The UNIVERSITY of GREENWICH

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The UNIVERSITY of GREENWICH TEI of Kavala

• POSTGRADUATE PROGRAMME
• Msc in Finance Financial Information System
• Course BANK MANAGEMENT
• Academic Year 2009 (Spring Semester)
• Campus TEI of Kavalla
• Lecturer Dr. Kostas Mavrides
• University of Cyprus
• Email mavrides_at_ucy.ac.cy
• Textbook Financial Institutions Management A
  Risk Management Approach, by A. Saunders
• or some other textbook of similar material and
  level such as
• Financial Institutions Management a modern
  Perspective, (latest edition) by A. Saunders
• Help from www.investopedia.com

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• Topics
• PART A
• Introduction to Banking
• Bank Management What is special about banks?
• Externalities in Banking
• Banking Regulation
• Risk in Banking Sources of Risk
• The Yield Curve
• Other sources of risk
• PART B
• Measuring and Managing Risk
• interest rate risk and others

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Expectations from Students

• Learn and Understand facts, concepts and
  practices in banking
• Learn Theories and Tools concerning Banking
  Management
• Develop own perspective and arguments

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Types of Banking Area of Concentration

• 1. Distinguish them using customers (Balance
  Sheet)
• Retail Banking
• Wholesale Banking
• Investment Banking
• Universal Bank
• 2. Based on geographic expansion of their market
  regional, super regional, national,
  international.
• 3. Some Other
• What is a Bank?
• based on its economic function
• based on its services to customers
• based on its legal existence
• European Union the key determinants
• Elsewhere

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What makes a Banking Institution Special?

• Economic Externalities
• Positive or Negative Externality
• An action (or transaction) by one economic
  agent, imposing costs on other economic agent
  which is not normally part of the transaction.
• Asset Transformer issues financial claims that
  are far more attractive to household savers than
  the claims issued directly by corporations e.g.
  deposits against corporate bonds.
• Domino Effect in Banking Very Liquid Deposits on
  Demand (or short notice) are backed by very
  Illiquid Assets.
• Massive Withdraws of Deposits
• Interrelation
• Behavior of Savers (Depositors)

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More about what makes banks special
Promotion of an Efficient Payment System
(checking accounts) Positive or Negative
Externality? Impact on the Money Supply Credit
Allocation e.g. buying a house Agency Costs
High Regulation Entry, Deposits, Loans, etc
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Description of a Bank's Major Financial
Statements

• Balance Sheet
• The Nature of a Bank's Assets and Liabilities
• Highly Liquid Assets Liab.
• Highly Leverage
• Profit Loss Statement (or Income Statement)
• ROE NI/TE and ROA NI/TA
• Off Balance Sheet Items
• Economies of Scale in Banking
• Economies of Scope in Banking
• Book Value Accounting Historical Cost
• Market Value Accounting Marking to Market
• Net Worth Value of the Bank to its owners
• Market Value of Assets - Market Value of
  Liabilities
• Market Capitalization of A Publicly Listed
  Institution?
• Insolvency Market Value of Net Worth is zero or
  negative
• Deviation of Market Value From Book Value

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Sources of Risks in Banking

• Risks in Banking
• Interest Rate Risk
• Credit Risk
• Foreign Exchange
• Liquidity Risk
• Technological Risk
• Sovereign Risk
• Off Balance Sheet Risk
• Interest Rate Risk
• Fixed Interest Rate Instruments Vs Floating
  Interest rate Instruments
• Refinancing Risk the risk that the cost of
  rolling over (reborrowing) will rise above the
  return earned on asset investment
• Reinvestment Risk

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More about Risks in Banking

• Credit Risk
• The three Cs of Lending Money
• Credit
• Character
• Collateral
• Firm Specific Credit Risk risk of default
  associated with the specific project undertaken
  by the borrowing firm
• Systematic Risk risk of default associated with
  the general macroeconomic conditions affecting
  all borrowers
• How can a Bank reduce its credit risk with an
  insurance contact?
• How does this affect the interest rate?

