Financial markets and institutions, Dispense di Economia degli Intermediari Finanziari

Scarica Financial markets and institutions e più Dispense in PDF di Economia degli Intermediari Finanziari solo su Docsity! 1. Financial Markets and Institution Financial System and intermediation is the system than enables lenders to transfer fund and resources through financial intermediaries. Financial intermediaries are institutions that connects surplus and deficit agents. [Families= surplus; Firms= deficit] How are these agents connected? There are 2 channels that connect these agents: 1. Indirect channel: borrower borrow funds from the financial markets through indirect means (financial intermediaries) – process called financial intermediation. 2. Direct channel: borrower can borrow funds directly from the lender by selling them financial instruments. Financial Instruments Securities: any financial instrument that can be traded – 2 types; 1. Financial assets: legal claim on future financial benefits. 2. Real assets: tangible assets that determine the productive capacity of an economy. Financial System Regulated by: - Financial intermediaries; there are stock brokers which don’t have risks (only buyers get it). - Financial market (Indirect Channel); set of transaction related to financial instruments. - Financial instruments: a legally enforceable agreement between two or more parties regarding a right of payment - Regulation and Supervision Its Functions: - Transfer resources from surplus to deficit spending units - Monetary function (provides a payment system - Allows for risk management - Allows for the transmission of monetary policy Financial markets are essential for economic efficiency; they allow funds to move from people who lack of productive investment opportunities to people who have such opportunities. Financial instruments – Debt and Equity Instruments have a monetary value or represent a legally enforceable agreement between two or more parties regarding a right to payment of money. A firm can obtain funds in a financial market in 2 ways: 1. Issue debt (bond, mortgage); a contractual agreement by the borrower to pay back the holder of the instrument with fixed dollar amounts at regular intervals ( Interests ) until a specific date ( maturity ). Maturity: numbers of years until that instrument’s expiration date; a. Short-term: expiration date within 1 year. b. Long-term: expiration date is in over 10 years. c. Intermediate-term: the expiration date is in between 1 year or 10 years. Foreign bonds; denominated in a foreign currency and sold in a foreign market Euro bonds; Denominated in one currency but sold in a different market 2. Issuing Equities (common stock); claims on the net income (income after expenses and taxes). - Equities often make periodic payments (Dividends) and are considered long-term securities because they don’t have a maturity date. - Owning a stock means you own a portion of the firm which translates in having the right to take part in important issues of the firm and elect its directors. Advantages and disadvantages of owning a company’s equity rather than its debts: 1. Advantages: Equity holders benefit from any increases in the corporation’s profitability or assets value; While debt holders do not take part of the benefit since their payments are fixed. 2. Disadvantages: An equity holder is a residual claimant; corporation must pay all its debt holder before it pays its equity holder. Financial Instruments – Negotiable and Non-Negotiable instruments We can distinguish Direct and Indirect Channel through the characteristic of the instruments. 1. Direct Channel: we have negotiable instruments Characteristics of negotiability: - Standardization - Divisibility - External condition 5. Hedge funds: Type of mutual fund requiring large investment, long holding periods and are subject to few regulations. Types of investment intermediaries - Contractual Savings Institutions CSIs acquire funds from consumer at periodic intervals on a contractual basis and have fairly predictable future payout requirements. 1. Life insurance companies: receive funds from policy premium, can invest in less liquid companies since actual benefit pay outs are close to those predicted. 2. Fire and Casualty Insurance companies: receive funds from policy premiums, they must invest in more liquid companies, since loss are difficult to predict. 3. Pension and government retirement funds: Hosted by corporations, state and Local governments. They acquire funds from employee’s payroll contributions, they invest in corporate securities, provide retirement income via annuities. 2. Financial Balances The first main function of the financial system is to transfer resources among economic units. In order to do this, it should provide ways of clearing and setting payments which are all the activities from the time a commitment is made for a transaction until it is settled. The Financial System plays 2 important functions: 1. Provides ways of Clearing and Settling Mechanism (CSMs); - A process that underlines all payment transaction between two payment service providers (PSPs), that make possible the accomplishment of former task. - CSMs, is invisible to the end-user of the single euro payment area (SEPA) - Clearing denotes all activities from the time a commitment is made for a transaction until it’s settled. – This process turns the promise of payment into the actual movement of money from one account to another (2 different PSPs are involved) 2. It allows the transfer of resources (financial balances - focus on the OBJECT of the transaction) among economic unit (institutional sectors – focus on SUBJECT of the transaction as to say the actors involved) possible. Real and Financial Circuit Using money to finalize transaction implies 2 circuits: 1. Real Circuit: good, service, productive factors (inputs) 2. Monetary Circuit: prices (income), productive factors remuneration (wages, salaries) These two circuits are equal because the value of good/services which are sold, is equal to the remuneration for their production. Analyzing an Economic Unit The acquisition of good and services represent the use of REAL ASSETS, while the purchase of credit or shares determine the use of FINANCIAL ASSETS. In the FINANCIAL CIRCUIT; suppliers of production factor (labor, capital) earn wages, salaries, which they transfer to enterprises, paying the prices to buy goods and services or use savings to lend money (credit) to acquire share in enterprises. Each ECONOMIC UNIT generates; 1. Flows • Income from labor. • Investments and dividend from their savings in business activities. 2. Stocks • Include both assets (given by the cumulative savings over time and any debts) • And the level of liabilities - investments in both real assets (real estate) and financial assets (bank deposits, securities) Macro Analysis 1. Aggregate Demand; the quantity of the total output demanded by the economic system over a period of time Y=C+S 2. Aggregate Supply (GDP); as the quantity of the total output supplied by the economic system over a period of time (production capacity) GDP=C+I To identify when the economic system is in equilibrium: Y=GDP > C+S=C+I > I=S • Savings are the base for investments Investments in the real and financial assets is made possible thanks to assets and liabilities: I + DAF (change in financial assets) = S + DPF (change in debt) AR (real assets) + AF (financial assets) = P (equity) + PF (financial liabilities) Financial Balance SF = S - I = DAF(changes in financial assets) - DPF (changes in debts) The savings accumulates in the system are the basis for investment expenses, valid on overall system level but no for individual economic units; Economic units’ equilibrium: SF = S – I Disinvestments What has been said so fare is incomplete, since we must also consider the possibility of making disinvestments (Sales) of real assets or financial assets and the possibility of reductions of financial liabilities (repayments) I + DAF + repayments (-DPF) = S +DPF + disinvestments (-DAF - DAR) E.G S= 20k ; I= 15k ; Securities 10K 1. I + DAF = S + DPF 15k + 10k = 20k + 5k 2. I + DAF + repayment (-DPF) = S + DPF + disinvestment (-DAF - DAR) 15k + 12k + 8k = 20k + 5k + 10k 3. (DAF + debt repayment) – (DPF + disinvestment) (12k + 8k) – (5k + 10k) = 5k Institutional Sectors Each institution sector makes choices that has an impact on savings and investments and financial balance: Firms; S<I SF<0 deficit Household; S>I SF>0 surplus Public Administration; S<0 SF>0 deficit Rest of the world; SF>0 surplus The financial institution enters the real circuit with the intermediation function. The Balance is achieved when there’s a transfer of financial resources from surplus to deficit units. Use of funds Source of funds Transaction costs Reduced by the F.I through developing expertise and taking advantage of economies of scale. Transaction costs influence the Financial Structure; Problem: if you want to invest in stocks in the stock market, you can buy just a small number of shares or if you want to buy a bond it requires 10k due to the high transaction of brokerage commission. Therefore, you can only make a restricted number of investments. Solution: to bundle the funds of many investors together so that they can take advantage of economies of scale – the reduction of costs per dollar of investment as the size of transactions increases, reducing Transaction Costs for single investor; the best Financial Intermediaries for the economies of scale is mutual fund. Types of Costs Then we have 3 other costs; 1) Fragmentation costs - are associated with the imperfect divisibility of financial instruments, because they are tailored for the funding needs of borrowers which don’t always match saver’s preferences. 2) Information costs – are related to: 1. The search and evaluation of counterparties for the exchange (screening). 2. To the monitoring of creditworthiness 3) Operating costs – costs that define the contractual clauses governing the exchange, to prepare document to carry out the transaction (contracting costs). Asymmetric Information – Adverse Selection and Moral Hazard Both moral hazard and adverse selection are used in economics, risk management, and insurance to describe situations where one party is at a disadvantage as a result of another party's behaviour. 1. Adverse Selection Is the problem created by asymmetric information before the transaction occurs. Adverse selection describes a situation in which one party in a deal has more accurate and different information than the other party. The party with less information is at a disadvantage to the party with more information. - this is occurs when potential borrowers who are most likely to produce an undesirable (adverse) outcome - the bad credit risks- are the ones who most actively seek out a loan and are thus most likely to be selected. - Due to the fact that adverse selection enhance the possibility that loans might be made to bad credit risks, lenders may decide not to make any loans even though good credit risks exist in the market. 