Financial Institutions

GESTIN BANCARIA
Master en Banca y Finanzas

Cuantitativas (QF), 2008
Santiago Carb Valverde

Universidad de Granada
Santiago Carb Valverde

Universidad de Granada
scarbo@ugr.es
Materiales docentes en:
http://www.ugr.es/~scarbo/MASTERQF08.html
Esquema de trabajo:
Transparencias en ingls
Presentaciones de papers en clase
Examen final
Referencia bsica:
- SAUNDERS, A. Y M.M. CORNETT (2000):
FINANCIAL INSTITUTIONS MANAGEMENT: A
MODERN PERSPECTIVE, 4 EDICIN, MCGRAW
HILL, NEW YORK, ESTADOS UNIDOS.
- SINKEY, J. (2001): COMMERCIAL BANK FINANCIAL
MANAGEMENT, SEXTA EDICIN, PRENTICE HALL,
NEW YORK, ESTADOS UNIDOS.
4
Tema 1
LA INDUSTRIA DE SERVICIOS
FINANCIEROS: LAS ENTIDADES DE
DEPSITO
(LECTURA DE REFERENCIA:
BHATTACHARYA Y THAKOR, 1993)
Why study Financial Markets and

Institutions?
They
They are
are the
the cornerstones
cornerstones of
of the
the overall
overall
financial
financial system
system in
in which
which financial
financial
managers
managers operate
operate
Individuals
Individuals use
use both
both for
for investing
investing
Corporations
Corporations and
and governments
governments use
use both
both
for
for financing
financing
Overview of Financial Markets
Primary
Primary Markets
Markets versus
versus
Secondary
Secondary Markets
Markets
Money
Money Markets
Markets versus
versus Capital
Capital
Markets
Markets
Foreign
Foreign Exchange
Exchange Markets
Markets
Primary Markets versus

Secondary Markets
Primary
Primary Markets
Markets
markets
markets in
in which
which users
users of
of funds
funds (e.g.
(e.g.
corporations,
corporations, governments)
governments) raise
raise
funds
funds by
by issuing
issuing financial
financial instruments
instruments
(e.g.
(e.g. stocks
stocks and
and bonds)
bonds)
Secondary
Secondary Markets
Markets
markets
markets where
where financial
financial instruments
instruments
are
are traded
traded among
among investors
investors (e.g.
(e.g.
Bolsa
Bolsa Madrid,
Madrid, NYSE,
NYSE, NASDAQ)
NASDAQ)
8
Money Markets versus Capital

Markets
Money
Money Markets
Markets
markets
markets that
that trade
trade debt
debt securities
securities with
with
maturities
maturities of
of one
one year
year or
or less
less (e.g.
(e.g.
Spanish
Spanish Government
Government bonds,
bonds, U.S.
U.S.
Treasury
Treasury bills)
bills)
Capital
Capital Markets
Markets
markets
markets that
that trade
trade debt
debt (bonds)
(bonds) and
and
equity
equity (stock)
(stock) instruments
instruments with
with
maturities
maturities of
of more
more than
than one
one year
year
9
Money Market Instruments Outstanding,

1990-1999 ($Bn)
10
Capital Market Instruments Outstanding,

1990-1999 ($Bn)
11
Foreign Exchange Markets
FX
FX markets
markets deal
deal in
in trading
trading one
one currency
currency for
for
another
another (e.g.
(e.g. dollar
dollar for
for yen)
yen)
The
The spot
spot FX
FX transaction
transaction involves
involves the
the immediate
immediate
exchange
exchange of
of currencies
currencies at
at the
the current
current exchange
exchange
rate
rate
The
The forward
forward FX
FX transaction
transaction involves
involves the
the
exchange
exchange of
of currencies
currencies at
at aa specified
specified date
date in
in the
the
future
future and
and at
at aa specified
specified exchange
exchange rate
rate
12
Overview of Financial
Institutions (FIs)
Institutions
Institutions that
that perform
perform the
the essential
essential function
function of
of
channeling
channeling funds
funds from
from those
those with
with surplus
surplus funds
funds
to
to those
those with
with shortages
shortages of
of funds
funds (e.g.
(e.g. banks,
banks,
thrifts,
thrifts, insurance
insurance companies,
companies, securities
securities firms
firms and
and
investment
investment banks,
banks, finance
finance companies,
companies, mutual
mutual
funds,
funds, pension
pension funds)
funds)
13
Flow of Funds in a World without

FIs: Direct Transfer
Financial Claims
(Equity and debt
instruments)
Suppliers of
Funds
(Households)
Users of Funds
(Corporations)
Cash
Example: A firm sells shares directly to investors without going

through a financial institution
14
Flow of Funds in a world with

FIs: Indirect transfer
FI
(Brokers)
Users of Funds
Suppliers of Funds
FI
(Asset
transformers)
Financial Claims
(Equity and debt securities)
Financial Claims
(Deposits and Insurance policies)
15
Types of FIs
Commercial
Commercial banks
banks
depository
depository institutions
institutions whose
whose major
major assets
assets are
are
loans
loans and
and major
major liabilities
liabilities are
are deposits
deposits
Thrifts
Thrifts and
and savings
savings banks
banks
depository
depository institutions
institutions in
in the
the form
form of
of savings
savings banks,
banks,
savings
savings and
and loans,
loans, credit
credit unions,
unions, credit
credit
cooperatives
cooperatives
Insurance
Insurance companies
companies
financial
financial institutions
institutions that
that protect
protect individuals
individuals and
and
corporations
corporations from
from adverse
adverse events
events
(continued)
16

Securities
Securities firms
firms and
and investment
investment banks
banks
financial
institutions that
that underwrite
underwrite
securities
securities and
and engage
engage in
in securities
securities
brokerage
brokerage and
and trading
trading
Finance
Finance companies
companies
financial
institutions that
that make
make loans
loans to
to
individuals
individuals and
and businesses
businesses
Mutual
Mutual Funds
Funds
financial
institutions that
that pool
pool financial
financial
resources
resources and
and invest
invest in
in diversified
diversified portfolios
portfolios
Pension
Pension Funds
Funds
financial
institutions that
that offer
offer savings
savings
plans
plans for
for retirement
retirement
17
Services Performed by Financial

Intermediaries
Monitoring
Monitoring Costs
Costs
aggregation
aggregation of
of funds
funds provides
provides greater
greater
incentive
incentive to
to collect
collect aa firms
firms information
information
and
and monitor
monitor actions
actions
Liquidity
Liquidity and
and Price
Price Risk
Risk
provide
provide financial
financial claims
claims to
to savers
savers with
with
superior
superior liquidity
liquidity and
and lower
lower price
price risk
risk
(continued)
18

Transaction
Transaction Cost
Cost Services
Services
transaction
transaction costs
costs are
are reduced
reduced through
through
economies
economies of
of scale
scale
Maturity
Maturity Intermediation
Intermediation
greater
greater ability
ability to
to bear
bear risk
risk of
of mismatching
mismatching
maturities
maturities of
of assets
assets and
and liabilities
liabilities
Denomination
Denomination Intermediation
Intermediation
allow
allow small
small investors
investors to
to overcome
overcome
constraints
constraints imposed
imposed to
to buying
buying assets
assets
imposed
imposed by
by large
large minimum
minimum denomination
denomination
size
size
19
Services Provided by FIs

