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Banking Regulation Copy Notes

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This is an extract of our Banking Regulation Copy document, which we sell as part of our Banking Regulation Notes collection written by the top tier of City University students.

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The products sold and the risks faced by modern FIs are becoming more complex and increasingly similar because of:
1) DEREGULATION: increased competition; consolidation within the country
(M&A); diversification across products and geography (foreign bank entry)
a. Glass-Steagall Act, 1933:
i. Separation between Investment Banks (IBs) & Commercial
Banks (CBs)
ii. CBs are with deposits but restricted asset choice
IBs are without deposits but greater freedom on the asset side iii. IBs have protection from CBs competition in the equity market iv. CBs are subject to many regulations related to capital, risk, etc,
while IBs are subject to only Securities and Exchange
Commission b. Financial Service Modernization Act, 1999:
i. Removes barriers between CBs, Insurance companies and IBs ii. Creation of "financial services holding companies" that could engage in banking, insurance and securities activities (it basically does everything, and so they hold the highest share of total assets)
iii. Large banks could place certain activities in its subsidiaries 2) FINANCIAL INNOVATION: new derivative market
Understanding these changes are important because the risks of FIs change together with these structure and activities of banks.
Although product and geographical diversification and derivative instruments were supposed to reduce the risk faced by FIs, they have actually resulted in higher systemic risk.

DEREGULATION and FINANCIAL INNOVATION facilitates a change of the business model from "originate and hold" to "originate and distribute".
 ORIGINATE and HOLD: creation of FUNDING liquidity through
1) Banks hold loan to maturity 2) Banks hold credit risk 3) Banks have an incentive to screen and monitor borrowers 4) Banks have an incentive to price risk correctly
 ORIGINATE and DISTRIBUTE: creation of MARKET liquidity through
1) Better risk sharing between banks and markets 2) Banks get rid of the associated credit risk 3) Banks get new funds to originate new loans from this sale 1 4) Less incentive to screen and monitor borrowers, and price risk correctly

This change in the business model resulted in a dramatic increase in systemic risk of the financial system due to:

i. Lower screening standards - higher average credit risk ii.
The originator of the ABS gets rid of the underlying credit risk iii.
If banks lose their ability to sell/securitize at a fair price then it will create
Market liquidity risk (cannot trade loans and thus no liquidity provision)

iv. Market liquidity risk feeds back into funding liquidity risk

LIQUIDITY RISK arises for 2 reasons:

1. LIABILITY SIDE liquidity problems:
a. Risk that many depositors demand immediate cash for their financial claims b. ST lenders do not renew their credit lines

2. ASSET SIDE liquidity problems:
a. The risk of being unable to satisfy claims like loans commitments b. Drop in investment portfolio value (caused by increase in interest rate)


I. Demand deposits - have a high degree of withdrawal risk.
Withdrawals can be instantaneous and largely expected by the DI
manager, such as pre-weekend cash withdrawals. Despite the 0 explicit interest paid on demand deposit accounts, competition among DIs and other FIs has resulted in the payment of implicit interest, or payments of interest-in-kind on these accounts. Finally, demand deposits have an additional cost in the form of non-interest bearing reserve requirements the DI must hold.

II. NOW accounts - are interest-bearing. The major difference between
NOW accounts and demand deposits is that NOW accounts require the depositor to maintain a minimum account balance to earn interest. The payments of explicit interest and the existence of minimum balance requirements make NOW accounts potentially less prone to withdrawal risk than demand deposits.

III. Passbook savings - are generally less liquid than demand deposits and
NOW account for 2 reasons. First, they are non-checkable and usually involve physical presence at the FI for withdrawal. Second, the DI has the legal power to delay payment or withdrawal requests, which provides important withdrawal risk control to DI managers.

