Financial Institutions Management a Risk Management Approach Solutions

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মুখ্য Financial Institutions Management: A Risk Management Approach Solutions Manual

Financial Institutions Management: A Risk Management Approach Solutions Manual

Anthony Saunders, Marcia Millon Cornett

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This is the complete version of the Solutions Manual.

Saunders and Cornett's Financial Institutions Management: A Risk Management Approach provides an innovative approach that focuses on managing return and risk in modern financial institutions. The central theme is that the risks faced by financial institutions managers and the methods and markets through which these risks are managed are becoming increasingly similar whether an institution is chartered as a commercial bank, a savings bank, an investment bank, or an insurance company. Although the traditional nature of each sector's product activity is analyzed, a greater emphasis is placed on new areas of activities such as asset securitization, off-balance-sheet banking, and international banking.

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Solutions for End-of-Chapter Questions and Problems: Chapter One 1.  What are five risks common to all financial institutions?  Five risks common to all financial institutions include default or credit risk of assets, interest rate risk caused by maturity mismatches between assets and liabilities, liability withdrawal or liquidity risk, underwriting risk, and operating risks. 2.  Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial institutions.  In a world without FIs the users of corporate funds in the economy would have to directly approach the household savers of funds in order to satisfy their borrowing needs. In this economy, the level of fund flows between household savers and the corporate sector is likely to be quite low. There are several reasons for this. Once they have lent money to a firm by buying its financial claims, households need to monitor, or check, the actions of that firm. They must be sure that the firm's management neither absconds with nor wastes the funds on any projects with low or negative net present values. Such monitoring actions are extremely costly for any given household because they require considerable time and expense to collect sufficiently high-quality information relative to the size of the average household saver's investments. Given this, it is likely that each household would prefer to leave the monitoring to others. In the end, little or no monitoring would be done. The resulting lack of monitoring would reduce the attractiveness and increase the risk of investing in corporate debt and equity. The net result would be an imperfect allocation of resources in an economy. 3.  Identify and explain three economic disincentives that would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial institutions.  Investors generally are averse to directly purchasing securities because of (a) monitoring costs, (b) liquidit; y costs, and (c) price risk. Monitoring the activities of borrowers requires extensive time, expense, and expertise. As a result, households would prefer to leave this activity to others, and by definition, the resulting lack of monitoring would increase the riskiness of investing in corporate debt and equity markets. The long-term nature of corporate equity and debt securities would likely eliminate at least a portion of those households willing to lend money, as the preference of many for near-cash liquidity would dominate the extra returns which may be available. Finally, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume. 4.  Identify and explain the two functions FIs perform that would enable the smooth flow of funds from household savers to corporate users.  FIs serve as conduits between users and savers of funds by providing a brokerage function and by engaging in an asset transformation function. The brokerage function can benefit both savers and users of funds and can vary according to the firm. FIs may provide only transaction services, such as discount brokerages, or they also may offer advisory services which help reduce 1 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  information costs, such as full-line firms like Merrill Lynch. The asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers, and using the proceeds to purchase the primary securities of corporations. Thus, FIs take on the costs associated with the purchase of securities. 5.  In what sense are the financial claims of FIs considered secondary securities, while the financial claims of commercial corporations are considered primary securities? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers?  Funds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claims, which are considered primary securities, are purchased by FIs whose financial claims therefore are considered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securities of commercial corporations. However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs, and price risk of placing the investments directly with the commercial corporation are reduced because of the efficiencies of the FI. 6.  Explain how financial institutions act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process?  By putting excess funds into financial institutions, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is utilized properly by the borrower. This agglomeration of funds resolves a number of problems. First, the large FI now has a much greater incentive to collect information and monitor actions of the firm because it has far more at stake than does any small individual household. In a sense, small savers have appointed the FI as a delegated monitor to act on their behalf. Not only does the FI have a greater incentive to collect information, the average cost of collecting information is lower. Such economies of scale of information production and collection tend to enhance the advantages to savers of using FIs rather than directly investing themselves. Second, the FI can collect information more efficiently than individual investors. The FI can utilize this information to create new products, such as commercial loans, that continually update the information pool. Thus, a richer menu of contracts may improve the monitoring abilities of FIs. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate providers and users of funds in the economy. Thus, by acting as a delegated monitor and producing better and more timely information, FIs reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy. 7.  What are five general areas of FI specialness that are caused by providing various services to sectors of the economy?  First, FIs collect and process information more efficiently than individual savers. Second, FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds. Third, by diversifying the asset base FIs provide secondary securities with lower price risk conditions than primary securities. Fourth, FIs 2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  provide economies of scale in transaction costs because assets are purchased in larger amounts. Finally, FIs provide maturity intermediation to the economy which allows the introduction of additional types of investment contracts, such as mortgage loans, that are financed with shortterm deposits. 8.  What are agency costs? How do FIs solve the information and related agency costs experienced when household savers invest directly in securities issued by corporations?  Agency costs occur when owners or managers take actions that are not in the best interests of the equity investor or lender. These costs typically result from the failure to adequately monitor the activities of the borrower. If no other lender performs these tasks, the lender is subject to agency costs as the firm may not satisfy the covenants in the lending agreement. That is, agency costs arise whenever economic agents enter into contracts in a world of incomplete information and thus costly information collection. The more difficult and costly it is to collect information, the more likely it is that contracts will be broken. Because the FI invests the funds of many small savers, the FI has a greater incentive to collect information and monitor the activities of the borrower because it has far more at stake than does any small individual household. 9.  How do large FIs solve the problem of high information collection costs for lenders, borrowers, and financial markets?  One way financial institutions solve this problem is that they develop of secondary securities that allow for improvements in the monitoring process. An example is the bank loan that is renewed more quickly than long-term debt. When bank loan contracts are sufficiently short term, the banker becomes almost like an insider to the firm regarding informational familiarity with its operations and financial conditions. Indeed, this more frequent monitoring often replaces the need for the relatively inflexible and hard-to-enforce covenants found in bond contracts. Thus, by acting as a delegated monitor and producing better and timelier information, FIs reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy. 10.  How do FIs alleviate the problem of liquidity risk faced by investors who wish to buy securities issued by corporations?  FIs provide financial or secondary claims to household and other savers. Often, these claims have superior liquidity attributes compared with those of primary securities such as corporate equity and bonds. For example, depository institutions issue transaction account deposit contracts with a fixed principal value (and often a guaranteed interest rate) that can be withdrawn immediately on demand by household savers. Money market mutual funds issue shares to household savers that allow those savers to enjoy almost fixed principal (deposit-like) contracts while often earning interest rates higher than those on bank deposits. Even life insurance companies allow policyholders to borrow against their policies held with the company at very short notice. 11.  How do financial institutions help individual savers diversify their portfolio risks? Which type of financial institution is best able to achieve this goal? 3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Money placed in any financial institution will result in a claim on a more diversified portfolio. as long as the returns on different investments are not perfectly positively correlated, by exploiting the benefits of size, FIs diversify away significant amounts of portfolio risk—especially the risk specific to the individual firm issuing any given security. This risk diversification allows an FI to predict more accurately its expected return on its asset portfolio. A domestically and globally diversified FI may be able to generate an almost risk-free return on its assets. As a result, it can credibly fulfill its promise to households to supply highly liquid claims with little price or capital value risk. FIs best able to achieve this goal include banks that lend money to many different types of corporate, consumer, and government customers. Insurance companies have investments in many different types of assets. Investments in a mutual fund may generate the greatest diversification benefit because of the fund's investment in a wide array of stocks and fixed income securities. As long as an FI is sufficiently large to gain from diversification and monitoring, its financial claims are likely to be viewed as liquid and attractive to small savers compared with direct investments in the capital market. 12.  How can financial institutions invest in high-risk assets with funding provided by low-risk liabilities from savers?  FIs exploit the law of large numbers in their investments, achieving a significant amount of diversification, whereas because of their small size, many household savers are constrained to holding relatively undiversified portfolios. This risk diversification allows an FI to predict more accurately its expected return on its asset portfolio. A domestically and globally diversified FI may be able to generate an almost risk- free return on its assets. As a result, it can credibly fulfill its promise to households to supply highly liquid claims with little price or capital value risk. 13.  