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Bachelor Studies in Finance
Year 2, Spring 2012
Overview
1. Asset-liability management (ALM)
2. Off-balance sheet business in banking
3. Loans sales and the process of securitization
BANKING
Lecture 5
Managing banks
Ewa Kania, Department of Banking
2
1.
Asset-liability management
•
Coordinated and simultaneous decisions
on financing and
investing are taken by a bank’s Assets and Liability
Committee (ALCO). It is the single most important
management group and function in a bank.
•
The
main objective is to maximize profits
and shareholders’
wealth. To achieve these ends, banks take financing decisions
(how to acquire finance), make investment decisions (how to
allocate finance to most profitable investments), and control
resources (how to conserve finance).
•
In practice ALM is a short-term (0-90 days) and intermediate-
term (3-12 months) planning function within a bank’s long-
run plan (1-5 years).
•
Asset management aims
are:
(1) to maximize return on loans and securities
(2) to minimize risks
(3) to keep adequate liquidity
•
From an accounting viewpoint, the key variables of ALM are
(1) NII – net interest income
(2) ROA – return on assets
(3) ROE – return on equity
•
Liability management aims
are:
(1) to maximize return in the interbank market
(2) to minimize cost of deposits
•
From an economic viewpoint, the key variable is the MVE –
market value of equity.
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Stage 2
(cont’d)
Reserve-position management
Liability management
• A three-stage approach to balance-sheet coordinated
management:
Stage 1. Global (or general) approach
focuses on coordinated
management of a bank’s assets, liabilities and capital. It
requires coordination of various specific functions that can be
identified in Stage 2.
Stage 2. Identification of specific components
distinguishes
between various components of a bank’s balance sheet used
in coordinating its overall portfolio management. It is based
on planning, directing, and controlling the levels, changes and
mixes of various balance sheet accounts, which generate the
bank’s income-expense statement (Stage 3).
Liquidity management
Reserve-position liability
management
Securities management
Loan-position liability
management
Loan management
Long-term debt management
Fixed-asset management
Capital management
Stage 3. Balance sheet generates profit and loss account
•
Stage 3 illustrates a bank’s profit and loss account as
generated by its on- and off-balance sheet items, given prices
and interest rates.
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Stage 3
(cont’d)
profit = interest revenue – interest expenses – provision for loan
losses + non-interest revenue – non-interest expense – taxes
Liquidity
is the ability of a bank to pay its obligations when they
fall due.
•
Trade-off between liquidity and profitability
:
banks should calculate the opportunity cost of the amount
kept as liquid assets because they do not earn interest (or are
very low yielding).
Policies to achieve objectives
:
1.
Spread management
2.
Loan quality
•
Bank’s reserves
are an insurance against the costs associated
with deposit outflows. There are two types of reserves:
required and excess reserves.
3.
Generating fee income and service charges
4.
Control of non-interest operating expenses
5.
Tax management
•
In the event of a need to obtain liquidity a bank has four
options:
– borrowing from other banks
– selling some if its securities
– selling some of its loans
– borrowing from the central bank.
6.
Capital adequacy
The objectives of ALM usually are expressed in terms of net
interest income and minimization of the variability of the
bank’s market value of equity.
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2.
Off-balance sheet business in
banking
Capital adequacy management
•
Capital in banking signals to what extent the bank is safe and
sound, in other words, solvent. Solvency is the ability of a
bank to repay its obligations ultimately.
•
OBS activities
have no asset-backing and therefore are also
called
contingent
liabilities business. They refer to promises
or commitments of the bank to undertake certain types of
business in the future.
•
There is a trade-off between solvency (safety) and returns: the
higher the capital, the lower the ROE. From the viewpoint of
regulators capital is a necessary buffer to absorb potential
losses before they must be charged against deposits.
•
The earnings generated from OBS operations are fee-related.
When a contingent event occurs, the item or activity will be
written in the asset (or liability) side of the balance sheet.
•
Regulatory capital
is the amount of capital required by
regulators.
•
Economic capital
is the capital that a bank decides it should
hold to cover the risks it is undertaking.
