Banking

In this section, you will learn: the types of banks about securitization of bank loans the kinds of risks banks face and how they

manage these risks what causes bank runs and bank panics how deposit insurance reduces bank runs but

increases moral hazard about the regulation of banks

Types of banks Commercial banks

largest category, about 7000 in U.S.

Savings institutions, aka savings and loan associations (S&Ls) Originally, mutual banks (owned by depositors),

focused on savings deposits & mortgage loans Over time, became corporations, branched into

other types of deposit accounts and loans

Types of banks Credit unions

nonprofit, owned by their depositors (“members”)

each restricts membership to a specific group, e.g. teachers, veterans

Finance companies raise funds by issuing bonds and borrowing from

banks do not accept deposits, therefore less regulated many specialize in a specific type of loan,

e.g. car loans, subprime mortgages

Loans and Deposits by Type of Bank, 12/31/2009

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Large vs. small banks Community bank

small, < $1 billion in assets operates in a small geographic area they account for 90% of all commercial banks

by number, but account for a small portion of total bank assets

have a niche in small business lending

Large banks capable of making huge loans to corporations enjoy economies of scale

Subprime lenders Subprime lenders specialize in high-risk loans,

charge (sometimes astronomically) high rates Subprime finance companies

introduction of credit scoring fueled rapid growth, esp. subprime mortgages

Payday lenders make small short-term loans charge high fees, commonly equivalent to

400-500% APR controversial

Subprime lenders Pawnshops

Small, short-term loans using borrowers’ property as collateral

Loan sharks illegal, organized crime violate usury laws encourage repayment using threats of violence in decline due to competition from payday

lenders and pawnshops

Securitization Securitization: the process of creating

securities backed by pools of loans with similar characteristics

Mortgage-backed securities (MBS) the most prevalent type of securitized asset more liquid than the underlying loans MBS backed by subprime mortgages played

important role in the recent economic crisis

The securitization process Borrowers take out loans from commercial banks

or finance companies. The lenders sell their loans to the securitizer, a

large financial institution. The securitizer gathers a large pool of similar

loans, e.g. $100 million of subprime mortgages. The securitizer issues new securities that entitle

their owners to a share of the payments the original borrowers make on the underlying loans.

The securities are bought by financial institutions and traded in secondary markets.

Fannie and Freddie Federal National Mortgage Association (FNMA,

or Fannie Mae), created in 1938 Federal Home Loan Corporation (Freddie Mac),

created in 1970 both created to increase supply of mortgage

loans, help more people achieve “the American dream”

Fannie and Freddie are the largest securitizers of mortgages

Fannie and Freddie Fannie and Freddie are government sponsored

enterprises (GSEs), private corporations linked to the government. Perceived to have implicit govt backing,

therefore can borrow funds at lower cost than other financial institutions can.

Suffered huge losses on subprime mortgages in 2007-2008.

To prevent bankruptcy, federal government put Fannie and Freddie under conservatorship.

NOW YOU TRY:Benefits of securitization List all the parties involved in the securitization

of prime mortgages (e.g. by Fannie or Freddie). For each, name at least one benefit they

receive.

ANSWERS:Benefits of securitization Homebuyers/borrowers

Easier to get loans, lower interest ratesbecause securitization increases the pool of funds available for making home loans

Banks profit from selling loans for more than they

lent, can use proceeds to make more loans achieve geographic diversification: sell loans

made in their community, buy MBS backed by loans throughout the country, thus protected from local shocks

ANSWERS:Benefits of securitization Securitizers

Earn income from securitizing mortgages and selling MBS

Buyers of MBS get assets that are (usually) safe and very

liquid

The subprime mortgage fiasco The housing bubble. House prices…

rose 71% during 2002-2006 fell 33% during 2006-2009

Risky lending Subprime lenders lowered standards regarding

borrowers income, credit Zero down payment loans, adjustable rate

mortgages with low initial “teaser rates” Lenders resold loans, so less concerned with

default risk

The subprime mortgage fiasco The crash

Falling house prices put many homeowners “underwater” – market value of house less than amount owed on mortgage

Homeowners couldn’t afford payments, couldn’t borrow more

Rising delinquencies and foreclosures

Change in U.S. house price index and rate of new foreclosures, 1999-2009

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The subprime mortgage fiasco Consequences: huge losses for

