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Economics of financial intermediation

Introduction

Financial markets are the investment environment, financial system allows transfer of
money/financial resources between savers (surplus of funds) and borrowers (need of funds), thus
the goal is efficient allocation of goods by means of organization.
Components are:
- Assets: allow t o transfer resources across people and may take different form as for
maturity, contract type
- Institutions: intermediaries between savers and borrowers
- Markets: place where transfers are possible

Assets can be real assets, real goods allowing production and output determining firm’s
productive capacity and net income, and financial assets, secondary securities on real assets.
Three different macro classes of financial assets:
- Fixed income or debt are payment fixed or determined by formulas if i isn’t fixed and may
be money market debt (liquid, short-term, low credit risk) or capital market debt (longer
term, safe or risky)
- Common stock or equity which grants and transfer ownership in a corporation, payments
aren’t fixed but depend on performance
- Derivative securities whom value is placed on prices of other securities, main use is to
transfer risk between financial institutions (CDS).

Financial assets play the role of transferring resources in form of contract and transfer
consumption by means of savings to future date.
Allow to separate ownership from management of firm.
Have information role as capital flows to companies are granted if have good prospect evaluated
by lenders (banks).
Improve corporate governance as disclosure implies need of well-behave as for accounting
scandals, auditors tighten rules of corporate governance.
Over there have been changes with decreasing interest rate yield, increasing debt, and size of
investible world and countries involved, however there is still predominance of US. World stock
market capitalization has grown progressively a part from crisis period and there is huge increase
in derivatives market slowing down after 2008.

Players are corporation, business firms as net borrowers; households as net savers; government
can perform both roles. Financial intermediaries are placed in between and perform essential
function of channeling funds and have different regulation according to the role as may be
depositary institutions which collect deposits, or non depositary institutions as finance companies,
investment banks as act as brokers, mutual funds and hedge funds, where difference lies on risk
strategies, rules and different classes of investors, insurance companies.

Financial institution risks are:


- Interest rate risk: value of assets depends on interest rate as for mortgages but is relevant
for any asset and liability with different impact as deposits can be withdrawn quickly
- Credit risk: important for lending institutions as borrower may not repay
- Market risk: focused on price changes with different incidence
- Liquidity risk: either don’t have resources to repay or there is none to buy them and no
possibility to close a position
- Operating risk: related to use of real assets as for reputational problems

There is need of strong regulation for these institutions as they bear systemic risk, having great
impact on economy. In Europe there is Basel regulation with need of enough liquidity to repay
deposits, then bond holders and finally equity holders. Normally banks operate with 3 or 4% of
equity over total assets, with debt over assets of 95%. Is also relevant deposit insurance and core
goal of regulation is to avoid crisis.

In a world without FI there is no intermediary between savers and borrowers having higher costs
due to asymmetric information or exploitation of power and collective action problem and ex post
supervising problem. Contract would be difficult to sign with higher cost of screening and
monitoring, lower liquidity, higher price risk.
FI facilitate transfer of money, acting as brokers, and can be counterpart for both parties, asset
transformation, having active role collecting cash by households and giving back assets giving cash
to corporations taking assets of different type.
Function of FI are brokerage, facilitate contract between parties providing information and
transaction services with no exchanges with parties reducing relative costs through economy of
scale; and asset transformation, transform deposits into loans producing new financial assets
purchasing direct assets by corporations (primary securities) and selling financial claims to
investors (secondary securities).
FI are big pulling together lot of resources with high level of diversification in portfolio and have
incentives to monitor agents (corporations) as is their job, collecting and producing information
according to contract. Diversification spreads risk with lower total one and FI can manage it
because of size and different type of assets, with total variance of portfolio lower than the sum as
correlation isn’t perfect.
Other services are:
- Reduce transaction costs
- Credit allocation
- Intergenerational transfers
- Payment services
- Denomination intermediation
- Maturity intermediation
- Transmission of monetary policy

Main objective of regulation is to ensure soundness of overall system, enhance net social welfare,
protect depositors and users of savings including prevention of unfair practices. With social
protection there is also private benefit as deposits will increase. For private we talk of net
regulatory burden which is the difference between private costs of regulation and private
benefits. There are 6 types of regulation and impact:
- Safety and soundness of regulation protecting against risk of FI failure as with minimum
capital requirement (Basel requires 8% of risk-weighted assets) that is relevant in crisis
period as need to inject funds (TARP in US), encourage diversification of assets (no more
than 10% equity invested in single borrower, guaranty funds granting some deposits also in
case of failure to avoid bank runs (DIF,SIPC), monitoring and surveillance
- Monetary policy regulation relying on central bank needing enough liquid assets and
reserves
- Credit allocation regulation supports socially important sectors with a cap on interest rate
- Consumer protection regulation to prevent discrimination in lending (CRA,HMDA, not
Basel)
- Investor protection regulation is similar and against insider trading, lacking in Eu
- Entry regulation prescribes who can perform FI activities, private cost of deregulation is
competition.

