, 786n Net worth, 196, 606–607 New Century Financial, 79 New issues, 89, 90, 102, 661–662 See also Underwriting activities underpricing, 667 New York Board of Trade (NYBOT), 488 New York Futures Exchange (NYFE), 488 New York Life, 149 New York state insurance company investments, 13 insurance guarantor funds, 157, 168, 590, 666 investment banks in, 667 New York Stock Exchange (NYSE) capital adequacy, 610 Intercontinental Exchange acquires, 87 market making, 92 New Century Financial and, 79 price risk, program trading, 93 transaction costs, New Zealand finance companies, 82 insurance companies, 169–170 Nguyen, T., 678, 678n Nikko Asset Management, 106 NikkoCiti Trust and Banking Corp., 106 Nippon Life Insurance, 169 NKSJ Holdings, 169 No arbitrage profits, 302 No-load funds, 125–126 878 Index Nomura Trust & Banking Co., 106 Nonbank banks, 43, 656–660, 671–672 Nonfinancial corporations, loan purchases, 803 Noninterest expenses, technology and, 507 Noninterest income, 47 Nonperforming loans, sovereign, 433 Nonrevolving consumer loans, 282 Nordea, 630 North American Free Trade Agreement (NAFTA), 681 Northern Trust Bank (NT), 359–360, 391 Northern Trust Co., 692 Northwestern Mutual, 149 Norwest, 671 Notional value, 477, 478, 775 NOW accounts, 34, 203 costs, 553–554 withdrawal risk, 553 NYMEX Holdings, 87 O Obama, Barack, 2, 12, 35, 104, 277, 529, 616, 672 Och-Ziff Capital Management Group, 137 Odey, Crispin, 141 Odey Asset Management, 141 OECD See Organisation for Economic Co-operation and Development (OECD) Off-balance-sheet (OBS) activities, 173, 474–497 See also Mortgagebacked securities basis risk, 706 affiliate risk, 475, 495–496 cash flows and repricing/ funding gap model, 210 commercial bank, 36–38, 812–813 contingent assets and liabilities, 474 credit risk and, 275, 622–627 derivative contracts, 250–251, 273, 475, 476–478, 488–492, 496–497 in financial crisis of late 2000s, 476–477, 483, 484, 491–492, 812–813 in maturity/duration gap model, 273 letters of credit, 475, 478, 485–487 loan commitments, 475, 478, 481–485 loans sold, 475, 493 macrohedging, 704–706, 775 non-Schedule L activities returns and risks, 479–493, 496–497 role in risk reduction, 496–497 Schedule L activities settlement risk, 475, 494 solvency of financial institutions, 36–38, 475–478 when-issued (WI) trading, 475, 492–493 Off-balance-sheet (OBS) assets, 36–38, 475–478 Off-balance-sheet (OBS) liabilities, 36–38, 475–478 Off-balance-sheet (OBS) risk, 173, 185–186, 188, 494 Office of Federal Housing Enterprise Oversight (OFHEO), 836–837 Office of the Comptroller of the Currency (OCC) bank examinations, 585 and Federal Financial Institutions Examination Council (FFIEC), 14, 14n bank holding company activities, 654–655, 666 commercial banks and, 40 derivative contracts and, 719, 785 money laundering controls, 527 regulation of national banks, 299 savings institutions and, 52 Office of Thrift Supervision, 52, 666, 669, 785 Off-market swaps, 772–773 Off-market trading systems, 695 Offshore hedge funds, 143 Oil prices, 61, 96, 161–162 OIS (overnight index swap) rate, 785 Omega Advisors, 141 Omnibus Budget Reconciliation Act of 1993, 574 On-balance-sheet items basis risk, 706 converting to securitized assets, 813–816 credit risk-adjusted assets, 618–622 hedging, 395–397, 775 macrohedging, 704–706 One-bank holding companies (OBHCs), 495 Online banking, 510, 514, 523 Online customer-facing technology, 509 Open-end mutual funds, 123, 135, 371, 802–803 See also Mutual funds Open market operations, 197–199, 369 Open positions, 392 Operating ratio, 164–165 Operational Research Inc., 532 Operational risk, 173, 186–188, 503–534 capital adequacy and, 632–634 costs, 515–518 economies of scale, 515–517, 519–521, 531–533 economies of scope, 517–521, 531–533 evolution of payments system, 522–529 insolvency and, 532 loss event types, 634 nature and types, 529–531, 634 nature of, 504 other operational risks other operational risks, 531–533 regulatory issues, 531–533 sources, 505 technological innovation, 505–529 Operation Twist (2011), 224 Opportunities hedge funds, 139 Option(s), 36–37, 477, 480, 488–489, 728–750 basic features, 728–732 binomial model, 735, 736–740 Black-Scholes model, 478n., 577, 735–736 bond or bond portfolio, 735–740 buying call option on a bond, 729–730 buying put option on a bond, 731, 733–734 caps, 750, 751–753, 758 catastrophe risk, 749–750 collars, 750–751, 755–757, 758 credit risk, 748–749, 758 Index 879 delta of an option, 477–478, 478n., 743–744 floors, 750, 754, 758 foreign exchange risk, 747–748 futures options, 740–742 futures versus, 734–735 futures versus, 734–735 hedging