2. Moral Hazard Is the problem created by asymmetric information after the transaction occurs. - Moral Hazard in financial markets if the risk (hazard) that the borrower might engage in activities that might seem undesirable to the lender, because they make it less likely that the loan will be paid back. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan. The problems created by adverse selection and moral hazard are significant impediments to the well- functioning of financial markets which, once again, financial intermediaries can alleviate. - Small savers can provide their funds to the financial markets by lending these funds to trustworthy intermediaries, which in turn lends the funds out either by making loans or by buying securities such stock or bonds. The result is that financial intermediaries can afford to pay lender-saver interest or provide substantial services. Agency theory The analysis of how asymmetric information problems affect behavior is known as agency theory. Agency problem occurs when one party (agent) is allowed to make decisions on the behalf of the other one (principal), but he just cares about its own businesses. This is the principal agent problem. The lemon problem assuming the existence of 2 borrowers A and B, with 2 different investments project where the project of A is less risky than the project of B. Therefore Ra<Rb. Due to lack of information about both projects, a single price is formed: Rm=Ra+Rb/2. To obtain funding: - Borrower A: will have to pay a higher price to be in equilibrium. - Borrower B: will have to pay a lower price to be in equilibrium The problem arises when A doesn’t want to pay an higher price than B and lenders will not finance A as B. 3. Financial Regulation and Supervision Financial supervision’s goals are; 1. Financial Stability: In order to avoid inflation, crisis or shock, and to monitor each intermediary to ensure the well behaving of the actor. 2. System Efficiency: In order to allocate financial resource in the most valuable way possible, and also to deliver goods and services in a way that minimizes costs and maximizes value. 3. Competition: encourages efficient and innovative financial services 4. Investor protection: Information transparency and fairness of intermediaries’ behavior Supervision Instruments 1. Structural Supervision: it uses powers of authorization to shape the structure of the system. - it is based on the paradigm STRUCTUE – CONDUCT – PEROFORMANCE. - By adjusting the market structure one can influence the level of efficiency of the system and its trade-off with respect of stability. 2. Information supervision: It includes all the communication and information tools that can reduce the information asymmetries typical of the financial activities. The information supervision wants to implement the conditions of: 1. Transparency: clarity and completeness of the information provided to investors in the direct and indirect exchange circuit. 2. Fairness: verifying compliance with the rules of conduct to which intermediaries are required to comply. The areas of application of this type of supervision concern the dissemination of information related to: financial transaction, issuers, intermediaries. The information flow is toward the issuers, the investors, the supervisory authorities and the bodies responsible for the function and management of the securities markets. Micro prudential Supervision Micro prudential supervision= How to understand if the bank can be evaluated by the ECB The ECB with the BoI, is responsible for supervising Italian banks and banking groups, by regularly evaluating their financial situation, verifying their compliance with prudential requirements, taking any supervisory measures necessary and performing stress test. All of these tasks are carried out by the Joint Supervisory Teams (JSTs), composed of BoI’s staff and by a coordinator appointed by the ECB and by an Italian sub-coordinator. Significance criteria: criteria that makes a bank significant Size The total value of its assets exceeds 30€ Economic Importance For the specific country or the EU economy as a whole Cross Border Activities The total value of its assets exceeds 5€ billion and the ration of its cross-border assets/liabilities in more than one other participating Member State to its total assets/liabilities, is above 20% Direct Public Financial Assistance It has requested or received funding from the European Stability Mechanism or the European Financial Stability Facility A supervised bank can also be considered significant if it is one of the 3 most significant banks established in a particular country. Less significant Less significant: Specific controls are done through document analysis and on-site inspections at intermediaries’ offices to check the quality and accuracy of the data submitted and gaining a better understanding of how they’re organized. Italian banks and banking groups are supervised directly by the BoI, with regard to Securities Investment Firms (SIMs) and managers of collective investment undertaking, the consolidated Law on finance tests the BoI with supervising risk control, stability, and sound and prudent management – if management irregularities or violations are discovered during the supervision, they incur in sanction procedures, because they could result in the imposition of administrative penalties so measures can be taken as requiring the implementation of recovery plans, in the most serious cases even a special administration. So, BoI monitors all these institutions (SIMs, EMIs) by performing analyses and taking measure designed to promptly uncover signs of anomalies in technical or organizational structures and to require appropriate corrective action. Specific Measures: Specific measures are taken when a crisis arises concerning the entities’ financial situation (stakeholder’s meeting is convened, the closure of a branch…) When the crisis doesn’t appear to be avoidable, the bank can order to devalue its shares and other regulatory capital instruments. If the crisis persists, the BoI can initiate the resolution or the compulsory administrative liquidation procedure. Macroprudential supervision It identifies the risk factors and vulnerability of the financial system that could threaten its stability in order to prevent or constrain/limit their effect in real economy. The sound and prudent management of individual intermediaries and the stability of the financial system as a whole are complementary objectives, the reason why if there’s a crisis in such intermediary, that play a crucial role in terms of payment and settlement system all the other linked intermediaries are impacted, due to their common exposure to certain risk factors. Consob As to say the “Commissione Nazionale per le Società e Borsa”, is the public authority responsible for regulating the Italian Financial Markets, for this reason its aim is to protect public investments, it ensures: - Transparency and correct behavior by financial market participants - Accuracy of the facts represented in the prospectus related to offering transferable resources securities to the investing public. - Disclosure of complete and accurate information to the investing public by listed companies. - Compliance with regulations by auditors entered in the special register - It conducts investigation with respect to potential infringements of insider dealing and market manipulation. - Regulates: the provision of investment services and activities by intermediaries, the reporting obligations of companies listed on regulated markets and appeals for public investment - Monitors: market management companies and the transparency and orderly performance of negotiations as well as the transparency and correct nature of the intermediaries as a whole and financial advisor. - Sanctions: the entities monitored. - Checks: the information disclosed to the market by entities launching appeals for public investment and information contained in the accounting document of listed companies. - Communicates: with operators and investors with a way to providing a more effective service and to develop the financial awareness of investors - Cooperates: with other domestic and international authorities appointed to organize and operate financial markets. IVASS The institute for the supervision of insurance, it’s an institute with legal personality under public law whose goal is prudent management of insurance. IVASS pursues the stability of the financial system and markets. EU System of Financial Supervision ESFS The main objective of the ESFS is to ensure that the rules applicable to the financial sector are adequately implemented in order to preserve financial stability and to promote confidence in the financial system as a whole and provide sufficient protection for financial outcomes. This system is embodied by 3 European Supervisory Authorities; 1. The European Security and Markets Authorities (ESMAs) based in Paris 2. The European Banking Authority (EBA) based in Paris 3. The European Insurance and Occupational Pensions Authorities (EIOPA) based in Frankfurt ESAs contribute to develop a unified set of rules for EU financial markets, including the area of anti- money-laundering. They also help to foster supervisory convergence among supervisory authorities, in order to fight against financial crime. ESAs play a key role to ensure that the entire EU is well regulated and supervised. The Joint Supervisory Teams (JST) Is a form of cooperation between ECB and the other nationals banks. There are for instance; credit institutions, banking subsidiaries. The size of a JST depends on the size of the linked banks. Each JSTs comprises: 1. A coordinator: not from the country in which he works, for a period of 3/5 years. 2. A National sub-coordinator: responsible for clearly defined thematic or geographic areas. 