Benefiting the Overall Economy
Money
Money Supply
Supply Transmission
Transmission
Depository
Depository institutions
institutions are
are the
the conduit
conduit
through
through which
which monetary
monetary policy
policy actions
actions
impact
impact the
the economy
economy in
in general
general
Credit
Credit Allocation
Allocation
often
often viewed
viewed as
as the
the major
major source
source of
of
financing
financing for
for aa particular
particular sector
sector of
of the
the
economy
economy (e.g.
(e.g. farming
farming and
and real
real estate)
estate)
(continued)
20
Services Provided by FIs Benefiting

the Overall Economy
Intergenerational
Intergenerational Wealth
Wealth Transfers
Transfers
life
life insurance
insurance companies
companies and
and pension
pension
funds
funds provide
provide savers
savers with
with the
the ability
ability to
to
transfer
transfer wealth
wealth from
from one
one generation
generation to
to
the
the next
next
Payment
Payment Services
Services
efficiency
efficiency with
with which
which depository
depository
institutions
institutions provide
provide payment
payment services
services
directly
directly benefits
benefits the
the economy
economy
21
Risks Faced by Financial Institutions
Interest
Interest Rate
Rate Risk
Risk
Foreign
Foreign Exchange
Exchange Risk
Risk
Market
Market Risk
Risk
Credit
Credit Risk
Risk
Liquidity
Liquidity Risk
Risk
Off-Balance-Sheet
Off-Balance-Sheet Risk
Risk
Technology
Technology Risk
Risk
Operation
Operation Risk
Risk
Country
Country or
or Sovereign
Sovereign Risk
Risk
Insolvency
Insolvency Risk
Risk
22
Regulation of Financial
Institutions
FIs
FIs provide
provide vital
vital financial
financial services
services to
to all
all sectors
sectors
of
of the
the economy;
economy; therefore,
therefore, their
their regulation
regulation is
is
in
in the
the public
public interest
interest
In
In an
an attempt
attempt to
to prevent
prevent their
their failure
failure and
and the
the
failure
failure of
of financial
financial markets
markets overall
overall
23
Globalization of Financial Markets

and Institutions
Financial
Financial Markets
Markets became
became more
more global
global as
as the
the
value
value of
of stocks
stocks traded
traded in
in foreign
foreign markets
markets
soared
soared
Foreign
Foreign bond
bond markets
markets have
have served
served as
as aa major
major
source
source of
of international
international capital
capital
Globalization
Globalization also
also evident
evident in
in the
the derivative
derivative
securities
securities market
market
24
Factors Leading to Significant Growth in

Foreign Markets
The
The pool
pool of
of savings
savings from
from foreign
foreign investors
investors has
has
increased
increased
International
International investors
investors have
have turned
turned to
to U.S.
U.S. and
and
other
other markets
markets to
to expand
expand their
their investment
investment
opportunities
opportunities
Information
Information on
on foreign
foreign investments
investments and
and markets
markets
is
is now
now more
more accessible
accessible (e.g.
(e.g. internet)
internet)
Some
Some mutual
mutual funds
funds allow
allow ability
ability to
to invest
invest in
in
foreign
foreign securities
securities with
with low
low transaction
transaction costs
costs
Deregulation
Deregulation has
has enhanced
enhanced globalization
globalization of
of capital
capital
flows
flows
25
Tema 2
POR QU SON ESPECIALES LOS
INTERMEDIARIOS BANCARIOS?
(LECTURA DE REFERENCIA: ALLEN Y

SANTOMERO (1997)
Why Are Financial

Intermediaries Special?
Objectives:
Develop the tools needed to measure and
manage the risks of FIs.
Explain the special role of FIs in the
financial system and the functions they
provide.
Explain why the various FIs receive special
regulatory attention.
Discuss what makes some FIs more special
than others.
27
Without FIs
Equity & Debt
Households
Corporations
(net savers)
(net borrowers)
Cash
28
FIs Specialness
Without FIs: Low level of fund flows.
Information costs:
Economies of scale reduce costs for FIs to
screen and monitor borrowers
Less liquidity
Substantial price risk
29
With FIs
FI
Households
Cash
Deposits/Insurance
Policies
(Brokers)
FI
(Asset
Transformers)
Corporations
Equity & Debt
Cash
30
Financial Structure Puzzles: a

way to explain the role of FIs
stocks are not the most important source of external
financing for businesses
issuing debt and equity is not the main way that
businesses finance operations
indirect financing is more important than direct financing
banks are the most important source of external funds
for businesses
financial industry is one of the most heavily regulated
industries
only large, well-known firms have access to the securities
markets
collateral is an important part of debt contracts for
businesses and households
debt contracts are complex and often contain many
restrictions for the borrower
31
Transaction Costs
information and other transaction costs in
financial system can be substantial
How do transaction costs affect investing?
How can financial intermediaries reduce
transaction costs?
32
Asymmetric Information
one party to a transaction has better
information to make decisions than
the other party
asymmetric information in financial
market causes two main problems
adverse selection
moral hazard
33
Adverse Selection
asymmetric information problem that
occurs prior to a transaction
examples of adverse selection
result of adverse selection is that
lenders may decide not to make loans
if they can not distinguish between
good and bad credit risks
34
Moral Hazard
asymmetric information problem that
occurs after a transaction
risk that borrower will undertake risky
activities that will increase the
probability of default
result of moral hazard is that lenders
may decide not to make a loan
35
Lemons Problem
idea presented in article by George Akerlof
in terms of lemons in used car market
used car buyers are unable to determine
quality of car - good car or lemon?
What amount is buyer willing to pay for
this used car of unknown quality?
How can buyer improve information on
quality?
36
Lemons Problem in Stock and Bond

Market
asymmetric information prevents investors from
identifying good and bad firms
What price will these investors pay for stock?
Who has better information about the firm?
Which firms will come to the market for financing
under these conditions?
37
Principal-Agent Problem
define the principal-agent problem
Who is the principal and who is the
agent?
What problem does a separation of
ownership and control cause?
How could we prevent principal-agent
problem?
38
Solutions to Financing
Puzzles
lemons or adverse selection problem tells
why marketable securities are not the
primary source of financing
situation is similar in corporate bond
market
tells why stocks are not the most
important source of external financing
39
More Solutions to Financial

Structure Puzzles
importance of financial intermediaries
explains importance of indirect financing
explains why banks are most important
source of external financing
explains why markets are only available
to large, well-known firms
40
Functions of FIs
Brokerage function
Acting as an agent for investors:
e.g. Merrill Lynch, Charles Schwab
Reduce costs through economies of scale
Encourages higher rate of savings
Asset transformer:
Purchase primary securities by selling
financial claims to households
These secondary securities often more
marketable
41
Role of FIs in Cost Reduction

Information costs:
Investors exposed to Agency Costs
Role of FI as Delegated Monitor (Diamond,
1984)
Shorter term debt contracts easier to monitor
than bonds
FI likely to have informational advantage
42
Services Performed by FIs
Monitoring Costs
Liquidity and Price Risk
Transaction Cost Services
Maturity Intermediation
Denomination Intermediation
43
Services Provided by FIs

Money Supply Transmission
Credit Allocation
Intergenerational Wealth
Transfers
Payment Services
(continued)
44
Regulation of FIs
Regulation is not costless
Net regulatory burden.
Safety and soundness regulation

Monetary policy regulation
Credit allocation regulation
Consumer protection regulation
Investor protection regulation
Entry regulation
45
Changing Dynamics of
Specialness
Trends in the United States