with in maturity/duration gap model, 273 interest rate risk, 742–746, 751–757 writing call option on a bond, 730–731 writing put option on a bond, 731–732 writing versus buying, 732–735 Option-adjusted spread (OAS), 239n., 830, 832–836 assumptions, 833–834 derivation, 835–836 promised payment (PMT), 834– 835, 840 Option models of default risk, 310–315 borrower’s payoff from loans, 310–311 debt holder’s payoff from loans, 311–312 Moody’s Analytics Option Model, 310, 313–315, 577 theoretical framework, 310 to calculate default risk premiums, 312–313 Option pricing models Black-Scholes, 478n., 577, 735–736 of deposit insurance, 576–577 Moody’s Analytics Option Model, 313–315 Options Clearing Corporation, 729 Ordinary least squares (OLS) regression, 713–714 Ordinary life insurance, 150–151 Organisation for Economic Co-operation and Development (OECD) country risk assessment model (CRAM), 620–621, 621n., 634–635, 681 nature of, 621n Outside money, 13 Overaggregation, repricing/ funding gap model, 209 Overcollateralization insurance, 849 Overseas Direct Investment Control Act of 1964, 679 Overshooting reserve target, 546, 547–549 Over-the-Counter Derivatives Market Act of 2009, 785 Owen, Martin, 476 P Pacific Investment Management, 140 Paine Webber Group, 87, 136 Pakistan, 681 Paletta, Damian, 571n Palia, Darius, 678, 678n Papouis, Kyriacos, 476 Partial risk factor approach, 462–463 Participations in loans, 799, 800 Passbook savings accounts costs, 554 in maturity/duration gap model, 273 in repricing/funding gap model, 203–204 withdrawal risk, 554 Pass-through securities, 816–838 FHLMC/Freddie Mac, 248–249, 476, 491, 618, 618n., 766, 808, 809, 818, 827, 836–838, 839 default risk by bank/trustee, 822–823 default risk by mortgagees, 821–822 FNMA/Fannie Mae, 248, 476, 491, 618, 618n., 766, 808, 809, 817–818, 827, 829, 836–838 gap exposure, 821 GNMA/Ginnie Mae, 618, 817, 819, 821, 822–823, 827–829, 839–840 illiquidity exposure, 821 incentives and mechanics, 818–823 mortgage pass-through strips, 844–847 prepayment models, 828–836 prepayment risk, 822–823, 824–828 Paulson, Henry, 491, 657 Paulson, John, 141 Paulson & Co., 137 Payday loans, 75–76 Payments system, 3, 9–10 competition risk, 529 crime and fraud risk, 527–528 daylight overdraft risk, 524–526 international technology transfer risk, 526 regulatory risk, 528 tax avoidance, 528–529 technology and evolution of, 522–529 Pecora Commission, 653 Pemex, 412 Pension Benefit Guaranty Corporation (PBGC), 569, 593–594 Pension funds See Private pension funds Pension Protection Act of 2006, 594 People’s Insurance Co of China, 169 Performing loans, sovereign, 432 Personal credit institutions, 71 Personal identification numbers (PINS), 527 Phishing scams, 511–512 Pierce, Jim, 360–361 Pigeonhole approach, 326 PIIGS (Portugal, Ireland, Iceland, Greece, and Spain), 386 Pine River Capital Management, 141 PINS (personal identification numbers), 527 Piper, Matt, 477 Piper Jaffray, 102 Pitney Bowes, 529, 672 Plain vanilla, 770 PNC Bank NA, 692 PNC Financial Morgan Stanley, 496 PNC Financial Services Corp., 27, 69, 391, 468, 516, 616 Point-of-sale (POS) debit cards, 510, 514 Poland, debt service ratio (DSR), 427–428 Poldauf, P., 400n Policy loans, 153 Policy reserves, 154 Political risk, 425–426, 680, 686 Ponzi schemes, 112, 137, 144, 505, 591, 592, 593 Population groups, in statistical country risk analysis (CRA), 424 880 Index Portfolio Manager (Moody’s Analytics), 326, 331–335 Portfolio risk diversification and, risk-based capital ratio, 635 RiskMetrics, 442–445, 447–450 statistical country risk analysis (CRA) and, 426–428 Portugal country or sovereign risk, 635, 681 debt crisis, 275, 681 exchange rate swings, 386 in financial crisis of late 2000s, 62, 174, 413, 415, 681 investment ratio (INVR), 423 Position trading, 92 PO strips, 846–847 Potential exposure, 625 Preauthorized debits/credits, 510 Preferred stock, commercial bank, 35 Premiums earned, 162 Prepayment models, 828–836 option models, 832–836 other empirical models, 831–832 PSA model, 830–831 Prepayment risk, 273, 822–823, 824–828 housing turnover, 827–828 refinancing, 826 Price risk, 3, 4–5, 7–8, 423 Price–yield curve, 254–256, 264–268 Primary credit, 369, 587–588, 589 Primary Dealer Credit Facility (PDCF), 589 Primary securities, 5–6 Prime lending rate, 285, 289–291 Principal agent versus, 6, 92 investment banker as, 89 Principal transactions, 92 Private equity funds, 91 See also Venture capital Volcker Rule, 26, 440 Private pension funds calculation of insured deposits, 581 financial crisis of late 2000s and, 594 guaranty programs, 569, 593–594 insurance company plans, 