3. A team of experts: which allocate tasks among the team’s member, in the larger one. 2. Single Resolution Mechanism SRM resolution is the restricting of a bank by a resolution authority though the use of resolution tools in order to safeguard public interest, continuity of the bank’s critical functions, financial stability and minimal costs to tax-payers. Banks provide vital services to citizens, business and the economy. Therefore, due to its essential role the authorities have considered the necessity to put up tax-payers’ money to trust in the banking system and avoid broader systematic damage. A resolution action must be taken only when it’s necessary in the public interest or when winding up the bank under normal insolvency proceedings would no generate the same resolution objectives. Resolution tools are to be used to intervene in a failing bank so as to ensure the continuity of the Banks’ critical financial and economic functions, while minimizing the impact of the economy and financial system. Bank’s shareholders and creditors will bear the losses. Resolution Objectives are: - to ensure the continuity of the critical functions: the SRB identifies whether the bank carries out any critical functions that may have an adverse impact on the real economy and financial stability. - to avoid significant adverse effects on financial stability, preventing contagion and maintain market discipline. These situations could arise whether the financial system is exposed to a disruption. - to protect public funds by minimizing reliance on extraordinary public financial support. - to protect depositors covered by the investor compensation scheme directive ICSD. - to protect client fund and client assets. Conditions met to put an entity into resolution - The bank is failing or likely to fail FOLTF; For the “Banking Union”, it’s determined by the ECB, the SRB may also determine that a bank is considered FOLFT, if it has informed the ECB, and the latter one cannot decline if it hasn’t reacted within 8 days. - There are no supervisory or private sector measures that can restore the bank viability within a reasonable time-frame - Resolution necessary in the public interest. Bail-in and Bail-out; Bail-in: when a company’s shareholders or creditors bear the losses by having a portion of their debt written off or covered into equity. Avoiding the Moral Hazard. Bail-Out: a person other than shareholders and creditors (e.g. government) rescue a company by injecting money to prevent negative consequences in the F.S. or in the real economy. Resolution vs insolvency The overarching objective of the BRRD (Bank Recovery and Resolution Directive) resolution regime is to make sure that a bank can be resolved swiftly with minimal risk to financial stability. This should be achieved without negative impact on the real economy and without the need to spend taxpayer money to stabilize a failing bank. Resolution objectives are much broader than the objectives of normal insolvency proceedings Within that context, the resolution authority would also seek to ensure that No Creditor would be worse off in resolution than insolvency the called “No Creditor Worse Off” test. General rules governing resolution a. Shareholders have to bear first losses b. No creditor shall incur higher losses than they would have incurred if the bank had been wound up under normal insolvency proceedings. c. Creditors will bear losses after shareholders d. Natural and legal people are made liable subject to national law for the failure e. Creditors of the same class are treated in a equal manner. f. The manager and senior manager must be replaced, except when maintaining them is considered necessary for the aim. g. Covered deposits are fully protected. According to DGSD 100k is a great level of protection. 3. The European Deposit Insurance Scheme (EDIS) Settled up in November 2015 by the commission, for bank deposits in the euro area, this is a part of the broader package of the economic and monetary union. It’s a built on the system of national deposit guarantee schemes (DGS) – all deposits over 100k are protected through DGS all over EU. The EDIS would provide a stronger and more uniform degree of insurance, reducing the vulnerability of national DGS. The EDIS would be applied to deposits below 100k among all the banks in the Banking Union, so then if one these banks is placed into solvency or resolution, the EDIS or DGS will intervene. Central Banks Are the most important players in financial markets, as the government authorities in charge of monetary policy. Its actions affect interest rates, the amount of credit, and the money supply – all of which has a direct impact on financial markets and on aggregate output and inflation. The European Central Banks (ECB) Was born on June, 1, 1998 to handle the transitional issues of the nations that comprise the Eurozone. All of the member state of the EU has to comply with a set of economic and legal conditions. In January, 1, 1999 only 11 EU member state had adopted the euro. All of the Eurozone retain their own National Central Banks (NCBs) and their own banking systems. In 2017, 19 countries have joined the euro area. Eurozone Is an economic and monetary union embodied by all the member state of the EU that have adopted the euro as their currency. There are 12 regional FED located in major U.S cities. They act as the operating arm of the FED, and implement the FED’s dual mandate of long-term price stability and macroeconomic stability through creating jobs. It generated income form services provided to banks members and from interest earned on government security – any excess is funneled in the U.S Treasury. Similarities Between the ECB and FED - Both are entities that bind a number of regional central banks together - Both are independent institutions with decentralized structure - The ECB supports political independence and the Fed is highly independent from government. Differences between the ECB and the FED 1. ECB - The primary objective is to achieve price stability - The NCBs control their own budgets and the budget of the ECB - It uses a hierarchical mandate, placing the goal of price stability above all other goals 2. FED - Its dual mandate and monetary policy objective is to deliver price stability and to support macroeconomic objectives for growth and employment - The budget of FED is controlled by the board of Government. - It uses a dual mandate, where maximizing employment stable prices, and moderate long-term rates are all give equal importance. 5. Mortgage What is a mortgage? A mortgage is a long-term loan secured by real estate. This loan is amortized: the borrowers pay it off over time in some combination of principal and interest payments that will be the full payment of the debt at the deadline. Characteristics of the Residential Mortgage: 1. Mortgages Interest Rates the stated rate on a mortgage loan is determined by 3 rates: - Market Rates (long-term): general rates on Treasury bonds; it’s determined by the supply of and demand for long-term funds influenced by several factors. - Terms: long-term mortgages have higher rates. - Discount point: a form of prepaid interest. That lower your interest rates and result in savings throughout the loan term. E.G.: you have to choose between a 12% 30 y. mortgage or a 11.5% mortgage with with 2 discount point (you would borrow 100k). a) examine the 12% mortgage with financial calculator, you can calculate the payment for a loan based on a constant payment and a constant interest rate. n (tot. number of payments for the loan) = 360 i (interest rate for the loan) = 1.0 PV (present value)= 100k PMT= 1.028,61$ b) examine the 11.5% with the same method: n= 360 i= 0,95 PV= 100k PMT= 990,29$ Analysis: if you want to live there 12 month, the 2k upfront cost isn’t worth the monthly savings therefore many mortgages lenders will point to the 30y. one, but although the calculation is correct, you have to determine the present value of the savings 38.32$ equals the 2k upfront: i: 1 PV: -2k PMT: 38,32 n: 74 months, around 6.2y So, if you think you will stay there for that time, you should choose the upfront formula, otherwise, you should accept the 12% loan. Result: paying the points, you will save 38.32$ each month, however you have to pay 2k upfront, this decision must be taken considering how long you will live there, keeping the same mortgage. 2. Loan Terms Mortgage loan contracts contain many legal terms that need to be understood. Most protect lender from financial loss: - Collateral: the lending institution will place a lien against the property; with the lien the property becomes a security for a loan, and gives the lenders the rights to sell the property if the underlying loan defaults. No one can purchase the property without paying off the lien. All this explain the importance a title has in the world of real estate. - Down payment: to obtain a mortgage loan, the lenders could require to make a down payment on the property, as to say to pay a portion of the purchase price. Useful to avoid a default situation from borrowers. If real estate price drop, even of a small amount, the balance of the loan will exceed the volume of the collateral. Obviously, the amount of the down payment depends on the type of mortgage loan. We saw in the hosing downturn beginning in 2006 that many borrowers discovered their property was worth less than the owned and default rates skyrocketed. Example: cost of the house 200k, you have 40k for the down payment, so you need 160k loan to purchase the house. Your loan-to-value (the ratio of a loan to the value of an asset purchased) in percentage: 160l/200k= 0,8 multiply by 100% -> 80% PMI (Private Mortgage Insurance) Is an insurance policy that guarantees to make up any discrepancy between the value of the property and the loan amount. The private mortgage insurance is required when you LTV (loan to value) is above 80%, because it protects the lenders from default and it’s paid by borrowers (20/30$ per month for a 100k loan). It’s usually required on loans with less than a 20% of down payment. If the - The development of risk management policies represents the permanent concern of the management of banking institutions. these policies must be retrieved in each level of the bank's framework by applying specific tools. All banks set up risk management departments to monitor, manage and measure risks by continuously measuring the risk of its current portfolio, loans deposits. - The recent financial crisis has generated changes in terms of risk management, the solvency requirements of financial entities and the behaviors of financial markets participants in such situations Risk in Banking Before the crisis in 2007, the regulations and financial innovation made banking industry more complex, larger and dependent on financial markets' development, with the widespread use of financial instruments, these factors lead banks to take on new risks. Regulatory Solutions 1. Initial BASEL 1 ACCORD mostly focused on applying common minimum capital requirements related to banks' credit risk exposure 2. BASEL 2 ACCORD with 3 risk buckets (banks should hold capital against 3 main types of risk) these risks are: credit risk, market risk and operational risk (operational risk is the most difficult one: new controversial and hard to define and quantify) - BASEL 2 allows banks to use their own internal assessment model. 