Decline in share of depository institutions.
Increases in pension funds and investment
companies.
May be attributable to net regulatory burden
imposed on depository FIs.
Technological changes affect delivery of financial
services and regulatory issues
Potential for regulations to be extended to hedge
funds
Result of Long Term Capital Management
disaster
46
Future Trends
Weakening of public trust and confidence in FIs may
encourage disintermediation
Increased merger activity within and across sectors
Citicorp and Travelers, UBS and Paine Webber
More large scale mergers such as J.P. Morgan
and Chase, and Bank One and First Chicago
Growth in Online Trading
Increased competition from foreign FIs at home and
abroad
Mergers involving worlds largest banks
Mergers blending together previously separate
financial services sectors
47
Tema 3
ORGANIZACIN INDUSTRIAL DEL
SECTOR BANCARIO
(LECTURA DE REFERENCIA: HUMPHREY

ET AL. (2006))
3. Bank competition
3.1. BANK COMPETITION
THE STRUCTURE-CONDUCT-PERFORMANACE (SCP)
PARADIGM: Many empirical studies have considered
concentration - mainly the Herfindahl-Hirschman
Index (HHI) - as a proxy for bank market power
following the Structure-Conduct-Performance (SCP)
paradigm (Berger and Hannan, 1989; Hannan and
Berger, 1991).
However, several contributions to the banking
literature during the last two decades have cast doubt
on the consistency and robustness of concentration as
an indicator of market power (Berger, 1995; Rhoades,
1995; Jackson 1997; Hannan, 1997).
49
IO theory predicts a correspondence between the

Lerner index (L) as the spread between prices (P)
and marginal costs (C) divided by prices - and the
HHI so that , where is a conjecture parameter
showing the response of the industry output to
changes to a unit output change by the firm, and is
the industry price elasticity of demand. If =1 there
is a monopoly solution while if =0, then a Bertrand
solution holds with L=0.
Hence, the correspondence depends upon
restrictive assumptions on the conjecture and
demand elasticity parameters.
50
As contestability increases in a market, the

reliability of the HHI as a measure of market power
is significantly limited.
Therefore, changes in the stability of the banking
sector as a consequence of industry restructuring or
liberalization may cast doubt on the validity of the
HHI as a dynamic measure of competition.
Instability will also affect conjecture and elasticity
parameter so that the relationship between market
power and concentration becomes blurred.
51
Although the SCP hypothesis of a positive relationship

between concentration and profits can be derived from
oligopoly theory under these assumptions of different
solutions to a Cournot model, it is not warranted under
alternative models.
Some empirical studies have even tested and rejected the

hypothesis of Cournot conduct in the banking industry
(Roberts, 1984; Berg and Kim, 1994). Econometric
developments have permitted the emergence of empirical
papers from the so-called New Empirical Industrial
Organization (NEIO) perspective, by directly estimating the
parameters of a firm's behavioral equation and, in
particular, marginal costs - to directly obtain indicators such
as the Lerner Index (Schmalensee, 1989).
52
Although price to marginal costs indicators are not

new from a theoretical standpoint, marginal costs
have only been econometrically estimated during
the last two decades. Applications to the banking
industry as in Shaffer (1993), Ribon and Yosha
(1999) or Maudos and Fernndez de Guevara
(2004) have already shown that these price to
marginal costs indicators are frequently
uncorrelated with concentration ratios.
53
The definition of the mark-up and the

Lerner index can be directly derived from a
simplified market structure model
(Bresnahan, 1989) where banking firms are
supposed to produce a single good.
Assuming that banks behave as profit
maximizers, the general expression for
intermediate oligopolistic market structures
with m banks operating in the market is
expressed as:
54
p
p C '( y j , w j )
y j
y
with j y j y and j 1,..., m
where p is the price of the bank product; C(yj,

wj) is a cost function defined for each bank
j where yj is the quantity produced by firm
j in the industry and wj represents the
vector of prices of the factors of bank j. The
parameter j expresses the degree of
market power from perfectly competitive
(j = 0) to monopolist (j = 1). This can be
alternatively written as:
55
1
p C '( y j , w j ) j
%
1 p
where
y
% y
where the mark-up of price over marginal cost ([p

C(yj, wj)]) equals the inverse of the semi-elasticity
on bank product demand (1/) times the market
structure parameter (j). Therefore, higher values of
the mark-up measure will indicate a worsening of
bank competition conditions either by a decrease in
the semi-elasticity of demand on bank product () or
an increase in the market structure parameter ( j).
56
The mark-up is used to compute the Lerner index,

which is a relative margin computed as [p C(yj,
wj)] / p. Higher values of the Lerner index also
indicate a worsening of competition conditions.
57
58
59
60
61
62
63
64
65
66
67
68
Table 1: Bank Interest Cost Efficiency--DFA, 1992-2001

Interest Cost Equation:
External Influences
Technical Influences
External+Technical
External+Technical+Internal
EFF
.69
.91
.922
.989
INEFF
.45
.10
.085
.011
% Unexplained
10.5%
2.2%
1.93%
0.16%
Savings Banks:
.999
.001
0.04%
Commercial Banks:
.993
.007
0.17%
69
Table 2: Bank Operating Cost Efficiency--DFA, 1992-2001

Operating Cost Equation:
External Influences
Internal Influences
External+Technical
EFF
.52
.65
.67
.72
.89
INEFF
.92
.54
.49
.39
.12
% Unexplained
13.2%
12.0%
15.3%
8.6%
4.3%
Savings Banks:
.94
.06
1.9%
Commercial Banks:
.96
.04
1.6%
70
Table 3: Bank Interest Cost Efficiency--DEA, 1992-2001

Interest Cost Equation:
External+Technical
EFF
.83
.92
.93
INEFF
.20
.09
.08
Savings Banks:
.97
.03
Commercial Banks:
.92
.09
71
Table 4: Bank Operating Cost Efficiency--DEA, 1992-2001

Operating Cost Equation:
External+Technical
EFF
.95
.96
.98
INEFF
.05
.04
.02
Savings Banks:
.98
.02
Commercial Banks:
.99
.01
72
73
74
Introduccin
Existen, al menos, tres dimensiones

en las que se precisan avances para
lograr un diagnstico ms preciso de
la realidad competitiva de la industria
bancaria de la UE y poder arbitrar
polticas acordes con los objetivos de
integracin y la mejora del acceso a
los servicios bancarios
75
Tema 4
GOBIERNO Y ESTRUCTURA
ORGANIZATIVA DE LA BANCA
(MATERIAL DEL PROFESOR)
It is the ability to foretell what is going to happen

tomorrow, next week, next month, and next year. And to
have the ability afterwards to explain why it didnt
happen.
Sir Winston Churchill
What are Financial

Intermediaries (FIs)?
Financial Securities: contingent claims on
future cash flows debt, equity, derivatives,
hybrids.
All firms liabilities & net worth are
predominately comprised of financial
securities.
But most firms hold real assets such as
inventory, plant & equipment, buildings.
FIs assets are predominately comprised of
financial securities.
78
Transparent, Transluscent and Opaque FIs

F in a n c ia l I n t e r m e d ia t io n : T h e F lo w o f F u n d s a n d P r im a r y S e c u r it ie s
F u n d s S u r p l u s U n it s
B ro k e rs
F u n d s D e f ic it U n it s
D e a le rs
U n d e r w r it e r s
In v e s tm e n t B a n k s
M u tu a l F u n d s
B anks
In s u r a n c e C o m p a n ie s
79
What Services Do FIs Provide?
Information
Liquidity
Reduced Transaction Costs
Transmission of Monetary Policy
Credit Allocation
Payment Services
Intergenerational Wealth Transfer
80
FIs are the most regulated of

all firms
Safety and Soundness Regulation
Deposit Insurance
Monetary Policy Regulation

Reserve Requirements
Credit Allocation Regulation (eg., mortgages)

