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Financial
Institutions
Management
A Risk Management Approach
The McGraw Hill Series in Finance, Insurance, and Real Estate
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Financial
Institutions
Management
A Risk Management Approach Eleventh 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. Dorn
Professor of Finance
Bentley University

Otgontsetseg (Otgo)
Erhemjamts
Dean of the School of Management,
Professor of Finance
University of San Francisco
 Final PDF to printer

FINANCIAL INSTITUTIONS MANAGEMENT

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To my son and daughter, Nick and Emily.
Anthony Saunders

To my parents, Tom and Sue.

Marcia Millon Cornett

To my best friend and husband, Tumen.

Otgo Erhemjamts
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. Profes-
sor 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.
Courtesy of Anthony Saunders 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. He was an academic consultant for the FDIC.
He also held a visiting position in the research department of the International Mon-
etary 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,
including Credit Risk Measurement: New Approaches to Value at Risk and Other Para-
digms, third 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 jour-
nals as the Journal of Finance, the Journal of Money, Credit and Banking; the Journal
Courtesy of Marcia Million of Financial Economics; Financial Management; and the Journal of Banking and Finance.
Cornett
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 and Otgo Erhemjamts, Dr. Cornett has recently com-
pleted work on the eighth edition of Financial Markets and Institutions (McGraw Hill
Education). Along with Troy Adair and John Nofsinger, Dr. Cornett has recently com-
pleted work on the sixth edition of Finance: Applications and Theory (McGraw Hill
­Education). Dr. Cornett serves as an Associate E ­ ditor for the Journal of Banking and
Finance, Journal of F
­ inancial ­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 Associa-
tion, and the Western Finance Association.

vi
 About the Authors vii

Otgontsetseg (Otgo) Erhemjamts

Otgo Erhemjamts is a Dean of the School of Management, and a Professor of Finance
at the University of San Francisco. She received her PhD in Finance from Georgia State
University. Her research interests are in corporate social responsibility, ESG, sustainable
finance, corporate finance, and corporate governance. Her work has appeared in repu-
table academic journals including the Journal of Business Ethics; Journal of Banking and
Finance; Journal of Money, Credit, and Banking; Journal of Financial Research; The Finan-
cial Review; and Journal of Risk & Insurance. She is in the top 10% of authors on SSRN by
all-time downloads. Professor Erhemjamts taught graduate and undergraduate courses in
Courtesy of Chris San investments, equity research, sustainable investing, corporate finance, risk management,
Antonio-Tunis and financial institutions courses at Bentley University and Georgia State University.
She was a Co-Principal Investigator on a $2.4 million NSF IUSE Grant on “Broadening
the fusion of STEM and business curricula in undergraduate sustainability education.”
Dr. Erhemjamts is a member of the Financial Management Association, the American
Finance Association, and the Eastern Finance Association.
Preface
The last 35 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 increas-
ingly global in nature. Many forces contributed to this breakdown in interindustry
and intercountry barriers, including financial innovation, technology, taxation, and
regulation. Then in 2008–2009, the financial services industry experienced the worst
financial crisis since the Great Depression. Since March 2020, the industry has been
dealing with the effects of the COVID-19 pandemic. 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 securi-
tization, off-balance-sheet banking, competition from fintech and big tech firms, and
on changes occurring as a result of the financial crisis as well as the pandemic.
When the first edition of this text was released in 1994, it was the first to ana-
lyze 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 bal-
ance 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 eleventh edition of this text takes the same innovative approach taken in the
first ten editions and focuses on managing return and risk in modern financial insti-
tutions (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 man-
aged are similar whether an institution is chartered as a commercial bank, a savings
bank, an investment bank, or an insurance company.
As in any stockholder-owned corporation, the goal of FI managers should always
be to maximize the value of the financial institution. However, pursuit of value
maximization does not mean that risk management can be ignored.
Indeed, modern FIs are in the risk management business. As we discuss in this
book, in a world of perfect and frictionless capital markets, FIs would not exist and
individuals would manage their own financial assets and portfolios. But since real-
world financial markets are not perfect, FIs provide the positive function of bearing
and managing risk on behalf of their customers through the pooling of risks and the
sale of their services as risk specialists.

INTENDED AUDIENCE
Financial Institutions Management: A Risk Management Approach is aimed at upper-
level undergraduate, and graduate students. 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.

viii
 Preface ix

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, 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 1 introduces the special functions of FIs and takes an analytical look at
how financial intermediation benefits today’s economy. Chapters 2 through 6 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 6. In Chapter 7, we preview the risk measurement and management sec-
tions 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 8 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 inter-
est rate volatility and the mismatching of asset and liability durations on FI risk expo-
sure. 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 do 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.
x Preface

In addition, modern FIs do more than generate returns and bear risk through tradi-
tional maturity mismatching and credit extensions. They also are increasingly engaging
in off-balance-sheet activities to generate fee income (Chapter 16) and making tech-
nological investments to reduce costs (Chapter 17). Financial technology, or fintech,
refers to the use of technology to deliver financial solutions in a manner that competes
with traditional financial methods. While similar to technology, fintech is defined as
“technology-enabled innovation in financial services that could result in new business
models, applications, processes, or products with an associated material effect on the
provision of financial services.” Risks of digital disruption stemming from increased
competition by fintech and big tech firms are discussed in detail in Chapter 18.
In Chapter 19, we begin the risk management section by looking at ways in which
FIs can insulate themselves from liquidity risk. In Chapter 20, 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 21. Chapter 22 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 diver-
sification opportunity set. Chapters 23 through 27 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 for-
wards (Chapter 23); options, caps, floors, and collars (Chapter 24); swaps (Chapter 25);
loan sales (Chapter 26); and securitization (Chapter 27).

CHANGES IN THIS EDITION

Each chapter in this edition has been revised thoroughly to reflect the most up-to-
date information available. End-of-chapter questions and problem material have also
been expanded and updated to provide a complete selection of testing material.
The following are some of the new features of this revision:
Chapter 1
• Includes updated discussions on the risks of digital disruption from fintech and
big tech firms.

Chapter 2
• Includes new discussions on changes in U.S. commercial banks’ financial asset port-
folio due to the COVID-19 pandemic, as well as 2021 stress tests and their results.
• Includes a brief description of the 2018 Economic Growth, Regulatory Relief, and
Consumer Protection Act (EGRRCPA).
• Includes an updated discussion on Brexit and its damage to the U.K.’s economic
growth.

Chapter 3
• Includes a new discussion on Trump administration’s rule on predatory payday loans.

Chapter 4
• Includes a new discussion on the evolution of the traditional broker-dealer busi-
ness model from commission-based services to fee-based services.
 Preface xi

Chapter 5
• Includes a new discussion on net new cash flows for mutual funds during the
COVID-19 pandemic.
• Includes new discussions on inflows and outflows of the government and prime
money market funds during the COVID-19 pandemic, as well as how SEC’s money
market reforms exacerbated the liquidity problems for money market funds dur-
ing the pandemic.

Chapter 6
• Includes an updated figure on insured losses from U.S. catastrophes, such as 2020
Midwest thunderstorms, and 2021 Hurricane Ida.
• Includes a new discussion on total and insured losses from natural disasters world-
wide for 2019, 2020, and 2021.

