GESTIÓN BANCARIA

Master en Banca y Finanzas

Cuantitativas (QF), 2008

Santiago Carbó Valverde

Universidad de Granada
2
 Santiago Carbó Valverde
Universidad de Granada
scarbo@ugr.es

Materiales docentes en:

http://www.ugr.es/~scarbo/MASTERQF08.html

3
 Esquema de trabajo:
 Transparencias en inglés
 Presentaciones de papers en clase
 Examen final

 Referencia básica:
- SAUNDERS, A. Y M.M. CORNETT (2000):
FINANCIAL INSTITUTIONS MANAGEMENT: A
MODERN PERSPECTIVE, 4ª EDICIÓN, MCGRAW
HILL, NEW YORK, ESTADOS UNIDOS.

- SINKEY, J. (2001): COMMERCIAL BANK

FINANCIAL MANAGEMENT, SEXTA EDICIÓN,
PRENTICE HALL, NEW YORK, ESTADOS UNIDOS.

4
 Tema 1
LA INDUSTRIA DE SERVICIOS
FINANCIEROS: LAS ENTIDADES DE
DEPÓSITO

(LECTURA DE REFERENCIA:
BHATTACHARYA Y THAKOR, 1993)
Why study Financial Markets and
Institutions?


 They
They areare the
the cornerstones
cornerstones of of the
the overall
overall
financial
financial system
system inin which
which financial
financial
managers
managers operate
operate

 Individuals
Individuals useuse both
both for
for investing
investing

 Corporations
Corporations and and governments
governments use use both
both
for
for financing
financing

6
Overview of Financial Markets


 Primary
Primary Markets
Markets versus
versus
Secondary
Secondary Markets
Markets

 Money
Money Markets
Markets versus
versus Capital
Capital
Markets
Markets

 Foreign
Foreign Exchange
Exchange Markets
Markets

7
Primary Markets versus
Secondary Markets

 Primary
Primary Markets
Markets
 markets
markets inin which
which users
users of
of funds
funds (e.g.
(e.g.
corporations,
corporations, governments)
governments) raiseraise
funds
funds by
by issuing
issuing financial
financial instruments
instruments
(e.g.
(e.g. stocks
stocks and
and bonds)
bonds)

 Secondary
Secondary Markets
Markets
 markets
markets where
where financial
financial instruments
instruments
are
are traded
traded among
among investors
investors (e.g.
(e.g.
Bolsa
Bolsa Madrid,
Madrid, NYSE,
NYSE, NASDAQ)
NASDAQ)
8
Money Markets versus Capital
Markets

 Money
Money Markets
Markets
 markets
markets that
that trade
trade debt
debt securities
securities with
with
maturities
maturities of
of one
one year
year or
or less
less (e.g.
(e.g.
Spanish
Spanish Government
Government bonds,
bonds, U.S.
U.S.
Treasury
Treasury bills)
bills)

 Capital
Capital Markets
Markets
 markets
markets that
that trade
trade debt
debt (bonds)
(bonds) and
and
equity
equity (stock)
(stock) instruments
instruments with
with
maturities
maturities of
of more
more than
than one
one year
year

9
Money Market Instruments Outstanding,
1990-1999 ($Bn)

1400
1400
1200
1200
1000
1000
800
800
600
600
400
400
200
200
00
1990
1990 1995
1995 1999
1999
Commercial
Commercialpaper
paper Fed
FedFunds
Fundsand
andRepo
Repo
U.S.
U.S.T-bills
T-bills Banker's
Banker'saccept.
accept.
10
Capital Market Instruments Outstanding,
1990-1999 ($Bn)

20000
20000
15000
15000
10000
10000
5000
5000
00
1990
1990 1995
1995 1999
1999
Corp.
Corp.stocks
stocks Res.
Res.Mortgages
Mortgages
Comm/farm
Comm/farmmort.
mort. Corp.
Corp.bonds
bonds
Treas.
Treas.Sec.
Sec. St.
St.&&Loc.
Loc.Gov.
Gov.bonds
bonds
U.S.
U.S.gov
govowned
ownedagencies
agencies U.S.
U.S.gov
govsponsored
sponsoredagencies
agencies
Bank
Bankand
andconsumer
consumerloans
loans 11
Foreign Exchange Markets

 “FX”
“FX” markets
markets deal
deal in
in trading
trading one
one currency
currency for
for
another
another (e.g.
(e.g. dollar
dollar for
for yen)
yen)

 The
The “spot”
“spot” FX
FX transaction
transaction involves
involves the
the immediate
immediate
exchange
exchange ofof currencies
currencies at at the
the current
current exchange
exchange
rate
rate

 The
The “forward”
“forward” FXFX transaction
transaction involves
involves the
the
exchange
exchange ofof currencies
currencies at at aa specified
specified date
date in
in the
the
future
future and
and at
at aa specified
specified exchange
exchange raterate

12
Overview of Financial
Institutions (FIs)

 Institutions
Institutions that
that perform
perform the
the essential
essential function
function
of
of channeling
channeling funds
funds from
from those
those with
with surplus
surplus
funds
funds to
to those
those with
with shortages
shortages of of funds
funds (e.g.
(e.g.
banks,
banks, thrifts,
thrifts, insurance
insurance companies,
companies, securities
securities
firms
firms and
and investment
investment banks,
banks, finance
finance companies,
companies,
mutual
mutual funds,
funds, pension
pension funds)
funds)

13
Flow of Funds in a World without
FIs: Direct Transfer
Financial Claims
(Equity and debt
instruments)
Users of Funds Suppliers of
(Corporations) Funds
(Households)
Cash

Example: A firm sells shares directly to investors without going

through a financial institution

14
Flow of Funds in a world with
FIs: Indirect transfer

FI
Users of Funds Suppliers of Funds
(Brokers)

FI
(Asset
transformers)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and Insurance policies)

15
Types of FIs
 Commercial
Commercial banks
banks
 depository institutions whose major assets are
depository institutions whose major assets are
loans
loans and
and major
major liabilities
liabilities are
are deposits
deposits
 Thrifts
Thrifts and
and savings
savings banks
banks
 depository institutions in the form of savings banks,
depository institutions in the form of savings banks,
savings
savings and
and loans,
loans, credit
credit unions,
unions, credit
credit
cooperatives
cooperatives
 Insurance
Insurance companies
companies
 financial institutions that protect individuals and
financial institutions that protect individuals and
corporations
corporations from
from adverse
adverse events
events

(continued)
16

 Securities
Securities firms
firms and
and investment
investment banksbanks
 financial institutions that underwrite
financial institutions that underwrite
securities
securities and
and engage
engage inin securities
securities
brokerage
brokerage and and trading
trading

 Finance
Finance companies
companies
 financial institutions that make loans to
financial institutions that make loans to
individuals
individuals and
and businesses
businesses

 Mutual
Mutual Funds
Funds
 financial institutions that pool financial
financial institutions that pool financial
resources
resources andand invest
invest in
in diversified
diversified
portfolios
portfolios

 Pension
Pension Funds
Funds
 financial institutions that offer savings
financial institutions that offer savings
plans
plans for
for retirement
retirement
17
Services Performed by Financial
Intermediaries

 Monitoring
Monitoring Costs
Costs
 aggregation
aggregation of of funds
funds provides
provides greater
greater
incentive
incentive to
to collect
collect aa firm’s
firm’s information
information
and
and monitor
monitor actions
actions

 Liquidity
Liquidity and
and Price
Price Risk
Risk
 provide
provide financial
financial claims
claims to
to savers
savers with
with
superior
superior liquidity
liquidity and
and lower
lower price
price risk
risk

(continued)
18

 Transaction
Transaction Cost
Cost Services
Services
 transaction costs are reduced through
transaction costs are reduced through
economies
economies ofof scale
scale

 Maturity
Maturity Intermediation
Intermediation
 greater ability to bear risk of mismatching
greater ability to bear risk of mismatching
maturities
maturities of
of assets
assets and
and liabilities
liabilities

 Denomination
Denomination Intermediation
Intermediation
 allow small investors to overcome
allow small investors to overcome
constraints
constraints imposed
imposed to to buying
buying assets
assets
imposed
imposed by
by large
large minimum
minimum denomination
denomination
size
size

19
Services Provided by FIs
Benefiting the Overall Economy

 Money
Money Supply
Supply Transmission
Transmission
 Depository institutions are the conduit
Depository institutions are the conduit
through
through which
which monetary
monetary policy
policy actions
actions
impact
impact the
the economy
economy in in general
general

 Credit
Credit Allocation
Allocation
 often viewed as the major source of
often viewed as the major source of
financing
financing for
for aa particular
particular sector
sector of
of the
the
economy
economy (e.g.
(e.g. farming
farming and
and real
real estate)
estate)

(continued)
20
Services Provided by FIs Benefiting
the Overall Economy

 Intergenerational
Intergenerational WealthWealth Transfers
Transfers
 life insurance companies and pension
life insurance companies and pension
funds
funds provide
provide savers
savers with
with the
the ability
ability to
to
transfer
transfer wealth
wealth from
from one
one generation
generation to to
the
the next
next

 Payment
Payment Services
Services
 efficiency with which depository
efficiency with which depository
institutions
institutions provide
provide payment
payment services
services
directly
directly benefits
benefits the
the economy
economy

21
Risks Faced by Financial Institutions

 Interest
Interest Rate
Rate Risk
Risk
 Foreign
Foreign Exchange
Exchange Risk
Risk
 Market
Market Risk
Risk
 Credit
Credit Risk
Risk
 Liquidity
Liquidity Risk
Risk
 Off-Balance-Sheet
Off-Balance-Sheet Risk
Risk
 Technology
Technology Risk
Risk
 Operation
Operation Risk
Risk
 Country
Country oror Sovereign
Sovereign Risk
Risk
 Insolvency
Insolvency Risk
Risk

22
Regulation of Financial
Institutions

 FIs
FIs provide
provide vital
vital financial
financial services
services toto all
all sectors
sectors
of
of the
the economy;
economy; therefore,
therefore, their
their regulation
regulation isis
in
in the
the public
public interest
interest

 In
In an
an attempt
attempt to to prevent
prevent their
their failure
failure and
and the
the
failure
failure of
of financial
financial markets
markets overall
overall

23
Globalization of Financial Markets
and Institutions

 Financial
Financial Markets
Markets became
became more
more global
global as
as the
the
value
value of
of stocks
stocks traded
traded in
in foreign
foreign markets
markets
soared
soared

 Foreign
Foreign bond
bond markets
markets have
have served
served asas aa major
major
source
source of
of international
international capital
capital

 Globalization
Globalization also
also evident
evident inin the
the derivative
derivative
securities
securities market
market

24
 Factors Leading to Significant Growth in
Foreign Markets

 The
The pool
pool of
of savings
savings from
from foreign
foreign investors
investors hashas
increased
increased

 International
International investors
investors have
have turned
turned to to U.S.
U.S. and
and
other
other markets
markets toto expand
expand their
their investment
investment
opportunities
opportunities

 Information
Information onon foreign
foreign investments
investments and and markets
markets
is
is now
now more
more accessible
accessible (e.g.
(e.g. internet)
internet)

 Some
Some mutual
mutual funds
funds allow
allow ability
ability to
to invest
invest in
in
foreign
foreign securities
securities with
with low
low transaction
transaction costs
costs

 Deregulation
Deregulation has
has enhanced
enhanced globalization
globalization of of capital
capital
flows
flows

25
 Tema 2
¿POR QUÉ SON ESPECIALES LOS
INTERMEDIARIOS BANCARIOS?

(LECTURA DE REFERENCIA: ALLEN Y

SANTOMERO (1997)
 Why Are Financial
Intermediaries Special?

