Financial markets, credit and banking, Dispense di Economia E Tecnica Dei Mercati Finanziari

Scarica Financial markets, credit and banking e più Dispense in PDF di Economia E Tecnica Dei Mercati Finanziari solo su Docsity! 1 FINANCIAL MARKETS, CREDIT AND BANKING (II PARTE) INVESTMENT COMPANIES Definition by SEC (Security exchange commission). Generally, investment company is a company that issues security and is primarily engaged in the business of investing in securities. It invests money it receives on a collective basis and each investor shares in the profits and losses in proportion to the investor interest in investment companies. The performance of the investment company will be based on (not identical to) the performance of the securities and other assets owned (difference is based on costs charged on the different vehicles). Mutual fund is gathering money from investors. Investors could be retailed clients, private banking clients or institutional clients. The mutual fund is not investing on its own, but it has a fiducial relationship with investors who are investing money into the mutual funds. We have seen clients could be individual clients who invest in general less than 5 thousand dollars/euro, private banking clients so individual clients who invest above that amount and institutional clients which are pension funds, insurance companies and private/banking. Money are collected into a common pool which then invest through the investment manager into cash and securities like bond or equities or other capital market securities and sometimes even derivatives (ex: a derivative used by fund manager experts in fixing income funds is when they have to make a bet to future boom on interest rate and they make a swap. If they expect interest rate will go up, they can swap long term bonds into floating rate swap to be less expose to interest rate increases). Mutual funds allow investors to gain diversification and professional management according to a specific objective of return which could be obtained at low cost and of course it is the result for the investor. Federal securities categorize investment companies into 3 types: - Mutual funds legally known as open-end companies - Closed-end funds legally known as closed-end companies - UITs legally known as unit investment trust (close to mutual funds) Each type has its own unique features, mutual funds and unit funds share redeemable (when investors want to sell their shares they sell them back to the fund of trust or to a broker acting for the fund of trust and they get back the equivalent of the asset of the fund which is called Net Asset Value). Closed and funds shares are not redeemable, when closed-end funds investors want to sell their shares they sell them generally to other investors on the secondary market and the price decided by the market or they have to wait till when the funds will be closed (there is in general an expiration date). 2 Main types of investment companies: - Open-end mutual funds sell new shares (investors buy shares) to investors and redeem outstanding shares on demand (when they want) at their fair market values (fair market value means that evaluation of assets of mutual funds called net assets value is calculated on the basis of the closing prices of the listed markets. This approach is also called marked to market approach). Open end mutual funds sell shares to public and redeemed them from the public, liquidity is never a concerned to fund shareholders. Because funds invested in large amount they are able to negotiate very low transaction costs, it means that small investors and even institutional investors are able to obtain diversified portfolios on more favourable terms they could achieve of their own. In addition, mutual funds provide other services to investors, including among others: free exchange of investment between mutual companies funds (from money market to fixed income one or equity one and this is important when investors have to rebalance their portfolio of funds in function of the behaviour of financial markets or in a change of risk portfolio of investor himself). The other service is the automatic period reinvestment and reinvestment on fund distribution which is important to avoid market timing effect such as automatic periodic investment. If you want to invest in an equity funds which is subject to a strong volatility it is better to divide investment in small parts and invest gradually in the market and it is make in automatic. o The first MF was established in Boston in 1924 o By 1970, 361 MFs held about $50 billion in assets - Hedge funds (HFs) (closed-end funds) are a type of investment pool that solicits funds from (wealthy) individuals (private banking clients and institutional clients, not public) and other investors (commercial banks) and invests these funds on their behalf. Unlike mutual funds, they can use the leverage (invest more than the money that the edge funds were able to collect through loans and through credit lines allowed by banks, they are exempt from disclosure and distributional requirements which means that there is less protection for investors, and investors should know what they are buying). - Money market funds (MMMFs) were introduced in 1972. They are important because they provide nomination, intermediation to individual investors because MMMs securities have the nominations that are too large and individual investors usually invest small amounts in mutual funds. They also offer historically higher rates of return than bank accounts. Recall that investors deserve to place some of their funds in liquid and secure assets like bank deposit which are yielding low return (close to zero). Money market mutual funds were affected by Regulation Q in US which limited the rate of interest banks should pay on deposit and raising open market rates induce high return for investors. - Tax-exempt MMMFs were introduced in 1979. In Euro countries there is a distortion because there is negative interest rate applied by European Central Bank for deposit facilities to banks which is today -0.5% (all the money market rates are negative today and MMFs are not able to give positive return). (esente dal pagamento delle imposte) 5 Mutual funds are now the second largest financial intermediaries and if rate of growth continue to increase they will soon overtake the banks. As result of rapid growth commercial banks, insurers and other institutions have also began operating investment management funds. The 25 largest funds today manage however 73% of industry assets indicated that anyway there are large economies of scale in fund expenses that promote large sizes. Italian open-end fund industry Opportunity to see how the Italian industry is organized because there are interested elements. This graph comes from Italian association of asset management and there has been a very strong roof in mutual funds industry from 2003 (529 billion) to 2020 (1 trillion). In 2008 -2009 there was a very strong crisis also in Italy (Lemhan brothers). The spread of BTP (long tern Italian government bond) (spread between Italian and German government bond) were very high in 2011 and many banks were forced to find liquidity through the issues of bank bonds and asking clients to switch from mutual funds into bank bonds. Another element is that in 2003, 72% of assets were invested in domestic funds (promote and domiciliation was in Italy. Domiciliation means that they apply Italian rules and Italian processes). Funds have to apply the low of the country they are in but in the past 15 years (2003 – 2020) other countries as Luxemburg and Ireland were faster in the approval of funds, more flexible in adopting new rules and less burocratic and at the very beginning more favourable in terms of fiscal rate. All these measures have been very opportune and the growth of distributional funds in Italy has been just for foreign domicile funds where we have roundtrip and cross borders. - Roundtrip funds: funds were sponsor is still an Italian asset management companies, but domiciliation of the fund is based main in Luxemburg or Ireland. - Cross borders: foreign asset managers (US like Fidelity) which have established an investment companies in Ireland for example and they sell through European passport their funds to different countries in Europe and also in Italy (now it has increased a lot). TYPES of mutual funds The MF has two sectors according to maturity - Short term funds (maturity less than one year) invest in securities with original maturities of less than one year o Money market mutual funds (MMMFs) are funds consisting of various mixtures of money market securities. o Tax-exempt money market mutual funds contain various mixed of those money market securities with an original maturity of less than one year. Investing in short term bonds issued by federally tax exempt entities (municipal securities) which are yielding a lower returns. - Long-term funds (more than one year) invest in portfolios of securities with original maturities of more than one year 6 o Equity funds consists of common and preferred stock o Bond funds consist of fixed-income capital market debt securities o Hybrid funds consist of both stock and bond securities Money market mutual funds (MMMFs) provide an alternative investment to interest-bearing deposits at commercial banks. They give up positive insurance but gain high rate of return. - Bank deposits are relatively less risky, because they are FDIC (federal deposit insurance corporation) insured, and generally offer lower returns than MMMFs. FDIC insures deposits till a coverage limit of 250,000 dollars per depositor and per FDIC banks. It means if a saver has free deposits in 3 different banks and banks are insured by FDIC and in these 3 banks the saver has 200,000 dollars he has a guarantee (insurance) for a total of 600,000 dollars. It is probably a safe bet to gain a slightly higher rate of return as only one money market mutual funds has ever failed, risk is very low. It is important that individual participation in mutual funds is becoming more widespread as financial education increases and interest in the stock market continues. Long term funds grew to 75% in 2006 as stock market perform well before falling back in 2007, as mortgage market failure effect spill over into stock and long term investment. In 2007-2008 flows to money market funds increase before declining as the economy recover and more investors become seeking higher yield, low rates of return continue do date investment in money market funds. In 2016 long term funds were about 82% of total funds after falling to as low as 59% due to crisis in the economy. Money market funds share actually grew to about 40% during to the crisis in part because the FED insured all money fund account. Households own the majority of MFs Split between long and short term funds used to be about 60 (long term) – 40 (short term) but increasing education increase holding in long term funds and in particularly equity (today typical owner has 94 thousands invested in at least 4 funds). - Owned 57.4% of long-term funds in 2013 - Owned 38.4% of short-term funds in 2013 - 44.4% of all US households owned MFs in 2016 – which represents – 55.9 million households. - Typical owner has $94,300 invested in four funds. Number of mutual funds, 1980 – 2016 Number of funds has grown along diversification. In 1990 there were less types of funds with respect to today’s funds. Now there are specialized equity funds according to sectors, geography, possibility of growth or specialized in different markets, some of them can be exposed more or less to risks. Industry offers always new typologies of funds in order to attract interest of investors sometimes in the form of structured funds in general. In Italy there were created some of them which are similar to bonds with a specific maturity. 7 Target date funds were offering a minimum yield to minimize coupon of a fixed rate bond so in that case we have a target date fund of 7 years with a minimum return of 2% per year which was below the coupon of government bond with the same maturity but with the possibility to gain more in a target date fund because it can be invested in a more diversified way with some components of high risk like equities. Selected characteristics of household owners of mutual funds Observe how demographic characteristics have changed during time (1995 – 2016). Income has improved and also the wealth. Another interesting thing is that risky components of the mutual funds owned have been riskier (equity and hybrid which was not part of assets in 1995. Households owners are less risky adverse because of financial education and professional of financial advisors). Other types of investment company funds An open-end MF is a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares. - In 2016, there were $16,350 billion invested in 8,105 open-end mutual funds. A closed-end investment company is a specialized investment company that has a fixed supply of outstanding shares (no issue new shares or redeem them from investors), but invests in the securities and assets of other firms. They are former mutual funds that have decided to close to new investors, they are too big and they are not able to manage new investors (Fidelity funds). They are traded like stocks at premium or discount to net asset value of the funds, there are not empirical evidences able to explain the reason why premium and discount exist. - In 2016, there were $265 billion invested in 545 closed-end funds. A unit investment trust, such as a real estate investment trust, is a fund that sells a fixed number of redeemable shares that are redeemed on a set termination date. They are levered and can have extreme rate of return. They are levered and they can have extreme rate of returns, unit investment trust are fixed composition funds that may hold up to 20-25 investment but the composition of portfolio is static so there is not possibility of diversification. It has a fixed termination or liquidation date. - In 2016, there was about $74.25 billion invested in over 5,188 UITs Mutual fund prospectus and objectives MF managers must specify their fund’s investment objectives in a prospectus (a formal summary of a proposed investment), which is made available to potential investors. 10 A mutual funds should not technically go bankrupt, absent of substantial derivative position because they own only the market value of their holding. However, in September 2008 the primary mutual funds broke the buck as we have seen. As disadvantage of open-end nature of mutual funds is the need to hold cash reserve to handle redemptions from funds shareholders, without a cash reserve the mutual funds can be forced to sell funds holding to redeemed shares. A dramatic case happened in 1987, at the time funds had low cash reserve so it was forced to sell funds. Mutual fund costs Costs to a mutual fund’s investors are different, not all of them have the same costs. Load charge, load is usually a front end load (higher costs) which means that this fees paid up front when the investor buys shares in the fund, it is conceptually equivalent to a broker commission, the maximum size allowed is 8.5% which is very high (very few funds charge load over 5% because of competition and some funds charge no load). Some funds charge back end load instead (or, in addition) to front end loan, in this case the investor pays the load when the shares are sold which means that at the beginning you do not payed nothing (in some case you have to pay an exit fee). It is better with respect to front end load because you earn nothing on the amount that goes to the broker whereas that money could be invested for the holding period on the back-end load. No load funds are directly marketed consequently, brokers sell load funds so if you want a no load fund you have to look at it by your own. Statistical performance of load funds is not better with respect to no load funds and those investors who use load funds pay for the advice of a broker as to what type of fund is appropriate for them but there is no other return for paying the load charge. The different classes usually represent different methods of assessing the load charge, some funds charge holding period contingent back and loads such that the load is reduced if the investor leaves their money with the funds for longer period and usually this is after 5 years and after 5 years the load is zero. The best choice will depend on the terms of the funds, the expected time the investor will stay in the funds we expected in the funds and sometimes the amount invested. - Class A shares (front-end load) have higher costs because less money is invested with the front load deduction, the real cost of a front-end load is virtually worse than the stated load. If you have 1000 dollar to invest and you place your money in a 5% front end load you get an investment worth 950 dollars so 5% of 1000 (you pay a commission of 50 dollars which gives a gain of 50/950 which means 9.26%). For longer expected holding period class B is better which has not front-load but incurred in a back end load with a larger 12-B 1 fee. - Class B shares (back-end load). It is better because of the reduce of the 12-B 1 fee after the conversion. 12-B 1 fee called hidden law: for some reasons the security exchange commission allows funds to assess the 12-B 1 fees in addition to a front-end load. With a front end load the investor purchasing the fund shares pays all the commission while with the 12-B 1 plan the load is accessed on all the funds shareholders and so the load amount percentage appears smaller. Marketing and services costs can’t be no more than 0.25% and management fees are no more than 0.75% per year (maximum of 1% per year). 