Chapter 7
• Includes a new discussion on risks of digital disruption and fintech, as well as an
updated discussion on technology risks.
• Includes a new discussion on how climate risk may adversely affect the balance
sheet of FIs and how the global financial system responds to shocks. In addi-
tion, there is a new discussion on steps financial regulators are taking on climate-
related financial risk disclosure and analysis.

Chapter 8
• Includes a new discussion on the Fed’s response to the COVID-19 pandemic.

Chapter 10
• Includes a new discussion on student loan defaults.
• Includes new figures on interest rates on consumer loans, and on recovery rates
on defaulted debt during the COVID-19 pandemic.

Chapter 11
• Includes a new discussion on loan concentration risk that arose during the Great
Recession.
• Includes new discussions on criticized loan, as well as CRE loan exposures, and
how they increased during the COVID-19 pandemic.

Chapter 12
• Includes improved and more detailed descriptions of the liquidity coverage ratio
(LCR) components.

Chapter 13
• Includes a new discussion on Turkish lira’s downward decline in 2021.
• Includes a new discussion on U.S. dollar performance during the COVID-19
pandemic.

Chapter 14
• Includes a new discussion on sovereign defaults and their global impact. In par-
ticular, defaults by Argentina and Ecuador are discussed which were exacerbated
by the COVID-19 pandemic.
• Includes a new discussion on hyperinflation in Venezuela.
xii Preface

Chapter 15
• Includes a new and updated discussion on changes in Volcker rule since 2019.
• Includes a new discussion on the 2019 revisions to the revised standardized
approach for market risk.

Chapter 16
• Includes new examples of big losses on derivatives.
• Includes a new discission on when issued trading data, and patterns observed dur-
ing the COVID-19 pandemic.

Chapter 17
• Includes a new discussion of the 2021 Gartner CIO Survey regarding the top IT
spending categories such as cybersecurity, data analytics, API architecture, AI and
machine learning, and cloud solutions.
• Includes a new discussion on threats from social engineering, such as baiting,
phishing, vishing, and spear fishing.

Chapter 18
• Includes an improved description of the risks of digital disruption stemming from
increased competition by fintech and big tech firms.
• Includes a new section on how big tech firms such as Google, Apple, Amazon,
and Facebook are transforming fintech. There is also a new section on regulatory
approaches towards big tech firms.
• Includes new discussions on stablecoins, central bank digital currencies (CBDCs),
and decentralized finance (DeFi).

Chapter 19
• Includes a new discussion on the elimination of minimum reserve requirements
and the corresponding “ample” reserves regime.

Chapter 20
• Includes a new discussion Fed’s actions following the Great Recession through
the COVID-19 pandemic.
• Includes a new discussion on the performance of Pension Benefit Guaranty Corpo-
ration’s (PBGC’s) two insurance programs during the pandemic.

Chapter 21
• Includes a new and updated table with risk weights for credit risk-weighted assets
under Basel III.
• Includes a new and updated table with credit conversion factors for off-balance
sheet contingent or guaranty contracts under Basel III.
• Includes a new discussion on the standardized approach for counterparty credit
risk (SA-CCR).
• Includes a new and updated discussion on the standardized approach for opera-
tional risk.
 Preface xiii

Chapter 22
• Includes a new discussion on the new rule issued by the Federal Reserve Board,
which imposed single-counterparty credit limits on large bank holding companies.
• Includes a new discussion on the growing importance of nonbank financial inter-
mediaries (NBFIs) and how they contributed to financial instability during the
COVID-19 pandemic.

Chapter 25
• Includes a new discussion on the March 2021 Progress Report on the transition
from LIBOR to SOFR by the Alternative Reference Rates Committee (ARRC).

Chapter 26
• Includes new discussions on how the leveraged loan market was severely affected
by the COVID-19 pandemic.

Chapter 27
• Includes a new discussion on the uniform mortgage-backed security (UMBS),
launched by the FHFA.
• Includes a new discussion on collateralized loan obligations (CLOs) and how they
are contributing to the growth of the leveraged loan market.

We have retained and updated these features:

• The risk approach of Financial Institutions Management has been retained, keep-
ing the first section of the text as an introduction and the last two sections as a
risk measurement and risk management summary, respectively.
• We again present a detailed look at what is new in each of the different sectors
of the financial institutions industry in the first six chapters of the text. We have
highlighted the continued international coverage with a global issues icon
throughout the text.
• Chapter 17 includes material on electronic technology and the Internet’s impact
on financial services. Technological changes occurring over the last two decades
have changed the way financial institutions offer services to customers, both
domestically and overseas. The effect of technology is also referenced in other
chapters where relevant.
• Coverage of credit risk models (including newer models, such as Moody’s
Analytics, ­CreditMetrics, and CreditRisk+) remains in the text.
• Coverage in the Product and Geographic Expansion chapter explores the
increased inroads of banks into the insurance field, the move toward nationwide
banking (in the United States), and the rapid growth of foreign banks and other
intermediaries in the United States.
• Numerous highlighted in-chapter Examples remain in the chapters.
• Internet references remain throughout each chapter and Internet questions are
found after the end-of-chapter questions.
• An extensive problem set, including web exercises, can be found at the end
of each chapter that allows students to practice a variety of skills using the same
data or set of circumstances.
xiv Preface

ANCILLARIES
All supplemental materials for both students and instructors can be found on the
McGraw Hill website for the eleventh edition of Financial Institutions Management at
www.mhhe.com/saunders11e. Instructor materials are password protected for
your security.
Print versions are available by request only—if interested, please contact your
McGraw Hill/Irwin representative. The following supplements are available for the
eleventh edition.

For Students
• Multiple-Choice Quizzes for each chapter consist of multiple-choice questions
that reflect key concepts from the text. These quizzes have instant grading.
• Appendices consist of material that has been removed from previous editions of
the print textbook to allow room for new topics.

For Instructors
• The Test Bank, offers multiple-choice and true/false questions that are designed
to apply specifically to this text and this edition’s revisions.
• The Instructor’s Manual, contains answers to the text’s Questions and Problems
at the end of each chapter and chapter outlines.
• The PowerPoint Presentations, summarize the main points of each chapter in a
step-by-step fashion. These slideshows can be edited by instructors to customize
presentations.
• The Digital Image Library contains electronic versions of all figures and tables
from the eleventh edition of the text.
Acknowledgments
Finally, we would like to thank the numerous colleagues who assisted with the pre-
vious editions of this book. Of great help were the book reviewers whose painstak-
ing comments and advice guided the text through its eight revisions.
Jack Aber Elyas Elyasiani
Boston University Temple University–Philadelphia
Brian J. Adams Joseph Finnerty
University of Portland University of Illinois
Michael H. Anderson Margaret Forster
University of Massachusetts–Dartmouth University of Notre Dame
Mounther Barakat Jack Clark Francis
University of Houston–Clear Lake Baruch College–CUNY
Sreedhar Bharath James H. Gilkeson
University of Michigan University of Central Florida
Rita Biswas Anurag Gupta
SUNY–Albany Case Western Reserve University
M. E. Bond John H. Hand
University of Memphis Auburn University
Qiang Bu Mahfuzul Haque
Pennsylvania State–Harrisburg Indiana State University–Terre Haute
Yea-Mow Chen Yan He
San Francisco State University San Francisco State University
Robert Chersi Alan C. Hess
Pace University University of Washington–Seattle
Jeffrey A. Clark William Hudson
Florida State University Saint Cloud State University
Robert A. Clark Ray Jackson
Butler University University of Massachusetts–Dartmouth
Ethan Cohen-Cole Kevin Jacques
University of Maryland–College Park Georgetown University and Office of the
S. Steven Cole Comptroller of the Currency
University of North Texas Julapa Jagtiani
James Conover Federal Reserve Bank of Chicago
University of North Texas Craig G. Johnson
Douglas Cook California State University–Hayward
University of Mississippi Deniz Kebabci Tudor
Kenneth Daniels San Francisco State University
Virginia Commonwealth University Elinda Kiss
Paul Ellinger University of Maryland–College Park
University of Illinois Nelson J. Lacey
David Ely University of Massachusetts at Amherst
San Diego State University

