FIN 683 Financial Institutions Management The Specialness of Banks

Transcription

1 FIN 683 Financial Institutions Management The Specialness of Banks Professor Robert B.H. Hauswald Kogod School of Business, AU Alternative Views on the Financial System Increasingly complex financial instruments have contributed to the development of a far more flexible, efficient and hence resilient financial system than the one that existed a quarter century ago. - Alan Greenspan, November 2005 The bright new financial system for all its rich rewards and unimaginable wealth for some has failed the test of the marketplace by repeatedly risking a cascading breakdown of the system as a whole. - Paul Volcker, April

2 Bank Losses and Credit Crunch Credit crunch: contraction in the supply of credit a contraction in the supply funds in a market Who is contracting their supply of credit? Banks because of losses that initially stemmed from the subprime mortgage market Losses spread to other credit markets Commercial real estate loans Leverage loans Other subprime consumer loans 3 Financial System Architecture Financial institutions profits outsized i.e., they exceed value added The model interrupted: the credit crunch A crunch can involve multiple markets US: 1990 to 1992 Scandinavia: 1991 to 1994 Japan: 1992 to 2000 US: 2008 to

3 Financial System Architecture: Normal Flow of Funds $ Financial Intermediaries $ $ Saver/ Investors $ Business Consumers $ $ $ Securities Markets $ $ 5 Financial System Architecture: Credit Squeeze or Crunch A CRUNCH $ Financial Intermediaries $ $ Saver/ Investors $ Business Consumers $ $ $ Securities Markets $ $ 6

4 Financial System Profits: Outsized 1980s 2007 Percent of gross domestic value-added 8% 15% Percent of private sector employment 4% 5% Percent of stock market capitalization 6% 19% Percent of corporate profits 10% 40% Continued financial sector growth even after the fundamentals weakened or fell away. What about executive compesation? 7 Finance Sector Profit & Gross Value-Added (% of total corporate) 8

5 Credit-Crunch Evidence Bank liquidity creation fell dramatically predates inception of banking crisis (April or August 2007) Fed s Senior Loan Officer Survey began showing tightening loan standards in 2006 Index turned negative in early 2007 (net negative response by lenders) escalating in third quarter The net percentage of large and medium-sized banks, and the net percentage of small banks, that reported a tightening of standards was 55.4% and 51.8% respectively. None of the surveyed banks reported any easing of standards. Comparable to prior to comparable crunches in 1990 or Liquidity Contraction: (Liquidity = Liquidity Transformation) Abnormal amount of liquidity creation around 1990 credit crunch (1990:Q1 1992:Q4) (in $ billion) Source: Financial Crisis and Bank Liquidity Creation, Allen N. Berger and Christa H.S. Bouwman, University of South Carolina working paper(august 2008). 10

6 Liquidity Contraction: (Liquidity = Liquidity Transformation) Abnormal amount of liquidity creation around the dot.com bubble and the Sept. 11 terrorist attack (2000:Q2 2002:Q3) (in $billions) Source: Financial Crisis and Bank Liquidity Creation, Allen N. Berger and Christa H.S. Bouwman, University of South Carolina working paper(august 2008). 11 Liquidity Contraction: (Liquidity = Liquidity Transformation) Abnormal amount of liquidity creation in today s crisis (2007:Q3 2008:Q1) (in $billions) Source: Financial Crisis and Bank Liquidity Creation, Allen N. Berger and Christa H.S. Bouwman, University of South Carolina working paper(august 2008). 12

7 Financial Market (Liquidity = Trading Liquidity) (a) Sources: Bank of England, Bloomberg, Chicago Board Options Exchange, Debt Management Office, London Stock Exchange, Merrill Lynch, Thomson Datastreamand Bank calculations (see Bank of England Financial Stability Report (April 2008). (a) The liquidity index shows the number of standard deviations from the mean. It is a simple unweighted average of nine liquidity measures, normalised on the period The series shown is an exponentially weighted moving average. The indicator is more reliable after 1997 as it is based on a greater number of underlying measures. 13 Spillovers to Other Markets Bank loan market: interbank market Commercial paper market Traditional Asset-backed Residential and commercial mortgage markets Consumer loan market Prime Subprime Junk bond market Private placement market 14

