Final Exam Review

Chapter 13 Off Balance Sheet Risk Poses an uncertainty The value of these assets and how much they are leveraged. It is not clear and can impact investors

Contingent Assets An item or activity that, when a contingent event occurs, moves onto the balance side of the balance sheet

Contingent Assets and Liabilities Assets and liabilities off the balance sheet that potentially can produce positive or negative future cash flows for an FI

Contingent Liability An item or activity that, when a contingent even occurs, moves onto the liability side of the balance sheet

Loan commitment agreements A contractual commitment to make a loan up to a stated amount at a given interest rate in the future A contractual commitment by an FI to lend to a firm a certain maximum amount at given interest rate terms Defines the length of time over which the borrower has the option to take down this loan

Take down risk (TYCO) ??The risk that the borrower will take down the loan at an interest rate that is below that of the market and the issuer will have to relay the funds to the borrower?? In February 2002, Tyco International unexpectedly drew down $14.4 billion in credit lines from bans such as Bank of America and J. P. Morgan Chase after being shut out of the commercial paper market when investors began to doubt its accounting practices. To some extent, at least, the back-end fee on unused amounts is designed to create incentives for the borrower to take down lines in full to avoid paying this fee. However, in actuality, many lines are only partially drawn upon.

Commercial letters of credit Contingent guarantees sold by an FI to underwrite the trade or commercial performance of the buyer of the guaranty In economic terms, the FI that sells the Letter of Credit (LC) is selling insurance against the frequency or severity of some particular future occurrence. Further, similar to the different

lines of insurance sold by property-casualty insurers, LC contracts differ as to the severity and frequency of their risk exposures The FIs role is to provide a formal guaranty that payment for goods shipped or sold will be forthcoming regardless of whether the buyer of the goods defaults on payment.

Chapter 16 Sources of operational risk Employee risk: human error and/or internal fraud o employee turnover; key personnel risk; fraud risk; error; rogue trading; money laundering; confidentiality breach Technology risk: Failure or deteriorating systems o programming error; model risk; mark-to-market error; management information; IT systems outage; telecommunications failure; technology provider failure; contingency planning Customer risk: contractual disputes o contractual disagreement; dissatisfaction; default Capital Asset risk: destruction by fire or other natural catastrophe o safety; security; operating costs; fire/flood External risk: external fraud o taxation risk; legal risk; war; collapse of markets; reputation risk; relationship risk

Float -

The interval between the deposit of a check and when funds become available for depositor use; that is, the time it takes a check to clear at a bank

Chapter 17 Fire-sale price The price received for an asset that has to be liquidated (sold) immediately The price an asset holder must accept for the immediate sale may be far less than it would receive with a longer horizon over which to negotiate a sale Threatens the solvency of an FI

Purchased liquidity management (in red) An adjustment to a deposit drain that occurs on the liability side of the balance sheet Federal funds market or repo market Managing the liability side preserves asset side of balance sheet Borrowed funds likely at higher rates than interest paid on deposits Deposits are insured Regulatory concerns: growth of wholesale funds and the potential for serious problems in credit crunch

Stored liquidity management (in red) An adjustment to a deposit drain that occurs on the asset side of the balance sheet Liquidate assets o In absence of reserve requirements, banks tent to hold reserves. E.g., in U.K. reserves 1% or more. Downside: opportunity cost of reserves o Decreases size of balance sheet o Requires holding excess non-interest-bearing assets o Combine purchased and stored liquidity management

Bank runs A sudden and unexpected increase in deposit withdrawals form a Depository Institution Can arise due to concern about banks solvency Demand preferences are on a first come first served basis o Depositors place in line matters

Pro rata distribution on investment funds in proportion distribution of funds Funds distributed to investors according to the amount invested in the company Asset losses will be shared on a pro rata basis so there is no advantage to being first in line

Managing liquidity on basis of assets (selling) or maintaining balance sheet on basis of liabilities

Chapter 19 Moral hazard The loss exposure faced by an insurer when the provision of insurance encourages the insured to take more risks With deposit insurance, a highly leverage bank whose debt holders need not monitor the Dis (borrowers) actions has a strong incentive to undertake excessively risky investment decisions, such as in its loan-generating activities

Capital forbearance Regulators policy of allowing an FI to continue operating even when its capital funds are fully depleted

Prompt corrective action When banks are in trouble, regulators do this Mandatory actions that have to be taken by regulators as a DIs capital ratio falls

The Too Big to Fail doctrine Bear Stearns and Lehman Brothers o Bear Stearns was bailed out by the government o Lehman Brothers was allowed to crash and burn Too Big to Fail Banks Banks that are viewed by regulators as being too big to be closed and liquidated without imposing a systemic risk to the banking and financial system

Discount window from the FED Central bank lender of last resort facility For example, suppose a DI has an unexpected deposit drain close to the end of a reserve requirement period and cannot meet its reserve target. It can seek to borrow from the central banks discount window facility

Chapter 20 Net worth (shareholders equity) of the bank A measure of an FIs capital that is equal to the difference between the market value of its assets and the market value of its liabilities

Mark-to-Market Allowing balance sheet values to reflect current rather than historical prices Marking the balance sheet items to their current prices