xv
xvi Acknowledgments

Robert Lamy Kenneth Rhoda

Wake Forest University LaSalle University
Rick LeCompte Tara Rice
Wichita State University Boston College
Andrew Light Stephen Rush
Liberty University University of Connecticut–Storrs
Chunlin Liu Don Sabbarese
University of Nevada–Reno Kennesaw State University
Barry Marchman Daniel Singer
Georgia Institute of Technology Towson University
Patricia C. Matthews Duane Stock
Mount Union College University of Oklahoma–Norman
Robert McLeod Richard Stolz
University of Alabama California State University–Fullerton
Jamie McNutt Michael Toyne
Rutgers–Camden Northeastern State University
Ardavan Mobasheri Haluk Unal
Bernard M. Baruch College–CUNY University of Maryland
Richard Patterson James A. Verbrugge
Indiana University–Bloomington University of Georgia
Joe Peek Hsinrong Wei
University of Kentucky–Lexington Baruch College–CUNY
Roberto Perli Sonya Williams-Stanton
University of Maryland University of Michigan–Ann Arbor
Marcelo Pinheiro Alexander Wilson
George Mason University University of Arizona
Anna Pomeranets Robert Wolf
Florida Atlantic University University of Wisconsin–La Crosse
Rose M. Prasad David Zalewski
Central Michigan University Providence College
Hong Qian Shaorong Zhang
Oakland University Marshall University
Andreas Rauterkus Lina Zhou
University of Alabama–Birmingham Augustana College

We very much appreciate the contributions of the book team at McGraw Hill
­Education: Stephanie DeRosa, Associate Portfolio Manager; Stacy Proteau, Product
Developer, Sarah Hurley, Marketing Manager; Melissa M. Leick and Katie Reuter,
Content Project Managers.
Anthony Saunders
Marcia Millon Cornett
Otgo Erhemjamts
Brief Contents
PART ONE
Introduction 1 15 Market Risk 457
1 Why Are Financial Institutions
Special? 2
2 Financial Services: Depository
Institutions 26
3 Financial Services: Finance
Companies 70
4 Financial Services: Securities Firms
and Investment Banks 85
5 Financial Services: Mutual Fund and
Hedge Fund Companies 116
6 Financial Services: Insurance
Companies 158
7 Risks of Financial Institutions 186
PART TWO
Measuring Risk 211
8 Interest Rate Risk I 212
9 Interest Rate Risk II 243
10 Credit Risk: Individual Loan Risk 282
11 Credit Risk: Loan Portfolio and
Concentration Risk 333
14 Sovereign Risk 428
16 Off-Balance-Sheet Risk 499
17 Technology and Other
Operational Risks 527
18 Risk of Digital Disruption and
Fintech 560
PART THREE
Managing Risk 591
19 Liability and Liquidity
Management 592
20 Deposit Insurance and Other
Liability Guarantees 611
21 Capital Adequacy 652
22 Product and Geographic
Expansion 699
23 Futures and Forwards 740
24 Options, Caps, Floors, and Collars 777
25 Swaps 815
26 Loan Sales 846
27 Securitization 863

12 Liquidity Risk 362

13 Foreign Exchange Risk 396 Index 908

xvii
Contents
PART ONE
INTRODUCTION 1
Chapter One
Why Are Financial Institutions
Special? 2
Introduction 2
Financial Institutions’ Specialness
FIs Function as Brokers 5
FIs Function as Asset Transformers
Information Costs 6
Liquidity and Price Risk 7
Other Special Services 7
Other Aspects of Specialness
The Transmission of Monetary Policy 8
Credit Allocation 9
Intergenerational Wealth Transfers or Time
Intermediation 9
Payment Services 9
Denomination Intermediation 9
Specialness and Regulation 10
Safety and Soundness Regulation 11
Monetary Policy Regulation 12
Credit Allocation Regulation 13
Consumer Protection Regulation 13
Investor Protection Regulation 14
Entry Regulation 14
The Changing Dynamics of Specialness
Trends in the United States 15
Global Trends 21
Summary 22
Appendix 1A
The Financial Crisis: The Failure of Financial
Services Institution Specialness 25
(www.mhhe.com/saunders11e)
Appendix 1B
Monetary Policy Tools 25
(www.mhhe.com/saunders11e)
Size, Structure, and Composition of the Industry 29
Balance Sheet and Recent Trends 33
Other Fee-Generating Activities 40
Regulation 40
Industry Performance 47
Savings Institutions 50
Size, Structure, and Composition of the Industry 50
Balance Sheet and Recent Trends 53
4 Regulation 54
Industry Performance 55
5 Credit Unions 57
Size, Structure, and Composition of the Industry 57
Balance Sheet and Recent Trends 58
Regulation 60
8 Industry Performance 60
Global Financial Performance 62
Summary 65
Appendix 2A
Financial Statement Analysis Using a Return
on Equity (ROE) Framework 69
(www.mhhe.com/saunders11e)
Appendix 2B
Commercial Banks’ Financial Statements
and Analysis 69
(www.mhhe.com/saunders11e)
Chapter Three
15 Financial Services: Finance
Companies 70
Introduction 70
Size, Structure, and Composition of the
Industry 70
Balance Sheet and Recent Trends 74
Assets 74
Liabilities and Equity 78
Industry Performance 79
Regulation 81
Global Issues 83
Summary 83

Chapter Two
Financial Services: Depository Chapter Four
Institutions 26 Financial Services: Securities Firms
and Investment Banks 85
Introduction 26
Commercial Banks 28 Introduction 85
xviii
 Contents xix