8 Credit Squeeze Example: U.S. SME Market o = open lending channel x = constricted lending channel 15 Credit Squeeze Example: Japanese SME Market, o = open lending channel x = constricted lending channel 16

9 Current Credit Squeeze: U.S. SME Market o = open lending channel x = constricted lending channel 17 Credit-Crunch Causes Banks suffer a shock that affects their ability and/or incentive to lend Many types of potential shocks: historical shocks include, for example: Capital shock (US , Japan ) Regulatory reporting shock (US ) Regulatory scrutiny shock (US ) Risk-based capital shock (US ) Currently: capital shock caused initially by losses in the subprime mortgage market 18

10 Capital-Shock Mechanics Banks must meet required capital requirements (e.g, S.E./T.A. > 8%) Banks have target capital requirements driven by reputation/credibility effects Losses deplete capital, i.e., shareholder equity Banks must either Raise more equity: e.g., sovereign wealth funds Reduce assets by contracting lending: balance sheet shrinks 19 Banking in the News February 29, 2008, 11:59 am, WSJ Banks May Need to Shrink by $2 Trillion on Subprime Losses Mortgage losses, compounded by contemporary risk management and accounting practices could prompt banks and other lenders to shrink their lending and other assets by a staggering $2 trillion, a new study concludes. The resulting withdrawal of credit could knock one to 1.5 percentage points off economic growth, significantly compounding the impact of collapsing home construction and softer consumer spending due to lower home wealth, the study, presented at a joint academic-wall Street forum in New York Friday. 20

11 Securities Loans TA BIG BANK ,000 Bank charges off $10 in loan losses Securities Loans TA Deposits S.E. TL&SE SE/TA =8% BIG BANK Deposits S.E. 875 TL&SE SE/TA = 8% ,000 Securities Loans TA BIG BANK Deposits S.E. TL&SE SE/TA = 7.07% 875 Bank reduces loans by $ WSJ 3/4/08 22

12 Economist (August 9-15, 2008) 1/19/2016 WSJ 1/18/08 Bank Specialness Robert B.H. Hauswald 23 Financial Intermediaries are Special Special role of FIs in the financial system and the functions they provide FIs receive special regulatory attention Some FIs more special than others Put the recent/current financial crisis into perspective consequences: credit crunch origins: revisited later 1/19/ Bank Specialness Robert B.H. Hauswald

13 Without FIs Households (net savers) Equity & Debt Cash Corporations (net borrowers) 1/19/ Bank Specialness Robert B.H. Hauswald FIs Specialness Without FIs: Low level of fund flows. no aggregation: transaction costs no scale economies in screening, monitoring, etc. Information costs Economies of scale reduce costs for FIs to screen and monitor borrowers Less liquidity Substantial price risk 1-26

14 With FIs Households FI (Brokers) Corporations Cash Deposits/Insurance Policies FI (Asset Transformers) Equity & Debt Cash 1-27 Brokerage Functions Acting as an agent for investors: e.g. Merrill Lynch, Bank of America 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 Transformation of financial risk 1/19/ Bank Specialness Robert B.H. Hauswald

15 Role of FIs in Cost Reduction Investors exposed to Agency Costs asymmetric information + conflict of interest Role of FI as Delegated Monitor FI likely to have informational advantage Economies of scale in obtaining information. FI as an information producer Shorter term debt contracts easier to monitor than bonds Greater monitoring power and control Acting as delegated monitor, FIs reduce information asymmetry between borrowers and lenders 1-29 Specialness of FIs FI have an advantage in assuming certain risks Liquidity and Price Risk: why? Secondary claims issued by FIs have less price risk Demand deposits and other claims are more liquid More attractive to small investors FIs have advantage in diversifying risks 1/19/ Bank Specialness Robert B.H. Hauswald