152 loan purchases, 802 trends, 25–26, 114 Private placements, 89 Process management risk, 634 Procter & Gamble, 476 Product diversification, 652–667 activity restrictions in U.S., 660 commercial banking/commerce activities, 657–658 commercial banking/insurance activities, 656–657 commercial banking/investment banking activities, 653–656 competition, 666–667 conflicts of interest, 664–665 deposit insurance, 665–666 economies of scale/scope, 663 issues in, 661–667 nonbank financial service/ banking activities, 658–659 nonbank financial service/ commerce activities, 660 regulatory oversight, 666 safety and soundness, 661–663 Product diversification benefit, 663 Product risk, 634 Profitability of FIs forecasting interest rates in, 225 technology and, 505–507, 512–518 Program trading, 93, 131 Promised payment (PMT), 834–835, 840 Prompt corrective action (PCA) policy, 50, 580 capital zones, 579–580, 585, 615–616 Property–casualty insurance companies, 148–149, 157–168 balance sheet and recent trends, 159–168 capital adequacy, 638–639 catastrophe insurance, 718 guaranty programs, 569, 590–591 industry characteristics, 157–159 international issues, 168–170 largest, 114, 158, 167, 168, 169 liquidity risk, 370–371 regulation, 168 types, 158–159 Proprietary trading, Volcker Rule, 26, 440 Provision for loan losses, 46, 277n Prudential, 169 Prudential Financial, 155 Prudential of America, 149 Prudent person concerns, 389, 389n Public-Private Investment Fund (PPIF), 38 Public–Private Investment Program (PPIP), 38, 491–492 Public Securities Association (PSA), 830–831 Pulley, L B., 520n Pull-to-par, 736 Purchased liquidity management, 355 Purchasing power parity (PPP), 400, 401–402, 423n Pure arbitrage, 93 “Pure” credit swaps, 783, 783n Put options, 488–489 buying, 731, 732–734 macrohedging with, 745, 746 writing, 731–733 Q QTL (qualified thrift lender) test, 13, 42, 50–51 Qualitative default risk models, 292–294 borrower-specific factors, 292–293 market-specific factors, 293–294 Quantitative default risk models, credit scoring models, 294–298 Quantity risk, 423 R Rajaratnam, Raj, 145 RAROC (risk-adjusted return on capital) models, 307–310 duration to estimate loan risk, 307–309 loan default rates to estimate loan risk, 309–310 Rate-sensitive assets (RSA), 199–200, 201–202, 204–208, 209 Rate-sensitive liabilities (RSL), 199–200, 202–208, 209 Ray, S C., 520n Raymond James Financial, 88 RBS Citizens National Association, 692, 801 R class bonds, 842 Real estate investment trusts (REITs), 123 Index 881 Real estate loans, 280–282 See also Mortgage(s) Real interest rate, 399–400 Recourse, 493, 797 Redwood Capital Management, 140 Refinancing risk, 175, 176, 200, 826 Regional banks, 30 Regional securities firms, 88 Regions Bank, 692 Regions Financial, 29, 87, 616, 673 Regulation D, 541, 806n Regulation F, 526 Regulation J, 525 Regulation of financial institutions, 10–15, 251–252 See also names of specific regulations and types of financial institutions breakdown in crisis of late 2000s, 10 commercial banks, 39–44, 339, 585, 669–672, 680, 683 consumer protection regulation, 11, 13–14, 41, 43, 44, 532–533 credit allocation regulation, 11, 13, 339 credit unions, 55–57, 59 derivative securities, 718–719, 734 entry and chartering regulation, 11, 14–15 finance companies, 80–81 geographic expansion, 669–672, 685 hedge funds, 112, 136, 137, 143–145 insurance companies, 13, 156– 157, 168, 299, 339, 669 investor protection regulation, 11, 14, 131 merger guidelines, 674–677 monetary policy regulation, 11, 13 moral hazard, 12n mutual fund, 11, 14, 120, 122, 128, 131–134, 143 net regulatory burden, 11, 12, 14 product diversification issues, 666 safety and soundness regulation, 11–12 savings institutions, 49–52, 669 securities firm/investment bank, 11, 14, 86–87, 96, 101–104 technology and operational risks, 531–533 Regulation Q ceilings, 13, 49, 203 Regulator forbearance, 49 Regulatory risk, 528 Reinsurance, 162 Reinvestment risk, 175, 176, 200–201 Relationship banking, 32 Repricing/funding gap model, 196, 199–210, 219–225 advantages, 200 book value accounting, 208, 226 cash flows from off-balancesheet activities, 210 CGAP effects, 204–205, 207 cumulative one-year repricing gaps (CGAPs), 201, 203–208 gap ratio, 204 market value effects, 208, 226 overaggregation, 209 rate-sensitive assets (RSA), 199– 200, 201–202, 204–208, 209 rate-sensitive liabilities (RSL), 199–200, 202–208, 209 refinancing risk, 200 reinvestment risk, 200–201 repricing gap, 199 runoff problem, 209–210 spread effect, 206–207 weaknesses, 208–210 Republic New York Corporation, 30, 30n., 412 Repudiation, 416–417 Repurchase