Size, Structure, and Composition of the Industry 86 Chapter Seven

Key Activities 89 Risks of Financial Institutions 186
Balance Sheet and Recent Trends 98
Recent Trends 98 Introduction 186
Balance Sheet 102 Interest Rate Risk 187
Regulation 104 Credit Risk 189
Global Issues 109 Liquidity Risk 191
Summary 113 Foreign Exchange Risk 193
Country or Sovereign Risk 195
Market Risk 196
Chapter Five Off-Balance-Sheet Risk 197
Financial Services: Mutual Fund Technology and Operational Risks 199
and Hedge Fund Companies 116 Risk of Digital Disruption and Fintech 201
Insolvency Risk 202
Introduction 116 Other Risks and the Interaction of Risks 202
Size, Structure, and Composition of the Mutual Summary 205
Fund Industry 117
Historical Trends 117
Different Types of Mutual Funds 119
Mutual Fund Objectives 124
PART TWO
Investor Returns from Mutual Fund Ownership 127 MEASURING RISK 211
Mutual Fund Costs 131
Balance Sheet and Recent Trends for the Mutual Chapter Eight
Fund Industry 135 Interest Rate Risk I 212
Money Market Funds 135 Introduction 212
Long-Term Funds 137 The Level and Movement of
Regulation of Mutual Funds 138 Interest Rates 213
Global Issues in the Mutual Fund Industry 143 The Repricing Model 215
Hedge Funds 145 Rate-Sensitive Assets 217
Types of Hedge Funds 146 Rate-Sensitive Liabilities 218
Fees on Hedge Funds 151 Equal Changes in Rates on RSAs and RSLs 221
Offshore Hedge Funds 152 Unequal Changes in Rates on RSAs and RSLs 222
Regulation of Hedge Funds 153 Weaknesses of the Repricing Model 225
Summary 155 Market Value Effects 225
Overaggregation 225
The Problem of Runoffs 226
Chapter Six
Cash Flows from Off-Balance-Sheet Activities 226
Financial Services: Insurance Summary 227
Companies 158 Appendix 8A
Introduction 158 The Maturity Model 236
Life Insurance 159 (www.mhhe.com/saunders11e)
Size, Structure, and Composition of the Industry 159 Appendix 8B
Balance Sheet and Recent Trends 163 Term Structure of Interest Rates 236
Regulation 167
Property–Casualty Insurance 168 Chapter Nine
Size, Structure, and Composition of the Industry 169
Interest Rate Risk II 243
Balance Sheet and Recent Trends 170
Regulation 180 Introduction 243
Global Issues 181 Duration: A Simple Introduction 244
Summary 182 A General Formula for Duration 246
xx Contents

The Duration of Interest-Bearing Bonds 248 Newer Models of Credit Risk Measurement
The Duration of Zero-Coupon Bonds 250 and Pricing 306
The Duration of Consol Bonds (Perpetuities) 250 Summary 323
Features of Duration 251 Appendix 10A
Duration and Maturity 251 Credit Analysis and Loan Underwriting 332
Duration and Yield 252 (www.mhhe.com/saunders11e)
Duration and Coupon Interest 252 Appendix 10B
The Economic Meaning of Duration 253 Black–Scholes Option Pricing Model 332
Semiannual Coupon Bonds 257 (www.mhhe.com/saunders11e)
Duration and Interest Rate Risk 258
Duration and Interest Rate Risk Management Chapter Eleven
on a Single Security 258
Credit Risk: Loan Portfolio and
Duration and Interest Rate Risk Management
on the Whole Balance Sheet of an FI 261
Concentration Risk 333
Immunization and Regulatory Considerations 268 Introduction 333
Difficulties in Applying the Duration Model 269 Simple Models of Loan Concentration Risk 334
Duration Matching Can Be Costly 270 Loan Portfolio Diversification and Modern
Immunization Is a Dynamic Problem 270 Portfolio Theory (MPT) 338
Large Interest Rate Changes and Convexity 271 Moody’s Analytics RiskFrontier Model 341
Summary 273 Partial Applications of Portfolio Theory 345
Appendix 9A Regulatory Models 349
The Basics of Bond Valuation 281 Summary 351
(www.mhhe.com/saunders11e) Appendix 11A
Appendix 9B CreditMetrics 356
Incorporating Convexity into the Duration Appendix 11B
Model 281 CreditRisk+ 359
(www.mhhe.com/saunders11e)
Chapter Twelve
Chapter Ten Liquidity Risk 362
Credit Risk: Individual Loan Risk 282 Introduction 362
Introduction 282 Causes of Liquidity Risk 363
Credit Quality Problems 283 Liquidity Risk at Depository Institutions 364
Types of Loans 286 Liability-Side Liquidity Risk 364
Commercial and Industrial Loans 286 Asset-Side Liquidity Risk 368
Real Estate Loans 288 Measuring a DI’s Liquidity Risk Exposure 370
Individual (Consumer) Loans 289 Liquidity Risk Measures 372
Other Loans 291 Liquidity Planning 382
Calculating the Return on a Loan 292 Liquidity Risk, Unexpected Deposit Drains, and Bank
The Contractually Promised Return on a Loan 293 Runs 382
The Expected Return on a Loan 295 Bank Runs, the Discount Window, and Deposit
Retail versus Wholesale Credit Decisions 296 Insurance 384
Retail 296 Liquidity Risk at Other Types of Financial
Wholesale 297 Institutions 385
Measurement of Credit Risk 298 Life Insurance Companies 385
Default Risk Models 299 Property–Casualty Insurers 386
Qualitative Models 299 Investment Funds 386
Quantitative Models 302 Summary 389
 Contents xxi

Chapter Thirteen Equities 467

Portfolio Aggregation 468
Foreign Exchange Risk 396
Historic (Back Simulation) Approach 471
Introduction 396 The Historic (Back Simulation) Model versus
Foreign Exchange Rates and Transactions 397 RiskMetrics 474
Foreign Exchange Rates 397 The Monte Carlo Simulation Approach 475
Foreign Exchange Transactions 398 Expected Shortfall 478
Sources of Foreign Exchange Risk Exposure 401 Regulatory Models: The BIS Standardized
Foreign Exchange Rate Volatility and FX Exposure 404 Framework 482
Foreign Currency Trading 405 The BIS Regulations and Large-Bank
FX Trading Activities 406 Internal Models 489
Foreign Asset and Liability Positions 408 Summary 493
The Return and Risk of Foreign Investments 408
Risk and Hedging 410 Chapter Sixteen
Multicurrency Foreign Asset–Liability Positions 414
Off-Balance-Sheet Risk 499
Interaction of Interest Rates, Inflation, and
Exchange Rates 415 Introduction 499
Purchasing Power Parity 416 Off-Balance-Sheet Activities and FI Solvency 500
Interest Rate Parity Theorem 418 Returns and Risks of Off-Balance-Sheet
Summary 420 Activities 504
Loan Commitments 506
Commercial Letters of Credit and Standby Letters of
Chapter Fourteen Credit 509
Sovereign Risk 428 Derivative Contracts: Futures, Forwards, Swaps, and
Options 512
Introduction 428
Forward Purchases and Sales of When-Issued
Credit Risk versus Sovereign Risk 433
Securities 515
Debt Repudiation versus Debt Restructuring 434
Loans Sold 516
Country Risk Evaluation 436
Non–Schedule L Off-Balance-Sheet Risks 517
Outside Evaluation Models 436
Settlement Risk 517
OECD Country Risk Classifications 440
Affiliate Risk 518
Internal Evaluation Models 440
The Role of OBS Activities in Reducing Risk 520
Using Market Data to Measure Risk: The Secondary
Summary 521
Market for LDC and Emerging Market Debt 449
Appendix 16A
Summary 452
A Letter of Credit Transaction 526
Appendix 14A
Mechanisms for Dealing with Sovereign
Risk Exposure 456 Chapter Seventeen
(www.mhhe.com/saunders11e) Technology and Other Operational
Risks 527
Chapter Fifteen Introduction 527
Sources of Operational Risk 530
Market Risk 457 Information Technology (IT) Risks 532
Introduction 457 Strategic Risk of IT 532
Calculating Market Risk Exposure 462 Cybersecurity Risk 533
The RiskMetrics Model 462 Technology Vendor and Third-Party Risk 535
The Market Risk of Fixed-Income Securities 463 Data Management Risk 537
Foreign Exchange 466 Risk of Ineffective Risk Management 538
xxii Contents

