LIQUIDITY RISK, CREDIT RISK AND MONETARY POLICY

Transcription

1 LECTURE 3 LIQUIDITY RISK, CREDIT RISK AND MONETARY POLICY 1

2 State Council CBRC PBC Depository Instituion Non-Depository FIs Stateowned CB: ICBC CCB BOC ABC BCommu Joint-Stock CB CTIIC Everbright Huaxia Minsheng Merchant Industrial Guangfa Pingan Pudong Development Hengfeng Rural FI Rural CB Rural Cooperativ e Bank Rural credi union Rural County banks City CB Postal Savings Banks Private Bank Foreign Bank Policy Bank Zheshang 2 Bohai DB EIBC ADBC State-owned Asset management Corporation Xinda Huarong Greatwall Orient Other NDFIs Trust, Finance, Motor Finance, Consumer Finance, Money Broker

3 Banking Reform Before 1979 People s Bank of China (PBC) was a monopoly Collected household deposit with the nation-wide branch network Facilitated the financing of economic plan, but not channel deposit to profitable projects Provided settlement of firms transaction and administered funding for working capital and short-term investment 3

4 Banking Reform 1st phase: Transformed PBC to be the central bank Established 4 State Owned Banks Industrial and Commercial Bank of China (ICBC) took over lending and deposit taking in the cities Agricultural Bank of China (ABC) did the same in the countryside China Construction Bank (CCB) focused on project financing Bank of China (BOC) handled foreign-trade and foreign exchange transactions Mandated to give loan to government project Loss making and resulted in rising NPL 4

5 Banking Reform ----Phase II 1994 onwards The People Congress issued The Law of PBC in March 1995 Allowed the PBC to play an increased regulatory role The PBC reorganized 31 provincial branches into 9 regional centers Reduce political interference from provincial leaders Analogous to the Fed System of the USA The Functions of the PBC To promote economic growth and stabilize the price To supervise the financial system (Transferred the banking supervision to China Banking Regulatory Commission (CBRC) in 2003) To make monetary policy under the leadership of the State Council 5

6 Banking Reform ----Phase II 1994 Onwards Established 3 policy banks China Development Bank focused on large-scale infrastructure projects Export-Import Bank focused on export promotion Agricultural Development Bank focused on supporting rural economy Commercial Banking Law 1995 SCBs are responsible for profit and assessing credit by themselves The power of national bank headquarters was strengthened: Personnel power centralized in Beijing to reduce political interference from provincial leaders Entry deregulation New banks emerge, such as Minsheng Bank was formed in 1996 Foreign banks 6

7 Banking Sector 1994 People s Banks of China Policy Banks (3) SCBs (4) Other Commercial Banks (100+) Non-bank Financial Institutions (1000+) Market Share > 70% Most important source of capital for firm Joint stock banks (JSBs), City commercial banks (CCBs), urban and rural credit 9/27/2017 ACEM, SJTU, cooperatives Nan Li 7

8 Reforming the State Owned Banks Cleaning up the NPL 1998: Ministry of Finance (MoF) issued special bonds and injected the bond proceeds as equity in the SOBs 1999: Transferred NPL to four asset management companies (AMCs) NPL transfer is a major step before the SOBs proceed with corporate restructuring by introducing foreign strategic investors and IPO 2004, Reform of state owned banks started, Bank of China and Construction Lt. Corp. established, state-owned commercial banks Capital stakes from strategic foreign investors To improve governance, management and efficiency IPO: In 2005, 3 SCBs were prepared for IPO Credit allocation and interest rate deregulation Foreign competition 8

9 Assets and Liabilities in Banking Trillions RMB Financial Instituitions China Total Asset Total Liability

10 China: Banking Structure % 12.5% 19.0% 19.0% 36.0% State Owned Joint Stock State Owned Joint Stock City Rural City Rural Other Other 10

11 Total Asset Policy banks& the CDB Largecommercialbanks Joint-stock commercialbanks Non-bank financialinstitutions Foreign banks rural city&urban 11

12 Recent Concern Increasing competition from non-bank financial instituion Mobile payment Internet banking, e-commerce Financial innovation 12

13 Mobile Payment in China 13

14 Mobile Payment in China 14

15 Mobile Payment in China 15

16 Mobile Payment in China Threat or opportunity for banking industry in China? 16

17 Mobile Payment in China Problems associated with the rapid growth of mobile payment in China: Why mobile payment grow in China so fast? Threat or partner of banking industry? Potential risks? How to regulate? 17

18 Part 2 LIQUIDITY RISK 18

19 Typical Liquidity Risk Exposure High exposure: Depository Institutions Moderate Exposure: Life Insurance Companies Low exposure: Mutual funds, hedge funds, pension funds, property casualty insurance companies.

