Lecture 01 – ExQu & SolAns

Exercises & Solutions

1. Consider the following balance sheet for MMC Bancorp (in millions of dollars):

Assets Liabilities/Equity

1. Cash and due from $ 6.25 1. Equity capital (fixed) $25.00

2. Short-term consumer loans 62.50

(1-year maturity) 2. Demand deposits 50.00

3. Long-term consumer loans 31.30

(2-year maturity) 3. One-month CDs 37.50

4. Three-month T-bills 37.50 4. Three-month CDs 50.00

5. Six-month T-notes 43.70 5. Three-month bankers’

acceptances 25.00

6. 3-year T-bonds 75.00 6. Six-month commercial paper 75.00

7. 10-year, fixed-rate mortgages 25.00 7. 1-year time deposits 25.00

8. 30-year, floating-rate mortgages

(reset every nine months) 50.00 8. 2-year time deposits 50.00

9. Premises 6.25

$337.50 $337.50

a. Calculate the value of MMC’s rate-sensitive assets, rate sensitive liabilities, and repricing gap over the next
year.

Looking down the asset side of the balance sheet, we see the following one-year rate-sensitive assets (RSA):

1. Short-term consumer loans: $62.50 million, which are repriced at the end of the year and just make the
one-year cut-off.

2. Three-month T-bills: $37.50 million, which are repriced on maturity (rollover) every three months.

3. Six-month T-notes: $43.70 million, which are repriced on maturity (rollover) every six months.

4. 30-year floating-rate mortgages: $50.00 million, which are repriced (i.e., the mortgage rate is reset) every
nine months. Thus, these long-term assets are RSA in the context of the repricing model with a one-year
repricing horizon.

Summing these four items produces one-year RSA of $193.70 million. The remaining $143.80 million is not rate
sensitive over the one-year repricing horizon. A change in the level of interest rates will not affect the interest
revenue generated by these assets over the next year. The $6.25 million in the cash and due from category
and the $6.25 million in premises are nonearning assets. Although the $131.30 million in long-term consumer
loans, 3-year Treasury bonds, and 10-year, fixed-rate mortgages generate interest revenue, the level of
revenue generated will not change over the next year since the interest rates on these assets are not expected
to change (i.e., they are fixed over the next year).
Looking down the liability side of the balance sheet, we see that the following liability items clearly fit the one-
year rate or repricing sensitivity test:

1. One-month CDs: $37.50 million, which mature in one months and are repriced on rollover.

2. Three-month CDs: $50 million, which mature in three months and are repriced on rollover.

3. Three-month bankers’ acceptances: $25 million, which mature in three months and are repriced on
rollover.

4. Six-month commercial paper: $75 million, which mature and are repriced every six months.

5. 1-year time deposits: $25 million, which are repriced at the end of the one-year gap horizon.

Summing these five items produces one-year rate-sensitive liabilities (RSL) of $212.5 million. The remaining
$125 million is not rate sensitive over the one-year period. The $25 million in equity capital and $50 million in
demand deposits do not pay interest and are therefore classified as non-paying. The $50 million in two-year
time deposits generate interest expense over the next year, but the level of the interest generated will not
change if the general level of interest rates change. Thus, we classify these items as fixed-rate liabilities.

The five repriced liabilities ($37.50 + $50 + $25 + $75 + $25) sum to $212.5 million, and the four repriced assets
of $62.50 + $37.50 + $43.70 + $50 sum to $193.70 million. Given this, the cumulative one-year repricing gap
(CGAP) for the bank is:

CGAP = (One-year RSA) - (One-year RSL) = RSA - RSL = $193.70 million - $212.5 million =

-$18.80 million

b. Calculate the expected change in the net interest income for the bank if interest rates rise by 1 percent on
both RSAs and RSLs. If interest rates fall by 1 percent on both RSAs and RSLs.

The CGAP would project the expected annual change in net interest income (NII) of the bank is:

NII = CGAP x R

= (-$18.80 million) x 0.01

= -$188,000

Similarly, if interest rates fall equally for RSAs and RSLs, NII will fall by:

= (-$18.80 million) x (-0.01)

= $188,000

c. Calculate the expected change in the net interest income for the bank if interest rates rise by 1.2 percent on
RSAs and by 1 percent on RSLs. If interest rates fall by 1.2 percent on RSAs and by 1 percent on RSLs.

The resulting change in NII is calculated as:

NII = [RSA x )RRSA] - [RSL x RRSL]

= [$193.70 million x 1.2%] - [$212.5 million x 1.0%]

= $2.3244 million - $2.125 million

= $199,400
2. The balance sheet of A. G. Fredwards, a government security dealer, is listed below. Market yields are in
parentheses and amounts are in millions.

Assets Liabilities and Equity

Cash $20 Overnight repos $340

1-month T-bills (7.05%) 150 Subordinated debt

3-month T-bills (7.25%) 150 7-year fixed rate (8.55%) 300

2-year T-notes (7.50%) 100

8-year T-notes (8.96%) 200

5-year munis (floating rate)

(8.20% reset every 6 months) 50 Equity 30

Total assets $670 Total liabilities and equity $670

a. What is the repricing gap if the planning period is 30 days? 3 months? 2 years?

Repricing gap using a 30-day planning period = $150m - $340m = -$190 million.
Repricing gap using a 3-month planning period = ($150m + $150m) - $340m = -$40 million.
Repricing gap using a 2-year planning period = ($150m + $150m + $100m + $50m) - $340m = $110 million.

b. What is the impact over the next three months on net interest income if interest rates on RSAs increase 50
basis points and on RSLs increase 60 basis points?

II = ($150m. + $150m.)(0.005) = $1.5m.

IE = $340m.(0.006) = $2.04m.

NII = $1.5m. – ($2.04m.) = -$0.54m.

c. What is the impact over the next two years on net interest income if interest rates on RSAs increase 50 basis
points and on RSLs increase 60 basis points?

II = ($150m. + $150m. + $100m. + $50m.)(0.005) = $2.25m.

IE = $340m.(0.0060) = $2.04m.

NII = $2.25m. – ($2.04m.) = $0.21m.

d. Explain the difference in your answers to parts (b) and (c). Why is one answer a negative change in NII, while
the other is positive?

For the 3-month analysis, the CGAP affect worked to decrease net interest income. That is, the CGAP was
negative while interest rates increased. Thus, interest income increased by less than interest expense. The
result is a decrease in NII. For the 2-year analysis, the CGAP affect worked to increase net interest income.
That is, the CGAP was positive while interest rates increased. Thus, interest income increased by more than
interest expense. The result is an increase in NII.
3. Use the following information about a hypothetical government security dealer named M. P. Jorgan. Market
yields are in parenthesis, and amounts are in millions.

Assets Liabilities and Equity

Cash $10 Overnight repos $170

1-month T-bills (7.05%) 75 Subordinated debt

3-month T-bills (7.25%) 75 7-year fixed rate (8.55%) 150

2-year business loans (7.50%) 50

8-year mortgage loans (8.96%) 100

5-year munis (floating rate)

(8.20% reset every 6 months) 25 Equity 15

Total assets $335 Total liabilities & equity $335

a. What is the repricing gap if the planning period is 30 days? 3 months? 2 years? Recall that cash is a non-
interest-earning asset.

Repricing gap using a 30-day planning period = $75m - $170m = -$95 million.
Repricing gap using a 3-month planning period = ($75m + $75m) - $170m = -$20 million.
Reprising gap using a 2-year planning period = ($75m + $75m + $50m + $25m) - $170m = +$55 million.

b. What is the impact over the next 30 days on net interest income if interest rates increase 50 basis points?
Decrease 75 basis points?

If interest rates increase 50 basis points, net interest income will decrease by $475,000.

NII = CGAP(R) = -$95m(0.005) = -$0.475m.

If interest rates decrease by 75 basis points, net interest income will increase by $712,500.

NII = CGAP(R) = -$95m(-0.0075) = $0.7125m.

c. The following one-year runoffs are expected: $10 million for two-year business loans and $20 million for
eight-year mortgage loans. What is the one-year repricing gap?

The repricing gap over the 1-year planning period =

= ($75m. + $75m. + $10m. + $20m. + $25m.) - $170m. = +$35 million.

d. If runoffs are considered, what is the effect on net interest income at year-end if interest rates increase 50
basis points? Decrease 75 basis points?

If interest rates increase 50 basis points, net interest income will increase by $175,000.

NII = CGAP(R) = $35m(0.005) = $0.175m.

If interest rates decrease 75 basis points, net interest income will decrease by $262,500.

NII = CGAP(R) = $35m(-0.0075) = -$0.2625m.

Questions & “Answers”

(please, keep in mind that the “answers” whenever provided are indicative and definitely not exhaustive!)

1. Discuss how do monetary policy decisions by central banks impact interest rates how has the increased level
of financial market integration affected interest rates? (chapter 8 pp.208-211)

Through its daily open market operations, such as buying and selling bonds and bills, a central bank seeks to
influence the money supply, inflation, and the level of interest rates. When the central bank finds it necessary
to slow down the economy, it tightens monetary policy by raising interest rates. The normal result is a
decrease in business and household spending (especially that financed by credit or borrowing). Conversely, if
business and household spending decline to the extent that the central bank finds it necessary to stimulate the
economy it allows interest rates to fall (an expansionary monetary policy). Such a drop in interest rates
promote borrowing and spending.

Increased financial market integration, or globalization, increases the speed with which interest rate changes
and volatility are transmitted among countries. The result of this quickening of global economic adjustment is
to increase the difficulty and uncertainty faced by a central bank as it attempts to manage economic activity
within the economy responsible for. Further, because FIs have become increasingly more global in their
activities, any change in interest rate levels or volatility caused by a central bank’s actions more quickly creates
additional interest rate risk issues for these companies.
2. What is the repricing gap, what is meant by rate sensitivity and on what financial performance variable does
the repricing model focus? Explain why is the length of time selected for repricing assets and liabilities
important when using the repricing model. Explain also what is the CGAP effect and if as a bank manager you
were quite certain that interest rates were going to rise/fall within the next six months, how would you adjust
the bank’s six-month repricing gap to take advantage of this anticipated rise/fall?

The repricing gap is a measure of the difference between the dollar value of assets that will reprice and the
dollar value of liabilities that will reprice within a specific time period, where repricing can be the result of a
rollover of an asset or liability (e.g., a loan is paid off at or prior to maturity and the funds are used to issue a
new loan at current market rates) or because the asset or liability is a variable rate instrument (e.g., a variable
rate mortgage whose interest rate is reset every quarter based on movements in a prime rate). Rate sensitivity
represents the time interval where repricing can occur. The model focuses on the potential changes in the net
interest income variable. In effect, if interest rates change, interest income and interest expense will change as
the various assets and liabilities are repriced, that is, receive new interest rates.

The length of the repricing period determines which of the securities in a portfolio are rate-sensitive. The
longer the repricing period, the more securities either mature or will be repriced, and, therefore, the more the
interest rate risk exposure. An excessively short repricing period omits consideration of the interest rate risk
exposure of assets and liabilities are that repriced in the period immediately following the end of the repricing
period. That is, it understates the rate sensitivity of the balance sheet. An excessively long repricing period
includes many securities that are repriced at different times within the repricing period, thereby overstating
the rate sensitivity of the balance sheet.

The CGAP effect describes the relation between changes in interest rates and changes in net interest income.
According to the CGAP effect, when CGAP is positive the change in NII is positively related to the change in
interest rates. Thus, an FI would want its CGAP to be positive when interest rates are expected to rise.
According to the CGAP effect, when CGAP is negative the change in NII is negatively related to the change in
interest rates. Thus, an FI would want its CGAP to be negative when interest rates are expected to fall.

When interest rates are expected to rise, a bank should set its repricing gap to a positive position. In this case,
as rates rise, interest income will rise by more than interest expense. The result is an increase in net interest
income. When interest rates are expected to fall, a bank should set its repricing gap to a negative position. In
this case, as rates fall, interest income will fall by less than interest expense. The result is an increase in net
interest income.
3. What are some of the weaknesses of the repricing model? How have large banks solved the problem of
choosing the optimal time period for repricing? What is runoff cash flow, and how does this amount affect the
repricing model’s analysis? (chapter 8 pp.221-223)

The repricing model has four general weaknesses:

(1) It ignores market value effects.

(2) It ignores information regarding the distribution of assets and liabilities within time buckets. Thus, if
assets, on average, are repriced earlier in the bucket than liabilities, and if interest rates fall, FIs are
subject to reinvestment risks.

(3) It ignores the problem of runoffs. That is, that some assets are prepaid and some liabilities are
withdrawn before the maturity date.

(4) It ignores income generated from off-balance-sheet activities.

Large banks are able to reprice securities every day using their own internal models so reinvestment and
repricing risks can be estimated for each day of the year.

Runoff cash flow reflects the assets that are repaid before maturity and the liabilities that are withdrawn
unexpectedly. To the extent that either of these amounts is significantly greater than expected, the estimated
interest rate sensitivity of the FI will be in error.
Lecture 02 – ExQu & SolAns

Exercises & Solutions

1. Two bonds are available for purchase in the financial markets. The first bond is a two-year,
$1,000 bond that pays an annual coupon of 10 percent. The second bond is a two-year,
$1,000, zero-coupon bond.

a. What is the duration of the coupon bond if the current yield to maturity (R) is 8
percent? 10 percent? 12 percent? (Hint: You may wish to create a spreadsheet program to assist
in the calculations.)

Coupon Bond: Par value = $1,000 Coupon rate = 10% Annual payments
R = 8% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t

1 $100 0.9259 $92.59 $92.59
2 1,100 0.8573 943.07 1,886.15
$1,035.67 $1,978.74
Duration = $1,978.74/$1,035.67 = 1.9106

R = 10% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
1 $100 0.9091 $90.91 $90.91
2 1,100 0.8264 909.09 1,818.18
$1,000.00 $1,909.09
Duration = $1,909.09/$1,000.00 = 1.9091

R = 12% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
1 $100 0.8929 $89.29 $89.23
2 1,100 0.7972 876.91 1,753.83
$966.20 $1,843.11
Duration = $1,843.11/$966.20 = 1.9076

b. How does the change in the yield to maturity affect the duration of this coupon bond?
Increasing the yield to maturity decreases the duration of the bond.

c. Calculate the duration of the zero-coupon bond with a yield to maturity of 8

percent, 10 percent, and 12 percent.

Zero Coupon Bond: Par value = $1,000 Coupon rate = 0%

R = 8% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
2 $1,000 0.8573 $857.34 $1,714.68
$857.34 $1,714.68
Duration = $1,714.68/$857.34 = 2.0000

R = 10% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
2 $1,000 0.8264 $826.45 $1,652.89
$826.45 $1,652.89
Duration = $1,652.89/$826.45 = 2.0000

R = 12% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
2 $1,000 0.7972 $797.19 $1,594.39
$797.19 $1,594.39
Duration = $1,594.39/$797.19 = 2.0000

d. How does the change in the yield to maturity affect the duration of the zero-coupon bond?

Changing the yield to maturity does not affect the duration of the zero coupon bond.

e. Why does the change in the yield to maturity affect the coupon bond differently than it
affects the zero-coupon bond?