 Objectives:
 Develop the tools needed to measure and
manage the risks of FIs.
 Explain the special role of FIs in the
financial system and the functions they
provide.
 Explain why the various FIs receive special
regulatory attention.
 Discuss what makes some FIs more special
than others.
27
Without FIs

Equity & Debt

Households Corporations
(net savers) (net borrowers)
Cash

28
FIs’ Specialness
 Without FIs: Low level of fund flows.
 Information costs:
 Economies of scale reduce costs for FIs to
screen and monitor borrowers
 Less liquidity
 Substantial price risk

29
With FIs

FI
(Brokers)
Households Corporations

Cash FI Equity & Debt

(Asset
Transformers)
Deposits/Insurance Cash
Policies

30
Financial Structure Puzzles: a
way to explain the role of FIs
 stocks are not the most important source of external
financing for businesses
 issuing debt and equity is not the main way that
businesses finance operations
 indirect financing is more important than direct financing
 banks are the most important source of external funds
for businesses
 financial industry is one of the most heavily regulated
industries
 only large, well-known firms have access to the
securities markets
 collateral is an important part of debt contracts for
businesses and households
 debt contracts are complex and often contain many
restrictions for the borrower

31
Transaction Costs
 information and other transaction costs in
financial system can be substantial

 How do transaction costs affect investing?

 How can financial intermediaries reduce

transaction costs?

32
Asymmetric Information
 one party to a transaction has better
information to make decisions than
the other party

 asymmetric information in financial

market causes two main problems
 adverse selection
 moral hazard

33
Adverse Selection
 asymmetric information problem that
occurs prior to a transaction
 examples of adverse selection
 result of adverse selection is that
lenders may decide not to make loans
if they can not distinguish between
“good” and “bad” credit risks

34
Moral Hazard
 asymmetric information problem that
occurs after a transaction
 risk that borrower will undertake risky
activities that will increase the
probability of default
 result of moral hazard is that lenders
may decide not to make a loan

35
Lemons Problem

 idea presented in article by George Akerlof

in terms of lemons in used car market
 used car buyers are unable to determine
quality of car - good car or lemon?
 What amount is buyer willing to pay for
this used car of unknown quality?
 How can buyer improve information on
quality?

36
Lemons Problem in Stock and Bond
Market

 asymmetric information prevents investors from

identifying good and bad firms
 What price will these investors pay for stock?
 Who has better information about the firm?
 Which firms will “come to the market” for financing
under these conditions?

37
Principal-Agent Problem

 define the principal-agent problem

 Who is the principal and who is the

agent?
 What problem does a separation of
ownership and control cause?
 How could we prevent principal-agent
problem?

38
Solutions to Financing
Puzzles
 lemons or adverse selection problem
tells why marketable securities are not
the primary source of financing

 situation is similar in corporate bond

market

 tells why stocks are not the most

important source of external financing
39
More Solutions to Financial
Structure Puzzles
 importance of financial intermediaries
explains importance of indirect financing

 explains why banks are most important

source of external financing

 explains why markets are only available

to large, well-known firms

40
Functions of FIs
 Brokerage function
 Acting as an agent for investors:
 e.g. Merrill Lynch, Charles Schwab
 Reduce costs through economies of scale
 Encourages higher rate of savings
 Asset transformer:
 Purchase primary securities by selling
financial claims to households
 These secondary securities often more
marketable

41
Role of FIs in Cost Reduction
 Information costs:
 Investors exposed to Agency Costs
 Role of FI as Delegated Monitor (Diamond,
1984)
 Shorter term debt contracts easier to monitor
than bonds
 FI likely to have informational advantage

42
Services Performed by FIs

 Monitoring Costs
 Liquidity and Price Risk
 Transaction Cost Services
 Maturity Intermediation
 Denomination Intermediation

43
Services Provided by FIs

 Money Supply Transmission

 Credit Allocation
 Intergenerational Wealth
Transfers
 Payment Services

(continued)
44
Regulation of FIs
 Regulation is not costless
 Net regulatory burden.
 Safety and soundness regulation
 Monetary policy regulation
 Credit allocation regulation
 Consumer protection regulation
 Investor protection regulation
 Entry regulation
45
Changing Dynamics of
Specialness
 Trends in the United States
 Decline in share of depository institutions.
 Increases in pension funds and investment
companies.
 May be attributable to net regulatory burden
imposed on depository FIs.
 Technological changes affect delivery of financial
services and regulatory issues
 Potential for regulations to be extended to hedge
funds
 Result of Long Term Capital Management
disaster

46
Future Trends
 Weakening of public trust and confidence in FIs may
encourage disintermediation
 Increased merger activity within and across sectors
 Citicorp and Travelers, UBS and Paine Webber
 More large scale mergers such as J.P. Morgan
and Chase, and Bank One and First Chicago
 Growth in Online Trading
 Increased competition from foreign FIs at home and
abroad
 Mergers involving world’s largest banks
 Mergers blending together previously separate
financial services sectors

47
 Tema 3
ORGANIZACIÓN INDUSTRIAL DEL
SECTOR BANCARIO

(LECTURA DE REFERENCIA: HUMPHREY

ET AL. (2006))
3. Bank competition
3.1. BANK COMPETITION
 THE STRUCTURE-CONDUCT-PERFORMANACE (SCP)
PARADIGM: Many empirical studies have considered
concentration - mainly the Herfindahl-Hirschman
Index (HHI) - as a proxy for bank market power
following the Structure-Conduct-Performance (SCP)
paradigm (Berger and Hannan, 1989; Hannan and
Berger, 1991).
 However, several contributions to the banking
literature during the last two decades have cast doubt
on the consistency and robustness of concentration as
an indicator of market power (Berger, 1995; Rhoades,
1995; Jackson 1997; Hannan, 1997).

49
 IO theory predicts a correspondence between the
Lerner index (L) – as the spread between prices (P)
and marginal costs (C’) divided by prices - and the
HHI so that , where is a conjecture parameter
showing the response of the industry output to
changes to a unit output change by the firm, and is
the industry price elasticity of demand. If =1 there
is a monopoly solution while if =0, then a Bertrand
solution holds with L=0.

 Hence, the correspondence depends upon

restrictive assumptions on the conjecture and
demand elasticity parameters.

50
 As contestability increases in a market, the
reliability of the HHI as a measure of market power
is significantly limited.

 Therefore, changes in the stability of the banking

sector as a consequence of industry restructuring or
liberalization may cast doubt on the validity of the
HHI as a dynamic measure of competition.
Instability will also affect conjecture and elasticity
parameter so that the relationship between market
power and concentration becomes blurred.

51
 Although the SCP hypothesis of a positive relationship
between concentration and profits can be derived from
oligopoly theory under these assumptions of different
solutions to a Cournot model, it is not warranted under
alternative models.

 Some empirical studies have even tested and rejected the

hypothesis of Cournot conduct in the banking industry
(Roberts, 1984; Berg and Kim, 1994). Econometric
developments have permitted the emergence of empirical
papers from the so-called New Empirical Industrial
Organization (NEIO) perspective, by directly estimating the
parameters of a firm's behavioral equation – and, in
particular, marginal costs - to directly obtain indicators such
as the Lerner Index (Schmalensee, 1989).

52
 Although price to marginal costs indicators are not
“new” from a theoretical standpoint, marginal costs
have only been econometrically estimated during
the last two decades. Applications to the banking
industry as in Shaffer (1993), Ribon and Yosha
(1999) or Maudos and Fernández de Guevara
(2004) have already shown that these price to
marginal costs indicators are frequently
uncorrelated with concentration ratios.

53
 The definition of the mark-up and the
Lerner index can be directly derived from a
simplified market structure model
(Bresnahan, 1989) where banking firms are
supposed to produce a single good.

 Assuming that banks behave as profit

maximizers, the general expression for
intermediate oligopolistic market structures
with m banks operating in the market is
expressed as:
54
 p
p  C '( y j , w j )  y j with  j y j  y and j  1,..., m
y
where p is the price of the bank product; C(yj,
wj) is a cost function defined for each bank
j where yj is the quantity produced by firm
j in the industry and wj represents the
vector of prices of the factors of bank j. The
parameter j expresses the degree of
market power from perfectly competitive
(j = 0) to monopolist (j = 1). This can be
alternatively written as:

55
 1 1 p
p  C '( y j , w j )   j where  y
   y
 where the mark-up of price over marginal cost ([p –
C’(yj, wj)]) equals the inverse of the semi-elasticity
on bank product demand (1/) times the market
structure parameter (j). Therefore, higher values of
the mark-up measure will indicate a worsening of
bank competition conditions either by a decrease in
the semi-elasticity of demand on bank product () or
an increase in the market structure parameter (j).

56
 The mark-up is used to compute the Lerner index,
which is a relative margin computed as [p – C’(yj,
wj)] / p. Higher values of the Lerner index also
indicate a worsening of competition conditions.

57
3.2. BANK EFFICIENCY: AN APPLICATION TO
THE SPANISH CASE

Previous Cost Efficiency Results in Banking

The average bank experiences total (operating + interest)

costs that are 20 to 25% higher than the most cost
efficient bank.

This is the conclusion of many individual studies as well

as the average result from 130 studies across 21
countries for 5 different frontier cost approaches.

Bank net income is from 15 to 20% of total costs. Thus

the average bank could more than double its profits/ROA
if it achieved frontier efficiency or "best practice".

Yet, cost efficiency seems relatively stable over time and

seemingly beyond the control of management.
58
Efforts to "explain" both the level of cost efficiency and its
apparent stability over time have not be very successful.

Almost all explanatory analyses have so far focused on balance

sheet "causes" or associations with measured inefficiency. Fixed
effects models (dummy variables) do better but do not identify the
causes.

The few studies that have looked at banks' external business

environment have been more successful.
(Berger & Mester, 1997; Dietsch & Lozano Vivas, 2000)

59
NEW EVIDENCE: A three-part Approach to Cost Efficiency
(a recent paper by Carbo, Humphrey and Lopez)

Explain efficiency differences using information on:

1. A bank's external business environment (following

Berger & Mester, 1997; Dietsch & Lozano Vivas, 2000);

2. A bank's technical ability to combine inputs into outputs

using a cost function specification--the standard approach;

3. A bank's internal productivity, using common peer

group
indicators to decompose remaining measured inefficiency.

As expect operating cost to reflect most efficiency differences,

we separate operating from interest costs.
60
 Estimation Approach

Parametric Model (Cost Function):

Distribution-Free approach to efficiency measurement--assumes

random errors estimated for each individual bank over 10 years
averages to zero, leaving an unexplained "inefficiency" residual
(Ui).

Bank with the smallest inefficiency residual (Umin) is on the cost

frontier. Efficiency is measured as: EFF = Umin/Ui.

If Umin/Ui = .80, resources used at most efficient bank are only

80% of those used at bank i. Inefficiency at bank i is (1 - .8)/.8 =
25%.

61
 Estimation Approach

Parametric Model (Cost Function):

As Fourier and translog cost functions give same initial results,

report parametric results using the simpler translog cost model.

Non-Parametric Model (Linear Programming):

Data Envelopment Analysis (DEA) determines bank that

produces a given output vector with minimum input cost.

As assume random error is zero, can determine EFF for each

year.

62
 Ensuring Comparability

Parametric Model: Distribution-Free approach represents

average EFF over 10 years. Thus report DEA results as a 10-
year average.

Non-Parametric Model: DEA approach does not truncate

"extreme" EFF values. Thus report untruncated Distribution-
Free results.

(Truncation raises efficiency values. Is used because

assumption that error for each bank averages to zero is likely
too strong to be met.)

63
 Efficiency of Spanish Banks (Cost Function Only)

Average Efficiency Estimates: 1992-2001 (1,540 panel obs.)

Parametric EFF = 85% (18% unexplained inefficiency)

R2 = .995 | Ui |/total cost = 5%

Non-Parametric EFF = 87% (16% unexplained inefficiency)

Other Spain 82% (Lozano, Pastor, & Pastor, 2002)

Estimates: 87% (Maudos & Pastor, 2003)

64
 Efficiency of Spanish Banks

Almost all efficiency studies stop here. Some go on to

regress
EFF values on various balance sheet "influences".

Low R2s (e.g., .10) are the typical result, so actual causes of
inefficiency remain largely unexplained.