agreements (RPs), 355n costs, 558 withdrawal risk, 558 Reputation, as borrower-specific default risk factor, 292 Required stable funding (RSF), 365, 366–367 Rescheduling, 416, 417 Research, 102 Research boutiques, 88 Reserve computation period, 542–543 Reserve maintenance period, 543–545 Reserve Primary Fund, 117, 128–129, 373, 592 Reserve requirements, 9, 13, 40–41, 285, 287–288, 355–356, 528 cash reserves, 539, 541 liquid asset management, 539–549 loan sales, 806 non-cash liquid assets, 549–550 overshooting reserve target, 546, 547–549 problem for U.S depository institutions, 541–545 reserve computation period, 542–543 reserve maintenance period, 543–545 reserve requirement “tax,” 539–540 transaction accounts, 34, 539, 541–542 undershooting reserve target, 545–547 Reserve requirement “tax,” 539–540 Residential Capital, 69 Residential real estate See also Mortgage(s) “bubble” (2001-), 19 collapse in mid-1980s, 49 consumer protection regulation, 11, 13–14 credit allocation role for, 3, decline in housing prices, 19–20 increase in residential mortgages, 19 Resolution Trust Corporation (RTC), 49–50, 50n., 805–806 Retail certificates of deposit (CDs) costs, 556 withdrawal risk, 555–556 Retail financial services advanced technology requirements, 511–512 credit decisions, 288, 289 impact of technology, 509–512 Retirement funds, 113 See also Private pension funds state/local government pension funds, 114 Retirement Protection Act of 1994, 593 Return on assets (ROA) calculating, 45n., 284–288 commercial bank, 31, 45–48 contractually promised returns on a loan, 284–288 credit union, 59–60 expected returns on a loan, 288 savings institution, 52–54 Return on equity (ROE) calculating, 45n commercial bank, 31, 45–48 finance company, 80 savings institution, 53–54 882 Index Return on the loan, 332 Return-risk trade-off liquid assets, 541–550 liquid asset management problem for depository institutions, 541–545 managing non-cash liquid assets, 549–550 overshooting reserve target, 546, 547–549 technology and, 508–509 undershooting reserve target, 545–547 Reuters, 125, 141 Revco, 808 Revenues international expansion and, 684–685 mergers and acquisitions and, 674 technology and, 514 Revolving loans, 76, 282–283 Richards, Bruce, 141 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, 29, 42, 43, 651, 670–671, 678, 682, 802 Riggs National Bank, 527 Risk arbitrage, 93 Risk-avoidance hedge funds, 138, 139 Risk-based capital ratios (RBC), 613–627, 631–636 Risk-based deposit insurance program, 578–579 Risk diversification, 178, 684–685 Risk Management Association (RMA), 294 RiskMetrics, 345, 441–450 criticism, 450, 450n daily earnings at risk (DEAR), 442–445, 447–450, 466 foreign exchange risk, 445–446 historic (back simulation) approach versus, 453–454 market risk of equities, 446–447 market risk of fixed-income securities, 442–445 origins and development, 441, 441n portfolio aggregation, 447–450 Risk of the loan, 332–333 Risks of financial institutions, 2–3, 173–190 country or sovereign risk See Sovereign risk credit (default) risk See Credit (default) risk crime and fraud risk See Crime and fraud risk foreign exchange risk See Foreign exchange risk insolvency risk See Insolvency risk interactions, 189 interest rate risk See Interest rate risk liquidity risk See Liquidity risk market risk See Market risk off-balance-sheet risk, 173, 185– 186, 188, 494 operational risk See Operational risk other risks, 189 price risk, 3, 4–5, 7–8, 423 shift away from risk management and measurement, 17–20 technology risk See Technology risk Risk weights, 620–621, 634–635 RJR Nabisco, 808 Robbins, Larry, 140 Roland, K P., 521n Rothschild, 95 Routine hedging, 698 Royal Bank of Scotland (RBS), 20, 62, 107, 286, 504, 630, 652 Runoff problem, repricing/funding gap model, 209–210 Rusnak, John, 476 Russia country or sovereign risk, 45, 276, 387 debt default, 429 financial crisis of 1997–1998, 387 S SAC Capital Partners, 143 Safe haven currency, 389 Safety and soundness regulation, 11–12, 38 Safety net, 81 Sales finance institutions, 71 Salesperson’s stake, 664 Salomon Brothers, 87, 88, 430, 431n., 493n., 660 Salomon Brothers/Smith Barney, 87, 88 Salomon Inc., 87 Santander Group, 82, 630 Sarbanes-Oxley Act of 2002, 102, 132, 295, 299n SAREB, 803 Sarkozy, Nicolas, 62 Saunders, A., 18n., 298n., 300n., 306n., 310n., 329n., 345n Savings Association Insurance Fund (SAIF), 49–50, 52, 571, 579 Savings associations (SAs), 48 Savings banks (SBs), 48 Savings institutions, 9, 26, 48–54 See also Depository institutions (DIs) balance sheet and recent trends, 50–52 Basel 2.5 (2009), 467, 612–613 Basel I (1993), 466, 