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Trends in Banking Today

• Disintermediation in Banking
• Some real examples from the international and
  the domestic market
• 1. USA Money Market Mutual Funds
• Commercial Paper
• 2. How about Greece? Any examples of banking
  disintermediation?
• 3. homework think for any other such
  examples

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EMH Portfolio Management

• Immunization Against Interest Rate Risk
• The Maturity Model
• The Duration Model
• The Reprising Model

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Managing Measuring Interest Rate Risk
Applying the Maturity Model on a Bank Balance
Sheet

Assumptions All securities are selling at par
value. The 2 year Government Bond yield is
5. The 15 year Mortgage yield is 9. The 1
year deposit pays 4.5 and the 5 Year Debenture
(Bond) pays 8. All interest payments are
annual and the Bank has a number of 100
million of stocks (common shares) outstanding
with a market price of 0.50 per share. .
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Questions

• a) Calculate the following
• Book Value of Equity?
• Net Worth (Market Value of Equity)?
• b) Calculate the weighted average maturity of its
  assets and its liabilities.
• c) Calculate the Maturity Gap.
• d) Describe the risk and analyze the impact of a
  small percentage change (an increase and a
  decrease) in interest rates on the market value
  of Equity.
• e) Suggest and explain specific ways to minimize
  the maturity gap.

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Answers
a. Book Value of Equity 50 and Net Worth50
b. Weighted average maturity of assets 10.66
and weighted average maturity of liabilities
2.6 c. Maturity Gap 10.66 - 2.6 8.6 d. The
Financial Institution has a positive maturity
gap. (In fact, there is a positive duration gap
too.) An interest rate increase would cause a
decrease in both the market value of assets and
in the market value of liabilities. However,
since the maturity of assets is more than the
maturity of liabilities, the market value of
Equity theoretically should decrease. On the
contrary, an interest rate decrease would cause
an increase in the market value of assets and in
the market value of liabilities. However, since
the maturity of assets is more than the maturity
of liabilities, the market value of Equity
theoretically should increase. e. The bank may
either decrease the duration of its assets or
increase the duration of its liabilities. This
may be accomplished though many ways some of
which are Accepting (issuing) deposits with
larger term to maturity, issue zero coupon bonds
with a large term to maturity (20 years) etc.
The same goal may be also accomplished by making
loans with shorter term to maturity, using
shorter maturities on new mortgages, use (or
offer to transform) variable rate on mortgages
instead of the fixed rate.
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DURATION MODEL

• The concept of duration
• A measure of the average life of a financial
  instrument (i.e. a fixed income security such as
  a bond) defined as the weighted average of the
  times until each payment is made, with weights
  proportional to the present value of the each
  payment.
• What it measures?
• The sensitivity of a financial security with
  respect to an infinitely small change in
  interest rate.
• Its Units?
• The Assymmetrical Impact of an equal Change in
  interest rates (an increase and a decrease of
  same absolute level) on Market Prices of Bonds
• The Concept of Convexity of a Bond

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Duration and the Time to Maturity

• Duration and Maturity
• Duration and Cash Payments i.e. Coupon Paymens
• Duration and the Yield to Maturity (current
  level of market interest rates)
• Duration measures the price sensitivity of a
  bond with respect to interest rate changes.
• Holding other factors constant,
• the duration of a coupon bond is higher when the
  bonds yield of maturity is lower,
• and when the term to maturity of the bond is
  longer,
• and when the coupon rate of the bond is lower.

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Calculating Duration

• Calculation of the
• a) Duration of a (straight) Bond
• PAR1000
• Maturity 2 years
• Coupon Interest 8
• Semiannual Interest Payments
• YTM 10
• N
• D ? PV (CFn) . t / PV of Bond
• n
• PV CFn . t / P
• where t is time until payment measured in
  years
• P of the Bond 40 / (1.05)1 40 / (1.05)2
  40 / (1.05)3 1040 / (1.05)4
• 964.54
• Use a Table

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• What are some of the practical problems with
  regard to applying the duration model in managing
  risk?

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Trends Shaping Modern Banking (today)

• Falling market share due to non banking
  institutions
• Globalization
• Competition from Non-Banking Institutions while
  the boundaries between them are becoming more and
  more blurred
• Consolidation fewer banks but much larger banks
  
• Technological Revolution in the way banking
  services are provided e.g. virtual banks
• New and more complex banking products
• Securitization another form of trend towards
  disintermediation
• Off Balance Sheet Placing

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Interest Rate Risk Exercise on Duration

• Suppose that you are managing an investment
  portfolio of 1.0 million. Your target duration
  is 10 years, and you can choose from two
  securities (bonds)
• Either a zero-coupon bond with maturity of 5
  years or a perpetuity (a consol).
• Each security is currently yielding a 5 rate
  (yield)
• Questions
• a. How much of each bond will you hold in your
  portfolio?
• b. How will these proportions (fractions) change
  next year if target duration is now nine years?
• c. (Ignore a and b above) You are managing a
  portfolio of 1.0 million and you can choose from
  two bonds (i) a 2 year coupon bond with annual
  payments at 10 interest rate, with today's yield
  at 11.5, and (ii) a zero coupon bond with
  maturity of 15 years.
• How will the proportions change if your target
  duration is 10 years?