11 A no load funds can charge a 12-B 1 fee of no more than 0.25% and still advertise has no load fund. As not in the maximum for load funds is 1% and access fees can vary according to shares. IMPORTANT: mutual funds can have different shares classes, sometimes is more convenient one with respect to another one. You can have a load or no load funds and what is important is that you know there are 3 types of fees: front end fee – no load fee – back end load fee. A mutual funds can have different classes MFs charge investors fees for the services they provide - Sales loads (front end or back end) - 12b-1 fees are fees related to the distribution costs of MF shares o Marking and distribution expenses cannot exceed 0.75% of a fund’s average net assets per year. o FINRAvalso imposes an annual cap of 0.25% on shareholder service fees. - MFs may offer different share classes with different combination of loads - A load fund is an MF with an up-front sales or commission charge that the investor must pay. - A no-load fund in an MF that does not charge up-front sales or commission charges on the sale of mutual fund shares to investors Example – this year an investor placed $10,000 in a mutual fund with a 6% load (one time fee) and estimated annual expenses of 1.35%. Fees are charged against average assets for the year. The fund’s gross return is 11.5%. What was the investor’s first year return net of loads and expenses? Amount initially invested: investment – (6% of investment) Amount after gross return: 9,400 x (1+annual gross return) Average asset value for year: amount after gross return + amount invested Fees: asset value for year x annual expenses Ending amount after fees: amount after gross return – fees Net rate of return: (ending amount after fees/initial investment) -1 Mutual fund regulation MFs are heavily regulated because they manage and invest small investors savings - The SEC is the primary regulator o The securities act of 1933 o The securities exchange act of 1934 - The investment advisers act and investment company act of 1940. - The insider trading and securities fraud enforcement act of 1988 (avoid abuses) - The market reform act of 1990 - The national securities market improvement act (NSMIA) of 1996 12 These acts required mutual funds to meet disclosure requirements similar to public issued of debt and equity and it introduces many anti-fraud procedures and limit of fees. Investors abuses – ethical problems Even with heavy regulation, investors abuse still occur - Market timing is short-term trading of mutual funds that seek to take advantage of short- term discrepancies between the price of mutual fund’s shares and out-of-date values on the securities in the fund’s portfolio. Buy mutual funds and sell them in a short period (usually the next date) to exploit them in overseas markets. - Late trading involves buys and sells long after prices have seen set at 4:00 pm E.T. NAV set for the value at that time, so they set up trade based in new info not already incorporated into the fund NAV. Late trading and market timing allow certain classes of investors to gain money in an unfair ways. - Directed brokerage occurs when brokers improperly influence investors on their fund’s recommendations. Mutual funds managers used brokers when they decide to buy and sell shares holding mutual funds when they decide to buy mutual funds and brokers agree to advice clients to purchase mutual funds regardless of whether it was the best for that particular client (overcharged clients). - Improperly assessed fees occur when brokers trick customers into thinking they are buying no-load funds or fail to provide discounts properly. Global issues - During the 1990s, mutual funds were the fasting growing financial institution in the US. - Worldwide investments (other than in the US) in mutual funds have increased over 187%, from $4.916 trillion in 1999 to $14.130 trillion in 2007. o This compares to growth of 75% is US funds. - Non-US mutual funds experienced bigger losses in total assets during the financial crisis. o Worldwide funds fell to 49.316 trillion (34.1%) in 2008, while US funds fell to $9.603 trillion (20%). - By 2016, worldwide investments in mutual funds increased to $21.16 trillion (an increase of 127% from 2008) while US investments increased to $18.13 trillion (an increase of 88.8%). Mutual funds growth oversees in concentrated in Japan, Luxemburg, France, Australia and Great Britain and they have a well-developed security market. Hedge funds Hedge funds (HFs) are investment pools that solicit funds from wealthy individuals (private banking clients) and other investors (ex: commercial banks) and invest these funds on their behalf. In 2016 total investment in hedge funds was 2.98 trillion, the more than 10.000 hedge funds are much less regulated than typical mutual funds because they are not open to the public. - Similar to MFs, but smaller funds under $100 million in assets are not required to register with the SEC. Not all hedge funds are required to be registered with the SEC, all those strictly requirements which concern mutual funds. - Subject to less regulatory oversight than mutual funds and generally can (and do) take significantly more risk than MFs. - Do not have to publicly disclose their activities to third parties and thus offer a high degree of privacy. 15 - Funds are exempt if they have less than 100 investors - Funds are exempt is the investors are “accredited” Hedge funds are only sold via private placements, and may not be offered or advertised to the general investing public Top hedge funds by fund earnings, 2008-2009 Absolutely trues is that hedge funds had a negative performance in 2008 but reaction was so quick and strong such that in 2009 they were already recover (some of them). Look at BlueGold Global High profile hedge funds problems The collapse of the two Bear Stearns hedge funds led to investor losses of $1.6 billion and led to the bankruptcy of the company. The funds bought CDOs which are collateralized that obligation which were obligations (funds) invested in securities which were linked to mortgage leverage linked bonds borrowed in a massive way and this type of bet enjoyed a positive spread at the beginning. Managers insured some but not all of the risk by purchasing credit default swap (a derivative capable to cover risk of failure of this kind of security). As subprime crisis unfolded and the value of CDO drop more than anticipated, creditors ask for additional collateral on loans. This lead to additional sales of subprime securities that exacerbated the problem leading to the assisted buyout and quickly run out of capital. Bernard Madoff investment securities run by former NASDAQ chairman Bernie Madoff run a $65 billion Ponzi scheme. Claiming to have 65 billion holding but apparently he had not purchased stocks since midden of 90s, he was arrested in 2008 and the form was liquidated by his sons. In October 2009, large hedge fund, Galleon Group LLC, was closed due to an insider trading scandal. The founder and other 20 were charged with criminal violations of inside trading loans. In July 2013, SAC capital was charged with pervasive violations of inside trading laws. 16 MONETARY POLICY in the Eurozone The origin of the European Monetary Union - In June 1988 the European Council assigned to a committee chaired by Jacques Delors, the then President of the European Commission, to study and propose concrete stages leading to the European Monetary Union. - 1 January 1999 introduction to the euro. The euro was a book-entry currency not a material one until 31 December 2001. Euro banknotes and coins were introduced in the Euro area on 1 January 2002. Euro area (countries adopted Euro) was made up at the beginning by 11 countries, Italy among them because it has met convergence criteria to be part of European monetary union (in the following year other countries joint it while now there are 19 countries). - 1 June 1998 appointment of the Executive Board of the European Central Bank (ECB) that is entrusted with the conduct of the monetary policy in the euro area 1 January 1999. Four national central banks like Bank of Italy loss their power (authority) as far as concerned adoption of decisions for the European zone. - The governors of the central banks of the non-euro area EU countries are members of the General Council of the ECB but they do not join the main decision-making body – the Governing Council – until they adopt the euro. The real decision-making body in the Euro area as far as concern monetary policy is not the ECB but the governing council. - 19 countries adopt the euro (dark blue) - 8 countries do not adopt the euro (light blue) - 27 countries composed the European Union The governance of the ECB The European system of Central Banks (ESCB) is formed by the European central bank (ECB) and the national central banks (NCBs) of all 27 European member states (EU). The main decision-making body is the Governing Council, which consists of the six members of the Executive Board (ECB) plus the governors of the central banks of the 19-euro area countries. Executive board of European central bank is made up of 6 members appointed by the European council and they are appointed for 8 years terms not renewable. Actual president is Christine Lagarde then we have vice president and other members as Fabio Panetta who is the general director of the Bank of Italy. The capital of the ECB - The capital of the ECB is held by the national central banks (NCBs) of all EU Member states amounts to 10.8 billion euro. 17 - The NCBs’ shares reflect, with equal weight, the respective country’s share in the total population and gross domestic product of the EU. - Euro area NCBs hold 7.5 billion euro paid up capital of ECB. Profits and losses of the ECB are allocated among the euro are NCBs according to given rules (80% distributed to National Central Banks while 20% is put into reserves). - The non-euro area NCBs contribute to the operational costs incurred by the ECB in relation to their shares they hold. Euro area NCBs’ contributions to the ECB’s capital Shares held by different national Central banks into the capital of ECB. Some changes in the shares occurred after Brexit, actually the three national central banks holding major shares in the capital of ECB are the German Bank, French Bank and Bank of Italy. Aims of the ECB (aims change over time) - The conduct of the monetary policy with the aim to maintain price stability within the euro area (this is the first aim). - The ECB is responsible for the prudential supervision in the euro area, within the single supervisory mechanism (one of the three pillars of the European Banking Union), that comprises the national competent authorities (from 4th November 2014 in accordance with regulation (EU) no.1024/2013). ECB is responsible for the supervision of Banking system. - In pursuing its objectives, the conduct of the ECB should be credible, trustworthy, transparent, accountable and independent. Monetary policy and supervisory tasks of the ECB Tasks of ECB as far as concern monetary policy and supervision starting from 2014. Responsibilities related to the monetary policy - Define and implement the monetary policy decisions taken by governing countries - Conduct of transactions of foreign exchange operations - Hold and manage the euro area’s foreign currency reserves of euro area - Promote and maintain the sound operation of payment systems, in particular the ECB among others manage the target (real time gross settlement system specifically used by ECB for the implementation of monetary policy but also that commercial banks and other intermediaries may also use) Other responsibilities - Banknotes (volume and issuance of them). It is important to say that while ECB is in charged for the definition of volume at the issuance of banknotes the printing and management of banknotes as the ones which are not in good conditions and have to be replaced belong to national central bank like Central Bank of Italy which together with the 20 - The balance sheet channel: opposite example, interest rate decreases and they are very low as nowadays. In this context, present value of assets held by borrowers increase (inverse relation between level of price and interest rate). If interest rates decrease or are very low that is going to exert positive effect on the present value on the assets held and if it increases it means that also the value of collateral (guarantees) that borrowers can use in order to get loans from banks and of course it facilitate the access to loan and also the financing of investments and of course it exerts positive effect on consumption. - The risk-taking channel: in this case let’s continue with example concern a low interest rate environment. If they are low banks will be much more confident on granting loans since present value of collaterals of borrowers is higher and if interest rates are low the capabilities of borrowers to cope with payments of periodic interest in much easier. On the other side, if interest rates are very high banks can refrain and do not want to give loans because they are not very profitable and therefore they are going to look for much more attractive or profitable business with are also much more risky for the banks themselves and undermine also the survival of banks when they do take on risky business looking for higher profit than those offered by the lending activities in a very low interest rate environment. Monetary policy is going to produce different impacts which ultimately exert effects on price stability. Monetary policy authority is going to set official interest rate also called policy rate that will affect expectations of economic agents involved in decisions concern investments and consumptions. Policy rates are going to influence also the level of interest rate in the money market and this interest rate (short term interest rate) is going to affect exchange rate, interbank rate and prices of assets and also quantity of money and credit within the economy. Of course, all of these phenomena are going to change level of supply and demand of goods and labour in the market together with level of wages and all of these factors are going to affect level of domestic prices but also the one of imported products (relationship between interest and exchange rates). Level of domestic prices and the one of imported things are going to affect price development (level of inflation). Official rates/policy rates are under the control of ECB there are other things that are exogenous and create shocks in economy and outside of the control of ECB (ex: change in price of commodity or nowadays Coronavirus or risk in sovereign risk for example the fact that due to public debt held by some countries and possible rising of this debt, now in this period, can make much more risky some countries holding an excessive level of public debt and risk premia paid by those countries increases too). Some other changes outside control of central bank can be the change in the level of bank capital which depends on the investment strategies of the banks and the possible effects of these strategies. If banks undertake risky business these ones can cause losses to banks and they are going to reduce levels of banks capital and bankruptcy of banks. Banking system and financial systems are an important medium for the transmission of monetary policy to real economy, therefore, soundness of financial system is extremely important. 21 The monetary policy instruments Target of ECB is prices stability (quantified in 2% annual increase of inflation rate). Which are the instruments used by ECB to reach target of price stability? The operational framework of the Euro system consists of the following set of instruments: - Standing facilities: this kind of transactions are accessed only by banks (or credit institutions) which are subject of minimum reserve requirements. Banks indeed have to maintain minimum reserve requirements in central bank, and they do have access to standing facilities and participate to open market transactions via standard tenders with ECB. While these transactions are limited to banks, some other transactions made by ECB can be made with other counterparties not in the banking systems. In addition to these standard tools used for the conduct of monetary policy since 2009 ECB has implemented non-standard monetary policy measures in order to cope with the financial crisis which affected global level major developed economies and the eurozone in our case. Within non-standard monetary policy measures, there are programs for assets purchase or for example the granting of medium-term and long-term financing to banking systems. - Minimum reserve requirements for credit institutions - Open market operations (not speak about it) Only institutions subject to minimum reserves (banks) may have access to the standing facilities and participate in open market operations based on standard tenders. For outright transactions, no restrictions are place a priori on the range of counterparties. In addition, since 2009 the ECB has implemented several non-standard monetary policy measures (ex: assets purchase programmes) to complement the regular operations of the Euro system. Overviews on Euro system standing facilities and open market operations Different transactions which are made by ECB, through them it is possible to define policy rate and affect short term interest rate in money market and via this then transmit monetary policy decisions to real economy affecting price stability (level of prices). Speaking about standing facilities we mean two types of transactions that banks can be vis à vis to ECB: - Deposit facility, banks can deposit excess liquidity (reserves) at the ECB for a period equivalent to 24 hours or overnights, this kind of deposit facilities is a discretion of each single bank (when there is excess liquidity can decide to deposit it in central bank and not in the interbank market). - Marginal lending facility: banks which are in the need of funding’s for a very short period of time equal to overnight or 24 hours can ask it to ECB. The finances granted by ECB has be collateralized to adequate or eligible collateral which are accepted by ECB. This kind is called REVERSE TRANSACTION because the next day the fund will be return to ECB by the bank. When ECB grants marginal lending facility, it is also acting as lender of last resort 22 because when banks cannot finance for immediate and urgent financial needs, they can rely of Central Banks which is going to finance each single bank. For these two kinds of facilities the ECB is going to set policy rates. Rate on marginal lending facility is equal to 0.25% which is the rate charged by ECB when granting the overnight loan to the banks while the rate on deposit facility (when banks deposit excess liquidity at ECB) is going to be remunerate with a negative rate by ECB (banks whenever deposit money at ECB they will have to pay ECB for that deposit of money, the amount returned by ECB the day after will be lower than money deposit before because of the negative interest rate equal to – 0.50%). Upper bound is equal to 0.25 while the lower bound is equal -0.5%. Negative rates started to be set by ECB on June 2014 and are still in force. About the effects of negative interest rates on banking systems and above all the effect on the economy there has been quite huge amount of papers and discussions, one of the main issue raised by prolonged negative interest rate environment is that profitability of banks is under pressure because of interest rates is low and that can undermine the survival of banks (especially the one heavily focused on lending. If interest rate remains too low for a long period of time it induces banks to get involved in businesses which are riskier than lending with possible effect on the balance sheets). Standing facilities - standardard tool The euro system can set the policy rates concerning the marginal lending facilities and deposit facilities (upper and lower bound of very short-term interest rate) and within these bounds we can find all the other short term interest rate within the money market and specifically the interbank rate. The Euro system offers credit institutions two standing facilities: - Marginal lending facility in order to obtain overnight liquidity from the central bank, against the presentation of sufficient eligible assets; actual marginal lending facility rate: 0.25%. - Deposit facility in order to make overnight deposits with the central bank. Standing facilities rates. Actual deposit facility rate: - 0.50% Videos 1. Reaction of German savers when a negative policy rate was introduced in 2014 2. How Draghi (former president of ECB) answers to German savers according to negative rates. 