Financial institutions management a risk management approach 9e saunders

www.freebookslides.com www.freebookslides.com Financial Institutions Management A Risk Management Approach www.freebookslides.com 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 Ross, Westerfield, and Jordan Essentials of Corporate Finance Ninth Edition FINANCIAL MANAGEMENT Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eleventh Edition Block, Hirt, and Danielsen Foundations of Financial Management Sixteenth Edition Shefrin Behavioral Corporate Finance: Decisions That Create Value Second Edition Brealey, Myers, and Allen Principles of Corporate Finance Twelfth Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition INVESTMENTS Bodie, Kane, and Marcus Essentials of Investments Tenth Edition Bodie, Kane, and Marcus Investments Tenth Edition Brealey, Myers, and Marcus 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Management: A Risk Management Approach Ninth Edition Saunders and Cornett Financial Markets and Institutions Sixth Edition www.freebookslides.com Financial Institutions Management A Risk Management Approach Ninth Edition Anthony Saunders John M Schiff Professor of Finance Salomon Center Stern School of Business New York University Marcia Millon Cornett Robert A and Julia E Doran Professor of Finance Bentley University www.freebookslides.com FINANCIAL INSTITUTIONS MANAGEMENT: A RISK MANAGEMENT APPROACH, NINTH EDITION Published by McGraw-Hill Education, Penn Plaza, New York, NY 10121 Copyright © 2018 by McGraw-Hill Education All rights reserved Printed in the United States of America Previous editions © 2014, 2011, and 2008 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 21 20 19 18 17 ISBN 978-1-259-71777-2 MHID 1-259-71777-1 Chief Product Officer, SVP Products & Markets: G Scott Virkler Vice President, General Manager, Products & Markets: Marty Lange Managing Director: James Heine Brand Manager: Chuck Synovec Product Developer: Noelle Bathurst Marketing Manager: Trina Maurer Director, Content Design & Delivery: Linda Avenarius Program Manager: Mark Christianson Content Project Managers: Melissa M Leick & Karen Jozefowicz Buyer: Susan K Culbertson Design: Studio Montage, Inc Content Licensing Specialists: Beth Thole Cover Image: Arpad Benedek/Getty Images Compositor: SPi Global 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 Names: Saunders, Anthony, 1949- author | Cornett, Marcia Millon, author Title: Financial 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 Description: Ninth Edition | Dubuque : McGraw-Hill Education, 2017 | Revised edition of the authors’ Financial institutions management, [2014] Identifiers: LCCN 2016047072 | ISBN 9781259717772 (alk paper) Subjects: LCSH: Financial institutions—United States—Management | Risk management—United States | Financial services industry—United States—Management Classification: LCC HG181 S33 2017 | DDC 332.1068—dc23 LC record available at https://lccn.loc gov/2016047072 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 mheducation.com/highered www.freebookslides.com To all my co-authors over the years Anthony Saunders To my parents, Tom and Sue Marcia Millon Cornett www.freebookslides.com 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 the Robert A and Julia E Dorn 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, corporate finance, and investments Articles authored by Dr Cornett have appeared in such academic journals as the Journal of Finance, the Journal of Money, Credit and Banking, the Journal of Financial Economics, Financial Management, and the Journal of Banking and Finance She was recently ranked the 124th most published author out of more than 17,600 authors and the number five female author in finance literature over the last 50 years Along with Anthony Saunders, Dr Cornett has recently completed work on the sixth edition of Financial Markets and Institutions (McGraw-Hill Education) Along with Troy Adair and John Nofsinger, Dr Cornett has recently completed work on the fourth edition of Finance: Applications and Theory (McGraw-Hill Education) Dr Cornett serves as an Associate Editor for the Journal of Banking and Finance, Journal of Financial ­Services Research, Review of Financial Economics, Financial Review, and Multinational Finance Journal 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 www.freebookslides.com Preface The last 30 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 ninth edition of this text takes the same innovative approach taken in the first eight 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 realworld 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 www.freebookslides.com 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 • 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 7, we preview the risk measurement and management sections with an overview of the risks facing a modern FI We divide the chapters on risk measurement and management into two sections: 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 risk incurred by FIs in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices www.freebookslides.com Preface  ix 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 are 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 up-todate 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: • Discussion of how financial institutions continue to recover from the financial crisis has been updated throughout the book Virtually every chapter includes new material detailing how the financial crisis affected risk management in financial institutions • Chapters 2, 7, and 14 include discussions of the continuing European and Argentine debt crisis as they affect the risk and return of financial institutions • A discussion of enterprise risk management has been added to Chapter • Excerpts from bank 10K statements have been added to most chapters The excerpts show how an actual bank measures and manages its risks for the pertinent topic • Detailed discussion and examples of the new international liquidity standards enacted as a result of the financial crisis have been added to Chapter 12 Liquidity planning has also been added to this chapter • Updates on the major changes proposed for the regulation of financial institutions are included where appropriate throughout the book • Chapter includes updates on new mutual fund regulation • Chapter discusses the Fed’s debate and eventual decision to increase interest rates from historic lows • Chapter 13 includes a discussion of banks’ manipulation of foreign exchange rates • The new BIS market risk rules and accompanying problems have been added to Chapter 15 • Chapter 19 includes extensive discussion and examples of the new insurance premium system used by depository institutions www.freebookslides.com 876 Index KeyCorp, 402, 479, 623 KMV Corporation, 315, 315n., 337 Knight Capital Group, Inc., 90, 101, 514 Kolatch, Jonathan, 143 KPMG Information Security Survey, 541 Kroszner, Randall, 16n Kuwait, in financial crisis of late 2000s, 63 L Lagged reserve accounting system (LRA), 552 Late