Saving Institutions

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History of Saving Institution

In Europe, savings institution originated in the 19th century. The first English savings bank was established in 1799,The first chartered savings bank in the United States was the Provident Institution for Savings in the Town of Boston, incorporated in December 13, 1816

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Savings institutions are financial intermediaries that raise funds mainly through time and checkable deposits and use the funds to provide loans, principally home mortgages, and to invest in securities.Sometimes referred to as thrift institutions,

Definition

Components of Saving InstitutionsComponents of Saving Institutions

Savings banks, are financial intermediaries that acquire funds at periodic intervals on a contractual basis.

They tend to invest their funds primarily in long-term securities such as corporate bonds, stocks, and mortgages.

Example insurance companies and pension funds.

“ A cooperative association organized to hold savings of

members in the form of dividend-bearing shares and to invest chiefly in home mortgage loans —called also savings and loan“

Known as mutual savings banks, the depositors and borrowers are members with

voting rights, and have the ability to direct the financial and managerial goals of the organization

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Ownership

mutual (owned by depositors)mutual-to-stock-conversions

Allow SIs to obtain additional capital by issuing stock

Provide owners with greater potential to benefit from performance

Make SIs more susceptible to hostile takeovers

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Ownership in Pakistan

State owned Saving institution National saving BankMutual owned Saving institution

Allied bank Limited (Owned by Ibrahim Group) Bank Alfalah Limited(Owned by Abu Dhabi Group) Abbasi Enterprise(Owned By Mr. Wajid Wasi)

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Difference between saving institution and commercial banks

Unlike commercial banks, thrifts have traditionally focused on residential mortgage lending rather than commercial lending

Unlike commercial banks, these institutions do not accept demand deposits.

Savings banks tend to be smaller and less complex than commercial banks

Savings institutions rely on the federal funds market to lend their excess funds or to borrow funds on a short-term basis

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Sources of funds

The main sources of funds for SIs are

Deposits Borrowed funds Capital

They obtain most of their funds from variety of savings and time deposits, including

Passbook saving,

Retail certificates of deposit(CDs) Money market deposit accounts(MMDAs)

Before 1978 SIs focused primarily on pass-book saving accounts

Since 1978, SIs are allowed to offer retail CDs with rates tied to Treasury bills

Since 1981, SIs are allowed to offer NOW accounts as a result of DIDMCA

Since 1986, all deposits were free from ceiling rates.

Firstly, they can borrow from other depository institutions that have excess funds in the federal funds market

Second, SIs can borrow through repurchase agreement(repo). With the repo an institution sell securities, shortly thereafter.

Third, SIs can borrow at the Federal Reserve, but this is not as common as the other alternative

The capital(or net worth) of an SI is primarily composed of

• retained earnings• funds obtained from issuing stock. During period when SIs are performing well,

capital is boosted by additional retained earnings.

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Uses of FundsUses of Funds

The main uses of funds in saving institutions are:CashMortgagesMortgage backed securitiesOther securitiesConsumer and commercial loansOther users

They maintain cash to satisfy reserve requirementThey are enforced by federal reserve system to maintain

reserveThey hold reserve in other institutions in return of various

services

Primary assets of saving institution Have long term maturities and are usually be prepaid

by borrowers 90% mortgages originated are homes purpose 10%work for commercial properties Mortgages can be sold in secondary market and

market value change in response to interest rate movement

There is interest rate risk as well as credit(default)risk To protect against interest rate risk saving institution

use variety of techniques To protect against credit rate risk mortgages serve as

collateral

To obtain funds SIS commonly issued securities backed by mortgagesSIS use available funds to purchase these securitiesThe seller may continue to service the mortgages It passes on the periodic payments to the purchaserIt retains a small amount as service fee

All SIS invested in two types of bondsTreasury bonds Corporate bondsSIS have also invested in Junk bondsTHE proportion of funds invested in

junk bonds varied substantially among SIS some stated imposed limits on this type of investments.

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Many SIS are attempting to increase their consumer loans and commercial loansBoth type of chartered include

•Federally chartered•State chartered

State chartered SIS were also granted more lending by their respective statesFederally chartered SIS are allowed to invest up to 30%of their assets in non mortgages loans and securitiesA maximum 10 % of assets can be used to provide non- real estate commercial loansSome saving institutions taken advantage of the de-regulatory acts by providing corporate and consumer loans,The maturities range between 1 to 4 yearsThe loss rate on mortgages loans has been significant lowers than the loss rate on credit card loans

Consumer and commercial loans

Saving banks provide temporary financing to other institutions through the use of repurchase agreementsThey can lend funds on short term basis in federal fund market

Other uses of funds

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Regulations of Saving institutions Regulations of Saving institutions

Saving institute are regulated at both

state levelfederal level

Supervision can be vary according to whether SI is

manualstock owned

In Pakistan Saving institutions are regulated by State Bank of Pakistan

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Regulatory assessment of Savings Regulatory assessment of Savings InstitutionsInstitutions

Regulators conduct periodic onsite examination.

They ensure minimum level of capital required and maintain their exposure to risk within a tolerable range.

SIs are monitored similar to commercial banks. They are assessed according to their capital adequacy, asset

quality, management, and sensitivity to market conditions

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Exposure to riskExposure to risk SIs are exposed to

Liquidity risk Credit riskInterest rate risk

Their sources and uses of funds differ from other banks so their exposure to risk varies as well.