How can individual savers use financial institutions to reduce the transaction costs of investing in financial assets?  By pooling the assets of many small investors, FIs can gain economies of scale in transaction costs. This benefit occurs whether the FI is lending to a corporate or retail customer, or purchasing assets in the money and capital markets. In either case, operating activities that are designed to deal in large volumes typically are more efficient than those activities designed for small volumes. By grouping their assets in FIs that purchase assets in bulk—such as in mutual funds and pension funds—household savers can reduce the transaction costs of their asset purchases. 14.  What is maturity intermediation? What are some of the ways in which the risks of maturity intermediation are managed by financial institutions?  If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by matching their asset and liability maturities through on- and off-balance sheet hedging activities and flexible access to the financial markets. A dimension of FIs' ability to reduce risk by diversification is that they can better bear the risk of mismatching the maturities of their assets and liabilities than can small household savers. Thus, FIs offer maturity intermediation services to the rest of the economy. Specifically, through maturity mismatching, 4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  FIs can produce long-term contracts, such as long-term, fixed-rate mortgage loans to households, while still raising funds with short-term liability contracts. By investing in a portfolio of longand short-term assets that have variable- and fixed-rate components, the FI can reduce maturity risk exposure by utilizing liabilities that have similar variable- and fixed-rate characteristics, or by using futures, options, swaps, and other derivative products. 15.  What are five areas of institution-specific FI specialness and which types of institutions are most likely to be the service providers?  First, commercial banks and other depository institutions are key players for the transmission of monetary policy from the central bank to the rest of the economy. Second, specific FIs often are identified as the major source of financing for certain sectors of the economy. For example, savings institutions traditionally serve the credit needs of the residential real estate market. Third, life insurance companies and pension funds commonly are encouraged to provide mechanisms to transfer wealth across generations. Fourth, depository institutions efficiently provide payment services to benefit the economy. Finally, money market and debt-equity mutual funds provide denomination intermediation by allowing small investors to purchase pieces of assets with large minimum sizes such as negotiable CDs and commercial paper issues. 16.  How do depository institutions such as commercial banks assist in the implementation and transmission of monetary policy?  Because the liabilities of depository institutions are a significant component of the money supply that impacts the rate of inflation, they play a key role in the transmission of monetary policy from the central bank to the rest of the economy. That is, depository institutions are the conduit through which monetary policy actions impact the rest of the financial sector and the economy in general. Indeed, a major reason the United States and world governments bailed out many depository institutions and increased the deposit insurance limit from $100,000 to $250,000 per person per bank during the financial crisis was so that central banks could implement aggressive monetary policy actions to combat collapsing financial markets. Monetary policy actions include open market operations (the purchase and sale of securities in the U.S. Treasury securities market), setting the discount rate (the rate charged on "lender of last resort" borrowing from the Federal Reserve), and setting reserve requirements (the minimum amount of reserve assets depository institutions must hold to back deposits held as liabilities on their balance sheets). 17.  What is meant by credit allocation regulation? What social benefit is this type of regulation intended to provide?  Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of the economy which are considered to be socially important. These may include housing and farming. Presumably the provision of credit to make houses more affordable or farms more viable leads to a more stable and productive society. 18.  Which intermediaries best fulfill the intergenerational wealth transfer function? What is this wealth transfer process? 5 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Life insurance companies and pension funds often receive special taxation relief and other subsidies to assist in the transfer of wealth from one generation to another. In effect, the wealth transfer process allows for the accumulation of wealth by one generation to be transferred directly to one or more younger generations by establishing life insurance policies and trust provisions in pension plans. Often this wealth transfer process avoids the full marginal tax treatment that a direct payment would incur. 19.  What are two of the most important payment services provided by financial institutions? To what extent do these services efficiently provide benefits to the economy?  The two most important payment services are check clearing and wire transfer services. Any breakdown in these systems would produce gridlock in the payment system with resulting harmful effects to the economy at both the domestic and potentially the international level. 20.  What is denomination intermediation? How do FIs assist in this process?  Denomination intermediation is the process whereby small investors are able to purchase pieces of assets that normally are sold only in large denominations. Because they are sold in very large denominations, many assets are either out of reach of individual savers or would result in savers' holding highly undiversified asset portfolios. For example, the minimum size of a negotiable certificate of deposit (CD) is $100,000 and commercial paper (short-term corporate debt) is often sold in minimum packages of $250,000 or more. Individually, a saver may be unable to purchase such instruments. However, by buying shares in a money market mutual fund along with other small investors, household savers overcome the constraints to buying assets imposed by large minimum denomination sizes. Such indirect access to these markets may allow small savers to generate higher returns on their portfolios as well. 21.  What is negative externality? In what ways do the existence of negative externalities justify the extra regulatory attention received by financial institutions?  A negative externality refers to the action by one party that has an adverse effect on another party who is not part of the original transaction. For example, bank failures may destroy household savings and at the same time restrict a firm's access to credit. Insurance company failures may leave households totally exposed in old age to catastrophic illnesses and sudden drops in income on retirement. Further, individual FI failures may create doubts in savers' minds regarding the stability and solvency of FIs in general and cause panics and even runs on sound institutions. FIs are special because of the various services they provide to sectors of the economy. Failure to provide these services or a breakdown in their efficient provision can be costly to both the ultimate sources (households) and users (firms) of savings. FIs are regulated to prevent this from happening. 22.  If financial markets operated perfectly and costlessly, would there be a need for financial institutions?  To a certain extent, financial institutions exist because of financial market imperfections. If information is available costlessly to all participants, savers would not need FIs to act as either 6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  their brokers or their delegated monitors. However, if there are social benefits to intermediation, such as the transmission of monetary policy or credit allocation, then FIs would exist even in the absence of financial market imperfections. 23.  Why are FIs among the most regulated sectors in the world? When is the net regulatory burden positive?  FIs are required to enhance the efficient operation of the economy. Successful financial institutions provide sources of financing that fund economic growth opportunities that ultimately raise the overall level of economic activity. Moreover, successful financial institutions provide transaction services to the economy that facilitate trade and wealth accumulation. Conversely, distressed FIs create negative externalities for the entire economy. That is, the adverse impact of an FI failure is greater than just the loss to shareholders and other private claimants on the FI's assets. For example, the local market suffers if an FI fails and other FIs also may be thrown into financial distress by a contagion effect. Therefore, since some of the costs of the failure of an FI are generally borne by society at large, the government intervenes in the management of these institutions to protect society's interests. This intervention takes the form of regulation. However, the need for regulation to minimize social costs may impose private costs to the FIs that would not exist without regulation. This additional private cost is defined as a net regulatory burden. Examples include the cost of holding excess capital and/or excess reserves and the extra costs of providing information. Although they may be socially beneficial, these costs add to private operating costs. To the extent that these additional costs help to avoid negative externalities and to ensure the smooth and efficient operation of the economy, the net regulatory burden is positive. 24.  What forms of protection and regulation do regulators of FIs impose to ensure their safety and soundness?  Regulators have issued several guidelines to insure the safety and soundness of FIs: a. b.  c. d.  25.  FIs are required to diversify their assets. For example, banks cannot lend more than 15 percent of their equity to a single borrower. FIs are required to maintain minimum amounts of capital to cushion any unexpected losses. In the case of banks, the Basle standards require a minimum core and supplementary capital based on the size of an FIs' risk-adjusted assets. Regulators have set up guaranty funds such as DIF for commercial banks, SIPC for securities firms, and state guaranty funds for insurance firms to protect individual investors. Regulators also engage in periodic monitoring and surveillance, such as on-site examinations, and request periodic information from the FIs. In the transmission of monetary policy, what is the difference between inside money and outside money? How does the Federal Reserve try to control the amount of inside money? How can this regulatory position create a cost for the depository institutions? 7 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Outside money is that part of the money supply directly produced and controlled by the Fed, for example, coins and currency. Inside money refers to bank deposits not directly controlled by the Fed. The Fed can influence this amount of money by adjusting reserve requirement and discount rate policies. In cases where the level of required reserves exceeds the level considered optimal by the FI, the inability to use the excess reserves to generate revenue may be considered a tax or cost of providing intermediation. 26.  What are some examples of credit allocation regulation? How can this attempt to create social benefits create costs to a private institution?  