Consumer Protection Regulation
Community Reinvestment Act, Home Mortgage
Disclosure Act, Truth in Lending Protection
Investor Protection Regulation

Entry Regulation
81
Types of FIs
Depository Institutions
Insurance Companies
Securities Firms and Investment
Banks
Mutual Funds
Finance Companies
Distinctions blurred by the GrammLeach-Bliley Act of 1999 that created
Financial Holding Companies (FHCs).
82
Features Common to Most FIs

High Amount of Financial Leverage
Low equity/assets ratios. Capital
requirements.
Off-balance sheet items
Contingent claims that under certain
circumstances may eventually become
balance sheet items (ex. Derivatives,
commitments)
Revenue: Interest Income & Fees
Costs: Interest Expenses and Personnel
83
Depository Institutions
Commercial Banks: accept deposits and make loans to
consumers and businesses.
Money Center Banks: Citigroup, Bank of NY,
BankOne, Bankers Trust (Deutschebank), JP Morgan
Chase and HSBC Bank USA.
Savings Associations (S&Ls)
Qualified Thrift Lender (QTL) mortgages must
exceed 65% of thrifts assets.
Savings Banks
Use deposits to fund mortgages & other assets.
Credit Unions and Credit cooperatives
Nonprofit mutually owned institutions (owned by
depositors).
84
Overview of Depository Institutions

In this segment, we explore the
depository FIs:
Size, structure and composition

Balance sheets and recent trends
Regulation of depository institutions
Depository institutions performance
85
Products of FIs
Comparing the products of FIs in 1950, to
products of FIs in 2003:
Much greater distinction between types of
FIs in terms of products in 1950 than in
2003
Blurring of product lines and services over
time
Wider array of services offered by all FI
types
86
Specialness of Depository FIs

Products on both sides of the balance
sheet
Loans
Business and Commercial
Deposits
87
Other outputs of depository FIs

Other products and services 1950:
Payment services, Savings products,
Fiduciary services
By 2003, products and services

further expanded to include:
Underwriting of debt and equity,
Insurance and risk management
products
88
Size of Depository FIs

Consolidation has created some very
large FIs
Combined effects of
disintermediation, global competition,
regulatory changes, technological
developments, competition across
different types of FIs
89
Largest Depository Institutions in the

US
Total Assets ($Billions)
Citigroup
J.P. Morgan Chase*
Bank of America**
Wells Fargo
Wachovia
Bank One*
Washington Mutual
Fleet Boston**
U.S. Bancorp
SunTrust Banks
$1,208.9
770.9
736.4
393.9
388.0
326.6
275.2
200.2
188.8
181.0
90
Organization of Depository
Institutions
Commercial Banks
Largest depository institutions are commercial
banks.
Differences in operating characteristics and
profitability across size classes.
Notable differences in ROE and ROA as well as

the spread
Thrifts
S&Ls
Savings Banks
Credit Unions
Mix of very large banks with very small banks
91
Functions & Structural

Differences
Functions of depository institutions

Regulatory sources of differences across
types of depository institutions.
Structural changes generally resulted

from changes in regulatory policy.
Example: changes permitting interstate
branching
Reigle-Neal Act (1994) in the US
In Spain, deregulation in 1989 concerning
savings banks operations
92
Commercial Banks
Primary assets:
Real Estate Loans: $2,272.3 billion

C&I loans: $870.6 billion
Loans to individuals: $770.5 billion
Investment security portfolio: $1,789.3
billion
Of which, Treasury bonds: $1,005.8 billion
Inference: Importance of Credit Risk

93
Commercial Banks
Primary liabilities:
Deposits: $5,028.9 billion
Borrowings: $1,643.3 billion
Other liabilities: $238.2 billion
Inference:
Highly leveraged
94
Small Banks, US
C&I
14%
Credit Card
1%
Consumer
8%
Real Estate
63%
Other
14%
95
Large Banks, US
C&I
18%
Credit Card
7%
Real Estate
44%
Consumer
10%
Other
21%
96
Structure and Composition

Shrinking number of banks:
14,416 commercial banks in 1985
12,744 in 1989
7,769 in 2004
Mostly the result of Mergers and

Acquisitions
M&A prevented prior to 1980s, 1990s
Consolidation has reduced asset share of
small banks
97
Structure & Composition

of Commercial Banks
Financial Services Modernization Act
1999
Allowed full authority to enter
investment banking (and insurance)
Limited powers to underwrite

corporate securities have existed only
since 1987
98
Composition of
Commercial Banking Sector
Community banks
Regional and Super-regional
Access to federal funds market to finance
their lending activities
Money Center banks

Bank of New York, Deutsche Bank (Bankers
Trust), Citigroup, J.P. Morgan Chase, HSBC
Bank USA
declining in number
99
Balance Sheet and Trends

Business loans have declined in
importance
Offsetting increase in securities and
mortgages
Increased importance of funding via
commercial paper market
Securitization of mortgage loans
100
Some Terminology
Transaction accounts
Negotiable Order of Withdrawal (NOW)
accounts (cuenta a la vista)
Money Market Mutual Fund
Negotiable CDs (certificados de
depsito): Fixed-maturity interest
bearing deposits with face values over
$100,000 that can be resold in the
secondary market.
101
Off-balance Sheet Activities

Heightened importance of off-balance
sheet items
Large increase in derivatives positions is
a major issue
Standby letters of credit
Loan commitments
When-issued securities
Loans sold
102
Trading and Other Risks

Allied Irish / Allfirst Bank
$750 million loss (2001)
National Australian Bank

$450 million loss (2004)
Failure of the U.K. investment bank

Barings
The Bankruptcy of Orange County in
California.
103
Other Fee-generating Activities

Trust services
Correspondent banking
Check clearing
Foreign exchange trading
Hedging
Participation in large loan and security
issuances
Payment usually in terms of noninterest
bearing deposits
104
Key Regulatory Agencies

FDIC and the Office of the Comprotroller of
the Currency in the US.
European Central Bank
National central banks
National Governments
Regional Governments
105
Web Resources
For more detailed information on the
regulators, visit:
http://www.ecb.int
http://www.bde.es
http://www.fdic.gov
http://www.occ.treas.gov
http://federalreserve.gov
106
Banking and Ethics

Some cases for the US:
Bank of America and Fleet Boston
Financial 2004
J.P. Morgan Chase and Citigroup 2003
role in Enron
Riggs National Bank and money
laundering concerns 2003
107
Savings Institutions
Comprised of:
Savings and Loans Associations
Savings Banks
Effects of moral hazard and regulator

forbearance. Quite a debate worldwhile.
108
Savings Institutions: Recent Trends

Industry is smaller overall
Intense competition from other FIs
mortgages for example
Concern for future viability in certain

countries.
109
Credit Unions
Nonprofit depository institutions owned by
member-depositors with a common bond.
Exempt from taxes and Community
Reinvestment Act (CRA) in the US.
Expansion of services offered in order to
compete with other FIs.
Very important in certain European
countries (Germany, Spain).
110
Global Issues
Near crisis in Japanese Banking
Eight biggest banks reported positive sixmonth profits
China
Deterioration, NPLs (nonperforming
loans) at 50% levels
Opening to foreign banks (WTO entry)
German bank problems in early 2000s
Implications for future competitiveness
111
Largest Banks in the World
112
Tema 5
La concesin de crdito,
el riesgo de crdito y
otros riesgos
(LECTURA DE REFERENCIA:
ALTUNBAS ET AL.,2007)
5.1. THE CONCEPT OF RISK

