FINM3006 Lectures Notes PDF

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FINM3006 LECTURES NOTES WEEK 1 FINANCIAL INTERMEDIATION The Role of Banks  Why do we need financing?  Economics explanations: 1. Consumers: smooth consumption creates more utility/preference 2. Entrepreneurs: mismatch between ideas and capital (money)  Why are banks important? o Investment (capital budgeting) vs. financing o Financing options (i.e. capital structure) – equity, direct (intermediated)  Investment: o i.e. capital budgeting o how to allocate funds  Financing: o i.e. capital structure o How should I fund the investment?  Investment vs. financing o Only some investors willing to invest in high risk projects o Financing options limited with high risk projects e.g. start-up small-med businesses, development projects  Invest for 2 reasons: o Want a return  2 options for financing – equity vs. debt o Key difference between equity and debt: debt makes a promise of return whereas equity doesn’t o If you break the promise – then in default  Equity – old ideas  Liabilities and OE – how you finance these ideas  Equity – personal savings, venture capital/private equity (intermediated funding), angel investors (direct funding), public stock sale (IPO)  Debt: o Banks – loans, intermediated funding o Bonds – public issues (direct funding – securitization), various classes/types  Direct vs. intermediated funding: o For given firm/project equity is riskiest, bank debt is safest o As risk increases, so does the likelihood of bank debt being the source of funds o Equity makes no promises, debt makes a promise  What risk do investors care about? o Credit/default risk – risk of non-payment o Liquidity risk – you invest so that you can liquidate (sell) when you need to fund consumption  Direct Funding:

o In a perfect market, no banks exist  intermediation is not needed – no frictions, everyone has information o Friction in the market: information asymmetry – leads to breakdown of direct financing o Friction in the market: liquidity – assets aren’t liquid, no market for it o Investors  firms/projects  investors o Less liquidity: no market for resale (varies across firms/projects) o Substantial price risk: even if market exists the depth may not be sufficient e.g. trading costs o Direct funding breaks down because of these frictions o Little or no monitoring o Risk of investment increases o High liquidity risk o Willingness to invest falls o Intermediated funding gets around these 2 problems INTERMEDIATED FUNDING  Cash goes from investors to the bank (financial intermediary)  then bank gives money to the firm in exchange for promise  Bank gives investors a security (promise) i.e. deposit  Bank has the incentive and the ability to do the monitoring – flow of funds can occur  Bank alleviates information problem  Liquidity problem – bank gives deposit in exchange which is instantaneously liquid  Banks can fund very illiquid investments  Mismatch between liquidity/liability of banks and their assets  liquidity mismatch gives rise to liquidity risk  Process of funding illiquid assets and liabilities is known as asset transformation  Agglomeration of funds resolves the following problems: o Reduced information costs/risk – economies of scale o Greater incentive for information collection and monitoring activities o Development of new secondary securities to more effectively monitor – short term debt contracts easier to monitor than bonds  Financial intermediaries (FIs) provide secondary claims to investors: o Provide investors with a safe asset o Highly liquid secondary claims have less price risk o E.g. bank provides demand deposits and invests in risk loans o These secondary securities are more marketable  How can FIs do this? o Diversification – credit risk, liquidity risk, less diversified institutions carry high default risk and more illiquid claims  Intermediation lowers risk and increases willingness to invest (indirectly)  Intermediated funding gets around the 2 problems  By reducing information and liquidity costs through o Monitoring o Diversification  Intermediated funding can increase marketability of risky investments

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How do banks reduce risk for themselves? What happens in bankruptcy? o Assets less than liabilities – can’t pay back o Order of payments:  Banks: covered bond  Senior debt holders  Subordinated debt  Hybrid – debt and equity  Equity – makes no promise o Risk goes in opposite direction – banks have lowest risk Bank loan contracts o Repayment terms o Pricing differs depending on risk  riskier = higher cost o Interest rate depends on risk o Bank contracts collection information – borrower discloses to bank an agreement o Covenants – positive/maintenance e.g. have to maintain quick ratio  if ratio falls below that value then in default o Negative covenants and restrictions o Default and remedies