3. The way US government sees the possible negative rate as a solution to boast the economy. Low interest rate environment is set by ECB in order to stimulate economic growth, the stimulus is affecting in different ways because some countries as Italy, Greece and Spain they due face difficult macroeconomic environment (ex: France and German level of inflation is double with 25 Open market transactions (OMT) – standard tool Five types of financial instrument are available in the Euro system for its open market operations. The most important instrument is the REVERSE TRANSACTION, which may be conducted in the form of a repurchase agreement (Repos) or as a collateralized loan. The name Reserve transaction because there is a first transaction with Euro-system like for example granting by Euro-System of loans to the banks participating to OMT after a period of time this lending/financing must be redeemed by banks financed returned the amount granting. We speak about collateralized loan because any type of transaction made by banks vis-à-vis the euro- system must be guarantee by a security (collateralized). Overtime the ECB large the type of securities that can be accepted as collateral for transactions with ECB and this was a way to allow banks to use different types of securities held in their balance sheet and have the access to open market transactions which could not be possible in any case the bank did not have eligible collateral stated by ECB (ex: treasury bonds, bonds issued by banks or corporates). The Euro-system may also make use of OUTRIGHT TRANSACTION (nothing else that outright purchase or sell of securities without opposite transaction, ECB purchases security from banks or sells security to banking system. No opposite transactions after the first one), issuance of debt certificates foreign exchange swaps and collection of fixed-term deposits (ECB issue that certificate which can be subscribed by banking system or for an exchange swaps specifically used for governance of exchange rate Euro vs other foreign currencies or we may have collection of fixed term deposit by ECB and it has a short-term maturity). à Implementation of monetary policy is made at local level by the national central bank. Transactions vis à vis the euro system and coordinated by ECB are regulated by the national bank. In Italy the bank of Italy is the national central bank with which vis-à-vis the banking system realized or performed open market transactions with the euro-system. Open market operations are initiated by the ECB, which decides on the instrument and the terms and conditions (ECB decides the kind of instrument and also terms and conditions like the maturity of transactions in the case of reverse transactions or swaps. ECB decides also the remuneration so the rate which is required for that kind of transaction and also the type of collateral). It is possible to execute open market operations on the basis of: - Standard tenders: 24 hours length – any bank can participate. Between opened and closed of the tenders. As we know, participants of standard tenders are banks under the MRR which is mandatory for them. - Quick tenders: 90 minutes length (they are not regular, but they can be performed by ECB in evaluation of ECB as far as concerned the need to perform this kind of tender. Quick tenders have a length equal to 90 minutes, we will see in which cases the ECB initiates these transactions managed at local level by national banks) - Bilateral procedures (ECB and single bank outside any standard tenders that meet in order to realize specific transactions). 26 Overview on Euro system standing facilities and open market operations Here we can see different operations: - MRO: main refinancing operations - Long-term refinancing operations - Fine-tuning refinancing operations - Structural operations Main refinancing operation (MRO) and long-term refinancing operations are conducted by via reverse transactions with the aim to provide liquidity at the bank. Fine-tuning operation which can be conducted with reverse transactions or swaps or by the collection of fixed deposits and this can be aimed to provide temporary liquidity to banks or can be aimed to absorbed liquidity (funds from the banking system). This is the case when the ECB collects announced that it is willing to collect fixed term deposits from the banking system, in this case, any time participating bank grants funds to ECB with given maturity the ECB is absorbing funds from banking system that will return to banking system at maturity of deposits that ECB collected. There are structural operations that can be performed via different types of instruments like reverse transactions (outright purchase or sell) or the issuance of certificate which do have longer maturity than the single fixed term deposits. Notice that we have information about maturity of these transactions which in the case of main refinancing operations and longer term refinancing operations maturity is fixed (1 week or three months) and in the case of fine tuning operations and structured operations maturity is not standard as well as the frequency of these transactions are not regular (not in all cases but in the majority of them). There is much more variety in the kind of procedure used for this kind of transactions (fine-tuning and structural operations), the ECB can use bilateral procedure or standard tenders or quick tenders. These are the set of tools used by euro system (ECB) to conduct monetary policy with the main aim already said to achieve price stability over medium term (target fixed at 2% as annual growth of prices in the euro zone). Look to policy rates which are referred to main refining operations, actually they are fixed rate while in the past they were floating interest rates tenders. Refinancing interest rate charged by ECB to banks is equal to 0%, notice that the main refining rate is in- between facility deposit facility rates (negative: - 0.50%) and the marginal lending facility rate (positive: 0.25%). Access to main refinancing operations with euro system announced on frequent and regular basis by ECB do carry an interest rate equal to 0%. 27 Open market transactions (OMT) can differ in terms of aim, regularity and procedure Main refinancing operations are regular liquidity-providing/absorbing reverse transactions conducted by the Euro system (temporary basis). They are executed in a decentralized manner by the national central banks on the basis of standard tenders and according to an indicative calendar. Banks can make their bid, pay fixed rate (0%) and then they receive full allotment (whatever is the demand of the bank participating to the lender) providing that these banks can collateralize (provide eligible collateral/guarantees for this temporary financing obtained by ECB). With these operations we have financing made by ECB on regular basis every week announced by ECN with standard tenders and all banks participating in the tenders can obtain funds which must be returned into 1 week (maturity of one week). Main refinancing operations are conducted on weekly basis and they have maturity equal to 7 days. Bank A participates to the tender and then it obtains (after conclusion of the tender) liquidity demanded via the local national central bank which manages the conduct/implementation of monetary policy at local level and then bank A will provide a collateral for the temporary funding, after one week Bank A will return money and it has back its collateral. Then, we may have longer term refinancing operations having a maturity equal to three months conducted via standard tenders every month. To this transactions can participate all the banking system with full allotment of request providing these requests are backed by eligible collateral. 1. They have a frequency and maturity of normally one week 2. Regular longer-term refinancing operations have a maturity of three months and are conducted each month Data from last open market transactions made by ECB and you can see that on the first on April we add two main refinancing operations with seven days and 3- month maturity. It is possible to see specific information found for this kind of transaction conducted for the provision of temporarily liquidity to banking system. Other OMT 1. Fine-tuning operations are performed on an ad hoc basis to manage the liquidity situation in the market and to steer interest rates. They are aimed at smoothing the effects on interest rates caused by unexpected liquidity fluctuations. Fine-tuning operations are primarily executed as reverse transactions but may also take the form of foreign exchange swaps or the collection of fixed-term deposits (for absorption of liquidity). We have non-regular transactions which are performed via reverse transactions or fixed term deposit (if there is temporary absorption of liquidity in the banking system). This kind of transactions are necessary to keep under control the level of interest rate in case of unexpected liquidity fluctuation in financial system which are in general observed by ECB in the interbank market (where banks exchange funds among them and any shortage of liquidity in this market will provocue increase in interest rate demanded by banks participating in this exclusive market and it can cause the level of interest rate to be 30 face some liquidity problems incurred by the single bank. It is collateralized by the single bank and if the amount is above a certain threshold this transaction can be authorized by ECB (huge amount of funds can interfere with monetary policy target of ECB, this is why while this transactions at national level are conducted by national central bank when there is a very huge amount the transaction should be authorized by ECB). Euro area credit institutions can receive central bank credit not only through monetary policy operations but exceptionally also through emergency liquidity assistance (ELA). ELA means the provision by a Euro-system national central bank (NCB) of central bank money to a solvent financial institution, or group of solvent financial institutions, that is facing temporary liquidity problems, without such operation being part of the single monetary policy. Responsibility for the provision of ELA lies with the NCBs concerned. This means that any costs of, and the risks arising from, the provision of ELA are incurred by the relevant NCB. The payment system – Target 2 à TARGET stands for Trans-European Automated Real-time Gross Settlement Express Transfer system - TARGET 2 is the real-time gross settlement (RTGS) system owned and operated by the Euro-system. This payment system is used for transfer of funds within euro zone and not only (also some other countries within European union or outside it can participate to target), transactions made by Target 2 are performed in real time (very few seconds). Settlement means to perform a given obligation like to make a payment and now this payment can be made on gross basis (each settlement is made individually without any possibilities to be compensated with other payments to be received from other counterparties within Target 2) or net basis (compensation system, Bank A has to pay 100 and Bank B has to pay 50 to A, the payments will be netted and only A will pay 50 to bank B). Target 2 works only of Gross Settlement Basis. - TARGET 2 is the second generation of TARGET introduced in 1999 with the euro (before there was the Target 1). - Payment transactions in TARGET2 are settled one by one on a continuous basis, in central bank money with immediate finality (payment is definite and can’t be amended). There is no upper or lower limit on the value of payments. - TARGET 2 settles payments related to monetary policy operations (Target 2 has way of transfer of funds from Europe system to banking system and vice versa is performed. It is used to settle monetary policy), interbank and customer payments, and payments relating to the operations of all large-value net settlement systems and other financial market infrastructures handling the euro (such as securities settlement systems or central counterparties). Target 2 in under the ownership of euro-system, but other than to be used as conduct of monetary policy it can be used for transfer of funds related to interbank markets or it can be used as transfer of funds requested by customers. Customers of banks in Italy required to transfer funds to counterparty in Germany and this operation can be made via target 2 also because it has a higher level of security (it is very quickly). Target 2 is very important for transfer funds which are related to different motivations, some for monetary policy or also other different types. 31 How to TARGET 2 work? Banks must hold an account in the national central bank because it operates also at local level and in that account, it is necessary to receive money or make payments to other counterparties (or vis à vis the euro system for what concern monetary policy). The platform is owned and managed by the Euro-system. Put simply it works as follows: - Bank A and Bank B both have accounts with a central bank - A payment in euro is to be made from Bank A to Bank B - Bank A submits the payment instructions to TARGET2 - Bank A’s account is debited (obviously Bank A must have the amount needed in the account), and Bank B’s account is credited – the payment is settled - TARGET 2 transfers the payment information to Bank B The monetary aggregates and money multiplier We have seen tools available by ECB for the conduct of monetary policy and then TARGET 2 as payment system via which the monetary policy operations are conducted and now consider monetary aggregates and money multiplier. First of all discuss what monetary aggregates are, they are means for payments which possess different degrees of liquidity and all these substitutes of currencies hold high level of liquidity. For the measurement of monetary aggregates in the euro zone is responsible the ECB which determines the stock of different monetary aggregates and the growth rates of them on a monthly basis. Analysis of the growth rate is important because the growth of money in circulation and substitute of money is important with the target of ECB to keep prices as much as possible stable over the medium term. Growth of money is important for the conduct of monetary policy to target a given aim or goal in terms of price stability. The monetary aggregates are derived from the liabilities of monetary financial institutions (MFI) basically banks and money market funds but also include some government liabilities (treasury securities as short term debt issued by government like for example in the case of Italy BOT (buoni ordinary del Tesoro) with one-year maturity or CTZ (certificati del Tesoro zero coupon) which have 2-year maturity). The ECB calculates the growth rates of monetary aggregates on a monthly basis. - M1 is the sum of currency in circulation issued by Central bank and overnight deposits held by banks with the central bank or for example with other banks which are very liquid because maturity is equal to 24h (extremely liquid). - M2 is the sum of M1, deposits with an agreed maturity of up to two years and deposits redeemable at notice up to three months (deposits as current accounts which have a notice up to 3 months). These are possible substitutes of M1 because they are nothing else that those deposits that savers hold with banks and that can be used to make payments in alternative to cash/currency (mean of payments used as substitutes of the currency). - M3 is the sum of M2 plus some instruments of money markets or used by banks like repurchase agreements, money market investments fund shares/units (invested in money market security) and debt securities with a maturity of up to two years (here we can include securities issued by government as CTZ or BOT that not only have short term maturity but which are very liquid). They are short term and very liquid, traded within secondary markets so transformed in liquidity in a very fast way. It is the less liquid but it includes instruments which by definition are very liquid, both because owner can ask in the case of money market funds for the redemption of the units held or in the case of debt 32 securities issued by government because there are organized secondary market which allow for transformation into liquidity these securities via transactions. From M1 to M3 we have different level of liquidity (more liquid is M1 while less one in M3 but also M3 contains very liquid elements). The ECB is going to monthly basis measures stocks of three aggregates, measures the growth and put into action monetary policy as transactions which are aimed to make the growth of these aggregate consistent with the target of monetary policy implemented by ECB. Money multiplier Monetary base = currency in circulation (C) + Bank reserves (free and compulsory) (BR) MB = C + BR (high powered money) Monetary base is the money which can be used to make payments and it is represented by currency in circulation issued by central banks and bank reserves which can be transformed into liquidity. Reserves are held by banks at the central bank via mandatory reserves as minimum reserve which banks are obliged to hold at the central banks or free reserves which banks can hold with the central bank or for example with other banks and because their characteristics they can be transformed into liquidity. Monetary based is the sum of currency and the high-powered money (reserves free or compulsory which are the more liquid kind of components). Money held by the public = currency in circulation (C) + bank deposit (D) M = C + D Money held by the public is the sum of currency in circulation and bank deposits. As already known, in order to make payments you can use currency or deposits. The balance of amount of money deposits in current account can be used to make transfers or payments to other bank customers (or other depositors. Ex: all of us has current account and it can be used to make payments to a friend of us by inserting an order to our bank to transfer a given amount of money). Money held by the public is made of these two components which are C and D which is called fiduciary money (represented by deposits, they provide our savings to banks and we trust that banks will return funds deposits at maturity and this also will imply that banks will be able in any moment to perform its obligation vis-à-vis the depositors above all in terms of redemption or transfer of payments). See how to calculate the money multiplier - Consider monetary base and divide it for the deposit which in a given moment are held by the public à MB/D= C/D + BR/D - Call C/D equal to c and BR/D equal to br which are two indicators of propensity of the public. c is the propensity to hold currency in relation to deposits (propensity of people to hold money). It Italy for example the propensity to hold currency is quite high with respect to other European countries. While br is the propensity of the banks to hold bank reserves with respect to amount of deposits collected (br is influenced by MRR, higher MRR higher br which depends also on propensity of banks to hold free reserves or excess reserves hold by banks at ECB above MRR which will depend also on costs of holding reserves (higher costs, lower propensity to hold excess free reserves). 