FIN 683 Financial Institutions Management The … Robert B.H. Hauswald Kogod School of Business, AU...

Professor Robert B.H. HauswaldKogod School of Business, AU

FIN 683Financial Institutions Management

The Specialness of Banks

“Increasingly complex financial instruments have contributed to thedevelopment of a far more flexible, efficient and hence resilient financial system than the one that existed a quarter century ago.”

- Alan Greenspan, November 2005

“The bright new financial system – for all its rich rewards and unimaginable wealth for some – has failed the test of the marketplace by repeatedly riskinga cascading breakdown of the system as a whole.”

- Paul Volcker, April 2008

Alternative Views on the Financial System

1/19/2016 2Bank Specialness © Robert B.H. Hauswald

Bank Losses and Credit Crunch• Credit crunch: contraction in the supply of credit

– a contraction in the supply funds in a market

• Who is contracting their supply of credit?– Banks because of losses that initially stemmed from

the subprime mortgage market

• Losses spread to other credit markets– Commercial real estate loans

– Leverage loans

– Other subprime consumer loans1/19/2016 3Bank Specialness © Robert B.H. Hauswald

Financial System Architecture

• Financial institutions’ profits “outsized”– i.e., they exceed value added

• The model interrupted: the “credit” crunch

• A crunch can involve multiple markets– US: 1990 to 1992

– Scandinavia: 1991 to 1994

– Japan: 1992 to 2000

– US: 2008 to 20101/19/2016 4Bank Specialness © Robert B.H. Hauswald

Saver/Investors

FinancialIntermediaries

SecuritiesMarkets

Business

$ $

$ $

Financial System Architecture:Normal Flow of Funds

Consumers

$

$

$

$

$


Saver/Investors

FinancialIntermediaries

SecuritiesMarkets

Business

$ $

$ $

Consumers

$

$

$

$

A “CRUNCH”

$


Financial System Architecture:Credit Squeeze or Crunch

1980s 2007

Percent of gross domestic value-added 8% 15%

Percent of private sector employment 4% 5%

Percent of stock market capitalization 6% 19%

Percent of corporate profits 10% 40%

Continued financial sector growth even after the fundamentals weakened or fell away.What about executive compesation?


Financial System Profits: Outsized

Finance Sector Profit & Gross Value-Added (% of total corporate)


Credit-Crunch Evidence

• Bank liquidity creation fell dramatically– predates inception of banking crisis (April or August 2007)

• Fed’s Senior Loan Officer Survey began showing “tightening” loan standards in 2006– Index turned negative in early 2007 (net negative response by

lenders) escalating in third quarter

– The net percentage of large and medium-sized banks, and the net percentage of small banks, that reported a tightening of standards was 55.4% and 51.8% respectively.

– None of the surveyed banks reported any easing of standards.

– Comparable to prior to comparable crunches in 1990 or 2001 1/19/2016 Bank Specialness © Robert B.H. Hauswald 9

Liquidity Contraction:(Liquidity = Liquidity Transformation)

Source: “Financial Crisis and Bank Liquidity Creation,” Allen N. Berger and Christa H.S. Bouwman, University of South Carolina working paper(August 2008).

Abnormal amount of liquidity creation around 1990 credit crunch(1990:Q1 – 1992:Q4) (in $ billion)

1/19/2016 Bank Specialness © Robert B.H. Hauswald 10

Abnormal amount of liquidity creation around the dot.com bubbleand the Sept. 11 terrorist attack

(2000:Q2 – 2002:Q3) (in $billions)




Abnormal amount of liquidity creation in today’s crisis(2007:Q3 – 2008:Q1) (in $billions)




Financial Market1992-2008 (Liquidity = Trading Liquidity)

Sources: Bank of England, Bloomberg, Chicago Board Options Exchange, Debt Management Office, London Stock Exchange, Merrill Lynch, Thomson Datastream and Bank calculations (see Bank of England Financial Stability Report (April 2008).

(a) The liquidity index shows the number of standard deviations from the mean. It is a simple unweighted average of nine liquidity measures, normalised on the period 1999–2004. The series shown is an exponentially weighted moving average. The indicator is more reliable after 1997 as it is based on a greater number of underlying measures.