Inefficiency usually attributed to typically unspecified:

Managerial policies & procedures
Organizational structure
Leadership ability

65
 Information On A Bank's External Business Environment

A. Interest Cost Equation:

3-month interest rate (affects funding costs)

B. Operating Cost Equation:

Average regional wage (influences labor costs)
Property cost index (affects branch costs)

C. Both Equations:
Asset size (not easily changed in short-run, mergers
excepted)
Regional GDP (loan demand & deposit supply)
Asset market share (market power indicator)
Regional location (rural versus city areas & income level)

(translog formulation: own, cross, and squared terms)

66
Information On A Bank's Technical Ability To Combine
Inputs Into Outputs (A Cost Function Specification)

A. Interest Cost Equation (1 input price):

Average cost of funding

B. Operating Cost Equation (3 input prices):

Average bank wage
Depreciation/value of physical capital
Opportunity cost of funds spent on material inputs

C. Both Equations (2 banking "outputs"):

Value of loans & value of security holdings
(will add value of off-balance-sheet activities later).

(translog formulation: own, cross, and squared terms)

67
 Information On A Bank's Internal Productivity
Using Common Peer Group Indicators

A. Interest Cost Equation:

Deposit/total asset ratio (higher ratio, lower funding cost)

B. Operating Cost Equation:

Number of ATMs (low cost way to deliver services)
Number of branches (high cost way to deliver services)
Labor/branch ratio (branch productivity indicator)
Deposit/branch ratio (branch productivity indicator)

C. Both Equations:
ATM/Branch ratio (more convenience, pay lower deposit
rate)
Loan/total asset ratio (higher ratio, can pay higher deposit
rate)

(translog formulation: own, cross, and squared terms) 68

 Table 1: Bank Interest Cost Efficiency--DFA, 1992-2001

Interest Cost Equation: EFF INEFF % Unexplained

External Influences .69 .45 10.5%
Technical Influences .91 .10 2.2%
External+Technical .922 .085 1.93%
External+Technical+Internal .989 .011 0.16%

Savings Banks:
External+Technical+Internal .999 .001 0.04%

Commercial Banks:
External+Technical+Internal .993 .007 0.17%

69
 Table 2: Bank Operating Cost Efficiency--DFA, 1992-2001

Operating Cost Equation: EFF INEFF % Unexplained

External Influences .52 .92 13.2%
Technical Influences .65 .54 12.0%
Internal Influences .67 .49 15.3%
External+Technical .72 .39 8.6%
External+Technical+Internal .89 .12 4.3%

Savings Banks:
External+Technical+Internal .94 .06 1.9%

Commercial Banks:
External+Technical+Internal .96 .04 1.6%

70
 Table 3: Bank Interest Cost Efficiency--DEA, 1992-2001

Interest Cost Equation: EFF INEFF

Technical Influences .83 .20
External+Technical .92 .09
External+Technical+Internal .93 .08

Savings Banks:
External+Technical+Internal .97 .03

Commercial Banks:
External+Technical+Internal .92 .09

71
 Table 4: Bank Operating Cost Efficiency--DEA, 1992-2001

Operating Cost Equation: EFF INEFF

Technical Influences .95 .05
External+Technical .96 .04
External+Technical+Internal .98 .02

Savings Banks:
External+Technical+Internal .98 .02

Commercial Banks:
External+Technical+Internal .99 .01

72
 Results So Far

External, Technical, and Internal variables together explain

almost all bank cost efficiency differences for Spain.

Internal/productivity influences, not balance sheet variables,

identify source of cost inefficiency.

Parameter signs show that operating cost falls and efficiency

rises when:
Deliver services using more ATMs vs. branches;
Each branch generates more deposits with less labor.

(The "black box" was never black, just not fully specified.)

73
 Results So Far

Earlier studies have found EFF to be relatively stable over

time.
The DEA results of this new paper are also relatively stable
by year (not shown).

Now look at time-series (mean) vs. cross-section (dispersion)

changes in unit operating cost (OC/TA).

Why? Because ATM/branch tradeoff and other productivity

indicators explain both cross-section OC efficiency
differences
and the observed time-series reduction in OC.

74
 Introducción
 Existen, al menos, tres dimensiones
en las que se precisan avances para
lograr un diagnóstico más preciso de
la realidad competitiva de la industria
bancaria de la UE y poder arbitrar
políticas acordes con los objetivos de
integración y la mejora del acceso a
los servicios bancarios

75
 Tema 4
GOBIERNO Y ESTRUCTURA
ORGANIZATIVA DE LA BANCA

(MATERIAL DEL PROFESOR)

“It is the ability to foretell what is going to happen
tomorrow, next week, next month, and next year. And to
have the ability afterwards to explain why it didn’t
happen.”

Sir Winston Churchill

What are Financial
Intermediaries (FIs)?
 Financial Securities: contingent claims on
future cash flows – debt, equity,
derivatives, hybrids.
 All firms’ liabilities & net worth are
predominately comprised of financial
securities.
 But most firms hold real assets such as
inventory, plant & equipment, buildings.
 FIs’ assets are predominately comprised of
financial securities.
78
Transparent, Transluscent and Opaque FIs

F in a n c ia l I n t e r m e d ia t io n : T h e F lo w o f F u n d s a n d P r im a r y S e c u r it ie s

F u n d s S u r p l u s U n it s B ro k e rs F u n d s D e f ic it U n it s

F u n d s S u r p l u s U n it s D e a le rs F u n d s D e f ic it U n it s

F u n d s S u r p l u s U n it s U n d e r w r it e r s F u n d s D e f ic it U n it s
In v e s t m e n t B a n k s

F u n d s S u r p l u s U n it s M u tu a l F u n d s F u n d s D e f ic it U n it s

F u n d s S u r p l u s U n it s B anks F u n d s D e f ic it U n it s

F u n d s S u r p l u s U n it s In s u r a n c e C o m p a n ie s F u n d s D e f ic it U n it s 79
What Services Do FIs Provide?
 Information
 Liquidity
 Reduced Transaction Costs
 Transmission of Monetary Policy
 Credit Allocation
 Payment Services
 Intergenerational Wealth Transfer

80
FIs are the most regulated of
all firms
 Safety and Soundness Regulation
 Deposit Insurance
 Monetary Policy Regulation
 Reserve Requirements
 Credit Allocation Regulation (eg., mortgages)
 Consumer Protection Regulation
 Community Reinvestment Act, Home Mortgage
Disclosure Act, Truth in Lending Protection
 Investor Protection Regulation
 Entry Regulation

81
Types of FIs
 Depository Institutions
 Insurance Companies
 Securities Firms and Investment
Banks
 Mutual Funds
 Finance Companies
 Distinctions blurred by the Gramm-
Leach-Bliley Act of 1999 that created
Financial Holding Companies (FHCs).
82
Features Common to Most FIs
 High Amount of Financial Leverage
 Low equity/assets ratios. Capital
requirements.
 Off-balance sheet items
 Contingent claims that under certain
circumstances may eventually become
balance sheet items (ex. Derivatives,
commitments)
 Revenue: Interest Income & Fees
 Costs: Interest Expenses and Personnel

83
Depository Institutions
 Commercial Banks: accept deposits and make loans to
consumers and businesses.
 Money Center Banks: Citigroup, Bank of NY,
BankOne, Bankers Trust (Deutschebank), JP
Morgan Chase and HSBC Bank USA.
 Savings Associations (S&Ls)
 Qualified Thrift Lender (QTL) mortgages must
exceed 65% of thrift’s assets.
 Savings Banks
 Use deposits to fund mortgages & other assets.
 Credit Unions and Credit cooperatives
 Nonprofit mutually owned institutions (owned by
depositors).

84
Overview of Depository Institutions
 In this segment, we explore the
depository FIs:
 Size, structure and composition
 Balance sheets and recent trends
 Regulation of depository institutions
 Depository institutions performance

85
Products of FIs
 Comparing the products of FIs in 1950, to
products of FIs in 2003:
 Much greater distinction between types of

FIs in terms of products in 1950 than in

2003
 Blurring of product lines and services over

time
 Wider array of services offered by all FI

types

86
Specialness of Depository FIs
 Products on both sides of the balance
sheet
 Loans
 Business and Commercial
 Deposits

87
Other outputs of depository FIs
 Other products and services 1950:
 Payment services, Savings products,
Fiduciary services
 By 2003, products and services
further expanded to include:
 Underwriting of debt and equity,
Insurance and risk management
products

88
Size of Depository FIs
 Consolidation has created some very
large FIs
 Combined effects of
disintermediation, global competition,
regulatory changes, technological
developments, competition across
different types of FIs

89
Largest Depository Institutions in the
US
Total Assets ($Billions)
Citigroup $1,208.9
J.P. Morgan Chase* 770.9
Bank of America** 736.4
Wells Fargo 393.9
Wachovia 388.0
Bank One* 326.6
Washington Mutual 275.2
Fleet Boston** 200.2
U.S. Bancorp 188.8
SunTrust Banks 181.0

90
Organization of Depository
Institutions
 Commercial Banks
 Largest depository institutions are commercial
banks.
 Differences in operating characteristics and
profitability across size classes.
 Notable differences in ROE and ROA as well as
the spread
 Thrifts
 S&Ls
 Savings Banks
 Credit Unions
 Mix of very large banks with very small banks

91
Functions & Structural
Differences
 Functions of depository institutions
 Regulatory sources of differences across
types of depository institutions.
 Structural changes generally resulted
from changes in regulatory policy.
 Example: changes permitting interstate
branching
 Reigle-Neal Act (1994) in the US
 In Spain, deregulation in 1989 concerning
savings banks operations

92
Commercial Banks
 Primary assets:
 Real Estate Loans: $2,272.3 billion
 C&I loans: $870.6 billion
 Loans to individuals: $770.5 billion
 Investment security portfolio: $1,789.3
billion
 Of which, Treasury bonds: $1,005.8 billion
 Inference: Importance of Credit Risk

93
Commercial Banks
 Primary liabilities:
 Deposits: $5,028.9 billion
 Borrowings: $1,643.3 billion
 Other liabilities: $238.2 billion
 Inference:
 Highly leveraged

94
Small Banks, US
C&I
14% Credit Card
1%
Consumer
8%

Other
Real Estate 14%
63%

95
Large Banks, US
C&I
18%

Real Estate Credit Card

44% 7%

Consumer
10%

Other
21%
96
Structure and Composition
 Shrinking number of banks:
 14,416 commercial banks in 1985
 12,744 in 1989
 7,769 in 2004
 Mostly the result of Mergers and
Acquisitions
 M&A prevented prior to 1980s, 1990s
 Consolidation has reduced asset share of
small banks
97
Structure & Composition
of Commercial Banks
 Financial Services Modernization Act
1999
 Allowed full authority to enter
investment banking (and insurance)
 Limited powers to underwrite
corporate securities have existed only
since 1987

98
Composition of
Commercial Banking Sector

 Community banks
 Regional and Super-regional
 Access to federal funds market to finance
their lending activities
 Money Center banks
 Bank of New York, Deutsche Bank (Bankers
Trust), Citigroup, J.P. Morgan Chase, HSBC
Bank USA
 declining in number

99
Balance Sheet and Trends
 Business loans have declined in
importance
 Offsetting increase in securities and
mortgages
 Increased importance of funding via
commercial paper market
 Securitization of mortgage loans

100
Some Terminology
 Transaction accounts
 Negotiable Order of Withdrawal (NOW)
accounts (“cuenta a la vista”)
 Money Market Mutual Fund
 Negotiable CDs (“certificados de
depósito”): Fixed-maturity interest
bearing deposits with face values over
$100,000 that can be resold in the
secondary market.
101
Off-balance Sheet Activities
 Heightened importance of off-balance
sheet items
 Large increase in derivatives positions is
a major issue
 Standby letters of credit
 Loan commitments
 When-issued securities
 Loans sold

102
Trading and Other Risks
 Allied Irish / Allfirst Bank
 $750 million loss (2001)
 National Australian Bank
 $450 million loss (2004)
Failure of the U.K. investment bank
Barings
The Bankruptcy of Orange County in
California.
103
Other Fee-generating Activities
 Trust services
 Correspondent banking
 Check clearing
 Foreign exchange trading
 Hedging
 Participation in large loan and security
issuances
 Payment usually in terms of noninterest
bearing deposits

104
Key Regulatory Agencies
 FDIC and the Office of the Comprotroller of
the Currency in the US.
 European Central Bank
 National central banks
 National Governments
 Regional Governments

105
Web Resources
 For more detailed information on the
regulators, visit:
http://www.ecb.int
http://www.bde.es
http://www.fdic.gov
http://www.occ.treas.gov
http://federalreserve.gov

106
Banking and Ethics
Some cases for the US:
 Bank of America and Fleet Boston

Financial 2004
 J.P. Morgan Chase and Citigroup

2003 role in Enron

 Riggs National Bank and money

laundering concerns 2003

107
Savings Institutions
 Comprised of:
 Savings and Loans Associations
 Savings Banks

 Effects of moral hazard and regulator

forbearance. Quite a debate worldwhile.