Risks facing all financial institutions can
be segmented into three separable types,
from a management perspective. These
are:
(i) risks that can be eliminated or avoided
by simple business practices,
(ii) risks that can be transferred to other
participants, and,
(iii) risks that must be actively managed
at the firm level.
114
The management of the banking firm relies

on a sequence of steps to implement a risk
management system. These can be seen as
containing the following four parts:
(i) standards and reports,

(ii) position limits or rules,
(iii) investment guidelines or strategies,
(iv) incentive contracts and compensation.
115
SOURCES OF RISK
For the sector as a whole, the risks can be
broken into six generic types:
- systematic or market risk
- credit risk
- counterparty risk
- liquidity risk
- operational risk
- legal risk
116
Systematic risk is the risk of asset value

change associated with systematic factors.
It is sometimes referred to as market risk,
which is in fact a somewhat imprecise term.
By its nature, this risk can be hedged, but
cannot be diversified completely away. In
fact, systematic risk can be thought of as
undiversifiable risk.
117
Credit risk arises from non-performance by

a borrower. It may arise from either an
inability or an unwillingness to perform in the
pre-committed contracted manner. This can
affect the lender holding the loan contract,
as well as other lenders to the creditor.
Therefore, the financial condition of the
borrower as well as the current value of any
underlying collateral is of considerable
interest to its bank
118
Counterparty risk comes from nonperformance of a trading partner. The nonperformance may arise from a
counterparty's refusal to perform due to an
adverse price movement caused by
systematic factors, or from some other
political or legal constraint that was not
anticipated by the principals.
Diversification is the major tool for
controlling nonsystematic counterparty risk.
119
Liquidity risk can best be described as the

risk of a funding crisis. While some would
include the need to plan for growth and
unexpected expansion of credit, the risk here
is seen more correctly as the potential for a
funding crisis.
Such a situation would inevitably be associated
with an unexpected event, such as a large
charge off, loss of confidence, or a crisis of
national proportion such as a currency crisis.
120
Operational risk is associated with the

problems of accurately processing, settling,
and taking or making delivery on trades in
exchange for cash. It also arises in record
keeping, processing system failures and
compliance with various regulations.
As such, individual operating problems are
small probability events for well-run
organizations but they expose a firm to
outcomes that may be quite costly.
121
Legal risks are endemic in financial contracting

and are separate from the legal ramifications of
credit, counterparty, and operational risks.
New statutes, tax legislation, court opinions and
regulations can put formerly well-established
transactions into contention even when all
parties have previously performed adequately
and are fully able to perform in the future.
122
5.2. REGULATION AND CREDIT

RISK: AN EXAMPLE FROM BASEL II
Historically, regulation has limited who
can:
open or charter new banks and
what products and services banks can
offer.
Imposing barriers to entry and

restricting the types of activities banks
can engage in clearly enhance safety
and soundness, but also hinder
competition.
123
It assumed that the markets for bank

products, largely bank loans and
deposits, could be protected and that
other firms could not encroach upon
these markets.
Not surprisingly, investment banks,
hybrid financial companies, insurance
firms, and others found ways to
provide the same products as banks
across different geographic markets.
124
However, there is another type of

regulation that has concentrated most
of the attention in the last three
decades, the bank capital regulation.
Changes in reserve requirements
directly affect the amount of legal
required reserves and thus change the
amount of money a bank can lend out. The
main recent example is BASEL II.
125
THE STRATEGIC IMPACT OF BASEL II

Basel 2 is a step change in the regulation of
capital adequacy. It will alter the industry frame
of reference for banks in many ways:
Regulators are clearly recognizing market realities
and seeking a much closer congruence between
regulatory and economic capital.
The new proposals are more complex and
sophisticated than earlier schemes. They will
also have to evolve as market conditions,
technology and financial management techniques
develop.
126
The calibration exercises that have resulted from

the various Quantitative Impact Studies (QIS) are
targeted (initially at least) to deliver broadly the
same amount of capital as the current Accord.
However, the mix of capital charges will
change significantly with the wider range of risk
weights and greater risk sensitivity of Basel 2.
Basel 2 will clearly be much more risk-sensitive
in assigning capital charges. Mortgage lending and
lending to higher quality borrowers will be
incentivised under Basel 2.
127
It is not clear whether the present or new Basel

Accord are a binding constraint on banks current
credit operations. Jackson et al (2001, Bank of
England WP) suggest that banks may employ
more conservative capital standards than those
imposed under Basel 1 or likely under Basel 2.
Compliance costs are likely to increase. Banks
will have to evaluate (as a kind of capital
investment decision) whether the costs (including
compliance costs) of moving to the more advanced
Basel 2 systems are worthwhile.
128
Banks will increasingly target better risk

management as a source of competitive
advantage. Increasingly, superior risk
management will become a key success
factor for those banks who are able to respond
successfully to the new environment.
Nevertheless, specialist banks who focus on a
smaller number of core products and services
should similarly be able to obtain risk
management benefits of specialization.
129
Basel 2 will enhance present securitisation

trends in banking. This will help in its turn to
emphasise further the strategic importance of
investment banking. At the same time, lending
bankers will face increasing adverse selection trends
as the better credits are able to access directly the
capital markets.
This trend will help to re-emphasise the
importance of credit skills in lending banks. It will
also put pressure on these banks to widen their
margins (in order to achieve the higher risk premia
needed to cover their more risky lending).
130
Governance will be an increasingly important issue in

the new regime. More disclosure is not enough by itself to
secure market discipline (the aim of Pillar 3). A wide
collection of new and improved governance structures will be
needed. These include:
a freer market in bank corporate control;

good corporate governance in banks;
incentive-compatible safety nets;
no bail-out policies;
and proper accounting standards.
Banks will be required to disclose more information

than ever before to the external market. This will involve
additional compliance costs. Strategically, it will reinforce any
competitive advantage gained by good risk-management
banks.
131
Under Pillar 3 and with likely changes in bank

governance arrangements, the prospects of takeovers (and no bail-outs) for individual banks who
are inefficient are likely to increase. This new
world is a likely further threat to concepts like
mutuality and subsidised (or at least protected from
competition) regional banking.
Insofar as the new capital regime allows nonbank financial companies a competitive
advantage (via lesser capital backing), banks will
attempt to alter the balance of competitive
advantage through regulatory arbitrage
132
More work is needed on stress testing under

Basel 2 and banks can expect further, more
detailed efforts from regulators in this area.
Already, stress testing appears to be a
standard management technique for many
banks and most banks that stress test do so at a
high frequency (daily or weekly): see Fender
and Gibson (Risk, 2001).
133
Perhaps the most fundamental strategic impact of

Basel 2 is that it will enhance the SWM
(Shareholder Wealth Maximisation) model as
the major strategic and managerial model for
banks. The essence of this model is its focus on
risk and return and the impact of this tradeoff on
bank value; the model also emphasises the need
for greater risk sensitivity in risk assessments and
pricing. Within this model, better risk
management is rewarded.
134
5.3. THE SPANISH SAVINGS BANKS AND THE

NEW REGULATORY FRAMEWORK
Although most of the strategic implications mentioned

earlier for retail banks apply also to Spanish savings
banks, there are some specific features of the Spanish
savings banks that may modify some of these
conclusions. These specific features are explored in this
section (and summarised in Diagram 1):
There have been some recent regulatory actions regarding

risk and capital in the Spanish banking system that should
be taken into account when defining the threats and
opportunities of the new framework for savings banks. The
development of a Default Hedging Statistical Fund (the
so-called FECI) by the Bank of Spain are two of the recent
developments in the regulatory field that impact on the
current solvency risk of Spanish savings banks
135
DIAGRAM 1. SPANISH SAVINGS BANKS AND THE NEW REGULATORY