trading abuses, 135, 136 Latin America See names of specific countries Lazard Ltd., 90, 97 Least-cost resolution (LCR) strategy, 589–590 Leeson, Nicholas, 488 Legal issues See also Regulation of financial institutions loan sales growth and, 815 Lehman Brothers Inc., 2, 27, 82, 88, 89, 104, 120, 130, 132–133, 188, 380–381, 425, 449–450, 487, 502, 580, 596, 599, 600, 663, 773 Lender of last resort, Lender-specific default risk factors, 441 Less developed countries (LDCs) See also Emerging markets and names of specific countries secondary market for debt, 442–444 sovereign risk and, 422 Letters of credit (LCs), 189, 486, 489, 496–499 commercial, 496–497 electronic initiation, 520 risks associated with, 498–499 standby, 496, 498, 793 Leverage as borrower-specific default risk factor, 298 highly leveraged transactions (HLTs), 805–806, 807, 809, 810, 812, 815, 816 Leverage adjusted duration gap, 251 Leveraged buyouts (LBOs), 807 Leverage ratio, 638, 643 Liabilities See also Balance sheet; Liability management commercial bank, 35–37 finance company, 79–80 investment banking market risk, 187–188 life insurance company, 157 off-balance-sheet (OBS), 37–39, 486–490 rate-sensitive liabilities (RSL), 203–204, 206–213 securities firm/investment bank, 102–103 Liability insurance, 163 Liability management, 559–571 See also Guaranty programs depository institution, 560–568 insurance company, 570 other fiduciary institutions, 571 Liability-side liquidity risk, 359–363 Liability withdrawal risk See Liquidity risk LIBOR See London Interbank Offered Rate (LIBOR) Life insurance companies, 151–161 accident and health insurance, 156 annuities, 153, 155, 156 balance sheet, 156–161 capital adequacy, 644–346 credit (default) risk, 180–182 guaranty programs, 597–598 industry characteristics, 152–161 insurance company, 577 international issues, 172–174 liquidity risk, 7, 378 mutual versus stock insurance companies, 152–153 price risk, private pension funds, 155–156 regulation, 159–161, 344–345 surrender value of policy, 378, 378n trends, 157–159 types of life insurance, 153–154 Limited-purpose finance companies, 18 Lincoln National, 159 Linear discriminant credit scoring model, 301–303 Linear probability credit scoring model, 300–301 Lipper Analytical Services, 129 Liquid asset management, 546–548 See also Guaranty programs; Liquidity risk bank runs/panics, 41, 362n., 376–377, 546, 576–577, 581, 588, 596 depository institution management problem, 549–553 insurance company, 570 liability structure for depository institutions, 568–570 liquid asset portfolio composition, 548 monetary policy, 547 non-cash liquid assets, 558 other fiduciary institutions, 571 overshooting reserve target, 554–555, 556–557 reasons, 546–548 return-risk trade-off, 549–559 taxation, 547–548 technology and, 519–520 undershooting reserve target, 554–556 Liquid assets ratio, 548 Liquidity costs, 4–5 Liquidity coverage ratio, 369–370, 371 Liquidity index, 368, 546–547 Liquidity premium theory, 227–228 Liquidity risk, 3, 4, 7–8, 132–133, 177, 182–184, 357–382, 822 See also Guaranty programs; Liquid asset management asset-side, 358–359, 363–365, 828 Bank for International Settlements (BIS) measures, 369–375 bank runs/panics, 41, 376–377, 546, 576–577, 581, 588, 596 causes, 358–359 deposit drains, 376–377 depository institution (DI), 7, 359–378 financial crisis of late 2000s, 357, 380 financing gap, 365–366 financing requirement, 365 hedge fund, 381 insolvency risk, 379 insurance company, 7, 378 liability management, 559–571 liability-side, 359–363 liquid asset management, 546–548, 568–571 liquidity index, 368, 546–547 loan sales, 814 market risk and, 364 measuring liquidity exposure, 365–368 mutual fund, 7, 379–381 net stable funding ratio (NSFR), 371–374 peer group ratio comparisons, 367–368 required stable funding (RSF), 372, 373–374 sources and uses of liquidity, 366–367 Lloyds TSB, 84 Load funds, 129–130 Loan commitment (line of credit), 284, 486, 489, 493–496 Loan commitment agreement, 493–496 Loan concentration risk, 279, 334–345 CreditMetrics model, 331, 350–353, 617 CreditRisk+ model, 331, 354–356 Moody’s Analytics Portfolio Manager model, 331, 337–340 partial applications of portfolio theory, 340–344 regulatory models, 344–345 simple models, 332–333 Loan loss ratios, 343–344 Loan loss reserves, 422 Loan migration matrix (transition matrix), 332 www.freebookslides.com Index  877 Loan origination fees, 290 Loan Pricing Corporation, 341, 808 Loan purchases, 809–810, 816–817 Loan sales, 803–817 bank loan sales, 804–817 buyers, 808–810 contract types, 806–807 factors affecting growth, 814–817 foreign bank, 812, 816–817 reasons, 813–814 sellers, 810–812 trends, 807–808 types, 804–806 Loan sharks, 77 Loans sold, 486, 503–504 Loan-to-value ratio, 286–287, 642 Loan volume-based models, 340–343 Logit model, 300–301 Lombard, 84 London Interbank Offered Rate (LIBOR), 776–777 as base lending rate, 290 in duration models, 276–277 interest rate manipulation, 109–110, 290, 516 liquidity risk and, 357 manipulation, 109–110 London International Financial Futures Exchange (LIFFE), 702n Long positions, net long in a currency, 398 Long-tail losses, 165 Long-Term Capital Management (LTCM), 140, 145, 145n., 488 Long-term mutual funds, 134 Loss adjustment expenses (LEA), 166–167 Loss ratio, 166 Loss risk, 164–165 Loyalty programs, 522 Luxembourg in financial crisis of late 2000s, 62 offshore hedge funds, 146 M M1, 8–9, 9n M2, 8–9, 9n Macaulay’s duration, 234–239 See also Duration Macro hedge funds, 142 Macrohedging, 704–713 with futures, 706–714 nature of, 704–705 off-balance-sheet effects, 710–713, 780–781 on-balance-sheet effects, 710–713 with put options, 752, 753 risk-minimizing futures position, 707–713 short hedge, 710–713 with swaps, 780–782 Macy’s, 806 Madoff, Bernard, 148, 599 Madoff Investment Securities, 115, 140, 148, 516, 599 Maine, interstate banking pacts, 678 Management fees, mutual fund, 130 Man Group, 144 Manulife Financial, 152 Marginal default probability, 307 Marginal mortality rate (MMR), 310–311 Market benchmarks, 341 Market making, 94, 402 Market Reform Act of 1990, 135 Market risk, 177, 187–188, 449–479, 541 Basel III (2010), 638–639 benefits of market risk measurement (MRM), 452 BIS regulations, 473–479 calculating, 453–473 capital adequacy and, 638–639 See also Capital adequacy expected shortfall (ES) approach, 470–473, 478 financial crisis of late 2000s, 187–188, 449–453, 466, 477–479, 638–639 historic (back simulation) approach, 462–465 large-bank internal models, 477–479 liquidity risk and, 364 marking-to-market, 125, 231, 615, 700–702, 726 Monte Carlo simulation approach, 466–468 RiskMetrics model, 350, 453–462, 465–466 standardized framework, 473–476 trading activities, 187–188 Market risk measurement (MRM), 452 Market segmentation theory, 228–229 Market-specific default risk factors, 299 Market timing abuses, 135, 136 Market timing hedge funds, 142 Market value arguments against market value accounting, 617–618 book value versus, 616–617 of capital, 615–618 credit risk and, 615–616 loan sale accounting, 