Credit allocation regulation supports the FI's lending to socially important sectors such as housing and farming. For example, the qualified thrift lender test (QTL) requires thrifts to hold 65 percent of their assets in residential mortgage-related assets to retain the thrift charter. Some states have enacted usury laws that place maximum restrictions on the interest rates that can be charged on mortgages and/or consumer loans. Such price and quantity restrictions may have justification on social welfare grounds—especially if society has a preference for strong (and subsidized) housing and farming sectors. However, they can also be harmful to FIs that have to bear the private costs of meeting many of these regulations. To the extent that the net private costs of such restrictions are positive, they add to the costs and reduce the efficiency with which FIs undertake intermediation. 27.  What is the purpose of the Home Mortgage Disclosure Act? What are the social benefits desired from the legislation? How does the implementation of this legislation create a net regulatory burden on financial institutions?  The HMDA was passed by Congress to prevent discrimination in mortgage lending. The social benefit is to ensure that everyone who qualifies financially is provided the opportunity to purchase a house should they so desire. The regulatory burden has been to require a written statement indicating the reasons why credit was or was not granted. 28.  What legislation has been passed specifically to protect investors who use investment banks directly or indirectly to purchase securities? Give some examples of the types of abuses for which protection is provided.  The Securities Acts of 1933 and 1934 and the Investment Company Act of 1940 were passed by Congress to protect investors against possible abuses such as insider trading, lack of disclosure, outright malfeasance, and breach of fiduciary responsibilities. 29.  How do regulations regarding barriers to entry and the scope of permitted activities affect the charter value of financial institutions?  The profitability of existing firms will be increased as the direct and indirect costs of establishing competition increase. Direct costs include the actual physical and financial costs of establishing a business. In the case of FIs, the financial costs include raising the necessary minimum capital to receive a charter. Indirect costs include permission from regulatory authorities to receive a 8 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  charter. Again in the case of FIs this cost involves acceptable leadership to regulators. As these barriers to entry are stronger, the charter value for existing firms is higher. 30.  What reasons have been given for the growth of investment companies at the expense of "traditional" banks and insurance companies?  The recent growth of investment companies can be attributed to two major factors: a.  Investors have demanded increased access to direct investment in securities markets. Investment companies allow investors to take positions in securities markets while still obtaining the risk diversification, monitoring, and transactional efficiency benefits of financial intermediation. Some experts would argue that this growth is the result of increased sophistication on the part of investors. Others would argue that the ability to use these markets has caused the increased investor awareness. The growth in these assets is inarguable.  b.  Recent episodes of financial distress in both the banking and insurance industries have led to an increase in regulation and governmental oversight, thereby increasing the net regulatory burden of "traditional" companies. As such, the costs of intermediation have increased, which increases the cost of providing services to customers.  31.  What events resulted in banks' shift from the traditional banking model of "originate and hold" to a model of "originate and distribute?"  As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of "originate and hold" to "originate to distribute." In the traditional model, banks take short term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk tradeoffs, banks shifted to an underwriting model in which they originated or warehoused loans, and then quickly sold them. Indeed, most large banks organized as financial service holding companies to facilitate these new activities. More recently activities of shadow banks, nonfinancial service firms that perform banking services, have facilitated the change from the originate and hold model of commercial banking to the originate and distribute banking model. These innovations removed risk from the balance sheet of financial institutions and shifted risk off the balance sheet and to other parts of the financial system. Since the FIs, acting as underwriters, were not exposed to the credit, liquidity, and interest rate risks of traditional banking, they had little incentive to screen and monitor activities of borrowers to whom they originated loans. Thus, FIs failed to act as specialists in risk measurement and management. 32.  How did the boom in the housing market in the early and mid-2000s exacerbate FI's transition away from their role as specialists in risk measurement and management? 9 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  The boom ("bubble") in the housing markets began building in 2001, particularly after the terrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial markets by providing liquidity to FIs. For example, the Federal Reserve lowered the short-term money market rate that banks and other financial institutions pay in the Federal funds market and even made lender of last resort funds available to non-bank FIs such as investment banks. Perhaps not surprisingly, low interest rates and the increased liquidity provided by Central banks resulted in a rapid expansion in consumer, mortgage, and corporate debt financing. Demand for residential mortgages and credit card debt rose dramatically. As the demand for mortgage debt grew, especially among those who had previously been excluded from participating in the market because of their poor credit ratings, FIs began lowering their credit quality cut-off points. Moreover, to boost their earnings, in the market now popularly known as the "subprime market," banks and other mortgage-supplying institutions often offered relatively low "teaser" rates on adjustable rate mortgages (ARMs) at exceptionally low initial interest rates, but with substantial step-up in rates after the initial rate period expired two or three year later and if market rates rose in the future. Under the traditional banking structure, banks might have been reluctant to so aggressively pursue low credit quality borrowers for fear that the loans would default. However, under the originate-to-distribute model of banking, asset securitization and loan syndication allowed banks to retain little or no part of the loans, and hence the default risk on loans that they originated. Thus, as long as the borrower did not default within the first months after a loan's issuance and the loans were sold or securitized without recourse back to the bank, the issuing bank could ignore longer term credit risk concerns. The result was deterioration in credit quality, at the same time as there was a dramatic increase in consumer and corporate leverage. The following questions and problems are based on material in Appendix 1B to the Chapter. 33. What are the tools used by the Federal Reserve to implement monetary policy? The tools used by the Federal Reserve to implement its monetary policy include open market operations, the discount rate, and reserve requirements. Open market operations are the Federal Reserves' purchases or sales of securities in the U.S. Treasury securities market. The discount rate is the rate of interest Federal Reserve Banks charge on "emergency" or "lender of last resort" loans to depository institutions in their district. Reserve requirements determine the minimum amount of reserve assets (vault cash plus bank deposits at Federal Reserve Banks) that depository institutions must maintain by law to back transaction deposits held as liabilities on their balance sheets. This requirement is usually set as a ratio of transaction accounts, e.g., 10 percent. 34.  Suppose the Federal Reserve instructs the Trading Desk to purchase $1 billion of securities. Show the result of this transaction on the balance sheets of the Federal Reserve System and commercial banks.  For the purchase of $1 billion in securities, the balance sheet of the Federal Reserve System and commercial banks is shown below. Change in Federal Reserve's Balance Sheet 10 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Assets Treasury securities  Liabilities Reserve account of + $1 b securities dealers' banks ---------------------------------------------------------------------------------------------------Change in Commercial Bank Balance Sheets Assets Reserve accounts at Federal Reserve 35.  + $1 b  Liabilities Securities dealers' demand deposit accounts  + $1 b  + $1 b  Explain how a decrease in the discount rate affects credit availability and the money supply.  Changing the discount rate signals to the market and the economy that the Federal Reserve would like to see higher or lower rates in the economy. Thus, the discount rate is like a signal of the FOMC's intention regarding the tenor of monetary policy. For example, raising the discount rate "signals" that the Fed would like to see a tightening of monetary conditions and higher interest rates in general (and a relatively lower amount of borrowing). Lowering the discount rate "signals" a desire to see more expansionary monetary conditions and lower interest rates in general. 36.  What changes did the Fed implement to its discount window lending policy in the early 2000s?  In January 2003, the Fed implemented changes to its discount window lending that increased the cost of borrowing but eased the terms. Specifically, three lending programs are now offered through the Feds discount window. Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight, at a rate above the Federal Open Market Committee's (FOMC) target rate for federal funds. Primary credit may be used for any purpose, including financing the sale of fed funds. Primary credit may be extended for periods of up to a few weeks to depository institutions in generally sound financial condition that cannot obtain temporary funds in the financial markets at reasonable terms. Secondary credit is available to depository institutions that are not eligible for primary credit. It is extended on a very shortterm basis, typically overnight, at a rate that is above the primary credit rate. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution. Secondary credit may not be used to fund an expansion of the borrower's assets. The Federal Reserve's seasonal credit program is designed to assist small depository institutions in managing significant seasonal swings in their loans and deposits. Seasonal credit is available to depository institutions that can demonstrate a clear pattern of recurring intra-yearly swings in funding needs. Eligible institutions are usually located in agricultural or tourist areas. Under the seasonal program, borrowers may obtain longer term funds from the discount window during periods of seasonal need so that they can carry fewer liquid assets during the rest of the year and make more funds available for local lending. 11 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  With the change, discount window loans to healthy banks would be priced at 1 percent above the fed funds rate rather than below as it generally was in the period preceding January 2003. Loans to troubled banks would cost 1.5 percent above the fed funds rate. The changes were not intended to change the Fed's use of the discount window to implement monetary policy, but significantly increase the discount rate while making it easier to get a discount window loan. By increasing banks= use of the discount window as a source of funding, the Fed hopes to reduce volatility in the fed funds market as well. The change also allows healthy banks to borrow from the Fed regardless of the availability of private funds. Previously, the Fed required borrowers to prove they could not get funds from the private sector, which put a stigma on discount window borrowing. With the changes, the Fed will lend to all banks, but the subsidy of below fed fund rate borrowing will be gone. 37.  