Increasing the yield to maturity on the coupon bond allows for higher reinvestment income that
more quickly recovers the initial investment. The zero-coupon bond, on the other hand, has no cash
flow (and therefore no reinvestment of income) until maturity.
2. Financial Institution XY has assets of $1 million invested in a 30-year, 10 percent semiannual
coupon Treasury bond selling at par. The duration of this bond has been estimated at 9.94
years. The assets are financed with equity and a $900,000, two-year, 7.25 percent semiannual
coupon capital note selling at par.

a. What is the leverage adjusted duration gap of Financial Institution XY?

The duration of the capital note is 1.8975 years.

Two-year Capital Note (values in thousands of $s)

Par value = $900 Coupon rate = 7.25% Semiannual payments
R = 7.25% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
0.5 32.625 0.9650 31.48 15.74
1 32.625 0.9313 30.38 30.38
1.5 32.625 0.8987 29.32 43.98
2 932.625 0.8672 808.81 1,617.63
900.00 1,707.73
Duration = $1,707.73/$900.00 = 1.8975

The leverage-adjusted duration gap can be found as follows:

Leverage − adjusted duration gap = D A − D L k = 9.94 −1.8975

$900,000
= 8.23 225years
$1,000,000

b. What is the impact on equity value if the relative change in all market interest rates is a
decrease of 20 basis points? Note: The relative change in interest rates is R/(1+R/2) =
-0.0020.

The change in net worth using leverage adjusted duration gap is given by:

E = − D A − D L k  * A *
R
R

= − 9.94 − (1.8975) 9
10

(1,000,000)( −0.0020) = $16,464
1+
2
c. Using the information calculated in parts (a) and (b), what can be said about the
desired duration gap for the financial institution if interest rates are expected to increase or
decrease.

If the FI wishes to be immune from the effects of interest rate risk (either positive or negative
changes in interest rates), a desirable leverage-adjusted duration gap (DGAP) is zero. If the FI is
confident that interest rates will fall, a positive DGAP will provide the greatest benefit. If the FI is
confident that rates will increase, then negative DGAP would be beneficial.

d. Verify your answer to part (c) by calculating the change in the market value of equity
assuming that the relative change in all market interest rates is an increase of 30 basis
points.
 R
E = − D A − D L k * A * = − 8.23225(1,000,000)(0.003) = − $24,697
R
1+
2
e. What would the duration of the assets need to be to immunize the equity from changes in
market interest rates?

Immunizing the equity from changes in interest rates requires that the DGAP be 0. Thus, (DA-DLk) = 0
 DA = DLk, or DA = 1.8975x0.9 = 1.70775 years.
3. A financial institution has an investment horizon of two years 9.33 months (or 2.777 years).
The institution has converted all assets into a portfolio of 8 percent, $1,000, three-year bonds that
are trading at a yield to maturity of 10 percent. The bonds pay interest annually. The portfolio
manager believes that the assets are immunized against interest rate changes.

a. Is the portfolio immunized at the time of bond purchase? What is the duration of
the bonds?

Three-year Bonds
Par value = $1,000 Coupon rate = 8% Annual payments
R = 10% Maturity = 3 years
t CFt DFt CFt x DFt CFt x DFt x t
1 80 0.9091 72.73 72.73
2 80 0.8264 66.12 132.23
3 1,080 0.7513 811.42 2,434.26
950.26 2,639.22
Duration = $2,639.22/$950.26 = 2.777

The bonds have a duration of 2.777 years, which is 33.33 months. For practical purposes, the bond
investment horizon is immunized at the time of purchase.

b. Will the portfolio be immunized one year later?

After one year, the investment horizon will be 1 year, 9.33 months (or 1.777 years). At this time, the
bonds will have a duration of 1.9247 years, or 1 year, 11+ months. Thus, the bonds will no longer be
immunized.

Two-year Bonds
Par value = $1,000 Coupon rate = 8% Annual payments
R = 10% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
1 $80 0.9091 72.73 72.73
2 $1,080 0.8264 892.56 1,785.12
965.29 1,857.85
Duration = $1,857.85/$965.29 = 1.9247
 c. Assume that one-year, 8 percent zero-coupon bonds are available in one year. What
proportion of the original portfolio should be placed in these bonds to rebalance the portfolio?

The investment horizon is 1 year, 9.33 months, or 21.33 months. Thus, the proportion of bonds that
should be replaced with the zero-coupon bonds can be determined by the following analysis:

21.33 months = wzero x 12 months + (1 – wzero)x1.9247x12 months  wzero = 15.92 percent

Thus, 15.92 percent of the bond portfolio should be replaced with the zero-coupon bonds after one
year.
Questions & “Answers”

(please, keep in mind that the “answers” whenever provided are indicative and definitely not
exhaustive!)

1. State and discuss the Features of Duration with the help of a coupon bond example (chapter 9
pp.247-249)

2. State and discuss the Economic meaning of Duration with the help of a coupon bond example
(chapter 9 pp.249-253)

3. Briefly identify three criticisms of using the duration gap model to immunize the portfolio of a
financial institution. Explain what is convexity, why it is a desirable feature to capture in a portfolio
of assets and discuss why it is critical for an FI manager who has a portfolio immunized to match a
desired investment horizon to rebalance the portfolio periodically. (chapter 9 pp.265-269)

The three criticisms are:

a Immunization is a dynamic problem because duration changes over time. Thus, it is

necessary to rebalance the portfolio as the duration of the assets and liabilities change
over time.
b Duration matching can be costly because it is not easy to restructure the balance sheet
periodically, especially for large FIs.

c Duration is not an appropriate tool for immunizing portfolios when the expected interest
rate changes are large because of the existence of convexity. Convexity exists because the
relationship between security price changes and interest rate changes is not linear, which
is assumed in the estimation of duration. Using convexity to immunize a portfolio will
reduce the problem.

Convexity is a property of fixed-rate assets that reflects nonlinearity in the reflection of price-yield
relationships. This characteristic is similar to buying insurance to cover part of the interest rate risk
faced by the FI. The more convexity in the price-yield relationship for a given asset, the more
insurance against interest rate changes is purchased.

Assets approach maturity at different rates of speed than the duration of the same assets
approaches zero. Thus, after a period of time, a portfolio of assets that was immunized against
interest rate risk will no longer be immunized. In fact, portfolio duration will exceed the remaining
time in the investment or target horizon, and changes in interest rates could prove costly to the
institution.

The growth of purchased funds markets, asset securitization, and loan sales markets have
considerably increased the speed of major balance sheet restructurings. Further, as these markets
have developed, the cost of the necessary transactions has also decreased. Finally, the growth and
development of the derivative securities markets provides significant alternatives to managing the
risk of interest rate movements only with on-balance-sheet adjustments.
Lecture 03 - ExQu & SolAns

Exercises & Solutions

1

a.
Why is credit risk analysis an important component of FI risk management? What recent activities by
FIs have made the task of credit risk assessment more difficult for both FI managers and regulators?

Credit risk management is important for FI managers because it determines several features of a
loan: interest rate, maturity, collateral and other covenants. Riskier projects require more analysis
before loans are approved. If credit risk analysis is inadequate, default rates could be higher and
push a bank into insolvency, especially if markets are competitive and margins are low.

Credit risk does not apply only to traditional areas of lending and bond investing. As banks and other
FIs have expanded into credit guarantees and other off-balance-sheet activities, new types of credit
risk exposure have arisen, causing concern among managers and regulators. Credit quality problems,
in the worst case, can cause an FI to become insolvent or can result in such a significant drain on
capital and net worth that they adversely affect its growth prospects and ability to compete with
other domestic and international FIs.

b.
Differentiate between a secured and an unsecured loan. Who bears most of the risk in a fixed-rate
loan? Why would FI managers prefer to charge floating rates, especially for longer-maturity loans?

A secured loan is backed by some of the collateral that is pledged to the lender in the event of
default. A lender has rights to the collateral, which can be liquidated to pay all or part of the loan.
Secured debt is senior to an unsecured loan (or junior debt) that has only a general claim on the
assets of the borrower if default occurs. With a fixed-rate loan, the lender bears the risk of interest
rate changes. If interest rates rise, the opportunity cost of lending is higher, while if interest rates fall
the lender benefits. Since it is harder to predict longer-term rates, FIs prefer to charge floating rates
for longer-term loans and pass the interest rate risk on to the borrower. With floating rate loans, the
loan rate can be periodically adjusted according to a formula so that the interest rate risk is
transferred in large part from the FI to the borrower.

c.

How does a spot loan differ from a loan commitment? What are the advantages and disadvantages
of borrowing through a loan commitment?

A spot loan involves the immediate takedown of the loan amount by the borrower, while a loan
commitment allows a borrower the option to take down the loan any time during a fixed period at a
predetermined rate. This can be advantageous during periods of rising rates in that the borrower
can borrow as needed at a predetermined rate. If rates decline, the borrower can borrow from other
sources. The disadvantage is the cost: often an up-front fee is required in addition to a back-end fee
for the unused portion of the commitment.
2

a.

Why are most retail borrowers charged the same rate of interest, implying the same risk premium or
class? What is credit rationing? How is it used to control credit risks with respect to retail and
wholesale loans?

Most retail loans are small in size relative to the overall investment portfolio of an FI and the cost of
collecting information on household borrowers is high. As a result, most retail borrowers are
charged the same rate of interest that implies the same level of risk.

Credit rationing involves restricting the amount of loans that are available to individual borrowers.
On the retail side, the amount of loans provided to borrowers may be determined solely by the
proportion of loans desired in this category rather than price or interest rate differences, thus the
actual credit quality of the individual borrowers. On the wholesale side, the FI may use both credit
quantity and interest rates to control credit risk. Typically, more risky borrowers are charged a
higher risk premium to control credit risk. However, the expected returns from increasingly higher
interest rates that reflect higher credit risk at some point will be offset by higher default rates. Thus,
rationing credit through quantity limits will occur at some interest rate level even though positive
loan demand exists at even higher risk premiums.

b.

Why could a lender’s expected return be lower when the risk premium is increased on a loan? In
addition to the risk premium, how can a lender increase the expected return on a wholesale loan?

An increase in risk premiums indicates a riskier pool of clients who are more likely to default by
taking on riskier projects. This reduces the repayment probability and lowers the expected return to
the lender. The lender often is able to charge fees that increase the return on the loan. However, the
fees may become sufficiently high as to increase the risk of nonpayment or default on the loan.

c.

What are covenants in a loan agreement? What are the objectives of covenants?

Covenants are restrictions that are written into loan or bond contracts that affect the actions of the
borrower. Covenants can include limits on the type and amount of new debt, investments, and asset
sales the borrower may undertake while the loan or bonds are outstanding. Financial covenants are
also often imposed restricting changes in the borrower’s financial ratios such as its leverage ratio or
current ratio. For example, a common restrictive covenant included in many bond and loan contracts
limits the amount of dividends a firm can pay to its equity holders. Clearly, for any given cash flow, a
high dividend payout to stockholders means that less is available for repayments to bondholders and
lenders. Moreover, bond yields, like wholesale loan rates, usually reflect risk premiums that vary
with the perceived credit quality of the borrower and the collateral or security backing of the debt.
Given this, FIs can use many of the following models that analyze default risk probabilities either in
making lending decisions or when considering investing in corporate bonds offered either publicly or
privately.
3.

a.

What is RAROC? How does this model use the concept of duration to measure the risk exposure of a
loan? How is the expected change in the credit risk premium measured? What precisely is LN in the
RAROC equation?

RAROC is a measure of expected loan net income in the form of interest plus fees less cost of
funding relative to some measure of asset risk. One version of the RAROC model uses the duration
model to measure the change in the value of the loan for given changes or shocks in credit quality.
While the loan’s duration and the loan amount are easily estimated, it is more difficult to estimate
the maximum change in the credit risk premium on the loan over the next year. Since publicly
available data on loan risk premiums are scarce, we turn to publicly available corporate bond market
data to estimate premiums. First, an S&P credit rating (AAA, AA, A, and so on) is assigned to a
borrower. Thereafter, the available risk premium changes of all the bonds traded in that particular
rating class over the last year are analyzed. The change in credit quality (R) is measured by finding
the change in the spread in yields between Treasury bonds and corporate bonds of the same risk
class on the loan. The actual value chosen is the highest change in yield spread for the same maturity
or duration value assets. In this case, LN represents the change in loan value or the change in
capital for the largest reasonable adverse changes in yield spreads. The actual equation for LN
looks very similar to the duration equation.

Net Income R
RAROC = where LN = − DLN x LN x where R is the change in yield spread .
Loan risk (or LN ) 1+ R

b.

An FI wants to evaluate the credit risk of a $5 million loan with a duration of 4.3 years to a AAA
borrower. There are currently 500 publicly traded bonds in that class (i.e., bonds issued by firms with
a AAA rating). The current average level of rates (R) on AAA bonds is 8 percent. The largest increase
in credit risk premiums on AAA loans, the 99 percent worst-case scenario, over the last year was
equal to 1.2 percent (i.e., only 6 bonds out of 500 had risk premium increases exceeding the 99
percent worst case). The projected (one-year) spread on the loan is 0.3 percent and the FI charges
0.25 percent of the face value of the loan in fees. Calculate the capital at risk and the RAROC on this
loan.

The estimate of loan (or capital) risk is:

ΔLN = -DLN x LN x (ΔR/(1 + R)) = -4.3 x $5m x (0.012/(1 + 0.08)) = $238,889

While the market value of the loan amount is $5 million, the risk amount, or change in the loan’s
market value due to a decline in its credit quality, is $238,889. Thus, the denominator of the RAROC
equation is this possible loss, or $238,889. To determine whether the loan is worth making, the
estimated loan risk is compared with the loan’s income (spread over the FI’s cost of funds plus fees
on the loan).

Spread = 0.003 x $5 million = $15,000

Fees = 0.0025 x $5 million = $12,500

$27,500

The loan’s RAROC is:

RAROC = $27,500/238,889 = 11.51%

Exercises

1. Assume a one-year Treasury strip is currently yielding 5.5 percent and an AAA-rated discount
bond with similar maturity is yielding 8.5 percent.

a. If the expected recovery from collateral in the event of default is 50 percent of principal
and interest, what is the probability of repayment of the AAA-rated bond? What is the
probability of default?

p(1 + k) +  (1 - p)(1 + k) = 1 + i. Solving for the probability of repayment (p):

1+ i
−  1.055 − 0.5
1+ k
p= = 1.085 = 0.9447 or 94 .47 percent
1−  1 − 0.5

Therefore the probability of default is 1.0 - 0.9447 = 0.0553 or 5.53 percent.

b. What is the probability of repayment of the AAA-rated bond if the expected recovery from
collateral in the case of default is 94.47 percent of principal and interest? What is the
probability of default?
1+ i
−  1.055 − 0.9447
1+ k
p= = 1.085 = 0.5000 or 50 .00 percent
1−  1 − 0.9447

Therefore the probability of default is 1.0 – 0.5000 = 0.5000 or 50.00 percent.

c. What is the relationship between the probability of default and the proportion of principal
and interest that may be recovered in case of default on the loan?

The proportion of the loan’s principal and interest that is collectible on default is a perfect substitute
for the probability of repayment should such defaults occur.
2. A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge
a servicing fee of 50 basis points. The loan has a maturity of 8 years with a duration of 7.5 years. The
cost of funds (the RAROC benchmark) for the bank is 10 percent. The bank has estimated the
maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2
percent, based on two years of historical data. The current market interest rate for loans in this
sector is 12 percent.

a. Using the RAROC model, determine whether the bank should make the loan?