815–816 marking-to-market, 125, 231, 615, 700–702, 726 Market value accounting, 200–201, 213 marking-to-market, 125, 231, 615, 700–702, 726 maturity/duration gap model, 213, 231–260 Market value effects, repricing/funding gap model, 213, 231 Market value risk, 178–179 Marking-to-market, 125, 231, 615, 700–702, 726 Markit, 790 Marshall, C., 540n MasterCard, 287 Maturity/duration gap model, 231–260, 269–278 credit (default) risk, 276 duration and interest rate risk, 246–255 See also Duration flat term structure, 273–275 floating-rate loans and bonds, 276–277 market value accounting in, 200–201, 213, 231 single security, 246–249 whole balance sheet of FI, 249–255 Maturity, duration versus, 239–240 Maturity intermediation, 3, 8, 178–180 MBNA, 89 McCarran-Ferguson Act of 1945, 159 McFadden Act of 1927, 42, 45, 677, 691 Medium-term notes, 568 Megamergers, 680 Mellon Bank, 810, 812 Mellon Financial, 30, 116–117 Merck, 100 Merger bid premiums, 685 Mergers and acquisitions commercial banks/banking, 2, 5, 11–12, 29–31, 55n., 81, 659, 662, 673, 679–685 cost, 680–685 Herfindahl-Hirschman Index (HHI), 682–683 highly leveraged transactions (HLTs), 805–806, 807, 809, 810, 812, 815, 816 largest firms, 97, 679, 680, 809 life insurance companies, 152 revenue, 682 savings institutions, 2, 10–12, 28, 54, 55 securities firm/investment banking activities, 86–88, 89, 96, 97, 107 synergies, 680–685 Meridian, 679 Merkel, Angela, 64 Merrill Lynch, 5, 86, 88–92, 95–96, 104, 107, 188, 449, 487, 502, 662–663, 773, 812 Merton, R C., 315, 315n., 317n., 743n Message centers, 522 MetLife, 151, 152, 160, 525, 623 Mexico debt moratorium, 422, 442 finance companies, 84 NAFTA (North American Free Trade Agreement), 688 sovereign debt, 443 MF Global Holdings, 101, 488 www.freebookslides.com 878 Index Microhedging, 704–705 Midland Bank, 488 Migration analysis, 332 Milacron, 600 Minimum risk portfolio, 336 Mitsubishi UFJ Financial Group, 20, 109, 637, 660 Mizuho FG, 637 Mobile devices, 48–49, 521, 523 Mobile home loans, 288 Model Act, 345 Moderate risk hedge funds, 142 Modern Portfolio Theory (MPT) correlation coefficient, 334, 334n., 338–340 efficient portfolio composition, 343 expected returns, 334 loan allocation deviation models, 341–342 loan loss ratio-based models, 343–344 loan portfolio diversification, 334–345 minimum risk portfolio, 336 Moody’s Analytics Portfolio Manager model, 331, 337–340 partial applications, 340–344 variance of returns (risk), 334 Modified duration, 243, 750–751 Monetary policy contractionary, 201 discount window operations, 367, 377–378, 555–556, 568, 594–596 expansionary, 201 financial crisis of late 2000s and, 200, 201–203 liquid asset management and, 547 open market operations, 201–203, 378 regulation of, 11, 13 transmission of, 3, 8–9 Money center banks, 31, 31n., 41, 810, 816 Money laundering, 107, 536, 691 Money market deposit accounts (MMDAs) costs, 563 withdrawal risk, 563 Money market mutual funds (MMMFs), 18, 18n., 118, 120, 121, 132–134, 563 cash management accounts (CMAs) and, 96, 662–663 commercial paper market and, 285–286 competition with commercial banks, 35 competition with savings institutions, 50 in financial crisis of late 2000s, 120, 132–133, 380–381, 598 liquidity risk, 7, 380–381 price risk, product diversification, 660 Temporary Guarantee Program of U.S Treasury, 121, 133, 381, 598 trends in U.S., 15–17, 133–134, 136–137 Money supply components, 8–9, 9n domestic money supply growth (MG), 436 inside money, 13 Monitoring costs, 4–5, 12, 693 Monte Carlo simulation approach, 466–468 Moody’s Analytics Credit Monitor, 315, 337 Moody’s Analytics Enterprise Risk Solutions, 315, 318–320 Moody’s Analytics Option Model, 315, 318–320, 584 Moody’s Analytics Portfolio Manager model, 331, 337–340 Moody’s Investors Service ratings, 63, 281, 307n., 332, 351 Moral hazard, 580 controlling depository institution risk taking, 581–593 depositor discipline, 587–592 nature of, 12n., 580n panic prevention versus, 581 regulatory discipline, 592–593 stockholder discipline, 582–587 Morbidity risk, 645 More risky hedge funds, 142 Morgan Guaranty, 41 Morgan Stanley, 27, 83, 88–90, 92, 97, 100, 104, 109, 147, 488, 623, 637, 663 Morgan Stanley Bank NA, 699 Morningstar, Inc., 124–125, 129 Mortality rate derivation of credit risk, 310–311 Mortality risk, 645 Mortgage(s), 286–287 adjustable-rate mortgages (ARMs), 19, 276–277, 286–287 defaults, 19–20, 81, 188, 280 finance company loans, 76, 78 fully amortized, 779–780, 829, 832 housing boom of early 2000s, 19, 81 life insurance company investments, 156–157 loan-to-value ratio, 286–287, 642 in maturity/duration gap model, 278 mortgage servicing, 78n risk weights, 628 securitized mortgage assets, 78 See also Asset securitization subprime market, 19–20, 47, 62, 81, 98, 101, 145, 151, 280, 282, 449, 501–502, 791 “teaser” interest rates, 19 Mortgage-backed securities, 36, 51–52, 106 See also Pass-through securities conflicts of interest, 672 IO/PO strips, 851, 854 IO strips, 852–853 in maturity/duration gap model, 278 mortgage-backed (asset) bonds (MBBs), 849–851 PO strips, 853–854 Mortgage coupons, 826 Mortgage pass-through strips, 851–854 Motor vehicle loans and leases, 75, 76 MSCI, 453n Multibank holding companies (MBHCs), 505–506, 677 Multichannel business information, 522 Multiyear restructuring agreements (MYRAs), 426 Munich Re Group, 173 Mutual funds, 114–148 See also Securities firms balance sheet and recent trends, 132–134 bond funds, 118, 119, 121–123, 132, 134 cash management accounts (CMAs), 96, 662–663 closed-end, 126–127, 126n., 379, 809–810 costs, 129–132 in financial crisis of late 2000s, 114, 115, 118, 120, 121, 124, 132– 134, 138, 380, 598 “flash crash” of 2010, 514 historical trends, 115–118 industry characteristics, 115–132, 144 international issues, 138–139 investing activities, 96 investor characteristics, 121–122 largest, 124–125 liquidity risk, 7, 132–133, 379–381 loan purchases, 809–810, 816–817 money market funds (MMMFs) See Money market mutual funds (MMMFs) net asset value (NAV), 125, 379–380 objectives, 123–125 open-end, 126, 139, 379, 809–810 performance/investor returns, 124– 125, 143 problems, 120, 132–133, 135–137 regulation, 11, 14, 123, 135–137, 147–148 trends, 26–27 trends in U.S., 116–123, 133–134 types, 118–123, 125–129 Mutual fund supermarkets, 130 Mutual organizations, 50 www.freebookslides.com Index  879 N NAFTA See North American Free Trade Agreement (NAFTA) Naive hedges, 703–704 Naked options, 741 NASDAQ, market making, 94 National Asset Bank, 810 National Association of Insurance Commissioners (NAIC), 159, 172, 331, 345, 644, 646 National Association of Securities Dealers (NASD), 135 National Bank Supervisor, 45 National Credit Union Administration (NCUA), 60, 597, 792 National Credit Union Share Insurance Fund (NCUSIF), 57n., 60, 597 Nationalization, 693 National Loan Bank, 810 National Securities Markets Improvement Act (NSMIA) of 1996, 103, 135 National treatment, 691 NationsBank, 28, 55n., 679 NatWest Bank, 488 Negative duration, 853 Negative externalities, 10, 10n Negotiable certificates of