After 2015 systemic banks are regulated by ECB in Eu whereas small banks are regulated by
national bank (as Bank of Italy). In Europe first Basel was in 80s to absorb losses in case of
problems as with capital requirement together with monetary activity. Pillars were capital
adequacy, supervisory review, market discipline. Basel I (1988) was focused on capital
requirement (8%) and evaluation of weighted assets (for ex state bonds bore 0 risk requiring 0
equity, corporation required 50% of loan in equity) plus there were specific rules for non
performing loans. In 1996 banks were allowed to weight market risk by themselves to improve
management of risk. In 2004 there is Basel II which introduces possibility to evaluate each risk, not
only market one, and usual disclosure. Basing capital only on risk management wasn’t safe enough
as for example government bonds don’t have 0 risk so Basel III was introduced with minimum
common equity and liquidity coverage ratio. Basel IV follows path of precedent. Last step is
European banking union.

Depositary institutions

May be commercial banks, saving institutions (smaller in size and number being local), credit
unions (non-profit providing credit with members’ deposits). Nowadays we have concentration of
services in same institutions whereas before there were significant differences. FI have special
balance sheet as products offered are in both sides, deposits and loans, being respectively liability
and assets. Concentration of banks is due to mergers in 90s, disintermediation due to growth of
stock market, global competition, regulatory changes, technological developments, completion
across different types of FI. All this led to decrease in failures with shrinking of banks from 14416
in 1985 to 5472 in 2015. Decreased asset shares of smaller banks.

Commercial banks
Offer full range of products and banking services being the largest group of depositary institutions
not specialized in a single area or consumer but providing services to anyone (main difference with
other FI). Business models and strategies are different among commercial banks as large banks
rely on financial information, algorithms and centralized decision making; small banks rely on
relationship banking with area and clients are small consumers mainly for real estate need as
mortgages, whereas large banks have also commercial and industrial loans as relevant part. Small
banks don’t have much importance in credit card services.
According to sector banks may be:
- Community banks common mainly in US specialized in relationship banking
- Regional or superregional which are larger banks with more services and access to federal
fund, rely on deposits
- Money center bank which isn’t different from previous in size but on relation with market
as don’t rely on deposits but on non-deposit funds or borrowed funds.
In financial statements there are different types of deposits as demand deposits, not bearing
interest and withdrawn at demand, NOW accounts, bearing interest, MMDA, similar to NOW but
negotiable in secondary market, other classes of deposits which are time deposits, restricted in
withdraw option as retail CD and wholesale CD depending on size (retail face value<100k,
wholesale face value>100k and negotiable). Deposits are on liability side. Assets side of bank have
longer maturity and are cash due, investment securities (liquid and negotiable), bonds, MBA, ABS,
other securities, loans and leases.
Stable deposits are cheapest funds for banks and are regulated differently than purchased funds
bearing higher interest rate and very short term.
Equity capital is much smaller than liability and assets with significant leverage effect and is safest
in crisis as first to be used to protect deposits.
Off balance sheet activities are items that move to assets or liabilities once contingent event
occurs and are notional amount of derivatives and other activities not realized yet as
commitments and contingencies. They need proper risk control.

Income statement is made up of interest income which is a relevant part as well as interest
expenses whereas non interest income/expenses are made up of all fees and fiduciary activities,
brokerage services, insurance services and weight much. Most used ratios are ROE, equity
multiplier, return on assets, profit margin, asset utilization. These ratios however don’t consider
risk and may increase bearing more. equity is treated differently as with Tier I; net interest margin
tells if bank is behaving profitably in core activities.
Trend since 1987 sees loans and investments as primary assets with business loans declining in
importance while securities and mortgages increased due to change in business model. After 70s
business loans decreased moving away from core banking, mortgages shows steady constant
growth having less impact in productive activity, decrease in security investment is mainly due to
regulation, consumer loan is increasing but fairly constant.
Banks are switching from lending to corporation to lending to state getting bonds, credit risk is
major exposure. Main sources of funding are deposits and borrowings, interest rate risk is relevant
mainly in liability side.
Until 70s banks were perceived as having screening and monitoring function, from originate and
hold there is shift to originate and distribute, as banks moved to selling in the market loans they
produced securized by MBS sponsor and SPV. In this way banks lower the risks and monitor is no
more required to be performed well as no incentive; loans are liquid as SPV buys them from banks
and divide in tranches according to risk: senior tranche, loans with short maturity and low risk
(AAA rate); mezzanine tranche, medium term loans with possibility of default (ABS,CDO); equity
tranche, riskier. After crisis regulation became stricter with Dodd Frank Act and Basel II and rating
agency reform, key regulation agencies in US are FDIC, deposit insurance; OCC, charter banks; FRS,
lender of last resort; state bank regulators. Relevant banking rules are McFadden Act, Glass-
Steagall act (repealed), Holding company act.

