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Financial Institutions, Risk Management, and Regulation

Dr. Gary Brester

MSU Department of Agricultural Economics and Economics

AGBE 445

Spring Semester

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OUTLINE

1. Banking Functions

2. Banking History

3. Banking Regulations

4. Stress Tests

5. Agricultural and Small Banks

6. International Competitiveness

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OUTLINE

1. Banking Functions

2. Banking History

3. Banking Regulations

4. Stress Tests

5. Agricultural and Small Banks

6. International Competitiveness

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Disclaimer

1. Banking and bank regulations

are complex

2. These regulations are evolving

3. Simplified somewhat for

illustration purposes

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Banking Functions1. Banks are payment agents

a. Facilitate payments through

checking accounts

b. Other electronic funds transfers

2. Banks are intermediaries

a. Facilitate transfer of money

between savers and

borrowers

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OUTLINE

1. Banking Functions

2. Banking History

3. Banking Regulations

4. Stress Tests

5. Agricultural and Small Banks

6. International Competitiveness

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Banking History

1. A banking crisis has occurred

approximately every 20 years

2. These crises disrupt financial flows

3. Implications can be minor or severe

a. Can have little impacts

on individuals

b. Or large impacts

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Safety and Soundness Regulation

1. Adequate liquidity to absorb shocks

2. Capital adequacy to cover all obligations

in the case of bank failure

3. Enforced by government agencies

a. Office of the Comptroller of the

U.S. Treasury

b. Securities and Exchange Commission

4. Bank concentration

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U.S. Bank Concentration

BanksAssets

($ Trillion)

Total Commercial Bank 13.9

JP Morgan 2.44

Bank of America 2.12

Citigroup 1.98

Wells Fargo 1.44

Top 4 Banks 7.98 (57%)

Top 20 Banks 10.6 (76%)

Total FDIC Banks = 6,900

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U.S. Bank Failures

YearNumber of

Failures

2000-2007 (total) 26

2008 25

2009 140

2010 157

2011 90

2012 43

2013 35

No failures in Montana since 2000

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OUTLINE

1. Banking Functions

2. Banking History

3. Banking Regulations

4. Stress Tests

5. Agricultural and Small Banks

6. International Competitiveness

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Regulatory Milestones

1. Basel (I, II, III)

a. Since 1983

b. International agreements

c. Guide to future domestic regulation

2. Sarbane-Oxley (2002)

3. Dodd-Frank (2010)

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Basel History

1. Basel agreements have evolved

since 1983

2. Capital adequacy for default risk

a. Been set at 8%

b. Equity must be greater than 8%

of some measure of assets

c. Modified to include Off balance sheet assets Customizable to banks

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Basel History

3. Considers capital for

a. Market risk

b. Liquidity risk

c. Operations risk

4. Considers the quality of capital

5. Leverage ratio established > 3%

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OUTLINE

1. Banking Functions

2. Banking History

3. Banking Regulations

4. Stress Tests

5. Agricultural and Small Banks

6. International Competitiveness

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Capital Sufficiency

1. Loan default

2. Market changes (Mark to Market)

3. Operations failure

4. Measure of capital adequacy

a. Risky capital ratio

Equity / Risky Asset Value

Must be greater than 8%

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Simplified Bank Balance SheetRisk Risky

Assets Million $ Weight Value Cash 3 0 0 Corp Securities 5 20% 1 Loans Operating 50 100% 50 House Mortgages 40 35% 14 Buildings 2 100% 2Total 100 67

Liabilities Demand Deposits 52 Bonds 40 Loss Reserve 0Total Liabilities 92

Equity 8

Sold Loans (Service) 35 10% 3.5Total Risky Assets 70.5

Risk Capital Ratio 0.113

Off Balance Sheet

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Basel Standardized Risk Weights

Claims on Sovereigns

AAA to AA 0%

A+ to A- 20%

Less than BBB+ 50% to 150%

Claims on Corporation Including Banks

AAA to AA 20%

A+ to A- 50%

Less than BBB+ 100% to 150%

Retail Products 75%

Residential Property 35%

Commercial Real Estate 100%

Other Assets 100%

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Basel Standardized Risk Weights1. All non-real estate agricultural loans

a. Set at 100%

2. Agricultural real estate loans

a. Generally set at 100%

b. But, sometimes reduces to rates

closer to home mortgages

3. Must have a risk capital ratio > 8%

4. Leverage ratio (2015)

a. LR = Tier 1 Capital/Total

Exposure

b. > 3%

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Basel Standardized Risk Weights

5. Tier 1 Capital

a. Common stock

b. Retained earnings

c. Preferred non-accumulating stock

d. No conflicts of interest

6. Total Exposure

a. All risky assets (weights > 0)

b. No risk weighting

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Simplified Total Exposure

1. Total exposure = 97 million

2. Tier 1 Capital = 8 million

3. Leverage ratio = 8/97 = 8.2%

4. Assume that one-half of the equity did

not qualify as Tier 1 capital

a. LR = 4/97 = 4%

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Effects of Declining Loan Quality