The Effect of Technology on Revenues Choice of Liability Structure 597

and Costs 539 Demand Deposits 597
Technology and Revenues 540 Interest-Bearing Checking (NOW) Accounts 599
Technology and Costs 541 Passbook Savings 600
Technology and the Evolution of the Money Market Deposit Accounts (MMDAs) 600
Payments System 545 Retail Time Deposits and CDs 601
Risks That Arise in an Electronic Transfer Wholesale CDs 602
Payment System 547 Federal Funds 603
Regulatory Issues and Technology and Operational Repurchase Agreements (RPs) 603
Risks 554 Other Borrowings 604
Summary 557 Liquidity and Liability Structures for U.S.
Depository Institutions 605
Liability and Liquidity Risk Management
Chapter Eighteen in Insurance Companies 607
Liability and Liquidity Risk Management
Risk of Digital Disruption and
in Other Financial Institutions 608
Fintech 560 Summary 608
Introduction 560 Appendix 19A
The Evolution of Fintech 561 Minimum Reserve Requirements 610
Changing Relationship Between Banks and (www.mhhe.com/saunders11e)
Fintechs 565 Appendix 19B
How Big Tech Is Transforming Fintech 567 Bankers’ Acceptances and Commercial Paper
The Types of Fintech Innovations 568 as Sources of Financing 610
Payments, Clearing, and Settlement Services 569 (www.mhhe.com/saunders11e)
Market Support Services 577
Credit, Deposit, and Capital-Raising Services 584 Chapter Twenty
Investment Management Services 585
Regulatory Approaches to Fintech 586
Deposit Insurance and Other
Fintech Charters and Other Licenses 586 Liability Guarantees 611
Regulating Big Techs 587 Introduction 611
International Regulations 588 Bank and Thrift Guaranty Funds 612
Summary 589 The Causes of the Depository Fund
Insolvencies 614
The Financial Environment 614
PART THREE Moral Hazard 615
MANAGING RISK 591 Panic Prevention versus Moral Hazard 616
Controlling Depository Institution Risk Taking 616
Chapter Nineteen Stockholder Discipline 617
Depositor Discipline 622
Liability and Liquidity
Regulatory Discipline 627
Management 592
Non-U.S. Deposit Insurance Systems 628
Introduction 592 The Discount Window 629
Liquid Asset Management 592 Deposit Insurance versus the Discount Window 629
Monetary Policy Implementation Reasons 593 The Discount Window 629
Taxation Reasons 593 Other Guaranty Programs 633
The Composition of the Liquid Asset Portfolio 594 National Credit Union Administration 633
Managing Liquid Assets Other than Cash 595 Property–Casualty and Life Insurance Companies 633
Liability Management 596 The Securities Investor Protection Corporation 634
Funding Risk and Cost 596 The Pension Benefit Guaranty Corporation 635
 Contents xxiii

Summary 637 Commercial and Investment Banking Activities 701

Appendix 20A Banking and Insurance 705
Calculation of Deposit Insurance Premiums 643 Commercial Banking and Commerce 706
Appendix 20B Nonbank Financial Service Firms and Banking 706
FDIC Press Release of Bank Failures 651 Nonbank Financial Service Firms and Commerce 708
(www.mhhe.com/saunders11e) Activity Restrictions in the United States
Appendix 20C versus Other Countries 709
Deposit Insurance Coverage for Commercial Banks Issues Involved in the Diversification of
in Various Countries 651 Product Offerings 710
(www.mhhe.com/saunders11e) Safety and Soundness Concerns 710
Economies of Scale and Scope 712
Conflicts of Interest 713
Chapter Twenty-One
Deposit Insurance 715
Capital Adequacy 652 Regulatory Oversight 715
Introduction 652 Competition 716
Capital and Insolvency Risk 655 Domestic Geographic Expansion 717
Capital 655 Regulatory Factors Affecting Geographic
The Market Value of Capital 656 Expansion 718
The Book Value of Capital 657 Insurance Companies 718
The Discrepancy between the Market and Book Thrifts 718
Values of Equity 658 Commercial Banks 718
Arguments against Market Value Accounting 658 Cost and Revenue Synergies Affecting
Capital Adequacy in the Commercial Banking Domestic Geographic Expansion by Merger
and Thrift Industry 660 and Acquisition 722
Credit Risk and Risk-Based Capital 662 Cost Synergies 722
Risk-Weighted Assets for Credit Risk 666 Revenue Synergies 723
Interest Rate Risk, Market Risk, and Risk-Based Merger Guidelines for Acceptability 724
Capital 683 Other Market- and Firm-Specific Factors
Operational Risk and Risk-Based Capital 684 Affecting Domestic Geographic Expansion
Summary 687 Decisions 727
Appendix 21A Global and International Expansions 727
Internal Ratings-Based Approach to Measuring U.S. Banks Abroad 728
Risk-Weighted Assets 695 Foreign Banks in the United States 731
Appendix 21B Advantages and Disadvantages of International
Methodology Used to Determine G-SIBs’ Expansion 734
Capital Surcharge 698 Advantages 734
(www.mhhe.com/saunders11e) Disadvantages 734
Appendix 21C Summary 735
Capital Requirements for Other Financial
Institutions 698
Chapter Twenty-Three
(www.mhhe.com/saunders11e)
Futures and Forwards 740
Chapter Twenty-Two Introduction 740
Forward and Futures Contracts 742
Product and Geographic Expansion 699 Spot Contracts 742
Introduction 699 Forward Contracts 742
Product Diversification 700 Futures Contracts 744
Segmentation in the U.S. Financial Services Forward Contracts and Hedging Interest
Industry 701 Rate Risk 745
xxiv Contents