Saving institutions
Are set to offer mortgages to community but are getting smaller due to competition

Credit unions
Still relevant for the system working for members and non-for profit goals; interest rate for loans
is smaller, deposit rates are higher. There is debate over unfairness in competition. Composition of
assets tends to focus on individual needs.
Non depositary institutions

Finance companies

First one was General Electric corporation to provide loans to costumers unable to get them from
banks. It started during great depression, after it in 50s there was huge competition from banks
and eventually entered in real estate market, credit card activities, auto financing.
Core activity is lending but don’t collect deposits. Many of them are affiliated to manufactory
corporations (Ford, Wolgswagen) having access to funds of parent. They set attractive rates to
costumers and is easier to sign contract with the costumer that are considered riskier for banks
and don’t require much information. Having many small loans to huge number of costumers there
is high diversification. They have limited regulation, way smaller than one of banks. In 1977 95% of
assets were from loans to consumers and business, most of debt comes from parent company. In
2015 there is grown of real estate, with less business loans (totally 78% of assets), more
investments in securities and others, less debt due to parent than before but still the majority
comes from there, equity is in line with banking strategy. They can be:
- Sales finance institutions: provide credit to costumer of parent, most of these are captive
(fully owned by parent manufactory)
- Personal credit institutions: specialized in installments to consumer (high risk, high rate)
not only related to parent
- Business credit institutions: specialized in business loans (ex equipment leasing, factoring
which is process of buying accounts from firm at discount)

Is concentrated business as largest 20 firms hold 65% of assets (mainly Citigroup). Major classes in
balance sheet are consumer loans, business loans, real estate. They face interest rate risk and
liquidity risk but mainly credit risk as based on loans. Growth in specialized loans as vehicles. Due
to competition in late 90s was common to provide 0 rate for purchases of cars with trend reversal
in 2015 back to original where bank interest rate is lower.
Subprime lender firms provide funds to risky costumers that can’t get them otherwise, providing
high interest rate, some of them are called loan shark as grant very high interest rate to
desperate-for-funds costumers.
Paylenders provide short term funds to cash-constraint individuals usually due at salary payment,
interest rate in high (=390% annual) and are banned in 15 states or regulated at state level.
Mortgages have become major component of finance company assets and may be first or second
mortgage in form of home equity loans after tax reform in 1986.
Business loans have fewer regulation than for banks.
They finance activities by debt and commercial paper with lower interest rate risk exposure having
medium-long term maturity for liabilities and short-medium term maturity for assets with lower
mismatch than one of banks. It was a successful business in late 90s and 2000s following the cycle
of the economy. Problems arise with subprime crisis and due to mortgages defaults this sector
was the first to be hit. They have little regulation, only for a maximum interest rate, but no
requirement for minimum capital or disclosure, definition by Fed is very broad. They are common
in US as in Eu are normally part of bigger institutions as subsidiaries of commercial banks or
industrial firm.
Securities brokerage firms and investment banks

Help transferring funds from surplus of fund holder to borrower but don’t transform the assets.
Investment banks specialize in raising debt or equity for firms/governments, thus originate,
underwrite and distribute issues of new securities, advise for mergers and acquisitions, tend to
operate at commercial level, not single costumer. Securities firms give help in trading being
specialized in secondary market, tend to deal with retail/individual costumers. Don’t require much
asses or equity to operate. Main activities are underwriting securities, market making, advising. As
other sector there has been consolidation by mergers and acquisitions with decline of 37% in
1987-2006.

Full line firms are largest as BOA, Morgan Stanley and perform all services of investment banks
acting as brokers in secondary market and underwriting securities in primary market. May be
commercial bank holding companies (operate with anyone), specialized in corporate business
(mainly for businesses), large investment banks (few branches and mainly deal with institutions),
remainder of industry, regional securities firm, specialized discount brokers, electronic trading
firms, venture capital firms, other.
Investment banking are activities related to IPO for underwriting and distribute, and to secondary
(seasoned) issues od debt and equity. In private offering brokers act as private placement agent
for a fee, in public offering investment banks underwrite securities with a best effort or
commitment basis.
Venture capital is a pool of money used to finance new and often high-risk firms. Don’t provide
funding in term of debt but require equity investment in firm promoting expertise of managers.
Market makers operate in secondary market for an asset, providing buy and sell price with bid ask
spread which is the commission. They hold monopoly power, can also act on behalf of themselves.
They trade with position trading, price arbitrage, risk arbitrage, program trading, stock brokerage,
electronic brokerage. Then there is investing, cash management, back-office and service functions,
mergers and acquisition. Recent trends are consolidation and competition with decline in trading
volume and commissions, before 70s in US there were fixed commissions. Primary regulator is
SEC. A dark pool in a trading place where agents and price are hidden and are close to certain
wealthy individuals.