1. Suppose that $3.5 million of a bank’s

housing loans could go into default

2. Must put $3.5 million into the Loss

Reserve category

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Loan Defaults Balance SheetRisk Risky

Assets Million $ Weight Value Cash 3 0 0 Corp Securities 5 20% 1 Loans Operating 50 100% 50 House Mortgages 40 35% 14 Buildings 2 100% 2Total 100 67

Liabilities Demand Deposits 52 Bonds 40 Loss Reserve 3.5Total Liabilities 95.5

Equity 4.5

Sold Loans (Service) 35 10% 3.5Total Risky Assets 70.5

Risk Capital Ratio 0.064

Off Balance Sheet

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Loan Defaults Balance SheetRisk Risky

Assets Million $ Weight Value Cash 43 0 0 Corp Securities 5 20% 1 Loans Operating 50 100% 50 House Mortgages 0 35% 0 Buildings 2 100% 2Total 100 53

Liabilities Demand Deposits 52 Bonds 40 Loss Reserve 3.5Total Liabilities 95.5

Equity 4.5

Sold Loans (Service) 35 10% 3.5Total Risky Assets 56.5

Risk Capital Ratio 0.080

Off Balance Sheet

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Agriculture and Risk Weights

1. Agriculture loan defaults are low

2. Agriculture returns correlations

a. Low with respect to other

sectors

b. High within agriculture

3. IRB models usually decrease risk

weights for agricultural loans if

a. A bank is not heavily

concentrated in agriculture

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Internal Risk Based Models1. Alternative to standardized risk

weights

2. IRB is used to customize risk weights

for individual banks

3. This can substantially lower

risk weights

a. Sometimes by as much as 12%

4. Risk weights decline as

a. Probability of defaults decline

b. Default correlations are reduced

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Comparing Two BanksCapital Ratio Target 10%

ROA 4%

Interest Paid Rate 3.5%

Bank

Item A B

Capital 10 10

Risky Capital 100 100

Risk Weight 25% 60%

Total Assets 400 166.67

Return on Assets over Operations 16 6.67

Interest Paid 13.65 5.48

Net Return 2.35 1.18

ROE 23.5% 11.8%

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Mark to Market1. Suppose that home interest rates

increase from 3% to 4%

2. Even if home mortgage rates have

been fixed at 3%

a. The value of the bank’s home

mortgages declines

3. Assume an average maturity of

12 years

a. The value of mortgages

declines from 40 million to 37.71

million

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Mark to Market Balance SheetRisk Risky

Assets Million $ Weight Value Cash 3 0 0 Corp Securities 5 20% 1 Loans Operating 50 100% 50 House Mortgages 37.71 35% 13.1985 Buildings 2 100% 2Total 97.71 66.1985

Liabilities Demand Deposits 52 Bonds 40 Loss Reserve 0Total Liabilities 92

Equity 5.71

Sold Loans (Service) 35 10% 3.5Total Risky Assets 69.7

Risk Capital Ratio 8.2%

Off Balance Sheet

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Mark to Market on Loans

1. Usually the interest rates on loans

and bonds move together

a. But not always

2. If rates on bonds decline

a. Bond value increases

b. Equity declines

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Mark to Market Risk Mitigation

1. Sell loans into the secondary market

2. Use complex risk instruments

a. Match variable and fixed

interest rates on bonds and loans

b. Match maturities on bonds

and loans

3. Use credit swaps and other derivatives

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Future Regulations

1. Consider diversification strategies of

loan portfolios

2. Make adjustments for bank size

3. More IRB customization using

mathematically complex models

a. Stress testing

b. Value at risk

c. Migration models

d. Interest rate spread models

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OUTLINE

1. Banking Functions

2. Banking History

3. Banking Regulations

4. Stress Tests

5. Agricultural and Small Banks

6. International Competitiveness

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Agriculture and Risk Weights

1. Agriculture loan defaults are low

2. Agriculture returns correlations

a. Low with respect to other

sectors

b. High within agriculture

3. IRB models usually decrease risk

weights for agricultural loans if

a. A bank is not heavily

concentrated in agriculture

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Small Bank Challenges1. Personnel capable of IRB analysis

a. Scarce and expensive

2. Access to secondary markets are

more difficult because of small size

3. Credit swaps are often not

accessible

4. Loan portfolios are usually

concentrated

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OUTLINE

1. Banking Functions

2. Banking History

3. Banking Regulations

4. Stress Tests

5. Agricultural and Small Banks

6. International Competitiveness

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International Comparisons

Item U.S.Developing Countries

Risk free interest rate includes inflation (LIBOR or U.S. T-bill based) 2.5% 2.5%

Bank margin 3.3% 4.8%

Inflation or currency risk 0 1.5%

Default risk 0.5% 4.0%

Political and Judicial risk 0 5.0%

Commercial farmer interest rate 6.3% 17.8%

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Credit Impediments:Developing Countries

1. Property rights

a. Not well-established or defined

b. Not useful for collateral Unable to recover

c. Real estate is often

not merchandisable

2. Lack of stable, uniform, and

enforceable business rules of law

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QUESTIONS