35 Problems in conducting monetary policy Lowering interest rates or supplying money are attempts to stimulate demand, but they may not work - Problems in consumer confidence - High unemployment - High debt levels (debt of households can be very high, and they do not want to increase it just to consume more). Excessive money creation may reduce the value of the currency and generate inflation - Inflation can cause interest rates to increase hurting growth - Loss in confidence of foreign investors could cause higher interest rates, hurting growth Global rescue programs Responses by governments and central banks to the financial crisis 2007 – 2008 - Expansion of retail deposit insurance - level of insurance provides to depositors in case of bank failure. - Direct injections of capital to improve lender’s balance sheet - they were made by local governments. - Debt guarantees (COVID-19 emergency) – issuance of guarantees way to restore trust in banking system other than expansion of insurance deposit and injection of capital. - Asset purchases or asset guarantees (COVID-19 emergency) – made by central banks to inject liquidity in order to face period of crisis. - Stress tests of banks - check banks abilities and resilience to face period of crisis (shocks). Nowadays, during the COVID-19 emergency some countries as our put into action some measures like the issuance of debt guarantees on loans granted by banking system to private borrowers and other measures as purchases of assets as far as concerned pandemic emergency purchase programme with the aim to make banking system more able to sustain the borrowing needs of economic agents other than to have liquidity to face and meet their own obligation without incurring into liquidity situations of stress. NERO = ROSSO BLU = NERO ROSSO = BLU ----------------------------------------------------------------- 36 BANKING MODELS AND TRENDS MAIN FEATURES OF BANKS A bank is an authorized and licensed financial intermediary (ex: Bank of Italy and ECB in Italy). In order to establish a new banks, it is necessary to comply with some minimum requirements defined by the regulators and it is necessary to receive the authorization of supervisor that in the case of Italian Banking System is the Bank of Italy and the European Central Bank. Bank of Italy and ECB are also involved in any events involving the banks like for example mergers and acquisition within the banking system that must be authorized by the supervisor as well as the closure of a bank is under the supervision of the supervisory authority. ECB is performing the role of supervisor of European banking system and in particular of the euro zone and it is in charge of the production of rules concerning the banking system. So, banks are special financial intermediaries because their conduct is strongly regulated and supervised. Perform services essential to financial markets: - Play a key role in the transmission of monetary policy to the real economy. The effective and efficient conduct of monetary policy has the fundamental requirement that the banking system operates in a wealthy and sound way. Keeping in sound and stable condition the banking system is an important task for supervisors and regulators of the banking industry. - Provide payment services. This is because deposits collected by banks thanks from different counterparties have also a monetary function, they can be accepted as means of payments via different types of instruments like for example bank transfers which are orders that depositors give to their banks in order to transfer money from one account to another or for example payments via debit cards or payments by checks. Banks through these services play a fundamental role, but they are also important in the financial markets where they have to settle transactions when for example two counterparties exchange securities. Payments are fundamental also in financial systems even if related to different determinants which determine the need to pay, this is way it is crucial the role of banks and they are soundness as long as they provide the payment function. The role of banks in the payments services industry has been challenged during these last few years because of the birth of new competitors such as IT giants or e-commerce giants such as Amazon or mobile services as Apple (non-financial competitors). Therefore, it is possible to imagine that in the next years the role of banks in the payment service industry will be attacked by the growth number of these competitors. - Provide maturity intermediation services. Banks collect funds from savers via deposits and other types of liabilities used by the banks to finance and lend money to different borrowers other than to invest in debt securities issued by specific issuers (borrowers). While transfer money from one part to the other, the bank performs a maturity intermediation service (maturity transformation role), counterparties preferences could not be respected without the help of the bank. Savers (creditors of banks) may have specific preferences concerned maturity of financial contracts signed with the banks, in general, the preferences of savers concern being able at any moment to withdraw or to invest just for a short period of time. These preferences could never match with the ones of borrowers which instead in general prefer longer maturity. Banks assume risks arises from maturity mismatched. This service is linked to credit intermediation function performed by banks (lending activities). 37 Banks are regulated and supervised to protect against disruption to the services they perform. It depends on their crucial role because of services they perform, given their importance in the credit function and transmission of monetary policy we can understand why it is important that they are highly regulated in order to keep them stable as much as possible. Think about disruption of a bank that can have on confidence of depositors and that the failure of a bank can have consequences on other banks and lending facilities. Banks enjoy a safety net (not only regulated and supervised but they are protected by this net) made by lender of last resort (something already seen, CB which via the marginal lending facility is involved in the provision of overnight liquidity to banks which are looking for short term financing to meet temporary liquidity constraints. CB nowadays is committed in the provision of financing to banking system in order to preserve their ability to serve the real economy and to face effect of pandemic covid-19 on their activities) and deposit insurance system (deposits made at banks by households and small/medium enterprises are insured against possible failure of the bank itself. It was revised during the global financial crisis (2008) in order to protect depositors, in case of bank failure they are repaid for 100,000 (200,000 in US) and it was made faster the repayment of depositors. In order to get insured each bank has to pay the annual premia which is related to the level of risk of each individual bank. Those premia are collected by an insurance fund active at national level and that will intervene only when the bank fails). Types of BUSINESS MODELS in banking Different ways to understand the banking system. We can rely of different business models considering different kind of segments of customers served by banks. Retail banking (specific focus on household and small/medium enterprises) is focused on: - Small Medium Enterprises and households. - High product standardization: in the provision of services delivered by retail banking to their customers there are highly standardized products for lending, payments or investments. - Unsophisticated financial needs (borrowing, investing, payments): services are highly standardized and it depends on the fact that financial needs of customers served by retail banks are quite simple, not complex at all and they are very common (not high differentiation in financial needs of customers and for this reason it is used the economy of scale). In the Italian banking system we can observe an highly orientation to retail banks, major player in the Italian system are retail banks. Wholesale banks (large customers) are focused on: - Business activities on commercial banking relationship with large customers: provision of financial products such as lending. - Get funding in the wholesale markets (ex: the interbank markets). They used to fund themselves by collecting funds by the issuance of bonds (placed in institutional investors or other banks) or they use the interbank markets. - Most wholesale banks also engage in retail banking. Speaking about wholesale banking we should consider corporate banking and investment banking. Therefore, we consider banks focused on large customers with very specific 40 Stakeholder-oriented banks (co-operative banks, savings banks, credit unions) On the other side, stakeholder oriented banks where profit is consider as a condition to continue to operate but it is not the main objective. - Not for profit: condition for bank to survive and operate within the banking system but it is not the main objective. - Strong orientation to stakeholders and communities: small companies or artisans are very active together with households. The main objective is to provide affordable access to shareholders. Focus on provision of financial support to financial community in which they operate by allowing affordable and cheaper access to financial services provided to their customers. There is a strong overlap between role of shareholders and customers. These banks are quite widespread in Italy while in Germany we do observe a lot of cooperative banks spread also in France, Spain, Netherlands and Austria. These banks were born in the middle of 90s century with the specific aim to favour financial inclusion as specifically artisans or small entrepreneurs face difficulties in accessing financing from banks that, at that time, served just big companies. They favour industrialization and development of small/medium entrepreneurship. SIGNIFICANT BANKS supervised by the ECB: criteria Significant banks are, according to the criteria defined by the European Central Bank, under the supervision of European Central Bank and it depends from the fact that because of their importance at national and European level it is extremely important that they are closely supervised by ECB which (remember) provides liquidity and financing the whole banking system. In order to decide whether a bank is significant or not we must observe certain criteria set by ECB. - Size: the total value of its assets exceeds 30 billion euro - Economic importance: for the specific country on the EU economy as a whole. - Cross-border activities: the total value of its assets exceed 5 billion euro and the ratio 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 during the global financial crisis or after wars. A supervised bank can also be considered significant if it is one of the three most significant banks established in a particular country. Non-significant banks are the ones which not meet these conditions and they are simply supervised by the National competent authority (National Bank as Bank of Italy). GLOBALLUY systemic important banks There is another category of banks formed by the globally systemic important banks (or GSIBs). In the case of insurance company we have a similar category called Globally Systemic Importance Insurances. In the case of banks the inclusion of a bank within this group depends on the matching of this banks with several criteria defined by Stability Board which every year publishes the list of banks which are considered globally important regarding to their sizes, activities performed, and the size of intermediation activities performed, interconnectedness with other parts of financial system. 41 Among them, in Italy we have just one bank in the list which is UniCredit. Being included in the list means that those banks will be required to hold more capital to face the risks to which they are exposed. Fact that this bank are demanded to hold additional capital is because their potential failure can have a terrible effect not only at a national level but also international because of their activities. As capital for banks is aimed to face potential losses they can incurred in their activities, globally systemic important banks are required to hold additional capital. BANK ASSETS LOANS generate the most revenue for retail banks. - Loans and securities continue to be the primary assets of the banking industry. Nowadays we can observe different situation, sometimes lending activities cover 50% but other times also 70% and 80% of total assets of the banks. The larger the share of the lending activities of total asset, that is typical the case of retail banks but also small and medium banks more focused on lending activities. - As capital markets continue to grow over time, the importance of lending for many counterparties decreased over time as companies could rise funds directly on the market from the market by issued securities. It is also true that in financial systems where the banking system still plays a fundamental role and the industrial sector is made by small and medium enterprises the banking system and bank lending still play an essential role for the financing of these kind of counterparties. SECURITIES generate revenue and provide banks with liquidity. Securities are held for different reasons. They can be used for liquidity reasons. 1. The first reason why banks have securities is that as securities have low risks (as treasury bonds or good rated corporate bonds) and are traded in developed secondary markets these kind of securities can be held by banks to meet liquidity needs because they can be easily converted in liquidity (low risk). 2. The second reason for which securities are held by banks is also to hold securities that can be held for meet collateral requirements set by the central banks for the provision of refining transactions. When spoke about monetary policy tool we highlight that in order to be financed by ECB in the short or medium term is necessary to collateralize the transaction through securities accepted by ECB. 3. The third reason is trading, banks used to have securities which are traded in the secondary markets and from this activity banks can derive profits. 4. The fourth reason why banks hold securities is for investment reasons, banks hold them until maturity in order to get returns provided by these securities or they can invest on stocks to have the control over the company issuing the stock the bank invested purchase of the stocks. For a retail bank which is very focused on the provision of lending, security holdings are quite low in terms of shares but in larger banks and more diversified banks, securities can play a very important role. CASH ASSETS are held to meet reserve requirements and to provide liquidity. Other than cash in this category there is the reserve requirements which banks must hold at the central bank and together with the minimum reserve requirement bank can hold free reserve, 42 excess reserve that deposit at the central bank in light of future investments of these liquidity in different type of assets. OTHER ASSETS include premises and equipment, other real estate owned, etc. which are also necessary for the conduct of the banking system, but of course they play a limited resource with respect to others. BANK LIABILITIES DEBT VS CENTRAL BANKS AND OTHER BANKS: collect funds via the refinancing from the ECB in the case of European banks or other banks for example in the wholesale market via short term loans granted by other banks or within organized interbank market where banks can collect funds. In Italy for example it was recently created an organized market which is called DEPO market where banks and financial intermediaries can exchange deposits with specific maturities ranging from overnight till the 12 months (1 year). DEBT VS CUSTOMERS (firms, households, PA (public administration), financial intermediaries different from banks such as financial companies, insurance companies). Banks can raise funds through different ways (different types of contract): - Transaction accounts: also called current account which are site account where depositors can deposit funds. - Time deposits: deposits with a given maturity which is in general short term - Repos: repurchase agreement which is another way through which the bank can raise funds. All of these ways have something in common: they have short maturity and they represent the larger important part of liabilities of a bank (especially retail banks while for wholesale banks it is made by interbank market or via the collection of issuance of securities placed with other financial intermediaries). CERTIFICATE OF DEPOSITS (CDs): in Italy they have a maturity ranging from 3 months till 5 years (medium-term and long-term maturities). Differently from US markets they do not enjoy very high favour in preferences of Italian investors even if the minimum amount is now very low (instead in the past they are used more). BONDS: senior and junior bonds. EQUITY CAPITAL (required by regulators to act as a buffer against losses in which any banks can incurred during its life). There is a minimum requirement (a minimum capital) in order to be authorized by the supervisory authority but it is also necessarily throughout the life of each individual bank. Equity capital is highly supervised via regulations (Basel Accord) that set a minimum capital requirement that each bank must have as far as concern different type of financial and non-financial risks to which banks are exposed. Even at European level the Basel Accord is adopted by different directives and applied in different European countries. The equity capital of bank is made by different components: - Common and non-common stock (preferred): - Reserves (legal and non-legal) 45 - Increasing completely with markets (via investment services, consultancy, securitisation, etc.). In addition, we have to add that funding from market is still representing an additional important funding source for banks, but it is an important way to invest on assets side. The decrease in the number of banks in EU At European level it is possible to observe the rationalization and aggregation of banks within the euro area and European Union. Number of banks within the euro area and European Union followed a downward trend which will continue in the future. What seen before is at the base of the Increase of share of concentration within national banking system where we observe an increase in the degree of concentration. The degree of concentration is proxied by shares of five larger credit institutions in total assets refer to total banking system at the national level. In some countries there is a very high degree of concentration but not always as France or Italy (Germany has an high number of banks in the country, many small banks formed by co-operative banks ). Nationwide banking and bank consolidation Bank consolidation: is it a good thing? CONS: - Fear of decline of small banks and small business lending. Small banks can disappear because medium and much more larger banks prefer bigger companies. - Rush to consolidation may increase risk taking and “too big to fail” concerns. An increase in the concentration within the banking system increase risk of banks which can exploit the too big to fail idea which means that when banks become huge their failure is a national concern, so everyone wants to avoid it (liquidity injection to help them). PROS: - Small local banks will survive. Some banks were born just to serve local communities that think not to be enough or effectively served by large banks. In Italy many cooperative banks disappear overtime 46 through mergers and acquisitions (transactions over time), but they still survive because they organized into cooperative groups in order to better exploit economies of scale and scope which can’t be achieved by individual small banks. - Increase competition. Increase concentration can have an outcome like the increase in competition but it is possible to minimize this risk (in the case of competition the ones the profit are banking customers). - Increased diversification of bank loan portfolios lessens likelihood of failures. Large banks would be able to better serve different kind of customers located in different geographical areas at national level but also located in different countries and they will be able to serve large and medium and small customers, they diversify their portfolio and decrease the risk. Bank size and activities continued Large banks and small banks are different in the composition of assets, in services provided and they are much more diversified for what concern financial services and the interbank market. Usually large banks tend to have less equity than do small banks (same for Italy, co-operative banks have higher level of equity with respect to large banks). Common differences between large and small banks - Larger banks generally lend to larger corporations, meaning their interest rate spreads and net interest margins have usually been narrower than those of smaller regional banks. - Large banks tend to pay higher salaries and invest more in buildings and premises than small banks. - Small banks usually hold fewer OBS assets and liabilities - Large banks tend to diversify their operations more and generate more noninterest income than small banks. - Large banks tend to use more interbank markets and have fewer core deposits. - Large banks tend to hold less equity than do small banks. The rise of shadow banking The FSB (financial stability board which is very focused in this problem) defined shadow banking “Any form of credit intermediation involving entities or activities partially or completely outside the traditional banking system”. It means that some banking activities linked to lending function of banks are more and more performed by some other intermediaries which are not banks and are not subject to the same degree of supervision and regulation as banks. Not only these intermediaries compete with banks but by competing in this area, they become subject to the same kind of risks to which banks are exposed but they do not benefit of the same safety net of banks. This intermediation process can generate banking risks and possible regulatory arbitrage. Unlike traditional banks that finance themselves mainly through deposits and have access, if necessary, to central bank liquidity, the “unregulated shadow banks” collect through the market/investors, exposing themselves to a potential shortage of liquidity, with the risk having to forcefully sell the assets in the portfolio at reduced prices or ask for support from the sponsor entities (including banks). 