Special Topics cont.

1
Special Topics cont.

• Week 13

2
Case Study SL Crisis

• Background
• Oil crisis in 1970s
• Inflation
• High interest rates
• Problems for depository institutions

3
What was the problem ?

• Spread based banking lending long, borrowing
  short.
• Regulation Q (price ceiling on interest on
  deposits).
• Disintermediation (savings going into direct
  finance process)

4
Interest Rate Risk

• Risk associated with borrowing short and lending
  long.
• If interest rates rise, liabilities will be
  turned over at new higher rates while the bank is
  still earning low rates on assets.

5
SLs hit hard

• SLs were given incentives to finance home
  ownership.
• Well diversified against CREDIT risk but not
  INTEREST RATE risk.
• Why not?

6
Capital shortage

• FSLIC (Federal Savings and Loan Insurance
  Corporation) should have shut down insolvent
  SLs and paid off depositors.
• It didnt.
• Why not?

7
Regulatory Forbearance

• Looking the other way.
• Loosening regulations.
• Hoping SLs would turn themselves around.
• Huge MORAL HAZARD problem.
• Long bomb strategy.

8
Zombie SLs

• Dead (insolvent)
• Living (still in operation)
• Killing the healthy (offering high rates to lure
  depositors away)

9
Corrupt practices

• Buy insolvent SL for next to nothing.
• Lure depositors with incentives.
• Lend money to cronies.
• Example Castle Grande trailer park in Arkansas

10
Financial Institutions Reform, Recovery, and
Enforcement Act (1989)

• FSLIC closed down.
• Resolution Trust Corporation to close down SLs
  and pay off depositors.
• Total cost to taxpayer 150 billion.

11
Managing Interest Rate Risk
12
Managing Interest Rate Risk

• Keep track of the gap
• rate sensitive assets rate sensitive
  liabilities
• Loan sales
• Fee income
• Derivatives (financial contracts as insurance)

13
Calculate the 1-year GAP (RSA-RSL)
(300100)-(1090160200200) -260
14
Loan Sales

• Longer term loans are sold reducing the gap.
• Loans are often securitizedpackaged into
  securities to be sold to investors.
• Example mortgage backed securities.

15
Derivatives

• Financial futures.
• To hedge an interest rate risk find a derivative
  whose value increases when interest rates rise
  (or when bond prices fall.)

16
Banking Industry Structure and Competition
Chapter 10
17
Historical Development of the Banking Industry

• Outcome Multiple Regulatory Agencies
• 1. Federal Reserve
• 2. FDIC
• 3. Office of the Comptroller of the Currency
• 4. State Banking Authorities

18
Dual Banking System

• State chartered banks operating along side
  nationally chartered banks.

19
The Decline in Banks as a Source of Finance
20
8,000 commercial banks in U.S. vs. a handful in
other countries.
Why?
McFadden Act (1927)
21
Reasons for consolidation

• IT
• Riegle-Neal Interstate Banking and Branching
  Efficiency Act of 1994

22
Bank Consolidation and Number of Banks
23
Separation of Banking from other Financial
Services Industries

• Glass-Steagall Act 1933
• Gramm-Leach-Bliley Financial Services
  Modernization Act of 1999