RAROC = Fees and interest earned on loan/Loan or capital risk

Loan risk, or LN = -DLN x LN x (R/(1 + R)) = -7.5 x $5m x (0.042/1.12) = -$1,406,250

Expected interest = 0.12 x $5,000,000 = $600,000

Servicing fees = 0.0050 x $5,000,000 = $25,000

Less cost of funds = 0.10 x $5,000,000 = -$500,000

Net interest and fee income = $125,000

RAROC = $125,000/1,406,250 = 8.89 percent. Since RAROC is lower than the cost of funds to the
bank, the bank should not make the loan.

b. What should be the duration in order for this loan to be approved?

For RAROC to be 10 percent, loan risk should be:

$125,000/LN = 0.10  LN = 125,000 / 0.10 = $1,250,000

 -DLN x LN x (R/(1 + R)) = 1,250,000

DLN = 1,250,000/(5,000,000 x (0.042/1.12)) = 6.67 years.

Thus, this loan can be made if the duration is reduced to 6.67 years from 7.5 years.

c. Assuming that duration cannot be changed, how much additional interest and fee income
will be necessary to make the loan acceptable?
Necessary RAROC = Income/Risk  Income = RAROC x Risk

= $1,406,250 x 0.10 = $140,625

Therefore, additional income = $140,625 - $125,000 = $15,625, or

$15,625/$5,000,000 = 0.003125 = 0.3125%.

Thus, this loan can be made if fees are increased from 50 basis points to 81.25 basis points.

d. Given the proposed income stream and the negotiated duration, what adjustment in the
loan rate would be necessary to make the loan acceptable?

Need an additional $15,625 => $15,625/$5,000,000 = 0.003125 or 0.3125%

Expected interest = 0.123125 x $5,000,000 = $615,625

Servicing fees = 0.0050 x $5,000,000 = $25,000

Less cost of funds = 0.10 x $5,000,000 = -$500,000

Net interest and fee income = $140,625

RAROC = $140,625/1,406,250 = 10.00 percent = cost of funds to the bank. Thus, increasing the loan
rate from 12% to 12.3125% will make the loan acceptable
3. Consider the following company balance sheet and income statement.

Balance Sheet:
Assets Liabilities and Equity
Cash $4,000 Accounts payable $30,000
Accounts receivable 52,000 Notes payable 12,000
Inventory 40,000 Total current liabilities 42,000
Total current assets 96,000 Long-term debt 36,000
Fixed assets 44,000 Equity 62,000
Total assets $140,000 Total liabilities and equity $140,000

Income Statement
Sales (all on credit) $200,000
Cost of goods sold 130,000
Gross margin 70,000
Selling and administrative expenses 20,000
Depreciation 8,000
EBIT 42,000
Interest expense 4,800
Earning before tax 37,200
Taxes 11,160
Net income $26,040

For this company, calculate the following:

a. Current ratio.

96,000/42,000 = 2.2857X

b. Number of days' sales in receivables.

52,000 x 365/200,000 = 94.90 days

c. Sales to total assets.

200,000/140,000 = 1.4286X

d. Number of days in inventory.

40,000 x 365/130,000 = 112.31 days

e. Debt to assets ratio.

(42,000 + 36,000)/140,000 = .5571 = 55.71%

f. Cash flow to debt ratio.

(42,000 + 8,000)/(42,000 + 36,000) = .6410 = 64.10%

g. Return on assets.

26,040/140,000 = 0.1860 = 18.60%

h. Return on equity.

26,040/62,000 = 0.4200 = 42.00%

Lecture 04 - ExQu & SolAns

Questions & Answers

1.

a. How do loan portfolio risks differ from individual loan risks?

Loan portfolio risks refer to the risks of a portfolio of loans as opposed to the risks of a single
loan. Inherent in the distinction is the elimination of some of the borrower-specific risks of
individual loans because of benefits from diversification.

b. What is migration analysis? How do FIs use it to measure credit risk concentration? What are its
shortcomings?

Migration analysis uses information from the market to determine the credit risk of an
individual loan or sectoral loans. With this method, FI managers track credit ratings, such as
S&P and Moody’s ratings, of firms in particular sectors or ratings classes for unusual declines
to determine whether firms in a particular sector are experiencing repayment problems. This
information can be used to either curtail lending in that sector or to reduce maturity and/or
increase interest rates. A problem with migration analysis is that the information may be too
late, because ratings agencies usually downgrade issues only after the firm or industry has
experienced a downturn.

c. What does loan concentration risk mean?

Loan concentration risk refers to the extra risk borne by having too many loans concentrated
with one firm, industry, or economic sector. To the extent that a portfolio of loans represents
loans made to a diverse cross section of the economy, concentration risk is minimized.

d. A manager decides not to lend to any firm in sectors that generate losses in excess of 5 percent of
capital.

i. If the average historical losses in the automobile sector total 8 percent, what is the
maximum loan a manager can lend to firms in this sector as a percentage of total capital?
Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate) = 0.05 x 1/0.08
= 62.5 percent of capital is the maximum amount that can be lent to firms in the
automobile sector.

ii. If the average historical losses in the mining sector total 15 percent, what is the maximum
loan a manager can lend to firms in this sector as a percentage of total capital?

Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate) = 0.05 x 1/0.15
= 33.3 percent of capital is the maximum amount that can be lent to firms in the mining
sector.
2.

a. An FI has set a maximum loss of 2 percent of total capital as a basis for setting concentration
limits on loans to individual firms. If it has set a concentration limit of 25 percent to a firm,
what is the expected loss rate for that firm?

Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate)

25 percent = 2 percent x 1/Loss rate => Loss rate = 0.02/0.25 = 8 percent

b. Explain how modern portfolio theory can be applied to lower the credit risk of an FI’s portfolio.

The fundamental lesson of modern portfolio theory is that, to the extent that an FI manager
holds widely traded loans and bonds as assets, or can calculate loan or bond returns, portfolio
diversification models can be used to measure and control the FI’s aggregate credit risk
exposure. By taking advantage of its size, an FI can diversify considerable amounts of credit
risk as long as the returns on different assets are imperfectly correlated with respect to their
default risk adjusted returns. By fully exploiting diversification potential with bonds or loans
whose returns are negatively correlated or that have a low positive correlations with those in
the existing portfolio, the FI manager can produce a set of efficient frontier portfolios, defined
as those portfolios that provide the maximum returns for a given level of risk or the lowest risk
for a given level of returns. By choosing portfolios on the efficient frontier, an FI manager may
be able to reduce credit risk to the fullest extent. As shown in Figure 11-2, a manager’s
selection of a particular portfolio on the efficient frontier is determined by the risk-return
trade-off.

c. Suppose that an FI holds two loans with the following characteristics:

Loan i Xi Ri σi σi2 .

1 0.55 8% 8.55% 73.1025% ρ12 = 0.24

2 0.45 10 9.15 83.7225 σ12 = 18.7758

Calculate the return and risk of the portfolio.

The return on the loan portfolio is: Rp = 0.55 (8%) + 0.45 (10%) = 8.90%

The risk of the portfolio is:

σp2 = (0.55)2 (73.1025%) + (0.45)2 (83722.5%) + 2 (0.55) (0.45) (18.7758%) = 48.36133%

or σp2 = (0.55)2 (73.1025%) + (0.45)2 (83722.5%) + 2 (0.55) (0.45) (0.24)(8.55%)(9.15%) =

48.36133% and σp = √ 48.36133% = 6.95%

Notice that the risk (or standard deviation of returns) of the portfolio, σp (6.95 percent), is less
than the risk of either individual asset (8.55 percent and 9.15 percent, respectively). The low
correlation of the returns of the two loans (0.24) results in an overall reduction of risk when
they are put together in an FI's portfolio.
3.

a. Why is it difficult for small banks and thrifts to measure credit risk using modern portfolio
theory?

The basic premise behind modern portfolio theory is the ability to diversify and reduce risk by
eliminating diversifiable risk. Small banks and thrifts may not have the ability to diversify their
asset base, especially if the local markets which they serve have a limited number of
industries. The ability to diversify is even more acute if these loans cannot be traded easily.

b. What is the minimum risk portfolio? Why is this portfolio usually not the portfolio chosen by
FIs to optimize the return-risk trade-off?

The minimum risk portfolio is the combination of assets that reduces portfolio risk as
measured by the standard deviation of returns to the lowest possible level. This portfolio
usually is not the optimal portfolio choice because the returns on this portfolio are low relative
to other alternative portfolio selections. By accepting some additional risk, portfolio managers
are able to realize a higher level of return relative to the risk of the portfolio.

c. The obvious benefit to holding a diversified portfolio of loans is to spread risk exposures so
that a single event does not result in a great loss to an FI. Are there any benefits to not being
diversified?

One benefit to not being diversified is that an FI that lends to a certain industrial or geographic
sector is likely to gain expertise about that sector. Being diversified requires that the FI
becomes familiar with many more areas of business. This may not always be possible,
particularly for small FIs.
Exercises & Solutions
1. Information concerning the allocation of loan portfolios to different market sectors is
given below.
Allocation of Loan Portfolios in Different Sectors (%) .

Sectors National Bank A Bank B

Commercial 30% 50% 10%

Consumer 40 30 40

Real Estate 30 20 50

Bank A and Bank B would like to estimate how much their portfolios deviate from the national
average.

a. Which bank is further away from the national average?

Using Xs to represent portfolio holdings:

Bank A Bank B
(X1j - X1 )2 (0.50 - 0.30)2 = 0.0400 (0.10 - 0.30)2 = 0.0400
(X2j - X2 )2 (0.30 - 0.40)2 = 0.0100 (0.40 - 0.40)2 = 0.0000

(X3j - X3 )2 (0.20 - 0.30)2 = 0.0100 (0.50 - 0.30)2 = 0.0400

n n =3 n =3


i −1
( X ij −X i ) 2  = 0.0600
i =1
 = 0.0800
i =1

 (X ij − X i )2
= i =1
A = 14.14 percent B = 16.33 percent
n
Bank B deviates from the national average more than Bank A.

b. Is a large standard deviation necessarily bad for an FI using this model?

No, a higher standard deviation is not necessarily bad for an FI because the FI could have
comparative advantages that are not required or available to a national well-diversified bank.
For example, an FI could generate high returns by serving specialized markets or product
niches that are not well diversified. Further, an FI could specialize in only one product, such as
mortgages, but be well-diversified within this product line by investing in several different
types of mortgages that are distributed both nationally and internationally. This would still
enable it to obtain portfolio diversification benefits that are similar to the national average.
2. A five-year fixed-rate loan of $100 million carries a 7 percent annual interest rate. The borrower is
rated BB. Based on hypothetical historical data, the probability distribution given below has been
determined for various ratings upgrades, downgrades, status quo, and default possibilities over the
next year. Information also is presented reflecting the forward rates of the current Treasury yield
curve and the annual credit spreads of the various maturities of BBB bonds over Treasuries.

New Loan
Probability Value plus Forward Rate Spreads at Time t
Rating Distribution Coupon $ t rt% ϕt% .

AAA 0.01% $114.82m 1 3.00% 0.72%

AA 0.31 114.60m 2 3.40 0.96

A 1.45 114.03m 3 3.75 1.16

BBB 6.05 4 4.00 1.30

BB 85.48 108.55m

B 5.60 98.43m

CCC 0.90 86.82m

Default 0.20 54.12m

a. What is the present value of the loan at the end of the one-year risk horizon for the case
where the borrower has been upgraded from BB to BBB?

$7m $7m $7m $107m

PV = $7m + + 2
+ + = $113.27 million
1.0372 (1.0436) 3
(1.0491) (1.0530) 4

b. What is the mean (expected) value of the loan at the end of year 1?

Year-end Probability Value Probability x Deviation Probability x

Rating (m of $) Value Deviation Squared

AAA 0.0001 $114.82 $0.01 6.76 0.0046

AA 0.0031 114.60 0.36 6.54 0.1325

A 0.0145 114.03 1.65 5.97 0.5162

BBB 0.0605 113.27 6.85 5.21 1.6402

BB 0.8548 108.55 92.79 0.49 0.2025

B 0.056 98.43 5.51 -9.63 5.1968

CCC 0.009 86.82 0.78 -21.24 4.0615

Default 0.002 54.12 0.11 -53.94 5.8197

1.000
 Mean = $108.06m

Variance = 17.5740

Standard Deviation = $4.19m

The solution table reveals a value of $108.06 million.

c. What is the volatility of the loan value at the end of year 1?

The volatility or standard deviation of the loan value is $4.19 million.

d. Calculate the 5 percent and 1 percent VARs for this loan assuming a normal distribution of
values.

The 5 percent VAR is 1.65 x $4.19m = $6.91m.

The 1 percent VAR is 2.33 x $4.19m = $9.76m.

e. Estimate the approximate 5 percent and 1 percent VARs using the actual distribution of
loan values and probabilities.

5% VAR = 95% of actual distribution = $108.06m - $98.43m = $9.63m

1% VAR = 99% of actual distribution = $108.06m - $86.82m = $21.24m

where: 5% VAR is approximated by 0.056 + 0.009 + 0.002 = 0.067 or 6.7 percent, and

1% VAR is approximated by 0.009 + 0.002 = 0.011 or 1.1 percent.

Using linear interpolation, the 5% VAR = $10.65 million and the 1% VAR = $19.31 million.
For the 1% VAR, $19.31m = (1 – 0.1/1.1) x $21.24m.

f. How do the capital requirements of the 1 percent VARs calculated in parts (d) and (e)
above compare with the capital requirements of the BIS and Federal Reserve System?

The Fed and BIS systems would require 8 percent of the loan value, or $8 million. The 1
percent VAR would require $19.31 million under the approximate method, and $9.76
million (2.33 x $4.19m) in capital under the normal distribution assumption. In each case,
the amounts exceed the Fed/BIS amount.
3. An FI has a loan portfolio of 10,000 loans of $10,000 each. The loans have a historical average
default rate of 4 percent and the severity of loss is 40 cents per dollar.

a. Over the next year, what are the probabilities of having default rates of 2, 3, 4, 5, and 8
percent?

e − m m n (2.71828) −4 x 4 2 0.018316x16
Pr obability of 2 defaults = = = = 0.1465 = 14.65%
n! 1x 2 2

e − m m n (2.71828) −4 x 43 0.018316x16
Pr obability of 3 defaults = = = = 0.1465 = 19.54%
n! 1x 2x3 6

n 2 3 4 5 8 .

Probability 14.65% 19.54% 19.54% 15.63% 2.98%

b. What would be the dollar loss on the portfolios with default rates of 4 and 8 percent?

Dollar loss of 4 loans defaulting = 4 x 0.40 x $10,000 = $16,000

Dollar loss of 8 loans defaulting = 8 x 0.40 x $10,000 = $32,000

c. How much capital would need to be reserved to meet the 1 percent worst-case loss
scenario? What proportion of the portfolio’s value would this capital reserve be?

The probability of 8 defaults is ~3 percent. The probability of 10 defaults is 0.00529 or

rounded up to 1 percent. The dollar loss of 10 loans defaulting is $40,000. Thus, a 1
percent chance of losing $40,000 exists.

A capital reserve should be held to meet the difference between the unexpected 1 percent
loss rate and the expected loss rate of 4 defaults. This difference is $40,000 minus $16,000
or $24,000. This amount is 0.024 percent of the total portfolio.
Lecture 06 - ch.19
Questions + Answers & Exercises + Solutions

Questions & Answers

1.

a. What are the benefits and costs to an FI of holding large amounts of liquid assets? Why are Treasury
securities considered good examples of liquid assets?