611 Basel II (2006), 466, 611–613, 681 Basel III (2010), 461–468, 612– 636, 648–650, 681 capital adequacy, 611–636 crisis of 1980s and 1990s, 571, 572, 616 deposit insurance programs, 40, 43, 48n., 49–50, 52, 570–571, 572, 573, 579, 590 geographic expansion, 669 in financial crisis of late 2000s, 52, 53–54 industry characteristics, 48–50, 52–54 mergers and acquisitions, 2, 10, 11–12, 27, 53, 54 qualified thrift lender (QTL) test, 13, 50–51 regulation, 49–52, 669 trends in U.S., 49–50 types, 48 Schaefer, S., 736n Scholes, M., 310, 310n Schwartz, E S., 736n Sears Roebuck, 282, 660 Sears Roebuck Acceptance Corp., 71 Seasonal credit, 588 Secondary credit, 369, 588 Secondary markets debt, 429–433 price risk and, 4–5 Index 883 Secondary reserves, 540 Secondary securities, Section 20 affiliates, 654 Secured loans, 278 Securities Act of 1933, 14, 131, 133, 136, 541 Securities and Exchange Commission (SEC), 26, 96, 101–103, 655–656 capital adequacy, 610 derivative contracts and, 719 hedge fund regulation, 112, 143–144 loan sales, 808–809 lower of cost or current market value (LOCOM) accounting, 226n mutual fund regulation, 11, 14, 120, 122, 128, 131–134, 143 Rule 15C-3-1, 636 swap regulation, 785 Securities Exchange Act of 1934, 14, 131 Securities firms, 84–108 See also Hedge funds; Investment banking; Mutual funds abuses and investigations, 95–96, 101–104, 112, 137, 144, 503, 505, 591, 592–593, 664 back-office activities, 94–96 balance sheet and recent trends, 96–100 broker function, capital adequacy, 610, 636 cash management activities, 94 discount brokers, 5, 88, 126 guaranty programs, 12, 104, 569, 591–593 in financial crisis of late 2000s, 2, 26, 39, 86, 87, 89, 99, 103–104, 105, 106–107 industry characteristics, 86–96 international issues, 85–86, 104–107, 591 investing activities, 94 largest firms, 84, 86–88, 89, 90, 95 liability management, 562–563 liquid asset management, 562–563 loan sales, 809 market-making activities, 92 regulation, 11, 14, 86–87, 96, 101–104 stock market crash of October 1987, 86, 92, 96, 131 trading activities, 86, 88, 92–93, 97–99, 101–103, 105, 183–184 trends in U.S., 15–17, 25–26, 96–99 underwriting activities, 84, 86, 87–88, 89–90, 96–99, 104–107, 661–664, 666–667 venture capital activities, 88, 88n., 91–92 Securities Industry and Financial Markets Association (SIFMA), 110, 828–829, 830–831 Securities Industry Association (SIA), 830–831 Securities Investor Protection Act of 1970, 104, 591 Securities Investor Protection Corporation (SIPC), 12, 104, 569, 591–593 Securitization See Asset securitization Securitized mortgage assets, 76 Security issues See also Crime and fraud risk cybercrime, 511–512, 527–528, 532–533 technology and, 511–512 Selective hedging, 698 Sellers bank loan, 803–806 swap, 768 Selvaggi, 29n Separate accounts, 155 September 11, 2001, terrorist attacks, 19, 98, 104, 161, 165– 168, 189, 503–504, 509, 526, 527, 588–589 Service quality, 514 Settlement risk, 475, 494, 7–11, 532–533 Severity of loss, 160–161 Shadow banking system, 18–19, 489–490, 658–659 Sharpe ratios, 139–141 Shell banks, 680 Short hedge, 703–706 Short positions net short in a currency, 388 writing a call option, 730–731, 732–733 writing a put option, 731–733 Short sales, hedge fund, 138, 139, 141–142 Signet, 671 Simulation historic (back simulation) approach, 450–454 Monte Carlo simulation approach, 454–458 Single-name CDSs, 780n SIPC (Securities Investor Protection Corporation), 12, 104, 569, 591–593 SLM Corp., 72 Small Business Association (SBA), 91 Small businesses, 509 capital market access, 667 small business investment companies (SBICs), 91 Smart cards (store-value cards), 510 SME Commercial Finance, 82 SMFG, 809 Smith Barney, 87, 88, 660 Smithson, C., 532n “Sniffer” programs, 533 Social media, 510 *Société Générale, 476, 530, 630 Sources and uses of liquidity, 358–359 South America, sovereign risk, 45 South Dakota, regulatory risk and, 528 Southeast Asia, sovereign risk, 45 South Korea country or sovereign risk, 276 debt rescheduling, 417 in financial crisis of late 2000s, 61 insurance companies, 169 U.S expansion abroad, 681 Southtrust, 87 Sovereign bonds, 431–432 Sovereign risk, 45, 173, 182–183, 412–433 country risk analysis (CRA), 418–433 credit quality problems, 276 credit risk versus, 416 current market for sovereign debt, 430–433 debt repudiation versus debt rescheduling, 412–415, 416–418 default of U.S sovereign debt, 386 884 Index Sovereign risk—Cont doctrine of sovereign-immunity, 432 early market for sovereign debt, 430 Economist Intelligence Unit (EIU), 419, 420 Euromoney Country Risk Index, 418–419 financial crisis of late 2000s