Financial Regulation Notes

Class 11: Other Prudential Regulation of Banks.

Banks

The oldest prudential restriction is the limit on loans to one borrower, also known as the lending
limit or single-borrower limit. The lending limit for national banks appears in 12 USC 84. This
limit also generally governs FDIC-insured thrift institutions. State law applies similar, but less
stringent, limits to state banks.

Why?
● Reduces risk that the failure of any one borrower will bring down the bank.
● No eggs all in one basket.
● Equitable rationing of scarce credit. Precludes someone from tying up a huge share of
the bank’s credit facility. Made sense when markets were small & credit potentially
scarce.

Section 84 keys the loan limit to a single borrower to the bank’s capital. Tier 1 Capital + Tier 2
Capital (limit = Tier 1 Capital).

A national bank’s loans to one borrower cannot exceed 15% of the bank’s capital. These loans
can be secured or unsecured. Secondarily, the bank can loan additional amounts to that
borrower totaling up to 10% of bank’s capital if the additional amounts are “fully secured by
readily marketable collateral having a market value … at least equal to the amount of the funds
outstanding.”

Q: so … banks can’t put eggs in one basket, but can put them in four baskets?

There are lots of stuff that the lending limit doesn’t apply to, like advancing additional money for
“taxes, insurance, utilities, security, operating expenses...”

A syndicated loan bundles together loans from a bunch of banks to meet the needs of a
borrower too big for any of them.

A nonconforming loan occurs when a loan is made within the lending limit, but then something
changes to make it no longer fall within the lending limit (example, bank’s capital decreases).

Insurance

Primary goal of insurance regulation is protecting policyholders against insolvency risk.

Capital Standards
“Capital and surplus” is meant to make a cushion against unexpected increases in liabilities and
decreases in the value of assets. Capital funds the expenses of a rehabilitation or liquidation
with minimal losses to claimants. When liabilities exceed assets, an insurer is insolvent.

Fixed minimum capital and surplus requirements, range greatly dpeending on state and
insurance lines. Higher for multi-line insurers. Higher for casualty lines. (Why?) These represent
a FLAT amount, like $3 million, that an insurer might be required to have.

Risk-based capital recognizes that insurers range in size and the types of risks they assume,
which makes fixed minimum capital standards inadequate for many companies.
The stated objective of NAIC’s RBC requirements are to provide a standard of capital adequacy
that (1) is related to risk, (2) raises the safety net for insurers, (3) is uniform among states, and
(4) provides authority for regulatory action when actual capital falls below the standard.

Four major categories of risk under RBC

1. asset risk
2. credit risk (uncollectable reinsurance/receiveables)
3. underwriting risk (pricing and reserve)
4. off-balance sheet risk (guarantees of parents obligations, excessive growth)

Insurer’s actual total adjusted capital (TAC) is measured against resulting total RBC amount to
determine RBC position. Insurers must report RBC and TAC in annual statements, but
calculating details are filed confidentially.

RBC Action Levels:

200% ACL, Company Action, “company must file plan.”

150% ACL, Regulatory Action, “commissioner must examine insurer.”
100% ACL, Authorized Control, “commissioner authorized to seize insurer.”
70% ACL, Mandatory Control, “commissioner required to seize insurer.”

Reserve Requirements mandated to set aside for future benefit payments and potential losses
on investments.

Investment Restrictions, limits on the amounts or relative proportions of different assets insurers
can hold to ensure adequate diversification and limit risk. Provisions vary between life-health
and property-liability insurers, recognizing differences in their liability structures and investment
needs.

Solvency Monitoring happens through financial reporting, early-warning systems, financial

analysis, and examinations. Annual/quarterly statements serve as a principal source of
information, but a number of other special reports are filed and used in regulatory monitoring.
Insurance commissioners may also require insurers to provide other information as necessary
to assess their financial condition (generally, auth’d to review all books and records of a
company at any time).
IRIS ratios

FAST ratios

Examination and Enforcement

Monitoring
Banks are hyper-scrutinized. More than any other business in the US.

CAMELS and stuff.

Potential punishments for banks and stuff

1. Conditional approvals
2. Written agreements
3. Cease-and-desist orders
4. Suspension, removal, and prohibition of personnel
5. Civil money penalties
6. Suspending or terminating federal deposit insurance
7. Civil litigation
8. Criminal prosecution
9. Conservatorship/receivership

Class notes for 11, Ron Feldman

Tensions Facing Bank Supervisors

Why bank supervision?