CAPITAL FRAMEWORK. KEY FEATURES
REGULATION: MARKET
DEVELOPMENTS
BASEL 2
STRATEGIC
IMPLICATIONS
SPANISH SAVINGS
BANKS AND THE NEW
REGULATORY CAPITAL
FRAMEWORK
CAPITAL REGULATION
AND OWNERSHIP
SECTORAL PROJECT
FOR THE GLOBAL
CONTROL OF RISK
136
The establishment of so-called statistical, pro-cyclical or

dynamic provisions:
Requiring banks to increase these provisions when the
business cycle is positive and reducing them during downturns
in order to favor intertemporal risk smoothing and loan
supply.
Basel 2 does not appear to change the view of banking as a
pro-cyclical business. Basel 2 could even exacerbate
cyclical effects. It is this contingency that has led the Bank
of Spain to establish the so-called pro-cyclical or dynamic
provisions.
The recent lending patterns of the Spanish savings
banks are known to reduce these pro-cyclical effects
since they have increased credit supply almost linearly over the
business cycle.
137
The lending behavior of savings banks has not

resulted in higher defaults. On the contrary,
default risk management at savings banks has
apparently been more efficient than for commercial
banks, a fact that may be largely explained by the
intertemporal risk smoothing advantages achieved
via a close contractual relationship with their
customers.
138
There are three main types of savings-bank

specific effects:
(1) those concerning the aim of Basel 2 and the
differences between economic and regulatory
capital;
(2) those that refer to specialization, size and lending
diversification;
(3) those related to the implementation of the new
capital adequacy requirements, including the
sectoral project of Spanish savings banks for the
global control of risk.
139
(i) Aim of Basel 2 and Economic and Regulatory

Capital Differences
While the objective of Stakeholder Wealth
Maximization (STWM) may match more closely
the nature of Spanish savings banks, SWM should
not be a problem for savings institutions since
they have to compete with commercial banks.
Nevertheless, the SWM model will be reinforced
by Basel 2 and Spanish savings banks may
benefit from recent regulatory changes that
stress their ownership status as private and
non-subsidised.
140
(ii) Size, specialisation and lending diversification

Specialist banks (like savings banks) focusing
on a smaller number of core products may also
be able to obtain the risk management
benefits of specialisation. Continuous
calibration and capital treatment may reduce the
potential loss of competitiveness in retail
banking. Servicing, relationship banking and
dynamic lending will also be valued positively.
141
(iii)
Final implementation of Basel 2 on Spanish savings
banks: the sectoral project for the global control of risk
The Spanish Confederation of Savings Banks (CECA)
has led an ambitious initiative to undertake a
sectoral project for the global control of risk.
Since this project is oriented to the whole savings
bank sector, it has to deal with various problems,
like the rigidities of employing a single model for all
institutions.
However, the project is targetted to provide
savings banks with adequate and centralised
human and technological resources in order to
implement their own model with a high standard of
quality.
142
The model for each line of business

incorporates risk measurement, control and
management operating with three different
working groups:
information management;
organization and procedures;
quantitative tools.
143
5.4. COMPARATIVE DESCRIPTIVE

STATISTICS
The credit risk of Spanish depository institutions
does not seem to be a concern in the shortrun.
The ratios doubtful assets/total exposures
and doubtful loans of other resident
sectors/total exposures of resident sectors
have decreased in recent years and are lower
than 1% (Table 1).
Statistical provisions have increased over
time as a percentage of total provisions (Table 1).
144
TABLE 1.
145
Source: Bank of Spain (Memory of Bank Supervision 2004)
Savings banks and credit co-operatives

have enjoyed higher margins compared to
commercial banks (Table 2). The margins are in
line with the European standards.
However, competitive presures have resulted in

a decrease of margins over time during the
last years.
146
TABLE 2.
147
As shown in Table 3, Spanish banks have

progressively changed their financial
structure to fulfill the requirements of
Basel 2.
Both Tier 1 and Tier 2 capital have
increased significantly in recent years.
Banks have increased both the average
weight of credit risk exposure and offbalance sheet exposure.
148
TABLE 3.
149
Changes in capitalization structure have led to an

anticipated fulfillment of Basel 2 requirements (Figure
1a).
Tier 1 capital has largely contributed to a reduction in
capital requirements, in a context of a significant increase
in risk-weighted assets (rise in overall business and
Santanders purchase of Abbey National) (Figure 1b).
However, Tier 1 capital has contributed to the growth
rate of capital (Figure 1c).
Reserves have contributed largely to the growth of
Tier 1 capital while the contribution of intangible assets has
been negative (Figure 1d).
150
FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS

BANKS IN SPAIN (1)
Source: Bank of Spain (Financial Stability Report, n.8, 2005, May)
151
FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS BANKS

IN SPAIN (2)
152
Measurement of credit risk
153
Types of Loans:
C&I (commercial and industrial) loans: secured and
unsecured
Syndication
Spot loans, Loan commitments
Decline in C&I loans originated by commercial
banks and growth in commercial paper market.
Downgrades of Ford, General Motors and Tyco
RE (real state) loans: primarily mortgages
Fixed-rate, variable rates
Mortgages can be subject to default risk when
loan-to-value declines.
154
*CreditMetrics (sistema patentado)

If next year is a bad year, how much will I lose on my
loans and loan portfolio?
VAR = P 1.65
Neither P, nor observed.
Calculated using:
(i)Data on borrowers credit rating; (ii) Rating
transition matrix; (iii) Recovery rates on defaulted
loans; (iv) Yield spreads.
155
* Credit Risk+ (sistema patentado)

Developed by Credit Suisse Financial Products.
Based on insurance literature:
Losses reflect frequency of event and severity of
loss.
Loan default is random.
Loan default probabilities are independent.
Appropriate for large portfolios of small loans.
Modeled by a Poisson distribution.
156
Credit risk measurement has evolved

dramatically over the last 20 years.
The five forces made credit risk
measurement become more important
than ever before:
(i) A worldwide structural increase in the
number of bankruptcies.
(ii) A trend towards disintermediation by
the highest quality and largest
borrowers.
157
(iii) More competitive margins on loans.

(iv) A declining value of real assets in
many markets.
(v) A dramatic growth of off-balance
sheet instrument with inherent
default risk exposure, including
credit risk derivatives.
158
Responses of academics and practitioners:
(i) Developing new and more sophisticated creditscoring/early-warning systems

(ii) Moved away from only analyzing the credit risk
of individual loans and securities towards
developing measures of credit concentration
risk
(iii) Developing new models to price credit risk
(e.g. RAROC)
(iv) Developing models to measure better the
credit risk of off-balance sheet instruments
159
Credit Risk Management