and, 61–62, 174, 182–183, 413–415 Institutional Investor Index, 419, 421 market data to measure risk, 429–433 market structure for sovereign debt, 430 risk weights, 620–621 secondary market for LDC and emerging market debt, 429–433 sovereign or country risk event, 416 statistical models, 420–429 S&P 500 Index, 93, 94, 121–122, 504 Spain debt crisis, 275, 681 exchange rate swings, 386 in financial crisis of late 2000s, 60, 62, 174, 413, 415, 681 SPDRs (Standard & Poor’s Depository Receipts), 124, 124n Spear, Leeds & Kellogg, 87 Special investment vehicles (SIVs), 489–490 Special-purpose equity mutual funds, 152 Special-purpose vehicles (SPVs), 18, 489–490, 658–659, 813–816, 821, 849–850 Special-situation hedge funds, 139 Spot contracts, 693 foreign exchange transactions, 384–386, 387, 390, 392 time lines, 694 Spot loans, 279 Spot market for FX, 387 Spread effect, 206–207 Spreads bid–ask, 92 call spread options, 749–750 commercial bank, 31 credit spread options, 748–749 option-adjusted spreads (OAS), 239n., 830, 832–836, 840 term structure of derivation of credit risk, 299–300 Standard Chartered Bank, 692 Standard Industrial Classification (SIC) codes, 326, 335 Standardized Approach to credit risk measurement, 532, 611, 613, 618–622, 631, 632–633, 635, 648–650 Standard & Poor’s credit ratings, 62, 276, 298–299, 302n., 306, 327, 345, 371, 386, 489–490 Standby letters of credit, 485, 486– 487, 786 State Farm Insurance Company, 114, 158, 167, 168, 169 State/local government pension funds, 114, 116 State regulation commercial bank, 39, 40 hedge fund, 144 insurance activities of statechartered banks, 656 insurance guaranty funds, 157, 168, 590–591, 666 interstate banking pacts, 670 life insurance company, 156 savings institution, 52 State Street Bank & Trust Company, 391, 616, 630, 692 State Street Corp., 27 Stock brokerage, 93 Stored liquidity management, 355–356 Strategic alliances, 105–106 “Stress tests,” 12, 35, 616 Strike price, 729–730 Strips mortgage pass-through, 844–847 zero-coupon Treasury bonds, 299 Structured investment vehicles (SIVs), 18, 658–659, 813–816, 849–850 Structured note-inverse floater swap arrangements, 773 Stuffing fiduciary accounts, 664 Subprime lenders, 73–75 Subprime mortgage market, 19–20, 46, 60, 79, 96, 99, 142, 148, 275– 277, 281–282, 438, 490–491, 784 Sumitomo Mitsui Financial Group, 106, 630 SunAmerica Financial Group, 149 SunTrust, 391, 468, 616 SunTrust Bank, 692 Super-NOW accounts, 553n Superregional banks, 30 Surrender value, 154, 370, 370n Swap markets, 767–768, 784–785 Swaps, 36–37, 478, 480, 489, 766– 786, 792–795 CDS indexes, 783, 812 credit default swaps (CDSs), 142, 148, 185, 188, 371, 477, 497, 612–613, 715, 779–783, 849 credit risk concerns, 784–786 currency swaps, 776–779 fixed-fixed, 776–778 fixed-floating, 778–779 in maturity/duration gap model, 273 interest rate swaps, 768–775 macrohedging, 773–775 netting, 786 payment flows, 786 pure credit, 783, 783n realized cash flows, 772–773 setting rates, 792–795 standby letters of credit, 786 swap buyers and sellers, 768 swap markets, 767–768, 784–785 total return, 781–782 Swaptions, 767n Sweep accounts, 543 Swiss National Bank, 61, 389 Switzerland in financial crisis of late 2000s, 60, 61, 389 insurance companies, 169 wire transfer systems, 523–524 Syndicated loans, 278, 417, 439, 799–800 See also Loan sales Systematic credit risk, 178 Systematic loan loss risk, 338–339 Systematic risk (beta), 122, 446 System failure risk, 634 Systemic risk, 583 T Tablet devices, 510–512 Tail the hedge, 710 Takedown risk, loan commitment, 483 Index 885 TALF (Term Asset-Backed Securities Loan Facility), 38, 491–492 Target, 672 TARGET (Trans-European Automated Real-Time GrossSettlement Express Transfer), 524 TARP program (2008–2009), 11–12, 35, 38, 155, 369, 491–492, 580– 581, 606, 656 Tax avoidance, 36, 528–529 Taxes provisions of TARP relief, 606 reserve requirement “tax,” 539–540 “tax avoidance” incentives, 36 Tax-exempt money market mutual funds, 117–118 Tax Reform Act of 1986, 76 Taylor series expansion, 265 TD Bank, 27 TD Bank National Association, 692 Teachers Insurance and Annuity, 149 Technology risk, 3, 173, 186–188 See also Operational risk as source of operational risk, 505 competition risk, 529 costs and, 515–518 crime and fraud risk, 527–528 crime and fraud, 187, 188, 476–477, 511–512, 527–528, 532–533 data backup, 512 daylight overdraft risk, 524–526 disaster recovery, 19, 503–504, 512, 588–590 economies of scale and, 515–517, 519–521, 531–533 economies of scope and, 517– 521, 531–533 electronic transfer systems, 524–529 evolution of payments system, 522–529 international