Investment companies

Pool funds from different investors and invest in any financial asset with diversified portfolio,
lower transaction costs, professionals with expertise. From 80s assets under management (funds)
have grown much with slowing down in 2000s due to scandals. They are often own by other
institutions as banks, insurance companies. They are:
- Unit trust: fixed portfolio unmanaged actively, decreased importance
- Mutual funds: pool of funds that can be either increasing/decreasing in size (open fund)
with NAV determining price of a share, or with fixed amount of shares (closed-end) in
which price is determined also by demand; price is set once a day
- Exchange traded funds (ETF): fixed number of shares traded as stock in intraday market
with continuous price, mainly replicate indexes
- Hedge funds: actively and heavily managed with less regulation, usually off-shores
Mutual funds

Huge growth in 90s, first one was in 1924, but in 2000s due to scandals confidence decreased. In
2008/9 lack of trust in managers with consequent 20% drop in importance. Total assets now are
13 trillion dollars. In 70s regulation helped growth, especially tax exempt money market mutual
fund in 1979, later started entering in pension funds. Low barriers to entry, strong competition,
low costs and low fees decreasing risk. Are usually owned by banks, insurance companies with
trend of consolidation. Each fund has own prospectus with stocks owned and strategy. Can be
long term or short term funds, where former means bond funds, equity funds, hybrid funds with
only macro risks involved, latter means market instruments as bots with short maturity (less than
60 d), less risky.
Equity funds in long term provide higher returns than bond funs even if more volatile. Equity funds
have always been the majority of mutual funds, growing fast until 2008 suffering much from crisis
and investors moved from active to passive funds. Majority of assets are held by individual
households that benefit from diversification, also many institutions invest in mutual funds. Money
market mutual funds became important during crisis as the instruments are considered very close
to deposits, being also insured by public guarantee. During crisis G insurance lasted one year for
MMMFs. Now majority own funds in retirement funds employer-sponsored, with preference
towards equity funds. Among each category of fund there are differences in strategies, major
providers of funds are Kinguard and Fidelity, objective is usually index fund or growth/income and
global funds requiring higher management and fees. Returns come from income and dividends of
underlying portfolio that can be either distributed to investors or remain within the fund. Value of
one share is NAV. Mutual funds on average performed not better than Wilshare index (passive
emulating 5000 stocks). Average alpha is lower than 0 with performance mainly based on luck.
Mutual funds charge fees that can be on entry and exit (load funds), however are losing
importance. Annual fees are common to all mutual funds that can be set at maximum of 1% (12 b-i
regulation in US). Limited in leverage and highly regulated with possibility of short sell. Primary
regulators are SEC, NASD with emphasis on small investors.

ETF

Tend to be owned by sh/small investors. Passive managed funds that mainly track on index and
are traded like stocks, costs are quite low as no strategies but just replication with decreasing
commissions due to competition and higher leverage. Can be accessed only through brokers, are
closed-end funds. Biggest ETF is iShares. Annual fees are small mainly made by algorithms.

Hedge Funds

Are free in what they do as can also stop cash outflow, relatively unconstrained in strategies and
unregulated, charging very high fees as active management is involved. Supposed to make money
all the time working with 0 beta. Usually run by and for rich individuals and can’t advertise for
small investors. They grew until 2007. In 2008 some regulation was put in place. In passive
management no effort to find over/under valued assets as all values are taken to be optimal ones
relying on efficiency of market and no attempt to time the market with strategies based on
diversification. Active management tries to time the market relying on not perfect efficiency of
markets. Before 2010 no regulation, now there is SEC to avoid systemic risk. Hedge funds differ in
type according to risk taken that cane be: risk avoidance (0 beta), moderate risk (long term
investments), more risky (high leverage). Hedge funds’ strategies are equity (look for over/under
priced stocks), macro (misprices in macro environment), arbitrage (mispricing in futures, stocks,
fixed income).
Equity strategies can specialize in discretionary long-short equity, meaning inspection of the firm,
financial statements. There is bias towards buying position as prices usually move up.
Quant equity is based on algorithm, lot of resources needed to find mismatches. Fixed income
strategies are based on yield curve of interest rate.