47 Universe of shadow banking intermediaries is measured on annual basis by the financial stability board. Different shadow banking measures: MUNFI (monitoring universe of non-bank financial intermediation): securitization vehicle, speculative and non-speculative investment funds, financial companies active in the granting of credit, pension funds, insurances, brokers with lending functions (brokers acting in the security lending) etc. In all of these cases we have intermediaries which are related with lending activities. Other than securitization vehicles which hold loans that are sold by banks through securitization process, also investment funds can grant loans because of the revision of regulation as far as concern investments. It is also the case of financial companies which are active in the granting of consumer loans and mortgage loans. Insurance companies can make loans to customers even if it is a small part of their business or also brokers. As we can see there is a large number of intermediaries allowed to enter the lending system even if it is a marginal business for some of them. OFI (other financial intermediaries which is subsample): all financial intermediaries minus pension funds and insurance companies which do have a quite strong regulation and supervision of their activities. Investment funds can grant loans because revision of regulation as far as concern investment, this is the case of financial companies. A number of intermediaries can enter this business even if in some cases it is a marginal business. Assets of financial intermediaries Data about monitoring report produced on annual basis and available on financial stability board website. If we measure this sample of countries, the importance of assets held by banks the importance is quite high in absolute terms but in relative terms their shares have decreased in favour of other financial intermediaries (OFI) whose role has increased over time. The total amounts and leverages of different intermediaries have changed over time with the other financial intermediaries increased over time. 50 BANKS’ FINANCIAL STATEMENT AND ANALYSIS BANKS’ FINANCIAL STATEMENT Introduction of most important and well-known indicators to access the performance of banks. Balance sheet is a complex document made by very different parts: - Report on operations – the top management of the bank provides an analysis and description of results achieved by the bank during the past year and it also provides comments and analysis of major events occurred in the past year (mergers and acquisitions made by the bank for example but also investments made in new technologies). It provides a comprehensive overview of the performance of the company considering macroeconomic environment into which the bank operates. - Balance sheet - Income statement - Statement of comprehensive income – income statement adjusted for the fair value evaluation of balance sheet items which are measured at fair value but with those results of fair value evaluation they are accounted in valuation until those items are sold or dismissed by the banks. - Changes in shareholders’ equity - Statement of cash flows – generated in the past year. - Notes to the financial statement – they are very important for the analysis and evaluation of banking performance. If we want to have a deep understanding we need to analysis deeply the notes of financial statement. Balance sheet – Assets 51 Items reported on assets side of the balance sheet are reported according to a decreasing degree of liquidity (on the top we have most liquid and, on the bottom, there are the less liquid assets). On the top (most liquidly assets) there are: - CASH ASSETS and CASH EQUIVALENT: reserves held by the banks which are free reserves or excess reserves held by the bank at the central banks, but we don’t find the minimum reserve requirements which is instead included in the items due from bank (here we can find also different types of loans made by banks to other banks via the interbank market). - ITEMS DUE FROM BANKS: o Minimum reserve requirement: Loans made by banks to other banks also via interbank markets. We spoke about minimum reserve requirements when faced conduct of monetary policy by the ECB in the eurozone. o Customer loans: Loans made to customers so households but also public administration and financial intermediaries different from banks (loans made to financial companies or insurance companies – every type of loan made by banks to a counterparty different from bank). They are reported in the balances net of adjustments made for the losses which the bank estimates to face or it has already recorded. The items loans to customers are net of those adjustments, indeed the regulation of those adjustments they are very complex (simply remember that loans are net of adjustments which are reported in the income statements or profit and loss). Here we can find loans which are measured at amortized costs (major part of loans included into the loans to customers) but also loans to customers measured at fair value through comprehensive income (loans designed to be sold and for this reason measured at fair value with the effect on evaluation) or through the income statement (effect of fair value valuation is reported in the income statement as in the case of loans to customers securitized or aimed to be sold as in the case of syndicated loans sold by the bank). Loans to customers represent the major component of European banking system, the share of loans to customer is higher for small and medium retail banks focused on lending activities while it is less important for large banks which much more diversified assets held. A typical indicator used to analyse if a bank is more focused in lending activities than other, the way is to build a ratio of customer loans over total assets, higher ratio means higher orientation of bank to lending activities. - FINANCIAL ASSETS MEASURED AT FAIR VALUE TRHOUGH INCOME STATEMENT: typically, stocks, different types of bonds or derivatives other than some other assets as investment funds units or private equity units. The point is that financial assets held by banks are measured at fair value through income statement or through comprehensive income. o In the financial assets measured at fair value through income statement we can find financial assets held for trading purposes. These are stocks, bonds, derivates that the banks want to trade in order to make profit. o Another part of financial assets is represented by assets designated at fair value through income statement (in larger banks they are assets kept for trading). In general, the banks aim to keep them for investment purposes. 52 - FINANCIAL ASSETS MEASURED AT FAIR VALUE THROUGH COMPREHENSIVE INCOME: typically, financial assets that the bank aims to sell in the future and therefore they are measured at fair value with the effect reported in the valuation reserve. Banks allocated here financial items also held since they are accepted as collateral for refinancing obtained by central bank. - HEDGING DERIVATIVES: specific items where the banks report all the derivates used for hedging purposes with positive market value (it means that within this derivative position the bank hold credits vis a vis counterparties of the credit derivatives and therefore, they are reported on the assets side because they represent a credit position. Instead, when they represent a debit position, they are reported of the liability side). - EQUITY INVESTMENT: shares held by the bank in subsidiaries or in companies which allows the banks to retain the control of these companies or even if these shares do not grant the control of the company in which the shares are held, these kind of equity investments are considered strategic by the banks (this is the reason why they are equity investments). o Property, equipment and intangible assets o Tax assets o Other assets: here we can find assets represented by commodities held by banks like for example investments in gold or other precious metals held by banks. EARNING ASSETS: they provide to the banks the chance to earn dividends or interests to realized profit from the sale of assets held. Non-earning assets are fixed investments (property, equipment, intangible assets) but also tax assets and the other assets. Balance sheet – Liabilities 55 accepted or collected by depositors the rates offer by the banks are almost 0 while in the case of time deposits the rate offered by the bank is slightly positive. For securities issued interest rate reflects the maturity of these securities and also their riskiness. Banks with high rating banks can pay extremely low interest rates while a risky bank can pay higher interest rates. The part of liabilities paying the lower actually level of interest rate is represented by due to banks and due to customers. - Net noninterest income = noninterest income (fees obtained by the bank as OBS) – noninterest expense (fees paid by the bank to other intermediaries for services obtained). It is formed by effects of fair value evaluation of elements in the balance sheet calculated at fair value through income statement or profit and loss. For large bank the size of net interest income is larger than what we can find for small and medium banks, profitability largely depend on different between interest income and interest expenses. - Income before taxes and extraordinary items (EBTEI) = net interest income – provision for loan losses + noninterest income – noninterest expense. Loan losses have a strong effect on profitability of the company. - Net income = EBTEI – income taxes +/- extraordinary items Representation of income statement having regard effect of activities of the bank in profitability terms. These effects can be appreciated via net interest income, non-net interest income and income before taxes and extraordinary items. Income statement as European banks present it. Net interest income as the difference (interest income – interest expenses) already seen. Other than net interest income we find net fee and commission income and then the profits (losses) of financial assets and liabilities designated at fair value). We find profits on financial assets held for trading other than the effect of measurement at fair value of assets and liabilities held by the bank. OPERATING INCOME or expenses typically represented by effect of sales of financial assets held by the bank but aimed to be sold in the future. Non-interest income of the bank is largely formed by 56 the net fees and commission income plus profit and losses of financial assets and liabilities designated at fair values. If we want to understand the degree of diversification of the bank, we can build an indicator (ratio) where numerator is the net interest income and at denominator we have the sum of net interest income plus net fees and commission income, profit and losses of financial assets and liabilities at fair value and other operating income or expenses. Higher amount of this ratio, the higher will be the dependence of the bank from net interest income. It means also that the bank does not rely on other businesses like those generated fees and commissions or, for example, rely on profit derived from investing activities on securities or trading activities. The sum of these components (net interest income, net fees, profits on financial assets and other operating operations) determines the operating income. From operating income, we can deduct personal and administrative expenses and adjustments to properties, equipment and intangible assets. The sum of personal and administrative expenses determines the operating costs. The difference between operating income and operating costs determine the OPERATING MARGIN. Losses experienced by banks may hit profitability of bank itself (European banks experienced and suffer a lot because of this phenomenon, their profitability was destroyed by losses incurred in the lending activities other than losses incurred in financial assets held for trading and investments). Other then adjustment to loans we can find provisions on some other assets (not only loans). Calculate then the gross income and deducted taxes to obtain the net income or loss. Example – income statement Determine the amount of interest revenues which are necessary for the bank to achieve return on equity equal to 50% or an amount equal to 30 million euros. As known already we consider the formula of return on equity which is made by net income and equity held by the bank. Calculate the amount of interest revenues (income) that the bank should earned in order to achieve the return on equity required. In the application of the formula, as we known that return on equity equal to 50% corresponds to a net income equal to 30 million, the unknown term is the interest revenues (how much should be the interest revenue to guarantee 30 millions of net income) and net non-interest income and the tax rate but also provision for loan losses. Solving the formula for the unknown term we find the required interest revenue which is equal to 170.45 million of euro. 57 RELATIONSHIP between income statement and balance sheet Net income is nothing else then algebraic sum of profitability earned on assets side (each component) minus cost of liabilities held by the banks minus provision for loan losses plus non- interest income earned minus the non-interest expenses minus the taxation. There is a direct relationship between the income statement and the balance sheet of banks FINANCIAL STATEMENT ANALYSIS Why financial statement analysis is important and how it can be conducted? It is important for different parties (agents) as shareholders to appreciate effort made by top managers in conducted the banking system, banks in general and also other stakeholders such as investors who can invest in liabilities issued by bank but also for borrowers who can find better condition in banks which are much more profitable and efficient other then in banks which face some profitability problems. Financial statement analysis is important for bank supervisors such as ECB and also other financial authorities at national level that control non-significant banks. It can be conducted using accounting ratios that can be analysed over time (time series) in order to access the development of the performance of the bank overtime or in a cross-sectional analysis and the performance of a bank is compared with other banks (important to choose banks with similar characteristics: peer banks) Financial statement analysis is based on accounting ratios - Time series analysis is the analysis of financial statement over a period of time. Access development of performance of the bank over time. - Cross-sectional analysis is the analysis of financial statements comparing one firm with others. Used for peer banks. Most financial statement analyses are a combination of time series analysis and cross-sectional analysis. BANK PROFITABILITY – ROE (return on equity) Indicator for the performance of the banks. Return on equity (ROE) analysis begins with ROE and then breaks it down into its components. ROE measures the amount of income after taxes earned for equity capital contributed by the bank’s stockholders. 60 The impact of market niche and size Distinction between retail and wholesale banks and large/small banks which present different balance sheet and different income statement because they operate in different market niches Retail banks operate with funding from small customers like households or small firms so they tend to have a large part of their funding made by these counterparties while on the assets side they hold a large portion of loans to customers. Wholesale banks tend to have a large part of their funding coming from interbank market or institutional investors invested in liabilities issued by bank. Their assets are made by larger loans granted to large firms and also be quite active in investing in securities). Large banks compared with small banks have peculiarities, large banks have a lower amount of equity than small banks, they use more the interbank market and hold less deposits, they have higher expenses as salaries and they want to diversify more their activities, for this reason they generate more non-interest income than small banks. Retail and wholesale commercial banks operate in different market niches that should be noted when performing financial statement analysis. Large banks have greater access to purchased funds and capital market compared to small banks: - Lends to large banks generally operating with lower amounts of equity capital than small banks. - Large banks generally use more repurchased funds and fewer core deposits. - Large banks tend to put more into salaries, premises, and other expenses than do small banks. - Large banks tend to diversity their operations and services more than small banks, and they also generate more noninterest income. Application – compare the results of UniCredit group - Intesa Sanpaolo group (active in retail banking but they are active in corporate and investment banking other than insurance sector and private banking. They are very diversified bank acting not only at national level but also at European level), Medio Banca (specialized in corporate investment banking and specialized in retail banking) and Banca Mediolanum (offering of private banking services such as wealth management services other than having being also acted in some retailed banking activities (last year above all) for example in granting loans to households and private customer). - Size: total assets over 2014 – 2019 and their annual growth (%) - Asset diversification: incidence of net customer loans to total assets (%) - Asset quality: NPL ratio (%) over 2014 – 2019 - Capital: equity to total assets (%) - Profitability: ROAE ROAA (%) over 2014 – 2019 - Managerial efficiency: cost-to-income (%) over 2014 – 2019 61 CAMELS ratings Regulators use CAMELS ratings to evaluate the safety and soundness of banks. Camels ratings rely heavily on financial statement data. Components: CAPITAL ADEQUACY: evaluated in relation to the volume of risk assets. The bank’s growth experience, plan and prospects and the strength of management. ASSET QUALITY: evaluated by the level, distribution and severity and adversely classified assets; the level and distribution of nonaccrual and reduced-rate assets; the adequacy of the allowance for loan losses; and management’s demonstrated ability to administer and collect problem credits. MANAGEMENT QUALITY: evaluated against virtually all factors necessary to operate the bank within accepted banking practices and in a safe/sound manner. EARNINGS: evaluated with respect to their ability to cover losses and provide adequate capital protection, trends, peer group comparisons, the quality and composition of net income, and the degree of reliance on interest-sensitive funds. LIQUIDITY: evaluated in relation to the volatility of deposits, the frequency and level of borrowings, the use of brokered deposits, technical competence, availability of assets readily convertible into cash, and access to money markets or other sources of funds. SENSITIVITY TO MARKET RISK: reflects the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect an FI’s earnings or economic capital. Camels ratings range from 1 to 5 - Composite 1 – banks are basically sound in every respect - Composite 2 – banks are fundamentally sound but may have modest weaknesses correctable in the normal course of business. - Composite 3 – banks exhibit financial, operational, or compliance weaknesses rating from moderately severe to unsatisfactory. - Composite 4 – banks have an immoderate volume of serious financial weaknesses or a combination of other conditions that are unsatisfactory. - Composite 5 – banks have extremely high immediate or near-term probability of failure. 