IV. Money market deposit accounts (MMDA) - are liquid but not as liquid as demand deposits and NOW accounts. In the US, MMDAs are checkable but subject to restrictions on the number of checks written on each account per month, the number of transfers per month, and the minimum denomination of the amount of each check.
V. Retail time deposits and CDs - are fixed-maturity instruments and carry early withdrawal penalties (before maturity) such as the loss of a certain number of month's interest. These instruments have relatively low withdrawal risk compared with demand deposits and NOW
2) WHOLESALE CDs - allow depositors to liquidate their positions in these
CDs by selling them in the secondary market rather than settling up with the
DI, as a result, a depositor can sell a relatively liquid instrument without causing adverse liquidity risk exposure for the DI. The only withdrawal risk is 3 that these wholesale CDs are not rolled over and reinvested by the holder of the deposit claim.
3) FEDERAL FUNDS - since the funds generated from these purchases are borrowed funds, not deposits, they are not subject to reserve requirements nor deposit insurance premium payments to the FDIC. While DIs with excess cash reserves can invest some of this excess in interest-earning liquid assets such as
T-bills, an alternative is to lend excess reserves for short intervals to other DIs seeking to increase short-term funding. The interbank market for excess cash reserves is called the FEDERAL FUNDS market. Fed funds are short-term uncollateralized loans made by one DI to another; more than 90% of such transactions have maturities of 1 day. For the borrowing DIs, there is no risk that the fed funds they have borrowed can be withdrawn within the day,
however, there is a risk that the funds will not be rolled over by the lending DI
the next day. Nevertheless, since fed funds are uncollateralized loans,
institutions selling fed funds normally impose maximum credit caps on borrowing DI.
4) REPO AGREEMENTS (RPs or repos) - can be viewed as collateralized fed funds transactions. Here, the DI with excess reserves sells fed funds for 1 day.
The next day, the borrowing DI returns the fed funds plus 1 day's interest.
Since a credit risk exposure exists for the lending DI because the borrowing
DI may be unable to repay the fed funds the next day, the lender may seek collateral backing for the 1-day loan. Collateral is normally in the form of Tbills, T-notes, T-bonds, and MBSs!

I. Commercial paper - is an unsecured ST promissory note issued to raise ST cash.

II. Medium-term notes (often in 5-7 years range).

FIs can manage liquidity needs in 3 ways:
1) Stored liquidity management - adjustment on the asset side though the use of stored cash reserves 2) Purchased liquidity management - adjustment on the liability side through:
a. Fed funds b. Repo market c. Issuing fixed-maturity wholesale CDs d. Selling bonds 3) Liquidation of assets at fire-sale prices

BANK RUN - occurs when many depositors withdraw their money all at the same time. Bank run can turn liquidity problem into a solvency problem (e.g. Northern
Measures to REDUCE the likelihood of BANK RUNS:
1) DEPOSIT INSURANCE: offers depositors various degrees of insurance protection (up to $250,000 in the US; €100,000 in EU; and £85,000 in the
UK). If a depositor believes a claim is totally secure, even if the bank is in trouble, the depositor has no incentive to run. So, deposit insurance deters runs

4 as well as contagious runs & panics. But this protection encourages banks to take excessive risk - MORAL HAZARD!
2) LENDER OF LAST RESORT: Central Bank provides solvent but illiquid banks with liquidity when needed usually at a rate of penalty interest rate.
However, this also encourages banks to take excessive risk - MORAL
3) SUSPENSION OF CONVERTIBILITY: no further withdrawals after a given threshold is reached 4) NARROW BANKING: force banks to invest only in assets with ST maturity.
But, there will be little value creation since valuable investment projects are mostly LT

1) EXERCISE OF OBS LOAN COMMITMENTS: when a borrower draws on its loan commitment, the FI must fund the loan immediately → demand for liquidity. Then satisfy the liquidity needs by selling investment securities,
2) DROP IN INVESTMENT PORTFOLIO VALUE (caused by increase in interest rate)

INTEREST RATE RISK - the risk incurred when maturities of its assets and liabilities are mismatched and interest rates are volatile, creating either refinancing or reinvesting risks.