Bonds

Are fixed income classes with premium known in advance and according to maturity belong to
money market or capital market. The price is given by the sum of discounted values of all future
payments (coupons and face value). Coupon may be fixed or not, usually as percentage of FV, both
determined by contract along with maturity and periodicity of payments. If bond has fixed rate r
then can be evaluated as annuity. Normally bonds are semi-annual, French ones are usually
annual. In Italy shorter maturity ones are BOTs. Zero coupon don’t pay any coupon but only FV (as
BOT,CTZ). Some have variable rate coupons (CCT) varying according to formula, some have fixed
coupons with fixed i (BTP). Then with real coupons we have adjusted for inflation and
remboursement is market value (BTPeur, BTPItalia). There are also corporate bonds which bear
higher default risk. Bonds rates are:
- Coupon rate: as percentage of FV
- Discount rate: is same of coupon rate if FV=par value but are usually different and
measures opportunity cost in investing in an other source
- Yield to maturity: rate that makes price equal to PV
- Rate of return: profit/investment

With negative capital gain and positive coupon rate the yield<coupon rate, all the way around if
capital gain> coupon gain yield> coupon rate. A comparable bond is one with same yield to
maturity based on idea that investors will keep the bond until the maturity and all coupons are
reinvested with same yield. Governments are risk free but bear other risks as interest rate one,
high yield bonds with high default risk are called junk bonds. There is negative relation between
interest rate and P, and most effected ones are longer maturity, lower coupon rate (as
reinvestment is lower and bear less the risk as can’t well adjust), lower initial YTM (as cash flow in
future is smaller for high YTM thus are less risky and affected) bonds.
P and interest rate are related but not linearly as there is convex relation, with increase in YTM
resulting in smaller price change than a decrease of equal magnitude. Good indicator of risk is
duration which is dp/dy thus is price change to changes in YTM, being a weighted average where
weights are time. Zero coupon are riskier as duration is equal to maturity. However duration is just
an approximation and works only for small changes. Duration for perpetuity is (1+y)/y. for
investors is better to have a more convex bond as bonds are less price sensitive for increase in
interest rate than for a decrease. Yield curve measures relationship between yield and maturity
for similar assets. Normally is upward sloping.

Equity

Gives investors ownership in a corporation. Can be common stock with full right of voting and
limited liability but residual claims or preferred stock where no voting right allowed but constant
divided cash. Sources of gain are dividends and capital appreciation but none of these are certain.
Difficulty is to find fundamental value relying on intrinsic value discounting all future expected
dividends. Form balance sheet we estimate book value but we don’t take into account future
contingencies and performance that would be reflected in MV, thus book value is useful mainly for
liquidating firms.
Dividend discount model says tat stock price should equal PV all of future dividends as perpetuity
based on different assumptions:
- Dividends are all the same
- Dividends grow at constant rate g
- Two different growth rate g1 and g2
To evaluate risk associated we use r and as benchmark usually S&P or Dow. Growth rate instead is
evaluated trough ROE and b which is plowback rate, rate of non distributed earnings, and
g=ROE*b. retained earnings are better for growth as are reinvested in the company.
For firms that don’t pay dividends the value is given by assets already in place plus NPV of future
investments (PVGO). Valuation can be made by comparable with firms within same sector, if easy
to evaluate, comparing growth rate, price to book ratio, price to cash flow ratio, price to sales
ratio and MV.
Also P/E is indicator of growth increasing when PVGO increases or ROE increases, decreasing when
r increases. P/E is historical data in denominator and forward looking data in nominator and can
be manipulated through accounting and has seasonal cycle related to inflation. Free cash flow
approach discounts free cash flow instead of dividends. None of these models is perfect and
analysts are forced to make simplifying assumptions, very sensitive to changes in inputs.

Risk

Ex ante expected return is used to calculate possible return associating to each scenario a
probability and an expected value for return. Risk is calculated by SD of the expected return. To
compare risk we use risk adjusted return, Sharpe ratio=Risk premium/(SD-risk premium).
In portfolio return is weighted average of returns, variance is weighted average of variances if
stocks are completely independent. Effect of diversification is to reduce risk of portfolio if not
perfectly positively correlated.
Returns are random variables assuming normally distributed SD is complete measure of risk and
so is Sharpe ratio. If returns aren’t normally distributed we underestimate risk and extreme values.
Stocks have return that appear to be normally distributed but higher kurtosis.
Government bonds aren’t normally distributed as much safer. Variance of portfolio is weighted
sum of covariances. We can have portfolio with 0 risk if p=-1.