62 TYPES OF RISKS INCURRED BY FINANCIAL INSTITUTIONS The management of risks to which financial intermediaries are exposed represent the bulk of activities performed by financial intermediaries and by the management of risk financial intermediaries derive their profitability or they can be hit by the management of these risks up to experienced losses or failed and disappear from the market. Risks at financial institutions One of the major objectives of a financial institution’s (FI’s) managers is to increase the FI’s returns for its owners. Increased returns typically come at the cost of increased risk, which comes in many forms: - Credit risk - Liquidity risk - Interest rate risk - Market risk - Off-balance-sheet risk - Foreign exchange risk - Country and sovereign risk - Operational risk - Insolvency risk CREDIT RISK Credit risk is the risk that the promised cash flows from loans (granted for example by banks) and securities (debt securities held by banks or other intermediaries such as financial companies, insurance companies may be not paid in full or may not be paid at all). In such circumstances the default of borrowers can lead to losses for financial intermediaries which undermine the profitability and also the survival. The loans or debt securities issued by borrowers (corporations or individuals) present a high probability to be repaid with a limited upside return and a low probability of default but a potential downside risk (risk to experience losses due to default of borrowers in repaying the obligation). Probability of default is a proxy indeed of ability of borrowers to repay obligation). FIs make loans or buy bonds backed by a small percentage of capital. - Thus, banks, financial companies, investment funds and insurance companies can be significantly hurt by credit risk. Many financial claims issued by individuals or corporations have: - Limited upside return (with a high probability) - Large downside risk, risk to experienced large losses due to default of borrowers due to repaying obligations (with a low probability of default) Ex: 3% probability of default means that 3 out of 100 among those identified typically default in fulfil their obligation of repaying loans granted by banks. Calculation of probability of default is essential because it said to a bank if accept or not and also interest rate charges must take into account the probability of default (interest rate reflects the probability of default: higher probability of default, higher interest rate because higher is the remuneration demanded by the financial intermediaries to be exposed to a given borrower). 65 Effect of unexpected deposit withdrawal Adjusting to a deposit withdrawal using asset sales (in millions). A bank has assets made by cash assets an non-liquid assets while on the other side deposits and equity. € 15 million deposit withdrawal met with liquidating €10 million cash assets and liquidation of € 10 millions of nonliquid assets at “fire sale” price of € 5 million. Because of the urgent need to liquidate these assets the bank does it at fire sale which means decrease the price and the loss experienced by the bank will be equal to 5 million. The bank sold 10 million with book value equal to 10 but receiving just 5. Loss experienced is 5 million and it will hit the equity (profitability first and also equity). It is easier to liquidate very liquid assets with respect to less liquid assets (the ones that do not enjoy an organized market in which they are traded). - What is the effect on equity? Why? The bank decides to use cash and liquidate 10 million of nonliquid assets but because of urgent need to liquidate these assets bank is forced to do it at fire-sale accepting lower prices with respect to one reported in balance sheets. The effect on equity is 5 million, cash equal zero and nonliquid assets decrease. The bank sold assets with a book value equal to 10 but receiving just 5 (loss experienced which is equal to 5 will hit the equity again). INTEREST RATE RISK Already see in security evaluation, changes of it will cause a change in security price (negative relationship between dynamics of interest rates and those of prices). Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched and interest rates are volatile. Maturity transformation (different maturities between assets and liabilities, banks are exposed to this type of risk because they perform the transformation) involves an FI buying primary securities (loans or other new securities) or assets and issuing secondary securities (deposits) or other liabilities to fund the assets with different maturities. Typically, banks perform a maturity transformation. If an FI’s assets are longer-term relative to its liabilities, it faces refinancing risk (maturity of liabilities is lower than maturity of assets). - The risk that the cost of substitution of short-term liabilities will increase due to the increase of interest rate in the market. - The risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments. 66 If an FI’s assets are short-term relative to its liabilities, it faces reinvestment risk (maturity of assets are lower than maturity of liabilities) - The risk that the returns on funds to be reinvested will fall below the cost of funds. - The risk of the financial intermediary is that the return of the funds will be reinvested at a lower interest rate if the interest rate fall. Ex: Financial intermediary with 100 million of fixed earning assets that mature in 2 years. The assets earn an average of 7%. These are funded by 6-month CD liabilities paying 4%. What is the bank’s net interest margin (NIM). Average maturity of assets is 2 years (redemption of assets) while these assets are financed by liabilities with maturity equal to 6 months. Cost of substitution (interest rate paid on new liabilities substituting those already expired will depend on changes of interest rate in the market). Average interest rate on assets in 7% while the one on liabilities is 4%. 3% correspond to net interest margin = ((7%-4%) x 100 million) / 100 million). What happens if in 6-month interest rate increases by 1%? Interest rate on assets side (since it is fixed) is equal to previous one but on the liabilities side it changes (liabilities expire/mature in 6 month and they are substituted with other liabilities for other 6-month but since interest rate in the market has increased, bank is forced to increase the interest rate too in order to be able to collect funds with increase in interest rate). Increase in costs due to change in interest. In that case, the net interest margin will decrease since the interest rate paid on liabilities has increased and therefore the net interest margin changes from 3% to 2% à refinancing risk (risk of refinance assets side with shorter term liabilities with an increase in cost due to increase of interest rate in the market). Interest rates affect price of securities held by financial intermediary and it is what is analysed already. Speak also about immunization and we have seen that in the case of financial intermediaries, if they want to be immunized, they should have assets with equal maturity then liabilities held. It will immunize the financial intermediary against interest rate changes but on the other side it will not allow financial intermediary to exploit in a proper way maturity mismatched. If financial intermediaries expect interest rate will decrease, it would be profitable to exploit maturity mismatched having assets with longer maturity than liabilities (if interest rate decreases, the roll-over of liabilities (substitution of expired liabilities with new liabilities) will be made with a lower interest rate and it will have a positive effect on the net interest margin of financial intermediary). 67 All FIs face price risk (market value uncertainty). - The risk that the price of the security changes when interest rates change. - It is possible to have immunization in order to be protected by interest rate changes. FIs can hedge or protect themselves against interest rate risk by matching the maturity of their assets and liabilities. - This approach is inconsistent with their asset transformation function. MARKET RISK (different from book: market risk considers interest rate risk, price risk, exchange risk and volatility risk related to volatility of different prices or financial variables like interest rate in the market. In the book instead market risk referring only to a specific business of financial intermediaries, specifically related with the trading of assets and liabilities and above all assets). Market risk is the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices. - Closely related to interest rate and foreign exchange risk. - Adds risk of trading activity – that is market risk is the incremental risk incurred by an FI (in addition to interest rate of foreign exchange risk) caused by an active trading strategy. Trade securities to profit but this exposed the financial intermediary to another risk, which is the incremental risk, which is specifically related to wide activities in trading. Wider is the trading activity exerted by financial intermediary the wider is their exposure to market risk (changes in interest rates, exchange rates for assets denominated in different countries but also price risks and volatility risks). FIs’ trading portfolios are differentiated from their investment portfolios on the basis of time horizon and liquidity. - Trading assets, liabilities and derivatives are highly liquid. - Investment portfolios are relatively illiquid and are usually held for longer periods of time. Ex: Banking book and trading book of a banks The investment banking book and trading book of a commercial bank. Here we can understand that while on asset side financial intermediaries (banks) hold some assets like loans or other illiquid assets not subject to trading some other financial activities are composed of the so-called trading book (bonds, foreign currency, equity and derivatives). Higher these portions of assets held for trading reason, wider is the exposure of bank to market risk. In fact, some assets as loans are not valued assessed as fair value but they are evaluated through amortization (amortized costs). Therefore, these kind of values on these assets are not marked to market continuously as it would be the case if it would be evaluated via the fair value. Of course, it has some implications in terms of the ability of banks because larger the portion on liabilities subject to marked to market (fair value criteria) larger is the exposure of the banks and their profitability to changes in interest rates, foreign exchange rate, price changes and the changes in volatility. 70 Considering at the end the net return which is equal to (amount converted obtained at the end – amount landed at the beginning) and divided by the amount landed at the beginning. Consider exchange rate moves to 1.09 so there is an appreciation of euro, calculate the return considering not only the interest rate offered by the loan but also the effect of foreign exchange risk (exchange rate changes occurred). The original amount lent by the bank is 100 million dollars which is euro terms are equal to more or less 92 millions euros, in one year the borrower repays 100 millions dollars also adding the 9% which is the interest to be paid (total amount refunded it 109 millions of dollars). The bank has to convert this amount into euro, the conversion of 100 millions with the new exchange rate which is equal to 1.15 will imply that in euro terms the 100 millions will become more or less 87 millions of euro and of course, it will imply a loss for the bank because it invested 92% of euros to grant 100 millions of dollars loan but when the loan was returned the bank was able just to convert this 100 millions having 87 millions of euros. This will imply a negative return equal to -6.09% return which is partially compensated by the fact that the bank will receive 9% in terms of interest rate on the loan and therefore this partially reduce the negative return experienced by the bank. COUNTRY RISK and SOVEREIGN RISK These two risks are treated as synonyms, but they are not in reality. Country risk is the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments. Foreign borrowers default because of external factors such as interference of foreign government. Foreign corporations may be unable to pay principal and interest even if they desire to do so. - Foreign governments may limit or prohibit debt repayment due to foreign currency shortages or adverse political changes. Foreign government stops the conversion of the national currency into foreign currency. Ex: Argentinian borrower receives a loan from a Spanish bank and the loan in denominated in euro. If Argentina government stops the conversion of pesos in euro, it will be impossible for the Argentinian borrower to repay the obligation vs Spanish bank since the conversion of pesos into euro is not allowed by the government or because of government decision to stop conversion (limitation of conversion is linked to shortages in the reserve held by government in foreign currency). 71 Internal conflicts (civil wars) or wars with other countries and natural disasters can also affect the ability of foreign borrowers to repay their foreign debt. Sometimes the occurrence of country risk is related to occurrence of natural disaster as heart quakes which can damage the financial infrastructures within a country and not only and this can cause for the borrower the lack of capabilities to repay their obligation. In many cases the country risk occurs because of sovereign entity intervention as mentioned before but in some other cases country risk can be due to other causes like political conflicts or civil wars. In all of these cases foreign borrowers are unable to repay obligation for external causes. Sovereign risk In this case we mean specific situation in which sovereign entity (government) declares default from its obligation such as the repayment of bond issued. This default can affect both national investors but also foreign investors. Sovereign risk relates with the default of specific sovereign entity or a given government. Sovereign risk is the risk of the default of sovereign borrowers. In history we have several cases of sovereign default and in many cases some Latin American countries were more than ones involved in these defaults. Argentina was involved recently in a new case of default, in Europe we have a well-known case related to this risk. Sovereign risks (as well as country risks) are risks in which financial intermediaries are more and more exposed due to the internationalization of their activities and globalization of the financial and economic activity. OPERATIONAL RISK Operational risk is defined as the risk of suffering losses deriving from the inadequate or malfunctioning of procedures, human resources and internal systems, or from external events. In the case of operational risk that exposure can only cause losses once a specific event causing operational risk occurs. Operational risk is a risk that once it occurs it can only cause losses and that is why operational risk is also defined as pure risk since it can only cause losses. This is different from other risks because when these changes in interest rate in the market occurs it is possible for the financial intermediary to profit or to lose from these changes, but it is not the case for operational risk. For this reason, we can distinguish financial risks (the ones seen before) from which financial intermediaries can profit or loose while on the other side the operational risk can only cause losses even if there are some forms of mitigation for these losses (insurance contracts). - External events: losses cause by external causes (ex: legal and regulatory changes (which determine losses for the financial intermediaries or at least increased costs to fulfil the 72 new regulatory changes occurred), theft, vandalism, robberies, earthquakes and other natural disasters which can damage the financial intermediary ability to continue to perform its operation). - Processes: defective or inadequate internal procedures and controls which cannot be allowed properly to access the different type of risks to which the financial intermediary is exposed. Even in the trading activities the malfunctioning of internal controls can be responsible of losses of trading activities which are born in trading activities but indeed are related with defective internal controls which do not allow to detect quickly trading losses. - IT: hardware and software failures, computer frauds (hacker incursions, data loss). - Human resources: events such as errors, fraud, violations of internal rules and procedures, incompetence and negligence problems which can cause losses to financial intermediaries. As stated while for some causes of operational risk a possible remedy can be represented by insurance contracts for some other causes of operational risk the revision of the organization of financial intermediary is the necessary condition for the mitigation of the occurrence of operational risk. Among different causes, many of them are related with internal organization of the financial intermediary itself. Peculiarities, they affect each type of companies and not only the one involved in financial services industry: - Inevitably arise with the pursuit of business - They are pure risks since they mainly involve manifestations of loss and not of profit. - The operational risk includes legal and regulatory risk (the risk of losses deriving from violations of laws or regulations, contractual or extra-contractual liability or other disputes. This is also the kind of