3. BASEL 3 INITIATIVES aimed at raising the core capital levels of institution (in particular of undercapitalized ones) making an effect at reducing the cyclicality of credit and increases in the capital requirements for those institutions relying on short-term market funding Risk Faced by Banks 1. Credit risk 2. Market risk 3. Liquidity risk 4. Operational risk 5. Reputational risk 1. Credit risk Is the inability of a customer to repay the principal and/or interests on the loan on time. The BASEL Committee on Banking Supervision (BCBS) defines credit risk as "the potential that a bank borrower, or counter party, will fail to meet its payment obligations regarding the terms agreed with the bank. it includes both uncertainties involved in repayment of the bank's dues and repayment of dues on time. The default usually occurs because of inadequate income or business failure. - IT is also the risk of a decline in the credit standing of a counter-party, such deterioration doesn't imply default, but increases the probability of a default. This risk is called, MIGRATION RISK, whether the rating agency downgrades the public credit issued (securities or bond). Migration Risk: The risk that a bond will be downgraded to a lower credit rating by one of the independent ratings agencies, reflecting its likelihood of default. As a bond migrates its price usually falls. Types of Risks; 1. Spread Risk: an increase in the spread required to borrowers such as, bond issuers by the market. When risk aversion increases due to instability the spread differential between good quality and bad-quality bond may rise (flight quality). 2. Recovery Risk: in case of insolvent assets of the counterparty, when the recovery rate is lower than initially predicted because of a lower liquidation value or unexpected delays in cashing bad assets. 3. Sovereign Risk: The potential a nation's government will default on its sovereign debt by failing to meet its interest or principal payments. It’s typically low, and private subject cannot have an individual specific risk lower than the country, in which they’re settled. Moral Hazard and Adverse selection Moral Hazard Is the problem created by asymmetric information after the transaction occurs. - Moral Hazard in financial markets if the risk (hazard) that the borrower might engage in activities that might seem undesirable to the lender, because they make it less likely that the loan will be paid back. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan. Adverse Selection Is the problem created by asymmetric information before the transaction occurs. Adverse selection describes a situation in which one party in a deal has more accurate and different information than the other party. The party with less information is at a disadvantage to the party with more information. - this is occurs when potential borrowers who are most likely to produce an undesirable (adverse) outcome the bad credit risks are the ones who most actively seek out a loan and are thus most likely to be selected. - Due to the fact that adverse selection enhance the possibility that loans might be made to bad credit risks, lenders may decide not to make any loans even though good credit risks exist in the market. Managing Credit Risks This regard the investigation made by banks on borrowers' ability to repay their loans before and after the loan has been made (screening and monitoring functions) because of their aim to maximize value and the responsibility they have towards their depositors and deposits insurers to be safe and sound. - banks act like delegated monitors for lenders, by providing new technologies and innovation in the design and enforcement of contracts. (Essential for the protection of banks' owners and lenders). Activities: 1. Screening and Monitoring: collecting reliable information on prospective borrowers. Some institutions specialize in regions or industries gaining expertise in evaluating particular firms or individuals. - Essential is to verify if the borrowers are complying with the terms. 2. Long-term customer relationship: analyzing checking accounts, saving account or previous loans which provide valuable information to easily determine credit worthiness. 3. Loan commitments: arrangements where the bank agrees to provide a loan up to a fixed amount. 4. Collateral: Number of securities given for loan. The sum you wish to borrow is that large that it must be secured by a collateral. 5. Compensating Balances: the portion of an unsecured loan that is kept on deposit at a lending institution to protect the lender and increase the lender's return. 6. Credit rationing: the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate. Credit Risk Exposure Measures the potential magnitude of loss if a default occurs. The probability of default (PD) measures how likely a loan will not be repaid and will fall into default. It must be calculated for each borrower. Doesn't depend only on the borrower's characteristics but also on the economic environment. Another type of mismatch another type of mismatch could occur when the maturity of bank's liabilities is longer than the maturity of the assets. The banks can be seen as "long-funded", in this case the bank should be aware of the risk of reinvesting their funds in the second period at a rate that may be less advantageous that the previously one and couldn't be able to forecast it. Exchange Risk Is related to money denominated in the currency of another nation or group of nations. As the sharply increment of a more global banking markets, the importance of international activities (foreign direct investments) has increased. However, the actual return bank earn on foreign investments may be altered by changes in exchange rates. As other prices, the exchange rate is influenced by supply and demand. Foreign exchange risk: is the risk that exchange rate fluctuation affect the value of a bank’s assets, liabilities and off-balance-sheet activities denominated in a foreign currency. 3. Liquidity Risk Risk associated with the inability to liquidate a security quickly and at a fair market price. - the risk of a bank that cannot do day-to-day transaction due to inability to produce necessary short-term liquidity, this is generate in the balance sheet a mismatch between the size and maturity of assets and liabilities. Therefore, banks have to manage their liquidity in order to front predictable and unpredictable demands. 4. Operational Risk Is the risk of loss resulting from inadequate or failed internal processes, people and system or from external events. It occurs due to human error or mistakes. Examples are: - incorrect information filled in during clearing a check. - confidential information leaked due to system failure. Categories: 1. legal risk: the risk that contracts that are not legally enforceable or documented correctly could disrupt or negatively affect the operations, profitability or solvency of the banks. 2. human risk: potential losses due to a human error, done willingly or unconsciously. 3. IT/system risk: potential losses due to system failures and programming error 4. Processes risk: potential losses due to improper information processing, leaking or hacking of information and inaccuracy of date processing. 5. Reputational Risk Is the risk that strategic management’s mistakes may have consequences for the reputation of a bank. There’s even the risk that negative publicity may affect a bank’s customers choice or bank profitability. This risk arises from the negative perception on the part of customer, counterparties, shareholders… Consequences of loss of good reputation: - Loss of current and future customers - Exist of Key employees, inability to have top talented - Loss of current or future business partners - Increased costs of funding in credit or equity markets - Loss of revenues - Decline in stock price and shareholders confidence - Penalties and/or litigation - Decline in global prestige. - Years to recover the reputation. Types of Risks: - Inflation risk: an increase in price lever for g/s will erode the purchasing power of a bank’s earning and returns. - Settlement or payment risk (herstatt): it happens in the interbank market; when one party through a contract fails to deliver money or assets to the counterparty at the settlement (e.g time zone) - Regulatory risk: a changed in regulatory policy - Competitive risk: when a borrower has the right to pay off the loan early, thus reducing the lender’s expected rate of return. - Management risk: when managers lack the ability to make commercially profitable and other decision. That can even be the dishonesty of employees. - Strategic risk: risk that arise from changes in the strategic implementation. 7. MIFID 1 & 2 MIFID 1 markets in financial instruments directive come into force on November 1 2007 because The European Financial System was fragmented and there was the need of improvements Weaknesses before MIFID 1 - Poor degree of harmonization to achieve a full integration of the EU financial system - Obsolete rules of investor protection and excessive rigidity of rules - Range of investments sources and financial instruments not in line with developments - Different approaches to the regulation of market structure. Main Objectives 1. integrity of the financial system to ensure fair and honest professional conduct by operators and the importance of protecting weak investors. 2. Efficiency of the financial system pursued through the strengthening of competition, new system of governance, transparency of pre- and post-trade. In order to create a unified financial system, there are several pillars: 1. Maximum harmonization: related to the harmonization of the rules, we can have it only fi there's the same basic principles 2. Mutual recognition: when a financial instrument, intermediary, market or trading value is accepted and authorized to operate all around EU. 3. Home member state supervision: a SIM which is Italian but operates in other EU state must be supervised by CONSOB (origin state) Main Areas of Reform: 1. Intermediaries and financial services - investment services - organizational requirements - sustainability, rules of execution only - Best execution policies 2. Financial Markets - Trading venues - Transparency rules - Admission of operators and F.I - Transaction Reporting 2. Evaluation of competition 