Hedging Interest Rate Risk with Appendix 24A

Futures Contracts 746 Microhedging with Options 814
Microhedging 746 (www.mhhe.com/saunders11e)
Macrohedging 747
Routine Hedging versus Selective Hedging 747 Chapter Twenty-Five
Macrohedging with Futures 748 Swaps 815
The Problem of Basis Risk 755
Hedging Foreign Exchange Risk 757 Introduction 815
Forwards 757 Swap Markets 816
Futures 757 Interest Rate Swaps 817
Estimating the Hedge Ratio 761 Realized Cash Flows on an Interest Rate Swap 821
Hedging Credit Risk with Futures and Forwards 764 Macrohedging with Swaps 822
Credit Forward Contracts and Credit Risk Hedging 765 Currency Swaps 825
Futures Contracts and Catastrophe Risk 767 Fixed-Fixed Currency Swaps 825
Regulation of Derivative Securities 767 Fixed-Floating Currency Swaps 827
Summary 769 Credit Swaps 828
Appendix 23A Total Return Swaps 830
Microhedging with Futures 776 Pure Credit Swaps 832
(www.mhhe.com/saunders11e) CDS Indexes 832
Swaps and Credit Risk Concerns 833
Netting and Swaps 834
Chapter Twenty-Four Payment Flows Are Interest, Not Principal 835
Options, Caps, Floors, and Collars 777 Standby Letters of Credit 835
Introduction 777 LIBOR Transition 835
Basic Features of Options 777 Summary 837
Buying a Call Option on a Bond 778 Appendix 25A
Writing a Call Option on a Bond 779 Setting Rates on an Interest Rate Swap 843
Buying a Put Option on a Bond 780
Writing a Put Option on a Bond 780 Chapter Twenty-Six
Writing versus Buying Options 781
Loan Sales 846
Economic Reasons for Not Writing Options 781
Regulatory Reasons 783 Introduction 846
Futures versus Options Hedging 783 The Bank Loan Sales Market 847
The Mechanics of Hedging a Bond or Bond Definition of a Loan Sale 847
Portfolio 784 Types of Loan Sales 847
Hedging with Bond Options Using the Binomial Model 785 Types of Loan Sales Contracts 849
Actual Bond Options 789 Trends in Loan Sales 851
Using Options to Hedge Interest Rate Risk The Buyers and the Sellers 852
on the Balance Sheet 791 Why Banks and Other FIs Sell Loans 857
Using Options to Hedge Foreign Reserve Requirements 857
Exchange Risk 796 Fee Income 858
Hedging Credit Risk with Options 797 Capital Costs 858
Hedging Catastrophe Risk with Call Spread Liquidity Risk 858
Options 798 Factors Affecting Loan Sales Growth 858
Caps, Floors, and Collars 799 Access to the Commercial Paper Market 858
Caps 800 Customer Relationship Effects 859
Floors 803 Legal Concerns 859
Collars 804 BIS Capital Requirements 859
Caps, Floors, Collars, and Credit Risk 807 Market Value Accounting 859
Summary 807 Asset Brokerage and Loan Trading 859
 Contents xxv

Government Loan Sales 860 Government Sponsorship and Oversight of FNMA

Credit Ratings 860 and Freddie Mac 887
Purchase and Sale of Foreign Bank Loans 860 The Collateralized Mortgage Obligation (CMO) 890
Summary 861 Creation of CMOs 890
Class A, B, and C Bond Buyers 893
Other CMO Classes 893
Chapter Twenty-Seven The Mortgage-Backed Bond (MBB) or Covered
Securitization 863 Bond 894
Introduction 863 Innovations in Securitization 896
Mechanisms Used to Convert On-Balance-Sheet Mortgage Pass-Through Strips 896
Assets to a Securitized Asset 864 Securitization of Other Assets 899
The Pass-Through Security 867 Can All Assets Be Securitized? 900
GNMA 868 Summary 902
FNMA 868 Appendix 27A
FHLMC 869 Fannie Mae and Freddie Mac Balance Sheets 907
The Incentives and Mechanics of Pass-Through (www.mhhe.com/saunders11e)
Security Creation 869
Prepayment Risk on Pass-Through Securities 874
Prepayment Models 879 Index 908
 Part One
Introduction
1. Why Are Financial Institutions Special? 2
2. Financial Services: Depository Institutions 26
3. Financial Services: Finance Companies 70
4. Financial Services: Securities Firms and Investment Banks 85
5. Financial Services: Mutual Fund and Hedge Fund Companies 116
6. Financial Services: Insurance Companies 158
7. Risks of Financial Institutions 186
Chapter One
See Appendices Online at www.mhhe.com/saunders11e
• Appendix 1A: The Financial Crisis: The Failure of Financial Services Institution Specialness
• Appendix 1B: Monetary Policy Tools

Why Are Financial

Institutions Special?
INTRODUCTION
Over the century, the financial services industry has come full cycle. Originally, the
banking industry operated as a full-service industry, performing directly or indirectly
all financial services (commercial banking, investment banking, stock investing ser-
vices, insurance providers, etc.). In the early 1930s, the economic and industrial col-
lapse resulted in the separation of some of these activities. In the 1970s and 1980s,
new, relatively unregulated financial services industries sprang up (mutual funds,
brokerage funds, etc.) that separated financial services functions even further. As we
entered the 21st century, regulatory barriers, technology, and financial innovation
changes were such that a full set of financial services could again be offered by a
single financial services firm under the umbrella of a financial services holding com-
pany. Not only did the boundaries between traditional industry sectors change, but
competition became global in nature as well. For example, JPMorgan Chase is the
world’s fifth largest financial services holding company, operating in 62 countries.
The firm operates a ­commercial bank, JPMorgan Chase Bank, and an investment
bank, J.P. Morgan Securities (which also sells mutual funds). During the 2008–2009
financial crisis, this financial services holding company purchased a savings institu-
tion, Washington Mutual, and several investment banks, including Bear Stearns.
Then came the late 2000s when the United States and indeed the world expe-
rienced a collapse of financial markets second only to that experienced during the
Great Depression. The financial crisis produced a major reshaping of all financial
institution (FI) sectors and the end of many major FIs, e.g., Bear ­Stearns and Lehman
Brothers. The result was a call by the Obama administration to again separate activi-
ties performed by individual FIs.
As the competitive environment changes, attention to profit and, more than ever,
risk becomes increasingly important. The major themes of this book are the measure-
ment and management of the risks of financial institutions. Financial institutions (e.g.,
banks, credit unions, insurance companies, and mutual funds) perform the essential
function of channeling funds from those with surplus funds (suppliers of funds) to
those with shortages of funds (users of funds). In 2021, U.S. FIs held assets totaling

2
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spring is at hand. The great shiny hoods look more like snails than
like flowers; and indeed usually the flowers are not in sight at all, so
well are they shielded by these hood-like leaves.
But each little hidden flower has four flower leaves, four stamens,
and one pistil. When they have been dusted with pollen by fly
visitors, and are preparing to turn into fruit, the purple hoods wither
away. Then the plant sends up clusters of large bright green leaves.
In June you see these great leaves everywhere in the wet woods.
So if you wish to be on hand to welcome the very first flower of the
year, you must begin to keep your eyes open by the end of February.
You must visit the swamps each day, and look for the purple hoods
inside which are snugly hidden the little blossoms of the skunk
cabbage.
And I advise you now to take a sheet of paper and make a list of
the plants as you find them in flower. Put down the date of each
blossom as it appears, and the place where you find it. If you begin
to do this as children, and keep it up when you are older, you will
take real delight in the habit. Each year it will interest you more and
more to turn back to the old lists and discover whether the flowers
are on time, or whether they are late or early in making their first
appearance.
I hope your teacher will start you at once with such a list; for the
sooner you begin, the more complete will be your pleasure in this
delightful season.
 PUSSY WILLOWS

S OON after the skunk cabbage has sent up its purple hoods
comes the pussy-willow season. But it is not every child who has
the luck to be in the country at this time.
There is a clean, sweet smell in the air. Down in the boggy
meadow, just before nightfall, the little frogs sing so loud that you
wonder if they are trying to make you believe the birds have come
back.
The brook is getting a bright green border. The buds on the trees
are so big that you feel sure in a few hours they must burst open.
And you know that each new day may bring with it some happy
surprise,—a bird, a leaf, or a flower that you have not seen for many
a long month.
So when you find the willow branches set thick with silken pussies,
you know that a happy time has begun, at least for you country
children.
And even the city children learn to love these soft pussies when
they are placed in tall vases on the teacher’s desk.
If you look carefully at the different branches, you see that they
bear different kinds of pussies; and your teacher will tell you, or
perhaps you will discover yourselves, that these different branches
were broken from different trees.
 Fig. 197

Do you know what each “pussy,” or tassel, is made up of?