108
Savings Institutions: Recent Trends
 Industry is smaller overall
 Intense competition from other FIs
 mortgages for example
 Concern for future viability in certain
countries.

109
Credit Unions
 Nonprofit depository institutions owned by
member-depositors with a common bond.
 Exempt from taxes and Community
Reinvestment Act (CRA) in the US.
 Expansion of services offered in order to
compete with other FIs.
 Very important in certain European
countries (Germany, Spain).

110
Global Issues
 Near crisis in Japanese Banking
 Eight biggest banks reported positive six-
month profits
 China
 Deterioration, NPLs (nonperforming

loans) at 50% levels

 Opening to foreign banks (WTO entry)

 German bank problems in early 2000s

 Implications for future competitiveness
111
 Largest Banks in the World
Bank Assets
($Millions)
Citigroup (USA) 1,097,000
Mizuho Financial Group (Japan) 945,688
UBS (Switzerland) 825,000
Sumitomo Mitsui Fin. (Japan) 802,674
Deutsche Bank (Germany) 794,984
Bank of Tokyo-Mitsubishi (Japan) 789,495
112
Tema 5
La concesión de crédito,
el riesgo de crédito y
otros riesgos

(LECTURA DE REFERENCIA:
ALTUNBAS ET AL.,2007)
5.1. THE CONCEPT OF RISK
 Risks facing all financial institutions can
be segmented into three separable types,
from a management perspective. These
are:
 (i) risks that can be eliminated or avoided
by simple business practices,
 (ii) risks that can be transferred to other
participants, and,
 (iii) risks that must be actively managed
at the firm level.

114
 The management of the banking firm relies
on a sequence of steps to implement a risk
management system. These can be seen as
containing the following four parts:
 (i) standards and reports,
 (ii) position limits or rules,
 (iii) investment guidelines or strategies,
 (iv) incentive contracts and compensation.

115
SOURCES OF RISK
For the sector as a whole, the risks can be
broken into six generic types:
- systematic or market risk
- credit risk
- counterparty risk
- liquidity risk
- operational risk
- legal risk

116
 Systematic risk is the risk of asset value
change associated with systematic factors.
It is sometimes referred to as market risk,
which is in fact a somewhat imprecise term.
 By its nature, this risk can be hedged, but
cannot be diversified completely away. In
fact, systematic risk can be thought of as
undiversifiable risk.

117
 Credit risk arises from non-performance by
a borrower. It may arise from either an
inability or an unwillingness to perform in the
pre-committed contracted manner. This can
affect the lender holding the loan contract, as
well as other lenders to the creditor.

 Therefore, the financial condition of the

borrower as well as the current value of any
underlying collateral is of considerable
interest to its bank

118
 Counterparty risk comes from non-
performance of a trading partner. The non-
performance may arise from a
counterparty's refusal to perform due to an
adverse price movement caused by
systematic factors, or from some other
political or legal constraint that was not
anticipated by the principals.

 Diversification is the major tool for

controlling nonsystematic counterparty risk.

119
 Liquidity risk can best be described as the
risk of a funding crisis. While some would
include the need to plan for growth and
unexpected expansion of credit, the risk here is
seen more correctly as the potential for a
funding crisis.

 Such a situation would inevitably be associated

with an unexpected event, such as a large
charge off, loss of confidence, or a crisis of
national proportion such as a currency crisis.

120
 Operational risk is associated with the
problems of accurately processing, settling,
and taking or making delivery on trades in
exchange for cash. It also arises in record
keeping, processing system failures and
compliance with various regulations.

 As such, individual operating problems are

small probability events for well-run
organizations but they expose a firm to
outcomes that may be quite costly.

121
 Legal risks are endemic in financial
contracting and are separate from the legal
ramifications of credit, counterparty, and
operational risks.

 New statutes, tax legislation, court opinions

and regulations can put formerly well-
established transactions into contention even
when all parties have previously performed
adequately and are fully able to perform in the
future.
122
5.2. REGULATION AND CREDIT
RISK: AN EXAMPLE FROM BASEL II
 Historically, regulation has limited
who can:
 open or charter new banks and
 what products and services banks can
offer.
 Imposing barriers to entry and
restricting the types of activities
banks can engage in clearly enhance
safety and soundness, but also hinder
competition.
123
 It assumed that the markets for bank
products, largely bank loans and
deposits, could be protected and that
other firms could not encroach upon
these markets.
 Not surprisingly, investment banks,
hybrid financial companies, insurance
firms, and others found ways to
provide the same products as banks
across different geographic markets.
124
 However, there is another type of
regulation that has concentrated
most of the attention in the last three
decades, the bank capital regulation.
 Changes in reserve requirements
…directly affect the amount of legal
required reserves and thus change the
amount of money a bank can lend out. The
main recent example is BASEL II.

125
THE STRATEGIC IMPACT OF BASEL II

 Basel 2 is a ‘step change’ in the regulation of

capital adequacy. It will alter the industry ‘frame
of reference’ for banks in many ways:
 Regulators are clearly recognizing market realities
and seeking a much closer congruence between
regulatory and economic capital.
 The new proposals are more complex and
sophisticated than earlier schemes. They will
also have to evolve as market conditions,
technology and financial management techniques
develop.

126
 The calibration exercises that have resulted from
the various Quantitative Impact Studies (QIS) are
targeted (initially at least) to deliver broadly the
same amount of capital as the current Accord.
However, the mix of capital charges will
change significantly with the wider range of risk
weights and greater risk sensitivity of Basel 2.

 Basel 2 will clearly be much more risk-sensitive

in assigning capital charges. Mortgage lending and
lending to higher quality borrowers will be
incentivised under Basel 2.

127
 It is not clear whether the present or new Basel
Accord are a binding constraint on bank’s current
credit operations. Jackson et al (2001, Bank of
England WP) suggest that banks may employ
more conservative capital standards than those
imposed under Basel 1 or likely under Basel 2.

 Compliance costs are likely to increase. Banks

will have to evaluate (as a kind of capital
investment decision) whether the costs (including
compliance costs) of moving to the more advanced
Basel 2 systems are worthwhile.

128
 Banks will increasingly target better risk
management as a source of competitive
advantage. Increasingly, superior risk
management will become a ‘key success
factor’ for those banks who are able to respond
successfully to the new environment.

 Nevertheless, specialist banks who focus on a

smaller number of core products and services
should similarly be able to obtain risk
management benefits of specialization.

129
 Basel 2 will enhance present securitisation
trends in banking. This will help in its turn to
emphasise further the strategic importance of
investment banking. At the same time, lending
bankers will face increasing ‘adverse selection’ trends
as the better credits are able to access directly the
capital markets.

 This trend will help to re-emphasise the

importance of credit skills in lending banks. It will
also put pressure on these banks to widen their
margins (in order to achieve the higher risk premia
needed to cover their more risky lending).

130
 Governance will be an increasingly important issue in
the new regime. More disclosure is not enough by itself to
secure market discipline (the aim of Pillar 3). A wide
collection of new and improved governance structures will
be needed. These include:

 a freer market in bank corporate control;

 good corporate governance in banks;
 incentive-compatible safety nets;
 ‘no bail-out’ policies;
 and proper accounting standards.

 Banks will be required to disclose more information

than ever before to the external market. This will involve
additional compliance costs. Strategically, it will reinforce
any competitive advantage gained by good risk-
management banks.

131
 Under Pillar 3 and with likely changes in bank
governance arrangements, the prospects of take-
overs (and no bail-outs) for individual banks who
are ‘inefficient’ are likely to increase. This ‘new
world’ is a likely further threat to concepts like
mutuality and subsidised (or at least protected from
competition) regional banking.

 Insofar as the new capital regime allows non-

bank financial companies a competitive
advantage (via lesser capital backing), banks will
attempt to alter the balance of competitive
advantage through regulatory arbitrage

132
 More work is needed on stress testing under
Basel 2 and banks can expect further, more
detailed efforts from regulators in this area.
Already, stress testing appears to be a
standard management technique for many
banks and most banks that stress test do so at a
high frequency (daily or weekly): see Fender
and Gibson (Risk, 2001).

133
 Perhaps the most fundamental strategic impact of
Basel 2 is that it will enhance the SWM
(Shareholder Wealth Maximisation) model as
the major strategic and managerial model for
banks. The essence of this model is its focus on
risk and return and the impact of this tradeoff on
bank value; the model also emphasises the need
for greater risk sensitivity in risk assessments and
pricing. Within this model, better risk
management is rewarded.

134
5.3. THE SPANISH SAVINGS BANKS AND THE
NEW REGULATORY FRAMEWORK

 Although most of the strategic implications mentioned

earlier for retail banks apply also to Spanish savings
banks, there are some specific features of the Spanish
savings banks that may modify some of these
conclusions. These specific features are explored in this
section (and summarised in Diagram 1):
 There have been some recent regulatory actions regarding
risk and capital in the Spanish banking system that should
be taken into account when defining the threats and
opportunities of the new framework for savings banks.
The development of a Default Hedging Statistical Fund
(the so-called FECI) by the Bank of Spain are two of the
recent developments in the regulatory field that impact on
the current solvency risk of Spanish savings banks

135
DIAGRAM 1. SPANISH SAVINGS BANKS AND THE NEW REGULATORY
CAPITAL FRAMEWORK. KEY FEATURES

REGULATION: MARKET STRATEGIC

DEVELOPMENTS– IMPLICATIONS
BASEL 2

SPANISH SAVINGS
BANKS AND THE NEW
REGULATORY CAPITAL
FRAMEWORK

SECTORAL PROJECT
CAPITAL REGULATION FOR THE GLOBAL
AND OWNERSHIP CONTROL OF RISK

136
 The establishment of so-called statistical, pro-cyclical or
dynamic provisions:
 Requiring banks to increase these provisions when the
business cycle is positive and reducing them during
downturns in order to favor intertemporal risk
smoothing and loan supply.

 Basel 2 does not appear to change the view of banking as a

pro-cyclical business. Basel 2 could even exacerbate
cyclical effects. It is this contingency that has led the Bank
of Spain to establish the so-called pro-cyclical or dynamic
provisions.

 The recent lending patterns of the Spanish savings

banks are known to reduce these pro-cyclical effects
since they have increased credit supply almost linearly over
the business cycle.

137
 The lending behavior of savings banks has not
resulted in higher defaults. On the contrary,
default risk management at savings banks has
apparently been more efficient than for commercial
banks, a fact that may be largely explained by the
intertemporal risk smoothing advantages achieved
via a close contractual relationship with their
customers.