(a)


Spillovers to Other Markets

• Bank loan market: interbank market

• Commercial paper market– Traditional

– Asset-backed

• Residential and commercial mortgage markets

• Consumer loan market– Prime

– Subprime

• Junk bond market• Private placement market


Credit Squeeze Example:U.S. SME Market


o = open “lending channel”x = constricted “lending channel”

Credit Squeeze Example: Japanese SME Market, 1990-2000



Current Credit Squeeze:U.S. SME Market



Credit-Crunch Causes• Banks suffer a shock that affects their ability

and/or incentive to lend

• Many types of potential shocks: historical shocks include, for example:– Capital shock (US 1990-92, Japan 1990-2000)

– Regulatory reporting shock (US 1990-92)

– Regulatory scrutiny shock (US 1990-92)

– Risk-based capital shock (US 1990-92)

• Currently: “capital shock” caused initially by losses in the subprime mortgage market


Capital-Shock Mechanics

• Banks must meet required capital requirements (e.g, S.E./T.A. > 8%)

• Banks have target capital requirements driven by reputation/credibility effects

• Losses deplete capital, i.e., shareholder equity

• Banks must either– Raise more equity: e.g., sovereign wealth funds

– Reduce assets by contracting lending: balance sheet shrinks


February 29, 2008, 11:59 am, WSJ

Banks May Need to Shrink by $2 Trillion on Subprime Losses

Mortgage losses, compounded by contemporary risk management andaccounting practices could prompt banks and other lenders to shrink theirlending and other assets by a staggering $2 trillion, a new study concludes.

The resulting withdrawal of credit could knock one to 1.5 percentage pointsoff economic growth, significantly compounding the impactof collapsinghome construction and softer consumer spending due to lowerhome wealth,the study, presented at a joint academic-Wall Street forum in New York Friday.

Banking in the News


BIG BANKSecurities

Loans

Deposits300

TA

S.E.

TL&SE

700

1,000

920

80

1,000

BIG BANKSecurities

Loans

Deposits300

TA

S.E.

TL&SE

690

990

920

70

BIG BANKSecurities

Loans

Deposits300

TA

S.E.

TL&SE

575

875

805

70

SE/TA =8%

Bank charges off$10 in loan losses

SE/TA = 7.07%

SE/TA = 8%

990

875 Bank reduces loans by$115


WSJ 3/4/081/19/2016 22Bank Specialness © Robert B.H. Hauswald

WSJ 1/18/08

Economist (August 9-15, 2008)1/19/2016 23Bank Specialness © Robert B.H. Hauswald

Financial Intermediaries are Special

• Special role of FIs in the financial system and the functions they provide– FIs receive special regulatory attention

– Some FIs more special than others

• Put the recent/current financial crisis into perspective– consequences: credit crunch

– origins: revisited later

1-24 Bank Specialness © Robert B.H. Hauswald1/19/2016

1-25

Without FIs

Corporations

(net borrowers)

Households

(net savers)

Cash

Equity & Debt

1/19/2016 Bank Specialness © Robert B.H. Hauswald

1-26

FIs’ Specialness

• Without FIs: Low level of fund flows.– no aggregation: transaction costs

– no scale economies in screening, monitoring, etc.

• Information costs– Economies of scale reduce costs for FIs to screen

and monitor borrowers

• Less liquidity

• Substantial price risk1/19/2016 Bank Specialness © Robert B.H. Hauswald

1-27

With FIs

Cash

Households Corporations

Equity & Debt

FI

(Brokers)

FI

(Asset Transformers)Deposits/Insurance

PoliciesCash


1-28

Brokerage Functions

• Acting as an agent for investors:– e.g. Merrill Lynch, Bank of America

– Reduce costs through economies of scale

– Encourages higher rate of savings

• Asset transformer:– Purchase primary securities by selling financial

claims to households

– These secondary securities often more marketable

– Transformation of financial risk1/19/2016 Bank Specialness © Robert B.H. Hauswald

1-29

Role of FIs in Cost Reduction

• Investors exposed to Agency Costs– asymmetric information + conflict of interest

• Role of FI as Delegated Monitor– FI likely to have informational advantage

– Economies of scale in obtaining information.

• FI as an information producer– Shorter term debt contracts easier to monitor than bonds

– Greater monitoring power and control

– Acting as delegated monitor, FIs reduce information asymmetry between borrowers and lenders


1-30

Specialness of FIs

• FI have an advantage in assuming certain risks– Liquidity and Price Risk: why?

• Secondary claims issued by FIs have less price risk

• Demand deposits and other claims are more liquid – More attractive to small investors

• FIs have advantage in diversifying risks1/19/2016 Bank Specialness © Robert B.H. Hauswald

1-31

Other Special Services

• Reduced transactions costs

• Maturity intermediation

• Transmission of monetary policy.

• Credit allocation (areas of special need such as home mortgages)

• Intergenerational transfers or time intermediation

• Payment services (FedWire and CHIPS)

• Denomination intermediation


1-32

Specialness and Regulation

• FIs receive special regulatory attention.