perimeter chosen by the international regulatory authorities for the banking system which included into operational risk other than the causes already seen also legal and regulatory risks but they excluded the so called strategic and reputational risk which in literature of operational risk are typically included within different causes but for the international regulatory authority they are not. - Strategic and reputational risks are also operational risks but not included within the bank capital adequacy regulation. Basel committee (regulatory authority) excluded them from operational risk, reason why strategic and reputational risk are excluded depend on the fact that they are quite difficult to measure while some other operational risks are easier to measure than strategic and reputational risk. Why? Because it is easier to collect data of operational risk for what concern losses for earthquakes or financial intermediaries or IT frauds or other kind of risk like legal disputes but to measure and collect data on the losses caused by strategic risk it is more difficult to measure. INSOLVENCY RISK Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities. Financial intermediary is not able to repay its obligation and is not able to face the decline of assets relative to liabilities. Larger capital held by financial intermediary, higher is the ability to face sudden changes in assets relative to its liabilities (true in general for banks). Insolvency risk is a consequence or an outcome of one or more of the risks previously described: 75 - FIs make loans to corporations, individuals and governments. - FIs accept the risks of loans in return for interest that (hopefully) covers the costs of funding net of defaults and, as a result, are exposed to credit risk. Loan portfolio management Banks loan policy includes the desired portfolio flows to limit risks such as collateral requirements and minimum ratios. Other provisions includes standards for granting loans, requirements for monitoring loans, policies on inside loans and documentation required to evaluate a non- application and so on. Many banks now use standards application forms for each type of loan and the loan officer is traded according to the specific standard used by that bank. Risk diversification: - Diversification by amount - Diversification by productive sectors - Geographical diversification - Diversification by technical forms - Diversification by duration - Diversification by currency Risk limitation: - Rationing and forms of implementation (amortizing…) - Borrowing from multiple lenders - Request for guarantees (real and/or personal), imposing of covenants. Credit portfolio policies depend on: There is a set of risks that can undermine the portfolio: - Degree of aversion/risk appetite of management - Level of capitalization of the bank (more capitalized and more volume of credit) - Features of liabilities (liabilities mix, better diversification allows more volume of credit) - Characteristics of the structure/organization of the bank - Company size/territorial structure (small medium companies, real estate, large companies and so on). Definition of credit risk Fundamental is to distinguish between expected and unexpected values, the first one give the possibility to access potential credit loss and can be charged as costs in profit and loss of financial institutions and negative items in evaluation of credit risk in the balance sheet of financial institutions. The second one has to be evaluated according to capital requirement according to unexpected events. It is important to make this distinction to take decisions related to level of equity and cost of credit. At the individual exposure level, credit risk is expressed - Not only in the risk of insolvency but also in the risk of deterioration of creditworthiness, which, although not giving rise to insolvency, may give rise to an increase in the probability of insolvency in the future. Credit risk = default risk (default) + migration risk (migration) 76 Measure of credit risk The risk of credit is measured by the loss the bank would incur in case of default. 1. Expected loss: when the bank borrows money to a client, it takes into account a non-null probability to lose money due to risk of default or of delays in the payments and risk of deterioration of the credit risk. 2. Unexpected loss: it is the real source of risk and it is covered with the capital requirements. It is important to distinguish between expected and unexpected loss in order to take decisions relating to: - Credit impairment - Level of equity - Cost of credit 1. Expected loss There is a problem of information asymmetries in credit activities because financial institutions have less information with respect to the borrower, usually what happens is that financial institutions assign a credit score to the borrower according to quantitative and qualitative analysis For each score expression of quality of credit is associated to a specific expected probability of default and of losses. Expected loss is equal to average value of the loss rate distribution of that specific score class, this expected loss is charged on the price of the loan, it is recorded in the accounting as cost in the profit and loss and as adjusted item in the credit book and it could be stabilized if there is a growing amount of transaction. Total amount of losses is the sum of expected losses of each transaction. Average loss (average value of the loss rate distribution) - It is charged in the pricing - It is recorded in the accounting - It could be stabilized just if there will be a growing volume of transactions. - The total amount of the expected loss of a portfolio is the sum of the expected loss of each transaction. The concept here is just to see that here there is the same average/mean but the standard deviation is very different, different years, different rates and different expected loss but the standard deviation of the second set of data is higher than the first one. 77 Expected and unexpected loss First graph: historical behaviours of losses (loss rate) for a specific rating score (loss rate average on y axis and deviation is the line in between the graph). Average is the expected loss that we can consider for the future but the deviation in negative, above average cost rate is the unexpected loss. Second graph: Distribution of all the losses can be associated with frequencies which looking at the past (frequencies looking at past and they become probability when looking forward). We can see that that there a negative curve that can be associated to lower scores, covering expected loss through prices and adjusted items is as to cover the biggest part of the potential loss but there is still risk and we have to cover unexpected loss in order to have a small tail on the very far right of distribution. Components - It is the ex ante measure in case of default of the borrower - It is the loss the bank is incurring in a certain time horizon (12 months) - It is to be considered as a price (as a spread to be paid by the borrower to remunerate the lender for the credit risk). Probability of default associated to the score class: it is the probability of the default. The time horizon considered by the regulators’ is 12 months. Quality of the borrower. Loss given default which is a function of the score and of the guarantee or type of loan: it is an estimation of the amount of the loss in case of default. Severity of loss. The amount is a function of the type of loan and of the guarantees. Exposure at default because it could have been already payments in terms of interest: it is the exposure at the moment in which there will be the default. Amount of the loan. 2. Unexpected loss – It is very important for the capital requirements of the bank (Basel regulation). It is not recorded in the accounting. It has to be covered through equity. It could be reduced through diversification. The effective losses are aligned with expected losses only when long term horizons are considered (it means in the long run). The bank does require capital in order to compensate periods in which are larger than expected losses. 80 - Problems related to real estate and junk bond lending surfaced at banks, thrifts, and insurance companies in the late 1980s and early 1990s. - Concerns related to the rigid increase of credit cards and auto lending occurred in the late 1990s. - Commercial lending standards declined in the late 1990s, which led to increases in high- yield business loan delinquencies. - Concerns shifted to technology loans in the late 1990s and early 2000s. - Mortgage delinquencies, particularly with subprime mortgages, surged in 2006-2008 and mortgage and credit card delinquencies continued to be a concern but have improved recently. We can see that noncurrent loan rate (linked to long term loan) and quarterly net charge-off-rate (ratio defined as net charge off divided average total loans which is given by federal deposit insurance corporation on quarterly basis). From 2010 rate decline and now it is very low due to crisis. Problem now is to see what happen with the strong impact of Corona Virus. History of bank regulation BASEL I - Accord published in 1988 to establish prudential framework and in particular for banking activities. Establishment of minimum capital requirement against credit and market risk (set or rules enlarged to all banks). - Very simple in application, it applies just to credit volumes without any types of further analysis. Aim is to enlarge the perimeter of risk considered and meanwhile improving the criteria to measure the risk and necessary capital to be allocated. - Easy to achieve significant capital reduction with little or no risk transfer. Overly simple rules were subject to “regulatory arbitrage” and poor risk management. BASEL II - Accord published in 2004, aim to enlarge perimeter of risks and improve criteria to measure the risk and necessary capital to be allocated. The weaker point of Basel I was to have too rigid risk parameter which were not capable to take into account specific qualities of borrowers or of assets in the accounts. - More risk sensitive: standard method created to evaluate rate parameters to rating borrowers or an internal rating based approach where for each loan the bank should be able to calculate different measures (expected loss with probability of default, loss given default, maturity and exposition to default). - Treats both exposures and banks very inequality. Profoundly altered bank behaviour but contained “gaps” that banks exploited. 81 BASEL III - Initial rules text issued in 2010 (2011) but continues to evolve (all previous measure were not able to avoid instability of financial markets and institutions). There were institutions during crises too big to fail and with a too high leverage, so it increases the capital requirements, potential control by regulators for each financial institution. In addition, there has been the introduction of anticyclical buffer to be accumulated when the situation is sound and to be used when there is a recession and it introduces limits to the level of ratios. - Addresses perceived shortcoming of Basel II. - Greatest impact on trading book, bank liquidity and bank leverage. Will increase capital charges materially and make certain banking activities much more capital intensive. Types of banks (derived from Basel accords) STANDARDIZED They are measuring credit risk basing on external credit ratings (late sophisticated ones and sophisticated capital requirements and highest capital burdens). Measure credit risk pursuant to fixed risk weights based on external credit assessments (ratings). - Least sophisticated capital calculations (requirements: highest capital burdens); least differentiation in required capital between safer and riskier credits. - Generally highest capital burdens. FOUNDATION IRB (internal rating based banks) The foundation internal rating based used internal credit risk models for which, at the end, they are capable to formulate and calculate for each loan a probability of default (loss given default, exposure to default and maturity). There is more differentiation in capital requirements between safer and riskier credits. - Measure credit risk using sophisticated formulas using internally determined inputs of probability of default (PD) and inputs fixed by regulators of loss given default (LGD), exposure at default (EAD) and maturity (M). - More risk sensitive capital requirements; more differentiation is required capital between safer and riskier credits. More differentiation in capital requirements between safer and riskier credit. ADVANCED IRB (internal rating based) It is similar to the previous one but with maximum sensitivity of capital requirements in function of the risk associated for each loan and there is the need to have a robust internal risk management system and data. With foundation internal rating based banks the probability of default is calculated by banks and the other risks factors are provided by regulators. With advanced internal rating based banks all risk factors are computed by the bank itself. From the bank of the first type till the advanced internal rating based bank there is a reduction in the total regulatory capital requirement. - Measure credit risk using sophisticated formulas and internally determined inputs of PD, LGD, EAD, and M. - Most risk-sensitive (although not always lowest) capital requirements; most differentiation in required capital between safer and riskier credits. - Transition to advanced IRB status only with robust internal risk management systems and data. 82 Under Basel II and Basel III, banks have strong incentive to move to IRB status by improving risk management systems, thereby reducing required total regulatory capital US regulators did not adopt foundation IRB or the standardized approach under Basel II US banks using Advanced IRB are referred to as Advanced Approaches banks. Introduction of internal ratings based Pricing risk-adjusted: every borrower has a pricing which is a function of the risk run by the bank. The bank assigns a rating to each borrower with internal analysis model. Adverse selection – risk requires compensation: the higher the risk, the greater the risk premium. The bank is not able to observe whether a potential borrower is a good or a bad credit risk, what happens is that the potential lender will demand a risk premium based on the average risk (rating). Borrowers who know that they are low risk withdrawal from the market to avoid paying the high cost, leaving only the bad credit risks applying for high interest rate loans. Banks address the adverse selection problem by screening in details loan applicants. This process allows banks to charge interest rates that differ across borrowers: the better someone’s personal credit score, for example, the lower the interest rate on a loan. It is in the interest of the “good” borrower to get a good rating because in that way it will get quantity and pricing better than the average. If you are a good borrower you can get a good rating and the pricing would be even better, the process of giving loans should be very standardized in order to be able to cope with big volumes. It is important to understand that all the information and applications are done in a proper way according to transparency. Internal ratings based: pricing We have different measures: Numerator - % of expected loss = probability of default * LGD (loss given default) - cost of borrowing for the bank to find the loan) * quantity of debt which is (1-VaR) Cost of funding (kd) for the quantity required by the bank to fund the loan which is 1 – the quantity that are required to be used from the capital of the bank and the quantity of the capital required in order to cope with the loan is the credit VaR. - Cost of equity = var * cost of capital (equity) - Operational costs (they are the cost that we have to apply to the loan in order to remunerate the capital and the operational costs and expected loss). - Ke: cost of equity - Kd: cost of debt (cost of funding) Denominator - Part of loan effectively repaid to the bank (1 – expected loss) - Expected loss: PD (probability of default) * LDG (loss given default) 85 FIs do not desire to become involved in loans that are likely to go into default. The other major aspect is the assessment of the pledge access and its ability to serve as collateral. The lender must ensure that the house is free and old back taxes that could prevent seizure in the event of foreclosure and power of sale. In the event of default, lenders usually have recourse - Foreclosure is the process of taking possession of the mortgaged property in satisfaction of a defaulting borrower’s indebtedness and forgoing claim to any deficiency. (sales in the collateral when the loan is not repaid in exchange of discharging the debt) - Power of sale is the process of taking the proceedings of the forced sale of a mortgaged property in satisfaction of the indebtedness and returning to the mortgagor the excess over the indebtedness or claiming any shortfall as an unsecured creditor. (save the collateral and selling it to pay of the loan when the borrower fails to repay the loan) An excess sale, beyond the amount, will return to the mortgage and if the sales value is not sufficient to discharge the debt, the lender becomes unsecured creditor of the difference. Lender must ensure legal description is correct, the value of collateral is decided by appraisal, some financial institutions used their own appraisals but some of them are independent (some appraisals are decided just looking at the property while others are decided after more detailed inspections). The appraisal process relies of sales price of near buy homes that are supposed to be comparable properties, this is one of the reason why you should not purchase the most expensive house in the neighbourhood. 86 Consumer and small business lending Techniques are very similar to that of mortgage lending. Scored similarly to real estate loans but there is a greater emphasis according to capabilities of cashflows to repay the loan (individual character). Evaluation of small businesses is quite more difficult. However, non-mortgage consumer loans focus on the ability to repay rather than on the property. Credit models put more emphasis on personal characteristics. Small business loan decisions often combine computer-based financial analysis of borrower financial statements with behavioural analysis of the business owner. Many small firms find themselves in financial difficulties in history, some financial institutions employed a minimum time in business requirements to grant a loan or include the time in business in the credit scoring model. Profitability is not large considering while it is more consider the effort used and extra time. Credit evaluation process is used to emphasis cash flows, soundness of business plan and character of the borrower. Mid-market commercial and industrial lending It is a loan to corporation with annual sales of 5 million to 1 hundred million dollars. Loan maturity is from few weeks to 8 years or more and from small amounts 1 hundred k dollars to 1 million for larger corporations. The evaluation process is more detailed and required the lender to subjectively and objectively evaluate the loan application. It is generally a profitable market for credit granting FIs. Typically, mid-market corporates: - They have a recognizable corporate structure. - They do not have ready access to deep and liquid capital markets. Commercial loans can be for as short as a few weeks to as many years. - Short-term loans are used to finance working capital needs. - Long-term loans are used to finance fixed asset purchases. Mid-market C&l lending Steps in the process may include meet in the applicant customers and suppliers in particular if there is one or only few measures of buyers and suppliers of a product or services. - Generally, at least two loan officers must approve a new loan customer. - Large credit requests are presented formally to a credit approval officer and/or committee - Five C’s of credit: o Character o Capacity: cash flow to service the loan o Collateral: specific maximum loan to value ratio in the loan policy o Conditions: assessing the impact of changing in economic conditions of ability to repay the loan o Capital: ability to prevent insolvency. 