16 Other Special Services Reduced transactions costs Maturity intermediation Transmission of monetary policy. Credit allocation (areas of special need such as home mortgages) Intergenerational transfers or time intermediation Payment services (FedWire and CHIPS) Denomination intermediation 1-31 Specialness and Regulation FIs receive special regulatory attention. Rationale: banks provide externalities Positive externalities: services, information Negative externalities of FI failure Special services provided by Fis: vital Institution-specific functions such as money supply transmission (banks), credit allocation (thrifts, farm banks), payment services (banks, thrifts), etc. 1-32

17 Regulation of FIs Objective of regulatory policy: Protect ultimate sources and users of savings Including prevention of unfair practices such as redlining and other discriminatory actions Primary role: Ensure soundness of the overall system Goes hand in hand with supervision is banking the most regulated/supervised sector? 33 Regulation Safety and soundness regulation: targeted at individual institutions protect depositors Regulations to increase diversification No more than 10% of equity to single borrower Minimum capital requirements TARP and Capital Purchase Program Systemic soundness like the military, always fighting the last crisis 1/19/ Bank Specialness Robert B.H. Hauswald

18 Fragmented Regulation Guaranty funds: Deposit insurance fund (DIF): Securities Investors Protection Fund (SIPC) Monitoring and surveillance: FDIC monitors and regulates DIF participants Increased regulatory scrutiny following crises Regulation is not costless Net regulatory burden 1-35 Web Resources For information on regulation of DIs and investment firms visit: FDIC SIPC Federal Reserve Appendix 1B of text

19 Monetary Policy Federal Reserve directly controls outside money Bulk of money supply is inside money: deposits Reserve requirements facilitate transmission of monetary policy Explains the heavy involvement of the FRB in regulating banks expertise 1/19/ Bank Specialness Robert B.H. Hauswald Credit Allocation Regulation Supports socially important sectors such as housing and farming political rather than economic reasons Requirements for minimum asset amounts in a particular sector or maximum interest rates or fees Qualified Thrift Lender Test (QTL) 65 percent of assets in residential mortgages Usury laws and Regulation Q (abolished) 1-38

20 Consumer Protection Consumer protection regulation Community Reinvestment Act (CRA) Home Mortgage Disclosure Act (HMDA) Effect on net regulatory burden FFIEC processed info on as many as 17 million mortgage transactions in 2009 Analysts questioning the net benefit 1-39 Consumer Protection Regulation Potential extensions of regulations CRA to other FIs such as insurance companies in light of consolidation and trend toward universal banking New additions: Consumer Financial Protection Agency (2009) Credit card reform bill effective

21 Investor Protection Regulation against abuses such as insider trading, lack of disclosure, malfeasance, breach of fiduciary responsibility Key legislation Securities Acts of 1933, 1934 Investment Company Act of 1940 Primary regulator: SEC 1-41 Entry Entry regulation: fragmentation changed in 1933: state banking unsustainable: inter-state branching Level of entry impediments affects profitability and value of charter. Regulations define scope of permitted activities Financial Services Modernization Act of 1999 Affects charter value and size of net regulatory burden 1/19/ Bank Specialness Robert B.H. Hauswald

22 Web Resources For more information on regulation of depository institutions visit: FFIEC Federal Reserve FDIC OCC Changing Dynamics of Specialness Decline in share of depository institutions and insurance companies Increases in investment companies May be attributable to net regulatory burden imposed on depository FIs Financial Services Modernization Act Financial services holding companies 1/19/ Bank Specialness Robert B.H. Hauswald

23 Risk and the Financial Crisis Reactions to FSM Act and other factors: more competition between banks and markets banks became hedge funds Shift from originate and hold to originate and distribute Affects incentives to monitor and control risk. Shift to off balance sheet risks Degraded quality and increased risk Housing market bubble encouraged subprime market and more exotic mortgages 1-45 Global Trends US FIs facing increased competition from foreign FIs Only 2 of the top ten banks are US banks Foreign bank assets in the US typically more than 10 percent As high as 21.9 percent Emerging-market banks are becoming important: BRICS 1-46