 - within countries and between EU trading venues from different countries: - competition between trading venues (Italy vs France) belonging to the same typology. - Competition between different typology of trading venues (RM vs MTF): RM is stronger considering that market operators are managing the trading venue. Therefore, there's more protection despite a market MTF 3. Technological Innovation - tends to lower barriers to entry 4. Different needs of trading enhance competition: - level of information desired or necessary - degree of speed exchange - size of the transaction Aims and Results Results: - increasing competition - greater integration - wider choice of financial institution and instruments - lower transaction costs Unresolved Challenges: - difficulties in the transmission of the benefit to the investor - evolution of new technologies and procedures - weakness in the regulation of non-equity instruments - need of further protections in the investor MFID 2 Europe considered the rise of the MIFID 2 on the 3rd of January 2018. Timeline - Adopted by parliament - Publication on the official journal 12/06/14 - Entered in force 2/07/14 - Implemented in countries' legislation 3/07/16 - Applied 30 months after 3/01/17 New Key elements of the regime 1. introduction of organized trading facility OTF and revision of IS regulations - OTF: It's defined as a multiple system in which parties buying and selling interest in non- equity instruments (bonds, structured finance products...) are able to interact in the system in a contractual way. The discretion in order execution is the main difference from RM and MTF. Both market operators for investment firms and OTF can use it but in the OTF, when orders arrive, market operators can retract the order or match it with other in the system. EU regulated those market operators that acted outside the law and needed the approval to use the discretion. MIFID came to force to implement protection as best execution. It's prohibited to operate in the OTF and SI in the same legal entity. - Systematic Internalizers (SI): (Before the MIFID II Fineco was the first and only). Investment firms though an organized, systematic and substantial basis deals on own account by executing orders outside RM, MTF AND OTF. Two quantitative thresholds that's are harder for investment firms considering that they are not systematic internalized: - determine whether the firm deal on own account on a "frequent and systematic" basis. It is measured by the number of OTC trades in the financial instrument carried out on own account by executing client orders. - determine whether the investment firm does so on a "substantial basis". It's measured by both OTC trading in relation to the total trading of the firm in a specific financial instrument or by the size of the firm's OTC trading compared to the total. Trading in the EU in a specific financial instrument. 2. trading obligation for equity and derivatives: investment firms are obligated to continue in RM, MTF or SI or trading venues in third countries transaction in shares admitted to trading in RM or traded on trading venues. The obligation cannot lead in cases of "proper reason" for trading outside the trading venue established. proper resons: 1) Nonsystematic ad hoc, irregular and infrequent OTC transaction 2) Transactions carried out between "eligible counterparties or professionals" and do not contribute the price formation. 3. transparency regime for equity-like and non-equity: we show in MIFID 1 transparency regime only for shares admitted to trading in RM in EU. In the MIFID 2 we add equity-like securities, non-equity financial instruments. Transparency requirements (some for RM, MTF and OTF) calibrated according to the instruments under negotiation. 4. Algorithmic and high-frequency trading (HFT): Based on computer making orders, there are several rules to regulate those investment firms who want to engage in algorithmic trading, any trading where computer finds automatically individual parameters of orders. Firms who decide to implement this mechanism must have a systems and risk controls and are subject to appropriate thresholds and limits. Law and Market New trading venues not covered by MIFID, more limitations due to an inadequate regulatory transparency for non-equity F.I, potential adverse effects from the fragmentation of liquidity and information, greater transparency for less regulated areas but the Financial System is a vital, ever- changing system, it’s impossible to keep up on its continuously evolution. 8. Banks The bank balance sheet: To understand how banks work, it is possible to start looking at the bank balance sheet. It is a list of a bank's assets and liabilities - Total assets = total liabilities + capital The balance sheet highlights the sources of banks funds (liabilities) and uses to which the funds are put through assets. The banks invest these liabilities (sources) into assets (use) in order to create value for their capital providers. Banks obtain funds acquiring assets as securities and loans, and charge interest rates on their assets higher than the interest rate on liabilities to earn profits. Liabilities the bank acquires funds by issuing liabilities such as: 1. Checkable deposits: Are bank accounts that allow the owner to write checks to third parties. They include non-interest bearing and interest bearing and even money market deposit account (MMDAs). Usually checkable deposits make up 10% (lowest-cost) of bank liabilities because depositors prefer to have liquidity to purchases goods. A characteristic that 6. Other assets: are just physical capital owned by the bank. Basic Banking The process of selling liabilities with certain characteristics and buying assets is called asset transformation, for instance banks transform saving deposit into a mortgage loan. The bank borrows short and lends long means that it makes long-term loans and funds them by issuing short-dated deposits. Example: If the bank opens a checking account with a $100 bill, these money are deposited into the vault cash due to the rise of bank’s assets. Knowing that the vault cash is nothing but reserves + currency we could organize the BS as: Opening a checking account led to an increase in the bank’s reserves equal to increase in checkable deposit. The same thing could have happened whether the account was opened at another bank. When’s a check written on account at one bank is deposited into another the collector bank receives additional deposits gaining an equal number of reserves, this line of reasoning could have been done with losses too. It’s important to remember this once the bank has received the 100$ checkable deposit, it is obliged to keep a certain fraction as required reserves assuming that the amount is equal to 10%. Although serving extra $100 is costly there are 2 ways to make profits: -invest in securities; -make loans: we said earlier those loans provide the largest profit for the banks because lenders are subject of moral hazard. Banks implement efficient instrument to evaluate potential borrowers using the 5 C’s that are character, capacity, collateral, conditions and capital before agreeing the loan. Banks are gaining profits using the method of “borrowing short and lending long”. If for example the loan has an interest rate of 10% per year the bank earns $90 x 10% = $9 from its loan each year. If a $100 of checkable deposits is in a now account with a 5% of interest rate and there’s a supplemental cost of $3, the cost per year of these deposits is $100 x 5% + $3 = $8 and as a consequence the bank’s interest per year is $1. General Principle of Bank Management The BANK MANAGER has 4 primary concerns: 1. liquidity management in order to understand if there's enough cash to pay its depositors where there's a deposits outflow; 2. asset management he/she has to pursue an acceptably low level of risk by buying low rate of default and diversifying asset holdings. He/she also manage the credit risk, arising because borrowers may default and interest- rate risk, the riskiness of earning and returns from interest-rate changes; 3. liability management acquires funds at low costs; 4. capital adequacy management the amount of capital the bank should maintain. Liquidity Management and the Roles of Reserves In case of deposit outflows and assuming that the bank has ample excess reserves and all the required reserves ratio is 10%, if the depositor would withdraw $10 million occurs: The bank as a result loss $10mil of reserves therefore now its required reserves are $90 mil. x 10% = $9mil. with a surplus of $1mil. Concluding if a bank has ample excess reserves, a deposit outflows doesn’t necessitate changes in other parts of its BS. Let’s now analyze the case in which the bank has an insufficient excess reserve: When it suffers the $10 mil. outflow it a reserves requirement of $9 mil but its reserves are currently $0, therefore to cover this shortfall it has 4 basic options: 1. borrowing funds from other banks int the federal fund market or form corporations: if the bank acquires $9mil. from the Fed its activity cost is the interest rate on the borrowing. 2. sell some of its securities: for instance, selling $9 mil in securities and depositing them in the reserves. Transaction costs are quite modest, but the other securities the bank holds are less liquid and transaction costs can be appreciably higher. 3. Borrowing form Fed: the bank could borrow fund by Fed in a form of discount loans and the costs associated with this action are the discount rate. 4. there are 2 more sub-methods: - reducing its loans by the amount required and increasing the reserves. If the bank has several short-term loans renewed at fairly short intervals, it can reduce its total amount by calling in loans in other words not renewing some loans. This action could be risky because the bank can lose clients. - reducing its loans and sells them off to other banks: can be very costly considering that banks are not willing to invest on uncertain loans and are not willing to pay the full value of them. As conclusion excess reserves are insurance against the cost associated with deposits outflows. The higher the cost associated with deposits outflows; the more excess reserves banks want to hold. The direct relationship between ROA and ROE is determined by the EQUITY MULTIPLIER (EM) that indicates the amount of assets per dollar of equity capital: 17 = .00'(0 '23-(4 5.)