20 Liquidity Risk Sudden inability to meet asset or liability demands, can arise on both sides of balance sheet Infrequent but can destroy a bank if serious Liquidity is a difficult risk to manage 20

21 Causes of Liquidity Risk: Liability side Reliance on demand deposits Core deposits provide bank with stable funding, comprising generally savings, fixed (except Jumbo CDs) and some portion of demand deposits Net deposit drain is how much deposit withdrawals exceed additions, and can be forecast using probability distribution Seasonality effects in net withdrawal patterns 21

22 Distrubtion of Net Deposit Drains 22

23 Causes of Liquidity Risk: Asset Side May be forced to liquidate assets too rapidly Faster sale may require much lower price May result from OBS loan commitments and other credit lines Levels of loan commitments were dangerously high according to regulators 23

24 Measure Liquidity Risk: Asset Side Much easier to control through loan management Measuring liquidity exposure Net Liquidity Statement lists sources and uses of funds Typical ratios for peer group ratio comparison are: Loan/Deposits, Borrowed funds/total assets, Loan Commitments/Total assets Liquidity ratio Liquidity index: can be constructed as weighted average of Fire Sale Price/Fair Market Price of asset. Ratio ranges from 0 to 1. Financing gap and financing requirement Financing gap = average loan average deposits Financing requirement (borrowed fund) = financing gap + liquid asset Liquidity planning uses a great deal of forecasting 24

25 Sources of Liquidity Net Liquidity Position 1. Total cash-type assets $2, Maximum borrowing funds limit 12, Excess cash reserves 500 Total $14,500 Uses of Liquidity 1. Funds borrowed $6, Federal Reserve borrowing 1,000 Total 7,000 Total Net Liquidity $7,500 25

26 Manage Liquidity Risk: Liability side Purchased liquidity management Federal funds market or repo market. Managing the liability side preserves asset side of balance sheet. Borrowed funds likely at higher rates than interest paid on deposits. Deposits are insured 26

27 Choice of Liability Structure Transaction accounts: Demand deposit and NOW accounts, Passbook Savings Accounts, Money market deposit accounts Retail Time Deposit and CDs Wholesale CDs and Time Deposit Borrowed fund Fed funds and repos Other borrowings Bankers acceptances, Commercial paper, Medium-term notes, Discount window loans. Tradeoff between withdrawal risk and cost of fund 27

28 Funding Risk versus Cost Liquidity management: a Knife-Edge problem. 28

29 Manage Liquidity Risk: Asset Side Stored Liquidity Management Liquid assets. In absence of reserve requirements, banks tend to hold reserves. E.g. In U.K. reserves ~ 1% or more. Downside: opportunity cost of reserves. Decreases size of balance sheet Requires holding excess non-interest-bearing assets Combine purchased and stored liquidity management 31

30 Liquid Asset Management Liquid Asset Examples: cash, T-bills, T-notes, T-bonds Return-risk trade-off for holding liquid asset Benefits of holding large quantities of liquid assets cash immediacy Costs of holding liquid assets reduced return Constrained optimization Privately optimal reserve holdings Regulator imposed reserve holdings 32

31 Minimum Reserve Requirement Reasons for regulating: Monetary policy Multiplier effect of changes in reserve requirements Taxation Due to absence of interest on reserves, requiring reserves constitutes transfer of a resource to the central bank. Composition of liquid asset portfolio U.S. banks: cash-based, but banks view government securities as buffer reserves. Cash and government securities in countries such as U.K. (20%) Singapore: 20% for liquid asset and 3% for cash reserve 33