FINANCIAL INTERMEDIATION – facts, market structure and trends  Reserve Bank Australia – control inflation, monetary policy, cash rate, exchange rates o Liquidity management risk, how they manage cash backs  Quantitative easing: buying lots of different types of bonds, then inject money into the economy and increase liquidity  very new, modern day macro  Loan portfolios o Differences between large and small banks o Real estate takes up large amount  Bank Balance Sheets o Bank performance often compared using ratios built from the balance sheet e.g. ROA and ROE o Current regulation has requirements on the nature of bank assets o All banks heavily reliant on debt  Commercial bank balance sheets o Banks are highly leveraged and hold little equity compared with total assets o Even relatively small percentage of loan defaults could make bank insolvent o Banks hold very little cash o Overtime,  Off-balance Sheet Activities o Heightened importance of off-balance sheet items – OBS assets, OBS liabilities o Large increase in derivatives positions is a major issue o Standby letters of credit o Loan commitments o When-issued securities

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o Trading of derivatives – give rise to market risk o Growth in off-balance sheet activity has been very large – 240% growth Consolidation in banking industry Shrinking number of banks in US Mergers and acquisitions Regulatory changes Bank failures – US FDIC created after the Great Depression Market has become a lot more concentrated in the US US Regulatory Structure o Complicated structure o Dual-banking system o Each state has its own regulator – 50 regulators o 3 federal regulators o Federal level: banks insured by FDIC (federal deposit insurance corporation) o Role is in preventing contagious runs or panics & insures deposits o Levies insurance premiums on member banks o Manages deposit insurance fund o OCC (Office of the comptroller of the Currency) – primary function to charter national banks (entry) and close them (exit) o FRS (Federal Reserve System) – central bank, monetary policy o State bank regulators o Dual banking system: coexistence of nationally and state-chartered banks AUS Structure o Banks, credit unions, building societies – Authorised Deposit-taking Institutions (ADIs) – all treated the same o Provide bulk of banking services to Australian households, businesses, governments o APRA o ADIs make up majority of assets (56%) o Banks – 56 banks in AUS o 4 major domestic banks have largest market shares in retail and commercial banking sectors – “four pillars” – 75-80% o Four pillars policy – these 4 banks cannot ever merge o CBA is biggest AUS bank o Other domestic banks account for 10% o Remainder is foreign subsidiaries o Mutual ADIs – bundle credit unions, building society, mutual banks o With mutual structure, they focus on their members o Anyone can join and become a member, in the US a ‘common bond’ is required o APRA o Non-deposit taking finance companies  these institutions do not take deposits but have traditionally provided strong competition in consumer lending o They are not required to hold a banking license Every 5-10 years enquiry

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Wallis Enquiry The Wallis Committee recommended the introduction of 3 agencies, each with specific functional responsibilities – APRA, ASIC, RBA ASIC: Australian Securities and Investments Commission o Responsible for market integrity and consumer protection across financial system o Sets standards for financial market behaviour with aim to protect investor and consumer confidence

WEEK 2 NEWS:  RBA say interest rate cut looking likely following coronavirus havoc  In last 12 months, a lot of retail outlets have been bankrupt  Chains gone into administration – spending is down  Wage growth is slow  Corona outbreak has increased the degree of uncertainty as to what will happen to consumption and investment in next 12 months  RBA decided to cut interest rates by 25 basis points – cash rates at 0.5%, historically low  Coronavirus clouded near-term outlook for the global economy  Global growth will be lower than expected  Long-term government bond yields fallen to record lows in many countries o Bond yields fall as people exist risky assets and restore value in safe assets  Potential for stimulus package to counter effects of corona virus  Increase in government spending  China allows banks to delay bad loan recognition on coronavirus  Small and medium sized businesses who need to pay debt can delay repaying their debt FINANCIAL STATEMENTS OF BANKS  2 key reports – find data we need for ratios  Balance sheet: provides investor or regulator with snapshot of a bank’s assets and liabilities  Income statement: gives sense of how balance sheet is changing over time – income and expenses  Asset or liability substitution can be seen by in the balance sheet through time  BS is a record of activities – stock o Assets – loans to companies and individuals, cash and liquid assets, allowance for losses (-) o Liabilities – customer deposits, bonds repos and CP, SHE o Assets = liabilities o Allowance for loan losses: provisions for expected losses  Loan Accounts o Gross loans: sum of all loans o Nonperforming loans: 90 days past due o Charge-offs: failed loans