Each tassel is made up of many tiny flowers.
But willow flowers are built on quite a different plan from cherry
flowers. If you pick apart one of these tassels, and examine a single
blossom, you will find it hard to believe that it is a flower at all.
On one branch the tassels are all golden yellow. The flowers that
make up these yellow tassels have neither flower leaves nor pistils.
Each blossom has two stamens which are fastened to a little fringed
leaf, and nothing more. Such a flower, much magnified, is given in
the picture (Fig. 197). The golden color comes from the yellow pollen
which has been shaken from the dust boxes.
The other branch is covered with silvery green tassels. Each
flower in these tassels is made up of a single pistil, which is also
fastened to a little fringed leaf (Fig. 198).
 Fig. 198

So you see the building plan used by one kind of pussy-willow

flowers is nothing but two stamens; while the plan used by the other
kind is still simpler, it is nothing but one pistil.
The golden dust is carried by the bees from the willows which bear
dust boxes to those other willows whose flowers have only
seedboxes.
When they have given to the bees their pollen, the yellow tassels
fade away; but the silvery green tassels, on account of their
seedboxes, grow large and ripe, turning into the fruit shown in Fig.
62, p. 61; and this fruit is one of the kind which scatters its seeds
abroad by fastening them to silky sails.
 ALDERS AND BIRCHES

T HERE is another shrub or low tree growing along the brook’s

edge which flowers almost as early as the willows.
This is the alder.
Perhaps you noticed last fall that these alders were hung with a
quantity of little green tassels. These tassels did not fall off with the
leaves in November. Through the long winter they clung to the shrub.
Sometimes they wore little coats of ice which made them look like
the glass ornaments on a Christmas tree.
When the warm weather came, they put off their ice coats, and
grew larger and longer, and at last let out a quantity of stamens.

Fig. 199

But on the same alder tree that bears these tassels with flowers
made up of stamens or dust boxes (Fig. 199, a), you find also the
tassels flowers made up of pistils (Fig. 199, b).
If you make a search, you will find the little upright clusters
composed of these flowers with pistils.
Late in the year, when these clusters have turned into fruit, they
look like this picture (Fig. 200).
 Fig. 200

The pretty birches are cousins to the alders, and keep house in
much the same way, bearing the tassels with stamens (Fig. 201, a)
and the little clusters made up of flowers with pistils (Fig. 201, b) on
the same tree.

Fig. 201

The tassels on some of the birches are very beautiful. When full
grown, they are golden yellow, and so long and soft and graceful that
one feels like stroking them and playing with them as he would with
a kitten.
I hope every country child who reads this book and does not
already know the willows, the alders, and the birches, will make their
acquaintance this spring, and will examine their two kinds of flowers.
And I hope that branches from the different trees will be brought into
the city schoolroom, so that all can see these flowers, which are
among the very earliest of the year.
 THE GREAT TREES

M OST people seem surprised to learn that all kinds of trees have
flowers. In March and April they go to the woods in search of
the trailing arbutus, the violet, the anemone; and when they have
picked a quantity of these, they come home and say, “These are the
only flowers we saw to-day.”
But if they had looked overhead, up into the trees, they would
have seen many more; for each tree has its own flower, and most of
the trees blossom very early in the year, before they put out their
leaves. There is a good reason for this, which I will tell you by and
by.

Fig. 202

One of the early trees to flower is the swamp maple. In March or

April its bright red blossoms tinge the wet woods with warm color.
Sometimes the snow lies thick on the ground at this season, and the
little red flower clusters fall, and look wonderfully pretty against the
smooth white sheet which is drawn beneath the trees.
At the same season, in our city parks and streets, sharp eyes will
discover the yellowish blossoms of the silver maple. Both of these
trees flower before they leaf.
The building plan used by maple flowers is rather confusing. In
one flower you will find both calyx and corolla, but not in another.
One blossom will have both stamens and pistils, another will have no
pistils.

Fig. 203

Fig. 202 shows you a blossom from the sugar maple. It has
stamens, but no pistils. Next you see what was once a flower
containing both stamens and pistils (Fig. 203). The withered stamens
can still be seen; and the pistil is turning into the well-known maple
key.

Fig. 204

Fig. 205
 The great elms also put out their flowers before their leaves. Here
you see a flower cluster from the white elm (Fig. 204). Fig. 205
shows you one of these little flowers enlarged; and in Fig. 206 you
have the blossom cut open so as to display its pistil, which grows
into the winged fruit you saw on p. 62.

Fig. 206

In some of our city streets grows the poplar. Its flowers are
crowded into long green tassels. Many of these fall to the pavement
below, and lie there, looking like great caterpillars. These tassels are
those which bear the flowers with stamens. Now, if we were in the
woods, we should be pretty sure to find near by another poplar
whose tassels do not fall so quickly. This is because these are made
up of flowers with pistils. They cling to the tree not only till they have
been powdered with pollen from the neighboring poplar, but till their
tiny seeds have had time to ripen and are ready to start out on their
life journey.
 THE UNSEEN VISITOR