A major benefit to an FI of holding a large amount of liquid assets is that it can offset any unexpected
and large withdrawals without reverting to asset sales or emergency funding. If assets have to be sold
at short notice, FIs may not be able to obtain a fair market value. It is more prudent to anticipate
withdrawals and keep liquid assets to meet the demand. On the other hand, liquid assets provide
lower yields, so the opportunity cost for holding a large amount of liquid assets is high. FIs taking
conservative positions by holding large amounts of liquid assets will therefore have lower profits.

Treasury securities are considered good examples of liquid assets because they can be converted into
cash quickly with very little loss of value from current market levels.

b. How is an FI’s liability and liquidity risk management problem related to the maturity of its assets
relative to its liabilities?
For most FIs, the maturity of assets is greater than the maturity of liabilities. As the difference in the
average maturity between the assets and liabilities increases, liquidity risk increases. In the event that
liabilities begin to leave the FI or are not reinvested by investors at maturity, the FI may need to
liquidate some of its assets at fire-sale prices. These prices would tend to deviate further from their
market value as the maturity of the assets increase. Thus, the FI may sustain larger losses.

c. What concerns motivate regulators to require DIs to hold minimum amounts of liquid assets?
Regulators prefer DIs to hold more liquid assets because this ensures that they are able to withstand
unexpected and sudden withdrawals. In addition, regulators are able to conduct monetary policy by
influencing the money supply through liquid assets held by DIs. Finally, reserves held at the Fed by
financial institutions also are a source of funds to regulators, since they pay little interest on these
deposits. That is, a minimum required liquid asset reserve requirement is an indirect way for
governments to raise additional “taxes” from DIs. While these reserves are not official government
taxes, having DIs hold cash in the vault or cash reserves at the central bank (when there is only a small
interest rate compensation paid) requires DIs to transfer a resource to the central bank.

d. How do liquid asset reserve requirements enhance the implementation of monetary policy? How
are reserve requirements a tax on DIs?
In the case of DIs, reserve requirements on net transaction deposits allow regulators to increase or
decrease the money supply in an economy. The reserve requirement against these deposits limits the
ability of DIs to expand lending activity. Further, reserves represent a form of tax that regulators can
impose on DIs. By raising the reserve requirements, regulators cause DIs to transfer more balances
into non-earning assets. This tax effect is even larger in cases where inflation is stronger.
2.

a. Define the reserve computation period, the reserve maintenance period, and the lagged reserve
accounting system.
The reserve computation period is a two-week period beginning every other Tuesday and ending on
a Monday over which the required reserves are calculated. The actual reserve calculation is
accomplished by multiplying the average daily net transaction accounts balance over this 14-day
period times the required reserve ratio. The exact amount of this reserve calculation is not known
with certainty until the end of the computation period.
The reserve maintenance period is the 14-day period over which the average level of reserves must
equal or exceed the required reserve target.
The lagged reserve accounting system occurs when the reserve maintenance period begins after the
reserve computation period is completed. As long as these two periods do not overlap, the DI should
have little uncertainty regarding the amount of reserves necessary to follow regulatory guidelines.

b. In July of 1998 the lagged reserve accounting (LRA) system replaced a contemporaneous reserve
accounting (CRA) system as the method of reserve calculation for DIs.
i. Contrast a contemporaneous reserve accounting (CRA) system with a lagged reserve
accounting (LRA) system.

Under LRA, the DI holds reserves against the amount of deposits that had been in the DI 30 days
prior. The DI knows its required reserves on every day of the reserve maintenance period. Since
reserve requirements are stated in the form of average daily balances, the DI can adjust its reserves
over the maintenance period to exactly equal the average reserve requirement. Under CRA, the two-
week reserve maintenance period for meeting the reserve target began only two days after the start
of the computation period. Thus, CRA resulted in only a two-day window during which required
reserves were know with certainty.

ii. Under which accounting system, CRA or LRA, are DI reserves higher? Why?

Ceteris paribus, one would expect reserves to be higher under the CRA than under the LRA, because
under the LRA the DI knows its reserve requirement exactly on every day of the reserve
maintenance period. There is no need for the DI to hold excess reserves as a cushion against an
unforeseen increase in reserve requirements. DIs are able to keep their reserves to the minimum
required level. Under CRA, the DI does not know its reserve requirement until the last two days of
the reserve maintenance period. Since those are the days during which Fed fund rates are most
volatile, DIs attempt to avoid large reserve shortages late in the reserve maintenance period. They
will therefore tend to hold excess reserves early in the maintenance period that may be reduced on
the last two days of the settlement week.

iii. Under which accounting system, CRA or LRA, is DI uncertainty higher? Why?

Since information is complete during the entire settlement week under LRA, but complete under
CRA only during the last two days of the maintenance period, there is more uncertainty about
reserve requirements under the CRA than under the LRA.
3.

a. Consider the assets (in millions) of two banks, A and B. Both banks are funded by $120 million in
deposits and $20 million in equity. Which bank has a stronger liquidity position? Which bank
probably has a higher profit?

Bank A Assets Bank B Assets

Cash $10 Cash $20

Treasury securities 40 Consumer loans 30

Commercial loans 90 Commercial loans 90

Total assets $140 Total assets $140

Bank A is more liquid because it has more liquid assets than Bank B. Although it has less cash, Bank A
has $40 million in Treasury securities, which are highly liquid assets. Bank B probably earns a higher
profit because the return on consumer loans should be greater than the return on Treasury
securities. However, comparing the loan portfolios is difficult because it is impossible to evaluate the
credit risk contained in each portfolio using just the information provided.

b. What is the “weekend game”? Contrast a DI's ability and incentive to play the weekend game
under LRA as opposed to CRA.
Since Friday balances are carried over the weekend and are counted for Saturday and Sunday, they
carry more weight in the reserve computations. Thus, DIs developed a strategy to send deposits
offshore on Friday, thereby reducing their Friday closing deposit balances. When these deposits
were bought back on Monday, average daily deposit balances were reduced, thereby decreasing
reserve requirements. Although the ratio of weekends to total days in the reserve computation
period is the same under LRA as under CRA (2/7 or 4/14), there is greater flexibility for DIs to play
the weekend game under LRA. That is because the DI has complete information about reserve
requirements on each day of the maintenance period. However, because of the uncertainty under
CRA, there is greater incentive for DIs to play the weekend game under CRA than under LRA.

c. Under CRA, when is the uncertainty about the reserve requirement resolved? Discuss the
feasibility of making large reserve adjustments during this period of complete information.
Under CRA, the uncertainty regarding reserve requirements is resolved on the last two days of the
reserve maintenance period (on the last Tuesday and Wednesday of the 14 day period). However,
since these are also the days of greatest volatility in the fed funds rate, it could be very costly for the
reserve manager to make large reserve adjustments or corrections during this two-day period.
Moreover, since the fed funds market is comprised of active traders that deal daily with one
another, a large reserve imbalance would lead to abnormal fed funds transactions and would be
quickly detected and exploited (to the detriment of the original DI) by other DI traders.
Exercises & Solutions

1.

a. The average daily net transaction accounts deposit balance of a local bank during the most recent
reserve computation period is $325 million. The amount of average daily reserves at the Fed during
the reserve maintenance period is $21.2 million and the average daily vault cash corresponding to
the maintenance period is $4.3 million.

i. What is the average daily reserve balance required to be held by the bank during the
maintenance period?

Reserve requirements = (0 x $16.0m) + ($122.3m - $16.0m)(0.03) + ($325m - $122.3m) (0.10) = 0 +

$3.198m + $20.270m = $23.459 million

After subtracting the average daily balance of vault cash of $4.3 million, the bank needs to maintain
a target daily average of $19.159 million ($23.459 million - $4.3 million) during the maintenance
period.

ii. Is the bank in compliance with the reserve requirements?

Yes. The bank has average reserves of $21.2 million.

This amount exceeds the required amount by $2.041 million.

iii. What amount of reserves can be carried over to the next maintenance period either as
excess or shortfall?

A maximum of 4 percent of the gross required reserves can be carried over to the next maintenance
period.
Thus, 0.04 x $23.459 million = $0.9384 million can be carried over to the next maintenance period.
The bank has deposited $1.1026 million ($2.041m - $0.9384m) in low interest paying accounts at the
Fed that cannot be counted towards next period’s required reserves.

iv. If the local bank has an opportunity cost of 6 percent and deposits at the Fed pay 2
percent, what is the effect on the income statement from this reserve period?

A total of $1.1026 million has an opportunity cost of no earnings at the 6 percent rate.

Thus, the loss would be $1.1026m(0.060 - 0.020)(14/365) = $1,691.66.

b. City Bank has estimated that its average daily net transaction accounts balance over the recent
14-day reserve computation period was $225 million. The average daily balance with the Fed over
the 14-day maintenance period was $6.7 million, and the average daily balance of vault cash over
the two-week computation period was $6 million.

i. Under the rules effective in 2018, what is the amount of average daily reserves required to
be held during the reserve maintenance period for these net transaction accounts
balances?

Reserve requirements = (0 x $16.0m) + ($122.3m - $16.0m)(0.03) + ($225m - $122.3m) (0.10)

= 0 + $3.189m + $10.270m = $13.459 million

After subtracting the average daily balance of vault cash of $6.5 million, the bank needs to maintain
a daily average of $7.459 million ($13.459 million - $6 million) during the maintenance period.

ii. What is the average daily balance of reserves held by the bank over the maintenance
period? By what amount were the average reserves held higher or lower than the required
reserves?

The average daily balance over the maintenance period was $7.2 million.
Therefore, average reserves held were short $0.259 million.

iii. If the bank had transferred $20 million of its deposits every Friday over the two-week
computation period to one of its offshore facilities, what would be the revised average
daily reserve requirement?

For the 14-day period, the sum of its daily average is = $225m x 14 = $3,150m.
If $20 million is transferred on Friday, the total reduction is $120 million over two weekends ($20m x
3 days x 2 weekends), and the total 14-day balance is $3,030m.
The average daily deposits will be $216.429 million.
Reserve requirements = (0 x $16.0m) + ($122.3m - $16.0m)(0.03) + ($216.429m - $122.3m) (0.10) = 0
+ $3.189m + $9.413m = $12.602 million.

City Bank needs to maintain average reserves of $6.602 million ($12.602 million - $6 million) during
the maintenance period.

Since it had $7.2 million of reserves, extra reserves of $0.598m per day can be carried forward to the
next reserve maintenance period.
2.

a. A bank has an average balance of transactions accounts, July 14 to 27, of $850.55 million. The
average balance in the cash account is $19.150 million over this period. The bank is carrying forward
a deficit of $1.756 million from the last reserve period. Calculate the net reserve requirement for the
reserve maintenance period from August 13 to 26.

Calculate the minimum reserves that may be maintained and the maximum reserves that will count
toward the next reserve maintenance period, August 27 to September 9.

Average balance of transactions accounts, July 14-27 = 850.55m

16.0m at 0% $ 0

$122.3m - $16.0m at 3% 3.189m

$850.55m - $122.3m at 10% 72.825m

Gross reserve requirement 76.014m

Daily average vault cash Aug 10-23 19.150m
Net reserve requirement $56.864m
Reserve carry forward from last period

daily average amount = 1.756m 1.756m

Reserves to be maintained with Fed $58.620m target reserves

Minimum reserves to be maintained

-.04(76.014m) = -3.041m $55.579m minimum reserves

Maximum reserves to be maintained

+.04(76.014m) = +3.041m $61.661m maximum reserves

b. If over the first 12 days of the current reserve maintenance period the average daily reserves held
by the bank in exercise (2) were $56 million (or 12 x $56m = $672 m cumulative total over the 12
days), what does the bank need to hold as reserves over the last two days to (i) exactly meet the
reserve requirement, (ii) meet the minimum reserve, and (iii) meet the maximum reserve?

i. To meet the reserve requirement: Over the first 12 days the bank should have held a cumulative
reserve of $58.620m x 12 = $703.440m. The bank is running a shortfall of $703.440m - $672m =
$31.440m. Thus, the cumulative balance over the last two days, August 25 and 26, needs to be:

$58.620m + 58.620m + $31.440m = $148.680m

ii. To hit the minimum cumulative balance: Over the first 12 days the bank should have held a
cumulative reserve of $55.579m x 12 = $666.948 m. The bank is running a surplus of $666.948m -
$672m = -$5.052 m. Thus, the cumulative balance over the last two days, August 25 and 26, needs to
be:

$55.579m + $55.579m - $5.052m = $106.106m

iii. To hit the maximum cumulative balance: Over the first 12 days the bank should have held a
cumulative reserve of $61.661m x 12 = $739.932m. The bank is running a shortfall of $739.932m -
$672m = $67.932m. Thus, the cumulative balance over the last two days, August 25 and 26, needs to
be:

$61.661m + $61.661m + $67.932m = $191.254m

Or the bank must run a reserve balance between $106.106 million and $191.254 million

over the two days, August 25 and 26.

3.

a. An FI has estimated the following annual costs for its demand deposits: management cost per
account = $140, average account size = $1,500, average number of checks processed per account per
month = 75, cost of clearing a check = $0.10, fees charged to customer per check = $0.05, and
average fee charged per customer per month = $8.

i. What is the implicit interest cost of demand deposits for the FI?

Cost of clearing checks = $0.10 x 75 x 12 = $90.00

Cost of managing each account = $140.00

Per check fee per account = $0.05 x 75 x 12 = -$45.00

Fee received per account = $8 x 12 = -$96.00

Total cost per account = $89.00

The average (imputed) interest cost of demand deposits = $89.00/1,500 = 5.93 percent.

ii. If the FI has to keep an average of 8 percent of demand deposits as required reserves with
the Fed paying no interest, what is the implicit interest cost of demand deposits for the FI?

If the bank has to keep 8 percent as reserves, its use of funds is limited to 0.92 x $1,500 per account,
or $1,380. The average (imputed) interest cost = $89/$1,380 = 6.45 percent.

iii. What should be the per-check fee charged to customers to reduce the implicit interest
costs to 3 percent? Ignore the reserve requirements.

For an average imputed interest cost of 3 percent, the total cost per account = 1,500 x 0.03 = $45.
This means that the total cost per account should be decreased by $44 ($89 - $45) and the per-check
fee charged to customers should be increased to $89 ($45 + $44).
Thus, the fee per-check should be raised to $89/(75 x 12) = $0.0989 per check.

b. A NOW account requires a minimum balance of $750 for interest to be earned at an annual rate
of 4 percent. An account holder has maintained an average balance of $500 for the first six months
and $1,000 for the remaining six months. The account holder writes an average of 60 checks per
month and pays $0.02 per check, although it costs the bank $0.05 to clear a check.

i. What average return does the account holder earn on the account?

Gross interest return = Explicit interest return + Implicit interest return

Interest earned by account holder ($500 x 0.00 x 6/12) + ($1,000 x 0.04 x 6/12) = $20.00
Implicit fee earned on checks ($0.05-$0.02) x 60 x 12 = $21.60
Average deposit maintained during the year (6/12 x 500) + (6/12 x 1,000) = $750.00

Average interest earned = ($20.00 + $21.60)/750 = 5.55 percent

 ii. What is the average return if the bank lowers the minimum balance to $400?

If the minimum balance requirement is lowered to $400, the account holder earns an extra $500 x
0.04 x 6/12 = $10 in interest.
The average interest earned = $51.60/750 = 6.88 percent.

iii. What is the average return if the bank pays interest only on the amount in excess of $400?
Assume that the minimum required balance is $400.

