International Finance

Transcription

1 International Finance FINA 5331 Lecture 3: The Banking System William J. Crowder Ph.D.

2 Historical Development of the Banking System Bank of North America chartered in 1782 Controversy over the chartering of banks. National Bank Act of 1863 creates a new banking system of federally chartered banks Office of the Comptroller of the Currency Dual banking system Federal Reserve System is created in 1913.

3 Time Line of the Early History of Commercial Banking in the United States

4 Primary Supervisory Responsibility of Bank Regulatory Agencies Federal Reserve and state banking authorities: state banks that are members of the Federal Reserve System. Fed also regulates bank holding companies. FDIC: insured state banks that are not Fed members. State banking authorities: state banks without FDIC insurance.

5 Financial Innovation and the Growth of the Shadow Banking System Financial innovation is driven by the desire to earn profits A change in the financial environment will stimulate a search by financial institutions for innovations that are likely to be profitable Financial engineering

6 Responses to Changes in Demand Conditions: Interest Rate Volatility Adjustable-rate mortgages Flexible interest rates keep profits high when rates rise Lower initial interest rates make them attractive to home buyers Financial Derivatives Ability to hedge interest rate risk Payoffs are linked to previously issued (i.e. derived from) securities.

7 Responses to Changes in Supply Conditions: Information Technology Bank credit and debit cards Improved computer technology lowers transaction costs Electronic banking ATM, home banking, ABM and virtual banking Junk bonds Commercial paper market

8 Responses to Changes in Supply Conditions: Information Technology Securitization To transform otherwise illiquid financial assets into marketable capital market securities. Securitization played an especially prominent role in the development of the subprime mortgage market in the mid 2000s.

9 Avoidance of Existing Regulations: Loophole Mining Reserve requirements act as a tax on deposits Restrictions on interest paid on deposits led to disintermediation Money market mutual funds Sweep accounts

10 Financial Innovation and the Decline of Traditional Banking As a source of funds for borrowers, market share has fallen Commercial banks share of total financial intermediary assets has fallen No decline in overall profitability Increase in income from off-balance-sheet activities

11 Bank Share of Total Nonfinancial Borrowing,

12 Financial Innovation and the Decline of Traditional Banking Decline in cost advantages in acquiring funds (liabilities) Rising inflation led to rise in interest rates and disintermediation Low-cost source of funds, checkable deposits, declined in importance Decline in income advantages on uses of funds (assets) Information technology has decreased need for banks to finance short-term credit needs or to issue loans Information technology has lowered transaction costs for other financial institutions, increasing competition

13 Banks Responses Expand into new and riskier areas of lending Commercial real estate loans Corporate takeovers and leveraged buyouts Pursue off-balance-sheet activities Non-interest income Concerns about risk

14 Structure of the U.S. Commercial Banking Industry Restrictions on branching McFadden Act and state branching regulations. Response to ranching restrictions Bank holding companies. Automated teller machines.

15 Size Distribution of Insured Commercial Banks, March 30, 2011

16 Ten Largest U.S. Banks, 2010

17 Bank Consolidation and Nationwide Banking The number of banks has declined over the last 25 years Bank failures and consolidation. Deregulation: Riegle-Neal Interstate Banking and Branching Efficiency Act f Economies of scale and scope from information technology. Results may be not only a smaller number of banks but a shift in assets to much larger banks.

18 Benefits and Costs of Bank Consolidation Benefits Increased competition, driving inefficient banks out of business Increased efficiency also from economies of scale and scope Lower probability of bank failure from more diversified portfolios Costs Elimination of community banks may lead to less lending to small business Banks expanding into new areas may take increased risks and fail

19 Number of Insured Commercial Banks in the United States,

20 Separation of the Banking and Other Financial Service Industries Erosion of Glass-Steagall Act Prohibited commercial banks from underwriting corporate securities or engaging in brokerage activities Section 20 loophole was allowed by the Federal Reserve enabling affiliates of approved commercial banks to underwrite securities as long as the revenue did not exceed a specified amount U.S. Supreme Court validated the Fed s action in 1988

21 Separation of the Banking and Other Financial Service Industries Gramm-Leach-Bliley Financial Services Modernization Act of 1999 Abolishes Glass-Steagall States regulate insurance activities SEC keeps oversight of securities activities Office of the Comptroller of the Currency regulates bank subsidiaries engaged in securities underwriting Federal Reserve oversees bank holding companies