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Answer

• a. Duration of Perpetuity is 1 (1/0.05) 21
• w x 5 (1-w) x 21 10
• 21-16w 10
• w 0.6875
• Therefore, 0.6875 million invested in the zero
  coupon and the rest in the perpetuity.
• b. w x 4 (1-w) x 21 9
• 21-17w 9
• w 0.7059
• Therefore, 0.7059 million invested in the zero
  coupon and the rest in the perpetuity. The
  proportion invested in the zero increases to
  12/17 and the proportion in the perpetuity falls
  to 5/17.
• c. 1.859/0.9745 1.908
• w x 1.908 (1-w) x 15 10
• One possible answer is a proportion of w0.3818
  on the coupon bond and 0.6282 on the zero coupon
  bond.A.2 Why is it important to utilize market
  values, as opposed to book (accounting) values,
  in financial decision making for Financial
  Institutions?
• Discuss/Present your answer with reference to a
  "zombie" banking institution.

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More Analysis of Duration

• Duration of a Zero Coupon Bond Maturity
• Duration of a Perpetuity 1 1/yield
• Exercise
• 1. Calculate the Duration on a Eurobond that pays
  coupons annually with 8 coupon rate, par value
  of 1000, given that the current yield is 8.
• Answer D 4,992.71/1000 4.993 years
• 2. Calculate the Duration of a Consol
  (Perpetuity) with par value of 1000, given that
  the current yield is 5.
• Answer D 21 years
• The Features of Duration
• Duration increases with the maturity of a fixed
  income security (asset or liability) but at a
  decreasing rate
• Duration decreases as yield increases
• Duration and Coupon The higher the coupon (or
  promised payment), the lower its duration

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Duration as a Portfolio Management Tool

• Interest rate risk consists of two components
• Price risk and Reinvestment risk.
• These two risk components move in opposite
  direction if duration equals horizon date, the
  two types of risk exactly offset each other,
  resulting in zero net interest-rate risk. This
  strategy is known as immunization.
• Some of the problems associated with this
  strategy
• the portfolio is protected against one interest
  rate change only thus, once interest rate change
  the portfolio must be rebalanced to maintain
  immunization duration assumes a horizontal yield
  curve (not the shape most commonly observed)
• duration also assumes that any shifts in the
  yield curve are parallel (resulting in a
  continued horizontal yield curve)
• duration is an approximation
• in exercising immunization in practice, the
  portfolio manager may have trouble locating
  acceptable bonds that produce immunized
  portfolios
• finally, both duration and horizon dates change
  with the mere passage of time, but not in a
  lockstep fashion, thus rebalancing is required.

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• Although immunization is considered a passive
  bond management strategy, considerable
  rebalancing must occur, as indicated above.
• Also, the tradeoffs between the transaction costs
  and not being perfectly immunized at all times.

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Discussion

• The concept of immunization against interest
  rate risk within the framework of bank's balance
  sheet.
• Describe Duration under normal banking
  conditions.
• Besides requiring a collateral for a loan, how
  could a bank hedge a financial asset (i.e. a car
  loan) against credit risk?
• Compare the goal of immunization for a bank
  differs from the goal of immunization for a
  pension fund?
• The concept of disintermediation in banking
• Provide real examples in banking (either on the
  asset or on the liability side of the balance
  sheet) where disintermediation occurred.

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Difficulties in Applying the Duration Model to
Real World Bank Balance Sheets

• Duration Matching Can be Costly
• Immunization is a Dynamic Problem
• Large Interest Rate Changes and Convexity
• .
• Floating Rate Loans and Bonds

The Problem of the Flat Term Structure
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INTEREST RATE SWAP

• The Mechanics and the Reasoning behind the
  transaction
• What is an interest rate swap?
• Parties involved
• The Payers and the Intermediary
• Types of Swaps
• Notional Principle
• Absolute Advantage and Comparative (Relative)
  Advantage