87 The five C’s access by asking some questions on different elements such as production of marketable outputs, capacity and conditions, supplies and cost of inputs, firms advantages - Is it a differentiate product with high marked – up? - This firm sales can be sensitive to technological changes? - Firms producing similar commodities can have different advantages as suppliers procurements or economies of scale? - Is management trustworthy? Has management cooperate with loan officer analysis? - Have they been excessively cooking the book? - What is the employee moral and turnover rate? - How credible is the business plan? Does the firm plan at all? - Does the firm likely to acquire additional funds where needed? - To what extent does the business rely on one or only a few key people that can’t be replaced? - Is the firm in the growing industry or it is still in the market share from competitors the only way to generate sales growth? - Has the firm allocate sufficient resources to market sales product? - Is the firm at risk from loosing distribution channels to competitors? - Is the firm dependent on sales to one or only a few countries? - Does the firm has sufficient equity? - Do the firm managers has sufficiently equity for what concern their performance? - What is the firm’s capacity? - How specific are assets the assets to specific borrowers? Are they useful only for firms in the same industry? - FIs perform cash flow analyses, which provide information regarding an applicant’s expected cash receipts and disbursements. Cash flow is the primary source to access the capacity of the borrower. - Statements of cash flows separate cash flows into operations activities, investing activities, financing sources. The lender will wish to access the cash flow is sufficient to service the potential loan. A wise lender ask for a schedule of actual cash disbursements and receipts, the statement of cash flow does not provide these types of information. Cash flows from operations result from producing and selling firm products including net income, depreciation and operations related to working capital account such as changes in inventory. Cash flow from investing in cash flow purchase and sale of fixed assets as well as financial activities. Cash flow from financing comes from changes in financial account such as short and long debt and equity. Problems in the operational cash flows it can be financed by cash flow from financing but it is a red flag and it is not used in the long run. - FI’s may also perform ratio analyses o Time-series analyses o Cross-sectional analyses Various ratios can be analysed, the numbers are calculated from the balance sheet: - Liquidity ratios = they measure the firms ability to repay debts in the short run. o Current ratio (current assets/current liabilities) o Quick ratio or asset cash (cash + cash equivalents + receipts by current liabilities) 90 It gives information to the lender. Limitations are: - Creation of caricatures of reality - Weightings of variable are statistical artefacts and not theoretically - All models are simplification of reality they do not consider relationships, reputations… - There are not agents that collect data Credit analysis – Large C&l lending The Moody’s model is based on option pricing, the common stocks of a corporate borrower can be viewed as a call option on the firm value with an exercise price equal to the book value of the firm debt. The option feature is represented by the limited liability of common stock, if the value of assets is less then the value of the debt, the equity holder default (this is equivalent to not exercise the option). If the value of assets at that maturity is greater than the value of the debt, the equity holder exercises the option on firm value by paying off the debt. Using the value of stock it is possible to determine the underlying imply asset volatility and market value of the firm assets. With these data and the amount of debt it is possible to estimate the probability that the call option win up in the money do not default and out of the money default. Probability of default is called EDF or expected default frequency, Moody’s provides EDFs for 60 thousand public companies and a lot of private companies worldwide. Simulations have shown that Moody’s model outperformed both Altman’s Z-model and rating changes by Standard and Poor’s. Moody’s model will normally predict changes in the default probability ahead of ratings because the expected default frequency are constructed using stock market data which are updated frequency in periodic internals. Moody’s analytics (KMV) credit monitor model uses the option pricing model of Merton, Black and Scholes to calculate expected default frequencies (EDF) for over 60,000 public companies and many private ones worldwide. The EDF predicts the probability of whether the market value of the firm’s assets will fall below required debt repayments in one year. Implied PD from bond spreads Calculate the probability of default from a bond spread and the probability of default from a risky borrower. There are bonds issued by corporates which could have a default risk and the company is not able to pay interests and capital before maturity of the bond. The risk of default implied the possibility for the lender to lose part of capital invested in the bond. The price of a corporate bond must reflect no only the spot rates of default free bonds but also a risk premium to reflect the default risk. The extra return on credit spread is asked to compensate investor for the risk of default of the underlining security. We know that the expected loss is given by the probability of default * loss given default, which is also called severity of loss which is the amount of money the borrow will recover once there will be the default divided for the exposition of default at that time. 91 This is important because there are 2 cases: - Recover = 0 - Recover > 0 Remember that the loss given default is equal to 1-RR (recovery rate). We have risk free rate (typically the yield of government bond) and risky bond (typically yield of the bond issued by the corporate). Under the assumption of neutrality we have that one dollar invested in free rate is equal (when RR=0) to one dollar invested in the risk free rate multiplied by 1- probability of default so in order to find probability of default we have to adjust the formula. In case of RR > 0 the formula is much more complicated, it is the difference between risky rate and risk free rate divided by 1+ risky rate multiplied for 1-RR or the loss given default. Find out probability of default taking into consideration probability of default founding considering the relationship between two ratios. PD = probability of default of a risky borrower i = annual interest risk-free rate r = annual interest rate of risky bonds Under the assumption of neutrality we show calculations. Find out the probability of default. The risk free rate is 5.5% and the risky bond rate is 8.5%. Bond risk free is the yield of government bond with maturity of 5 years and on the other side we have the corporate bond with maturity of 5 years. Probability of default in case of non recovery rate we find out there is 2.76% and with the recovery rate the probability of default will be higher around 7%. Setting the risk-adjusted interest rate Same formula as before, in case of neutrality 1 dollars invested in risk free rate is equal to 1 dollars invested in risky rate. Rearrange this formula considering recovery rate 1-given default. Already seen this formula in internal ratings based considering pricing. - 1-PD*LGD is equal to 1-EL 92 The estimation of funding cost or base loan rate (BR) BR (base loan rate) is the minimum rate required to hit a certain profit target such as a mark-up over the lenders cost of funds. What is important is that this rate is based on lenders cost of funds. Historically the primary rate was the rate of interest a bank charge its best customers on loans of 1 million dollars or more. Subprime lending becomes common due to the competitiveness of lending market and the prime rate term has evolved to mean the base lending rate. Variable rate on business loans are common for loans with maturity greater than 1 year and in this case the rate can fluctuate with money market rate like Labor or the banks’ prime rate. Example of how to calculate the base loan rate on the basis of the funding sources of the bank. We have liabilities (when bank borrows money) so it is -0.35% then 0.75 and then 0.9. In order to calculate the loan rate we have to calculate the weight of each of these funding source and multiply the mean at the weight for the rate in order to have the weighted rate and then the base loan rate. (try to do it) Setting the credit risk premium The credit risk premium (m) can be set based on historical default rates on loans of this category and rates of return on defaulted loans. For instance, in order to earn the base loan rate of say 9% if the default history of a given loan category is as follow: m = risk premium 0.09 should be the final result or 9 Basis points. Conceptually a bank can calculate the ROE as well as the ROA on a loan. Notice that there are other specific terms to be take into consideration such as originator fees which are no more than 1% of loan amount or fees paid to the bank to compensate it. Then there are compensating balances, non interest bearing deposits where the borrower is required to hold the bank while the loan is outstanding (percentage of credit line or of the drawdown of credit line). Consider also reserve requirement of banks that should be taken into consideration for the compensating balances. 95 Causes of liquidity risk There are two causes of liquidity risks. - The liability side reason occurs when there is an expected withdrawal of liabilities, it could happen because of unexpected withdrawals of deposits or unanticipated policy claims which can force the financial institution (insurance company) to sell assets or borrow more funds. If the financial institution does not have enough liquid assets to sell it is not able to obtain additional funds and the financial institution has to liquidate long term investments at a price below market value (fire sale price). If the liquidate assets must be marked down to market (it has to be priced at market value) then, there could occur balance sheet losses and equity write downs. - Asset side reason occurs when there is unexpected increases in assets, it could be like unexpected drawn down on credit line or unexpected loan demand. Another example can be the unanticipated default of loans that can generate additional cash needs because in this case the bank needs to write off the loan and to get the equivalent in funding and in addition, another example could be an unexpected payment on a contingent item such as the bank acceptances and financial stand-by letters of credit. Again, financial institution may solve its needs by selling liquid assets on borrowing funds. Liquidity risk arises for two reasons: 1. The liability side reason occurs when an FI’s liability holders, such as depositors or insurance policyholders, seek to cash in their financial claims immediately. - FIs must meet the withdrawals with stored or borrowed funds - Can be costly if assets can only be sold at fire-sale prices 2. The asset-side reason arises when the FI needs to fund loans immediately - Again, FIs may meet this need by running down cash assets, selling off other liquid assets, or borrowing funds. - Unexpected loan demand can occur when off-balance-sheet loan commitments are drawn down suddenly and in large volumes. - FIs are contractually obliged to supply funds through loan commitments immediately should they be drawn down. Liquidity risk and depository institutions (Dis) Depository institutions’ balance sheets typically have: - Large amounts of short-term liabilities, such as demand deposits and other transaction accounts, that must be paid out immediately if demanded by depositors. - Large amounts of relatively illiquid long-term assets, such as commercial loans and mortgages. Illiquid means that it is very much time consuming to find a buyer and the price is not the right one but the fire one. Depository institutions have large amounts of transactions and saving deposits that customers can make immediately if they want to do that. These accounts give to depositor a put option with the exercise price equal to the amount of their deposits. Banks estimate the amount of core deposit that in general are relatively stable on a day to day base and estimate expected growth in deposit. Core deposits are low turnover accounts that are at the bank for reason different from interest rates earned, it means that they are in terms of volumes relative stable and they may be placed at the bank for convenience needs or because the customer has some other relationship with the institution. 96 Depository institutions know that normally only a small portion of demand deposits will be withdrawn on any given day. - Most demand deposits act as core deposits (they are a stable and long-term funding source). Deposit withdrawals are normally offset by the inflow of new deposits. Depository institutions managers monitor net deposit drains (net deposit withdrawals which are withdrawals less increases in deposits). All those net deposit drains have in general a seasonal component increasing during Christmas and vacation time, they are quite predictable on a daily basis particularly if a bank has a substantial deposit component. If a bank has a large amount of retail/core deposit it could be less risky for the bank itself. Depository institutions manage a drain on deposits in two major ways: 1. Stored liquidity management is an adjustment to a deposit drain that occurs on the asset side of the balance sheet. o FI liquidates some of its assets, utilizing stored liquidity (in addition to reserve requirements deposit institutions tend to hold excess reserves, this liquidity has an opportunity cost due to the low or negative rate of return). 2. Purchased liquidity management is an adjustment to a deposit drain that occurs on the liability side of the balance sheet. Banks can obtain funds by borrowing additional cash in the money market called purchase liquidity on liability management. o Rely on the ability to acquire funds from brokered deposits and borrowings. o Used primarily by the largest banks with access to the money market and other non-deposit sources of fund. 1. Stored liquidity management Liquidity can be stored by investing in cash and/or liquidate security that can earn higher rate of return with respect to cash. Primary reserves are cash and deposits at the central bank. The minimum liquidity requirements on depository institutions, typically a percentage on transaction deposits, is a reserve that is kept by the bank because this is required by the regulator, but banks generally hold substantial excess reserve which then can be used for liquidity purposes. The percentage of the reserve requirement of course can be changed by central bank to allow commercial banks to use it with more flexibility and this happens in particularly in March due to Corona virus. Recall that central bank impose to have more liquidity with respect to other financial institutions. Another point to be underline is that when managers of a financial institution use and store liquidity to fund deposit drains the composition of the balance sheet changes which means that there will be less deposit and less reserve on other side after the change. - Liquidating cash stores and selling existing assets. - Banks hold cash reserves in their vaults and at the Federal Reserve in excess of minimum requirements to meet liquidity drains. - When managers utilize stored liquidity to fund deposit drains, the composition of the balance sheet changes. 97 2. Purchased liquidity management Purchased liquidity instruments include the possibility to purchase funds into a market called Fed funds market which is an overnight borrowing between banks and other financial institutions to keep reserve requirements at federal reserve for what concern US). Then there is a market for the repurchase of Repo agreements (they are a short term loan with a security pledge for collateral, in this case banks are using as collateral not mortgage back bonds as in the case of hedge funds but high level of ratings papers so they keep these securities in their balance sheet using them as collateral in order to get the money). Then, other instruments could be to issue fixed maturity certificates of deposit which are distributed among the customers or issue additional notes/bonds. The bank could issue a bond which is a corporate bond but, in this case, the corporate is the bank itself. Usually, these kinds of instruments are very expensive for the bank because in order to place these bonds into the market they need to attract investors and it will depend on the rating of the bank but also on liquidity available to the market so the source of funding could be expensive. Purchased liquidity includes: - Market for purchased funds o Fed funds market o Repurchase (repo) agreement markets - Issue additional fixed-maturity certificates of deposits - Issue additional notes and bonds Purchase liquidity management allows financial institutions to maintain the overall size of their balance when faced with liquidity demands without disturbing the size/composition of the asset size of the balance sheet. Purchased liquidity may be expensive relative to stored liquidity and could adds to volatility of interest expense. Remember that purchase liquidity sources were harder to be obtained during financial crisis. Ex: suppose that in order to attract new funding the bank has to issue new bonds and of course it is much more expensive than store liquidity management because the bank has to pay a risk premium in order to attract investors. Usually bank bonds could be quite longer (3-5-6 years or more), if there will be movement in the interest rate it could be good to issue a long term bond if there is an increase in the interest rate but on the other side, if there is a decreasing interest rate it could be more expensive and it adds volatility in the interest expenses of the bank. This is just to give the idea of how managers may decide among different typologies of sources for the funding of banks. It is riskier for banks to depend too much on purchased on wholesales funds as source of provide liquidity because it is less risky to rely on a retail deposit. The practice of purchasing liquidity is recent and it began in 1960s with the adventure of secondary market for negotiable certificate of deposits. For what concerns the purchasing liquidity it is important to underline that they can be expensive and that they can increase interest rate sensitivity of a bank liability because the bank adds interest rate sensitive funds to meet liquidity needs and therefore, there is a reduction in the proportion of funding from core deposits.