22 Separation of Banking and Other Financial Services Industries Throughout the World Universal banking No separation between banking and securities industries British-style universal banking May engage in security underwriting Separate legal subsidiaries are common Bank equity holdings of commercial firms are less common Few combinations of banking and insurance firms

23 Separation of Banking and Other Financial Services Industries Throughout the World Some legal separation Allowed to hold substantial equity stakes in commercial firms but holding companies are illegal

24 Thrift Industry: Regulation and Structure Savings and Loan Associations Chartered by the federal government or by states Most are members of Federal Home Loan Bank System (FHLBS) Deposit insurance provided by Savings Association Insurance Fund (SAIF), part of FDIC Regulated by the Office of Thrift Supervision Mutual Savings Banks Approximately half are chartered by states Regulated by state in which they are located Deposit insurance provided by FDIC or state insurance

25 Thrift Industry: Regulation and Structure Credit Unions Tax-exempt Chartered by federal government or by states Regulated by the National Credit Union Administration (NCUA) Deposit insurance provided by National Credit Union Share Insurance Fund (NCUSIF)

26 International Banking Rapid growth Growth in international trade and multinational corporations Global investment banking is very profitable Ability to tap into the Eurodollar market

27 Eurodollar Market Dollar-denominated deposits held in banks outside of the U.S. Most widely used currency in international trade Offshore deposits not subject to regulations Important source of funds for U.S. banks

28 Structure of U.S. Banking Overseas Shell operation Edge Act corporation International banking facilities (IBFs) Not subject to regulation and taxes May not make loans to domestic residents

29 Foreign Banks in the U.S. Agency office of the foreign bank Can lend and transfer fund in the U.S. Cannot accept deposits from domestic residents Not subject to regulations Subsidiary U.S. bank Subject to U.S. regulations Owned by a foreign bank

30 Foreign Banks in the U.S. Branch of a foreign bank May open branches only in state designated as home state or in state that allow entry of out-of-state banks Limited-service may be allowed in any other state Subject to the International Banking Act of 1978 Basel Accord (1988) Example of international coordination of bank regulation Sets minimum capital requirements for banks

31 Ten Largest Banks in the World, 2011

32 Banking and the Management of Financial Institutions

33 The Bank Balance Sheet Liabilities Checkable deposits Nontransaction deposits Borrowings Bank capital

34 The Bank Balance Sheet Assets Reserves Cash items in process of collection Deposits at other banks Securities Loans Other assets

35 Balance Sheet of All Commercial Banks, June 2011

36 Basic Banking: Cash Deposit Vault Cash First National Bank First National Bank Assets Liabilities Assets Liabilities +$100 Checkable deposits +$100 Reserves +$100 Checkable deposits +$100 Opening of a checking account leads to an increase in the bank s reserves equal to the increase in checkable deposits

37 Basic Banking: Check Deposit Assets Cash items in process of collection First National Bank +$100 Checkable deposits Liabilities +$100 When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves First National Bank Second National Bank Assets Liabilities Assets Liabilities Reserves +$100 Checkable deposits +$100 Reserves -$100 Checkable deposits -$100

38 Basic Banking: Making a Profit First National Bank First National Bank Assets Liabilities Assets Liabilities Required reserves Excess reserves +$100 Checkable deposits +$100 Required reserves +$90 Loans +$90 +$100 Checkable deposits +$100 Asset transformation: selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics The bank borrows short and lends long

39 General Principles of Bank Management Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk

40 Liquidity Management: Ample Excess Reserves Assets Liabilities Assets Liabilities Reserves $20M Deposits $100M Reserves $10M Deposits $90M Loans $80M Bank $10M Loans $80M Bank $10M Securities $10M Capital Securities $10M Capital Suppose bank s required reserves are 10% If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet

41 Liquidity Management: Shortfall in Reserves Assets Liabilities Assets Liabilities Reserves $10M Deposits $100M Reserves $0 Deposits $90M Loans $90M Bank $10M Loans $90M Bank $10M Securities $10M Capital Securities $10M Capital Reserves are a legal requirement and the shortfall must be eliminated Excess reserves are insurance against the costs associated with deposit outflows

42 Liquidity Management: Borrowing Assets Liabilities Reserves $9M Deposits $90M Loans $90M Borrowing $9M Securities $10M Bank Capital $10M Cost incurred is the interest rate paid on the borrowed funds