If the bank only pays interest on balances in excess of $400, the explicit interest earned = ($100 x
0.04 x 6/12) + ($600 x 0.04 x 6/12) = $2 + $12 = $14.
The implicit fee earned on checks = $21.60, and the average interest earned = $35.60/$750 = 4.75%

iv. How much should the bank increase its check fee to the account holder to ensure that the
average interest it pays on this account is 5 percent? Assume that the minimum required
balance is $750.

Interest earned (both explicit and implicit) = $750 x 0.05 = $37.50.

Fees to be earned through check clearing = $37.50 - $20 = $17.50. Fee subsidy per check = 17.50/(60
x 12) = $0.0243.
So, the bank should charge $0.05 - $0.0243 = $0.0257 per check.
Lecture 07 - ch.20
Questions + Answers & Exercises + Solutions

Questions & Answers

1.

a. What is a contagious run? What are some of the potentially serious adverse social welfare
effects of a contagious run? Do all types of FIs face the same risk of contagious runs?

A contagious run is an unjustified panic condition in which liability holders withdraw funds from
an FI without first determining whether the institution is at risk. This action usually occurs at a
time that a similar run is occurring at a different institution that is at risk. The contagious run
may have an adverse effect on the level of savings that may affect wealth transfers, the supply
of credit, and control of the money supply. Depository institutions and insurance companies face
the most serious risk of contagious runs.

b. How does federal deposit insurance help mitigate the problem of bank runs? What other
elements of the safety net are available to DIs in the United States?

Bank runs are costly to society since they create liquidity problems and can have a contagion
effect. Because of the first-come, first-serve nature of deposit liabilities, DI depositors have
incentives to run on the DI if they are concerned about solvency. As a result of the external cost
of runs on the safety and soundness of the entire banking system, the Federal Reserve has put
into place a safety net to remove the incentives to undertake DI runs. The primary pieces of this
safety net are deposit insurance and other guaranty programs that provide assurance that funds
are safe even in cases when the FI is in financial distress. Other elements of the federal safety
net are access to the lender of last resort (discount window borrowing), reserve requirements,
and minimum capital guidelines.

c. Contrast the two views on, or reasons why, depository institution insurance funds can
become insolvent.

One view is that insolvency can be explained by external events in the financial environment
such as the rise in interest rates and oil prices that took place in the early 1980s or the crash of
the housing market in the 2000s. The other view is that deposit insurance brings about the types
of behaviour that lead to eventual insolvency. In particular, deposit insurance contributes to the
moral hazard problem whereby DI owners and managers are induced to take on risky projects
because the presence of deposit insurance substantially reduces the adverse consequences to
the depositors of such behaviour.
2.

a. What is moral hazard? How did the fixed-rate deposit insurance program of the FDIC
contribute to the moral hazard problem of the depository institution industry?

Moral hazard occurs in the depository institution industry when the provision of deposit
insurance or other liability guarantees encourages the institution to accept asset risks that are
greater than the risks that would have been accepted without such liability insurance.

The fixed-rate deposit insurance administered by the FDIC created a moral hazard problem
because it did not differentiate between the activities of risky and conservative lending
institutions. From 1933 until January 1, 1993, regulators based deposit insurance premiums on a
DI’s deposit size rather than on its risk, and the deposit insurance scheme implemented in 1993
did not impose a fee that fully covered a DI’s risk. Further, the 1980s and (to some extent) 2000s
were periods of deregulation, increased risk taking, and capital adequacy forbearance rather
than stringent activity regulation and tough capital requirements. Moreover, for the FSLIC, the
number of bank examinations and examiners actually fell between 1981 and 1984. Finally,
prompt corrective action and closure for severely undercapitalized banks did not begin until the
end of 1992.The combination of excessive risk-taking together with a forbearance policy
followed by the regulators contributed to the moral hazard problems in the depository
institutions industry.

b. How does a risk-based deposit insurance program solve the moral hazard problem of
excessive risk taking by DIs? Is an actuarially fair premium for deposit insurance always
consistent with a competitive banking system?

A risk-based deposit insurance program should deter FIs from engaging in excessive risk-taking
as long as it is priced in an actuarially fair manner, meaning that insurance pricing is based on
the perceived risk of the insured institution. Such pricing currently is being practiced by
insurance firms in the property-casualty sector. However, since the failure of commercial banks
can have significant social costs, regulators have a special responsibility towards maintaining
their solvency, even providing them with some form of subsidies. In a completely free market
system, it is possible that DIs located in sparsely populated areas may have to pay extremely
high premiums to compensate for a lack of diversification or investment opportunities. These DIs
may have to close down unless subsidized by the regulators. Thus, a strictly risk-based insurance
system may not be compatible with a truly competitive banking system.

This suggests that, ideally, regulators should design the deposit insurance contract with the
trade-off between moral hazard risk and DI panic or run risk in mind. For example, by providing
100 percent coverage of all depositors and reducing the probability of runs to zero, the insurer
may be encouraging certain DIs to take a significant degree of moral hazard risk-taking
behaviour. On the other hand, a very limited degree of deposit insurance coverage might
encourage runs and panics, although moral hazard behaviour itself would be less evident.

c. What are three suggested ways a deposit insurance contract could be structured to reduce
moral hazard behavior?

Deposit insurance contracts could be structured to reduce moral hazard behaviour by (1)
increasing stockholder discipline, (2) increasing depositor discipline, and (3) increasing regulator
discipline.
3. What is capital forbearance? How does a policy of forbearance potentially increase the costs of
financial distress to the deposit insurance fund as well as the stockholders?

Capital forbearance refers to regulators’ permitting an FI with depleted capital to continue to operate.
The primary advantage occurs in the short run through the savings of liquidation costs. In the long
run, the likely cost is that the poorly managed FI will become larger, more risky, but no more solvent.
Eventually even larger liquidation costs must be incurred.

4. What are some ways of imposing stockholder discipline to prevent FI managers from engaging in
excessive risk taking?

Two ways of imposing stockholder discipline to prevent excessive risk taking are (a) through a risk-
based deposit insurance program and (b) through increased capital requirements and stricter closure
rules.

Risk-based deposit insurance premiums ensure that DIs engaging in riskier activities will have to pay
higher premiums. One reason for the savings institution crisis was the fixed-rate deposit insurance
premiums that did not differentiate between risky and conservative DIs. As a result, stockholders of
DIs in financial difficulties had nothing to lose by investing in projects that had high payoffs because
depositors were protected by the FDIC insurance program.

Stockholder discipline also is increased if DIs are required to hold more capital and regulators
stopped the practice of capital forbearance and followed a more prompt corrective action program.
The more capital a DI has, the less likely the failure of a DI in the event of a decline in the market value
of assets. This protects not only the depositors but also the FDIC, which provides the insurance.
Further, while in the short term, forbearance may save the insurance fund some liquidation costs, in
the long run, owners of bad banks or thrifts have continuing incentives to grow and take additional
risks in the hope of a large payoff that could turn the institution around. This strategy potentially adds
to the future liabilities of the insurance fund and to the costs of DI liquidation. Using a prompt
corrective action program, riskier activities are met with progressively harsher mandatory actions
being taken by regulators as capital ratios fall. Under this carrot-and-stick approach, a bank or thrift is
placed into receivership within 90 days of the time when its capital falls below some positive book
value level, that is, when it is critically undercapitalized (currently 2 percent of assets for DIs). To the
extent that the book value of capital approximates true net worth or the market value of capital, this
enhances stockholder discipline by imposing additional costs on DI owners for risk taking. It also
increases the degree of coinsurance, in regard to risks taken, between DI owners and regulators such
as the FDIC.

5. What is the too-big-to-fail doctrine? What factors caused regulators to act in a way that caused this
doctrine to evolve?

Large DIs are not generally allowed to fail because of the draining effects on the resources of the
insurance funds and the fear of contagious or systemic runs spreading to other large DIs. Thus, the
fear of significant negative effects on the financial system usually meant that both large and small
depositors in large DIs are protected. Indeed, during the financial crisis of 2008-2009, the Federal
Reserve’s rescue of FIs such as Bear Stearns, AIG, and Citigroup and the $200 billion invested in over
640 banks through the Treasury Department’s Capital Purchase Program demonstrated that the TBTF
bailouts reached much further than anyone would have predicted.
Exercises & Solutions

1.

a. The following is a balance sheet of a commercial bank (in millions of dollars).

Assets Liabilities and Equity

Cash $5 Insured deposits $30
Loans 40 Uninsured deposits 10
Equity 5
Total assets $45 Total liabilities and equity $45
The bank experiences a run on its deposits after it declares it will write off $10 million of its loans
as a result of nonpayment. The bank has the option of meeting the withdrawals by first drawing
down its cash and then selling off its loans. A fire sale of the remaining loans in one day can be
accomplished at a 10 percent discount. They can be sold at a 5 percent discount if sold in two
days. The full market value will be obtained if they are sold after two days.

i. What is the amount of loss to the insured depositors if a run on the bank occurs on the
first day? On the second day?

Insured depositors will not lose any money because even if the bank does not make the
payment, they will be paid by the FDIC. Further, the value of the loans on the first day is 0.90
× $30 = $27m and their value on the second day is 0.95 × $30 = $28.5m. With its cash
reserves, it has a more than adequate amount to pay the insured depositors as long as the
uninsured depositors are not given the opportunity to cash in their deposits first.

ii. What amount do the uninsured depositors lose if the FDIC uses the insured depositor
transfer method to close the bank immediately? The assets will be sold in two days.

The value of the loans on the second day is 0.95 × $30 = $28.5m. With its cash reserves of $5
million, the bank has a total of $33.5 million to pay the depositors. The first $30 million goes
to the insured depositors. So, the uninsured depositors will receive the remaining $3.5
million, and thus they will lose $6.5 million out of their $10 million. The equity holders will
lose all of their capital.

b. A bank with insured deposits of $55 million and uninsured deposits of $45 million has
assets valued at only $75 million. What is the cost of failure resolution to insured
depositors, uninsured depositors, and the FDIC if an insured depositor transfer method is
used?

Neither the insured depositors nor the FDIC lose under the insured depositor transfer method.
Uninsured depositors receive $20 million (= $75m − $55m) equal to the cash (received from the
sale of the bank’s assets) remaining after insured depositors have been paid in full. This results
in a loss of $25 million (= $45m − $20m) for the uninsured depositors

c. A commercial bank has $150 million in assets at book value. The insured and uninsured
deposits are valued at $75 million and $50 million, respectively, and the book value of
equity is $25 million. As a result of loan defaults, the market value of the assets decreases
to $120 million. What is the cost of failure resolution to insured depositors, uninsured
depositors, shareholders, and the FDIC if an insured depositor transfer method is used?
Under the insured depositor transfer method, all losses will be borne by shareholders, followed
by uninsured depositors, before the FDIC takes any loss. Thus, in this example, neither the
insured depositors nor the FDIC lose under the insured depositor transfer method. Uninsured
depositors receive $45 million (= $120m − $75m) equal to the cash (received from the sale of the
bank’s assets) remaining after insured depositors have been paid in full. This results in a loss of
$5 million (= $50m − $45m) for the uninsured depositors. Shareholders will lose $25 million.
2.

Two depository institutions have composite CAMELS ratings of 1 or 2 and are “well capitalized.”
Thus, each institution falls into the FDIC Risk Category I deposit insurance assessment scheme.
Further, the institutions have the following financial ratios and CAMELS ratings:

Institution A Institution B
Leverage ratio (%) 8.25 7.58
Nonperforming loans and leases/gross
assets (%) 0.25 4.55
Other real estate owned/gross assets
(%) 0.54
Net Income before taxes/total assets
(%) 2.15
Brokered deposit ratio 84.56 79.68
One year asset growth 5.66 7.75
Loans as a Percent of Total Assets:
Construction & Development 0.40 0.30
Commercial & Industrial 11.35 15.66
Leases 0.45 1.05
Other Consumer 16.50 16.80
Loans to Foreign Government 0.00 0.60
Real Estate Loans Residual 0.00 0.00
Multifamily Residential 0.50 1.25
Nonfarm Nonresidential 0.00 0.00
1–4 Family Residential 38.85 40.15
Loans to Depository Banks 0.00 2.80
Agricultural Real Estate 4.55 0.00
Agricultural 7.40 0.00
CAMELS Components:
C 1 1
A 2 2
M 1 2
E 2 3
L 1 1
S 2 1

Calculate the initial deposit insurance assessment for each institution.

To determine the deposit insurance assessment for each institution, we set up the following
tables using 2016 rule:

CAMELS Components:
C 1 × 0.25 = 0.25 1 × 0.25 = 0.25
A 2 × 0.20 = 0.40 2 × 0.20 = 0.40
M 1 × 0.25 = 0.25 2 × 0.25 = 0.50
E 2 × 0.10 = 0.20 3 × 0.10 = 0.30
L 1 × 0.10 = 0.10 1 × 0.10 = 0.10
S 2 × 0.10 = 0.20 1 × 0.10 = 0.10
Weighted Average CAMELS 1.40 1.65
Component
Loans Mix Index:
(1) (2) (3) (4) (5) (5)
Institution Institution
A B
Weighted Loan Product of Loan Product
charge-off category as two category as of two
rate a percent of columns a percent columns
percent total assets of total
assets
Construction & Development 4.50 0.40 1.80 0.30 1.35
Commercial & Industrial 1.60 11.35 18.16 15.66 25.06
Leases 1.50 0.45 0.67 1.05 1.57
Other Consumer 1.46 16.50 24.09 16.80 24.53
Loans to Foreign Government 1.34 0.00 0.00 0.60 0.80
Real Estate Loans Residual 1.02 0.00 0.00 0.00 0.00
Multifamily Residential 0.88 0.50 0.44 1.25 1.10
Nonfarm Nonresidential 0.73 0.00 0.00 0.00 0.00
1–4 Family Residential 0.70 38.85 27.20 40.15 28.11
Loans to Depository Banks 0.58 0.00 0.00 2.80 1.62
Agricultural Real Estate 0.24 4.55 1.09 0.00 0.00
Agricultural 0.24 7.40 1.78 0.00 0.00
SUM (Loan Mix Index) 75.23 84.14

Base Assessment Rates for

Two Institutions
(1) (2) (3) (4) (5) (5)
Institution Institution
A B
Pricing Risk Contribution Risk Contribution
Multiplier Measure of Measure of
Value Assessment Value Assessment
Rate Rate
Uniform Amount 7.352 7.352
Leverage ratio (%) (1.264) 8.25 (10.428) 7.58 (9.581)
Nonperforming loans and 0.942 0.25 0.236 4.55 4.286
leases/gross assets (%)
Other real estate owned/gross 0.533 0.54 0.288 0.75 0.400
assets (%)
Net income before taxes/total (0.720) 2.15 (1.548) 1.85 (1.332)
assets (%)
Brokered deposits ratio 0.264 84.56 22.324 79.68 21.036
One year asset growth (%) 0.061 5.66 0.345 7.75 0.473
Loan mix index 0.081 75.23 6.093 84.14 6.816
Weighted average CAMELS 1.519 1.40 2.127 1.65 2.506
component ratings
Sum of contributions 26.79 31.95
Initial assessment rate 26.79 30.00
3.