I PROMISED to tell you why so many of the trees flower before they
leaf.
Many of these tree blossoms are neither bright enough to attract
the attention of the bees and butterflies, nor so fragrant as to tempt
the passing insects to visit them; for when the flower handkerchiefs
are not large and bright enough to signal the bees, the blossom often
gives notice of its presence by a strong perfume. How, then, is the
pollen from one flower to reach the pistil of another? And especially
how can this be arranged when the flowers with pollen may live quite
a way off—on another tree, in fact—from the flowers with pistils?
“Perhaps the birds carry it,” suggests some child.
But if these little flowers are not beautiful enough, or sweet-
smelling enough, to please the bees and butterflies, it is hardly
probable that the birds will pay them any attention.
So let us go out into the woods with our eyes and our ears wide
open, and see if we can discover some flower visitor that does not
ask for fine clothes and sweet smells.
Through the bushes comes the lisp of the song sparrow. From
overhead falls the note of the bluebird. The bees are buzzing about
the golden willow tassels. On the top of an old tree trunk a butterfly is
drowsing in the sun’s rays. But already we know that neither bird, nor
bee, nor butterfly will go out of its way to help our pale, scentless
little tree blossoms.
A squirrel darts from under cover, and runs along the stone wall.
Among the dead leaves at our feet a little striped snake lies in a
sluggish coil. But squirrel and snake would be alike useless as flower
visitors.
We are almost tempted to give up trying to guess the answer to
the riddle. Somewhat discouraged, we stop to rest on an old log
overgrown with delicate mosses.
A soft, sighing sound creeps through the pines at the foot of
yonder hill. Over the little hollow sweeps a gust of wind. A faint
cloud, as of dust, fills the air. One of the children begins to sneeze.
Where can the dust come from? The roads are still deep with mud.
And, besides, ordinary dust does not make us sneeze as though it
were pepper.
Ah, my friend, you are getting warm, very warm indeed; for this
dust is no dried earth from the highroad. No, it is made up instead of
golden grains from the dust boxes that are swaying in the wind on
yonder trees. And as the trees just now are bare of leaves, the
journey of the pollen through the air is an easy matter. It is carried
along by the wind, settling here, there, and everywhere, sometimes
in our throats and noses in such a fashion as to make us sneeze, but
also on the tops of many little pistils whose seeds cannot ripen
without its gift of new life.
And so, although we have not seen the visitor who befriends these
little flowers that are neither beautiful nor fragrant, we have heard his
voice as it came whispering through the pines; and we know that this
whisper is the gentle voice of the wind.
Now you understand that it is well for those trees whose flowers
depend upon the wind for their pollen, to blossom before their leaves
are out, and thus likely to interfere with the pollen in reaching its
destination.
 PLANT PACKAGES

Fig. 207

O N your walks through the woods these spring days I want you to
notice the neat and beautiful way in which plants do their
packing; for the woods now are full of plant packages,—little bundles
of leaves and flowers, done up with the greatest care.
Some of these have just appeared above the ground. Others have
burst from the branches of the trees and shrubs.
Of course, a plant does not like to send its young, delicate leaves
and flowers into the cold world without wrapping them up, any more
than your mother would like to send your baby brother out for the
first time without a great deal of just such bundling-up.
 Fig.
208

Fig.
209

And so well wrapped are many of these plant babies, that it is not
an easy matter to guess just what they are, what kinds of leaves and
flowers will appear when the wrappings have been thrown aside.
 Fig. 211

Fig. 210

Sometimes the package looks like the sharp-pointed object in the

picture at the head of this chapter (Fig. 207). Soon the leaves push
their way out of their papery envelope, and before long our friend
Jack-in-the-pulpit himself appears.
Sometimes it is such a woolly roll as you see in the next picture
(Fig. 208). This roll soon uncurls into a pretty fern (Fig. 209).
The beech tree folds its leaves like fans (Fig. 210). The preceding
picture (Fig. 211) shows you how carefully and cleverly the
hobblebush packs its young leaves.
During their babyhood many leaves wear a hairy coat as a
protection from both cold and heat; but when their green skin
becomes thicker, they throw this off.
Most of these plant packages are very interesting and beautiful,
and well worth your attention. I wish that during these weeks of early
spring the country schools would hold exhibitions of these babes in
the woods, asking each child to bring what he considers a good
specimen of a plant package.
 UNDERGROUND STOREHOUSES

L ONG ago we learned that certain plants stow away the food
which they are not fitted to use at the time in those thick
underground stems which most people call roots.
This food they hold over till the next year.
It is often a surprise, these spring days, to see how suddenly a
little plant will burst into blossom. One does not understand how it
has had time to get up such a display. Had it been obliged to depend
for food upon new supplies taken in by its roots and leaves, the
flower would have put off its first appearance for many a day.
So when a plant surprises you with any such sudden and early
blossoms, you can be pretty sure that its food supply has been on
hand all winter.
Both in the garden and in the woods you can see for yourselves
that this is so. In the garden perhaps the earliest flower to appear is
the lovely little snowdrop. The snowdrop’s food is stored away in the
“bulb,” as we call its thick, underground stem, which lies buried in the
earth.
The other early garden flowers, such as the hyacinth, crocus,
daffodil, and tulip, are able to burst into beautiful blossoms only
because of the care and labor with which they laid by underground
provisions last year.
And in the woods at this season you find the yellow adder’s
tongue, spring beauty, anemone, wake-robin, Jack-in-the-pulpit, wild
ginger, and Solomon’s seal. Each of these plants has stores of food
hidden in its underground stem. This may take the shape of a bulb,
or a tuber, or a rootstock; but in any case it shows you at once that it
is a little storehouse of food.
A collection of the different kinds of underground stems which
serve as storehouses for the early-flowering plants would be quite as
interesting to work over as a collection of plant packages.
 DIFFERENT BUILDING PLANS

T HIS morning let us take a stroll in the woods with the idea of
noticing the different building plans used by the early flowers.
First we will go to the spot where we know the trailing arbutus is
still in blossom. Pick a spray, and tell me the plan of its flower.
“There is a small green cup, or calyx, cut into five little points,” you
say; “and there is a corolla made up of five flower leaves.”
But stop here one moment. Is this corolla really made up of five
separate flower leaves? Are not the flower leaves joined in a tube
below? If this be so, you must say that this corolla is five-lobed, or
five-pointed, not that it has five flower leaves.
“And there are ten pins with dust boxes, or stamens.”
Yes, that is quite right.
“And there is one of those pins with a seedbox below, one pistil,
that is, but the top of this pistil is divided into five parts.”
Well, then, the building plan of the trailing arbutus runs as follows:
—
1. Calyx.
2. Corolla.
3. Stamens.
4. Pistil.
So far, it seems the same plan as that used by the cherry tree, yet
in certain ways this plan really differs from that of the cherry
blossom. The calyx of the cherry is not cut into separate leaves, as is
that of the arbutus; and its corolla leaves are quite separate, while
those of the arbutus are joined in a tube.
 Fig. 212

The cherry blossom has more stamens than the arbutus. Each
flower has but one pistil. But the pistil of the arbutus, unlike that of
the cherry, is five-lobed.
So, although the general plan used by these two flowers is the
same, it differs in important details.
Above you see the flower of the marsh marigold (Fig. 212). Its
building plan is as follows:—
1. Flower leaves.
2. Stamens.
3. Pistils.
This, you remember, is something like the building plan of the
easter lily. The lily has a circle of flower leaves in place of calyx and
corolla. So has the marsh marigold. But the lily has six flower leaves,
one more than the marsh marigold, and only six stamens, while the
marsh marigold has so many stamens that it would tire one to count
them.
And the lily has but one pistil (this is tall and slender), while the
marsh marigold has many short, thick ones, which you do not see in
the picture.
So these two flowers use the same building plan in a general way
only. They are quite unlike in important details.
 Fig. 213

The pretty little liverwort and the delicate anemone use the same
building plan as the marsh marigold. This is not strange, as all three
flowers belong to the same family.
The yellow adder’s tongue is another lily. It is built on the usual lily
plan:—
1. Six flower leaves.
2. Six stamens.
3. One pistil.
The wild ginger (Fig. 213) uses the lily plan, inasmuch as it has no
separate calyx and corolla; but otherwise it is quite different. It has
no separate flower leaves, but one three-pointed flower cup. It has
stamens, and one pistil which branches at its tip.
The next picture (Fig. 214) shows you the seedbox, cut open, of
the wild ginger.

Fig. 214