Bank Three currently has $600 million in transaction deposits on its balance sheet. The Federal Reserve has currently set the reserve requirement at 10 percent of transaction deposits. a. Suppose the Federal Reserve decreases the reserve requirement to 8 percent. Show the balance sheet of Bank Three and the Federal Reserve System just before and after the full effect of the reserve requirement change. Assume Bank Three withdraws all excess reserves and gives out loans, and that borrowers eventually return all of these funds to Bank Three in the form of transaction deposits.  a. Panel A: Initial Balance Sheets Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------Bank Three Assets Liabilities Loans $540m Transaction deposits $600m Reserve deposits 60m at Fed Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------------Bank Three Assets Liabilities Loans $690m Transaction deposits $750m ($750m - $60m) ($60m x 0.08) Reserve deposits 60m at Fed 12 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  b.  Redo part (a) using a 12 percent reserve requirement.  Panel A: Initial Balance Sheets Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------Bank Three Assets Liabilities Loans $540m Transaction deposits $600m Reserve deposits 60m at Fed Panel B: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement Federal Reserve Bank Assets Liabilities Securities $60m Reserve accounts $60m --------------------------------------------------------------------------------------------------Bank Three Assets Liabilities Loans $440m Transaction deposits $500m ($500m - $60m) ($60m x 0.12) Reserve deposits 60m at Fed 38.  Which of the monetary tools available to the Federal Reserve is most often used? Why?  The Federal Reserve uses mainly open market operations to implement its monetary policy. Adjustments to the discount rate are rarely used because it is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes and because in addition to their effect on the money supply, discount rate changes often have great effects on the financial markets. Further, because changes in the reserve requirements can result in unpredictable changes in the money base (depending on the amount of excess reserves held by banks and the willingness of the public to redeposit funds at banks instead of holding cash (i.e., they have a preferred cash-deposit ratio)), the reserve requirement is rarely used by the Federal Reserve as a monetary policy tool. The unpredictability comes from at least two sources. First, there is uncertainty about whether banks will actually convert excess reserves (created from a decrease in the reserve requirement) into new loans. Second, there is uncertainty about what portion of the new loans will be returned to depository institutions in the form of transaction deposits. Thus, like the discount window rate, the use of the reserve requirement as a monetary policy tool increases the probability that a money base or interest rate target set by the FOMC will not be achieved.  13 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  39.  Describe how expansionary activities conducted by the Federal Reserve impact credit availability, the money supply, interest rates, and security prices. Do the same for contractionary activities.  Expansionary Activities: We described three monetary policy tools that the Fed can use to increase the money supply. These include open market purchases of securities, discount rate decreases, and reserve requirement decreases. All else constant, when the Federal Reserve purchases securities in the open market, reserve accounts of banks (and thus, the money base) increase. When the Fed lowers the discount rate, this generally results in a lowering of interest rates in the economy. Finally, a decrease in the reserve requirements, all else constant, results in an increase in reserves for all banks. In two of the three cases (open market operations and reserve requirement changes), an increase in reserves results in an increase in bank deposits and assets. One immediate effect of this is that interest rates fall and security prices to rise. In the third case (a discount rate change), the impact of a lowering of interest rates is more direct. Lower interest rates encourage borrowing. Economic agents spend more when they can get cheaper funds. Households, business, and governments are more likely to invest in fixed assets (e.g., housing, plant, and equipment). Households increase their purchases of durable goods (e.g., automobiles, appliances). State and local government spending increases (e.g., new road construction, school improvements). Finally, lower domestic interest rates relative to foreign rates can result in a drop in the (foreign) exchange value of the dollar relative to other currencies. As the dollar's (foreign) exchange value drops, U.S. goods become relatively cheaper compared to foreign goods. Eventually, U.S. exports increase. The increase in spending from all of these market participants results in economic expansion, stimulates additional real production, and may cause inflation to rise. Ideally, the expansionary policies of the Fed are meant to be conducive to real economic expansion (economic growth, full employment, sustainable international trade) without price inflation. Indeed, price stabilization can be viewed as the primary objective of the Fed. Contractionary Activities: We also described three monetary policy tools that the Fed can use to decrease the money supply. These include open market sales, discount rate increases, and reserve requirement increases. All else constant, when the Federal Reserve sells securities in the open market, reserve accounts of banks (and the money base) decrease. When the Fed raises the discount rate, interest rates generally increase in the open market. Finally, an increase in the reserve requirement, all else constant, results in a decrease in excess reserves for all banks. In all three cases, interest rates will tend to rise. Higher interest rates discourage credit availability and borrowing. Economic participants spend less when funds are expensive. Households, business, and governments are less likely to invest in fixed assets. Households decrease their purchases of durable goods. State and local government spending decreases. Finally, a decrease in domestic interest rates relative to foreign rates may result in an increase in the (foreign) exchange value (rate) of the dollar. As the dollar's exchange rate increases, U.S. goods become relatively expensive compared to foreign goods. Eventually, U.S. exports decrease. The decrease in spending from all of these market participants results in economic contraction, (depressing additional real production) and causes prices to fall (causing the rate of inflation to fall).  14 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Solutions for End-of-Chapter Questions and Problems: Chapter Two 1.  What are the differences between community banks, regional banks, and money-center banks? Contrast the business activities, location, and markets of each of these bank groups.  Community banks typically have assets under $1 billion and serve consumer and small business customers in local markets. In 2015, 89.5 percent of the banks in the United States were classified as community banks. However, these banks held only 7.5 percent of the assets of the banking industry. In comparison with regional and money-center banks, community banks typically hold a larger percentage of assets in consumer and real estate loans and a smaller percentage of assets in commercial and industrial loans. These banks also rely more heavily on local deposits and less heavily on borrowed and international funds. Regional or superregional banks range in size from several billion dollars to several hundred billion dollars in assets. The banks normally are headquartered in larger regional cities and often have offices and branches in locations throughout large portions of the United States. They engage in a more complete array of wholesale commercial banking activities, encompassing consumer and residential lending as well as commercial and industrial lending (C&I loans), both regionally and nationally. Although these banks provide lending products to large corporate customers, many of the regional banks have developed sophisticated electronic and branching services to consumer and residential customers. Regional and superregional banks utilize retail deposit bases for funding, but also develop relationships with large corporate customers and international money centers. Money center banks rely heavily on nondeposit or borrowed sources of funds. Some of these banks have no retail branch systems and most money center banks are major participants in foreign currency markets. These banks compete with the larger regional banks for large commercial loans and with international banks for international commercial loans. Most money center banks have headquarters in New York City. 2.  Use the data in Table 2-4 for banks in the two asset size groups (a) $100 million-$1 billion and (b) more than $10 billion to answer the following questions. a. Why were ROA and ROE strong for both groups over the 1990-2006 period? Why did ROA and ROE decrease over the period 2007-2009? Why did ROA and ROE increase over the period 2010-2015? Identify and discuss the primary variables that affect ROA and ROE as they relate to these two size groups.  The primary reason for the improvements in ROA and ROE from 1990s through 2006 may be related to the continued strength of the macroeconomy that allowed banks to operate with reduced bad debts, or loan charge-off problems. In addition, the continued low interest rate environment provided relatively low-cost sources of funds, and a shift toward growth in fee income provided additional sources of revenue in many product lines. The result is an increase in bank spreads (i.e., the difference between lending and deposit rates), resulting in higher income and, thus, ROA and ROE. Finally, a growing secondary market for loans allowed banks to control the size of the balance sheet by securitizing many assets. The bigger banks tend to fund 1 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  themselves in national markets and lend to larger corporations. This means that their spreads in the past (the 1990s and early 2000s) often were narrower than those of smaller regional banks, which were more sheltered from competition in highly localized markets. As a result, the largest banks' return on assets (ROA) was below that of smaller banks. In the late 2000s, the U.S. economy experienced its strongest recession since the Great Depression. Commercial banks' performance deteriorated along with the economy. As mortgage borrowers defaulted on their mortgages, financial institutions that held these "toxic" mortgages and "toxic" credit derivatives (in the form of mortgage backed securities) started announcing huge losses on them. Losses from the falling value of OBS securities reached over $1 trillion worldwide through 2009. Bigger banks held more of these toxic assets and, thus, experienced larger losses in income in 2008. As a result, they tended to see smaller spreads and lower, and even negative, ROAs and ROEs during this period. Losses resulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown of the world's financial and economic systems. As the economy recovered in 2010-2015, ROA and ROE returned closer to their pre-crisis levels. The recovery occurred quicker for bigger banks that received more government assistance and monitoring throughout the crisis. The biggest banks' ROAs and ROEs returned to positive by 2009, while the smaller banks' ROAs and ROEs remained negative until 2010. b. Why is ROA for the smaller banks generally larger than ROA for the large banks? Small banks historically have benefited from