deposit, 35 Negotiable instruments, 564–565 Net asset value (NAV), 379–380 Net charge-offs, 47–48 Net deposit drains, 360–361 Net exposure, 398–399 Netherlands in financial crisis of late 2000s, 62–64 insurance companies, 173 wire transfer systems, 532–533 Net interest income (NII), in repricing/ funding gap model, 200, 203–215 Net interest margin (NIM), 48 Net liquidity statement, 366–367 Net long (short) in a currency, 398 Net operating income, 47–48 Net premiums written (NPW), 162–163 Net regulatory burden, 11, 13, 14 Net stable funding ratio (NSFR), 371–374 Netting by novation, 793, 793n Net worth, 200, 614 New Century Financial, 81 New issues, 91, 92, 104, 669–670 See also Underwriting activities New York Board of Trade (NYBOT), 499 New York Futures Exchange (NYFE), 499 New York Life, 152 New York state insurance company investments, 13 insurance guarantor funds, 597 New York Stock Exchange (NYSE) capital adequacy, 618 market making, 94 New Century Financial and, 81 price risk, program trading, 95 transaction costs, New Zealand finance companies, 84 insurance companies, 173 Nikko Asset Management, 109 NikkoCiti Trust and Banking Corp., 109 No arbitrage profits, 307 No-load funds, 129–130 Nomura Trust & Banking Co., 109 Nonbank banks, 44, 664–665, 678–679 Nonfinancial corporations, loan purchases, 810 Noninterest expenses, technology and, 518 Noninterest income, 48 Nonperforming loans, sovereign, 444 Nonrevolving consumer loans, 288 Nordea, 637 North American Free Trade Agreement (NAFTA), 688 Northern Trust Bank (NT), 367–368, 402 Northern Trust Co., 699 Northwestern Mutual, 152 Norwest, 679 Notional value, 489–490, 780–781 NOW accounts, 35, 207 costs, 562 withdrawal risk, 561–562 NYMEX Holdings, 89 O Obama, Barack, 2, 12, 36, 106, 282, 623 OECD See Organisation for Economic Co-operation and Development (OECD) Off-balance-sheet (OBS) activities, 177, 485–508 See also Mortgage-backed securities affiliate risk, 486, 505–506 basis risk, 713 cash flows and repricing/ funding gap model, 214–215 commercial bank, 37–39 contingent assets and liabilities, 485 credit risk and, 280, 630–634 derivative contracts, 254–255, 278, 486–489, 499–502, 506–508 in financial crisis of late 2000s, 488, 490, 819 letters of credit, 486, 489, 496–499 loan commitments, 486, 489, 493–496 loans sold, 486, 503–504 macrohedging, 710–713, 780–781 in maturity/duration gap model, 278 returns and risks, 490–504 role in risk reduction, 506–508 settlement risk, 486, 504–505 solvency of financial institutions, 37–39, 486–490 when-issued (WI) trading, 486, 502–503 Off-balance-sheet (OBS) assets, 37–39, 486–490 Off-balance-sheet (OBS) liabilities, 37–39, 486–490 Off-balance-sheet (OBS) risk, 177, 189– 190, 192, 504–506 Office of Federal Housing Enterprise Oversight (OFHEO), 843–844 Office of the Comptroller of the Currency (OCC) bank examinations, 592 bank holding company activities, 662–663 commercial banks and, 41 derivative contracts and, 726, 792 and Federal Financial Institutions Examination Council (FFIEC), 14, 14n money laundering controls, 536 regulation of national banks, 304 savings institutions and, 53 Office of Thrift Supervision, 53, 677 Off-market swaps, 779 Off-market trading systems, 702 Offshore hedge funds, 146–147 Oil prices, 63, 98, 165 OIS rate See Overnight index swap (OIS) rate Omnibus Budget Reconciliation Act of 1993, 581 On-balance-sheet items basis risk, 713 converting to securitized assets, 820–823 credit risk-adjusted assets, 625–629 hedging, 405–407, 780–781 macrohedging, 710–713 One-bank holding companies (OBHCs), 505 Online banking, 521, 525, 531 Online customer-facing technology, 520 Open-end mutual funds, 126, 139, 379, 809–810 See also Mutual funds Open market operations, 201–203, 378 Open positions, 402 Operating ratio, 168 Operational Research Inc., 540 Operational risk, 177, 190–192, 513–542 capital adequacy and, 639–641 costs, 525–529 economies of scale, 526–528, 540–542 economies of scope, 528–529, 540–542 evolution of payments system, 530–538 insolvency and, 540–541 loss event types, 641 www.freebookslides.com 880 Index Operational risk—Cont nature and types, 538–540, 641 nature of, 514 other operational risks, 540–542 regulatory issues, 540–542 sources, 516 technological innovation, 516–518 Operation Twist (2011), 229 Option(s), 37–38, 489, 491, 499–500, 735–757 basic features, 735–739 binomial model, 742, 743–746 Black-Scholes model, 489n., 584, 742–743 bond or bond portfolio, 742–746 buying call option on a bond, 736–737 buying put option on a bond, 738, 740 caps, 757, 758–760, 765 catastrophe risk, 756–757 collars, 757, 762–764, 765 credit risk, 755–757, 765 delta of an option, 489, 750 floors, 757, 761, 765 foreign exchange risk, 754–755 futures options, 747–749 futures versus, 741–742 interest rate risk, 747–753, 757–765 in maturity/duration gap model, 278 writing call option on a bond, 737–738 writing put option on a bond, 738–740 writing versus buying, 739–742 Option-adjusted spreads (OAS), 837, 839, 840 assumptions, 840 derivation, 842–843 promised payment (PMT), 840–841, 847 Option models of default risk, 315–320 borrower’s payoff from loans, 315–316 to calculate default risk premiums, 317–318 debt holder’s payoff from loans, 316–317 Moody’s Analytics Option Model, 315, 318–320, 584 theoretical framework, 315 Option pricing models binomial, 742, 743–746 Black-Scholes, 489n., 584 Black-Scholes model, 742–743 of deposit insurance, 583–584 Moody’s Analytics Option Model, 318–320 Options Clearing Corporation, 736 Ordinary least squares (OLS) regression, 719–720 Ordinary life insurance, 153–154 Organisation for Economic Co-operation and Development (OECD) country risk assessment model (CRAM), 431, 433, 628, 628n., 642 nature of, 628n Outside money, 13 Overaggregation, repricing/funding gap model, 213–214 Overcollateralization insurance, 856 Overnight index swap (OIS) rate, 792 Overseas Direct Investment Control Act of 1964, 686 Overshooting reserve target, 554–555, 556–557 Over-the-Counter Derivatives Market Act of 2009, 792 Owen, Martin, 488 P Pacific Investment Management, 143 Paine Webber Group, 89 Pakistan, 688 Palia, Darius, 685 Papouis, Kyriacos, 488 Partial risk factor approach, 474 Participations in loans, 806, 807 Passbook savings accounts costs, 563 in maturity/duration gap model, 277–278 in repricing/funding gap model, 207–209 withdrawal risk, 563 Pass-through securities, 823–845 default by bank/trustee, 828–830 default risk by mortgagees, 828 FHLMC/Freddie Mac, 253, 487, 627, 627n., 773, 815, 816, 825, 834, 835–836, 843–845 FNMA/Fannie Mae, 252–253, 487, 627, 627n., 773, 815, 816, 824– 825, 834, 835–836, 843–845 gap exposure, 827 GNMA/Ginnie Mae, 627, 824–826, 828–830, 833–836, 840–843, 846–849, 852, 854 illiquidity exposure, 828 incentives and mechanics, 825–830 mortgage pass-through strips, 851–854 prepayment models, 835–843 prepayment risk, 829–830, 831–835 Paulson & Co., 144 Paulson, Henry, 502 Paulson, John, 144 Payday loans, 77–78 Payments system, 3, 10 competition risk, 537–538 crime and fraud risk, 535–536 daylight overdraft risk, 