•
A non-interest income item (or expense) will be generated in
the income statement.
•
Banks manage their economic capital directing capital
resources to different areas of business that aim to generate the
highest risk-adjusted returns.
•
OBS business
does not involve deposit funding
(cash reserves are not needed).
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•
The
major incentive
to engage in OBS activities is a chance
to meet regulatory requirements of strong capital position.
Banks do not increase their assets, but increase fee income.
•
Financial futures
are contracts to deliver and pay for a real
or financial asset on a pre-arranged date in the future for a
specified price.
•
OBS operations include
:
– financial derivatives,
– loan commitments (e.g., overdrafts),
– financial guarantees (e.g., letters of credit), and
– securities underwriting.
•
They are traded in organized markets (standard features);
thus, they are highly liquid as secondary markets exist.
•
They are usually offset before the actual delivery, e.g.,
a purchase is offset by a sale, or
vice versa
.
•
The clearing house of the exchange requires both parties to
deposit cash against the transaction (
initial margin
). In the
process of marking-to-market, further deposits are required
on a daily basis from the losing party.
•
The derivatives are used by banks
to manage
their balance
sheet positions or
to hedge
for risk management purposes.
•
The bank could also use derivatives
to speculate
(i.e., to
take a position with the objective of making a profit) on
anticipated price movements.
•
There is
no default risk
, as the exchange assumes the
defaulting party’s position and the payment obligations.
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•
Financial forwards
are contracts to exchange a real or
financial asset on a pre-arranged date in the future for a
specified price.
•
Options contracts
give holders the right but not the obligation
to buy (a call option) or sell (a put option) an underlying
security at a specified price (the exercise or strike price).
•
They are non-standard, are traded over-the-counter by two
partners such as two banks.
•
The purchase price of an option is called its premium.
•
Options can be traded on an exchange or OTC.
•
They are highly illiquid as there is no secondary market
(cannot be resold and bought as financial futures are).
•
The exchange-traded options are default-risk free.
•
Typically, banks are buyers rather than sellers of puts and calls
because of the considerable risks involved if market prices
move against the sellers.
•
All cash flows are required to be paid at one time on
maturity.
•
There is a default risk by the counterparty.
•
Special types of options are
caps and floors
. They give the
holder a right to purchase a FRA. Collars are hybrid products,
being partly a forward contract and partly an option.
•
The examples of forwards are:
– forward rate agreement (FRA)
– currency forwards
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•
Swaps
are agreements between two parties to exchange two
different forms of payment obligations. These are exchanges
of cash flows used to manage their asset-liability structure
or to reduce their cost of borrowing.
•
Loan commitments
are promises to lend up to a pre-specified
amount to a pre-specified customer at pre-specified terms. The
types of loan commitments are: revolving lines of credit, unused
overdraft facility, note issuance facilities.
•
Financial guarantees
are used to enhance the credit standing of
a borrower when a bank underwrites the obligations of this
party. Examples are: commercial letters of credit; bankers
acceptances; standby letters of credit.
•In
securities underwriting
a bank agrees to buy a set amount
of the securities that are not taken up by investors; a fee is paid
to the banks for providing the service.
•
Interest rate swaps
occur between borrowers and swap
dealers (banks). There is a fixed-to-floating or floating-to-fixed
interest rate conversion. Hence, swaps are used as a risk
management instrument to change the profile of interest rate
liabilities without disturbing the underlying borrowing.
•
Currency swaps
transfer the obligation for payment in one
currency to counterparty who undertakes an obligation for
payment in another currency. Counterparties agree to exchange
an equivalent amount of two currencies for a specified time.
Fixed-for-fixed currency swaps; fixed-for-floating currency
swaps; floating-for-floating currency swaps.
•
Other investment banking services also generate fee income not
leading to a balance sheet entry (e.g., advisory services;
origination of loans for distribution).
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3. Loans sales and the process of
securitization
What are the reasons for loan sales?
• First, similar to loan syndications, loan sales allow a bank to
diversify risks. It can originate a large loan but share its risk by
selling part of it.