Two depository institutions have composite CAMELS ratings of 1 or 2 and are “well capitalized.”
Thus, each institution falls into the FDIC Risk Category I deposit insurance assessment scheme.
Further, the institutions have the following financial ratios and CAMELS ratings:

Institution A Institution B
Leverage ratio (%) 8.55 8.25
Nonperforming loans and leases/gross
assets (%) 0.35 5.12
Other real estate owned/gross assets (%) 0.42 0.75
Net Income before taxes/total assets (%) 2.00 1.65
Brokered deposit ratio 84.20 79.50
One year asset growth 4.35 6.80
Loans as a Percent of Total Assets:
Construction & Development 0.00 0.00
Commercial & Industrial 10.56 18.68
Leases 0.65 2.15
Other Consumer 17.55 18.95
Loans to Foreign Government 0.00 0.60
Real Estate Loans Residual 0.00 0.00
Multifamily Residential 0.00 1.10
Nonfarm Nonresidential 0.00 0.00
1–4 Family Residential 41.10 37.41
Loans to Depository Banks 0.00 0.50
Agricultural Real Estate 1.10 0.35
Agricultural 0.40 0.40
CAMELS Components:
C 1 2
A 1 1
M 1 1
E 2 1
L 1 3
S 2 3

Calculate the deposit insurance assessment and the dollar value of the deposit insurance
premium for each institution.

To determine the deposit insurance assessment for each institution, we set up the following tables
using 2016 rule:

CAMELS Components:
C 1 × 0.25 = 0.25 2 × 0.25 = 0.50
A 1 × 0.20 = 0.20 1 × 0.20 = 0.20
M 1 × 0.25 = 0.25 1 × 0.25 = 0.25
E 2 × 0.10 = 0.20 1 × 0.10 = 0.10
L 1 × 0.10 = 0.10 3 × 0.10 = 0.30
S 2 × 0.10 = 0.20 3 × 0.30 = 0.30
Weighted Average CAMELS
Component 1.20 1.65
Loans Mix Index:
(1) (2) (3) (4) (5) (5)
Institution Institution
A B
Weighted Loan Product of Loan Product
charge-off category as two category as of two
rate a percent of columns a percent columns
percent total assets of total
assets
Construction & Development 4.50 0.00 0.00 0.00 0.00
Commercial & Industrial 1.60 10.56 16.89 18.68 29.89
Leases 1.50 0.65 0.98 2.15 3.23
Other Consumer 1.46 17.55 25.62 18.95 27.67
Loans to Foreign Government 1.34 0.00 0.00 0.60 0.80
Real Estate Loans Residual 1.02 0.00 0.00 0.00 0.00
Multifamily Residential 0.88 0.00 0.00 1.10 0.97
Nonfarm Nonresidential 0.73 0.00 0.00 0.00 0.00
1–4 Family Residential 0.70 41.10 28.77 37.41 26.19
Loans to Depository Banks 0.58 0.00 0.00 0.50 0.29
Agricultural Real Estate 0.24 1.10 0.26 0.35 0.08
Agricultural 0.24 0.40 0.10 0.40 0.10
SUM (Loan Mix Index) 72.62 89.21

Base Assessment Rates for

Two Institutions
(1) (2) (3) (4) (5) (5)
Institution Institution
A B
Pricing Risk Contribution Risk Contribution
Multiplier Measure of Measure of
Value Assessment Value Assessment
Rate Rate
Uniform Amount 7.352 7.352
Leverage ratio (%) (1.264) 8.55 (10.807) 8.25 (10.428)
Nonperforming loans and 0.942 0.35 0.330 5.12 4.823
leases/gross assets (%)
Other real estate owned/gross 0.533 0.42 0.224 0.75 0.400
assets (%)
Net income before taxes/total (0.720) 2.00 (1.440) 1.65 (1.188)
assets (%)
Brokered deposits ratio 0.264 82.20 21.701 76.50 20.196
One year asset growth (%) 0.061 4.35 0.265 6.80 0.415
Loan mix index 0.081 72.62 5.883 89.21 7.226
Weighted average CAMELS 1.519 1.20 1.823 1.65 2.506
component ratings
Sum of contributions 25.33 31.30
Initial assessment rate 25.33 30.00
Risk, Capital Adequacy & Regulation

net worth
A measure of an FI’s capital that is equal to the difference between the market value of its assets
and the market value of its liabilities.

book value
Historical cost basis for asset and liability values.

market value or mark-to-market basis

Allowing balance sheet values to reflect current rather than historical prices.

Basel Agreement
The requirement to impose risk-based capital ratios on banks in major industrialized countries.

1. Which are the five functions of an FI’s capital?

First, the primary means of protection against the risk of insolvency and failure is an FI’s
capital. Capital is used to absorb unanticipated losses with enough margin to inspire
confidence and enable the FI to continue as a going concern.

Second FIs need to hold enough capital to provide confidence to uninsured creditors that they
can withstand reasonable shocks to the value of their assets. Thus, capital protects uninsured
depositors, bondholders, and creditors in the event of insolvency, and liquidation.

Third, the FDIC, which guarantees deposits, is concerned that sufficient capital is held so that
their funds are protected, because they are responsible for paying insured depositors in the
event of a failure. Thus, the capital of an FI offers protection to insurance funds and ultimately
the taxpayers who bear the cost of insurance fund insolvency.

Fourth, by holding capital and reducing the risk of insolvency, an FI protects the industry from
larger insurance premiums. Such premiums are paid out of the net profits of the FI. Thus,
capital protects the FI owners against increases in insurance premiums.

Finally, capital also serves as a source of financing to purchase and invest in assets necessary
to provide financial services.

2. Why are supervisors/regulators concerned with the levels of capital held by an FI compared
with those held by a non-financial institution?

Regulators are concerned with the levels of capital held by an FI because of its special role in
society.

A failure of an FI can have severe repercussions to the local and/or national economy unlike
non-financial institutions.

Such externalities impose a burden on regulators to ensure that these failures do not impose
major negative externalities on the economy.

Higher capital levels will reduce the probability of such failures.

3. What is the difference between the economic definition of capital and the book value
definition of capital?

The book value definition of capital is the value of assets minus liabilities as found on the
balance sheet.

This amount often is referred to as accounting net worth.

The economic definition of capital is the difference between the market value of assets and
the market value of liabilities.

a. How does economic value accounting recognize the adverse effects of credit risk?

The loss in value caused by credit risk is borne first by the equity holders, and then by the
liability holders. With market value accounting, the adjustments to equity value are made
simultaneously as the losses due to this risk element occur. Thus, economic insolvency
may be revealed before accounting value insolvency occurs.

b. How does book value accounting recognize the adverse effects of credit risk?

Because book value accounting recognizes the value of assets and liabilities at the time
they were placed on the books or incurred by the firm, losses are not recognized until the
assets are sold or regulatory requirements force the firm to make balance sheet
accounting adjustments. In the case of credit risk, these adjustments usually occur after all
attempts to collect or restructure the loans have occurred.

4. What is the Basel Agreement?

The Basel Agreement identifies risk-based capital ratios agreed upon by the member countries
of the Bank for International Settlements.

The ratios are to be implemented for all DIs under their jurisdiction.

Further, most countries in the world now have accepted the guidelines of this agreement for
measuring capital adequacy.
5. What are the major features of the Basel III capital requirements?

The goal of Basel III is to raise the quality, consistency, and transparency of the capital base of banks
and to strengthen the risk coverage of the capital framework. (Figure 21.1)

Pillar I of Basel III calls for enhancements to both the Standardized Approach, discussed below, and
IRB Approach to calculating adequate capital. Changes to Pillar 1 include a greater focus on common
equity, the inclusion of new capital conservation and countercyclical buffers to the minimum level of
capital, significantly higher capital requirements for trading and derivatives activities, and a
substantial strengthening of counterparty credit risk calculations in determining required minimum
capital.

Pillar 2 calls for enhanced bank-wide governance and risk management to be put in place, such as
enhanced incentives for banks to better manage risk and returns over the long term, more stress
testing, and implementation of sound compensation practices.

Pillar 3 calls for the enhanced disclosure of risks, such as those relating to securitization exposures
and sponsorship of off-balance-sheet vehicles.

Under Basel III, depository institutions must calculate and monitor four capital ratios:

- common equity Tier I (CET1) risk-based capital ratio,

- Tier I risk-based capital ratio,
- total risk-based capital ratio, and
- Tier I leverage ratio.
6. What are the definitional differences between CET1, Tier I, and Tier II capital?

CET1 is primary or core capital of the DI. CET1capital is closely linked to a DI’s book value of
equity, reflecting the concept of the core capital contribution of a DI’s owners. CET1 capital
consists of the equity funds available to absorb losses. Basically, it includes the book value of
common equity plus minority equity interests held by the DI in subsidiaries minus goodwill.
Goodwill is an accounting item that reflects the amount a DI pays above market value when it
purchases or acquires other DIs or subsidiaries.

Tier I capital is the primary capital of the DI plus additional capital elements. Tier I capital is the
sum of CET1 capital and additional Tier I capital. Included in additional Tier I capital are other
options available to absorb losses of the bank beyond common equity. These consist of
instruments with no maturity dates or incentives to redeem, e.g., noncumulative perpetual
preferred stock. These instruments may be callable by the issuer after 5 years only if they are
replaced with “better” capital.

Tier II capital is supplementary capital. Tier II capital is a broad array of secondary “equity like”
capital resources. It includes a DI’s loan loss reserves assets plus various convertible and
subordinated debt instruments with maximum caps.

7. Under Basel III, what four capital ratios must DIs calculate and monitor?

Under Basel III, depository institutions must calculate and monitor four capital ratios: common
equity Tier I (CET1) risk-based capital ratio, Tier I risk-based capital ratio, total risk-based
capital ratio, and Tier I leverage ratio.

i) CET1 risk-based capital ratio = Common equity Tier I capital/risk-weighted assets

ii) Tier I risk-based capital ratio = Tier I capital (Common equity Tier I capital + additional Tier I capital)/

risk-weighted assets

iii) Total risk-based capital ratio = Total capital (Tier I + Tier II)/risk-weighted assets, and

iv) Tier I leverage ratio = Tier I capital / total exposure.

8. What is the risk-weighted assets in the denominator of the common equity Tier I (CET1) risk-
based capital ratio, the Tier I risk-based capital ratio, and the total risk-based capital ratio?

Under Basel III capital adequacy rules, risk-weighted assets (RWAs) represent the
denominator of the risk-based capital ratios.

Two components make up risk-weighted assets:

(1) risk-weighted on-balance-sheet assets and
(2) risk-weighted off-balance-sheet assets.
9. How is the leverage ratio for an DI defined?

The Basel III leverage ratio is defined as the ratio of Tier 1 capital to a combination of on- and
off-balance-sheet assets (total exposure).

Total exposure is equal to the DI’s total assets plus off-balance-sheet exposure.

For derivative securities, off-balance-sheet exposure is current exposure plus potential

exposure as described above.

For off-balance-sheet credit (loan) commitments a conversion factor of 100 percent is applied
unless the commitments can immediately be cancelled. In this case, a conversion factor of 0
percent is used (Table 21-9).

Once Basel III is fully phased in, to be to be adequately capitalized, a DI must hold a minimum
leverage ratio of 4.0 percent.

10. Identify the five zones of capital adequacy and explain the mandatory regulatory actions
corresponding to each zone.

Zone 1: Well capitalized. The CET1 risk-based capital (RBC) ratio exceeds 6.5 percent, Tier I RBC
ratio exceeds 8 percent, total RBC ratio exceeds 10 percent, and leverage ratio exceeds 5
percent. No regulatory action is required.

Zone 2: Adequately capitalized. The CET1 RBC ratio exceeds 4.5 percent, Tier I RBC ratio exceeds 6
percent, total RBC ratio exceeds 8 percent, and leverage ratio exceeds 4 percent.
Institutions may not use brokered deposits except with the permission of the FDIC.

Zone 3: Undercapitalized. The CET1 RBC ratio is less than 4.5 percent, Tier I RBC ratio is less than 6
percent, total RBC ratio is less than 8 percent, or leverage ratio is less than 4 percent.
Requires a capital restoration plan, restricts asset growth, requires approval for
acquisitions, branching, and new activities, disallows the use of brokered deposits, and
suspends dividends and management fees.

Zone 4: Significantly undercapitalized. The CET1 RBC ratio is less than 3 percent, Tier I RBC ratio is
less than 4 percent, total RBC ratio is less than 6 percent, or leverage ratio is less than 3
percent. Same as zone 3 plus recapitalization is mandatory, places restrictions on deposit
interest rates, interaffiliate transactions, and the pay level of officers.

Zone 5: Critically undercapitalized. Tangible equity to total assets is less than or equal to 2
percent. Places the bank in receivership within 90 days, suspends payment on
subordinated debt, and restricts other activities at the discretion of the regulator.

The mandatory provisions for each of the zones described above include the penalties for any of the
zones prior to the specific zone.
11. Explain the process of calculating risk-weighted on-balance-sheet assets.

Balance sheet assets are assigned to one of several categories of credit risk exposure.

The ¥$£ amount of assets in each category is multiplied by an appropriate weight, e.g., 0 percent, 20
percent, 50 percent, 100 percent, or 150 percent.

The weighted $£¥ amounts of each category are added together to get the total risk-weighted on-
balance-sheet assets

12. National Bank has the following balance sheet (in millions) and has no off-balance-sheet
activities.

Assets Liabilities and Equity

Cash $20 Deposits $960

Treasury bills 40 Subordinated debentures 25

Residential mortgages Common stock 45

(category 1; loan-to-value Retained earnings 40

ratio = 70%) 600 Total liabilities and equity $1,090

Business loans 430

Total assets $1,090

a. What is the CET1 risk-based ratio?

Risk-weighted assets = $20x0.0 + $40x0.0 + $600x0.5 + $430x1.0 = $730

The CET1 risk-based ratio is ($45 + $40)/$730 = 0.11644 or 11.644 percent.

b. What is the Tier I risk-based capital ratio?

Risk-weighted assets = $20x0.0 + $40x0.0 + $600x0.5 + $430x1.0 = $730

Tier I capital ratio = ($45 + $40)/$730 = 0.11644 or 11.644 percent.

c. What is the total risk-based capital ratio?

The total risk-based capital ratio = ($45 + $40 + $25)/$730 = 0.15068 or 15.068 percent.

d. What is the leverage ratio?

The leverage ratio is ($45 + $40)/$1,090 = 0.07798 or 7.798 percent.

e. In what capital risk category would the bank be placed?

The bank would be place in the well-capitalized category.

13. What is the capital conservation buffer?

How would this buffer affect your answers to question 12?

Basel III introduced a capital conservation buffer designed to ensure that DIs build up a capital
surplus, or buffer, outside periods of financial stress which can be drawn down as losses are
incurred during periods of financial stress.

The buffer requirements provide incentives for DIs to build up a capital surplus (e.g., by
reducing discretionary distributions of earnings (reduced dividends, share buy-backs and staff
bonuses)) to reduce the risk that their capital levels would fall below the minimum
requirements during periods of stress.

The capital conservation buffer must be composed of CET1 capital and are held separately
from the minimum risk-based capital requirements.

Under Basel III, a DI would need to hold a capital conservation buffer of greater than 2.5
percent of total risk-weighted assets to avoid being subject to limitations on capital
distributions and discretionary bonus payments to executive officers.

To have no limitations on the bank’s pay-out ratio,

the CET1 ratio must be > 7%,

the Tier I ratio must be > 8.5%, and

the total capital ratio must be > 10.5%.