-(.6 ROE = ROA x ROE This formula summarizes how to understand in % if bank's owners are getting an high return on equity. For instance, the first bank initially has $100 mil of assets and $10 mil of equity equal to an EM of 10, on the other side the second bank has $100 mil of assets and only $4 mil of equity equal to an EM of 25. Supposing a well- management we assume that the ROA is 1% for both banks. The ROE for bank n.1 is 10% and for the bank n.2 is 25%. We can clearly see that given the ROA, the lower the bank capital, the higher the return of the owner bank. 3. Trade-off between safety and returns to equity holders Obviously bank capital has both benefits and costs. Although bank capital reduces the likelihood of bankruptcy, it's costly because the higher is the capital, the lower is ROE at a given ROA. In other words, managers must decide how much safety that comes with higher capital (benefits) are likely to trad-off against the lower ROE that comes with higher capital (costs). In situations of larges losses on loans managers want to hold more capital to protect equity holders, in a contrary situation managers might santo to reduce capital and increase the ROE. 4. Bank Capital requirements Banks are obliged to keep a certain amount of capital by the government regulatory authorities. Off-Balance-Sheet Activities To adapt themselves to the more competitive environment of recent years, banks started to seeking profits by engaging in off-balance-sheet activities that consist activities that involve the trading of financial instruments and the generation of income from fees and loan sales, all of which affect bank profits but are not visible on bank balance sheets; these activities don’t appear on the BS and are grown more than fivefold since 80s. Loans and Sales It's called a secondary loan participation in which the bank sells all or part of the cash streamed in the loans, thereby removes the loans from its BS. Banks earns profits by selling it for an amount greater than the original so institutions are willing to buy it thanks its high interest rate. A higher price on these loans lead the institutions to earn slightly lower interest rate than the original interest rate (0.15%). Generation of Fee Income Banks generate income from fees by: - providing services as foreign exchange trades on a customer's behalf - guaranteeing debt securities as banker's acceptances (promise to pay if the party issuing cannot) - providing backup lines of credit, the most important in this category is the loan commitment, where for fees the banks agree to provide a loan at the customer's request. - Another one is, the "overdraft privileges" supplied for depositors that's can write checks in excess of their deposit balance. Other lines of credit for the bank include note issuance facilities, NIFs... All these activities increase the risk a bank faces. In other words, if the issuer of the security defaults, the bank must pay off the security's owner. The bank is obliged to lend loans even if it hasn't enough liquidity or if the creditor is a very poor credit risk. Trading Activities and Risk Management techniques Banks can even conduct transaction in the foreign e hang e market and these activities do not affect directly the BS. Here banks can reduce risk or facilitating other bank business, but they also join this market for speculation that is highly risky and could lead the bank to insolvency. Trading activities are highly profitable but also dangerous considering that it’s easy to make huge bet quickly. A particular problem for managers is the principal-agent problem: given the ability to bet, a trader has a incentive to take on excessive risks because if her/his strategy goes well, he/she will gain profits but if her/his strategy goes bad, the institution must cover the loss. To avoid this problem, financial institutions must set up internal controls for example, limiting the amount to bet or scrutinizing risk assessment procedures through latest technologies. A useful ethnic is the value-at-risk approach that can calculate the maximum loss that the institution is able to support. They can implement even the stress testing approach evaluating if the managers are able to front difficult situations. Measuring Bank Performance the BANK'S INCOME STATEMENT describes the source of income and expenses that affect the bank's profitability. Bank’s income statement 1. Operating income: It's the income that comes from a bank's ongoing operations generated by interest on its assets where this interest income represents the 65.4% of commercial bank's operating income. The interest income has a direct relationship with interest rate therefore its percentage of operating income is highest when interest rates are at peak levels. In 1981 the interest rate rose above 15% and so the interest income rose to 93%. Non-interest income (made up 34.6% of operating income in 2015) is generated by service charges on deposit accounts but most of all it comes from off-balance-sheet activities. 2. Operating expenses: Are all those expenses incurred in conducting the bank's ongoing operations. Essential to keep in mind for the bank is the interest expenses as the interest payments on its liabilities or deposits. This kind of interest as a direct relationship with interest rate too. The interest expenses reached its peak of 74% in 1981. Non-interest expenses include the costs of running a baking business (salary, rent...) Loan loss provision: is an income statement for uncollected loans and loan payments. This provision is used to cover different kind of loan losses such as non- performing loans, that incur lower than-previously-estimated payments. Loan losses provisions are then added to the loan losses reserves; represent the total amount of loan losses subtracted a company's loans. 3. Income: Net operating income is sought by bank managers, bank shareholders and bank regulators. It indicates how well is doing the bank on an ongoing basis. The bank can implement two items such as: gains (losses) on securities sold by banks and net extraordinary items but they are not likely to be used. Important items are the net income before taxes (profit before taxes) and the net income after taxes (profit after taxes) that tells us how well the bank is doing because it's nothing but the amount the bank could keep as retained earnings or dividends. The 1980s brought the third-world debt crisis; a sharp decline in energy prices in 1986, which caused substantial losses on loans to energy producers; and a collapse in the real estate market. As a result, provisions for loan losses were particularly high in the late 1980s, reaching a peak of 13% of operating expenses in 1987. After that, losses on loans began to subside, but they rose sharply Yield to Maturity Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures, with all payments made as scheduled and reinvested at the same rate. This aim is to determine how much money one would make by buying a bond and holding it for one year. To calculate the yield of maturity for a coupon bond is equal to the sum of the PV of all the coupon payments plus the PV of the final payment of the face value of the bond !"#$"% '()* = 10% = !" Distinction between Interest Rates and Returns Returns can differ from the interest rate because the the rate of return is the payment to the owner plus the change in its value expressed as a fraction of its purchase price !"#$ & '($ )"#$ & *+,-$ For instance, if the bond is bought for $1000 (fav) and held for one year and sold for $1200, considering a coupon rate of 10%; after one year of return: 100 0 10% + (1200 − 1000) 1000 = 300 1000 = 0,3 = 3% Initially the yield of maturity was 10% but this doesn’t mean that the return on a bond will equal the the interest on that bond. Summing up the rate of return is: Current Yield + Capital Gain Yield Maturity and Volatility of bond returns 1. only the bond whose return = yield is one with maturity = holding period 2. for bonds with maturity > holding period, as rate increase, price falls, implying capital loss 3. longer is maturity, grater is price change associated with interest rate change 4. longer is maturity, more return changes with change in interest rate 5. bond with high interest rate can still have negative return if the interest rises Summing up prices and returns more volatile for long-term bond because they have higher interest- rate risk. There are no interest-rate risk for any bond whose maturity equals holding period. Duration Stocks The bond price fluctuation depends on the exposure to an interest rate risk that is more true the longer the residual life of the tittle is, therefore the residual life is nothing but a measure of the risk of the bonds, this risk measurement is summarized in the duration or average duration of the bonds. Duration measures the time required to recover the price paid for the purchase of the debt security. To calculate the duration, we have to calculate the PV of the individual cash flow: The PV is divided by the negotiation price of the security obtaining the % weight that each flow has on the price paid, therefore what the share of the price recovered is. !"# =%& ! "#$ '(" (1 + ,)" /p 10. Stocks Stocks: shares of ownership in a company. Investing In Stocks An investor wants to buy stocks to earn something more, receive dividends and sell them at a higher price. In particular stock represents the ownership in a firm and gives to the owner the right of vote for directions and on certain issues. The stockholders have claim on all assets. Through the stock we can earn returns in 2 ways: - the price of the stock rise overtime - dividends are paid to the stockholders. There are 2 types of stocks: 1. common stocks: the stockholder is allowed to receive dividends and has the right to vote. 2. preferred stock: the stockholder receives a fixed dividend and doesn't usually vote. Computing the price of common stock: the one-period valuation model This model uses the expected dividend and the price over the next year: - when the maturity of a bond lengths, the duration - when interest rates rise, the duration of a coupon bond fall - the higher the coupon rate on the bond, the shorter the duration of the bond We could add to the former formula the discount rate as the proxy risk of the company: Computing the price of common stock: the multi-period valuation model A complementary return indicator that considers the set of cash flow expected from time 0 to time K. The maturity coincides with an indeterminate period K in perfect coherence with the undermined expiry of the stock investment. Although this is the most complete mechanism, it's complex and difficult to apply on a practical level because it's not easy to know they expect dividends at the end of each periods and it's difficult to evaluate the selling price due to the market fluctuation: Computing the price of common stock: the dividend discount model This formula explains the price of the share with reference only to dividends and is nothing but the sum of the PV of the expected dividends. This equation works similar to the former but assuming that k tends to ∞, in this case the longer the period, the lower of selling price , the higher of expected dividends. Here r represents the only rate that verifies the equality between the present stock price (fair price) and the sum of the present value of future expected dividends: Computing the price of common stock: the constant growth dividend discount model - $40 and the delivery price, fixed in the contract, is