43 Liquidity Management: Securities Sale Assets Liabilities Reserves $9M Deposits $90M Loans $90M Bank Capital $10M Securities $1M The cost of selling securities is the brokerage and other transaction costs

44 Liquidity Management: Federal Reserve Assets Liabilities Reserves $9M Deposits $90M Loans $90M Borrow from Fed $9M Securities $10M Bank Capital $10M Borrowing from the Fed also incurs interest payments based on the discount rate

45 Liquidity Management: Reduce Loans Assets Reduction of loans is the most costly way of acquiring reserves Calling in loans antagonizes customers Liabilities Reserves $9M Deposits $90M Loans $81M Bank Capital $10M Securities $10M Other banks may only agree to purchase loans at a substantial discount

46 Asset Management: Three Goals 1. Seek the highest possible returns on loans and securities 2. Reduce risk 3. Have adequate liquidity

47 Asset Management: Four Tools 1. Find borrowers who will pay high interest rates and have low possibility of defaulting 2. Purchase securities with high returns and low risk 3. Lower risk by diversifying 4. Balance need for liquidity against increased returns from less liquid assets

48 Liability Management Recent phenomenon due to rise of money center banks Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) Checkable deposits have decreased in importance as source of bank funds

49 Capital Adequacy Management Bank capital helps prevent bank failure The amount of capital affects return for the owners (equity holders) of the bank Regulatory requirement

50 Capital Adequacy Management: Preventing Bank Failure High Bank Capital Low Bank Capital Assets Liabilities Assets Liabilities Reserves $10M Deposits $90M Reserves $10M Deposits $96M Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M High Bank Capital Low Bank Capital Assets Liabilities Assets Liabilities Reserves $10M Deposits $90M Reserves $10M Deposits $96M Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M

51 Capital Adequacy Management: Returns to Equity Holders Return on Assets: net profit after taxes per dollar of assets net profit after taxes ROA = assets Return on Equity: net profit after taxes per dollar of equity capital net profit after taxes ROE = equity capital Relationship between ROA and ROE is expressed by the Equity Multiplier: the amount of assets per dollar of equity capital net profit after taxes equity capital EM = = Assets Equity Capital net profit after taxes assets ROE = ROA EM assets equity capital

52 Capital Adequacy Management: Safety Benefits the owners of a bank by making their investment safe Costly to owners of a bank because the higher the bank capital, the lower the return on equity Choice depends on the state of the economy and levels of confidence

53 Application: How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis Shortfalls of bank capital led to slower credit growth Huge losses for banks from their holdings of securities backed by residential mortgages. Losses reduced bank capital Banks could not raise much capital on a weak economy, and had to tighten their lending standards and reduce lending.

54 Managing Credit Risk Screening and Monitoring Screening Specialization in lending Monitoring and enforcement of restrictive covenants

55 Managing Credit Risk Long-term customer relationships Loan commitments Collateral and compensating balances Credit rationing

56 Managing Interest-Rate Risk First National Bank Assets Liabilities Rate-sensitive assets $20M Rate-sensitive liabilities $50M Variable-rate and short-term loans Variable-rate CDs Short-term securities Money market deposit accounts Fixed-rate assets $80M Fixed-rate liabilities $50M Reserves Checkable deposits Long-term loans Savings deposits Long-term securities Long-term CDs Equity capital If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits

57 Gap and Duration Analysis Basic gap analysis: (rate sensitive assets - rate sensitive liabilities) μ Δ interest rates = Δ in bank profit Maturity bucket approach Measures the gap for several maturity subintervals. Standardized gap analysis Accounts for different degrees of rate sensitivity.

58 Gap and Duration Analysis % Δ in market value of security - percentage point Δ in interest rate μ duration in years. Uses the weighted average duration of a financial institution s assets and of its liabilities to see how net worth responds to a change in interest rates.

59 Off-Balance-Sheet Activities Loan sales (secondary loan participation) Generation of fee income. Examples: Servicing mortgage-backed securities Creating SIVs (structured investment vehicles) which can potentially expose banks to risk, as it happened in the global financial crisis

60 Off-Balance-Sheet Activities Trading activities and risk management techniques Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market and speculation. Principal-agent problem arises

61 Off-Balance-Sheet Activities Internal controls to reduce the principalagent problem Separation of trading activities and bookkeeping Limits on exposure Value-at-risk Stress testing

62 Economic Analysis of Financial Regulation

63 Asymmetric Information and Financial Regulation Bank panics and the need for deposit insurance: FDIC: short circuits bank failures and contagion effect. Payoff method. Purchase and assumption method (typically more costly for the FDIC). Other form of government safety net: Lending from the central bank to troubled institutions (lender of last resort).