• Second, by selling a loan, a bank can originate a loan but have
other investors fund the loan. This can reduce the loan’s cost
of funding because costs of capital (and possibly reserve)
requirements are avoided.
•Hence,
there are limits on loan sales
. Loans of well-known
(less-known) firms that require little (much) screening and
monitoring are easy (difficult) to sell.
•
Loan sales
have taken place for over 100 years. When the
bank is selling only part of the loan, it is called loan
participation or loan syndication. As the loan is sold or
transferred, it is removed from the bank’s balance sheet.
•
However, the risk may stay with the originating bank
depending on whether the loan is sold with or without
recourse.
•
To qualify as a true loan sale, so that the loan can be
transferred from the selling bank’s balance sheet to the
buying bank’s balance sheet, the loan must be sold
without
recourse
. This means that the loan buyer cannot seek
compensation from the seller if the loan defaults.
•
Improvements in information technology have increased
information on firms, thereby increasing loan sales.
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•
The securitization must include
credit enhancements
. The
most common are senior and subordinated ABS tranches and
cash collateral accounts.
•
Securitization
is a method of raising capital from individual
and institutional investors, by transforming financial illiquid
assets, such as mortgage loans or credit card receivables, into
marketable securities.
•
The ABS representing the
senior tranche
are first in line to
obtain their promised payments from the loan payments, while
the subordinated tranche are second and bear the bulk of the
risk of loan defaults.
•
The proceeds derived from the sale of these securities can then
be used to fund new mortgage loans or other types of loans.
•
Securitization can reduce the
duration gap
between assets and
liabilities and hence reduce interest rate risk.
•
The safer senior tranche is sold to investors (e.g., pension
funds, mutual funds). It usually receives a AAA credit rating.
•
The net effects of these benefits can be improved ROA and
ROE ratios, enhanced customer service, reduced exposure to
concentration risks, and low cost source of funds.
ABS Trust
Assets
Liabilities
•
Asset securitizations
start by a bank that originates a portfolio
of loans, e.g., auto loans, and then sells them to a specially
created trust (Special Purpose Entity or SPE). Its assets are the
auto loans, while its liabilities are ABS.
Auto Loans
Cash Collateral
Subordinated Tranches (Equity)
Senior Tranche (Debt)
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Advantages vs. disadvantages of securitization to a bank
$1 Billion
Total Auto Loans
$15,000
Auto Loan
$10,000
Auto Loan
$3,000
Auto Loan
$6,000
Auto Loan
…..
Benefits
Costs
New funding source
Public/private credit risk
Special Purpose Entity
Increased liquidity
Overcollateralization
Enhanced ability to manage
interest rate risk
Valuation and packaging
$850m
AAA-Rated
$1 Billion
Total Auto Loan
ABS
Savings on:
reserve requirements,
deposit insurance premiums,
capital adequacy requirements
$100m A-Rated
$50m NR
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•
Historically, structured products have exhibited
superior return
profiles for investors
and reduced funding costs. Volatility in
the ABS market has been a fraction of the volatility experienced
in the corporate market.
•
The most common form of asset securitization involves selling
mortgage-backed securities
(MBS): securities that are claims
on the cash flows from a portfolio of mortgages. All non-
mortgage securitizations involve
asset-backed securities
(ABS).
•
Securitization has evolved to a vital funding source with an
estimated outstanding of €6.911 trillion in the US and €1.737
trillion in Europe as of the 4th quarter of 2008.
•
Other types of structured finance (SF) instrument are:
– Collateralized Debt Obligations (CDO) for corporate debt
– Collateralized Mortgage Obligations (CMO) for MBS
– Collateralized Loan Obligations (CLO) for corporate loans
– Collateralized Fund Obligations (CFO) involving private
equity fund or hedge fund assets (similar to CDO)
•
Securitization issuance (in € billions):
Year
2010
2009
2008
2007
European
379.9
414.1
711.1
453.7
U.S.
1,276.7
1,358.9
933.6
2,147.7
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