32 U.S. Cash Reserve Requirements Incremental reserve requirements against net transaction accounts: Less than $8.5 million 0.0% $8.5 million to $45.8 million 3.0% Over $45.8 million 10.0% Transaction accounts: deposits that permit the account holder to make multiple withdrawals by negotiable or transferable instruments (demand deposit, NOW accounts, share draft accounts offered by credit union) 34

33 China Reserve Ratio Small and Medium DFIs Large DFIs (Deposit) Reserve Ratio ( 存款准备金 ) In general high compare to other country Recently reduce the reserve ratio for special types of Fis in order to promot SME loans 35

34 Liquidity Risk and Bank Runs Can arise due to concern about bank s solvency. Failure of a related FI. Sudden changes in investor preferences. Demand deposits are first come first served. Depositor s place in line matters. Bank panic: systemic or contagious bank run. banking panics : 10,000 failed commercial banks. 37

35 Alleviating Bank Runs: Regulatory measures to reduce likelihood of bank runs: FDIC FDIC created in wake of banking panics , with original coverage: $2,500. Now $100,000. Between : FDIC worked. Failures accelerated in 1980 In 1991: Borrowed $30 billion from Treasury and still generated a $7 billion deficit Discount window Not without economic costs. 38

36 Causes of depository fund insolvency Financial Environment: Rise in interest rates. Collapse in oil, real estate and commodity prices. Increased competition. Moral Hazard: Deposit insurance encouraged underpricing of risk and reduced depositor discipline. Premiums not linked to risk. Role of implicit premiums Inadequate monitoring. 39

37 Trade-off: Moral hazard & bank run risk Insurance was not actuarially fairly priced. Reduced incentive for runs. Reduced incentives for depositors to monitor DIs Increased moral hazard. 40

38 Deposit Insurance Premium Bank A Bank B Assets Liabilities Assets Liabilities Real Estate Loans 100 Deposit 100 T-Bills 100 Deposit

39 Risk-Based Deposit Insurance Applying option pricing to insurance premiums: Limited liability of stockholders Practical problems in applying option pricing to insurance premiums DI s asset values and risk are not easily observable FDIC adopted risk-based premiums 1993 Increased capital requirements, stricter closure rules Prompt Corrective Action (1992). 42

40 Risk-Based Deposit Insurance Based on: Categories and concentrations of assets Categories and concentrations of liabilities insured, uninsured, contingent, noncontingent Other factors that affect probability of loss Deposit insurer s revenue needs. Beginning in January 2007 FDIC started calculating risk premiums in more aggressive manner (See Appendix 19A). 43

41 Controlling DI Risk Taking Regulatory discipline Perception of 2 weaknesses in regulatory practices: Frequency and thoroughness of examinations Forbearance shown to weakly capitalized banks (pre- 1991?) Examinations: improved accounting standards including market valuation of assets and liabilities; annual on-site examination of every bank; independent audits. Capital forbearance: Prompt Corrective Action. Transition to rules rather than discretion. 44

42 Controlling DI Risk Taking: Depositor Discipline Under current deposit insurance regulations, neither insured nor uninsured depositors have sufficient incentive to monitor Insured: Coverage ceiling is per bank or thrift Insurance cap can be increased by altering structure of deposit funds and by spreading deposits across banks. Higher interest rates provided incentive to deposit in riskier banks -up to coverage limit. 45

43 Solution: Controlling DI Risk Taking: Depositor Discipline Limits on brokered deposits: Controlled by FDICIA of 1991 Federal Deposit Insurance Reform Act of 2005: Leaves coverage cap at $100,000 per person per account Adjusted to inflation on 5-year basis ($10,000 increments as necessary) Cap for retirement accounts increased to $250,000 46

44 Controlling DI Risk Taking: Depositor Discipline Uninsured: Implicit 100% coverage from too big to fail Failure resolution post-fdicia January 1995 FDICIA required least-cost resolution. Systemic risk exemption. Insured depositor transfer (IDT) or haircut method encourages depositor vigilance. 47

45 Deposit Insurance in China Impicit insurance 2014/11/27: Deposit Insurance Regulation drafted 2015/02/17: Deposit Insurance Regulation announced 2015/05/01: effective 48