138
 There are three main types of “savings-bank”
specific effects:

(1) those concerning the aim of Basel 2 and the

differences between economic and regulatory
capital;
(2) those that refer to specialization, size and lending
diversification;
(3) those related to the implementation of the new
capital adequacy requirements, including the
sectoral project of Spanish savings banks for the
global control of risk.
139
(i) Aim of Basel 2 and Economic and Regulatory
Capital Differences
 While the objective of Stakeholder Wealth
Maximization (STWM) may match more closely the
nature of Spanish savings banks, SWM should not
be a problem for savings institutions since they
have to compete with commercial banks.
Nevertheless, the SWM model will be reinforced by
Basel 2 and Spanish savings banks may
benefit from recent regulatory changes that
stress their ownership status as private and
non-subsidised.

140
(ii) Size, specialisation and lending diversification

 Specialist banks (like savings banks) focusing

on a smaller number of core products may also
be able to obtain the risk management
benefits of specialisation. Continuous
calibration and capital treatment may reduce the
potential loss of competitiveness in retail
banking. Servicing, relationship banking and
dynamic lending will also be valued positively.

141
(iii) Final implementation of Basel 2 on Spanish savings
banks: the sectoral project for the global control of risk
 The Spanish Confederation of Savings Banks (CECA)
has led an ambitious initiative to undertake a
sectoral project for the global control of risk.
Since this project is oriented to the whole savings
bank sector, it has to deal with various problems,
like the rigidities of employing a single model for all
institutions.
 However, the project is targetted to provide
savings banks with adequate and centralised
human and technological resources in order to
implement their own model with a high standard of
quality.

142
 The model for each line of business
incorporates risk measurement, control and
management operating with three different
working groups:

 information management;

 organization and procedures;

 quantitative tools.

143
5.4. COMPARATIVE DESCRIPTIVE
STATISTICS
 The credit risk of Spanish depository institutions
does not seem to be a concern in the short-
run.

 The ratios “doubtful assets/total exposures”

and “doubtful loans of other resident
sectors/total exposures of resident sectors”
have decreased in recent years and are lower
than 1% (Table 1).

 “Statistical” provisions have increased over

time as a percentage of total provisions (Table 1).

144
 TABLE 1.

145
Source: Bank of Spain (Memory of Bank Supervision 2004)
 Savings banks and credit co-operatives
have enjoyed higher margins compared to
commercial banks (Table 2). The margins are in
line with the European standards.

 However, competitive presures have resulted in

a decrease of margins over time during the
last years.

146
 TABLE 2.

147
Source: Bank of Spain (Memory of Bank Supervision 2004)
 As shown in Table 3, Spanish banks have
progressively changed their financial
structure to fulfill the requirements of
Basel 2.

 Both Tier 1 and Tier 2 capital have

increased significantly in recent years.

 Banks have increased both the average

weight of credit risk exposure and off-
balance sheet exposure.

148
TABLE 3.

149
Source: Bank of Spain (Memory of Bank Supervision 2004)
 Changes in capitalization structure have led to an
anticipated fulfillment of Basel 2 requirements (Figure
1a).

 Tier 1 capital has largely contributed to a reduction

in capital requirements, in a context of a significant
increase in risk-weighted assets (rise in overall business
and Santander’s purchase of Abbey National) (Figure 1b).

 However, Tier 1 capital has contributed to the growth

rate of capital (Figure 1c).

 Reserves have contributed largely to the growth of

Tier 1 capital while the contribution of intangible assets
has been negative (Figure 1d).

150
FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS
BANKS IN SPAIN (1)

151
Source: Bank of Spain (Financial Stability Report, n.8, 2005, May)
FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS BANKS
IN SPAIN (2)

152
Source: Bank of Spain (Financial Stability Report, n.8, 2005, May)
Measurement of credit risk

153
 Types of Loans:
 C&I (commercial and industrial) loans: secured and
unsecured
 Syndication

 Spot loans, Loan commitments

 Decline in C&I loans originated by commercial

banks and growth in commercial paper market.
 Downgrades of Ford, General Motors and Tyco

 RE (real state) loans: primarily mortgages

 Fixed-rate, variable rates

 Mortgages can be subject to default risk when

loan-to-value declines.

154
*CreditMetrics (sistema patentado)
 “If next year is a bad year, how much will I lose on my
loans and loan portfolio?”
VAR = P × 1.65 × 
 Neither P, nor  observed.
Calculated using:
 (i)Data on borrower’s credit rating; (ii) Rating
transition matrix; (iii) Recovery rates on defaulted
loans; (iv) Yield spreads.

155
* Credit Risk+ (sistema patentado)
 Developed by Credit Suisse Financial Products.
 Based on insurance literature:
 Losses reflect frequency of event and severity of
loss.
 Loan default is random.
 Loan default probabilities are independent.
 Appropriate for large portfolios of small loans.
 Modeled by a Poisson distribution.

156
 Credit risk measurement has evolved
dramatically over the last 20 years.
 The five forces made credit risk
measurement become more important
than ever before:
(i) A worldwide structural increase in the
number of bankruptcies.
(ii) A trend towards disintermediation by
the highest quality and largest
borrowers.
157
(iii) More competitive margins on loans.
(iv) A declining value of real assets in
many markets.
(v) A dramatic growth of off-balance
sheet instrument with inherent
default risk exposure, including
credit risk derivatives.

158
 Responses of academics and practitioners:

(i) Developing new and more sophisticated credit-

scoring/early-warning systems
(ii) Moved away from only analyzing the credit risk
of individual loans and securities towards
developing measures of credit concentration
risk
(iii) Developing new models to price credit risk
(e.g. RAROC)
(iv) Developing models to measure better the
credit risk of off-balance sheet instruments

159
Credit Risk Management

 An FI’s ability to evaluate information and

control and monitor borrowers allows
them to transform financial claims of
household savers efficiently into claims
issued to corporations, individuals, and
governments
 An FI accepts credit risk in exchange for a
fair return sufficient to cover the cost of
funding (e.g., covering the cost of
borrowing, or issuing deposits)

160
Credit Scoring
 Credit scoring system
 a mathematical model that uses observed loan
applicant’s characteristics to calculate a score that
represents the applicant’s probability of default
 Perfecting collateral
 ensuring that collateral used to secure a loan is free
and clear to the lender should the borrower default
 Foreclosure
 taking possession of the mortgaged property to
satisfy a defaulting borrower’s indebtedness
 Power of sale
 taking the proceedings of the forced sale of property
to satisfy the indebtedness
161
Credit Scoring

 Consumer (individual) and Small-business lending

 techniques for scoring consumer loans very similar to
mortgage loan credit analysis but more emphasis
placed on personal characteristics such as annual
gross income and the TDS score
 small-business loans more complicated and has
required FIs to build more sophisticated scoring
models combining computer-based financial analysis
of borrower financial statements with behavioral
analysis of the owner

162
 Ratio Analysis

 Historical audited financial statements and projections

of future needs
 Calculation of financial ratios in financial statement
analysis
 Relative ratios offer information about how a business
is changing over time
 Particularly informative when they differ either from
an industry average or from the applicant’s own past
history

163
Common Size Analysis and
After the Loan
 Analyst can divide all income statement amounts
by total sales revenue and all balance sheet
amounts by total assets
 Year to year growth rates give useful ratios for
identifying trends
 Loan covenants reduce risk to lender
 Conditions precedent
 those conditions specified in the credit agreement or
terms sheet for a credit that must be fulfilled before
drawings are permitted

164
Large Commercial and
Industrial Lending
 Very attractive to FIs because transactions are
often large enough make them very profitable
even though spreads and fees are small in
percentage
 FIs act as broker, dealer, and adviser in credit
management
 The standard methods of analysis used for mid-
market corporates applied to large corporate
clients but with additional complications
 Financial ratios such as the debt-equity ratio are
usually key factors for corporate debt

165
The KMV Model
 Banks can use the theory of option pricing to
assess the credit risk of a corporate borrower
 The probability of default is positively related to:
 the volatility of the firm’s stock
 the firm’s leverage
 A model developed by KMV corporation is being
widely used by banks for this purpose

166
Calculating the Return on a
Loan
 A number of factors impact the promised return that an
FI achieves on any given dollar loan
 the interest rate on the loan
 any fees relating to the loan
 the credit risk premium on the loan
 the collateral backing the loan
 other nonprice terms (such as compensating
balances and reserve requirements)

167
Return on Assets (ROA)
11 ++ kk == 11++ff++(L
(L++m)
m)
11--(b(1
(b(1--R))
R))

where
where
kk == the
thecontractually
contractuallypromised
promisedgross
grossreturn
returnon
onthe
theloan
loan
ff == direct
directfees,
fees,such
suchas
asloan
loanorigination
originationfee
fee
LL == base
baselending
lendingrate
rate
mm== risk
riskpremium
premium
bb == compensating
compensatingbalances
balances
RR== reserve
reserverequirement
requirementcharge
charge

168
Risk-Adjusted Return on Capital
(RAROC)

 Rather than evaluating the actual or

promised annual cash flow on a loan as a
percentage of the amount lent (ROA), the
lending officer balances the loan’s
expected income against the loan’s
expected risk
 RAROC = One-year income on a loan/Loan
(asset risk or capital at risk

169
APPENDIX: Bank regulation and credit
risk: an example from Basel II and
savings banks

 Historically, regulation has limited who can:

 open or charter new banks and

 what products and services banks can offer.

 Imposing barriers to entry and restricting the

types of activities banks can engage in clearly
enhance safety and soundness, but also hinder
competition.

170
 It assumed that the markets for bank products,
largely bank loans and deposits, could be
protected and that other firms could not
encroach upon these markets.
 Not surprisingly, investment banks, hybrid
financial companies, insurance firms, and
others found ways to provide the same
products as banks across different geographic
markets.

171
 However, there is another type of
regulation that has concentrated
most of the attention in the last three
decades, the bank capital regulation.
 Changes in reserve requirements
…directly affect the amount of legal
required reserves and thus change the
amount of money a bank can lend out. The
main recent example is BASEL II.

172
 Basel 2 is a ‘step change’ in the regulation of
capital adequacy. It will alter the industry ‘frame
of reference’ for banks in many ways:
 Regulators are clearly recognizing market realities
and seeking a much closer congruence between
regulatory and economic capital.
 The new proposals are more complex and
sophisticated than earlier schemes. They will
also have to evolve as market conditions,
technology and financial management techniques
develop.

173
 The calibration exercises that have resulted from
the various Quantitative Impact Studies (QIS) are
targeted (initially at least) to deliver broadly the
same amount of capital as the current Accord.
However, the mix of capital charges will
change significantly with the wider range of risk
weights and greater risk sensitivity of Basel 2.

 Basel 2 will clearly be much more risk-sensitive

in assigning capital charges. Mortgage lending and
lending to higher quality borrowers will be
incentivied under Basel 2.

174
 It is not clear whether the present or new Basel
Accord are a binding constraint on bank’s current
credit operations. Jackson et al (2001, Bank of
England WP) suggest that banks may employ
more conservative capital standards than those
imposed under Basel 1 or likely under Basel 2.

 Compliance costs are likely to increase. Banks

will have to evaluate (as a kind of capital
investment decision) whether the costs (including
compliance costs) of moving to the more advanced
Basel 2 systems are worthwhile.

175
 Banks will increasingly target better risk
management as a source of competitive
advantage. Increasingly, superior risk
management will become a ‘key success
factor’ for those banks who are able to respond
successfully to the new environment.

 Nevertheless, specialist banks who focus on a

smaller number of core products and services
should similarly be able to obtain risk
management benefits of specialization.

176
 Basel 2 will enhance present securitisation
trends in banking. This will help in its turn to
emphasise further the strategic importance of
investment banking. At the same time, lending
bankers will face increasing ‘adverse selection’
trends as the better credits are able to access
directly the capital markets.
 This trend will help to re-emphasise the
importance of credit skills in lending banks. It
will also put pressure on these banks to widen
their margins (in order to achieve the higher risk
premia needed to cover their more risky lending).

177
 Governance will be an increasingly important
issue in the new regime. More disclosure is not
enough by itself to secure market discipline (the aim of
Pillar 3). A wide collection of new and improved
governance structures will be needed. These include:
a freer market in bank corporate control;
 good corporate governance in banks;
 incentive-compatible safety nets;
 ‘no bail-out’ policies;
 and proper accounting standards.