64 Government Safety Net Moral Hazard Depositors do not impose discipline of marketplace. Financial institutions have an incentive to take on greater risk. Adverse Selection Risk-lovers find banking attractive. Depositors have little reason to monitor financial institutions.

65 Government Safety Net: Too Big to Fail Government provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee Uses the purchase and assumption method Increases moral hazard incentives for big banks

66 Government Safety Net: Financial Consolidation Larger and more complex financial organizations challenge regulation Increased too big to fail problem Extends safety net to new activities, increasing incentives for risk taking in these areas (as has occurred during the global financial crisis

67 Restrictions on Asset Holdings Attempts to restrict financial institutions from too much risk taking Bank regulations Promote diversification Prohibit holdings of common stock Capital requirements Minimum leverage ratio (for banks) Basel Accord: risk-based capital requirements Regulatory arbitrage

68 Capital Requirements Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions There are two forms: The first type is based on the leverage ratio, the amount of capital divided by the bank s total assets. To be classified as well capitalized, a bank s leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank The second type is risk-based capital requirements

69 Financial Supervision: Chartering and Examination Chartering (screening of proposals to open new financial institutions) to prevent adverse selection Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk Filing periodic call reports

70 Assessment of Risk Management Greater emphasis on evaluating soundness of management processes for controlling risk Trading Activities Manual of 1994 for risk management rating based on Quality of oversight provided Adequacy of policies and limits for all risky activities Quality of the risk measurement and monitoring systems Adequacy of internal controls Interest-rate risk limits Internal policies and procedures Internal management and monitoring Implementation of stress testing and Value-at risk (VAR)

71 Disclosure Requirements Requirements to adhere to standard accounting principles and to disclose wide range of information The Basel 2 accord and the SEC put a particular emphasis on disclosure requirements The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board Mark-to-market (fair-value) accounting

72 Consumer Protection Consumer Protection Act of 1969 (Truth-inlending Act). Fair Credit Billing Act of Equal Credit Opportunity Act of 1974, extended in Community Reinvestment Act. The subprime mortgage crisis illustrated the need for greater consumer protection.

73 Restrictions on Competition Justified as increased competition can also increase moral hazard incentives to take on more risk. Branching restrictions (eliminated in 1994) Glass-Steagall Act (repeated in 1999) Disadvantages Higher consumer charges Decreased efficiency

74 Macroprudential Vs. Microprudential Supervision Before the global financial crisis, the regulatory authorities engaged in microprudential supervision, which is focused on the safety and soundness of individual financial institutions. The global financial crisis has made it clear that there is a need for macroprudential supervision, which focuses on the safety and soundness of the financial system in the aggregate.

75 Major Financial Legislation in the United States

76 Major Financial Legislation in the United States

77 Bank Failures in the United States,

78 The 1980s Savings and Loan and Banking Crisis Financial innovation and new financial instruments increased risk taking Increased deposit insurance led to increased moral hazard Deregulation Depository Institutions Deregulation and Monetary Control Act of 1980 Depository Institutions Act of 1982

79 The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 Financial Institutions Reform, Regulatory and Enforcement Act of 1989 Federal Deposit Insurance Corporation and Improvement Act of 1991 Cost of the bailout approximately $150 billion, or 3% of GDP.

80 Banking Crises Throughout the World Déjà vu all over again Deposit insurance is not to blame for some of these banking crises The common feature of these crises is the existence of a government safety net, where the government stands ready to bail out troubled financial institutions.

81 Banking Crises Throughout the World Since 1970

82 The Cost of Rescuing Banks in a Number of Countries

83 The Dodd-Frank Bill and Future Regulation The system of financial regulation is undergoing dramatic changes after the global financial crisis Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: The most comprehensive financial reform legislation since the Great Depression

84 The Dodd-Frank Bill and Future Regulation The Dodd-Frank Bill addresses 5 different categories of regulation: Consumer Protection Resolution Authority Systemic Risk Regulation Volcker Rule Derivatives

85 The Dodd-Frank Bill and Future Regulation There are several areas where regulation may be heading in the future: Capital Requirements Compensation Government-Sponsored Enterprises (GSEs) Credit Rating Agencies The Danger of Overregulation