• Rationale: banks provide externalities– Positive externalities: services, information

– Negative externalities of FI failure

• Special services provided by Fis: vital

• Institution-specific functions such as – money supply transmission (banks),

– credit allocation (thrifts, farm banks),

– payment services (banks, thrifts), etc.1/19/2016 Bank Specialness © Robert B.H. Hauswald

Regulation of FIs

• Objective of regulatory policy:– Protect ultimate sources and users of savings

– Including prevention of unfair practices such as redlining and other discriminatory actions

• Primary role: Ensure soundness of the overall system

• Goes hand in hand with supervision– is banking the most regulated/supervised sector?

Bank Specialness © Robert B.H. Hauswald1/19/2016 33

1-34

Regulation

• Safety and soundness regulation:– targeted at individual institutions

– protect depositors

• Regulations to increase diversification– No more than 10% of equity to single borrower

• Minimum capital requirements– TARP and Capital Purchase Program

• Systemic soundness– like the military, always fighting the last crisis


1-35

Fragmented Regulation

• Guaranty funds:– Deposit insurance fund (DIF):

– Securities Investors Protection Fund (SIPC)

• Monitoring and surveillance:– FDIC monitors and regulates DIF participants

– Increased regulatory scrutiny following crises

• Regulation is not costless– Net regulatory burden


1-36

Web Resources

• For information on regulation of DIs and investment firms visit:

FDIC www.fdic.gov

SIPC www.sipc.org

Federal Reserve www.federalreserve.gov

Appendix 1B of text www.mhhe.com/saunders7e


1-37

Monetary Policy

• Federal Reserve directly controls outside money

• Bulk of money supply is inside money: deposits

• Reserve requirements facilitate transmission of monetary policy

• Explains the heavy involvement of the FRB in regulating banks– expertise


1-38

Credit Allocation Regulation

• Supports socially important sectors such as housing and farming– political rather than economic reasons

• Requirements for – minimum asset amounts in a particular sector or

– maximum interest rates or fees

• Qualified Thrift Lender Test (QTL)– 65 percent of assets in residential mortgages

• Usury laws and Regulation Q (abolished) 1/19/2016 Bank Specialness © Robert B.H. Hauswald

1-39

Consumer Protection

• Consumer protection regulation– Community Reinvestment Act (CRA)

– Home Mortgage Disclosure Act (HMDA)

• Effect on net regulatory burden– FFIEC processed info on as many as 17 million

mortgage transactions in 2009

– Analysts questioning the net benefit


1-40

Consumer Protection Regulation

• Potential extensions of regulations – CRA to other FIs such as insurance companies

in light of consolidation and trend toward universal banking

• New additions: – Consumer Financial Protection Agency (2009)

– Credit card reform bill effective 2010


1-41

Investor Protection

• Regulation against abuses such as – insider trading,

– lack of disclosure,

– malfeasance, breach of fiduciary responsibility

• Key legislation– Securities Acts of 1933, 1934

– Investment Company Act of 1940

• Primary regulator: SEC1/19/2016 Bank Specialness © Robert B.H. Hauswald

1-42

Entry

• Entry regulation: fragmentation– changed in 1933: state banking

– unsustainable: inter-state branching

• Level of entry impediments affects profitability and value of charter.

• Regulations define scope of permitted activities– Financial Services Modernization Act of 1999

• Affects charter value and size of net regulatory burden1/19/2016 Bank Specialness © Robert B.H. Hauswald

1-43

Web Resources

• For more information on regulation of depository institutions visit:FFIEC www.ffiec.gov

Federal Reserve www.federalreserve.gov

FDIC www.fdic.gov

OCC www.occ.treas.gov


Changing Dynamics of Specialness

• Decline in share of depository institutions and insurance companies

• Increases in investment companies

• May be attributable to net regulatory burden imposed on depository FIs– Financial Services Modernization Act

• Financial services holding companies


1-45

Risk and the Financial Crisis

• Reactions to FSM Act and other factors:– more competition between banks and markets– banks became hedge funds

• Shift from “originate and hold” to “originate and distribute”– Affects incentives to monitor and control risk.– Shift to off balance sheet risks– Degraded quality and increased risk

• Housing market bubble encouraged – subprime market and more exotic mortgages


1-46

Global Trends

• US FIs facing increased competition from foreign FIs

• Only 2 of the top ten banks are US banks

• Foreign bank assets in the US typically more than 10 percent – As high as 21.9 percent

• Emerging-market banks are becoming important: BRICS


1-47

Largest Banks


1-48

Financial Crisis

• DJIA fell 53.8 percent in less than 1 ½ years as of mid-March 2009

• Record home foreclosures– 1 in 45 in default in late 2008

• Goldman Sachs and Morgan Stanley – only survivors of the major WS houses

– became “banks”


1-49

Financial Crisis

• AIG bailout

• Citigroup needed government support

• Many other banks applied for and received government guarantees

• Chrysler and GM declared bankruptcy in 2009

• Unemployment in excess of 10 percent

• Unprecedented liquidity injections by Fed– consequence? costs?