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o Allowance for possible loan losses:  Contra asset account  For potential future loan losses o Net loans = gross loans – allowance for possible loan losses IS: record of earnings and expense from activities – flow o Non-interest income – commissions/fees, gains on sales of loans, mortgage banking revenues, brokerage and insurance revenues o Income – expense = EBIT – tax = earnings o Profit = revenue – costs + provisions Allowance for loan losses: o Beginning ALL o + provision for loan loss o = adjusted allowance for loan losses o – actual charge-offs o + recoveries from previous charge-offs o = ending allowance for loan losses Off-Balance-Sheet Items o OBS items are contingent assets and liabilities that may affect the future status of the FIs report of condition Unused Commitments o Two main OBS groups are derivative activity and liquidity support facilities or lending related o Derivative activity is exchange traded or over-counter o OTC markets – contracts can be anything, no guarantee, subject to counterparty risk, negotiation between 2 people o Exchange traded: standardised, trade easily on market o Derivative activity: swaps, forwards, OTC options, credit derivatives Assessing Performance with Ratios ∞ E(D t ) o Value of firm: P0=∑ t t =0 (1+r) o Value of bank’s stock rises when expected dividends (profit) increase, risk of bank falls, market interest rates decrease, combination of expected dividend increase and risk decline

RATIO ANALYSIS  ROE (return on equity) o ROE = net income (after tax)/total equity capital o Amount of income (after taxes) earned for each dollar of equity capital contributed by owners o ROE can fall if profit decreases or equity increases o Profits decrease because revenue decreases or cost increase or provisions increase o Higher ROE generally preferred – however increase in ROE could indicate in risk o Higher equity increases bankruptcy risk o Increase in ROE might be a result of increased leverage which implies an increase in financial risk, increased likelihood of a regulatory violation

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ROA (return on assets) o ROA = net income (after tax) / total assets o Amount of income (after tax) earned for each dollar of assets ROE, ROA, EM o Can relate ROA and ROE through ‘equity multiplier’ (EM)  ratio of assets to equity o EM = total assets / total equity o EM is measure of leverage  higher EM = higher leverage ROA, PM, AU o ROA = PM x AU o PM = net income (after tax) / total operating income o AU = total operating income / total assets o PM: profit margin  measure bank’s ability to manage expense o Can break down PM further by breaking up sources of income and expense along the lines of the income report o AU: asset utilisation Income Ratios o Interest income ratio: IIR = interest income / total assets o Noninterest income ratio = o Net interest margin (NIM) = interest income – interest expense / earning assets The Spread o Sprd = (interest income/earning assets) – (interest expense/interest bearing liabilities) o Important o Higher spread Limitations: o Looking at banks ratios gives limited picture of bank’s performance o Ratio analysis should include cross-sectional analysis and analysis of time o Can use ratio analysis as a proxy for risk o Ratio analysis has no forward-looking components i.e. market risk, IR risk, credit risk o Can find weakness in ratios by considering the impact of capital structure changes, asset substitution, human capital, and risk

TOPIC 3: BANKING RISKS – LIQUIDITY RISKS  Any corporation/bank must take risk to earn profits beyond risk-free rate  Banks must manage risks which jeopardise earnings and potentially solvency  Risks for banks come from their activities – recorded on balance sheet  Loans are illiquid  Mismatch in balance sheet gives rise to liquidity risk  Maturity intermediation  Assets: loans to companies and individuals  illiquid and long-term  Liabilities – liquid and short-term – deposits  Interest Rate Risk: risk incurred by an FI when the maturities of its assets and liabilities are mismatched