In problem 12, all three of these conditions are met.

So, the bank has no limitations on its pay-out ratio.

14. What is the countercyclical capital buffer?

If the home country set a countercyclical capital buffer of 2.5 percent, how would this buffer
affect your answers to question 12?

Basel III also introduced a countercyclical capital buffer which may be declared by any country
which is experiencing excess aggregate credit growth.

The countercyclical buffer can vary between 0 percent and 2.5 percent of risk-weighted assets.

This buffer must be met with CET1 capital and DIs are given 12 months to adjust to the buffer
level.

Like the capital conservation buffer, if a DI’s capital levels fall below the set countercyclical
capital buffer, restrictions on earnings pay-outs are applied.

The countercyclical capital buffer aims to protect the banking system and reduce systemic
exposures to economic downturns. Losses can be particularly large when a downturn is
preceded by a period of excess credit growth.

The accumulation of a capital buffer during an expansionary phase would increase the ability
of the banking system to remain healthy during periods of declining asset prices and losses
from weakening credit conditions.

By assessing a countercyclical buffer when credit markets are overheated, accumulated capital
buffers can absorb any abnormal losses that a DI might experience when the credit cycle turns.

Consequently, even after these losses are realized, DIs would remain healthy and able to
access funding, meet obligations, and continue to serve as credit intermediaries.

To have no limitations on the bank’s pay-out ratio with a 2.5% buffer,

… the CET1 ratio must be > 9.5%,

… the Tier I ratio must be > 11.0%, and

… the total capital ratio must be > 13.0%.

In question 12, the bank’s

… CET1 is 11.644%,

… the Tier I ratio is 11.644%, and

… the total capital ratio is > 15.068%.

So, the bank has no limitations on its pay-out ratio.

15.

a. Onshore Bank has $20 million in assets, with risk-weighted assets of $10 million. CET1
capital is $500,000, additional Tier I capital is $50,000, and Tier II capital is $400,000.
How will each of the following transactions affect the value of the CET1, Tier I, and total
capital ratios? What will the new value of each ratio be?

The current value of the CET1 ratio is 5 percent ( $500,000 / $10m) , of the Tier I ratio
is 5.5 percent(($500,000 + $50,000) / $10m) , and the total capital ratio is 9.5 percent
(($500,000 + $50,000 + $400,000) / $10m) .
i. The bank repurchases $100,000 of common stock with cash. (Cash has a 0 risk
weight so risk-weighted assets do not change.)

CET1 capital decreases to $400,000, Tier I capital decreases to $450,000 and total
capital decreases to $850,000. Cash has a 0 risk weight so risk-weighted assets do
not change. Thus, the CET1 ratio decreases to 4 percent, the Tier I ratio decreases to
4.5 percent and the total capital ratio decreases to 8.5 percent.

ii. The bank issues $2 million of CDs and uses the proceeds to issue mortgage loans
with loan-to-value ratio of 95 percent. (The risk weight for this group of mortgages
is 50 percent)

The risk weight for this group of mortgages is 50 percent. Thus, risk-weighted
assets increase to $10 million + $2 million (0.5) = $11 million. The CET1 ratio
decreases to $500, 000 / $11 million = 4.54 percent, the Tier I ratio decreases to
$550, 000 / $11 million = 5 percent and the total capital ratio decreases to
$950, 000 / $11 million = 8.64 percent.

iii. The bank receives $500,000 in deposits and invests them in T-bills. (T-bills have a 0
risk)

T-bills have a 0 risk weight so risk-weighted assets remain unchanged. Thus, all
three ratios remain unchanged.

iv. The bank issues $800,000 in common stock and lends it to help finance a new
shopping mall. (The business loan’s risk weight is 100 percent.)

CET1 equity increases to $1.3 million, Tier I equity increases to $1.35 million, and
total capital increases to $1.75 million. The business loan’s risk weight is 100
percent. Thus, risk-weighted assets increase to $10 million + $800,000 (1) = $10.8
million. The CET1 ratio, increases to $1.3m / $10.8m = 12.03 percent, the Tier I
ratio increases to $1.35m / $10.8m = 12.50 percent, and the total capital ratio
increases to $1.75m / $10.8m = 16.20 percent.

v. The bank issues $1 million in non-qualifying perpetual preferred stock and

purchases general obligation municipal bonds.

CET1 and Tier I capital are unchanged. Total capital increases to $1.95 million.
General obligation municipal bonds fall into the 20 percent risk category. So, risk-
 weighted assets increase to $10 million + $1 million (0.2) = $10.2 million. Thus, the
CET1 ratio decreases to $500, 000 / $10.2 million = 4.90 percent, the Tier I ratio
decreases to $550, 000 / $10.2 million = 5.39 percent, and the total capital ratio
increases to 19.12 percent.

vi. Homeowners pay back $4 million of mortgage loans with loan-to-value ratio of 100
percent, and the bank uses the proceeds to build new ATMs. (This group of
mortgage loans have a risk weight of 50 percent)

This group of mortgage loans have a risk weight of 50 percent. The ATMs are 100
percent risk weighted. Thus, risk-weighted assets increase to $10 million + $4
million (0.50) + $4 million (1.0) = $16.0 million. The CET1 capital ratio decreases
to $500, 000 / $16.0m = 3.13 percent, the Tier I capital ratio decreases to
$550, 000 / $16.0m = 3.44 percent, and the total capital ratio decreases to
$950, 000 / $16.0m = 5.94 percent.
Lecture 09 - ch.26
Questions + Answers & Exercises + Solutions

Questions & Answers

1.

a. In addition to managing credit risk, what are some other reasons for the sale of loans by FIs?

The reasons for an increase in loan sales, apart from hedging credit risk, include:

(a) Removing loans from the balance sheet by sale without recourse reduces the amount of
deposits necessary to fund the FI, which in turn decreases the amount of regulatory reserve
requirements that must be kept by the FI.

(b) Originating and selling loans is an important source of fee income for the FIs.

(c) One method to improve the capital ratio for an FI is to reduce assets. This approach often is
less expensive than increasing the amount of capital.

(d) The sale of FI loans to improve the liquidity of the FIs has expanded the loan sale market. This
has made FI loans even more liquid and reduced FI liquidity risk even farther. Thus, by creating
the loan sales market, the process of selling the loans has improved the liquidity of the asset
for which the market was initially developed.

(e) Finally, loan sales have been considered a substitute for securities underwriting.

b. In addition to hedging credit risk, what are the factors that are expected to encourage loan sales in
the future? Discuss the impact of each factor.

The reasons for an increase in loan sales, apart from hedging credit risk, include:

(a) New capital requirements for credit risk, which suggests a further need for FIs to reduce their
risky portfolios and replace them with lower risk assets. This suggests increased loan sales
activity.

(b) Loan sales as trading instruments, which make it attractive for commercial banks and
investment banks to specialize in specific loan categories and to market them effectively, since
they require only brokerage functions as opposed to performing asset transformations.

(c) The increased involvement of the federal government in the loan sales market (through its
direct purchases of distressed loans held by financial institutions and its takeover of mortgage
giants Fannie Mae and Freddie Mac) during the financial crisis is seen as a reason for growth in
the loan sale market.

(d) The ability to allocate loan credit ratings should cause more investors to enter the market.

(e) The growth of distressed loans in international markets should provide opportunities for U.S.
domestic investors to enter this market at substantially reduced prices.
c. What are factors that may deter the growth of the loan sale market in the future? Discuss.

Several factors may deter the growth of the loans sales market. First, because of the ability for large
banks to underwrite commercial paper through investment bank subsidiaries, the need to sell short-
term bank loans as an imperfect substitute for commercial paper has decreased. Second, if
customers perceive the sale of its loan by an FI as an adverse statement about the customer’s value
to the FI, the FI may choose to not sell the loan for fear of decreasing revenue from the customer
relationships. Third, the distressed loan sale market has slowed because of legal implications from
the sale of HLT loans. Other creditors have questioned whether the secured position of the FI is
valid in the case of bankruptcy or other distressed-firm proceedings.
2.

What is the difference between loan participations and loan assignments?

In a loan participation, the buyer does not obtain total control over the loan. In an assignment, all
rights are transferred upon sale, thereby giving the buyer a direct claim on the borrower.

The unique features of participations in loans are:

• The holder (buyer) is not a party to the underlying credit agreement so that the initial contract
between loan seller and borrower remains in place after the sale.
• The loan buyer can exercise only partial control over changes in the loan contract’s terms. The
holder can vote only on material changes to the loan contract, such as the interest rate or
collateral backing.

The economic implication of these features is that the buyer of the loan participation has a double
risk exposure: a risk exposure to the borrower and a risk exposure to the loan selling FI. Specifically,
if the selling FI fails, the loan participation bought by an outside party may be characterized as an
unsecured obligation of the FI rather than as a true sale if there are grounds for believing that some
explicit or implicit recourse existed between the loan seller and the loan buyer. Alternatively, the
borrower’s claims against a failed selling FI may be set off against its loans from that FI, reducing the
amount of loans outstanding and adversely impacting the buyer of a participation in those loans. As
a result of these exposures, the buyer bears a double monitoring cost as well.

Because of the monitoring costs and risks involved in participations, loans are sold on an assignment
basis in more than 90 percent of the cases on the U.S. domestic market. The key features of an
assignment are:

• All rights are transferred on sale, meaning the loan buyer now holds a direct claim on the
borrower.
• Transfer of U.S. domestic loans is normally associated with a Uniform Commercial Code filing (as
proof that a change of ownership has been perfected).

While ownership rights are generally much clearer in a loan sale by assignment, frequently
contractual terms limit the seller’s scope regarding to whom the loan can be sold. In particular, the
loan contract may require either the FI agent or the borrower to agree to the sale. The loan contract
may also restrict the sale to a certain class of institutions, such as those that meet certain net
worth/net asset size conditions.

Currently, the trend appears to be toward loan contracts being originated with very limited
assignment restrictions. This is true in both the U.S. domestic and the foreign loan sales markets.
The most tradable loans are those that can be assigned without buyer restrictions. In addition, the
non-standardization of accrued interest payments in fixed-rate loan assignments (trade date,
assignment date, coupon payment date) adds complexity and friction to this market. Moreover,
while the FI agent may have a full record of the initial owners of the loans, it does not always have
an up-to-date record of loan ownership changes and related transfers following trades. This means
that great difficulties often occur for the borrower, FI agent, and loan buyer in ensuring that the
current holder of the loan receives the interest and principal payments due. Finally, the buyer of the
loan often needs to verify the original loan contract and establish the full implications of the
purchase regarding the buyer’s rights to collateral if the borrower defaults.
3.

a. What are the factors that, in general, allow assets to be securitized? What are the costs involved in
the securitization process?

In general the easiest assets to securitize are those that are homogenous and that can be valued
with relative precision. The homogeneity involves the characteristics of the contracts, such as
maturity, payment schedule, etc., while the valuation process is easiest if the underlying assets are
traded in the market. The costs of the securitization process include credit risk insurance,
guarantees, overcollateralization, valuation and packaging costs.

b. How does an FI use securitization to manage interest rate, credit and liquidity risks? Summarize how
each of the possible methods of securitization products affects the balance sheet and profitability of
an FI in the management of these risks.

In the process of intermediation on behalf of its customers, the FI assumes risk exposure. The FI can
reduce that risk exposure by altering its product base, thereby affecting the portfolio mix obtained
in the course of intermediation. However, this is likely to be quite costly in terms of customer good
will and loss of business. Securitization enables FIs to manage risk exposure by changing their
portfolio mix without alienating customers or changing the customer base and mix. That is,
customers are still serviced and the FI continues to intermediate. Balance sheet alterations are
made subsequent to and independent of the intermediation activity. Thus, the FI can make portfolio
changes and still fulfil the function of the intermediary.

Interest rate risk exposure is reduced by matching the durations of assets and liabilities.
Securitization enables the FI to accomplish this since the FI can determine which loans to package
and sell off. Credit risk exposure is minimized by selling loans without recourse. Securitization allows
the FI to sell off unmatched assets. Finally, securitization reduces liquidity risk, since the FI does not
have to fund the asset.

c. What three levels of regulatory taxes do FIs face when making loans? How does securitization
reduce the levels of taxation?

The three levels of taxes faced by FIs when making loans are a) capital requirements on loans to
protect against default; b) reserve requirements on demand deposits for funding the loans; and c)
deposit insurance to protect the depositors. If the loans are securitized, FIs end up only servicing the
loans since the loans no longer are on the balance sheet. As a result, no capital is required to
protect against default risk. Further, reserve requirements and deposit insurance will be reduced if
liabilities are also reduced. However, if the cash proceeds from the loan sales are used to invest in
other assets, then the taxes will still remain in place.
Exercises & Solutions

1.

a. An FI is planning to issue $100 million in BB rated commercial loans. The FI will finance the loans by
issuing demand deposits.

i. What is the minimum capital required under Basle III?

The minimum capital required on commercial loans = $100m × 1.0 × 0.08 = $8 million.

ii. What is the minimum amount of demand deposits needed to fund this loan assuming there is a
10 percent average reserve requirement on demand deposits?

Since there is an interaction between the demand deposits and cash reserves held, the answer
requires solving the following, assuming the $8 million is funded by equity and the reserve
requirements are kept as cash:

$100m + ( 0.10 ×DD) = DD + 8m => DD = 92m / 0.9 = $102.22 million

iii. Show a simple balance sheet with total assets, total liabilities, and equity if this is the only
project funded by the bank.

Assets Liabilities

Cash $10.22m Demand deposits $102.22m

Loan $100.00m Equity 8.00m

Total $110.22m $110.22m

iv. How does this balance sheet differ from Table 26-1? Why?

TABLE 26–1 FI Balance Sheet before and after a $20 Million Loan Sale (in millions)

Since the loans are Category 1 residential mortgages with a loan-to-value ratio between 60 and
80 percent, the example in Table 26-1 has a capital requirement of only 4 percent (8% × 0.5) of
the face value of the loan. Because the loans in this problem are BB rated commercial loans, the
bank must keep a full 8 percent of the loan to meet the risk-based capital ratio. Thus, the
balance sheet is $0.45m less than the Table 26-1 example.
b. Consider the FI in Exercise (a).

i. What additional risk exposure problems does the FI face?

First, the commercial loans financed with demand deposits present a serious duration gap
problem. Second, the loans are not very liquid. Under worst-case liquidity scenarios, the FI faces
the possibility of having to sell the loans at distressed prices.

ii. What are some possible solutions to the duration mismatch and the illiquidity problems?

The FI can lengthen the liability duration by issuing longer term CDs or capital notes, but this
solution is difficult in that each time the FI issues a commercial or longer-term residential loan,
it must rebalance the duration of the liabilities. A second solution is to use interest rate swaps
or other derivative products to hedge the mismatch in cash flow streams. Neither of these
techniques, however, resolves the problem of regulatory taxes.

iii. What advantages does securitization have in dealing with the FI’s risk exposure problems?

The process of securitization removes the loans from the balance sheet. Thus, the problems of
duration, liquidity, and regulatory taxes disappear. Further, the FI recovers the initial investment
and can repeat the loan origination process with potential to earn additional fees on the new
originations.
2.

a. Consider a GNMA mortgage pool with principal of $20 million. The maturity is 30 years with a
monthly mortgage payment of 10 percent per year. Assume no prepayments.

i. What is the monthly mortgage payment (100 percent amortizing) on the pool of mortgages?