Beginning of the Collapse

• Home prices plummeted in 2006-07– Mortgage delinquencies rose

– Forelosure filings increased 93 percent from July 2006 to July 2007

• Securitized mortgages led to large financial losses– Subprime mortgages

• Countrywide Financial bailed out and eventually taken over by Bank of America


Significant Failures and Events

• Bear Stearns funds filed for bankruptcy– Acquired by J.P. Morgan Chase

– Fed moved beyond lending only to Depository Institutions

• Government seizure of Fannie Mae and Freddie Mac

• Lehman Brothers failure

• Crisis spread worldwide1-51 Bank Specialness © Robert B.H. Hauswald1/19/2016

1-52

Rescue Plan

• Federal Reserve and other central banks infused $180 billion

• $700 billion Troubled Asset Relief Program (TARP)

• Still struggling in 2009

• $827 billion stimulus program– American Recovery and Reinvestment Act of


Conclusion

• Banks exist for many economic reasons: – there is no unique view, nor a unified theory

• Apart from transaction costs, the main reasons why financial intermediaries exist are– intertemporal insurance

– screening

– monitoring


1-54

Pertinent Websites

The Banker

Federal Reserve

FDIC

FFIEC

Investment Co. Institute

OCC

SEC

SIPC

Wall Street Journal

www.thebanker.com

www.federalreserve.gov

www.fdic.gov

www.ffiec.gov

www.ici.com

www.occ.treas.gov

www.sec.gov

www.sipc.org

www.wsj.com


When FIs Fail: Subprime Mortgages

• FIs involved both as brokers and asset transformers

• Packaged and sold mortgage-backed securities (MBS) and collateralized debt obligations (CDOs)– Many MBS’s had subprime mortgages

– Many CDO’s bought subprime mortgage MBS’s

• Invested in directly and indirectly in MBS and CDOs – asset-transformers


Subprime

• A subprime mortgage has lower underwriting standards

• Low “credit score” (e.g., a FICO score below 650)

• No documentation (Lo Doc): no income verification

• Loan/value ratio > 80%

• Also, often have “teaser” rates1/19/2016 Bank Specialness © Robert B.H. Hauswald 56

Asset Backed Securities

• MBS: security back by mortgages – a “trust” that owns mortgages and issues securities

to investors

– Can be engineered artificially to segment risk: ., defaults first go to the riskier traunches

• CDO: bond issued by a trust that owns fixed income debt obligations (or derivatives).– the problem CDOs have invested in subprime MBS

– Can be engineered to segment risk: Possibly double engineered!


The Perfect Storm

• What is the problem?– Housing prices have been falling

– Record number of defaults and foreclosures

– Subprime most affected

• What happened to the securities?

• What happened to the financial institutions which bought subprime paper?


Who’s Fault?

• Rating agencies looked only at recent MBS payment performance

• Many “originators” immediately sold mortgages– Insufficient screening and monitoring incentives

– Incentive to encourage home buyers to buy too much house

– Predatory lending


Greed and Fear

• Banks made lots of money creating MBS’s and CDO’s (100-150 bps)– These “packagers” lacked incentives to screen and

monitor

• Mostly an unregulated market– Fed examiners only saw narrow picture

• Some homebuyers may have been imprudent– Wanted to “keep up with the neighbors”

– Wanted to cash in on hot real estate market1/19/2016 Bank Specialness © Robert B.H. Hauswald 60

Housing Sales Decline and Inventories Rise

Inventory of Unsold Homes(months supply)

Existing homes

Single-family Home Sales (thousands)

Existing �

This image cannot currently be displayed.

New homes

600

800

1000

1200

1400

1600

2003 '04 '05 '06 '072400

3200

4000

4800

5600

6400

New


Housing Prices Fell …

Case-Shiller Home Price Index

-5

0

5

10

15

20

'75 '80 '85 '90 '95 2000 '05

Home price index change (percent change over prior year)

OFHEO price index


… with Larger Declines in Some Markets

(percent change over prior year)

-20

-10

0

10

20

30

40

50

'88 '90 '92 '94 '96 '98 '00 '02 '04 '06

Miami

Case-Shiller Home Price Index

Phoenix

San Diego

National


Subprime Mortgage BackedSecurities Issuance

$0

$150

$300

$450

$600

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

billi

ons

0%

6%

12%

18%

24%

← $ volume (billions)

% of total mortgage originations →

Source: Inside Mortgage Finance, “The 2007 Mortgage Market Statistical Annual”1/19/2016 64Bank Specialness © Robert B.H. Hauswald

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