equal to 45 euros; and the expiry is set at three month. Upon expiry in the first hypothesized case - market value of the barrel at maturity equal to 50 euros - the buyer he will receive a barrel paying only $45 with a profit of $5. The gain of the buyer corresponds to the loss of the seller, who will deliver for only $45 an asset that could instead sell on the market for $50. In the second case - market value of the barrel at maturity equal to $40, the parties reverse. The buyer will have to pay $45 what is actually worth 40, with a loss of $5, while the seller, for the same reason, will earn $5. Financial Future Markets Financial Future Contracts Another solution to hedge the interest-rate risk was the development of financial futures contracts, it specifies that a financial instrument must be delivered by one party to another on a state future date. For example, if the contract value is for $100k face value of bonds, these must be delivered when they're reached a maturity equals to 15 years and they mustn't be callable. In the case of a change in the coupon rate, the amount of bonds to be delivered is adjusted to reflect the different in value between the delivered bonds and the new coupon rate. Parties who have bought the bonds have taken a long position and the parties who sold them have taken a short position. Features of the future contracts are: - specific delivery of type of the security at future date - futures are standardized instruments (main difference with forwards contracts) - if rates increase, long contracts has a loss because the price will lose, although short contract has profit for the same reason. - Micro hedge: hedging the value of a specific assets - Macro hedge: hedging the entire value of a huge portfolio Traded on Exchange In the U.S. futures are traded in the CBOT and CME, or in the NY Futures Exchange and others. They are all regulated by the Commodity Futures Trading Commission. In EU, futures are traded on trading venues as RM and MTF. In Italy, futures are traded on IDEM, a regulated market managed by Borsa Italiana. Success of Futures 1. futures are more liquid because they trade standardized contracts 2. delivery a range of securities reduces the chance that a trader can corner the market 3. market to market daily to avoid the default risk 4. don't have to deliver physical assets. Thinks will reduce cost of transactions because futures close every day with a cash netting of positions. Market to Market daily To avoid the settlement risk that characterize the forward markets, here the market is daily. This means that both the counter parties have to pay a margin in order to take both positions. In order to do so, both actors assume brokers to give those money from the banks to the clearinghouse (a market institution that is like the counter party of both counter parties). This margin covers the volatility of underlying assets during the period that could generate risks. For instance if at t0 the value is $10 but at t1 it's $10,20 at the end of the day the clearinghouse takes 20 from the sellers (he/she cannot go against) and gives them to the buyer. As we said, the market-to-market daily is a good mechanism to avoid settlement risk but due to the ease of betting with few dollars or betting bigger capital, speculation is higher and dangerous for the financial system. Option Contracts Option contract contract to hold an offer to make a contract open for a fixed period of time - In the options contracts the counter parties earn the right to buy (call) or not and to sell (put) or not the underlying asset at the strike price until the expiration fixed date (American way) or at the expiration date (European one). This contract can be used for several financial instruments as individual stocks, stock index, futures... $10 $12 +! +" $10 $8 +! +" For instance, two counter parties agree to buy and sell a call option. B (buyer) buys the right to buy or not the stock at a future price of $10 at the expiration date, but to have this warranty B has to pay a premium ($1) to S (seller). Call Options Call option: the option to buy shares of stock at a specified time in the future Two cases arise for the buyer: 1. Buyer decides to buy when the market price at expiration date is higher than the strike price, because B buys the stock at a lower price (the established one) and gains $1. 2. Buyer decides not to buy the stock when the market price at expiration date is lower than the strike price, because it's not convenient, therefore the investor loses just the premium In the chart of the PAY OFF of the BUYER, at the beginning B has to pay the premium forcing negatively the line, and with S setts the strike price. At the exp. date if the price is higher B would buy the asset at the strike price. The maximum loss is only the amount of the premium, instead the maximum profit is equal to infinite and it can be very high. 12. Securitization Securitization: the process of transforming loans or other financial assets into securities. It's a technique used to covert liquid assets into tradable securities sold than, to the capital market investors. This method helps the originator to raise cash, but it is also a tool to transfer a credit risk. Parties in the Securitization 1. Originator: is usually the party (lender) who originally underwrites the asset (loan). Originators include capital financial companies, commercial banks, insurance companies... 2. Borrower: owes the originator payments on the underlying loan and therefore are ultimately responsible for the performance of the issued securities. Originators often maintain a service relation with the borrower. 3. Rating agency: the securities issued are assessed by a rating agency to allocate a rating to them. Investors require a minimum or higher rating of investment grade. This company is able to evaluate the risk and investors are able to buy ABS knowing the risk. It's preferable if the agency is honest and professional in order to gain us all. 4. Credit enhancement provider: used to improve the creditworthiness of the notes to be issued and protects investors from bearing all the risk of the collateral pool if the economic conditions deteriorate. (We can refer to bad loans). 5. Asset servicer: payments during the securitization are numerous, therefore a company provides to collect or segregate money for other institutions' behalf. Most of the time this service is provided by banks that earn fees and are likely to build a strong and tight relation with their debtors. 6. Investor: investors of the securities issued by the SPV, and are thus entitled to receive the repayment and interest based on the cash flow generated by the underlying assets. Collaterals ensures a payback to them. 7. Investment bank: mainly structures, underwrites and markets the securitization transaction. Interests’ conflicts may arise because investment banks sometimes are the owner of rating agencies, ABS or even SPV. For instance: A want to pay fixed interest-rate because A forecasts that in the future prices will increase. B instead things they will decrease so B wants to pay a variable interest-rate. After a while they changed their mind and want to swap. No one can predict who will win the just have to wait the exp.date How does the securitization work? 1 STEP The originator needs to transform credit into cash, because it doesn't want to wait until it’s payback provided by the debtor. Therefore, the originator starts to collaborate with the securitization purple vehicle (SPV) that is a firm, not an intermediary, in order to generate the securitization process. The SPV is called empty box because it owns low capital and this is the reason why it cannot provide the money to pay the credit of the originator. To get funds, the SPV issues bonds called Asset Baked Security ABS, (bonds backed by the assets of the originator) into the financial market. At this point investment banks, speculators, insurance companies...are interested to invest and buy ABS paying to the SPV the amount. SPV that are paid by the investors, is now able to transform the originator's credit into cash, withholding a part of the amount as profit. 2 STEP Investors have to receive a return at the end of the maturity date of the ABS by the SPV (it's in charge because it issued the bonds). Considering that SPV has already paid the originator and therefore it has no money, the only thing it can do is to hope that everything in the market will well- work. In other words, if everything works, SPV can use the money it earned and then segregated from the sale of the ABS, to pay the investors. On the other side if everything works, debtors will be able to pay back the credit the originator has. Credit risk tool The 2 BS aren't the same and it's important because the originator sells the asset to get funds at the end of the day without waiting to much and it gives the credit risk to the SPV. Once the SPV has sold the ABS to investors, it gave the credit risk to them; this happen because the credit risk follows the bonds. In cases of default of debtors, the party that has the credit risk is "investors", therefore the SPV won't be able to repay the investors that will suffer a huge loss. Thanks to this process the credit risk is no more in the sphere of the originator (bank). Before the securitization banks used to create the credit, risk and hold it (OTH), with the securitization the bank generates the credit risk making loans and distribute it in the financial system (0TD). The bank doesn't care about the likelihood of insolvency of its debtors, because using the securitization, at the end of the day it will have received money and will have given away the credit risk. Banks are usual to make NPLs (bad loans) with sub-primes, and this could be very dangerous for the F.S., this is why the presence of rating agencies is essential. Illiquid assets and types of ABS There are several assets that can be illiquid: - bank loans - residential mortgages - lease contracts - trade receivables - insurance premiums - NPL's The different types of ABS depend on the collateral type of the underlying portfolio: - Mortgage-Backed Securities MBS secured by the capital and interest rate payments of a single mortgage or a pool of mortgages - Collateralized debt obligations CODs are financial instruments that pools group of assets such as corporate bonds or a pool of bank loans or commercial real estate loans and bonds too. Credit enhancement To attract investors, during a securitization transaction it's only permitted to invest on securities with an investment grade rating. The rating of a security is evaluated by comparing it to certain parameter and a company's security have this investment grade rating if it has a strong capacity to meet its financial commitment to too. The credit enhancement has 2 forms: 1. External involves third-party guarantee such as: - letter of credit a commitment in which a commercial bank or institution is paid with a premium to cover any losses Benefit for originators: - Creation of liquidity investments - Funding diversification - Risk reduction and transfer - Regulatory capital relief Benefits for investors: - Tailored - Portfolio As mortgage defaults rose, banks and other FIs saw the value of their assets fall. Banks began the deleveraging process, when a company or individual attempts to reduce the debt. The most direct way for an entity to deleverage is to immediately pay off any existing debts and obligations on its balance sheet. The fall in the stock market and the rise in credit spreads weakened both firm and household balance sheets. Both consumption and real investment fell, causing a sharp contraction in the economy. 