An FIs ability to evaluate information and
control and monitor borrowers allows
them to transform financial claims of
household savers efficiently into claims
issued to corporations, individuals, and
governments
An FI accepts credit risk in exchange for a
fair return sufficient to cover the cost of
funding (e.g., covering the cost of
borrowing, or issuing deposits)
160
Credit Scoring
Credit scoring system
a mathematical
mathematical model that uses observed loan
loan
applicants characteristics to calculate aa score that
that
represents
represents the applicants probability of default
Perfecting collateral
ensuring that collateral used to secure a loan is free
and clear to the lender should
should the
the borrower
borrower default
default
Foreclosure
taking possession
possession of the
the mortgaged
mortgaged property
property to
satisfy a defaulting borrowers indebtedness
Power of sale
taking the
the proceedings of the
the forced
forced sale
sale of
of property
property
to satisfy the
the indebtedness
indebtedness
161
Credit Scoring
Consumer
Consumer (individual)
(individual) and
and Small-business
Small-business lending
lending
techniques
techniques for
for scoring
scoring consumer
consumer loans
loans very
very similar
similar to
to
mortgage
mortgage loan
loan credit
credit analysis
analysis but
but more
more emphasis
emphasis
placed
placed on
on personal
personal characteristics
characteristics such
such as
as annual
annual
gross
gross income
income and
and the
the TDS
TDS score
score
small-business
small-business loans
loans more
more complicated
complicated and
and has
has
required
required FIs
FIs to
to build
build more
more sophisticated
sophisticated scoring
scoring
models
models combining
combining computer-based
computer-based financial
financial analysis
analysis
of
of borrower
borrower financial
financial statements
statements with
with behavioral
behavioral
analysis
analysis of
of the
the owner
owner
162
Ratio Analysis
Historical
Historical audited
audited financial
financial statements
statements and
and projections
projections
of
of future
future needs
needs
Calculation
Calculation of
of financial
financial ratios
ratios in
in financial
financial statement
statement
analysis
analysis
Relative
Relative ratios
ratios offer
offer information
information about
about how
how a
a business
business
is
is changing
changing over
over time
time
Particularly
Particularly informative
informative when
when they
they differ
differ either
either from
from
an
an industry
industry average
average or
or from
from the
the applicants
applicants own
own past
past
history
history
163
Common Size Analysis and

After the Loan
Analyst
Analyst can
can divide
divide all
all income
income statement
statement amounts
amounts
by
by total
total sales
sales revenue
revenue and
and all
all balance
balance sheet
sheet
amounts
amounts by
by total
total assets
assets
Year
Year to
to year
year growth
growth rates
rates give
give useful
useful ratios
ratios for
for
identifying
identifying trends
trends
Loan
Loan covenants
covenants reduce
reduce risk
risk to
to lender
lender
Conditions
Conditions precedent
precedent
those
those conditions
conditions specified
specified in
in the
the credit
credit agreement
agreement or
or
terms
terms sheet
sheet for
for aa credit
credit that
that must
must be
be fulfilled
fulfilled before
before
drawings
drawings are
are permitted
permitted
164
Large Commercial and

Industrial Lending
Very
Very attractive
attractive to
to FIs
FIs because
because transactions
transactions are
are
often
often large
large enough
enough make
make them
them very
very profitable
profitable
even
even though
though spreads
spreads and
and fees
fees are
are small
small in
in
percentage
percentage
FIs
FIs act
act as
as broker,
broker, dealer,
dealer, and
and adviser
adviser in
in credit
credit
management
management
The
The standard
standard methods
methods of
of analysis
analysis used
used for
for midmidmarket
market corporates
corporates applied
applied to
to large
large corporate
corporate
clients
clients but
but with
with additional
additional complications
complications
Financial
Financial ratios
ratios such
such as
as the
the debt-equity
debt-equity ratio
ratio are
are
usually
usually key
key factors
factors for
for corporate
corporate debt
debt
165
The KMV Model
Banks
Banks can
can use
use the
the theory
theory of
of option
option pricing
pricing to
to
assess
assess the
the credit
credit risk
risk of
of a
a corporate
corporate borrower
borrower
The
The probability
probability of
of default
default is
is positively
positively related
related to:
to:
the
the volatility
volatility of
of the
the firms
firms stock
stock
the
the firms
firms leverage
leverage
A
A model
model developed
developed by
by KMV
KMV corporation
corporation is
is being
being
widely
widely used
used by
by banks
banks for
for this
this purpose
purpose
166
Calculating the Return on a

Loan
A
A number
number of
of factors
factors impact
impact the
the promised
promised return
return that
that an
an
FI
FI achieves
achieves on
on any
any given
given dollar
dollar loan
loan
the
the interest
interest rate
rate on
on the
the loan
loan
any
any fees
fees relating
relating to
to the
the loan
loan
the
the credit
credit risk
risk premium
premium on
on the
the loan
loan
the
the collateral
collateral backing
backing the
the loan
loan
other
other nonprice
nonprice terms
terms (such
(such as
as compensating
compensating
balances
balances and
and reserve
reserve requirements)
requirements)
167
Return on Assets (ROA)

11 ++ kk == 11++ff++(L
(L++m)
m)
11--(b(1
(b(1--R))
R))
where
where
kk == the
thecontractually
contractuallypromised
promisedgross
grossreturn
returnon
onthe
theloan
loan
ff == direct
directfees,
fees,such
suchas
asloan
loanorigination
originationfee
fee
LL == base
baselending
lendingrate
rate
m
m== risk
riskpremium
premium
bb == compensating
compensatingbalances
balances
RR== reserve
reserverequirement
requirementcharge
charge
168
Risk-Adjusted Return on Capital

(RAROC)
Rather than evaluating the actual or
promised annual cash flow on a loan as a
percentage of the amount lent (ROA), the
lending officer balances the loans
expected income against the loans
expected risk
RAROC = One-year income on a loan/Loan
(asset risk or capital at risk
169
APPENDIX: Bank regulation and credit

risk: an example from Basel II and
savings banks
Historically, regulation has limited who can:
open or charter new banks and
what products and services banks can offer.
Imposing barriers to entry and restricting the
types of activities banks can engage in clearly
enhance safety and soundness, but also hinder
competition.
170
It assumed that the markets for bank products,

largely bank loans and deposits, could be
protected and that other firms could not
encroach upon these markets.
Not surprisingly, investment banks, hybrid
financial companies, insurance firms, and
others found ways to provide the same
products as banks across different geographic
markets.
171
However, there is another type of

regulation that has concentrated most
of the attention in the last three
decades, the bank capital regulation.
Changes in reserve requirements
directly affect the amount of legal
required reserves and thus change the
amount of money a bank can lend out. The
main recent example is BASEL II.
172
Basel 2 is a step change in the regulation of

capital adequacy. It will alter the industry frame
of reference for banks in many ways:
Regulators are clearly recognizing market realities
and seeking a much closer congruence between
regulatory and economic capital.
The new proposals are more complex and
sophisticated than earlier schemes. They will
also have to evolve as market conditions,
technology and financial management techniques
develop.
173
The calibration exercises that have resulted from

the various Quantitative Impact Studies (QIS) are
targeted (initially at least) to deliver broadly the
same amount of capital as the current Accord.
However, the mix of capital charges will
change significantly with the wider range of risk
weights and greater risk sensitivity of Basel 2.
Basel 2 will clearly be much more risk-sensitive
in assigning capital charges. Mortgage lending and
lending to higher quality borrowers will be
incentivied under Basel 2.
174
It is not clear whether the present or new Basel