24 Largest Banks 1-47 Financial Crisis DJIA fell 53.8 percent in less than 1 ½ years as of mid-march 2009 Record home foreclosures 1 in 45 in default in late 2008 Goldman Sachs and Morgan Stanley only survivors of the major WS houses became banks 1/19/ Bank Specialness Robert B.H. Hauswald

25 Financial Crisis AIG bailout Citigroup needed government support Many other banks applied for and received government guarantees Chrysler and GM declared bankruptcy in 2009 Unemployment in excess of 10 percent Unprecedented liquidity injections by Fed consequence? costs? 1/19/ Bank Specialness Robert B.H. Hauswald Beginning of the Collapse Home prices plummeted in Mortgage delinquencies rose Forelosure filings increased 93 percent from July 2006 to July 2007 Securitized mortgages led to large financial losses Subprime mortgages Countrywide Financial bailed out and eventually taken over by Bank of America 1/19/ Bank Specialness Robert B.H. Hauswald

26 Significant Failures and Events Bear Stearns funds filed for bankruptcy Acquired by J.P. Morgan Chase Fed moved beyond lending only to Depository Institutions Government seizure of Fannie Mae and Freddie Mac Lehman Brothers failure Crisis spread worldwide 1/19/ Bank Specialness Robert B.H. Hauswald Rescue Plan Federal Reserve and other central banks infused $180 billion $700 billion Troubled Asset Relief Program (TARP) Still struggling in 2009 $827 billion stimulus program American Recovery and Reinvestment Act of

27 Conclusion Banks exist for many economic reasons: there is no unique view, nor a unified theory Apart from transaction costs, the main reasons why financial intermediaries exist are intertemporal insurance screening monitoring 53 Pertinent Websites The Banker Federal Reserve FDIC FFIEC Investment Co. Institute OCC SEC SIPC Wall Street Journal

28 When FIs Fail: Subprime Mortgages FIs involved both as brokers and asset transformers Packaged and sold mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) Many MBS s had subprime mortgages Many CDO s bought subprime mortgage MBS s Invested in directly and indirectly in MBS and CDOs asset-transformers 55 Subprime A subprime mortgage has lower underwriting standards Low credit score (e.g., a FICO score below 650) No documentation (Lo Doc): no income verification Loan/value ratio > 80% Also, often have teaser rates 56

29 Asset Backed Securities MBS: security back by mortgages a trust that owns mortgages and issues securities to investors Can be engineered artificially to segment risk:., defaults first go to the riskier traunches CDO: bond issued by a trust that owns fixed income debt obligations (or derivatives). the problem CDOs have invested in subprime MBS Can be engineered to segment risk: Possibly double engineered! 57 The Perfect Storm What is the problem? Housing prices have been falling Record number of defaults and foreclosures Subprime most affected What happened to the securities? What happened to the financial institutions which bought subprime paper? 58

30 Who s Fault? Rating agencies looked only at recent MBS payment performance Many originators immediately sold mortgages Insufficient screening and monitoring incentives Incentive to encourage home buyers to buy too much house Predatory lending 59 Greed and Fear Banks made lots of money creating MBS s and CDO s ( bps) These packagers lacked incentives to screen and monitor Mostly an unregulated market Fed examiners only saw narrow picture Some homebuyers may have been imprudent Wanted to keep up with the neighbors Wanted to cash in on hot real estate market 60

31 This image cannot currently be displayed. Housing Sales Decline and Inventories Rise Single-family Home Sales (thousands) Inventory of Unsold Homes (months supply) 1600 Existing 6400 Existing homes New 4000 New homes '04 '05 '06 ' Housing Prices Fell Home price index change (percent change over prior year) 20 Case-Shiller Home Price Index OFHEO price index -5 '75 '80 '85 '90 ' '05 62

32 with Larger Declines in Some Case-Shiller Home Price Index Markets (percent change over prior year) '88 '90 '92 '94 '96 '98 '00 '02 '04 '06-10 Miami Phoenix San Diego National Subprime Mortgage Backed Securities Issuance $600 24% $450 18% $ volume (billions) billions $300 12% % of total mortgage originations $150 6% $ % Source: Inside Mortgage Finance, The 2007 Mortgage Market Statistical Annual 64