533–535 international technology transfer risk, 535 regulatory risk, 536–537 tax avoidance, 537 technology and evolution of, 530–538 Pecora Commission, 661 Pemex, 422 Pension Benefit Guaranty Corporation (PBGC), 577, 599–601 Pension funds See Private pension funds Pension Protection Act of 2006, 600 Performing loans, sovereign, 443–444 Personal credit institutions, 72 Personal identification numbers (PINS), 535 Phishing scams, 522 Pierce, Jim, 368 Pigeonhole approach, 331 PIIGS See Portugal, Ireland, Iceland, Greece, and Spain (PIIGS) PINS See Personal identification numbers (PINS) Piper Jaffray, 104 Piper, Matt, 488 Pitney Bowes, 537–538, 679 Plain vanilla, 777 PNC Bank NA, 699 PNC Financial Morgan Stanley, 506 PNC Financial Services Corp., 28, 71, 402, 479, 527, 623 Point-of-sale (POS) debit cards, 521, 525 Poland, debt service ratio (DSR), 439–440 Policy loans, 156 Policy reserves, 157 Political risk, 437–438, 687, 693 Ponzi schemes, 148, 516 Population groups, in statistical country risk analysis (CRA), 437 Portfolio Manager (Moody’s Analytics), 331, 337–340 Portfolio risk diversification and, risk-based capital ratio, 642 RiskMetrics, 454–457, 459–462 statistical country risk analysis (CRA) and, 438–440 Portugal country or sovereign risk, 642, 689 debt crisis, 280, 689 exchange rate swings, 395 in financial crisis of late 2000s, 63, 178, 423, 689 investment ratio (INVR), 435 Portugal, Ireland, Iceland, Greece, and Spain (PIIGS), 395 Position trading, 94–95 PO strips, 853–854 Potential exposure, 632 Preauthorized debits/credits, 521 Preferred stock, commercial bank, 36 www.freebookslides.com Index  881 Premiums earned, 166 Prepay, 829 Prepayment models, 835–843 option models, 839–843 other empirical models, 838–839 PSA model, 837–838 Prepayment risk, 278, 829–830, 831–835 housing turnover, 834–835 refinancing, 833 Price risk, 3–5, 7–8, 436 Price–yield curve, 259–260, 269–273 Primary credit, 378, 594–595 Primary Dealer Credit Facility (PDCF), 596 Primary securities, 5–6 Prime lending rate, 290, 295–296 Principal agent versus, 6, 94 investment banker as, 91 Principal transactions, 94 Private equity funds, 93 See also Venture capital Volcker Rule, 27, 452 Private pension funds calculation of insured deposits, 588 financial crisis of late 2000s and, 600 guaranty programs, 577, 599–601 loan purchases, 809 trends, 26–27, 117 Private placements, 91 Process management risk, 641 Procter & Gamble, 488 Product diversification, 660–667 activity restrictions in U.S., 668 commercial banking/insurance activities, 664–665 commercial banking/investment banking activities, 661–667 competition, 674–675 conflicts of interest, 672 deposit insurance, 673 economies of scale/scope, 671 issues in, 668–675 nonbank financial service/commerce activities, 667–668 product diversification issues, 674 regulatory oversight, 673–674 safety and soundness, 669–671 Product diversification benefit, 671 Product risk, 641 Profitability of FIs forecasting interest rates in, 229–230 technology and, 516–518, 523–529 Program trading, 95, 135 Promised payment (PMT), 840–841, 847 Prompt corrective action (PCA), 586 capital zones, 586, 592–593, 621 policy, 51 Property–casualty insurance guaranty programs, 577, 597–598 liquidity risk, 379 Property–casualty insurance companies, 151, 161–172 balance sheet and recent trends, 163–171 capital adequacy, 646–647 catastrophe insurance, 725 industry characteristics, 161 international issues, 172–174 largest, 118 regulation, 172 types, 161–163 Proprietary trading, Volcker Rule, 27, 452 Provision for loan losses, 47, 283n Prudential, 173 Prudential Financial, 159 Prudential of America, 152 Prudent person concerns, 399, 399n Public-Private Investment Fund (PPIF), 39 Public–Private Investment Program, 39 Public Securities Association (PSA), 837–838 Pull-to-par, 743 Purchased liquidity management, 362 Purchasing power parity (PPP), 411–412, 436n Pure arbitrage, 95 “Pure” credit swaps, 790, 790n Put options, 500, 738 buying, 738, 739–742 macrohedging with, 752, 753 writing, 738–740 Q Qualified thrift lender (QTL) test, 13, 43, 51–52 Qualitative default risk models, 297–299 borrower-specific factors, 298–299 market-specific factors, 299 Quantitative default risk models, credit scoring models, 300–303 Quantity risk, 436 R Rajaratnam, Raj, 148 RAROC models See Risk-adjusted return on capital (RAROC) models Rate-sensitive assets (RSA), 203–204, 205–206, 209–213 Rate-sensitive liabilities (RSL), 203–204, 206–213 Raymond James Financial, 90 RBS Citizens National Association, 699 R class bonds, 849 Real estate investment trusts (REITs), 126 Real estate loans, 286–287 See also Mortgage(s) Real interest rate, 409–410 Recourse, 503, 804 Redwood Capital Management, 143 Refinancing risk, 179, 180, 204, 833 Regional banks, 31 Regional securities firms, 90 Regions Bank, 699 Regions Financial, 89, 623, 680 Regulation D, 549, 813n Regulation F, 534 Regulation J, 534 Regulation of financial institutions, 10–15, 256–257 See also names of specific regulations and types of financial institutions breakdown in crisis of late 2000s, 10 commercial banks, 40–46, 344, 592, 677–680, 690 consumer protection regulation, 11, 14, 42, 45, 541–542 credit allocation regulation, 11, 13, 344–345 credit union, 57–58, 60 derivative securities, 725–726 entry and chartering regulation, 11 finance companies, 82–83 geographic expansion, 676–680, 693 hedge funds, 115, 138, 140, 147–148 insurance companies, 13, 159–161, 172, 304, 345, 676 investor protection regulation, 11, 14, 135 merger guidelines, 682–685 monetary policy regulation, 11, 13 moral hazard, 12n mutual fund, 11, 14, 123, 125, 135–137, 147–148 net regulatory burden, 11, 13, 14 safety and soundness regulation, 11–12 savings institutions, 50–53, 677 securities firm/investment bank, 11–12, 14, 88–89, 98, 103–107 technology and operational risks, 540–542 Regulation Q ceilings, 13, 50, 207 Regulator forbearance, 50 Regulatory risk, 536–537 Reinsurance, 166 Reinvestment risk, 179, 204–205 Relationship banking, 33 Repricing/funding gap model, 200, 203–215 advantages, 204 book value accounting, 213, 231 cash flows from off-balance-sheet activities, 214–215 CGAP effects, 209–210, 212 cumulative one-year repricing gaps (CGAPs), 205, 207, 209–212 www.freebookslides.com 882 Index Repricing/funding gap model—Cont gap ratio, 207 market value effects, 213, 231 overaggregation, 213–214 rate-sensitive assets (RSA), 203–204, 205–206, 209–213 rate-sensitive liabilities (RSL), 203–204, 206–213 refinancing risk, 204 reinvestment risk, 204–205 repricing gap, 203 runoff problem, 214 spread effect, 211–212 weaknesses, 213–215 Republic New York Corporation, 31, 31n Repudiation, 428–429 Repurchase agreements (RPs), 362, 362n costs, 567 withdrawal risk, 566–567 Reputation, as borrower-specific default risk factor, 298 Required stable funding (RSF), 372, 373–374 Rescheduling, 426 Research, 104 Research boutiques, 90 Reserve computation period, 550–551 Reserve maintenance period, 551–553 Reserve Primary Fund, 120, 132, 380–381, 598 Reserve requirements, 9, 42, 292, 293n., 