Subprime lenders investment banks and other institutions holding

MBS

Contributed to the worst recession in decades

The business of banking A bank’s balance sheet summarizes its financial

condition at a point in time. It lists assets: what the bank owns,

including securities, loans, and reserves reserves: the portion of deposits not lent out

liabilities: what the bank owes others,including deposits and borrowings (from other banks or the Federal Reserve)

Net worth = assets – liabilities Net worth is also called equity or capital

Balance sheet for “Duckworth Bank”

Assets (uses of funds)

Liabilities and Net Worth(sources of funds)

Reserves $ 10 Deposits $ 70

Securities $ 10 Borrowings $ 20

Loans $ 80 Net Worth $ 10

TOTAL $100 TOTAL $100

Measuring bank profits Return on assets (ROA) = profits/assets Return on equity (ROE) = profits/capital Example:

Suppose Duckworth Bank’s profits = $2 Recall from Duckworth’s balance sheet:

assets = $100, net worth = capital = $10 So, ROA = $2/$100 = 2%

and ROE = $2/$10 = 10%

ROE is what the stockholders care about

Managing liabilities and assets Banks get most of their funds from deposits,

which generally cost less than borrowings On the asset side:

loans generate income but are not liquid reserves are liquid but generate no income

Liquidity management: how banks handle the tradeoff between liquidity and income

Federal Funds: short-term interbank loans banks take out when they need extra liquidity

Managing credit risk Credit risk (default risk): the risk that borrowers

will not repay their loans Banks reduce credit risk by requiring collateral,

an asset of the borrower that banks can seize if borrower defaults. Requiring collateral reduces… adverse selection: risky borrowers less likely to

take out loans moral hazard: after taking out a loan, borrower

has incentive to use the funds responsibly

Banks can also reduce credit risk by selling some of their loans

Managing interest rate risk Interest rate risk: the uncertainty in bank

profits arising from changes in interest rates maturity mismatch between liabilities and

assets – depositors can withdraw funds at any time, but many loans don’t mature for years

liabilities more rate-sensitive than assets: e.g., an increase in rates increases cost of borrowings more than income from loans

Managing interest rate risk To manage interest rate risk, banks can:

sell loans to reduce their exposure to rate changes

make loans with floating interest rates (also called adjustable rates), so an increase in interest rates increases income as well as costs

trade derivatives to hedge against interest rate changes

Equity and insolvency risk Insolvency: when assets < liabilities A wave of defaults can cause insolvency. Banks can protect themselves by holding more

capital. Equity ratio (ER) = capital/assets ER is related to return on equity:

ROE = profit/capital = (profit/assets)/(assets/capital)= ROA/ER

NOW YOU TRY:Balance Sheet Analysisa. Fill in the blank spaces on each balance sheet.

b. Compute ROA, ROE, and ER for each bank, assuming each bank has $1200 profit.

c. Which bankwould you rather own,and why?

Balance sheet for Apple BankAssets Liabilities

Reserves $2,000 Deposits $10,000Securities $10,000 Borrowings $6,000Loans $8,000 Net Worth ???

Balance sheet for Orange BankAssets Liabilities

Reserves $2,000 Deposits $8,000Securities $10,000 Borrowings ???Loans $8,000 Net Worth $6,000

ANSWERS:Balance Sheet Analysis

Apple & Orange have same ROA = 1200/20000 = 6%

Apple ROE = 1200/4000 = 30%

Orange ROE = 1200/6000 = 20%

Apple ER =4000/20000 = 20%

Orange ER =6000/20000 = 30%

Balance sheet for Apple BankAssets Liabilities

Reserves $2,000 Deposits $10,000Securities $10,000 Borrowings $6,000Loans $8,000 Net Worth $4,000

Balance sheet for Orange BankAssets Liabilities

Reserves $2,000 Deposits $8,000Securities $10,000 Borrowings $6,000Loans $8,000 Net Worth $6,000

Reason to choose Apple:• higher ROE, so more profitable for

owners

Reason to choose Orange:• higher ER, so less risk of

insolvency in the event assets lose value

CASE STUDYThe banking crisis of the 1980s

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S&L failures

CASE STUDYThe banking crisis of the 1980s Huge surge in bank, S&L failures during 1980s One cause: rising interest rates

Most S&Ls had huge maturity mismatch between rate-sensitive liabilities and long-term loans

Most loans made when interest rates were low Interest rates rose sharply during 1970s, 1980s.