 Banks will be required to disclose more

information than ever before to the external
market. This will involve additional compliance costs.
Strategically, it will reinforce any competitive
advantage gained by good risk-management banks.

178
 Under Pillar 3 and with likely changes in bank
governance arrangements, the prospects of take-
overs (and no bail-outs) for individual banks who
are ‘inefficient’ are likely to increase. This ‘new
world’ is a likely further threat to concepts like
mutuality and subsidised (or at least protected from
competition) regional banking.

 Insofar as the new capital regime allows non-

bank financial companies a competitive
advantage (via lesser capital backing), banks will
attempt to alter the balance of competitive
advantage through regulatory arbitrage

179
 More work is needed on stress testing under
Basel 2 and banks can expect further, more
detailed efforts from regulators in this area.
Already, stress testing appears to be a
standard management technique for many
banks and most banks that stress test do so at a
high frequency (daily or weekly): see Fender
and Gibson (Risk, 2001).

180
 Perhaps the most fundamental strategic impact of
Basel 2 is that it will enhance the SWM
(Shareholder Wealth Maximisation) model as
the major strategic and managerial model for
banks. The essence of this model is its focus on
risk and return and the impact of this tradeoff on
bank value; the model also emphasises the need
for greater risk sensitivity in risk assessments and
pricing. Within this model, better risk
management is rewarded.

181
 Although most of the strategic implications mentioned
earlier for retail banks apply also to Spanish savings
banks, there are some specific features of the Spanish
savings banks that may modify some of these
conclusions. These specific features are explored in this
section (and summarised in Diagram 1):

 There have been some recent regulatory actions regarding

risk and capital in the Spanish banking system that should
be taken into account when defining the threats and
opportunities of the new framework for savings banks. The
development of a Default Hedging Statistical Fund (the
so-called FECI) by the Bank of Spain are two of the recent
developments in the regulatory field that impact on the
current solvency risk of Spanish savings banks

182
DIAGRAM 1. SPANISH SAVINGS BANKS AND THE NEW REGULATORY
CAPITAL FRAMEWORK. KEY FEATURES

REGULATION: MARKET STRATEGIC

DEVELOPMENTS– IMPLICATIONS
BASEL 2

SPANISH SAVINGS
BANKS AND THE NEW
REGULATORY CAPITAL
FRAMEWORK

SECTORAL PROJECT
CAPITAL REGULATION FOR THE GLOBAL
AND OWNERSHIP CONTROL OF RISK

183
 The establishment of so-called statistical, pro-cyclical or
dynamic provisions:
 Requiring banks to increase these provisions when the
business cycle is positive and reducing them during
downturns in order to favor intertemporal risk
smoothing and loan supply.

 Basel 2 does not appear to change the view of banking as

a pro-cyclical business. Basel 2 could even exacerbate
cyclical effects. It is this contingency that has led the
Bank of Spain to establish the so-called pro-cyclical or
dynamic provisions.

 The recent lending patterns of the Spanish savings

banks are known to reduce these pro-cyclical effects
since they have increased credit supply almost linearly
over the business cycle.

184
 The lending behavior of savings banks has not
resulted in higher defaults. On the contrary,
default risk management at savings banks has
apparently been more efficient than for commercial
banks, a fact that may be largely explained by the
intertemporal risk smoothing advantages achieved
via a close contractual relationship with their
customers.

185
 There are three main types of “savings-bank”
specific effects:

(1) those concerning the aim of Basel 2 and the

differences between economic and regulatory
capital;
(2) those that refer to specialisation, size and
lending diversification;
(3) those related to the implementation of the new
capital adequacy requirements, including the
sectoral project of Spanish savings banks for the
global control of risk.

186
(i) Aim of Basel 2 and Economic and Regulatory
Capital Differences
 While the objective of Stakeholder Wealth
Maximisation (STWM) may match more closely the
nature of Spanish savings banks, SWM should not
be a problem for savings institutions since they
have to compete with commercial banks.
Nevertheless, the SWM model will be reinforced by
Basel 2 and Spanish savings banks may
benefit from recent regulatory changes that
stress their ownership status as private and
non-subsidised.

187
(ii) Size, specialisation and lending diversification

 Specialist banks (like savings banks) focusing

on a smaller number of core products may also
be able to obtain the risk management
benefits of specialisation. Continuous
calibration and capital treatment may reduce the
potential loss of competitiveness in retail
banking. Servicing, relationship banking and
dynamic lending will also be valued positively.

188
(iii) Final implementation of Basel 2 on Spanish savings
banks: the sectoral project for the global control of risk
 The Spanish Confederation of Savings Banks (CECA)
has led an ambitious initiative to undertake a
sectoral project for the global control of risk.
Since this project is oriented to the whole savings
bank sector, it has to deal with various problems,
like the rigidities of employing a single model for all
institutions.
 However, the project is targetted to provide
savings banks with adequate and centralised
human and technological resources in order to
implement their own model with a high standard of
quality.

189
 The model for each line of business
incorporates risk measurement, control and
management operating with three different
working groups:

 information management;

 organization and procedures;

 quantitative tools.

190
COMPARATIVE DESCRIPTIVE
STATISTICS
 The credit risk of Spanish depository institutions
does not seem to be a concern in the short-
run.
 The ratios “doubtful assets/total exposures”
and “doubtful loans of other resident
sectors/total exposures of resident sectors”
have decreased in recent years and are lower
than 1% (Table 1).

 “Statistical” provisions have increased over

time as a percentage of total provisions (Table 1).

191
 TABLE 1.

192
Source: Bank of Spain (Memory of Bank Supervision 2004)
 Savings banks and credit co-operatives
have enjoyed higher margins compared to
commercial banks (Table 2). The margins are in
line with the European standards.

 However, competitive presures have resulted in

a decrease of margins over time during the
last years.

193
 TABLE 2.

194
Source: Bank of Spain (Memory of Bank Supervision 2004)
 As shown in Table 3, Spanish banks have
progressively changed their financial
structure to fulfill the requirements of
Basel 2.

 Both Tier 1 and Tier 2 capital have

increased significantly in recent years.

 Banks have increased both the average

weight of credit risk exposure and off-
balance sheet exposure.

195
TABLE 3.

196
Source: Bank of Spain (Memory of Bank Supervision 2004)
 Changes in capitalization structure have led to an
anticipated fulfillment of Basel 2 requirements
(Figure 1a).
 Tier 1 capital has largely contributed to a
reduction in capital requirements, in a context of a
significant increase in risk-weighted assets (rise in
overall business and Santander’s purchase of Abbey
National) (Figure 1b).
 However, Tier 1 capital has contributed to the
growth rate of capital (Figure 1c).
 Reserves have contributed largely to the growth
of Tier 1 capital while the contribution of intangible
assets has been negative (Figure 1d).

197
FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS
BANKS IN SPAIN (1)

198
Source: Bank of Spain (Financial Stability Report, n.8, 2005, May)
FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS BANKS
IN SPAIN (2)

199
Source: Bank of Spain (Financial Stability Report, n.8, 2005, May)
Other Risks Faced by Financial
Intermediaries

200
 Risks Faced by Financial
Intermediaries
 Liquidity Risk
 Interest Rate Risk
 Market Risk
 Off-Balance-Sheet Risk
 Foreign Exchange Risk
 Country or Sovereign Risk
 Technology Risk
 Operational Risk
 Insolvency Risk
201
Market Risk
 Incurred in trading of assets and liabilities (and
derivatives).
 Examples: Barings & decline in ruble.
 DJIA dropped 12.5 percent in two-week period July,
2002.
 Heavier focus on trading income over traditional
activities increases market exposure.
 Trading activities introduce other perils as was
discovered by Allied Irish Bank’s U.S. subsidiary,
AllFirst Bank when a rogue trader successfully
masked large trading losses and fraudulent
activities involving foreign exchange positions

202
Off-Balance-Sheet Risk
 Striking growth of off-balance-sheet
activities
 Letters of credit
 Loan commitments
 Derivative positions
 Speculative activities using off-
balance-sheet items create
considerable risk

203
Technology and Operational Risk
 Risk that technology investment fails to
produce anticipated cost savings.
 Risk that technology may break down.
 CitiBank’s ATM network, debit card system

and on-line banking out for two days

 Wells Fargo

 Bank of New York: Computer system failed

to recognize incoming payment messages

sent via Fedwire although outgoing
payments succeeded

204
Technology and Operational Risk
 Operational risk not exclusively
technological
 Employee fraud and errors
 Losses magnified since they affect
reputation and future potential
 Merrill Lynch $100 million penalty

205
Country or Sovereign Risk
 Result of exposure to foreign government
which may impose restrictions on repayments
to foreigners.
 Often lack usual recourse via court system.
 Examples:
 Argentina • Indonesia
 Russia • Malaysia
 South Korea • Thailand.

206
Country or Sovereign Risk
 In the event of restrictions, reschedulings, or
outright prohibition of repayments, FIs’
remaining bargaining chip is future supply of
loans
 Weak position if currency collapsing or

government failing
 Role of IMF
 Extends aid to troubled banks

 Increased moral hazard problem if IMF

bailout expected

207
Liquidity Risk
 Risk of being forced to borrow, or sell assets in a very
short period of time.
 Low prices result.
 May generate runs.
 Runs may turn liquidity problem into solvency
problem.
 Risk of systematic bank panics.
 Example: 1985, Ohio savings institutions insured by
Ohio Deposit Guarantee Fund
 Interaction of credit risk and liability risk
 Role of FDIC (see Chapter 19)

208
Insolvency Risk
 Risk of insufficient capital to offset
sudden decline in value of assets to
liabilities.
 Continental Illinois National Bank and
Trust
 Original cause may be excessive
interest rate, market, credit, off-
balance-sheet, technological, FX,
sovereign, and liquidity risks.
209
Insolvency Risk Management
 Net worth
 a measure of an FI’s capital that is equal to the difference
between the market value o its assets and the market value of
its liabilities
 Book Value
 value of assets and liabilities based on their historical costs
 Market value or mark-to-market value basis
 balance sheet values that reflect current rather than historical
prices

210
Central Bank & Interest Rate Risk
 Federal Reserve Bank: U.S. central bank
 Open market operations influence money supply,
inflation, and interest rates
 Oct-1979 to Oct-1982, nonborrowed reserves target
regime – did not work
 Implications of reserves target policy:
 Increases importance of measuring and managing
interest rate risk.
 Effects of interest rate targeting.
 Lessens interest rate risk
 Greenspan view: Risk Management
 Focus on Federal Funds Rate
 Simple announcement of Fed Funds increase,
decrease, or no change.

211
Implications

 Emphasizes importance of:

 Measurement of exposure
 Control mechanisms for direct market
risk—and employee created risks
 Hedging mechanisms

212
Market Risk
 Market risk is the uncertainty resulting from
changes in market prices .

 Affected by other risks such as interest rate

risk and FX (foreign exchange) risk
 It can be measured over periods as short as
one day.
 Usually measured in terms of dollar
exposure amount or as a relative amount
against some benchmark.

213
Market Risk Measurement
 Important in terms of:
 Management information
 Setting limits
 Resource allocation (risk/return tradeoff)
 Performance evaluation
 Regulation
 BIS and Fed regulate market risk via capital
requirements leading to potential for overpricing
of risks
 Allowances for use of internal models to calculate
capital requirements

214
Tema 6
ANATOMÍA DE LAS CRISIS
BANCARIAS: LA CRISIS
CREDITICIA DE 2007 Y 2008

(MATERIAL DEL PROFESOR)

 Asymmetric information and its
implications
 Banking crises
 Definition of a banking crisis.
 Recent evidence and why we should care.
 Sources of banking crises.
 Regulatory responses
 Strengthening regulation and supervision.
 Reforming the financial safety net (deposit
insurance and lender of last resort).
216
Asymmetric Information
and its Implications
Definition

 Information is asymmetric when one party to an

economic relationship or transaction has less
information about it than the other party or
parties.
 Pervasive role in financial markets.