The monthly mortgage payment, PMT, is (the monthly interest rate is 0.10 / 12 = 0.00833 ):

$20𝑚 = 𝑃𝑀𝑇 𝑥 𝑃𝑉𝐴𝑛=360,𝑘=0.00833 ⇒ 𝑃𝑀𝑇 ≈ $175,510

1
1−( )
(1 + 𝑘)𝑛
$20𝑚 = 𝑃𝑀𝑇 𝑥 ⇒ 𝑃𝑀𝑇 ≈ $175,510
𝑘
1
1−( )
(1 + 0.00833)360
$20𝑚 = 𝑃𝑀𝑇 𝑥 ⇒ 𝑃𝑀𝑇 ≈ $175,510
𝑘

ii. If the GNMA insurance fee is 6 basis points and the servicing fee is 44 basis points, what is the
yield on the GNMA pass-through?

The GNMA's annual interest rate is 0.10 − 0.0044 − 0.0006 = 9.5 percent. The monthly interest
rate is 0.095 /12 = 0.0079167 or 0.79167 percent.

iii. What is the monthly payment on the GNMA in part (b)?

The monthly GNMA payment, PMT, is : $20m = PVA n=360, k=0.79167% × PMT => PMT = $168,170.84

iv. Calculate the first monthly servicing fee paid to the originating FIs.

The first monthly servicing fee, SF, is (the monthly fee rate is 0.44% /12 = 0.0367% ):

SF = (0.000367)$20m = $7,333.

v. Calculate the first monthly insurance fee paid to GNMA.

The first monthly insurance payment, IP, is (monthly insurance rate is 0.06% /12 = 0.005% ):

IP = (0.00005)$20m = $1,000

b. Calculate the value of (a) the mortgage pool and (b) the GNMA pass-through in question (a.) if
market interest rates increase 50 basis points. Assume no prepayments.

i. The mortgage pool's value, PV, is (the monthly discount rate is 10.5% /12 = 0.875% ):

PV = $175,514.31 × PVA n=360,k=0.875% = $19,187,359

ii. The GNMA's value, PV, is (the monthly discount rate is 10% /12 = 0.8333% ):

PV = $168,170.84 × PVA n=360,k=0.8333% = $19,163, 205

c. What would be the impact on GNMA pricing if a pass-through is not fully amortized? What is the
present value of a $10 million pool of 15-year mortgages with an 8.5 percent per year monthly
mortgage coupon if market rates are 5 percent? The GNMA guarantee fee is 6 basis points and the
FI servicing fee is 44 basis points.

i. Assume that the GNMA is fully amortized.

There are 180 monthly payments (15 years × 12 months). The GNMA monthly coupon rate is
8.5% − 0.5% = 8 percent per year, and the monthly GNMA pass-through payment is:
$10m = PVA n=180, k=0.6667% × PMT => PMT = $95,565.21.

The present value of the GNMA at a 5 percent market rate is:

PV = $95,565.21× PVA n=180, k=0.004167% = $12, 084, 721.63.

ii. Assume that the GNMA is only half amortized. There is a lump sum payment at the maturity of
the GNMA that equals 50 percent of the mortgage pool's face value.

If there is a 50 percent amortization, the monthly GNMA pass-through payments are:

$10m = PMT × PVA n=180, k=0.6667% + $5m × PVn=180, k=0.6667% => PMT = $81,115.94

The present value of the GNMA at a 5 percent market rate is:

PV = $81,115.94 × PVA n=180, k=0.004167% + $5m × PVn=180, k=0.004167% = $12, 623, 051.35.
3.

a. If 150 $200,000 mortgages in a $60 million 15-year mortgage pool are expected to be prepaid in
three years and the remaining 150 $200,000 mortgages are to be prepaid in four years, what is the
weighted-average life of the mortgage pool? Mortgages are fully amortized, with mortgage coupon
rates set at 10 percent to be paid annually.

The annual mortgage payment is $60 million

$60 million = PVA n=15, k=10% × PMT => PMT = $7,888, 426.61 . Annual mortgage payments,

with no prepayments, can be decomposed into principal and interest payments (in millions of $s):

Interest Principal Remaining

Year Balance Payment Payment Payment Principal

1 $60.000 $7.888 $6.000 $1.888 $58.112

2 58.112 7.888 5.811 2.077 56.034
3 56.034 7.888 5.603 2.285 53.749
4 53.749 7.888 5.375 2.513 51.236

The first year's interest is $6 million (0.10 × $60 million). Deducting this from the first year's
mortgage payment yields a principal payment of $1,888,426.61 at the end of the first year, and an
outstanding principal $58,111,573.39.

The second year's interest payment is 0.10 × $58,111,573.39 = $5,8111,157.34.

Deducting this from the annual mortgage payment yields a second annual principal payment of
$2,077,269.27, for a principal outstanding of $56,034,304.12.

The third year's regular interest payment is $5.603 million. Deducting this from the annual mortgage
payment yields a third annual principal payment of $2.285 million for a principal outstanding of
$53,749,307.92.

The principal outstanding at the end of the fourth year, without prepayments, is $51,235,812.10.

However, at the end of the third year, half of the mortgages in the mortgage pool are completely
prepaid. That is, at the end of the third year, an additional principal payment of

50% × $53,749,307.92 = $26,874,653.96

is received for a remaining outstanding principal balance of $26.875 million.

The total third year principal payment is therefore $29.16 million = the regular principal payment of
$2.285 million plus an extra payment of $26.875 million.

The fourth year annual interest payment is 10% × $26.875 million = $2.687 million, leaving a regular
fourth year principal payment of $7.888 million − $2.687 million = $5,200,961.21.

This end-of-fourth-year principal payment would have left an outstanding principal balance of
$21,673,692.75, which is paid in full at the end of the year.

Fourth year principal payments total $26.875 million = $5.201 million, plus $21.674 million.
 Prepayments alter the annual cash flows for years 3 and 4 as follows (in millions of $s):

Year Balance Payment Interest Principal Balance

3 56.034 7.888 5.603 29.160 26.875

4 26.875 7.888 2.687 26.875 0

Calculating the weighted average life:

Time Expected Principal Payments Time x Principal

1 1.888m 1.888
2 2.077m 4.154
3 29.160m 87.48
4 26.875m 107.5
60.000m 201.022

WAL = 201.022 / 60 = 3.35 years

b. What is the weighted-average life (WAL) of a mortgage pool supporting pass-through securities?
How does WAL differ from duration?

The weighted-average life is calculated as the product of the amount of principal payment times the
timing of the payment divided by the total amount of principal outstanding. Duration differs from
WAL by using the present value of cash flows relative to the current present value of the asset as
the weights in calculating the average life.
Lecture 10 - & ch.27
Questions + Answers & Exercises + Solutions

Questions & Answers

1. Why are yields higher on loan sales than on commercial paper issues with similar
maturity and issue size?

Commercial paper issuers generally are blue chip corporations that have the best credit
ratings. Banks may sell the loans of less creditworthy borrowers, thereby raising required
yields. Indeed, since commercial paper issuers tend to be well-known companies,
information, monitoring, and credit assessment costs are lower for commercial paper
issues than for loan sales. Moreover, since there is an active secondary market in
commercial paper, but not for loan sales, the commercial paper buyer takes on less
liquidity risk than does the buyer of a loan sale.

2. What are highly leveraged transactions? What constitutes the federal regulatory definition
of an HLT?

A highly leveraged transaction is a loan to finance an acquisition or merger. Often the

purchase is a leverage buyout with a resulting high leverage ratio for the borrower. U.S.
federal bank regulators have adopted a definition that identifies an HLT loan as one that
(1) involves a buyout, acquisition, or recapitalization and (2) doubles the company’s
liabilities and results in a leverage ratio higher than 50 percent, results in a leverage ratio
higher than 75 percent, or is designated as an HLT by a syndication agent.

3. How do the characteristics of an HLT loan differ from those of a short-term loan that is
sold?
Some of the common characteristics of the two types of loans are listed below:

Short-term loans HLT loans

Secured by the assets of borrowing firm. Secured by the assets of the borrowing
firm.

Short-term maturity (90 days or less). Long-term maturity (often 3 to 6 years).

Yields closely tied to the commercial Floating rates tied to LIBOR, the prime
rate,
paper rate. or a CD rate (plus 200 or more basis
points).

Sold in units of $1 million and up. Strong covenant protection.

Loans to investment grade borrowers Classified as nondistressed or distressed.

or better.

Exercises & Solutions

1. A bank has made a three-year $10 million loan that pays annual interest of 8 percent. The
principal is due at the end of the third year.
 a. The bank is willing to sell this loan with recourse at an interest rate of 8.5 percent.
What price should it receive for this loan?

If the bank sells with recourse, it should expect:

800,000 800,000 10,800,000

𝑃𝑉 = + 2
+ = 9.872 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
(1 + 0.085) (1 + 0.085) (1 + 0.085)3

b. The bank has the option to sell this loan without recourse at a discount rate of 8.75
percent. What price should it receive for this loan?

If the bank sells without recourse, it should expect:

800,000 800,000 10,800,000

𝑃𝑉 = + + = 9.809 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
(1 + 0.0875) (1 + 0.0875)2 (1 + 0.0875)3

c. If the bank expects a 0.5 percent probability of default on this loan, is it better to sell
this loan with or without recourse? It expects to receive no interest payments or
principal if the loan is defaulted.

If sold with recourse and the expected probability of default is taken into account, it
should expect to receive (0.995) x $9.872 = $9.822, which is still higher than selling it
without recourse. The bank should sell the loan with recourse as this option has a
higher expected value (approximately $8,995 higher). The difference represents the
premium the bank effectively earns for retaining the default risk, which at only 0.5%
probability, is worth accepting. So, it should sell it with recourse.

2. An FI is planning to issue $100 million in BB rated commercial loans. The FI will

finance the loans by issuing demand deposits.

a. What is the minimum capital required under Basle III?

The minimum capital required on commercial loans = $100m x 1.0 x 0.08 = $8 million.

b. What is the minimum amount of demand deposits needed to fund this loan assuming
there is a 10 percent average reserve requirement on demand deposits?

Since there is an interaction between the demand deposits and cash reserves held, the
answer requires solving the following, assuming the $8 million is funded by equity
and the reserve requirements are kept as cash:

$100m + (0.10 x DD) = DD + 8m => DD = 92m/0.9 = $102.22 million

c. Show a simple balance sheet with total assets, total liabilities, and equity if this is the
only project funded by the bank.

Assets Liabilities
Cash $10.22m Demand deposits $102.22m
Loan $100.00m Equity 8.00m
Total $110.22m $110.22m
 d. How does this balance sheet differ from Table 26-1? Why?

Since the loans are Category 1 residential mortgages with a loan-to-value ratio
between 60 and 80 percent, the example in Table 26-1 has a capital requirement of
only 4 percent (8% x 0.5) of the face value of the loan. Because the loans in this
problem are BB rated commercial loans, the bank must keep a full 8 percent of the
loan to meet the risk-based capital ratio. Thus, the balance sheet is $0.45m less than
the Table 26-1 example.

3. City Bank has made a 10-year, $2 million loan that pays annual interest of 10 percent.
The principal is expected to be paid at maturity.

a. What should City Bank expect to receive from the sale of this loan if the current
market interest rate on loans of this risk is 12 percent?

The loan generates:

• Annual interest payment: $200,000 ($2,000,000 × 10%)
• Principal repayment at maturity: $2,000,000
•
The present value calculation at 12% discount rate:
• PV of the annuity (interest payments):
$200,000 × [(1 − 1/(1.12)10 )/0.12] = $𝟏, 𝟏𝟐𝟗, 𝟕𝟒𝟑
• PV of the principal repayment: $2,000,000/(1.12)10 = $𝟔𝟒𝟒, 𝟐𝟒𝟕. 𝟕𝟎
Total expected sale price: $1,774.
This represents approximately 88.70% of the loan's face value.

b. The price of loans of this risk is currently being quoted in the secondary market at
bid-offer prices of 88-89 cents (on each dollar). Translate these quotes into actual
prices for the above loan.

The prices of these loans are being quoted at 88 cents and 89 cents to the dollar.
In the case of the above loan, it will translate into $1.56 ($1.774 million x 0.88) and
$1.58 million ($1.774 million x 0.89), i.e., a dealer is willing to buy such loans at
$1.56 million and sell them at $1.58 million.

c. Do these prices reflect a distressed or non-distressed loan? Explain.

This loan is categorized as non-distressed as

i) the implied yield at the midpoint price (12.04%) is very close to the current market
rate (12%) with only a 0.04 percentage point spread,

ii) the spread between the implied yield and the contractual rate (12.04% - 10% =
2.04 percentage points) represents normal market conditions rather than distress,

iii) the market is pricing the loan very close to its theoretical value (88.5 cents vs. 88.7
cents theoretical), indicating efficient pricing and normal trading conditions, and

iv) the narrow bid-ask spread (88-89 cents, or just 1 cent) suggests good liquidity and
market confidence in the loan's valuation.
4. Consider a mortgage pool with principal of $20 million. The maturity is 30 years with a
monthly mortgage payment of 10 percent per year. Assume no prepayments.

a. What is the monthly mortgage payment (100 percent amortizing) on the pool of
mortgages?

Use the amortization formula: 𝑷𝑴𝑻 = 𝑷 × [𝒓(𝟏 + 𝒓)𝒏 ] / [(𝟏 + 𝒓)𝒏−𝟏 ]

• Principal (P) = $20,000,000
• Monthly interest rate (r) = 10% ÷ 12 = 0.8333%
• Number of payments (n) = 30 × 12 = 360
The monthly mortgage payment is $175,514.31

b. If the insurance fee is 6 basis points and the servicing fee is 44 basis points, what is
the yield on the pass-through?

The yield on the pass-through is the mortgage rate minus the fees:
•Mortgage rate: 10.00% , Insurance fee: 0.06% (6 basis points)
• Servicing fee: 0.44% (44 basis points), & Total fees: 0.50% (50 basis points)
•
Pass-through yield = 10.00% - 0.50% = 9.50% annually
Monthly pass-through yield = 9.50% ÷ 12 = 0.79%

c. What is the monthly payment on the pass-through in part (b)?

The monthly payment on the pass-through is the mortgage payment minus the fee payments.

For the first month:

• Original mortgage payment: $175,514.31
• Fee payments: $8,333.33 (addition of d) + e))
• Pass-through payment: $175,514.31 - $8,333.33 = $167,180.98
Note: This payment will change each month as the outstanding principal decreases.

d. Calculate the first monthly servicing fee paid to the originating FIs.

The servicing fee is 44 basis points (0.44%) per year on the outstanding principal:
Monthly servicing fee = $20,000,000 × (0.44% ÷ 12)
Monthly servicing fee = $20,000,000 × 0.000367
Monthly servicing fee = $7,333

e. Calculate the first monthly insurance fee paid to.

The insurance fee is 6 basis points (0.06%) per year on the outstanding principal:
Monthly insurance fee = $20,000,000 × (0.06% ÷ 12)
Monthly insurance fee = $20,000,000 × 0.00005
Monthly insurance fee = $1,000

Breakdown of the first monthly payment:

Total mortgage payment: $175,514 , Interest at 10%: $166,666 , Principal reduction: $8,847
Servicing fee: $7,333 , Insurance fee: $1,000 , Net to investors: $167,180.98
After the first payment, the remaining principal will be $19,991,152.35.