Lots of government support, and as a result they take more risk than otherwise, so supervision
should limit but not prevent excessive risk taking.
Enforce specific laws not directly related to solvency, like consumer protection, and others, like
anti-money laundering and BSA.

Tensions facing supervisors that matter to lawyers, and are interrelated:

1. Numbers versus risk management
2. Rules/checklists versus discretion
3. Headquarters versus field
4. Single versus multiple supervisors

Numbers versus risk management

● Why focus on risk management?
○ Typical source of bad numbers
■ Less costly to address earlier
● Why pressure to focus on the numbers?
○ Less "push back"
 ○ "actual" problem, not just potential problem

Rules/checklists vs discretion
● Pros of discretion
○ Hard to anticipate facts and circumstances at bank
■ Checklists will generated no targeted responses
● "too tough" or "too loose"
● Cons of discretion
○ Inconsistency
○ Hard to implement ("What should I do?")
○ "capture":: repeat regulator starts to see things like bank does

Headquarters versus field

● Challenge of working with HQ from field
○ Responding to forces seemingly unrelated to core tasks
○ National policies do not fit a certain locale
○ Not close enough to real work
● Challenge of working with field from HQ
○ Captured
○ Inconsistent
○ Unaware of "big picture"

Single versus multiple supervisors

● Challenges of multiple supervisors
○ More complexities (information sharing)
■ Even if supervisors on the same page
○ Supervisors may view objectives differently
■ Even if have similar duties
○ Supervisors may have different objectives

CAMELS

Employment Asst Comm of Ins, new speaker

Insurance, regulated at state level
State of domicile, where they are incorporated or chartered. State with highest level of
insurance powers. Lead state concept, identify which state is best positioned to be lead on the
group for making the exams as effective as possible. Unlike banking, p/c short tail lines like
auto or personal. Long-tailed lines, like workers comp and life insurance.

RBC, complicated algorithm attributing risk to operations of company. Number, authorized

capital level <ACL> authorized capital level, authorized control level.

1000 rbc isnt better than 600. RBC is really for looking at poorly capitalized institutions, not to
differentiate between well-capitalized institutions
Accounting based on statutory accounting, not GAAP. For example, tables and chairs owned by
the insurance company have no value. Mostly because an insurance company selling chairs to
pay claims is so totally in trouble.

Blind-spots
"acceleration risk":: capital measures started to work in reverse, lowering ratings in broad
sectors across the financial services sector; covenants requiring collateral calls as a downgrade
occurs. Collateral calls caused increased liquidity problems. Investment portfolios were low as
well, and sometimes had to be sold when not necessary otherwise at fire sale prices to satisfy
collateral calls.

New litigation risk, saw value of what they held go low, speculators would come in and offer
2cents on the dollar.

Distinguish between defense to state of domicile versus lead state concept:

State of domicile, has the right to put out of business, invade, whatever.
Other states can only revoke certification to sell in their own state.

Actions and the such are only as valuable as the data which underlie them.

Both speakers together, q&a

Insurance companies can have runs, wher policyholders seek to extract policy benefits.
:.

Class 12: Derivatives & Exchanges

Option: a contract that gives the holder the right, but not the obligation, to buy or sell the
underlying asset at a specified price within a specified period of time.
● Call option (buying or writing)
● Put option (buying or writing)

CBOE (Chicago Board of Options Exchange) in 1973 was the first exchange devoted solely to
trading options. 1982, financial futures options contracts (options on financial futures contracts
like Treasury bond futures contracts) started trading.

Swap: an agreement between two parties to exchange assets or a series of cash flows for a
specific period of time at a specified interval.

Swaps were introduced in the early 80s. Credit swaps at the heart of 08-09 crisis.

Types of swaps:
● Interest rate swaps
 ● Currency swaps
● Credit swaps
● Commodity swaps
● Equity swaps

Interest rate swap: an exchange of fixed interest payments for floating interest payments by two
counterparties.
Swap buyer: by convention, makes the fixed-rate payments in an interest rate swap transaction.
Swap seller: by convention, makes the floating-rate payments in an interest rate swap.

Off-market swaps: swaps that have non-standard terms that require one party to compensate
another.
Fully amortized mortgages: mortgage portfolio cash flows that have a constant payment.