362–363, 537 cash reserves, 548 liquid asset management, 547–558 loan sales, 813 non-cash liquid assets, 558 overshooting reserve target, 554–555, 556–557 problem for U.S depository institutions, 549–553 reserve computation period, 550–551 reserve maintenance period, 551–553 reserve requirement “tax”, 547–548 transaction accounts, 35, 547, 549–550 undershooting reserve target, 554–556 Reserve requirement “tax”, 547–548 Residential Capital, 71 Residential real estate See also Mortgage(s) “bubble” (2001–), 19 collapse in mid-1980s, 50 consumer protection regulation, 11, 14 credit allocation role for, 3, decline in housing prices, 19–20 increase in residential mortgages, 19 Resolution Trust Corporation (RTC), 50–51, 51n., 813 Retail certificates of deposit (CDs) costs, 564 withdrawal risk, 564 Retail financial services advanced technology requirements, 522–523 credit decisions, 294 impact of technology, 520–522 Retirement funds, 116 See also Private pension funds state/local government pension funds, 117 Retirement Protection Act of 1994, 600 Return on assets (ROA) calculating, 45n., 290–293 commercial bank, 32 contractually promised returns on a loan, 290–293 credit union, 60–61 expected returns on a loan, 293–294 savings institution, 53–55 Return on equity (ROE) calculating, 45n commercial bank, 32 finance company, 82 savings institution, 54 Return on the loan, 337–338 Return-risk trade-off liquid asset management problem for depository institutions, 549–553 liquid assets, 549–559 managing non-cash liquid assets, 558 overshooting reserve target, 554–555, 556–557 undershooting reserve target, 554–556 Reuters, 129, 144 Revco, 815 Revenues international expansion and, 692–693 mergers and acquisitions and, 681–982 technology and, 525 Revolving loans, 77, 288 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, 43, 44, 659, 678, 689, 809 Riggs National Bank, 536 Risk-adjusted return on capital (RAROC) models, 312–315 duration to estimate loan risk, 312–314 loan default rates to estimate loan risk, 314–315 Risk arbitrage, 95 Risk-avoidance hedge funds, 142–143 Risk-based capital ratios (RBC), 621, 638–643 Risk-based deposit insurance program, 584–585 Risk diversification, 182, 692–693 Risk Management Association (RMA), 299 RiskMetrics, 350, 453–462 criticism, 462, 462n daily earnings at risk (DEAR), 454, 459–462, 477 foreign exchange risk, 457–458 Historic (back simulation) approach versus, 465–466 market risk of equities, 458–459 market risk of fixed-income securities, 454–457 portfolio aggregation, 459–462 RiskMetrics model, 453–462, 465–466 Risk of the loan, 338 Risks of financial institutions, 2–3, 177–194 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, 193 interest rate risk See Interest rate risk liquidity risk See Liquidity risk market risk See Market risk off-balance-sheet risk, 177, 189–190, 192 operational risk See Operational risk other risks, 193 price risk, 3–5, 7–8, 436 technology risk See Technology risk Risk weights, 628, 641–642 RJR Nabisco, 815 Robbins, Larry, 143 Role in monetary policy regulation, 13 Routine hedging, 705–706 Royal Bank of Scotland (RBS), 63, 110, 291, 514, 637 Runoff problem, repricing/funding gap model, 214 Rusnak, John, 488 Russia country or sovereign risk, 46, 281, 397 debt default, 442 financial crisis of 1997–1998, 397 S SAC Capital Partners, 146 Safe haven currency, 400 Safety and soundness regulation, 11–12, 39 Safety net, 83 Sales finance institutions, 72 Salesperson’s stake, 672 Salomon Brothers, 90, 503n., 667 Salomon Brothers/Smith Barney, 90 Salomon Inc., 89 Santander Group, 84, 637 Sarbanes-Oxley Act of 2002, 136, 300, 304n www.freebookslides.com Index  883 SAREB, 810 Sarkozy, Nicolas, 64 Saunders, A., 18n., 303n., 305n., 311n., 315n., 334n., 350n Savings Association Insurance Fund (SAIF), 50–51, 53, 579, 585 Savings associations (SAs), 49 Savings banks (SBs), 49 Savings institutions, 9, 27, 49–55 See also Depository institutions (DIs) balance sheet and recent trends, 51–53 Basel I (1993), 477, 619 Basel II (2006), 477, 619–620 Basel 2.5 (2009), 477, 478, 620 Basel III (2010), 473–479, 620, 621, 624–636, 656–658 capital adequacy, 619–643 crisis of 1980s and 1990s, 623 deposit insurance programs, 41, 49n., 50–51, 53, 578–579, 580, 584, 597 in financial crisis of late 2000s, 53–55 geographic expansion, 677 industry characteristics, 49–51, 53–55 mergers and acquisitions, 2, 10–12, 28, 54, 55 qualified thrift lender (QTL) test, 13, 51–52 regulation, 676 trends in U.S., 51–53 types, 49 Schaefer, S., 743n Scholes, M., 315, 315n Schwartz, E S., 743n Sears Roebuck, 287, 667 Sears Roebuck Acceptance Corp., 72 Seasonal credit, 595 Secondary credit, 378, 595 Secondary markets debt, 442–444 price risk and, 4–5 Secondary reserves, 548 Secondary securities, Section 20 affiliates, 662 Secured loans, 284 Securities Act of 1933, 14, 135, 136, 140, 549 Securities and Exchange Commission (SEC), 27, 98, 103–105, 663–664 capital adequacy, 618 derivative contracts and, 726 hedge fund regulation, 115, 147–148 loan sales, 815–816 mutual fund regulation, 11, 14, 123, 124, 132, 135–137, 147 Rule 15C-3-1, 643 swap regulation, 792 Securities Exchange Act of 1934, 14, 135–137 Securities firms, 86–111 See also Hedge funds; Investment banking; Mutual funds abuses and investigations, 97–98, 103–107, 115, 140, 148, 672 back-office activities, 96–98 balance sheet and recent trends, 98–102 broker function, capital adequacy, 618, 643–644 cash management activities, 96 discount brokers, 5, 90, 130 in financial crisis of late 2000s, 2, 27, 40, 88, 89, 91, 101, 105–111 guaranty programs, 12, 106, 577, 598–599 industry characteristics, 88–98 international issues, 87–88, 107–110 investing activities, 96 largest firms, 86, 88–92, 97 liability management, 570–571 liquid asset management, 570–571 loan sales, 817 market-making activities, 94 regulation, 11, 14, 88–89, 98, 103–107 stock market crash of October, 94 stock market crash of October 1987, 88, 98, 135 trading activities, 88, 90, 94–95, 99–102, 103–105, 107–110 trends, 26–27 trends in U.S., 15–17, 98–101 underwriting activities, 86, 88, 89, 91, 98–101, 107–110, 669–675 venture capital activities, 90, 90n., 93–94 Securities Industry and Financial Markets Association (SIFMA), 836–837 Securities Industry Association (SIA), 837 Securities Investor Protection Act of 1970, 107, 598 Securities Investor Protection Corporation (SIPC), 12, 107, 577, 598–599 Securitization See Asset securitization Securitized mortgage assets, 78 Security Federal Corp., 208, 209, 212 Security issues See also Crime and fraud risk cybercrime, 523, 535–536 technology and, 523 Selective hedging, 705–706 Sellers bank loan, 810–812 swap, 775 Separate accounts, 157 September 11, 2001, terrorist attacks, 19, 100, 106, 193, 520, 536, 595–596 Service quality, 525 Settlement risk, 486, 504–505 Severity of loss, 164–165 Shadow banking system, 18–19, 500–501 Sharpe ratios, 143 Shell banks, 687 Short hedge, 710–713 Short positions net short in a currency, 398 writing a call option, 737–738, 739–740 writing a put option, 738–740 Short sales, hedge