CREDIT RISK on the ASSET SIDE - the risk that promised cash flows from loans and securities held by FIs may not be paid in full or in part.
1) FIs needs to MONITOR AND COLLECT INFORMATION about borrowers whose assets are in their portfolios and to monitor those borrowers over time.
2) DIVERSIFICATION of different types of loans. This diversification across assets reduces the overall credit risk in the asset portfolio and thus increases the probability of partial or full repayment of principal or interest. In particular, diversification reduces individual firm-specific credit risk, such as the risk specific to holding the bonds or loans of General Motors, while still leaving the FI exposed to systematic credit risk, such as factors that simultaneously increase the default risk of all firms in the economy.
3) RISK SHARING through SECURITIZATION - transfer credit risk to others 4) OBS DERIVATIVES (are like an insurance which are used to eliminate the credit risk of loans) - assets stay on the B/S but their risk weights are reduced to 0 thus increasing/improving the capital ratio. Example: Credit Default Swap
(CDS). BUT there is a risk that the PROTECTION SELLER may
DEFAULT if the underlying security defaults because protection seller is also investing in the same security! Thus, the protection may become worthless!

SECURITIZATION: rather than holding loans on the B/S until maturity, shortly after origination, the FI packages and sells loans and other assets (backed securities) to investors for cash, which can then be used to originate new loans/
assets, thereby starting the securitization cycle over again.
 ADVANTAGE: by packaging and selling loans to outside parties, the FI
removes considerable liquidity, interest rate and credit risk from its B/S. Thus,
securitization allows DI to become more liquid, provides an important source of fee income, and helps reduce the effects of regulatory burden. Before the financial crisis, the main purpose was not to share the risk but to circumvent the regulatory capital requirement!
 DISADVANTAGE: it can lead to poor loans underwriting and failure to monitor borrower activity. This loosening of incentives was an important factor leading to the global financial crisis 2008-09.
The basic mechanism of securitization is via removal of assets from the B/S of the FIs by creating OBS subsidiaries called SPV or SIV. These shadow banks have no access to central bank liquidity provisions or deposit insurance. Further, their activities occur beyond the reach of federal monitoring and regulation.
 SPV (Special Purpose Vehicle)
FI selects a pool of loans and sells them to an OBS SPV. The SPV packages the loans together and creates new securities backed by the cash flows from the underlying loan pool (ABS). The SPV sells newly created ABS to investors such as insurance companies and pension funds, and uses the proceeds to pay the loan-originating FI for the loans. The SPV earns fees from the creation and servicing of the newly created ABS. All cash flows from the loans are passed through the SPV and allocated according to the terms of the
ABS contract to the ultimate investors. The life of the SPV is limited to the maturity of the ABS. THE CREDIT RISK BELONGS TO AN
 SIV (Structured Investment Vehicle)
SIV is more lucrative than SPV and the lifespan of SIV is not tied to any security. Instead, SIV invests in assets that are designed to generate higher returns than the SIV's costs of funds. The SIV sells commercial paper (or bonds) to investors in order to raise the cash to purchase the bank's loans. The
SIV then holds the loans purchased from the banks on its own B/S until maturity. These loan assets held by the SIV back the debt instruments
(commercial paper and bonds) issued by the SIV to investors, and so the SIV's commercial paper liabilities are considered asset-backed commercial paper
(ABCP). The major difference between a SIV and a traditional bank is that the
SIV cannot issue deposits to fund its assets.
Unlike an SPV, the SIV does not simply pass through the payments on the loans to the ABCP investors. Indeed, SIV investors have no direct rights to the cash flows on the underlying loans in the portfolio; rather, they are entitled to the payments specified on the SIV's debt instruments. That is, the SIV's
ABCP obligations carry interest obligations that are independent of the cash flows from the underlying loan/assets that is backing the debt instruments.
Thus, in the traditional form of securitization, the SPV only pays out what it receives from the underlying loans in the pool of assets backing the ABS. In 7

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