Basel Agreements The requirement to impose risk-based capital ratios on banks in major industrialized countries Basel I basic Basel agreement from the Bank of International Settlements o Explicitly incorporated the different credit risks of assets (both on and off balance sheet) into capital adequacy measures. Basel II o Pillar 1: calculation of regulatory minimum capital requirements Credit risk: both on and off balance sheet Market Risk: (Standardized v. Internal Ratings-Based Approach) Operational Risk: (Basic Indicator v. Standardized v. Advanced Measurement Approach) o Pillar 2: regulatory supervisory review so as to complement and enforce minimum capital requirements calculated under Pillar 1 Specifies importance of regulatory review o Pillar 3: requirements on rules for disclosure of capital structure, risk exposures, and capital adequacy so as to increase FI transparency and enhance market/investor discipline Specifies detailed guidance on disclosure of capital structure, risk exposure and capital adequacy of banks

Tier 1 Capital Primary or core capital Closely linked to the banks book value of equity, reflecting the concept of the core capital contribution of a banks owners Basically includes the book value of common equity plus an amount of perpetual (nonmaturing) preferred stock plus minority equity interests held by the bank

Tier 2 Capital Supplementary capital Broad array of secondary capital resources Includes a banks loan loss reserves up to a maximum of 1.25% of the risk-adjusted assets plus various convertible and subordinated debt instruments with maximum caps

Chapter 27 Securitization The packaging and selling of loans and other assets backed by securities

Prepayment risk IO Strip A bond sold to investors whose cash flows reflect the monthly interest payments received from a pool of mortgages Negative Duration: relationship in which the price of a bond increases or decreases as yields increase or decrease The investor pays off more of the principle earlier often causing a refinancing of the securitization at a lower interest rate

Chapter 4 Investment banking and securities firms IPOs An initial, or first time, public offering of debt or equity by a corporation Goal is to raise capital for the company Involves the raising of debt and equity securities for corporations or governments Includes the origination, underwriting, and placement of securities in money and capital markets for corporate or government issuers

The Chinese Wall Separate private and public functions to prevent information from crossing

Private areas of the bank deal with insider information that may not be publicly disclosed An information barrier implemented within a firm to separate and isolate persons who make investment decisions from persons who are privy to undisclosed material information which may influence those decisions

Chapter 22 In Market Merger A merger of two or more companies that deal with the same banking and in the same area

Market Extension Merger A merger of two or more companies that deal in different types of banking and could be in different areas also

Chapter 20 Maybe Depositor transfer Resolution Method

Short Answer Topics JP Morgan had a loan commitment to TYCO, what kind of risk did they have with respect to this loan commitment (in detail)? How could they have mitigated that risk? o Risks Off Balance Sheet Risk Take down risk In February 2002, Tyco International unexpectedly drew down $14.4 billion in credit lines from bans such as Bank of America and J. P. Morgan Chase after being shut out of the commercial paper market when investors began to doubt its accounting practices. o Mitigate the risk Insert certain language into the loan commitment agreement Material Adverse Clause Put into the agreement language that can nullify the agreement should the financials of either company dramatically change Chase and Chemical Case: Which company was in a weaker negotiating position and why? o Chase Chemical was better capitalized Chases market to book value was less than Chemical (87% v. 94.72%) Chemicals efficiency ratio (63%) is less than Chases efficiency ratio (66.33%) Less is better, like in golf scores

What is a bank run? What are some possible clauses of a bank run? What feature of a demand deposit contract contributes to a bank run? o A sudden and unexpected increase in deposit withdrawals form a Depository Institution o Can arise due to concern about banks solvency o Who gets their money: first come first served How does moral hazard relate to financial institutions and the recent financial crisis? What is the too big to fail doctrine and how did it evolve? o Moral hazard occurs when banks take a higher risk in an investment because their funds are backed by such institutions as the FDIC o If people feel like they are insulated from the possibility of negative effects, they are more likely to act rashly and make more risky investments o Too Big to Fail exacerbates this moral hazard because big banks can make these risky investments and if they fail, they will be bailed out by the government and will get all their money back that they lost on the failed investment o How did it evolve? What is one of the most important trends in investment banking over the last 20 years? o Starting to invest their own equity in their own balance sheet???? Goldman Sachs and Paulson: Abacus 2007how did they get into trouble in connection to this trend? o They have raised tremendous capital, with huge balance sheets????? o Got in trouble by building a failing financial product and selling it to investors while Paulson & Co. hedged against Abacus by buying credit default swaps Private equity firms: How do PEFs create value to their investors with respect to the buyouts of other companies? o Increase earnings o Multiple expansion o Delever: pay down the debt that you borrowed Securitization: What has been the effect of securitization on the asset portfolios of financial institutions? o In old days, held on balance sheet o Now, they sell them and get liquidity which comes with fees that they earn o Allows for an overall greater expansion Boston Chicken IPO: What did Merrill do well in the transaction for Boston Chicken? What did they do poorly? Who was Merrills client? o Well: closed the deal o Poorly: mispriced the IPO, undervalued $20 v. the actual market price at nearly $48 o Client: institutional investors that they were selling to, and Boston