a larger spread between the cost of funds and the rate on assets, each of which is caused by the less severe competition in the localized markets. In addition, small banks have been able to control credit risk more efficiently and to operate with less overhead expense than large banks. c. Why is the ratio for ROE consistently larger for the large bank group? ROE is defined as net income divided by total equity, or ROA times the ratio of assets to equity. Because large banks typically operate with less equity per dollar of assets, net income per dollar of equity is larger. d. Using the information on ROE decomposition in Appendix 2A, calculate the ratio of equity to total assets for each of the two bank groups for the period 1990-2015. Why has there been such dramatic change in the values over this time period and why is there a difference in the size of the ratio for the two groups? ROE = ROA x (Total Assets/Equity) Therefore, (Equity/Total Assets) = ROA/ROE  Year 1990 1995  ROE 9.95% 13.48%  $100 million - $1 Billion ROA TA/Equity Equity/TA 0.78% 12.76 7.84% 1.25% 10.78 9.27%  ROE 6.68% 15.60%  Over $10 Billion ROA TA/Equity 0.38% 17.58 1.10% 14.18  Equity/TA 5.69% 7.05%  2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  2000 2001 2003 2006 2007 2008 2009 2010 2013 2015  13.56% 12.24% 12.80% 12.20% 10.34% 3.68% -0.15% 3.35% 8.76% 9.08%  1.28% 1.20% 1.27% 1.24% 1.06% 0.38% -0.01% 0.36% 0.93% 1.00%  10.59 10.20 10.08 9.84 9.75 9.68 15.00 9.31 9.41 9.08  9.44% 9.80% 9.92% 10.16% 10.25% 10.32% 6.67% 10.75% 10.62% 11.01%  14.42% 13.43% 16.37% 13.40% 9.22% 1.70% 1.44% 6.78% 9.61% 9.31%  1.16% 1.13% 1.42% 1.35% 0.92% 0.16% 0.15% 0.75% 1.07% 1.03%  12.43 11.88 11.53 9.93 10.02 10.62 9.71 9.60 8.98 9.04  8.04% 8.41% 8.67% 10.07% 9.98% 9.41% 10.29% 10.42% 11.13% 11.06%  The growth in the equity to total assets ratio has occurred primarily because of the increased profitability of the entire banking industry and (particularly during the financial crisis) the encouragement of regulators to increase the amount of equity financing in the banks. Increased fee income, reduced loan loss reserves, and a low, stable interest rate environment have produced the increased profitability which in turn has allowed banks to increase equity through retained earnings. Smaller banks tend to have a higher equity ratio because they have more limited asset growth opportunities, generally have less diverse sources of funds, and historically have had greater profitability than larger banks. 3.  What factors caused the decrease in loan volume relative to other assets on the balance sheets of commercial banks? How has each of these factors been related to the change and development of the financial services industry during the 1990s and 2000s? What strategic changes have banks implemented to deal with changes in the financial services environment?  Business loans were the major asset on banks' balance sheets between 1965 and 1987. Since then, corporations have utilized the commercial paper markets with increased frequency rather than borrow from banks. In addition, many banks have sold loan packages directly into the capital markets (securitization) as a method to reduce balance sheet risks and to improve liquidity. Finally, the decrease in loan volume during the early 1990s and 2000s was due in part to the short recession in 2001 and the much stronger recession and financial crisis in 2007-2009. As deregulation of the financial services industry occurred during the 1990s, the position of banks as the primary financial services provider eroded. Banks of all sizes have increased the use of off-balance-sheet activities in an effort to generate additional fee income. Letters of credit, futures, options, swaps, and other derivative products are not reflected on the balance sheet, but do provide fee income for the banks. 4.  What are the major uses of funds for commercial banks in the United States? What are the primary risks to a bank caused by each of these? Which of the risks is most critical to the continuing operation of a bank?  Loans and investment securities continue to be the primary assets of the banking industry. Commercial loans are relatively more important for the larger banks, while consumer, small 3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  business loans, and residential mortgages are more important for small banks. Each of these types of loans creates credit, and to varying extents, liquidity risks for the banks. The security portfolio normally is a source of liquidity and interest rate risk, especially with the increased use of various types of mortgage-backed securities and structured notes. In certain environments, each of these risks can create operational and performance problems for a bank. 5.  What are the major sources of funds for commercial banks in the United States? How does this differ for small versus large banks?  The primary sources of funds are deposits and borrowed funds. Small banks rely more heavily on the local deposit base (transaction, savings, and retail time deposits), while large banks tend to utilize large, negotiable time deposits and nondeposit liabilities such as federal funds and repurchase agreements. The supply of nontransaction deposits is shrinking because of the increased use by small savers of higher-yielding money market mutual funds. 6.  What are the three major segments of deposit funding? How are these segments changing over time? Why? What strategic impact do these changes have on the profitable operation of a bank?  The three major segments of deposit funding are transaction accounts, retail savings accounts, and large time deposits. Transaction accounts are checkable deposits that include deposits that do not pay interest and NOW accounts that pay interest. Retail savings accounts include passbook savings accounts and small, nonnegotiable time deposits. Large time deposits include negotiable certificates of deposits that can be resold in the secondary market. The importance of transaction and retail accounts is shrinking due to the direct investment in money market mutual funds by individual investors. These funds pay a competitive rate of interest based on wholesale money market rates by pooling and investing funds while requiring relatively small-denomination investments by mutual fund investors. The changes in the deposit markets have made theses traditionally low cost sources of funding more expensive and coincide with the efforts to constrain the growth on the asset side of the balance sheet. 7.  How does the liability maturity structure of a bank's balance sheet compare with the maturity structure of the asset portfolio? What risks are created or intensified by these differences?  The liability structure of bank balance sheets tends to reflect a shorter maturity structure than does the asset portfolio with relatively more liquid instruments, such as deposits and interbank borrowings, used to fund less liquid assets such as loans. Thus, maturity mismatch or interest rate risk and liquidity risk are key exposure concerns for bank managers. 8.  The following balance sheet accounts (in millions of dollars) have been taken from the annual report for a U.S. bank. Arrange the accounts in balance sheet order and determine the value of total assets. Based on the balance sheet structure, would you classify this bank as a community bank, regional bank, or money center bank? Assets  Liabilities and Equity 4  Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Cash $ 2,660 Fed funds sold 110 Investment securities 6,092 Net loans 29,981 Other assets Premises Total assets  Demand deposits $ 5,939 NOW accounts 12,816 Savings deposits 3,292 Certificates of deposit 9,853 (under $100,000) Other time deposits 2,333 Short-term borrowing 2,080 Long-term debt 1,191 Other liabilities 778 Equity 3,272 Total liab. and equity $41,554  1,633 1,078 $41,554  This bank has funded the assets primarily with transaction and savings deposits. The certificates of deposit could be either retail or corporate (negotiable). The bank has very little (∼5 percent) borrowed funds. On the asset side, about 72 percent of total assets ares in the loan portfolio, but there is no information about the type of loans. The bank actually is a small regional bank with $41.5 billion in assets, but the asset structure could easily be a community bank if the numbers were denominated in millions, e.g., $41.5 million in assets. 9.  What types of activities are normally classified as off-balance-sheet (OBS) activities?  OBS activities include issuing various types of guarantees (such as letters of credit), which often have a strong insurance underwriting element, and making future commitments to lend. Both services generate additional fee income for banks. Off-balance-sheet activities also involve engaging in derivative transactions—futures, forwards, options, and swaps. a. How does an OBS activity move onto the balance sheet as an asset or liability? The activity becomes an asset or a liability upon the occurrence of a contingent event, which may not be in the control of the bank. an item or activity is an off-balance-sheet asset if, when a contingent event occurs, the item or activity moves onto the asset side of the balance sheet or an income item is realized on the income statement. Conversely, an item or activity is an offbalance-sheet liability if, when a contingent event occurs, the item or activity moves onto the liability side of the balance sheet or an expense item is realized on the income statement. b. What are the benefits of OBS activities to a bank? OBS activities generate fee income for banks. The initial benefit is the fee that the bank charges when making the commitment. By moving activities off the balance sheet, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business. At the same time, they can avoid regulatory costs or "taxes" since reserve requirements and deposit insurance premiums are not levied on off-balance-sheet activities. Thus, banks have both earnings and regulatory "tax avoidance" incentives to undertake activities off their balance sheets. c. What are the risks of OBS activities to a bank? 5 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Off-balance-sheet activities, however, can involve risks that add to the overall insolvency exposure of an FI. Indeed, at the very heart of the financial crisis were losses associated with offbalance-sheet mortgage-backed securities created and held by FIs. Losses resulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown of the world's financial and economic systems. However, off-balance-sheet activities and instruments have both riskreducing as well as risk-increasing attributes, and, when used appropriately, they can reduce or hedge an FI's interest rate, credit, and foreign exchange risks. 10.  Use the data in Table 2-6 to answer the following questions. a. What was the average annual growth rate in OBS total commitments over the period from 1992-2015?  $209,532.2 = $10,075.8(1+g)23 ⇒ g = 14.10 percent b. Which categories of contingencies have had the highest annual growth rates? Category of Contingency or Commitment Commitments to lend Future and forward contracts Notional amount of credit derivatives Standby contracts and other option contracts Commitments to buy FX, spot, and forward Standby LCs and foreign office guarantees Commercial LCs Securities borrowed Notional value of all outstanding swaps  Growth Rate 6.99% 12.53% 34.31% 13.94% 7.74% 9.17% -0.98% 11.20% 22.13%  Credit derivatives grew at the fastest rate of 34.31 percent, yet they have a relatively low outstanding balance of $8,487.1 billion. The rate of growth in the swaps area has been the second strongest at 22.13 percent, the dollar volume is large at $117,481.3 billion in 2015. Option contracts grew at an annual rate of 13.91 percent with a dollar value outstanding of $31,549.0 billion. Clearly the strongest growth involves derivative areas. c. What factors are credited for the significant growth in derivative securities activities by banks? The primary use of derivative products has been in the areas of interest rate, credit, and foreign exchange risk management. As banks and other financial institutions have pursued the use of these instruments, the international financial markets have responded by extending the variations of the products available to the institutions. However, derivative securities have not grown in significance since the financial crisis. Part of the Wall Street Reform and Consumer Protection Act, passed in 2010 in response to the financial crisis, is the Volker Rule which prohibits U.S. depository institutions (DIs) from engaging in proprietary trading (i.e., trading as a principal for the trading account of the bank). This includes any transaction to purchase or sell derivatives. 