fund, 142, 143 Signet, 679 Simulation historic (back simulation) approach, 462–465 Monte Carlo simulation approach, 466–468 Single-name CDSs, 787n SIPC See Securities Investor Protection Corporation (SIPC) Small Business Association (SBA), 93 Small businesses, 520 small business investment companies (SBICs), 93 Smart cards (store-value cards), 521 SME Commercial Finance, 84 SMFG, 816 Smith Barney, 89, 90, 667 Smithson, C., 540n “Sniffer” programs, 541 Social media, 521 Société Générale, 488, 637 Sources and uses of liquidity, 366–367 South America, sovereign risk, 46 South Dakota, regulatory risk and, 536–537 Southeast Asia, sovereign risk, 46 South Korea country or sovereign risk, 281 debt rescheduling, 428 in financial crisis of late 2000s, 62 insurance companies, 173 Southtrust, 89 Sovereign bonds, 443 Sovereign risk, 46, 177, 186–187, 422–444 country risk analysis (CRA), 429–444 credit quality problems, 281 credit risk versus, 426 debt repudiation versus debt rescheduling, 428–429 default of U.S sovereign debt, 395 doctrine of sovereign-immunity, 443 Economist Intelligence Unit (EIU), 431 Euromoney Country Risk (ECR) Index, 430 financial crisis of late 2000s and, 63–64, 178, 186–187 Institutional Investor Index, 431, 432 internal evaluation models, 433–441 market data to measure risk, 442–444 www.freebookslides.com 884 Index Sovereign risk—Cont market structure for sovereign debt, 442 risk weights, 628 secondary market for LDC and emerging market debt, 442–444 sovereign or country risk event, 426 statistical models, 433–441 Spain debt crisis, 280, 689 exchange rate swings, 395 in financial crisis of late 2000s, 62, 64, 178, 423–425, 689 SPDRs See Standard & Poor’s Depository Receipts (SPDRs) Spear, Leeds & Kellogg, 89 Special investment vehicles (SIVs), 500–501 Special-purpose equity mutual funds, 156 Special-purpose vehicles (SPVs), 18, 500–501, 820–823, 856 Special-situation hedge funds, 142 S&P 500 Index, 96, 124–125, 514 Spot contracts, 700 foreign exchange transactions, 392–395, 398, 400, 402 time lines, 701 Spot loans, 284 Spot market for FX, 398 Spread effect, 211–212 Spreads bid–ask, 94 call spread options, 756–757 commercial bank, 32 credit spread options, 755–756 option-adjusted spreads (OAS), 837, 839, 840 term structure of derivation of credit risk, 304–305 Standard Chartered Bank, 699 Standard Industrial Classification (SIC) codes, 331, 341 Standardized Approach to credit risk measurement, 541, 620, 621, 625– 629, 639–640, 642, 656–658 Standard & Poor’s credit ratings, 64, 281, 304, 307n., 311, 332, 351, 379, 395 Standard & Poor’s Depository Receipts (SPDRs), 127, 128n Standby letters of credit, 496, 498, 793 State Farm Insurance Company, 117, 161, 172 State/local government pension funds, 117, 119 State regulation commercial bank, 40, 41 hedge fund, 148 insurance activities of state-chartered banks, 664 insurance guaranty funds, 597–598 interstate banking pacts, 678 life insurance company, 159 savings institution, 53 State Street Bank & Trust Company, 402, 623, 637, 699 State Street Corp., 28 Stock brokerage, 95 Stored liquidity management, 362–363 Strategic alliances, 109 “Stress tests”, 36, 623 Strike price, 736 Strips mortgage pass-through, 851–854 zero-coupon Treasury bonds, 304 Structured investment vehicles (SIVs), 18, 820–823, 856–857 Structured note-inverse floater swap arrangements, 780 Stuffing fiduciary accounts, 672 Subprime lenders, 76 Subprime mortgage market, 19–20, 47, 62, 81, 98, 101, 151, 280, 282, 449, 501–502, 791 Sumitomo Mitsui Financial Group, 109, 637 SunAmerica Financial Group, 152 SunTrust, 402, 479, 623 SunTrust Bank, 699 Super-NOW accounts, 561n Superregional banks, 31 Surrender value, 157, 378, 378n Swap markets, 774–775, 791–792 Swaps, 37–38, 489, 491, 500, 773–793, 798–802 CDS indexes, 790 credit default swaps (CDSs), 145, 151, 189, 191, 379, 488, 507, 620, 722, 786–790, 856 credit risk concerns, 791–793 currency swaps, 783–786 fixed-fixed, 783–785 fixed-floating, 785–786 interest rate swaps, 775–783 macrohedging, 780–782 in maturity/duration gap model, 278 netting, 792–793, 793n payment flows, 793 “pure” credit, 790, 790n realized cash flows, 778, 779–780 setting rates, 798–802 standby letters of credit, 793 swap buyers and sellers, 775 swap markets, 774–775, 791–792 total return, 788–789 Sweep accounts, 551 Swiss National Bank, 62, 400 Switzerland in financial crisis of late 2000s, 62, 400 wire transfer systems, 532–533 Syndicated loans, 284, 428, 450, 807 See also Loan sales Systematic credit risk, 182 Systematic loan loss risk, 343–344 Systematic risk (beta), 124, 458 System failure risk, 641 Systemic risk, 590 T Tablet devices, 521–523 Tail the hedge, 717 Takedown risk, loan commitment, 494–495 TALF See Term Asset-Backed Securities Loan Facility (TALF) TARGET See Trans-European Automated Real-Time Gross-Settlement Express Transfer (TARGET) Target, 679 TARP program (2008–2009), 11–12, 36, 39, 159, 377, 587, 613 Tax avoidance, 37, 537 Taxes provisions of TARP relief, 613 reserve requirement “tax”, 547–548 “tax avoidance” incentives, 37 Tax-exempt money market mutual funds, 121 Tax Reform Act of 1986, 78 Taylor series expansion, 270 TD Bank, 28 TD Bank National Association, 699 Technology risk, 3, 177, 190–192 See also Operational risk competition risk, 537–538 costs and, 525–529 crime and fraud, 191, 541 crime and fraud risk, 535–536 data backup, 523 daylight overdraft risk, 533–535 disaster recovery, 19, 523 economies of scale and, 526–528, 540–542 economies of scope and, 528–529, 540–542 electronic transfer systems, 533–538 evolution of payments system, 530–538 international technology transfer risk, 535 nature of, 516 profitability of FIs and, 516–518, 523–529 regulatory risk, 536–537 retail financial services and, 520–522 revenues and, 525 security issues and, 523 www.freebookslides.com Index  885 as source of operational risk, 516 wholesale financial services and, 519–520 Temporary Guarantee Program for money market mutual funds, 121, 133 Tennenbaum Capital Partners, 143 Tepper, David, 143 Term Asset-Backed Securities Loan Facility (TALF), 39 Term life insurance, 154 Term structure derivation of credit risk, 304–310 multiperiod debt instrument default probability, 306–310 one-period debt instrument default probability, 305–306 spreads, 304–305 Term structure of interest rates, 201, 224–230 forecasting interest rates, 229–230 liquidity premium theory, 227–228 market segmentation theory, 228–229 problem of flat yield curve, 273–275 unbiased expectations theory, 225–227 Terrorism attacks of September 11, 2001, 19, 100, 106, 191, 193, 520, 536, 595–596 political risk and, 687 Thailand finance companies, 84 U.S expansion abroad, 688 Third-party loans, 673 Thomson Reuters, 110 Thrift institutions See Savings institutions Tie-ins, 672 Tier I leverage ratio, 621, 622, 624 Tier I risk-based capital ratio, 621, 622, 624 Tier II capital, 624 Time deposits costs, 564 withdrawal risk, 564 Time intermediation, 9–10 Timing insurance, 824 “Tombstone” advertisements, 91 Too-big-to-fail (TBTF) guarantee, 589–590 Total