Portfolio

Goal is to minimize portfolio variance. In two assets case we can have variance=0 if p=-1, if p=1
then best option is to put all capital in less risky one, if p has different value then a combination
will be optimal choice. Risk and return are positively correlated, but usually non linearly according
to p. opportunity set is locus of all portfolios that can be constructed with risk and return
associated. However portfolio with SD=0 isn’t necessarily optimal but it depends on risk aversion.
Risk attitude depends on age, money availability, amount of capital thus changes continuously.
U=E(r)-1/2 A s^2 where A is coefficient of risk aversion and u is certainty equivalent. Given A we
can build indifference curves in the field risk, return. We maximize expected utility when
indifference curve is tangent to opportunity set. Efficient set is sub part of opportunity set which is
clearly dominated by another set, meaning that given same SD it has lower E(R).
In capital allocation we must consider also risk free asset, not really feasible in reality. Capital
allocation live in locus of all combination of risky asset and risk free asset. Adding this money
market to opportunity set, best portfolio is the one tangent as allows agent to move later in the
risk free line by lending or borrowing according to own risk aversion and preference.
If investors have homogenous beliefs, they all have same linear efficient set, called capital market
line. With slope given by Sharpe ratio.
In the procedure we thus have two-fund separation theorem as we first select the best objectively
portfolio M and then we add subjective preference in order to move in market line.
Thus in order:
- Security allocation: find minimum variance portfolio to exclude dominated ones
- Capital allocation: introducing money market line we chose portfolio tangent M
- With risk aversion we find for each agent best position along the money market line, the
point tangent with indifference curve
This model is incomplete as no frictions, no taxes, homogenous beliefs (on aggregate can be
similar), same rate for borrowing and lending.

Markowitz portfolio optimization model works in the same way but considering n assets. Each
asset in this framework can be thought in relation to market portfolio M in return and risk
associated B. if x is less risky than M then Bx<1 and E(Rx)<E(RM) and all the way around if asset is
riskier.
Assumption of this model is that market is efficient and all assets are correctly priced lying in SML
curve having all prices correct. If there is distance, a, from the SML line then if a is negative I
wouldn’t buy it, if is positive I would.
Also Sharpe ratio is non linear function, only one portfolio maximizes sharpe ratio and is M.

CAPM

Capital asset pricing model tries to attach a price to single assets, relating risk and return to M.
Risk can be decreased up until market risk by diversification. There are 2 risks:
- Idiosyomatic risk: asset risk, can be diversified
- Systematic risk: related to macro shocks, can’t be diversified
In equilibrium all investors hold M, containing all securities in proportion of total market volume,
in this case we have capital market line.
In aggregate market has 100% of M as borrowings and lending cancel out.
Active funds look for stocks with positive a, CAPM implies all stocks having 0 a as are perfectly
priced. Assumptions are rational individuals, single period horizon, homogenous expectations;
markets imply all assets perfectly tradable, all information available, no taxes. Problem of CAPM is
that it looks only at M, one variable, but requires extensions.

Risk
They are:
- Interest rate risk: measures impacts changing interest rate, is relevant for banks due to
mismatch in maturities of assets and liabilities. It impacts on immediate payments as loans
and on market prices, as bonds. If interest rate changes bank has to renegotiate funds. For
short funded institutions, liabilities having shorter maturity than assets, if interest rate
increases banks get funds at higher cost in order to repay liabilities due as assets will be
obtained later. Long funded institutions have liability’s maturity longer than asset’s one,
thus there is need to reinvest assets once are obtained, and if interest rate decreases there
would be a loss for the bank.
- Credit risk: considerable for banks referring to the possibility to not being fully repaid, core
activity of banks is to screen the borrowers giving appropriate interest rate, then to
monitor. This relates to firm-specific credit risk evaluation. When many borrowers default
at same time we talk of systematic credit risk related usually to macro conditions
- Liquidity risk: relevant when bank is solvent but hasn’t liquid assets to pay debt at the
moment, forcing banks to sell in short time illiquid assets lowering the price or to borrow
more funds. May be caused by different reasons as bank runs, commitments’ holders
suddenly exercising right to borrow, usually related to unexpected events. In this case the
single bank could go to central bank borrowing funds for higher interest rate. If may banks
face liquidity risk at same time central bank may be unable to help and banks would be
forced to have fire-sales (heavy discount), with equity used to cover asset loss
- Foreign exchange risk: risk that exchange rate movements affect assets of FI as for
depreciation. Normally banks invest in assets with positive carry, meaning that in stable
market condition there would be a gain, the risk can be easily hedged by derivatives.
- Country or sovereign risk: relates to the fact that foreign borrowings/repayments are
blocked by legal and government intervention, or natural disasters. This is a type of credit
risk and interest rate risk. Difficult to assess
- Market risk: related to changes in values due to market movements for trading assets (in
trading book, usually short term) implying other variables as exchange rate (incremental
risk). In trading book we have bonds, commodities, FX, equity, derivatives. Regulators now
pay special attention to this risk and its correlation with other ones
- Off balance sheet risk: related to contingent assets or liabilities as letter of credit, loan
commitments, derivative securities, having direct impact on future profitability and
relevant for performance and solvency
- Technology and operational risk fall in same category, added in Basel II in 90s, related to
extra events outside financial activities, resulting from inadequate or failed internal
process and may be technology risk, operational risk, reputational risk (more important on
last years)
- Insolvency risk: representing the event that the bank isn’t solvent and steam from other
risks.
Usually interest rate risk and off balance sheet risk are positively correlated.
These risks impact on net worth, value for owners and is difference between market value of
assets and liabilities, of FI affecting equity and solvency condition. As banks operate with small
equity the latter is easily eroded.