6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Thus, only the investment banking arm of the business is allowed to conduct such trading. The Volcker Rule was implemented in April 2014 and banks had until July 21, 2015 to be in compliance. The result has been a reduction in derivative securities held off-balance-sheet by these financial institutions. 11.  For each of the following banking organizations, identify which regulatory agencies (OCC, FRB, FDIC, or state banking commission) may have some regulatory supervision responsibility. (a) (b) (c) (d) (e)  State-chartered, nonmember, non-holding company bank. State-chartered, nonmember holding company bank State-chartered member bank Nationally chartered non-holding company bank. Nationally chartered holding company bank Bank Type (a) (b) (c) (d) (e)  12.  OCC  FRB  Yes Yes  Yes Yes Yes Yes  FDIC Yes Yes Yes Yes Yes  SB Comm Yes Yes Yes  What are the main features of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994? What major impact on commercial banking activity occurred from this legislation?  The main feature of the Riegle-Neal Act of 1994 was the removal of barriers to interstate banking. In September 1995 bank holding companies were allowed to acquire banks in other states. In 1997, banks were allowed to convert out-of-state subsidiaries into branches of a single interstate bank. As a result, consolidations and acquisitions have allowed for the emergence of very large banks with branches across the country. 13.  What factors normally are given credit for the revitalization of the banking industry during the decade of the 1990s? How is Internet banking expected to provide benefits in the future?  The most prominent reason was the lengthy economic expansion in both the U.S. and many global economies during the entire decade of the 1990s. This expansion was assisted in the U.S. by low and falling interest rates, and increasing spreads, during the entire period. The extent of the impact of Internet banking remains unknown. However, the existence of this technology is allowing banks to open markets and develop products that did not exist prior to the Internet. Initial efforts focused on retail customers more than corporate customers. The trend should continue with the advent of faster, more customer friendly products and services, and the continued technology education of customers.  7 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  14.  What factors are given credit for the strong performance of commercial banks in the early and mid-2000s?  The lowest interest rates in many decades helped bank performance on both sides of the balance sheet. On the asset side, many consumers continued to refinance homes and purchase new homes, an activity that caused fee income from mortgage lending to increase and remain strong. Meanwhile, the rates banks paid on deposits shrunk to all time lows. The result was an increase in bank spreads and net income In addition, the development and more comfortable use of new financial instruments such as credit derivatives and mortgage-backed securities helped banks ease credit risk off the balance sheets. Finally, information technology has helped banks manage their risk more efficiently. 15.  What factors are given credit for the weak performance of commercial banks in the late 2000s?  In the late 2000s, the U.S. economy experienced its strongest recession since the Great Depression. Commercial banks' performance deteriorated along with the economy. Sharply higher loss provisions and a very rare decline in noninterest income were primarily responsible for the lower industry profits. Things got even worse in 2008. Net income for all of 2008 was $10.2 billion, a decline of $89.8 billion (89.8 percent) from 2007. The ROA for the year was 0.13 percent, the lowest since 1987. Almost one in four institutions (23.6 percent) was unprofitable in 2008, and almost two out of every three institutions (62.8 percent) reported lower full-year earnings than in 2007. Total noninterest income was $25.6 billion (11 percent), lower as a result of the industry's first ever full-year trading loss ($1.8 billion), a $5.8 billion (27.4 percent) decline in securitization income, and a $6.6 billion drop in proceeds from sales of loans, foreclosed properties, and other assets. Net loan and lease charge-offs totaled $38.0 billion in the fourth quarter, an increase of $21.7 billion (132.7 percent) from the fourth quarter of 2007, the highest charge-off rate in the 25 years that institutions have reported quarterly net charge-offs. As the economy improved in the second half of 2009, so did commercial bank performance. While rising loan-loss provisions continued to dominate industry profitability, growth in operating revenues, combined with appreciation in securities values, helped the industry post an aggregate net profit. Noninterest income was $4.0 billion (6.8 percent) higher than 2008 due to net gains on loan sales (up $2.7 billion) and servicing fees (up $1.9 billion). However, the industry was still feeling the effects of the long recession. Provisions for loan and lease losses totaled $62.5 billion, the fourth consecutive quarter that industry provisions had exceeded $60 billion. Net charge-offs continued to rise, for an 11th consecutive quarter. 16.  How do the asset and liability structures of a savings institution compare with the asset and liability structures of a commercial bank? How do these structural differences affect the risks and operating performance of a savings institution? What is the QTL test?  The savings institution industry relies on mortgage loans and mortgage-backed securities as the primary assets, while the commercial banking industry has a variety of loan products, including mortgage products. The large amount of longer-term fixed rate assets continues to cause interest rate risk, while the lack of asset diversity exposes the savings institution to credit risk. Savings institutions hold less cash and U.S. Treasury securities than do commercial banks. On the 8 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  liability side, small time and saving deposits remain as the predominant source of funds for savings institutions, with some reliance on FHLB borrowing. The inability to nurture relationships with the capital markets also creates potential liquidity risk for the savings institution industry. The acronym QTL stands for Qualified Thrift Lender. The QTL test refers to a minimum amount of mortgage-related assets that a savings institution must hold to maintain its charter as a savings institution. The amount currently is 65 percent of total assets. 17.  How do savings banks differ from savings associations? Differentiate in terms of risk, operating performance, balance sheet structure, and regulatory responsibility.  The asset structure of savings banks is similar to the asset structure of savings associations with the exception that savings banks are allowed to diversify by holding a larger proportion of corporate stocks and bonds. Savings banks rely more heavily on deposits and thus have a lower level of borrowed funds. Both are regulated at both the state and federal level, with deposits insured by the FDIC's DIF. 18.  What happened in 1979 to cause the failure of many savings institutions during the early 1980s? What was the effect of this change on the financial statements of savings associations?  Over the period October 1979 to October 1982, however, the Federal Reserve's restrictive monetary policy action led to a sudden and dramatic surge in interest rates, with rates on T-bills rising as high as 16 percent. This increase in short-term rates and the cost of funds had two effects. First, savings associations faced negative interest spreads or net interest margins in funding much of their fixed-rate long-term residential mortgage portfolios over this period. Second, they had to pay more competitive interest rates on savings deposits to prevent disintermediation and the reinvestment of those funds in money market mutual fund accounts. Their ability to do this was constrained by the Federal Reserve's Regulation Q ceilings, which limited the rates savings associations could pay on traditional passbook savings account and retail time deposits. 19.  How did the two pieces of regulatory legislation─the DIDMCA in 1980 and the DIA in 1982─change the profitability of savings institutions in the early 1980s? What impact did these pieces of legislation ultimately have on the risk posture of the savings institution industry? How did the FSLIC react to this change in operating performance and risk?  The two pieces of legislation expanded the deposit-taking and asset-investment powers of savings associations. The acts allowed savings institutions to offer new deposit accounts, such as NOW accounts and money market deposit accounts, in an effort to reduce the net withdrawal flow of deposits from the institutions. In effect this action was an attempt to reduce the liquidity problem. In addition, savings institutions were allowed to offer adjustable-rate mortgages and a limited amount of commercial and consumer loans in an attempt to improve the profitability performance of the industry. Although many savings institutions were safer, more diversified, and more profitable, the FSLIC did not foreclose many of the savings institutions which were 9 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  insolvent. Nor did the FSLIC change its policy of assessing higher insurance premiums on companies that remained in high risk categories. Thus, many savings institutions failed, which caused the FSLIC to eventually become insolvent. 20.  How did the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 reverse some of the key features of earlier legislation?  FIRREA rescinded some of the expanded thrift lending powers of the DIDMCA of 1980 and the Garn-St Germain Act of 1982. The Act also the FIRREA of 1989—abolished the FSLIC and created a new insurance fund (SAIF) under the management of the FDIC. In addition, the act created the Resolution Trust Corporation (RTC) to close the most insolvent savings associations. Further, the FIRREA strengthened the capital requirements of savings institutions and constrained their non-mortgage-related asset-holding powers under a newly imposed qualified thrift lender, or QTL, test that requires that all thrifts must hold portfolios that are comprised primarily of mortgages or mortgage products such as mortgage-backed securities. The FDICA of 1991 amended the DIDMCA of 1980 by introducing risk-based deposit insurance premiums in 1993 to reduce excess risk-taking. FDICA also provided for the implementation of a policy of prompt corrective actions (PCA) that allows regulators to close banks more quickly in cases where insolvency is imminent. Thus, the ill-advised policy of regulatory forbearance should be curbed. 21.  What is the "common bond" membership qualification under which credit unions have been formed and operated? How does this qualification affect the operational objective of a credit union?  