46 Deposit Insurance in Other Countries Singapore: Deposit Insurance Scheme commenced on 1 April, 2006, follows the Deposit Insurance Act on 18 October Capital Reserve (12% and 20% for risk adjusted) EC established a single deposit insurance system at end of 1999 Coverage: 20,000 ECUs. Co-insurance through deductibles (10%). Japan: Similar system to U.S. Over the late 1990s and early 2000s experienced problems similar to those of the U.S. during the 1980s Over $400 billion in bad loans (2003) 10 million yen coverage 49

47 Part 3 CREDIT RISK 50

48 Credit Risk: key issues Some key measures required by New Basel Capital Accord EAD - Exposure at Default or credit exposure PD - Probability of Default LGD - Loss Given Default or recovery rate Haircut - empirical difference between book and market price at liquidation of collateral 51

49 Measurement of Credit Risk Key point: estimate default risk. Traditional Qualitative approach Credit scoring Newer models (reliance on financial market data) Term structure of credit risk approach Mortality rate approach RAROC (or RORAC) Option pricing approach CreditMetrics Credit Risk + 52

50 Qualitative Approach C&I loans Five Cs plus one of credit Cash flow analysis Ratio Analysis: liquidity, asset management, debt and solvency, profitability Cautions: Enron and Worldcom Common-Size Analysis and Growth Rates Identify trends Include loan covenants in loan aggrement Following approval: clear conditions precedent 53

51 Five Cs of credit Character: prob. that the loan application will try to honor the loan obligation Capacity: subjective judgment regarding the applicant s ability to pay the FI according to the term of the loan Collateral: assets the loan applicants offers as security backing the loan Condition: general economic trends and etc that might affect the applicants ability to meet the loan obligations Production Management Marketing Capital: general financial condition of the applicant as indicated by an analysis of the applicant s financial statement and his leverage Capital 54

52 The Six Basic C s of Lending Character Specific Purpose of Loan and Serious Intent to Repay Loan Capacity Legal Authority to Sign Binding Contract Cash Ability to Generate Enough Cash to Repay Loan Collateral Adequate Assets to Support the Loan Conditions Economic Conditions Faced By Borrower Control Could changes in laws and regulations adversely affect the borrower? Does loan meet the banks and regulation standards for loan quality?

53 Credit Scoring Models Altman s Linear Discriminant Model Z=1.2X X X X X 5 X 1 = Working capital/total assets. X 2 = Retained earnings/total assets. X 3 = EBIT/total assets. X 4 = Market value equity/ book value of LT debt. X 5 = Sales/total assets. If the Z>2.99 default is unlikely; if 2.7<Z<2.99 we should be on alert. If 1.8<Z<2.7 there is a moderate chance of default; if Z<1.8 there is a high chance of default 56

54 China Z-score Altman et al (2007) Z= X X X X 4 x1=asset liability ratio (total liabilities/total assets); x2 = rate of return on total assets (net profit/average total assets); X3= working capital to total asset ratio (working capital/total assets), where working capital equals current assets minus current liabilities; x4 = retained earnings to total assets ratio (retained earnings/total assets). 9/27/2017 ACEM, Shang Jiao Tong University, Nan Li 57

55 Credit Scoring Models Problems of Linear Discriminant Models Only considers two extreme cases (default/no default). Weights need not be stationary over time. Ignores hard to quantify factors including business cycle effects. Database of defaulted loans is not available to benchmark the model. 58

56 Case Study Credit Analysis for HG Timber Ltd Corporation

57 Background HG Timber Ltd Corporation is a private firm in Guangdong, the main products are various types of timber that can be used in construction and furniture making. It got several awards as the Excellent Private Firm, Excellent Tax Contributor and the top 50 private firms in China in the recent years. Its products are known for good quality. Currently, HG has developed to the largest timber company in China and it owns some timber bases abroad, ships for longdistance transportation, and some harbors. It has professional groups in the whole process of getting raw material, production, transportation and sales.