Treasury Bill rate peaked at 14% in 1981 Result: huge increase in costs without

corresponding increase in income

CASE STUDYThe banking crisis of the 1980s Another cause: the commercial real estate bust Early 1980s real estate boom:

surge in demand for comm. real estate loans banks relaxed lending standards to cash in on boom Congress allowed S&Ls to make commercial loans,

S&Ls made huge loans to real estate developers

Recession in early 1980s led to defaults Falling oil prices hurt Texas and Oklahoma Oversupply of commercial real estate led to

plummeting property prices, increasing defaults

Bank runs Bank run: when depositors lose confidence in a

bank and make sudden, large withdrawals Even if the loss in confidence is not justified, the

sudden withdrawals overwhelm the bank, deplete its liquid assets

To pay withdrawals, the bank must sell assets quickly, often at “fire sale” prices

Soon, bank capital is driven below zero

Bank panics Bank panic: simultaneous bank runs occurring at

many banks 18 bank panics in U.S. during 1873-1933 Early 1930s: bank panics caused 30% of banks

to fail, contributing to the Great Depression FDR’s “bank holiday” (March 6, 1933):

all banks closed until govt declared them solvent, helped end the bank panic

No bank panics in U.S. since 1933

Deposit insurance Deposit insurance: a government program that

compensates depositors when a bank fails Federal Deposit Insurance Corporation

(FDIC): created in 1933 provides insurance on deposits up to $250,000

(increased from $100,000 in 2008)

DISCUSSION QUESTION:Deposit Insurance How can deposit insurance reduce bank runs

and bank panics? How does deposit insurance affect the

incentives of depositors? banks?

Is deposit insurance a good idea?

Effects of deposit insurance Reduces bank runs/panics: depositors less likely

to withdraw funds since deposits are insured Eliminates depositors’ incentive to monitor banks

to insure banks are not taking excessive risks Reduces banks’ incentives to avoid making risky

high-interest loans

Deposit insurance exacerbates moral hazard in banking,

increases chance of future bank failures

Bank regulation Charter: a license to operate a bank Each bank applies for a charter from a state

agency or from the Office of the Comptroller of the Currency (OCC)

Every bank is regulated by one or more of these: Federal Reserve OCC FDIC state agencies

Restrictions on balance sheets Assets

banks can hold government bonds and safe corporate bonds, not stock or risky corp. bonds

no single loan can be “too large” (15% of bank capital for nationally chartered banks)

Capital U.S. requires minimum equity ratio = 5% 1988 Basel Accord requires capital equal 8% of

“risk adjusted assets,” a weighted average of assets (higher weights for riskier assets)

Bank supervision Banks required to report info about finances and

activities Bank examinations: regulators visit banks at

least annually to examine banks’ records, interview managers, etc.

Closing insolvent banks When a bank becomes insolvent, its depositors

may not know or care, due to deposit insurance Moral hazard becomes severe for insolvent

banks: managers figure they have nothing to lose by making very risky gambles

Result: net worth may become more negative before bank closes

Thus, regulators try to close insolvent banks quickly to prevent further losses

Closing insolvent banks Regulators allowed to close banks when

capital = 2% of assets or less They may do so, or may allow bank to operate Forbearance: a regulator’s decision not to

close an insolvent bank occurs to avoid the pain and costs of closing

the bank a gamble that the bank’s finances will improve exacerbated the S&L crisis because failing

banks were allowed to incur further losses

SECTION SUMMARY Banks are institutions that accept deposits

and make loans. Types include commercial banks, savings institutions, and credit unions. Finance companies make loans but do not accept deposits. Subprime lenders make loans to people with low incomes or bad credit.

Many bank loans, especially mortgages, are securitized. Securitization increases the funds available for loans and allows banks to reduce default risk and interest rate risk by selling loans.

SECTION SUMMARY A bank’s assets include its loans, reserves,

and securities. A bank’s liabilities include its deposits and borrowings. Net worth or bank capital is the difference between assets and liabilities. The balance sheet shows assets on the left and liabilities and net worth on the right.

Banks try to reduce credit (default) risk by screening and monitoring borrowers, and by requiring collateral. Banks reduce interest rate risk by selling loans, making adjustable rate loans, and hedging with derivatives.

SECTION SUMMARY A bank run occurs when depositors lose

confidence and make sudden withdrawals. They can cause otherwise healthy banks to fail.

Deposit insurance prevents bank runs by promising to pay off depositors if their bank fails. Deposit insurance increases the moral hazard that banks may take on excessive risks.

U.S. banks are regulated by a variety of agencies. Regulators restrict the riskiness of bank assets and require minimum levels of capital.