In organizing a credit union, members are required to have a common bond of occupation (e.g., police CUs) or association (e.g., university-affiliated CUs), or to cover a well-defined neighborhood, community, or rural district. The common bond policy allows anyone who meets a specific membership requirement to become a member of the credit union. The requirement normally is tied to a place of employment or residence. The primary objective of credit unions is to satisfy the depository and lending needs of their members. Because the common bond policy has been loosely interpreted, implementation has allowed credit union membership and assets to grow at a rate that exceeds similar growth in the commercial banking industry. Since credit unions are mutual organizations where the members are owners, employees essentially use saving deposits to make loans to other employees who need funds. Also, because credit unions are nonprofit organizations, their net income is not taxed and they are not subject to the local investment requirements established under the 1977 Community Reinvestment Act. This taxexempt status allows CUs to offer higher rates on deposits, and charge lower rates on some types of loans, than do banks and savings institutions. 22.  What are the operating advantages of credit unions that have caused concern among commercial bankers? What has been the response of the Credit Union National Association to the banks' criticisms? 10 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Credit unions are tax-exempt organizations. As a result, their net income is not taxed and they are not subject to the local investment requirements established under the 1977 Community Reinvestment Act. This tax-exempt status allows CUs to offer higher rates on deposits, and charge lower rates on some types of loans, than do banks and savings institutions. As CUs have expanded in number, size, and services, bankers have claimed that CUs are unfairly competing with small banks that have historically been the major lenders in small towns. For example, the American Bankers Association has stated that the tax exemption for CUs gives them the equivalent of a $1 billion per year subsidy. The Credit Union National Association's (CUNA) response is that any cost to taxpayers from CUs' tax-exempt status is more than made up in benefits to members and therefore the social good they create. CUNA estimates that the benefits of CU membership can range from $200 to $500 a year per member or, with more than 95 million members, a total benefit of $19 billion to $47.5 billion per year. CUNA has responded saying that the cost to tax payers from the tax-exempt status is replaced by the additional social good created by the benefits to the members. 23.  How does the asset structure of credit unions compare with the asset structure of commercial banks and savings institutions? Refer to Tables 2-5, 2-9, and 2-12 to formulate your answer.  The relative proportions of all three types of depository institutions are similar, with almost 30 percent of total assets held as investment securities and over 50 percent as loans. Savings institutions' loans are predominantly mortgage related, nonmortgage loans of credit unions are predominantly consumer loans, and commercial banks hold more business loans than either savings institutions or credit unions. On the liability side of the balance sheet, credit unions differ from banks in that they have less reliance on large time deposits and they differ from savings institutions in that they have virtually no borrowings from any source. The primary sources of funds for credit unions are transaction and small time and savings accounts. 24.  Compare and contrast the performance of the worldwide depository institutions with those of major foreign countries during the financial crisis.  Quickly after it hit the U.S., the financial crisis spread worldwide. As the crisis started, banks worldwide saw losses driven by their portfolios of structured finance products and securitized exposures to the subprime mortgage market. Losses were magnified by illiquidity in the markets for those instruments. As with U.S. banks, this led to substantial losses in their marked to market valuations. In Europe, the general picture of bank performance in 2008 was similar to that in the U.S. That is, net income fell sharply at all banks. The largest banks in the Netherlands, Switzerland and the United Kingdom had net losses for the year. Banks in Ireland, Spain and the United Kingdom were especially hard hit as they had large investments in mortgages and mortgage-backed securities. Because they focused on the domestic retail banking, French and Italian banks were less affected by losses on mortgage-backed securities. Continental European banks, in contrast to UK banks, partially cushioned losses through an increase in their net interest margins. A number of European banks averted outright bankruptcy thanks to direct support from the central banks and national governments. During the last week of September and first week of October 2008, the German government guaranteed all consumer bank deposits and arranged a 11 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  bailout of Hypo Real Estate, the country's second largest commercial property lender. The United Kingdom nationalized mortgage lender Bradford & Bingley (the country's eighth largest mortgage lender) and raised deposit guarantees from $62,220 to $88,890 per account. Ireland guaranteed deposits and debt of its six major financial institutions. Iceland rescued its third largest bank with a $860 million purchase of 75 percent of the banks stock and a few days later seized the country's entire banking system. The Netherlands, Belgium, and Luxembourg central governments together agreed to inject $16.37 billion into Fortis NV (Europe's first ever crossborder financial services company) to keep it afloat. However, five days later this deal fell apart, and the bank was split up. The Dutch bought all assets located in the Netherlands for approximately $23 billion. The central bank in India stepped in to stop a run on the country's second largest bank ICICI Bank, by promising to pump in cash. Central banks in Asia injected cash into their banking systems as banks' reluctance to lend to each other led the Hong Kong Monetary Authority to inject liquidity into its banking system after rumors led to a run on Bank of East Asia Ltd. South Korean authorities offered loans and debt guarantees to help small and midsize businesses with short term funding. The United Kingdom, Belgium, Canada, Italy, and Ireland were just a few of the countries to pass an economic stimulus plan and/or bank bailout plan. The Bank of England lowered its target interest rate to a record low of 1 percent hoping to help the British economy out of a recession. The Bank of Canada, Bank of Japan, and Swiss National Bank also lowered their main interest rate to 1 percent or below. All of these actions were a result of the spread of the U.S. financial market crisis to world financial markets. The worldwide economic slowdown experienced in the later stages of the crisis meant that bank losses became more closely connected to macroeconomic performance. Countries across the world saw companies scrambling for credit and cutting their growth plans. Additionally, consumers worldwide reduced their spending. Even China's booming economy slowed faster than had been predicted, from 10.1 percent in the second quarter of 2008 to 9 percent in the third quarter. This was the first time since 2002 that China's growth was below 10 percent and dimmed hopes that Chinese demand could help keep world economies going. In late October, the global crisis hit the Persian Gulf as Kuwait's central bank intervened to rescue Gulf Bank, the first bank rescue in the oil rich Gulf. Until this time, the area had been relatively immune to the world financial crisis. However, plummeting oil prices (which had dropped over 50 percent between July and October) left the area's economies vulnerable. In this period, the majority of bank losses were more directly linked to a surge in borrower defaults and to anticipated defaults as evidenced by the increase in the amount and relative importance of loan loss provision expenses. International banks' balance sheets continued to shrink during the first half of 2009 (although at a much slower pace than in the preceding six months) and, as in the U.S., began to recover in the latter half of the year. In the fall of 2009, a steady stream of mostly positive macroeconomic news reassured investors that the global economy had turned around, but investor confidence remained fragile. For example, in late November 2009, security prices worldwide dropped sharply as investors reacted to news that government-owned Dubai World had asked for a delay in some payments on its debt. Further, throughout the spring of 2010 Greece struggled with a severe debt crisis. Early on, some of the healthier European countries tried to step in and assist the debt ridden country. Specifically, in March 2010 a plan led by Germany and France to bail out Greece with as much as $41 billion in aid began to take shape. However, in late April Greek bond prices dropped dramatically as traders began betting a debt default was inevitable, even if 12 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  the country received a massive bailout. The selloff was the result of still more bad news for Greece, which showed that the 2009 budget deficit was worse than had been previously reported, and as a result politicians in Germany began to voice opposition to a Greek bailout. Further, Moody's Investors Service downgraded Greece's debt rating and warned that additional cuts could be on the way. Greece's debt created heavy losses across the Greek banking sector. A run on Greek banks ensued. Initially, between €100 and €500 million per day was being withdrawn from Greek banks. At its peak, the run on Greek banks produced deposit withdrawals of as high as €750 billion a day, nearly 0.5 percent of the entire €170 billion deposit base in the Greek banking system. Problems in the Greek banking system then spread to other European nations with fiscal problems, such as Portugal, Spain, and Italy. The risk of a full blown banking crisis arose in Spain where the debt rating of 16 banks and four regions were downgraded by Moody's Investor Service. Throughout Europe, some of the biggest banks announced billions of euros lost from write downs on Greek loans. In 2011, Crédit Agricole reported a record quarterly net loss of €3.07 billion ($4.06 billion U.S.) after a €220 million charge on its Greek debt. Great Britain's Royal Bank of Scotland revalued its Greek bonds at a 79 percent loss—or £1.1 billion ($1.7 billion U.S.)—for 2011. Germany's Commerzbank's fourth quarter 2011 earnings decreased by a €700 million due to losses on Greek sovereign debt. The bank needed to find €5.3 billion euros to meet the stricter new capital requirements set by Europe's banking regulator. Bailed out Franco-Belgian bank Dexia warned it risked going out of business due to losses of €11.6 billion from its break-up and exposure to Greek debt and other toxic assets such as U.S. mortgagebacked securities. Even U.S. banks were affected by the European crisis. In late 2010, U.S. banks had sovereign risk exposure to Greece totaling $43.1 billion. In addition, exposures to Ireland totaled $113.9 billion, to Portugal totaled $47.1 billion, and to Spain $187.5 billion. Worldwide, bank exposure to these four countries totaled $2,512.3 billion. Default by small country like Greece cascaded into something that threatened the world's financial system. Worried about the affect a Greek debt crisis might have on the European Union, other European countries tried to step in and assist Greece. On May 9, 2010, in return for huge budget cuts, Europe's finance ministers and the International Monetary Fund approved a rescue package worth $147 billion and a "safety net" of $1 trillion aimed at ensuring financial stability across Europe. Through the rest of 2010 and into 2012, Eurozone leaders agreed on more measures designed to prevent the collapse of Greece and other member economies. In return, Greece continued to offer additional austerity reforms and agreed to reduce its budget deficits. At times, the extent of these reforms and budget cuts led to worker strikes and protests (some of which turned violent), as well as changes in Greek political leadership. In December 2011, the leaders of France and Germany agreed on a new fiscal pact that they said would help prevent another debt crisis. Then French President Nicolas Sarkozy outlined the basic elements of the plan to increase budget discipline after meeting with German Chancellor Angela Merkel in Paris. The pact, which involved amending or rewriting the treaties that govern the European Union, was presented in detail at a meeting of European leaders and approved. Efforts by the EU and reforms enacted by the Greek and other European country governments appear to have worked. As on December 18, 2012, Standard & Poor's raised its rating on Greek debt by six notches to B minus from selective default Tuesday. S&P cited a strong and clear commitment from members of the euro zone to keep Greece in the common currency bloc as the main reason for the upgrade. 