Total return swap: a swap involving an obligation to pay interest at a specified fixed or floating
rate for payments representing the total return on a specified amount.

Pure credit swap: a swap by which an FI receives the par value of the loan on default in return
for paying a periodic swap fee.

Class notes:

Derivative: security whose price depends on the value of an underlying asset.

Reasons to use? Hedging (if you feel your risk exposure is too high to interest rate increases,
an interest rate swap might be good for you)

10/16/2012: Securitization and Credit Rating Agencies

Asset securitization: the packaging and selling of loans and other assets backed by securities.
● Selling loans to outside parties removes considerable liquidity, interest rate, and credit
risk from the portfolio, which means the FI can originate new loans/assets.
● Securitization allows FI asset portfolios to become more liquid, providing an important
source of fee income (FIs act as servicing agents for the assets sold).
● 2009, >61% of mortgages securitized. 1980, <15%.
● FI can use credit derivatives like asset securitization (and CDS) to separate risk
exposure from the lending process itself.
● Loosens incentives for good lending process: poor underwriting, shoddy documentation
and due diligence, failure to monitor, fraudulent activity from both lender and borrower.

How to securitize assets?

● Make an SPV or SIV.
● Sell loans to SPV/SIV.
● Create securities from loans, backed by cash flows.
● SPV sells to investors, getting fees from creation and servicing.
 ● SIV funds purchase of loans with commercial paper, makes fixed bond payments.

Why are SIVs too much like a bank and highly dangerous?
● Added liquidity risk from sophisticated lenders being more prone to “run” than bank
depositors.
○ No FDIC, and depositors rely on funds to meet daily obligations.
● Profitability of securitized assets is largely determined by SPV/SIV’s credit rating,
because most institutional investors are fiduciaries of others and are compelled either by
demand or legal requirements to buy only investment-grade securities.

Pass-through securities: “pass through” promised payments by households of principal and

interest on pools of mortgages created by financial institutions to secondary market investors
holding an interest in these pools.

Government-sponsored enterprises originally created mortgage-backed, pass-through

securities.

GNMA (Ginnie Mae) began in 1968 when it split off from FNMA. Two functions:
1. Sponsors mortgage-backed securities programs by FI.
2. Acts as guarantor to investors in mortgage-backed securities regarding timely pass-
through of principal and interest payments on sponsored bonds. (Timing insurance)
Timing insurance: service provided by a sponsor of pass-through securities (like GNMA)
guaranteeing the bondholder interest and principal payments at the calendar date provided.
GNMA supports only those pools those default or credit risk is insured by the Federal Housing
Administration, the Veterans Administration, the Department of Housing and Urban
Development’s Office of Indian and Public Housing, and USDA Rural Development. Targets
low-income families, young families, veterans.

FNMA began in 1938, but is now a private corporation owned by shareholders.

Sep 7, 2008, FHFA placed FNMA in conservatorship and stopped dividend payments (but
continued to make payments to bondholders). Done because failure of FNMA would have
broken the economy.

10/16/2012 Class Notes

Why securitize?

Usual way a bank makes money is the spread between lending expensive and borrowing cheap
(deposits).

When securitizing, making fees from sale of securities. Also, servicing fees for each transaction
as cash flows from mortgagee to bank and from bank to purchaser of security (investor).

Steps in securitization
 1. Arranger/sponsor arranges to buy loans from bank that originated.
2. Puts loans in SPE
3. Sells interests in SPe as mortgage-backed securities (MBS) bonds.
4. Cash raised from sale of MBS used to bank for loans.

Multiple tranches and repayment risk

● Class A, B, C
● Cash from early payments all flows first to class A, until all class A principal repaid.
● Then all cash from early payments flows to class B, until all class B principal repaid.
● Then, to class C (only remaining class)

Multiple tranches and credit risk

● If default on some loans, deduct first from payments to most subordinate class
● If defaults large enough that exceed payments to that class, then start deducting to next
most subordinate class
● And so on
● Most senior classes lose payments only if large number of defaults

SIV and Mortgage-backed CP

● Assemble loans and transfer to structured investment vehicle
● Issue commercial paper to finance SV
● CP must be constantly refinanced
Shadow Banking World!!!

Synthetic CDO
● Replicate income streams from regular CDOs, but without owning actual underlying
loans
● Find counter party who ... <<slide>>