To evaluate interest rate risk we look at exposure to it (no exposure is maturity of assets matches
perfectly with maturity of liabilities).
Measurement methods for interest rate risk are:
- Repricing or funding gap model: based on book value accounting cash flow analysis of
interest on assets sensitive minus interest on liabilities sensitive over a time interval. Banks
need to report quarterly, by regulation, repricing gap for certain time spam. A negative gap
tells that an increase of i is bad for the bank, a positive gap tells that a decrease of i is bad
for the bank. To asses impact on net income we asses impact on net interest rate. Criteria
are all assets and liabilities below or equal to time horizon (also fixed rate ones), all the
ones with floating rates, saving accounts, MMDAs depend on rate (fixed or floating). We
also use cumulative gap. Choice of time horizon may underestimate or overestimate the
mismatch. Cumulative gap/assets is gap ratio measuring exposure. In reality borrowing
rate and lending rate don’t change by same amount, being positively correlated but with
different spreads across periods leading to a more difficult analysis. Spread effects are such
that a positive one increases NII, negative one decreases NII after the evaluation by gap.
This means that having a 0 gap doesn’t eliminate risk exposure as there is spread.
Advantages of repricing model are simplicity and this is why small banks use it.
Disadvantages are consistent as this method uses accounting values, moreover the analysis
is very aggregative and mismatches within a same bucket may be consistent, it doesn’t
consider possibility of default or additional funds granted to borrower with continuous
changes in interest rate conditions (runoffs), off-balance sheet items aren’t included even
if relevant for risk management. Market value method instead evaluate assets and
liabilities according to current level of interest rate.
- Maturity model: not used anymore. Based on market value with rate sensitivity according
to maturity only, longer maturity has higher sensitivity with diminishing rate. Is looked at
average maturity of assets size and liability size and maturity gap is Ma-Ml. if gap is positive
and interest rate decreases then the bank is worse off. Usually banks have positive
maturity gap. Insurance companies are more likely to have match in maturities.
Immunization targets Ma=Ml; not appropriate for all FI and not really avoiding completely
interest rate risk. Leverage also measures exposure to interest rate, which isn’t eliminated
with immunization.
- Duration model: most complete one. It puts the other two methods together, being
weighted average time to maturity of a security measuring elasticity for price change
changing interest rate. To avoid risk we have to match durations of assets and liabilities.
Assumptions are no default risk and flat yield to maturity curve. Duration takes into
account leverage adjusted duration gap (the larger it is the larger is impact on equity), size
of FI, size of interest rate shock. Regulators require a given equity ratio, E/A and goal of
bank is to have 0 variation in it. Duration is a linear approximation, applying well only for
small changes but we should involve also convexity with second derivative. Duration
matching requires more efforts and is more costly than other two methods as every time
there is a mismatch FI should find liquid assets to manage, not always possible. Duration
changes continuously as variables do so, moreover YTM isn’t flat. There is trade off
between perfect immunization and effort to reach it.

Credit risk

Key role for FI in screening and monitoring. It follows business cycle having many more non
performing loans in bad periods than in good ones. This loans can be:
- C&I: having different maturities and interest rate that can be both fixed or floating. Loans
may be secured, having a collateral and being safer (lower interest rate charged) or
unsecured where no collateral is provided but banks have only junior claims. Usually a
group of FIs work together in providing a large loan, called syndication. Loans can be
immediately credited to borrower that withdraw all at once, spot loan, or through a credit
line where borrower withdraw only amount needed at times up to a certain maximum and
time spam, loan commitments. The trend for C&I loans is declining as is cheaper to get
funds directly from the market and disintermediation
- Real estate loans: most important ones, usually given to households and backed by the
house itself. Rate can be fixed or floating, being usually very long term with average
maturity in US of 28 years, changing according to market conditions. They seem safe
thanks to collateral however banks don’t need houses and their prices may decrease in the
market increasing risk.
- Consumer loans: small loans, usually for consumption. Non revolving loans are for one
period payment (as buying a car), in revolving loan there is a credit line to be withdrawn
and repaid with certain maximum and time spam. They are increasing due to easiness but
are hardly hit by systemic crisis and bad economy.