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Market Risk: risk incurred from assets and liabilities in an FI’s trading book due to changes in interest rates, exchange rates, and other prices Credit Risk: risk that promised cash flows from loans and securities held by FIs may not be paid in full Liquidity Risk: risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at less than fair market prices Comes from the mismatch in the liquidity of the assets and the finance for those assets How much they have in liquid assets vs. liquid liabilities Most liabilities are liquid for banks whereas cash they hold is small (e.g. around 5%) Mismatch from deposits (65-80%) and amount of cash you hold (5%) Source of risk o DIs must manage their liquidity risk so they can pay cash out when it is demanded o Deposit holders request withdrawals of their funds o Wholesale funding “withdrawals” – REPO financing, commercial paper financing o OBS demand from contingent assets/liabilities If banks run out of cash, the risk is that: o The DI must use a more expensive form of funding o DI’s assets are not liquid enough to sell without incurring a large cost, or worse, the DI is unable to find a buyer Banks don’t hold more cash – less cash they hold the better But promised instantaneous cash to depositors – how money markets used to manage liquidity risk All this money used to finance loans Cash comes from depositors, card holders If you can’t raise money in REPO or interbank market, the RBA gets involved Why do banks hold so little cash? o It is costly to do so (opportunity cost) o Liquidity risk is a result of ‘liquidity creation’ and is part of everyday management of a DI Banks can usually manage this mismatch well because the risk is usually idiosyncratic – use models to predict how much cash they need i.e. more around Christmas time Only in limited cases does liquidity risk threaten the solvency of a DI Causes of liquidity risk: retail liability side o In normal times only a portion of deposits are withdrawn each day, however each day new deposits are made o Deposits in total (core deposits) and net deposit drain o Some days might be in surplus and some days might be in deficit Two ways a DI might manage risk: o Stored liquidity management  hold more cash o Purchased liquidity management  more common, borrow more cash Purchased Liquidity management: o If long enough time horizon (> week) sell wholesale certificates of deposit, notes, bonds

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o If short-term (overnight to 1-week): Interbank borrowing @ LIBOR – enter money-market  trade cash  banks trade cash with eachother o Repo markets (cash borrower = repo seller) Repurchase Agreements (REPOS) o Secured borrowing and lending o Collateralised interbank transaction o Usually backed by government securities o Highly liquid and flexible source of funds o Cost: o Generally below cash/fed funds rate o Generally cheaper because handing over collateral o Yield generally below market interbank rate due to collateralised nature o Pricing: repo rate vs. haircuts o Repo rate = interest return = [($100 + interest/$100] x 100 o Difference between amount borrowed and amount paid back o Haircut = fair value – amount lent Causes of liquidity risk: asset side o Loan commitments and other contingent assets/liabilities on the OBS increase the cash demand for banks o Can bring about shortage of cash o Face same problems as with liquidity drains from liability side o Consider 2 common OBS items:  Commitments (contingent asset)  Letters of credit (contingent liability) Causes of liquidity risk: wholesale liability side o Relying on purchased liquidity can be a problem in times of market stress  Very volatile  Markets might dry up o What happens if you cannot refinance in the wholesale market – bank run o Lender of last resort: the central banks act as a liquidity backstop for banks in times of need Fed’s discount window o Borrowing on short-term basis (overnight) under repo transactions o Fed “discounts” collateral handed over in exchange for immediate funds o 3 levels of funding: o Primary credit (financially sound institutions): cost = fed funds rate + 50 bps o Secondary credit (institutions not eligible for primary credit): cost = primary + 50 bps o Seasonal (only for small institutions demonstrating clear seasonal patterns): cost varies Liquidity and the RBA o RBA holds responsibility of the stability of the financial system o RBA buys securities under repurchase agreement it does so in 2 classes:  General collateral  Private securities – asset-based securities Liquidity Risk Management

o Can be asset side e.g. hold more liquid assets o Can be liability side e.g. can issue less liquid liabilities o Or can do both – new regulatory approach has done both Measuring Liquidity Exposure – 5 methods 1. Peer group ratio comparison  Can compare certain key ratios and balance sheet features of one DI with similar Dis or to some market-wide benchmark  Loan commitments/assets  Deposits/total assets – higher ratio viewed as safer bank  Compare across banks and overtime 2. Net liquidity statement – from balance sheet  Shows sources and uses off liquidity  Net liquidity = sources – utilisation  Sources are: cash type assets, maximum amount of borrowed funds available, excess cash reserves 3. Liquidity Index  Measures potential loss a DI could suffer from sudden disposal of assets, compared to amount received under normal market conditions  0 liability maturity  institution is short-funded  borrow short-term to fund long-term assets  If asset maturity < liability maturity  long-funded  Market value risk independent of any cashflow risk  Cashflow risk: refinancing...