Lenders often do not know the riskiness of the
borrower applying for a loan;
 Lenders may not be able to observe whether the
borrower will invest in a safe or risky project.

218
 The very existence of financial institutions can
be explained on asymmetric-information
grounds.
 Reason: financial intermediaries
 specialize in gathering and analyzing infor-
mation about borrowers and their
investment projects.
 They thereby attenuate the incidence of
information asymmetries.
 From this perspective, they act as
delegated monitors.
219
General Implications

 Adverse selection. If the price of insurance

against a particular contingency is fixed
independently of the characteristics of the
behavior of the insured, individuals at greater
risk will choose to insure.
 Moral hazard. After a contract comes into
effect, insured agents have an incentive to
change their behavior in ways that adversely
affect the interests of the insurer.

220
 Free-rider problems. An agent that collects
infor-mation about a particular risk may be
unable to prevent other agents from using that
information (e.g. deposit insurance institution
that is unable to price risk accurately).
 Rational herding. Agents may choose to
disregard their own information and instead
react to information on the decisions taken by
other agents (information externalities).

221
 Principal-agent and monitoring problems.
A principal may be unable to observe perfectly
the actions of the agent to whom a certain
activity or responsibility is delegated.
Examples:
 Bank shareholders may not perfectly
observe investment decisions taken by
managers;
 regulators may not be able to determine the
exact degree of riskiness of loans made by
banks.
222
Implications for the credit market

 Adverse selection ensures that a

disproportionate number of “bad” projects
are presented for financing.
 Borrowers are induced to choose projects for
which the probability of default is higher,
because riskier projects are associated with
higher expected returns.
 May lead to credit rationing; see Stiglitz and
Weiss (1981).
 Banks may be tempted to engage in overly
risky lending activities in the presence of
deposit insurance.
223
Banking Crises
Definition of a Banking Crisis

Problematic, no standard definition:

Example: (Detragiache, Demirguc-Kunt (1998a)).

A distress episode is a crisis when
Ratio of nonperforming loans to total bank loans
exceeded 10%.
Cost of the rescue operation (or bailout) was at
least 2% of GDP.
 Episode involved a large-scale
nationalization of banks (and possibly other
institutions).
 Extensive bank runs took place or
emergency measures (deposit freezes,
prolonged bank holidays, or generalized
deposit guarantees) were enacted by the
government.

226
Problems

Information on nonperforming loans: often not

reliable and timely. Evergreening problem.
 Cost of rescue operations is often difficult to measure
due to the importance of quasi-fiscal costs,
contingent liabilities, and restructuring costs.
 Liquidity provided at below-market interest rates
(quasi-fiscal effect).
 Promise to bail out ailing banks provides an
implicit subsidy.

227
 Estimating the net costs of banking sector restructuring
is difficult; requires assumptions about
 amount of liquidity support;
 present and future incidence of nonperforming loans
and their recovery rate.
 Estimates are often calculated on a gross basis; leads
to overestimation by excluding (Hawkins and Turner
(1999))
 future proceeds from reprivatization;
 loan recovery;
 repayment of the liquidity assistance provided by the
government.

228
 “Run” or “event” criterion: A crisis can indeed,
in some cases, be dated that way.
 Problems
 Runs are often short lived.
 Dramatic “events” rarely represent either the
beginning, or the end, of the crisis.
 In most cases insolvency problems were
already present and worsening; event itself is
merely the point at which underlying problems
are revealed (either to the regulator or the
public).
229
Subprime Mortgage Crisis

230
Background Introduction
 What is Subprime lending? the practice of making loans to
borrowers who do not qualify for the best market interest
rate because of their deficient credit history or inability to
prove they could for the loans they are applying.
 Subprime loan involves high risks.
--housing market
--a combination of high interest rates, bad credit history and
murky financial situations associated with the applicants.

231
Causes of the Crisis
 Many factors created the crisis, but the most immediate
causes were a rising interest rate environment which caused
people with adjustable rate mortgages (ARM) to see
significant increases in their mortgage payments, and
declining property values as the national real estate market
finally began making corrections (Housing bubble bursts).

232
 Role of Mortgage lenders
--Incomplete lending procedure. For example, Many of the
sub-prime loans did not even require that borrowers
document the income listed on their loan application with a
pay stub. some of the lending probably involved actual
fraudulence where people misstated their income and
qualifications.
--adjustable-rate mortgages (ARM); interest-only
adjustable-rate mortgages

233
 Role of Subprime borrowers—homeowners
--With the assumption that housing prices would continue
to increase, many subprime borrowers are encouraged to
obtain ARM.
--Difficult to refinance due to declining property values.
 Role of Regulators
--In response to a concern that lending environment was too
easy or say, not properly regulated, the House and Senate
are both considering making some new bills to regulate
lending practices.

234
Part III- The countrywide influence and the
corresponding reactions
 Drastic fluctuation in stock market--investors began to
worry about whether the Subprime crisis will turn into a
global economic one.
 Many investment banks, mortgage lenders, real estate
investment trusts and hedge funds suffered significant
losses as a result of mortgage payment defaults or mortgage
asset devaluation.
--New Century Finance; American Home Mortgage
--Merrill Lynch;Citigroup

235
 The recession of housing market and the
continually increased oil prices will slow down the
step of economic growth rate of the U.S.

236
 Subprime Mortgage Crisis
 Sharp rise in home foreclosures in late 2006
 Only 9% in 1996, 13% in 1999, 20% in 2006
 $1.3 Trillion subprime mortgage as of March 2007
 The delinquency rate had risen to 21% by 2008

 Subprime Borrowers
 For poor credit history
 Limited income

 Subprime Lenders
 Greater risks
 High returns

237
New Model of Mortgage
Lending

238
Source: BBC News
 Causes of the Crisis
 The Housing Downturn
 Excess supply of home inventory
 Sales volume of new homes dropped
 Reduced market prices (10.4% 12/06-12/07)
 Increasing foreclosure rates

 Borrowers
 Difficulties in re-financing
 Begin to default on loans
 Walk away from properties
 Fraudulent misrepresentations

239
 Causes of the Crisis
 Financial Institutions
 Attraction from high returns
 Offered high-risk loan and incentives
 Believes that will pass on the risk to others

 Securitization
 Mortgage backed securities
 Risk readily transferred to other investors
 From 54% in 2001 to 75% in 2006

240
 Causes of the Crisis
 Government and Regulators
 Community Reinvestment Act, encourages the
development of the subprime debacle
 Glass-Steagall Act contributes to the subprime crisis
(FDIC back up)

 Central banks
 Less concerned with avoiding asset bubbles
 React after bubbles burst to minimize the impact
 No determination on monetary policy
 Institutions risk more because of Fed’s rescue

241
 Direct Impacts of the Crisis
 Stock Market

 08/15/07 Dow Jones had dropped below 13,000 from

July’s 14000
 First 3 weeks of 08, the Dow Jones Industrial Average
fell 9%
 1/18/08 Dow Jones/0.5%, S&P 500/0.6%, and
NASDAQ/0.3%
 01/21/08 (black Monday) the world’s biggest falls since
Sept. 11, 2001

242
 Direct Impacts of the Crisis
 Financial Institutions – Bankruptcy

 New Century Financial (USA)– Apr. 2, 2007

 American Home Mortgage (USA) – Aug. 6, 2007
 Sentinel management Group (USA) – Aug. 17, 2007
 Ameriquest (USA) – Aug. 31, 2007
 NetBank (USA) – Sept. 30, 2007
 Terra Securities (Norway) – Nov. 28, 2007
 American Freedom Mortgage Inc. (USA) – Jan. 30, 2007

243
 Direct Impacts of the Crisis
 Financial Institutions – Write-Downs

 Citigroup (USA) - $24.1 bln

 Merrill Lynch (USA) - $22.5 bln
 UBS AG (Switzerland) - $16.7 bln
 Morgan Stanley (USA) - $10.3
 Credit Agricole (France) - $4.8 bln
 HSBC (United Kingdom) - $3.4 bln
 Bank of America (USA) - $5.28 bln
 CIBC (Canada) – 3.2 bln
 Deutsche Bank (Germany) - $3.1 bln

By 02/19/08 losses or write-downs > U.S. $150 bln

Be expected exceeding $200 - $400 bln

244
 Domestic Impacts of the
Crisis
 Home Owners
 Housing prices down 10.4% in Dec. 07 vs. year-ago
 Sales of new homes dropped by 26.4% in 07 vs. 06
 By Jan. 2008, the inventory of unsold new homes stood
at 9.8 months, the highest level since 1981.
 Two million families will be evicted from their homes

 Minorities
 Disproportionate level of foreclosures in minority
 46% Hispanics, 55% blacks got higher cost loans

245
Domestic Impacts of the
Crisis
 Economy Condition
 Recession
 Low GDP growth rate
 Business close out or lose money (banks, builders etc.)
 Weak financial market
 Low consumer spending
 Lose jobs
 Other credit markets
 Credit card
 Car loan

246
Global Impacts of the Crisis
 Investors will be very cautious to act
 Lack confidence in stock/bound market
 Consumer spending will slowdown
 Lack of cash or unwilling to spend
 World economy may slip into recession
 U.S. economy condition will affect global economy
 GDP growth will be low
 Lose businesses
 Lose jobs
 Economy slow down

247
Global Impacts of the Crisis
 Financial market
 May take long time to recover
 Unemployment rate may be high
 Slow economy increase unemployment rate
 Exports will decrease in China, Korea, Taiwan
 GDP growth heavily depends on export

248
Government and Central Banks’
Actions
 08/2007, President Bush announced – Hope New Alliance
 02/13/08, President signed a tax rebates of $168 bln
 09/18/07, the Fed dropped rate ½ point
 10/31/07, ¼ point cut by Fed
 12/11/07, ¼ point cut by Fed
 01/22/08 the Fed slashed the rate by 3/4 points to 3.5%
 01/30/08 another cut of 1/2 points to 3%
 Central Banks have pumped billions of dollars to banks
 Central Banks of the world have done the same thing

249
 Tema 7
LAS REDES DE SEGURIDAD, LOS
SEGUROS DE DEPÓSITOS Y LOS
INCENTIVOS DE LA BANCA
INTERNACIONAL

LECTURA DE REFERENCIA: CARBÓ

ET AL. 2008. EN PRENSA
Banking Crises: Regulatory Responses

 Information disclosure.
 Strengthening regulation and supervision.

Reforming the financial safety net (deposit
insurance and lender of last resort).

251
Information disclosure


Transparency (e.g. improvements in standards for
data dissemination): viewed as important to crisis
prevention.

Can help markets to improve their pricing of risk,
prevent the buildup of imbalances, and force
policymakers to take timely action to address
vulnerabilities.

However: information disclosure is not a “cure-all.”
Information is noisy and can be misinterpreted;
perverse effect: bank runs.

252
Strengthening regulation and supervision


Current consensus: bank supervision needs to be
strengthened before financial liberalization.

Objectives: ensure adequate internal controls and
procedures, avoid concentrated patterns of credit or
market risk exposure...

…enforce accounting principles and disclosure
requirements...

…impose stricter asset classification and provisioning
practices that reduce the scope for delay in recognizing
bad loans, and encourage banks to make adequate
provisions against loan losses.

253
 Also: improve incentives for supervisors. Risks of
forbearance (leaving insolvent banks in operation) and
regulatory capture: create moral hazard, regulation
becomes ineffective.
 October 1997: Basle Committee on Banking Supervision
released 25 core principles for effective banking
supervision that cover
 licensing structure,
 prudential regulations and requirements,
 methods for on-site and off-site banking supervision,
 information requirements,
 prerogatives of supervisors.

254
 Prudential regulations aimed at containing risks associated
with capital flows:
 Limits on banks’ open net foreign currency positions
(difference between unhedged foreign-currency assets
and liabilities).
 Limits on exposure to volatility in equity and real-estate
markets…
 …would help to insulate the banking system from
bubbles associated with large capital inflows…
 …and help to avoid excessive concentration of credit risk.