return swaps, 788–789 Total risk-based capital ratio, 621, 622, 624, 634–635 Tourous, W N., 743n Trading activities See also Market risk electronic, 90, 94, 95, 525 Federal Reserve open market operations, 201–203, 378 foreign currency transactions, 392– 395, 401–403 forward, 393, 395, 400, 408–409 future, 702, 715–721 insider, 135, 148 Internet, 94, 95 late trading abuses, 135, 136 operational risk, 192 securities firm/investment bank, 88, 90, 94–95, 99–102, 103–105, 187–188 spot, 392–395, 398, 400, 402 trading portfolio versus investment portfolio, 450–452 types, 94–95 Trading at a discount, 127 Trading at a premium, 127 Transaction accounts, 35, 547, 549–550 Transaction costs, 3, Trans-European Automated Real-Time Gross-Settlement Express Transfer (TARGET), 533–535 Transparency International, 438, 439 Travelers Group, 55n., 525, 662, 667, 679 Travelers Insurance, 89, 90, 659, 662 Treasury bills, interest rates, 201–202 Treasury bonds duration of, 237–238, 245 on the run/off the run, 224 zero-coupon (strips), 304 Treasury management software, 520 Treasury strips, 304 Troubled Asset Relief Program (TARP; 2008–2009), 11–12, 36, 39, 159, 377, 587, 613 Trust services, 40 Turkey, financial crisis of early 2000s, 422 12b-1 fees, 130, 136 U UBS, 89, 110, 350, 400, 488, 637, 668 UBS Securities, 147 UBS Warburg, 104 Ukraine, 689 Unbiased expectations theory, 225–227 Undershooting reserve target, 554–556 Underwriting activities commercial bank, 662, 669–675 conflicts of interest, 672 life insurance company, 153–156 property–casualty insurance, 163–171 securities firm/investment banking, 86, 88–91, 98–101, 107–110, 669–675 Underwriting cycle, 169 Underwriting risk, Unearned premiums, 163 Unicredit Group, 637 Uniform Fraudulent Conveyance Act, 815 Union Bank of Switzerland, 350, 488 Unit banks, 677 United Airlines, 600 United Kingdom (UK) finance companies, 84 in financial crisis of late 2000s, 62, 423 insurance companies, 173 largest banks, 21, 62 LIBOR manipulation, 109–110, 290 mutual fund market, 138 nationwide banking, 678 residential real estate market, wire transfer systems, 532 United States advantages and disadvantages of international expansion, 692–694 assets held by FIs, 2–3, 15–17 European crisis of late 2000s, 62–64 evolution of payments system, 531–532 in financial crisis of late 2000s, See also Financial crisis of late 2000s firm-specific factors, 685 foreign exchange risk, 184–186 geographic expansion of financial institutions, 675–685 insurance companies, 173 largest depository institutions (DIs), 28 LIBOR manipulation, 109–110, 290 market-specific factors, 685 merger and acquisition synergies, 680–685 regulatory factors, 677 residential real estate market, segmentation of financial services industry, 661–667 terrorist attacks of September 11, 2001, 19, 100, 106, 193, 520, 536, 595–596 trends concerning FIs, 15–22 U.S banks abroad, 686–689 wire transfer systems, 532–533 Universal FI structure, 659, 668 Universal life insurance, 154 Unsecured loans, 284 Upfront fee, 493 Upstreaming, 670 USA Patriot Act of 2001, 106, 536, 687 U.S Bancorp, 28, 402, 479, 623 U.S Bancorp Equipment Finance, 73 U.S Bank National Association, 699 U.S Department of Housing and Urban Development (HUD), 812, 824 U.S Justice Department LIBOR manipulation, 109–110, 290 loan sales, 815 merger guidelines, 682–685 New Century Financial and, 81 U.S Senate Permanent Subcommittee on Investigations, 105, 672 www.freebookslides.com 886 Index U.S Treasury Department bailout of AIG, 151, 159, 379, 449–450, 487, 502 bank holding companies, 71 money laundering controls, 536 support for FDIC during financial crisis of late 2000s, 578, 579 Temporary Guarantee Program for money market mutual funds, 381, 598 Troubled Asset Relief Program (TARP; 2008–2009), 11–12, 39, 159, 377, 587, 613 Troubled Asset Relief Program Troubled Asset Relief Program (TARP; 2008–2009), 36 U.S Treasury securities, 224–225 Usury ceilings, 13, 77, 82, 289, 536–537 Utah, industrial loan corporations (ILCs), 537–538, 679 Venezuela domestic money supply growth (MG), 436 sovereign debt, 443 Venture capital, 90, 90n., 93–94 Verification of identities, 520 Veterans Administration (VA), 824, 828 Vieira, Paul, 110n VIPERS See Vanguard Large-Cap Index Participation Equity Receipts (VIPERS) Visa, 287 Volatility earnings, as borrower-specific default risk factor, 298 foreign exchange rate, 399–400 Volcker, Paul, 452 Volcker Rule, 27, 452 Vulture funds, loan purchases, 809 W V Value additivity, 846–847 Value at risk (VAR) framework banking book versus trading book, 450 Citigroup, 467–468 CreditMetrics model, 331, 350–353 expected shortfall (ES) approach, 470–473 Monte Carlo simulation approach, 466–468 RiskMetrics model, 350 “stressed VAR”, 477 Value hedge funds, 143 Vanguard, 123–124, 563 Vanguard Large-Cap Index Participation Equity Receipts (VIPERS), 128, 128n Variable life insurance, 154 Variable universal life insurance, 154 Variance of export revenue (VAREX), 436, 440 Variance of returns (risk), 334 Wachovia, 89, 663, 679, 681 Wall Street Journal Online, 708 Wall Street Reform and Consumer Protection Act of 2010, 14, 27, 36, 42, 45, 53, 106, 136–137, 147, 160, 452, 538, 542, 667, 677, 726, 792 Walmart, 675 international trade growth, 687 Washington Mutual Inc (WaMu), 2, 10–12, 28, 54, 55, 81, 82, 188, 192, 449–450, 487, 502, 588, 773 Waterstone Capital Management, 143 Wealth transfer, intergenerational, 3, 9–10 Weekend game, 550 Weighted-average life (WAL), 836 Wells Fargo, 28, 81, 90, 402, 479, 623, 637, 679, 681, 699, 806, 808 When-issued (WI) trading, 486, 502–503 Whole life insurance, 154 Wholesale certificates of deposit (CDs), 564–565, 568 costs, 565 withdrawal risk, 564–565 Wholesale financial services credit decisions, 295–296 impact of technology, 519–520 Wi-Fi hotspots, 523 Wireless technology, 48–49 Wire transfer systems, 10, 191, 504–505, 518, 519, 532–533 Workplace safety risk, 641 World Bank in financial crisis of late 2000s, 423 HIPC initiative, 428–429 sovereign risk, 422, 423 WorldCom, 100, 279, 311, 672 World Trade Organization (WTO), 688 World War II debt repudiation following, 428 X X-efficiencies, 680–685 Xerox, 667 Y Yellen, Janet, 202–203 Yield curve convexity of price–yield curve, 259–260, 269–273 Operation Twist (2011), 229 problem of flat term structure, 273–275 Yield, duration and, 240 Z Z class bonds, 849 Zero-coupon bonds corporate, 304 credit risk, 304 duration of, 238 Treasury strips, 304 Zhu, Changhong, 143 Z-score model in country risk analysis (CRA), 434 in credit risk analysis, 301n., 302, 307n www.freebookslides.com www.freebookslides.com www.freebookslides.com www.freebookslides.com ... Rose and Marquis Financial Institutions and Markets Eleventh Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Ninth Edition Saunders and Cornett Financial. .. Library of Congress Cataloging-in-Publication Data Names: Saunders, Anthony, 1949- author | Cornett, Marcia Millon, author Title: Financial institutions management : a risk management approach. .. 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