technology transfer risk, 526 nature of, 505 profitability of FIs and, 505–507, 512–518 regulatory risk, 528 retail financial services and, 509–512 revenues and, 514 security issues and, 511–512 wholesale financial services and, 508–509 Tennenbaum Capital Partners, 140 Tennyson, S., 520n., 521n Tepper, David, 140, 141 Term Asset-Backed Securities Loan Facility (TALF), 38, 491–492 Term life insurance, 151 Term structure derivation of credit risk, 298–305 multiperiod debt instrument default probability, 302–304 one-period debt instrument default probability, 300–301 spreads, 299–300 Term structure of interest rates, 197, 219–225 forecasting interest rates, 225 liquidity premium theory, 222–223 market segmentation theory, 223–224 problem of flat yield curve, 269–271 unbiased expectations theory, 220–222 Terrorism attacks of September 11, 2001, 19, 98, 104, 161, 165–168, 189, 503–504, 509, 526, 527, 588–589 political risk and, 680 Thailand finance companies, 82 insurance companies, 170 U.S expansion abroad, 681 Thakor, A V., 520n Third-party loans, 665 Third Point, 141 Thomson Reuters, 107 Thrift institutions See Savings institutions Tie-ins, 665 Tier I leverage ratio, 613–616 Tier I risk-based capital ratio, 613– 616, 617–618 Tier II capital, 617, 618 Time deposits costs, 556 withdrawal risk, 555–556 Time intermediation, Timing insurance, 817 Timme, S B., 520n TJ Maxx, 187 TJX Company, 187 Tokio Marine, 169 “Tombstone” advertisements, 89 Too-big-to-fail (TBTF) guarantee, 582–584 Total return swaps, 781–782 Total risk-based capital ratio, 613–616, 627–628 Tourous, W N., 736n Tower Group, 505n., 515 Trade secrets, 530 Trading activities See also Market risk computerized trading programs, 504 electronic, 88, 92, 93, 514 Federal Reserve open market operations, 197–199, 369 foreign currency transactions, 384–387, 391–392 forward, 385, 386–387, 390, 397–399 future, 695, 708–714 insider, 131, 145 Internet, 92, 93 late trading abuses, 131, 133 operational risk, 188 securities firm/investment bank, 86, 88, 92–93, 97–99, 101–103, 105, 183–184 spot, 384–386, 387, 390, 392 trading portfolio versus investment portfolio, 439–440 types, 92–93 Trading at a discount, 123 Trading at a premium, 123 Transaction accounts, 34, 539, 541–542 Transaction costs, 3, Transparency International, 425, 426 Travelers Group, 54n., 514, 654, 657, 660, 671 Travelers Insurance, 27, 87, 88, 651, 654, 657 Treasury bills, interest rates, 1965– 2012, 197–198 Treasury bonds duration of, 232–233, 240 on the run/off the run, 219 zero-coupon (strips), 299 Treasury management software, 509 Treasury strips, 299 886 Index Troubled Asset Relief Program (TARP; 2008–2009), 11–12, 35, 38, 155, 369, 491–492, 580–581, 606, 656 Trust services, 38 Turkey, financial crisis of early 2000s, 413 12b-1 fees, 126–127, 132 Tyco, 102 U UBS, 87, 107, 345, 390, 477, 630, 660 UBS AG, 528–529 UBS Securities, 144 UBS Warburg, 102 Ukraine, 681 Unbiased expectations theory, 220–222 Undershooting reserve target, 545–547 Underwriting activities commercial bank, 654, 661–664, 666–667 conflicts of interest, 664–665 life insurance company, 150–152 property–casualty insurance, 159–165 securities firm/investment banking, 84, 86, 87–88, 89–90, 96–99, 104–107, 661– 664, 666–667 Underwriting cycle, 165 Underwriting risk, Unearned premiums, 159 Unicredit Group, 630 Uniform Fraudulent Conveyance Act, 808 Union Bank National Association, 692 Union Bank of Switzerland, 345, 476 Unit banks, 669–670 United Airlines, 594 United Kingdom (UK) finance companies, 82 in financial crisis of late 2000s, 60, 61, 62, 400, 413 insurance companies, 169 largest banks, 20, 62 LIBOR manipulation, 106–107, 285, 286, 505 mutual fund market, 136 nationwide banking, 670 residential real estate market, wire transfer systems, 524 United States advantages and disadvantages of international expansion, 684–686 assets held by FIs, 2–3, 15–17 European crisis of late 2000s, 60–62 evolution of payments system, 523 firm-specific factors, 677–678 foreign banks in the U.S., 682–684 foreign exchange risk, 180–182 geographic expansion of financial institutions, 668–686 global and international, 678–686 in financial crisis of late 2000s, 2, 400 See also Financial crisis of late 2000s insurance companies, 169–170 largest depository institutions (DIs), 20, 27 LIBOR manipulation, 106–107, 285, 286 market-specific factors, 677–678 merger and acquisition synergies, 672–677 regulatory factors, 669–672 residential real estate market, 9, 19–20 segmentation of financial services industry, 653–660 terrorist attacks of September 11, 2001, 19, 98, 104, 161, 165–168, 189, 503–504, 509, 526, 