255
 Discourage excessive exposures of domestic firms and
(indirectly banks) by taxing short-term capital inflows (e.g.
Chile).
 Impose marginal reserve requirements on deposits
(higher as the maturity of deposits shortens); help to
 insulate the banking system from exposure to the risks of
abrupt reversals in capital flows;
 prevent a credit boom driven by a surge in bank deposits
(ensures a gradual expansion of banks' loan portfolios).
 Attractive goal when capital inflows take mostly the form of
short-term bank deposits.

256

Problems

measures could result in some degree of disintermediation of
capital inflows;

they do not discriminate between “weak” (or undercapitalized)
banks and “strong’” banks, whose behavior is less risky and
credit assessment capacity is strong.

Inadequate supervision: second-best argument for maintaining
restrictions on capital flows, imposing limits on lending growth, or
to proceed more gradually with financial liberalization.

257
Financial safety nets

 Deposit insurance and lender of last resort.


As with any form of insurance, they both tend to
exacerbate the problem of moral hazard:

If banks know (or believe) that they will be
rescued in case of liquidity problems, they will
have fewer incentives to manage their
portfolios prudently.

If depositors are insured against loss, they will
have limited incentives to monitor the
soundness of the institutions with which they
place their funds.
258
Financial safety nets--Deposit insurance

Benefits
 If depositors' funds are guaranteed, borrowers
need not worry about bank soundness.
 May eliminate costly runs (Diamond-Dybvig).
Pitfalls
 If deposits are guaranteed, depositors will not
monitor bank quality.
 Insolvent banks will continue to operate as long as
government guarantees are credible.
 Because they are not liable for doing poorly, banks
may take on riskier loans.
259
 Deposit insurance cannot prevent bank runs resulting from a
loss of confidence in the currency, because it generally
does not guarantee the foreign-currency value of deposits.

Mitigating Moral Hazard

 Reduce risk to the system by closely monitoring banks'
activities and supervising compliance with regulations.
 Limit explicit deposit insurance (coinsurance).
 Both insured and insurer are responsible for some loss.
Depositors may lose a certain % of the covered amount (UK)
or bear a specified fraction of the loss at different levels of
coverage (Italy).

260
 Limitations
 Partial deposit insurance may not
strengthen discipline; de facto treatment of
depositors after bank failures is often more
generous than de jure arrangements.
 Small depositors may be too dispersed or
too unsophisticated to exert much pressure
(through deposit withdrawals) on weak
banks.

261
 Adjust premiums for risk to induce greater monitoring by
depositors and enhance cautious lending practices.
 In practice, however: differences in premium rates across
banks are small.
Evidence
 Garcia (1999): survey of the characteristics of explicit
deposit insurance system (DIS) in 68 industrial and
developing countries.
 DIS: often introduced in the context of a crisis.
 Example: Asia: full guarantee of deposits put in place during
the crisis (Korea, Malaysia).

262
 Countries with Explicit Deposit Insurance Systems

Middle Western
Africa Asia Europe
East Hemisphere

Cameroon Bangladesh Austria Latvia Bahrain Argentina

Central African Republic India Belgium Lithuania Lebanon Brazil
Chad Japan Bulgaria Luxembourg Oman Canada
Congo Korea Croatia Macedonia Chile
Equatorial Guinea Marshall Islands Czech Rep. Netherlands Colombia
Gabon Micronesia Denmark Norway Dominican Rep.
Kenya Philippines Estonia Poland Ecuador
Nigeria Sri Lanka Finland Portugal El Salvador
Tanzania Taiwan France Romania Jamaica
Uganda Germany Slovak Rep. Mexico
Gibraltar Spain Peru
Greece Sweden Trinidad & Tobago
Hungary Switzerland United States
Iceland Turkey Venezuela
Ireland Ukraine
Italy United Kingdom

10 9 32 3 14

263
Source: Gillian (1999).
 Coverage levels: vary across countries.
 IMF: uses twice per capita income as a rule of thumb to
evaluate coverage levels (other factors: distribution of
deposits by size).
 Significant negative relation between per capita income and
DIS coverage ratio. Interpretation: moral hazard is stronger
in developing countries.
 Almost one-third of the total use risk-adjusted premiums.
 Co-insurance features: more limited.

264
 Shift away from voluntary DIS to compulsory schemes
(more than 80% now; 55 out of 68); reduces adverse
selection problems.
 DIS now tend to be funded by member institutions, with
access to emergency financing from the government.
 Trend toward excluding foreign-currency deposits from
coverage; in Garcia’s sample, 40% do so.
 Many countries that cover foreign-currency deposits pay
out in domestic currency to protect the DIS from exposure
to foreign exchange risk.

265
 Ratio of Deposit Coverage to per capita GDP, 1999
Chad Venezuela
Ro mania
Central African Republic
J amaica
Cameroo n
Greece
Oman
Sri Lanka
P eru Trinid ad and To b ag o
Uganda Tanzania
Norway United King d o m

Dominican Republic Po rtug al

Italy Gab o n
Bulg aria
India
Average ratios for: Swed en
Banglades h
the World - 3.0 Sp ain
Kenya
Africa - 6.2 Finland
Republic of Congo Asia - 4.0 Hung ary
Brazil Europe - 1.6 Netherland s

Taiwan Middle East - 3.4 Aus tria

Croatia Western Hemisphere - 3.2 Ireland

Germany
United States
Iceland
Argentina
Denmark
Equatorial Guinea
Chile
P hilippines Belg ium
France Bahrain
El Salvador Leb ano n

Czech Republic Switzerland

Luxemb urg
Colombia
Es t o nia
Lithuania
Ukrain
Slovak Republic
Po land
Nigeria Lat via
Canada Maced o nia

2 7 12 17 0 0.5 1 1.5 2

266
Source: Garcia (2000).
Impact on banking stability

 Limited evidence. Demirguc-Kunt and Detragiache

(1999): sample of 61 countries for 1980-97.
 Explicit DIS is detrimental to bank stability, when
bank interest rates are deregulated and institutional
environment is weak.
 Adverse impact tends to be stronger the larger the
coverage, when the scheme is funded, and where it
is run by the government rather than the private
sector.
 Interpretation: unless other safeguards are in
place, DIS induces more risk-taking.
267
Financial safety nets--Lender of last resort

Benefits
 Informational asymmetries: make solvent banks
vulnerable to deposit runs and/or inadequate access to
interbank lending in times of crisis.
 Domino effect or too big to fail problem (insolvent
bank): potential risk to stability of the financial system as a
whole following the failure of a solvent bank.
 Bail out is rational to avoid threats to the entire system.
Absence of a LOLR facility can drive illiquid banks into
insolvency by forcing them to liquidate their assets at “fire
sale” prices.

268
Pitfalls
 Direct financial cost involved in the explicit provision of
funds to insolvent institutions; potential losses.
 By insuring banks against the costs of liquidity or solvency
problems, the provision of liquidity may increase moral
hazard. Government guarantees may thus lead to greater
incentives to take on risky loans.
 The existence of a LOLR with the ability to print money can
allow inflationary beliefs to become self-fulfilling (Antinolfi,
Huybens, and Keister (2001)).

269
Implications
 Central bank needs to weigh the cost of providing capital to
a possibly insolvent bank against the cost of the instability
generated by not doing so.
 In practice: difficult.
 Constructive ambiguity: may limit moral hazard by
introducing an element of uncertainty into the provision of
LOLR assistance (Enoch, Stella, and Khamis (1997)).
 Difficult notion to pin down; encompasses, besides
uncertainty as to whether intervention will occur at all,
uncertainty regarding both its exact timing and the terms
and penalties attached to it.

270
Tema 8
MEDIOS DE PAGO: TARJETAS
BANCARIAS Y MERCADOS
BILATERALES

LECTURA DE REFERENCIA:
ROCHET Y TIROLE, 2003
 An Overview

The
Cardholder Banks Corporate Merchant Processor
Players
Issuing and Sponsor / POI
Acquiring

The Access Device Rewards Program Collateral

Programs (Card, Transponder, (Points, (Loyalty supplier, (setup, statements,
Specifics Terminals ….) coupons…) database, rules) printed materials)

The Technology
How!
(Systems, processing, hardware, firmware, Issuing)

272
Electronic Payment Systems

 Electronic commerce involves the exchange of

some form of money for goods and services.

 Implementation of electronic payment systems

is in its infancy and still evolving.

 Electronic payments are far cheaper than the

traditional method of mailing out paper
invoices and then processing payments
received.

273
Electronic Payment Systems

 Estimates of the cost of billing one person

vary between $1 and $1.50.

 Sending bills and receiving payments over

the Internet promises to drop the
transaction cost to an average of 50 cents
per bill.

 Today, four basic ways to pay for purchases

dominate business-to-consumer commerce.
274
Electronic Payment Systems

275
Electronic Payment Systems

 Electronic cash distribution and payment can

be handled by wallets, smart cards, or
proprietary, limited-use scrip.

 Scrip is digital cash minted by a company

instead of by a government.

 Companies like Payment Online sell packages

of payment processing services to Web
merchants that accept several types of
payments.

276
Payment Cards

 Payment cards are all types of plastic cards that

consumers use to make purchases:
 Credit cards
 such as a Visa or a MasterCard, has a preset
spending limit based on the user’s credit limit.

 Debit cards
 removes the amount of the charge from the
cardholder’s account and transfers it to the
seller’s bank.

 Charge cards
 such as one from American Express, carries no
preset spending limit.
277
Advantages and Disadvantages
of Payment Cards

 Advantages:
• Payment cards provide fraud protection.
• They have worldwide acceptance.
• They are good for online transactions.

 Disadvantages:
• Payment card service companies charge
merchants per-transaction fees and
monthly processing fees.

278
Payment Acceptance and
Processing
 Open and closed loop systems will accept
and process payment cards.

 A merchant bank or acquiring bank is a

bank that does business with merchants
who want to accept payment cards.

 Software packaged with your electronic

commerce software can handle payment
card processing automatically.
279
Payment Acceptance and
Processing

280
PAYMENT SYSTEMS ARE TWO-SIDED
MARKETS

-Card payment systems provide joint services to two

users: the cardholder and the merchant.
-Even if surcharging is allowed, merchants are reluctant
to do it.
-Thus it is important to send the correct price signal to
the cardholder, who has the last word about the means
of payment.
-We have a Two-Sided Market because the price
structure matters. 281
 OTHER TWO-SIDED MARKETS

Platform
Buyers Sellers

readers/viewers newspapers, TV operators advertisers

players video consoles game developers
computer users operating systems Software
consumers shopping malls developers
shops
For all these platforms, finding the appropriate business
model (price structure) is vital. 282
 OTHER TWO-SIDED MARKETS

Price structure is often skewed in two-sided markets:

Video consoles are subsidized by platforms
(extract revenue from developers)
Some TV channels and newspapers are free for
readers (only advertisers pay)
Most shopping malls subsidize buyers (free
parking)
This does not mean that prices should be regulated.
Also, traditional competition policy analysis (excessive
prices, predation) does not apply.
283
 THE ROLE OF INTERCHANGE FEES

- In proprietary systems (AMEX, Diners Club) the price

structure is chosen by the network.
- In four-party systems, payment services are provided
jointly by two providers: the issuer and the acquirer.
- The interchange fee is a transfer between the two
providers that sets the rule for allocating the total cost
of the card payment between these two providers.
284
 THE ROLE OF INTERCHANGE FEES
Prices and costs in a four-party system (system fees and costs
neglected)

marginal cost cI marginal cost c A

pays p  a
Issuer Acquirer
(a: interchange fee)

pays pays
p  pc ( pc : cardholder fee) p  pM ( pM : merchant
service charge)
sells good at price p
Cardholder Merchant

Thus decreasing a implies : cost decrease for acquirers

and revenue decrease (cost increase) for issuers
285