SIs commonly use short-term liabilities to finance long-term assets.

They depend on additional deposits to accommodate withdrawal requests.

If new deposits are not sufficient to cover withdrawal request, SIs can experience liquidity problems.

This problem can be solved by obtaining funds through repurchase agreements or borrowing funds in the federal funds market.

An alternative method for resolving this problem is, to sell assets in exchange for cash.

They can sell their treasury securities or even some of their mortgages in the secondary market..

Liquidity risk

The main reason for credit risk at SIs is mortgages.

Federal Housing Authority(FHA) mortgages originated by SIs insured against credit risk.

Conventional mortgages are not insured against credit risk.

Private insurance can be obtained from conventional mortgages, but SIs incur the risk themselves rather than pay for the insurance.

SIs exposure to credit risk increased because they rely on households for most of their income.

Credit risk

The exposure of SIs to interest rate risk is high They have a heavy concentration of fixed rate

mortgages The spread between their interest revenue and

interest expenses narrowed when interest rate increased.

The spread even becomes negative because rates on deposits increased beyond the fixed interest rates charged on mortgages

Interest rate risk

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Interaction with other Financial Interaction with other Financial InstitutionInstitution

SIs interacts with various types of financial institutions. Saving institutions compete with commercial banks and money market mutual funds to obtain funds as well as with finance companies in lending funds.

Types of financial institutions

Interaction with saving institutions

Commercial banks Compete with SIs in attracting deposits providing commercial loans

Finance companies Compete with SIs in providing consumers and commercial loans

Money market mutual funds

Compete with SIs in attracting short term investment from investors

Insurance companies Purchase mortgages from SIs in the secondary market

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Participation in Financial MarketParticipation in Financial Market

As SIs interact with other financial institutions, they rely on various financial markets, as summarized in this Exhibit;

Financial Markets How saving institution participate in this market

Money MarketsCompete with other depository institutions for short term deposits issuing by commercial papers

Mortgage MarketsSell mortgage in secondary market and issue mortgage backed securities

Bond MarketsPurchase bonds from their portfolio investment

Future MarketsHedge against interest rate movements by taking position in interest rate future

Option Markets Hedge against interest rate movement by purchasing a put option on interest rate futures.

Swap Markets Hedge against interest rate movement by engaging in interest rate swap

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Management of Interest Rate RiskManagement of Interest Rate Risk Savings institution can use following methods to manage

their interest risk Adjustable rate mortgage (ARMs)Adjustable rate mortgage (ARMs)

The interest rate on adjustable rate mortgages is tied to market-determined rates.

It enables Sis to maintain a more stable spread between interest revenue and interest expenses.

ARMs reduces the adverse impact of rising interest rates, they also reduce the favorable impact of declining interest rate.

While ARMs reduce the risks of SIs, they expose consumers to interest rate risk.

Interest Rate Future ContractsInterest Rate Future Contracts

This contract allows for the purchase of a specific amount of a particular debt security for a specified price at a future point in time.

Sellers of future contract are obligated to sell the securities for the contract price at the stated future point in time.

If interest rate rises, the market value of the securities represented by the future contract will decrease.

The SIs will benefit from the difference between the market value at which they can purchase these securities in the future and the future price at which they will sell the securities.

Interest Rate SwapsInterest Rate Swaps

Interest rate swap allows an SI to swap fixed-rate payment (an outflow) for variable-rate payments (an inflow).

The fixed-rate outflow payments can be matched against the fixed-rate mortgages held so that a certain spread can be achieved.

In a rising rate environment, the institution’s fixed-rate outflow payment from the swap agreement remains fixed, while the variable-rate inflow payment due to the swap increases.

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Valuation of Saving InstitutesValuation of Saving Institutes

Valued by:• Managers to monitor progress• Financial institutions to take acquisitionValue is based on present value of its future cash flowsValue changes in response to changes in expected cash flows ΔV = f[ΔE(CF), Δk] + -

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Factors that affect required Factors that affect required rate of returnrate of return

It can be modeled as: Δk = f(ΔR, R, ΔRP)RP) + ++ +Risk free Rate:Risk free Rate:An increase in the risk free results in a higher return required by investors which decreases the firm value.Risk Premium:Risk Premium:If the risk premium on SI rises, so will the required rate of return by investors who invest in SI. So increase in risk premium decrease its cash flows.

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Factors that affect Cash FlowsFactors that affect Cash Flows

Economic growthRisk-free interest rateIndustry conditionsManagement abilities

Enhance cash flows by increasing household demand for consumer loan or mortgage loan

Reduce the loan default Increase the demand for other financial

services(real estate and insurance services) because households have high disposable income

Cash flow is inversely related to interest rate movements

When interest rate decreases other market rates also decrease and demand for SI’ s loans increases which increases cash flows

Increase in interest rates reduce SI.s expected cash flows because the interest paid on deposits may increase more than interest earned on loans

Industry conditions like regulatory constraints, technology and competition also affect cash flows

If regulatory constraints are reduced the expected cash flows of some SI,s increase

Reduced regulatory constraints may cause les efficient SI,s to lose market share and result is reduction in cash flows

Efficient management abilities increase cash flows

Use technology that reduces expense Capitalize on regulatory changes by offering

diversified customer services Use derivatives securities to alter positional

return and increase cash flows