58 Background HG is also a generous contributor to the welfare of the local people. HG help to establish schools, hospitals, caring house for elders and etc. HG has very good reputation in the local area and officials including the mayor often visit HG company as an exemplary company. The major banking account for HG is with Bank A, mainly CNY loan and deposits. HG s major foreign currency transaction is with Bank B, In addition, HG has business with other 8 financial institutions. HG got credit line from three banks, Bank A, B and C. The total credit limit HG has is 6 Billion, and the credit rating of HG in these three banks is AAA and golden customer.

59 Performance in the past Sales (CNY in billions) Profit(CNY in billions) International Transaction ($billion)

60 Balance Sheet In billions CNY Liquid asset Liability cash Loan Account receivable Account payable inventory Bill payable Net fixed asset Equity Capital Intangibles Paid-up capital Total Asset Liability and Equity

61 Background HG now applies for a revolving credit line of 0.28 Billion CNY from Bank D, to be used for working capital and financing trade. No collateral. According to the local branch of Bank D, with the help of local government, they make a great effort to persuade HG to apply for this credit limit from Bank D instead of from other banks. If the credit limit is approved, HG agrees to transfer half of its CNY deposit and international transactions to Bank D.

62 Questions As a credit analyst in Bank D, given the information you have got so far, would you approve this loan application? Why and why not?

63 Questions HG has good credit ratings in other banks, good reputation in the local area, and is a generous contributor to the local welfare, are these positive factors for the credit quality? HG is vertically integrated. Is this a positive factor for the credit quality? In the recent years, the sales and profit is stable but the asset increases dramatically. How would you evaluate the financial strength of HG?

64 Part 4 MONETARY POLICY 67

65 Money Supply: US M1, measure the medium of exchange, the more narrowly defined measure, consists of the most liquid forms of money, namely currency and checkable deposits M2, reflect the store-of-value function of money M1 household holdings of savings deposits, small time deposits, and retail money market mutual funds (MMMF). M3: includes close substitute for money M2 large-denomination time deposits, repurchase agreements (RPs), and Eurodollars On March 23, 2006, the Board of Governors of the Federal Reserve System ceased publication of the M3 monetary aggregate. 68

66 Money Supply: China M0: currency in circulation M1 = M0 + checkable deposit of corporations M2 = M1+ time deposit of corporations and deposit of households 69

67 Who and How to Control Money Supply? 70

68 Open market operation: Purchases of securities by Federal Reserve, $500m Bank sell securities to Fed and get payment, and deposit these payments in their accounts held at their local Federal Reserve Bank

69 Open Market Operation $500 increase in demand deposit $100 as reserve $400 in excess reserve Federal Reserve $80 $64 Reserve ratio = 20% $51.2 Bank A Bank B Bank C Bank N $400 $400 $320 $320 $256 $256 $204.8 Borrower 1 Spend $ on Goods and Services $400 Producer 1of goods and services Receive $ and deposit in BankB Borrower2 $320 Producer 2 Borrower 3 $256 Producer 3 Borrower 4 9/27/ ACEM Shang Jiao Tong University, Nan Li

70 Money Multiplier Total new loans granted by the banking systems: = 400/0.2 = $2000 Money Multiplier = $2000/$400 = 5 = 1/0.2 Assumption: Public s cash-to-deposit ratio = 0 Loan-to-deposit ratio = 100%-reserve ratio What if Public s cash-to-deposit ratio = 10%? What if loan-to-deposit ratio < 100%-reserve ratio? 73

71 Who and How to Control Money Supply? Interest Rate Reserve Ratio cash-todeposit ratio Loan-todeposit ratio Money Multiplier Bank Reserve Money Base (M1, M2) 74

72 Who and How to Control Money Supply? Factors affect Money Multiplier: cash-to-deposit ratio Loan-to-deposit ratio Interest rates Who controls these ratios? 75

73 76

74 R and M: Only one can be controlled 77

75 Interest Rates and Loanable Funds Interest rates reflect supply and demand for loanable funds Shifts in supply or demand generate interest rate movements as market forces establish a new equilibrium 78