Peak of bankruptcy in 2005 is due to change in regulation. Industrial loans may seem the riskiest
ones but are the best planned ones as for cash flow, interest rate; whereas credit card and
consumer loans are usually low well-assessed and turn out to be riskier. Other loans are farm
loans, other banks, non bank FI, foreign banks, governments.
Starting point for loan is base lending rate, according to the type of loan, and measures interest
rate on average charged. Most used one is LIBOR even if scandals occurred. For long term loans
there is usually agreement of banks for it with rate of best borrowers in the past (rate with lower
default rates), now is an average with positive or negative mark ups according to creditworthiness.
Next step is to add risk premium to base lending rate, moreover banks charge fees usually not
interest bearing, as original fee (of); there are also non interest bearing compensation balance
requirement (margin of the loan required to hold on deposit usually with no or low interest rate).
Beyond banks have to stick with required reserves imposed on demand deposits to have liquid
assets. Return=1+k=1+((of+BR+premium)/(1-(b(1-RR)); E(r)=p(1+k)+(1-p)0, where k is contractual
interest rate, p is probability to repay, 1-p is probability of default, recovery rate is 0. Role of bank
to asses optimal k and p. as k increases also E(r) should increase but k is negatively related to p
and beyond a certain k is not profitable for the bank to charge as too many defaults, with credit
crunch. Ways of screening have changed over time mainly due to technology, starting from
relationship banking and soft information, and then with quantitative analysis and algorithm with
large banks. At retail level evaluation is based on precise information, through algorithm to define
creditworthiness, usually giving a simple reject or accept as output rather than an adjustment of
interest rate. The implication is credit rationing in crisis periods. For wholesale, as industrial loan,
the decision is different, based on firm evaluation, forward looking analysis, using quantitative
date as well as soft ones like fidelity, having both quantity and price adjustment also depending on
market conditions. Default risk measurement is more relevant for wholesale.
Risk models have as key variable the probability of default of borrower. Assessment is based on
information. Main models are qualitative models, using as inputs all soft information as reputation
in community and with bank, leverage of firm, volatility of earnings, collateral, and information of
market as business cycle, interest rate level; and quantitative models, using all observable
characteristics to calculate pd, evaluating the degree of these features to improve pricing, screen
out bad applicants, calculate reserves needed.

Linear Probability model; pd is sum of all relevant factors with degree plus the error, the job is to
find all relevant factors and betas using past data. Problems are reliance on past data for future
events and pd may be out of [0,1] with regression making no sense.
Logit model incorporates linear one forcing pd to stick in [0,1] as =1/(1+e^-pd).
Altmans discrimination model has same reasoning already giving the relevant factors and betas,
and according to level of the function (Z) classes of borrowers are defined.
Advantages of these models are easiness, disadvantages are reliance on past date, only two
scenarios (pay, not repay), everything not clearly observable or quantifiable (as reputation) isn’t
involved. Newer models take into account this.
In term structure deviation of credit risk we compare the class on instrument we are interest in to
risk free ones and risk premium is difference in interest rates, plotting both yield curves. We can
infer that p(1+k)=(1+i), assuming recovery rate=0, however usually is positive and we can add to
the evaluation (1-p)t(1+k)+p(1+k)=(1+i). in these models we mainly use market data, as yield
curve, forward looking and based on expectations. Probability of default depends on marginal
default probability (of each year) and cumulative one (having the product across years assuming
independence).
Mortality rate models wee developed by insurance companies looking at mortality rate (number
of defaults in year t/ outstanding loans in year t9 based on past data. It increases with years and
with lower rating.
RAROC model measures gain over risk and a loan is approved when RAROC> benchmark ROE.
Approaches t target risk are duration method or default rates at 5% quantile.
Option models are based on options, CALL and PUT, reasoning the same for debt and interest rate
as if the latter is too high the firm chose the option of default.

Credit risk in loan portfolio

We have to look at correlation among loans. Everything about diversification is applied here thus
no concentration is favorable. Migration analysis tracks ratings of firms in a particular sector or
rating class usually done by a matrix with possibility of changes among classes.
We can also set concentration limits usually by regulation.
Diversified loans aren’t feasible for all banks as usually small ones aren’t capable of due to size of
business and area; usually no possibility of having all liquid assets.
We do the analysis as in CAPM.
A way to address variables of the loan is Moody’s Analytics.
An other application is loan volume based models when market prices aren’t available to have
idea of what an aggregate portfolio looks like providing benchmark for the FI.
An other model is systematic loan loss risk giving sensibility of loan losses in a particular sector
relative to losses in FI portfolio.
Credit matrices is a value at risk framework. Credit Risk+ by Credit swisse focuses on calculating
required capital to absorb losses working with Poisson distribution.