527, 588–589 trends concerning FIs, 15–20 U.S banks abroad, 679–682 wire transfer systems, 523–526 U.S Bancorp, 27, 391 U.S Bancorp Equipment Finance, 71 U.S Bank National Association, 692 U.S Department of Housing and Urban Development (HUD), 805–806, 817 U.S Justice Department LIBOR manipulation, 106–107, 285, 286, 484, 505 loan sales, 808 merger guidelines, 674–677 New Century Financial and, 79 U.S Senate Permanent Subcommittee on Investigations, 103, 664 U.S Treasury Department bailout of AIG, 148, 155, 371, 438–439, 476, 491 bank holding companies, 70 money laundering controls, 527 support for FDIC during financial crisis of late 2000s, 570, 571 Temporary Guarantee Program for money market mutual funds, 117, 129, 373, 592 Troubled Asset Relief Program (TARP; 2008-2009), 11–12, 35, 38, 155, 369, 491–492, 580–581, 606, 656 website, 110 Universal FI structure, 651–652, 660 Universal life insurance, 151 Unsecured loans, 278 Up-front fee, 481 Upstreaming, 662 USA Patriot Act of 2001, 104, 527, 680 US Bancorp, 468, 616 Usury ceilings, 13, 75, 80, 283, 528 Utah, industrial loan corporations (ILCs), 529, 672 V Value additivity, 839–840 Value at risk (VAR) framework banking book versus trading book, 439–440 Citigroup, 455–456 CreditMetrics model, 326, 329n., 345–348 expected shortfall (ES) approach versus, 460, 461 Monte Carlo simulation approach, 454–458 RiskMetrics model, 345, 441–450, 450n., 453–454 “stressed VAR,” 466 Index 887 Value hedge funds, 139 Vanguard, 120–121, 122, 555 Variable life insurance, 151 Variable universal life insurance, 151 Variance of export revenue (VAREX), 423, 427–428 Variance of returns (risk), 328–339 Venezuela domestic money supply growth (MG), 423–424 sovereign debt, 432 Venture capital, 88, 88n., 91–92 Verification of identities, 509 Veterans Administration (VA), 817, 821–822 Vickery, 29n Vieira, Paul, 107n VIPERS (Vanguard Large-Cap Index Participation Equity Receipts), 124, 124n Visa, 282 Volatility earnings, as borrower-specific default risk factor, 293 foreign exchange rate, 389–390 Volcker, Paul, 440 Volcker Rule, 26, 440 Volkswagen, 464 Vulture funds, loan purchases, 801–802 W Wachovia, 87, 655, 671, 674 Wall Street Journal Online, 700, 701 Wall Street Reform and Consumer Protection Act of 2010, 14, 26, 35, 41, 43, 44, 52, 103, 133–134, 143–144, 156, 440, 530, 533, 656, 659, 669, 719, 785 Walmart, 668 Washington Mutual Inc (WaMu), 2, 10, 11–12, 27, 53, 54, 79, 80, 184, 188, 439, 476, 491, 582, 766 Waterstone Capital Management, 140 Wealth transfer, intergenerational, 3, Webster Financial, 29 Weekend game, 542 Weighted-averaged life (WAL), 829 Weiss, M A., 520n., 521n Wells Fargo, 27, 29, 79, 88, 391, 468, 616, 630, 671, 674, 692, 799 Wheelock, D C., 521n When-issued (WI) trading, 475, 492–493 Whole life insurance, 151 Wholesale certificates of deposit (CDs), 556–557, 560 costs, 556 withdrawal risk, 556 Wholesale financial services credit decisions, 288, 289–291 impact of technology, 508–509 Wi-Fi hotspots, 512 Wigand, James, 571 Wilson, J., 521n Wilson, P W., 521n Winton Capital Management, 137 Wireless technology, 47–48, 510–512 Wire transfer systems, 9–10, 187, 494, 507, 508, 523–524 Workplace safety risk, 634 World Bank in financial crisis of late 2000s, 413 HIPC initiative, 417–418 sovereign risk, 412, 413 WorldCom, 98, 102, 274, 306, 664 World Trade Organization (WTO), 681 World War II debt repudiation following, 416–417 international trade growth, 680 X X-efficiencies, 673–674 Xerox, 660 X-inefficiencies, 520–521 Y Yamachi Securities, 136 Yasuda Life Insurance Co., 136 Yield, duration and, 235 Yield curve convexity of price–yield curve, 254–256, 264–268 Operation Twist (2011), 224 problem of flat term structure, 269–271 U.S Treasury securities, 219–220, 302–304 Z Z class bonds, 842 Zero-coupon bonds corporate, 299 credit risk, 299 duration of, 233 Treasury strips, 299 Zhu, Changhong, 140 Z-score model in country risk analysis (CRA), 420 in credit risk analysis, 296n., 296–297, 302n Zurich Financial Services, 169 ... risks and the sale of their services as risk specialists INTENDED AUDIENCE Financial Institutions Management: A Risk Management Approach is aimed at upperlevel undergraduate and MBA audiences Occasionally... overlooking management decision making and risk management Over the last 20 years other texts have followed this change, such that a risk management approach to analyzing modern financial institutions. .. and Cornett Financial Institutions Management: A Risk Management Approach Eighth Edition Saunders and Cornett Financial Markets and Institutions Fifth Edition INTERNATIONAL FINANCE Eun and Resnick