76 Monetary Policy Tools China Open Market Opreation( 公开市场业务 ); Reserve Ratio Changes( 存款准备金 ) Central Bank Loan ( 中央银行贷款 ) ; Standing Lending Facility( 常备借贷便利 ) Interest Rate Changes ( 利率政策 ) ; Exchange Rate Changes( 汇率政策 ) Operation Targets Money Base( 基础货币 ); Bank Excess Reserve( 银行超额储备率 ) Interbank Offer Rate ( 银行间同业拆借市场利率 ); Interbank repo rate ( 银行间债券市场回购利率 ) Intermediate Targets Money Supply; Commercial Bank Loan( 商业银行贷款总量 ); Money Market trade volume( 货币市场交易量 ) 79 Objectives: Price Stability ; Economic Growth

77 New Monetary Policy Tools in China 2013: Standing Lending Facility(SLF, 常备借贷便利 ) Like Discount Window in the US 1-3months, for CB and PB 2013/01/18: Short-term liquidity operation (SLO, 短期流动性调节工具 ) Short term (7 day) reverse repo 2014/4/25 :Pledged Supplementary Lending (PSL, 抵押补充贷款 ) Specifically for NDB 2014/09: Medium-term Lending Facility (MLF) For qualified CB and PB, medium-term (3 months) collaterized lending base money 2017/1/20: Temporary Liquidity Facility(TLF, 临时流动性便利 ) 28 days, to ease the short-term liquidity crunch 9/27/2017 ACEM, Shang Jiao Tong University, Nan Li 80

78 Monetary Policy Tools for PBC Admin measure: Formal regulation Informal regulation Phone calls, set limit Add implicit barrier net regulatory burden 81

79 总资产 Total Assets 国外资产 Foreign Assets 外汇 Foreign Exchange 货币黄金 Monetary Gold Balansheet of PBC 其他国外资产 Other Foreign Assets 对政府债权 Claims on Government 中央政府 Central Government 对其他存款性公司债权 Claims on Other Depository Corporations 对其他金融性公司债权 Claims on Other Financial Corporations 对非金融性部门债权 Claims on Nonfinancial Sector 其他资产 Other Assets 9/27/2017 ACEM, Shang Jiao Tong University, Nan Li 总负债 Total Liabilities 储备货币 Reserve Money 货币发行 Currency Issue 其他存款性公司存款 Deposits of Other Depository Corporations 不计入储备货币的金融性公司存款 Deposits of financial corporations excluded from Reserve Money 发行债券 Bond Issue 国外负债 Foreign Liabilities 政府存款 Deposits of Government 自有资金 Own Capital 其他负债 Other Liabilities 82

80 Shrinking Balance Sheet? RMB100 million /27/2017 ACEM, Shang Jiao Tong University, Nan Li 83

81 Shrinking Balance Sheet? 国外资产 Foreign Assets 对政府债权 Claims on Government 对其他存款性公司债权 Claims on Other Depository Corporations 对其他金融性公司债权 Claims on Other Financial Corporations 其他资产 Other Assets 外汇 Foreign Exchange 9/27/2017 ACEM, Shang Jiao Tong University, Nan Li 84

82 Reason for declines in balancesheet Before 2014, surplus in current account and trade account, increases in foreign reserve and increases in reserve and government bonds according Asset increases fast After 2014, foreign asset decreases as the trade imbalance reduces, and reserve ratio decreases in 2015 and 2016 Total assets decreases in 2015 and 2016 March. Total asset decreases in 2017 Q1 In February due to increase in cash back In March due to government expenditure increases (govenemnt deposit decreases) 9/27/2017 ACEM, Shang Jiao Tong University, Nan Li 85

83 China Money Growth M0 M1 M

84 China Money Growth 2017Q1 M1 YtoY M2 YtoY 9/27/2017 ACEM, Shang Jiao Tong University, Nan Li 87

85 Balances of Monetary Policy Tool SLF MLF PSL /27/2017 in billions RMB ACEM, Shang Jiao Tong University, Nan Li 88

86 China Money Multiplier

87 Deposit & Interest Rates Deposit rate Inflation rate

88 Deposits and Loans Saving Deposit/Total Deposits Domestic medium- & long-term loans Domestic short-term loans Domestic bill financing /27/2017 ACEM, Shang Jiao Tong University, Nan Li 91