13 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  The situation in Greece and the European Union stabilized after 2012. However, a major debt payment was due from Greece to its creditors on June 30, 2015, a payment required to continue to receive rescue funds from the EU. Knowing that they could not make the payment, Greek officials met with Eurozone leaders in an attempt to get a better deal. Greece, however, was unwilling to agree to more spending cuts and other concessions requested by the EU and talks broke down. Greece would be the first developed country to default on its debt and faced the real possibility that it would be forced to leave the European Union. With its financial system near collapse and a debt payment due to the ECB on July 20, Greece was forced to continue negotiations with its creditors. A deal was reached on July 13 that essentially required Greece to surrender to all of its creditors' demands: including tax increases, pension reform, and the creation of a fund (under European supervision) that would hold some €50 billion in state-owned assets earmarked to be privatized or liquidated (with the proceeds to be used to pay off Greece's debt and help recapitalize its banks). The questions and problems that follow refer to Appendix 2B. 25.  The financial statements for First National Bank (FNB) are shown below: Balance Sheet - First National Bank Assets Cash $ 450 Demand deposits from other FIs 1,350 Investments 4,050 Federal funds sold 2,025 Loans 15,525 Reserve for loan losses (1,125) Premises 1,685 Total assets $23,960  Liabilities and Equity Demand deposits Small time deposits Jumbo CDs Federal funds purchased Equity  $ 5,510 10,800 3,200 2,250 2,200  Total liabilities/equity  $23,960  Income Statement - First National Bank Interest Income Interest expense Provision for loan losses Noninterest income Noninterest expense Taxes  $2,600 1,650 180 140 420 90  a. Calculate the dollar value of FNB's earning assets. Earning assets = investment securities + net loans = $4,050 + $2,025 + $15,525 – $1,125 = $20,475 b. Calculate FNB's ROA. 14 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  ROA = ($2,600 – $1,650 – $180 + $140 – $420 – $90)/$23,960 = 1.67% c. Calculate FNB's asset utilization ratio. Asset utilization = ($2,600 + $140)/$23,960 = 11.44% d. Calculate FNB's spread. Spread = ($2,600/$20,475) – ($1,650/($10,800 + $3,200 + $2,250)) = 2.54% 26.  Megalopolis Bank has the following balance sheet and income statement. Balance Sheet (in millions) Assets  Liabilities and Equity  Cash and due from banks $9,000 Investment securities 23,000 Repurchase agreements 42,000 Loans 90,000 Fixed Assets 15,000 Other assets 4,000 Total assets $183,000  Demand deposits $19,000 NOW accounts 89,000 Retail CDs 28,000 Debentures 19,000 Total liabilities $155,000 Common stock 12,000 Paid in capital 4,000 Retained earnings 12,000 Total liabilities and equity $183,000  Income Statement Interest on fees and loans Interest on investment securities Interest on repurchase agreements Interest on deposits in banks Total interest income Interest on deposits Interest on debentures Total interest expense Operating income Provision for loan losses Other income Other expenses Income before taxes Taxes Net income  $9,000 4,000 6,000 1,000 $20,000 9,000 2,000 $11,000 $9,000 2,000 2,000 1,000 $8,000 3,000 $5,000  For Megalopolis, calculate: 15 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  a. Return on equity Return on equity = 5,000m/28,000m = 17.86% b. Return on assets Return on assets = 5,000m/183,000m = 2.73% c. Asset utilization Asset utilization = (20,000m + 2,000m)/183,000m = 12.02% d. Equity multiplier Equity multiplier = 183,000m/(12,000m + 4,000m + 12,000m) = 6.54X e. Profit margin Profit margin = 5,000m/(20,000m + 2,000m) = 22.73% f. Interest expense ratio Interest expense ratio = 11,000m/(20,000m + 2,000m) = 50.00% g. Provision for loan loss ratio Provision for loan loss ratio = 2,000m/(20,000m + 2,000m) = 9.09% h. Noninterest expense ratio Noninterest expense ratio = 1,000m/(20,000m + 2,000m) = 4.55% i. Tax ratio Tax ratio = 3,000m/(20,000m + 2,000m) = 13.64%  16 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Solutions for End-of-Chapter Questions and Problems: Chapter Three 1.  What is the primary function of finance companies? How do finance companies differ from depository institutions?  The primary function of finance companies is to make loans to individuals and corporations. Finance companies differ from depository institutions in that they do not accept deposits, but borrow short- and long-term debt, such as commercial paper and bonds, to finance the loans. The heavy reliance on borrowed money has caused finance companies to generally hold more equity than depository institutions for the purpose of signaling solvency to potential creditors. Finally, finance companies are less regulated than depository institutions, in part because they do not rely on deposits as a source of funds. 2.  What are the three major types of finance companies? To which market segments do each of these types of companies provide service?  The three types of finance companies are (1) sales finance institutions, (2) personal credit institutions, and (3) business credit institutions. Sales finance companies specialize in making loans to customers of a particular retailer or manufacturer. An example is Ford Motor Credit. Personal credit institutions specialize in making installment loans to consumers. An example is HSBC Finance. Business credit institutions provide specialty financing, such as equipment leasing and factoring, to corporations. Factoring involves the purchasing of accounts receivable at a discount from corporate customers and assuming the responsibility of collection. An example is U.S. Bancorp Equipment Finance. 3.  What have been the major changes in the accounts receivable balances of finance companies over the 38-year period from 1977 to 2015?  The biggest change in the accounts receivable balances of finance companies over the last 38 years is that the amount of consumer and business loans has decreased from 95.1 percent of assets to 71.2 percent of assets. Real estate loans have replaced some of the consumer and business loans and are now 7.3 percent of assets. 4.  What are the major types of consumer loans? Why are the rates charged by consumer finance companies typically higher than those charged by commercial banks?  Consumer loans include motor vehicle loans and leases, other consumer loans, and securitized loans, with motor vehicles loans and leases taking the largest share. Other consumer loans include loans for mobile homes, appliances, furniture, etc. The rates charged by finance companies typically are higher than the rates charged by banks because the customers are considered to be riskier. Customers who seek individual (or business) loans from finance companies are often those judged too risky to obtain loans from commercial banks. 5.  Why have home equity loans become popular? What are securitized mortgage assets? 1 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Since the enactment of the Tax Reform Act of 1986 only loans secured by an individual's home offer tax-deductible interest for the borrower. Thus, these loans are more popular than loans without a tax deduction, and finance companies as well as banks, credit unions, and savings institutions have been attracted to this loan market. Securitization of mortgages involves the pooling of a group of mortgages with similar characteristics, the removal of these mortgages from the balance sheet, and the subsequent sale of interests in the pool to secondary market investors. Securitization of mortgages results in the creation of mortgage-backed securities (e.g., government agency securities, collateralized mortgage obligations), which can be traded in secondary mortgage markets. While removed from its balance sheet, the finance company that originates the mortgage may still service the mortgage portfolio for a fee. 6.  What advantages do finance companies have over commercial banks in offering services to small business customers? What are the major subcategories of business loans? Which category is largest?  Finance companies have advantages in the following ways: (1) finance companies are not subject to regulations that restrict the types of products and services they can offer; (2) because they do not accept deposits, they do not have the extensive regulatory monitoring; (3) they are likely to have more product expertise because they generally are subsidiaries of industrial companies; (4) finance companies are more willing to take on riskier customers; and (5) finance companies typically have lower overhead than commercial banks. The four categories of business loans are (1) retail and wholesale motor vehicle loans and leases, (2) equipment loans, (3) other business assets, and (4) securitized business assets. Equipment loans constitute over 40 percent of the business loans. 7.  What have been the primary sources of financing for finance companies?  Finance companies have relied primarily on short-term commercial paper and long-term notes and bonds. Over 60 percent of finance company funding comes from debt due to parents and debt not elsewhere classified. Unlike banks and thrifts, finance companies cannot issue deposits. Rather, to finance assets, finance companies rely heavily on short-term commercial paper, with many having direct sale programs in which commercial paper is sold directly to mutual funds and other institutional investors on a continuous day-by-day basis. Indeed, finance companies are now the largest issuers in the short-term commercial paper market. Most commercial paper issues have maturities of 30 days or less, although they can be issued with maturities of up to 270 days. 8.  How do finance companies make money? What risks does this process entail? How do these risks differ for a finance company versus a commercial bank?  2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.  Finance companies make a profit by borrowing money at a rate lower than the rate at which they lend. This is similar to a commercial bank, with the primary difference being the source of funds, principally deposits for a bank and money and capital market borrowing for a finance company. The principal risk in relying heavily on public debt as a source of financing involves the continued depth of the commercial paper and other debt markets. As experienced during the financial crisis of 2008-2009, economic recessions can affect these markets more severely than the effect on deposit drains in the commercial banking sector. In addition, the riskier asset customers may have a greater impact on the finance companies. 9.  Compare Tables 3-1 and 2-5. Which firms have higher ratios of capital to total assets: finance companies or commercial banks? What does this comparison indicate about the relative strengths of these two types of firms?  Table 3-1 indicates that finance companies had a ratio of capital to total assets of 12.8 percent in 2015. Commercial banks (Table 2-5) have 11.3 percent of total capital to total assets. The difference may be partially due to the fact that the commercial banks have FDIC insured deposits. This insurance

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