2008 September 15th is called the Black Monday in which one of the five biggest investment bank, Lehman Brothers went bankrupt and although the AIG (one of the biggest insurance companies) was able to sell insurance instruments and buy stocks at the same time, she collapsed and closed with a fall of 61%. This event shocked the world and spread a wave of distrust everywhere, none would believe into the financial system. As a neutral reaction, people wanted as much money as possible and banks too, booth was worried because the heart of the financial system was broken as to say the Interbank Deposit Market. The only possible solution was to give as much liquidity as possible to the financial system: - Fed cut the cost of money reducing the discount rate at 1.5% - ECB reduced the discount rate at 3.75% - Central banks reduced the discount rate at 0.5% They tried this maneuver to avoid as much as possible lasting repercussions on the real economy. 2009 In this year the world economy collapsed by almost 1%. In Europe and in U.S. the economy returns to growth in the third quarter and the fourth, but growth factors are weak as well as consumption and investment. In 2009 the Italian GDP collapsed by almost 5%. Europe was dive into two main line-ups: - Strong: Germany, France and Grand Britain - Pigs: Greece, Portugal, Spain, Ireland and Italy - they were the one most carefully controlled by the E.U. because they were considered the weakest ones. The problem of liquidity To help the system and markets, contingency measures were implemented: - Loans to banks in very high quantities and guaranteed by unreliable securities - Quantitative easing: purchase of medium / long-term bonds to support the quotations. The stock exchanges returned to growth despite the strong collapses of the first quarter. Rises and consequent gains are recorded, in the large emerging countries, due to the phenomenon of the 'carry trade': banks and funds have become indebted at rates very close to zero in the most industrialized countries and have invested in countries with higher growth and higher expected returns. A carry trade is typically based on borrowing in a low-interest rate currency and converting the borrowed amount into another currency if it offers a higher interest rate. These phenomena depend on the enormous amount of liquidity injected into the system and determine an increased importance of emerging countries in the world economy. New Scenarios The members of G7 contributed to the growth of the word economy for a value equal to about 70% in the 90s and equal to about 40% in the first year of the new century. The Bric countries have gone from around 20% to 45%: for these countries a growth rate of around 8% is expected. This was possible thanks to the 'carry trade' maneuver. THE CRISIS HAS DETERMINED A CHANGE IN THE CONDITIONS OF ECONOMIC STRENGTH. 2010 The world product increased by 5.0%. However the growth rate differs between the main areas: - in advanced economies 3.0%, - more vigorous in emerging and developing ones 7.3%. In emerging and developing countries, the recovery is very rapid, particularly in China and India which, with an average growth rate of 9.7%, continue to provide the main contribution to global growth. The countries belonging to the European Union in 2010 recorded a growth rate of 1.8%, the same observed in the euro area. Greece The sovereign crisis started when Greece admitted to be near to default. In 2010 Greece, with the new govern elected, declared that it had falsified numbers of the national budget in order to be allowed to join in the E.U. These numbers were far worse that investors started to sell their own government bonds, leading prices to decrease and incrementing the returns. The main problem was that speculators were bearish again Greece. Also, the market was worried about the general situation and continued to sell those bonds worsening prices and making high and high returns. The consequence was that Greece wanted to issue new government bonds, but it had to give back high returns, and as a result the public debt raised. At this point the spread gap between Greece and Germany was greater. PIGS countries Governments were forced to act austerity measures to diminish their public finances. The interest rates climbed to double- digit levels and the unemployment rates rose too (25% Spain). Despite the promise to help mad by the ECB, severe recessions resulted. The sovereign debt crisis widened the spreads and imposed a violent divergence in the assessments of sovereign risk expressed by the ratings and by the costs of credit default swaps. SPREAD - It's the difference between the 10 y yield of government bonds of a certain country and the benchmark (Germany) 2011 – ITALY At the begging of the crisis Italy was evaluated as strong as Belgium and similar or near to France. Investors started to acquire BTP once they had disinvested from Greece, Portugal and so on. When the perception of Italy has become that of a "peripheral" country its situation has become particularly problematic as it is a country that has a systemic dimension. Its Weaknesses were: - political instability Spain Monthly and quarterly data of spring and early summer, showed that the country's tax revenues were actually decreasing and the unemployment benefits had reached a peak Why 2012 was an epochal year? 5 elements took place in this year: 1. the LTRO by Mario Draghi 2. the default of an E.U. country 3. the union of the European Bank 4. " whatever it takes" 5. ESM European stability mechanism July The ECB announced the willing to introduce the Outright monetary Transactions OMT. The OMTs consist of purchases of government bonds on the secondary market, functional to the pursuit of price stability in the euro area. Thanks to his speech Mari Draghi explained to the world that none could have fought against the ECB, ending the speculative attacks. ESM The ECB announced the willing to introduce the Outright monetary Transactions OMT. The OMTs consist of purchases of government bonds on the secondary market, functional to the pursuit of price stability in the euro area. Thanks to his speech Mari Draghi explained to the world that none could have fought against the ECB, ending the speculative attacks 2014 The Governing Council of the ECB has repeatedly reduced official rates, which fell to around zero in September. In June, the Board also announced the start of targeted longer-term refinancing operations TLTRO. In September, the ABS purchase program was announced following the securitization of bank loans to companies and households (ABSPP) and of guaranteed bank bonds, with the objective to promote credit to the real economy and to stimulate growth. TLTRO The targeted longer-term refinancing operations are Eurosystem operations that provide financing to credit institutions. By offering banks long- term funding at attractive conditions they preserve favorable borrowing conditions for banks and stimulate bank lending to the real economy. The TLTROs, therefore, reinforce the ECB's current accommodative monetary policy attitude and strengthen the transmission of monetary policy by further incentivizing bank lending to the real economy. TLRTRO 2014 and 2016 The TLTROs conducted until March 2017 have been launched in two separate programs: - TLTRO-I, announced in June 2014 and consisting of 8 estate sales; - TLTRO-II, announced in March 2016 and composed of 4 estate sales. In both programs the financing obtainable from each bank depended on the amount of loans granted to non- financial companies and households (with the exception of those for house purchase). From 2015 to 2018 Quantitative easing (QE) The ECB started buying assets from commercial banks in March 2015 as part of its non-standard monetary policy measures. These asset purchases, also known as quantitative easing or QE, support economic growth across the euro area and help us return to inflation levels below, but close to, 2% APP The ECB's Asset Purchase Program (APP) is part of a package of non-standard monetary policy measures that also includes TLTROs, and which was initiated in mid-2014 to support the monetary policy transmission mechanism and provide the amount of policy accommodation needed to ensure price stability. It consists of: - Corporate sector purchase program (CSPP) - Public sector purchase program (PSPP) - ABS purchase program (ABSPP) - Third covered bond purchase program (CBPP3) APP net purchase by program Between October 2014 and December 2018, the Eurosystem conducted net purchases of securities under one or more of the APP. During the net asset purchase phase: - €60 billion from March 2015 to March 2016 - €80 billion from April 2016 to March 2017 - €60 billion from April 2017 to December 2017 - €30 billion from January 2018 to September 2018 - €15 billion from October 2018 to December 2018 2019 Between January 2019 and October 2019, the Eurosystem fully reinvested the principal payments from maturing securities held in the APP portfolios. The Governing Council aimed to maintain the size of its cumulative net purchases under each constituent program of the APP at their respective levels as at the end of December 2018. On 12 September 2019 the ECB Governing Council decided that "net purchases will be restarted under the Governing Council's asset purchase program (APP) at a monthly pace of €20 billion as from 1 November 2019. The Governing Council expects them to run for as long as necessary to reinforce the accommodative impact of its policy rates, and to end shortly before it starts raising the key ECB interest rates." TLTRO: The third TLTRO program consists of a series of 7 TLTRO, each with a maturity of three years, starting in September 2019 at a quarterly frequency. Borrowing rates in these operations can be as low as the average interest rate on the deposit facility prevailing over the life of the operation.