Accord are a binding constraint on banks current
credit operations. Jackson et al (2001, Bank of
England WP) suggest that banks may employ
more conservative capital standards than those
imposed under Basel 1 or likely under Basel 2.
Compliance costs are likely to increase. Banks
will have to evaluate (as a kind of capital
investment decision) whether the costs (including
compliance costs) of moving to the more advanced
Basel 2 systems are worthwhile.
175
Banks will increasingly target better risk

management as a source of competitive
advantage. Increasingly, superior risk
management will become a key success
factor for those banks who are able to respond
successfully to the new environment.
Nevertheless, specialist banks who focus on a
smaller number of core products and services
should similarly be able to obtain risk
management benefits of specialization.
176
Basel 2 will enhance present securitisation

trends in banking. This will help in its turn to
emphasise further the strategic importance of
investment banking. At the same time, lending
bankers will face increasing adverse selection
trends as the better credits are able to access
directly the capital markets.
This trend will help to re-emphasise the
importance of credit skills in lending banks. It
will also put pressure on these banks to widen
their margins (in order to achieve the higher risk
premia needed to cover their more risky lending).
177
Governance will be an increasingly important

issue in the new regime. More disclosure is not
enough by itself to secure market discipline (the aim
of Pillar 3). A wide collection of new and improved
governance structures will be needed. These include:
a freer market in bank corporate control;
good corporate governance in banks;
incentive-compatible safety nets;
no bail-out policies;
and proper accounting standards.
Banks will be required to disclose more

information than ever before to the external
market. This will involve additional compliance costs.
Strategically, it will reinforce any competitive
advantage gained by good risk-management banks.
178
Under Pillar 3 and with likely changes in bank

governance arrangements, the prospects of takeovers (and no bail-outs) for individual banks who
are inefficient are likely to increase. This new
world is a likely further threat to concepts like
mutuality and subsidised (or at least protected from
competition) regional banking.
Insofar as the new capital regime allows nonbank financial companies a competitive
advantage (via lesser capital backing), banks will
attempt to alter the balance of competitive
advantage through regulatory arbitrage
179
More work is needed on stress testing under

Basel 2 and banks can expect further, more
detailed efforts from regulators in this area.
Already, stress testing appears to be a
standard management technique for many
banks and most banks that stress test do so at a
high frequency (daily or weekly): see Fender
and Gibson (Risk, 2001).
180
Perhaps the most fundamental strategic impact of

Basel 2 is that it will enhance the SWM
(Shareholder Wealth Maximisation) model as
the major strategic and managerial model for
banks. The essence of this model is its focus on
risk and return and the impact of this tradeoff on
bank value; the model also emphasises the need
for greater risk sensitivity in risk assessments and
pricing. Within this model, better risk
management is rewarded.
181
Although most of the strategic implications mentioned

earlier for retail banks apply also to Spanish savings banks,
there are some specific features of the Spanish
savings banks that may modify some of these
conclusions. These specific features are explored in this
section (and summarised in Diagram 1):
There have been some recent regulatory actions regarding

risk and capital in the Spanish banking system that should
be taken into account when defining the threats and
opportunities of the new framework for savings banks. The
development of a Default Hedging Statistical Fund (the
so-called FECI) by the Bank of Spain are two of the recent
developments in the regulatory field that impact on the
current solvency risk of Spanish savings banks
182
DIAGRAM 1. SPANISH SAVINGS BANKS AND THE NEW REGULATORY

CAPITAL FRAMEWORK. KEY FEATURES
REGULATION: MARKET
DEVELOPMENTS
BASEL 2
STRATEGIC
IMPLICATIONS
SPANISH SAVINGS
BANKS AND THE NEW
REGULATORY CAPITAL
FRAMEWORK
CAPITAL REGULATION
AND OWNERSHIP
SECTORAL PROJECT
FOR THE GLOBAL
CONTROL OF RISK
183
The establishment of so-called statistical, pro-cyclical or

dynamic provisions:
Requiring banks to increase these provisions when the
business cycle is positive and reducing them during
downturns in order to favor intertemporal risk
smoothing and loan supply.
Basel 2 does not appear to change the view of banking as a
pro-cyclical business. Basel 2 could even exacerbate
cyclical effects. It is this contingency that has led the
Bank of Spain to establish the so-called pro-cyclical or
dynamic provisions.
The recent lending patterns of the Spanish savings
banks are known to reduce these pro-cyclical effects
since they have increased credit supply almost linearly over
the business cycle.
184
The lending behavior of savings banks has not

resulted in higher defaults. On the contrary,
default risk management at savings banks has
apparently been more efficient than for commercial
banks, a fact that may be largely explained by the
intertemporal risk smoothing advantages achieved
via a close contractual relationship with their
customers.
185
There are three main types of savings-bank

specific effects:
(1) those concerning the aim of Basel 2 and the
differences between economic and regulatory
capital;
(2) those that refer to specialisation, size and
lending diversification;
(3) those related to the implementation of the new
capital adequacy requirements, including the
sectoral project of Spanish savings banks for the
global control of risk.
186
(i) Aim of Basel 2 and Economic and Regulatory

Capital Differences
While the objective of Stakeholder Wealth
Maximisation (STWM) may match more closely
the nature of Spanish savings banks, SWM should
not be a problem for savings institutions since
they have to compete with commercial banks.
Nevertheless, the SWM model will be reinforced
by Basel 2 and Spanish savings banks may
benefit from recent regulatory changes that
stress their ownership status as private and
non-subsidised.
187
(ii) Size, specialisation and lending diversification

Specialist banks (like savings banks) focusing
on a smaller number of core products may also
be able to obtain the risk management
benefits of specialisation. Continuous
calibration and capital treatment may reduce the
potential loss of competitiveness in retail
banking. Servicing, relationship banking and
dynamic lending will also be valued positively.
188
(iii)
Final implementation of Basel 2 on Spanish savings
banks: the sectoral project for the global control of risk
The Spanish Confederation of Savings Banks (CECA)
has led an ambitious initiative to undertake a
sectoral project for the global control of risk.
Since this project is oriented to the whole savings
bank sector, it has to deal with various problems,
like the rigidities of employing a single model for all
institutions.
However, the project is targetted to provide
savings banks with adequate and centralised
human and technological resources in order to
implement their own model with a high standard of
quality.
189
The model for each line of business

incorporates risk measurement, control and
management operating with three different
working groups:
information management;
organization and procedures;
quantitative tools.
190
COMPARATIVE DESCRIPTIVE
STATISTICS
The credit risk of Spanish depository institutions
does not seem to be a concern in the shortrun.
The ratios doubtful assets/total exposures
and doubtful loans of other resident
sectors/total exposures of resident sectors
have decreased in recent years and are lower
than 1% (Table 1).
Statistical provisions have increased over
time as a percentage of total provisions (Table 1).
191
TABLE 1.
192
Savings banks and credit co-operatives

have enjoyed higher margins compared to
commercial banks (Table 2). The margins are in
line with the European standards.
However, competitive presures have resulted in

a decrease of margins over time during the
last years.
193
TABLE 2.
194
As shown in Table 3, Spanish banks have

progressively changed their financial
structure to fulfill the requirements of
Basel 2.
Both Tier 1 and Tier 2 capital have
increased significantly in recent years.
Banks have increased both the average
weight of credit risk exposure and offbalance sheet exposure.
195
TABLE 3.
196
Changes in capitalization structure have led to an

anticipated fulfillment of Basel 2 requirements
(Figure 1a).
Tier 1 capital has largely contributed to a
reduction in capital requirements, in a context of a
significant increase in risk-weighted assets (rise in
overall business and Santanders purchase of Abbey
National) (Figure 1b).
However, Tier 1 capital has contributed to the
growth rate of capital (Figure 1c).
Reserves have contributed largely to the growth of
Tier 1 capital while the contribution of intangible assets
has been negative (Figure 1d).
197
FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS

BANKS IN SPAIN (1)
198
FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS BANKS

IN SPAIN (2)
199
Other Risks Faced by Financial

Intermediaries
200
Risks Faced by Financial

Intermediaries
Liquidity Risk
Interest Rate Risk
Market Risk
Foreign Exchange Risk
Country or Sovereign Risk
Technology Risk
Operational Risk
Insolvency Risk
201
Market Risk
Incurred in trading of assets and liabilities (and
derivatives).
Examples: Barings & decline in ruble.
DJIA dropped 12.5 percent in two-week period July,
2002.
Heavier focus on trading income over traditional
activities increases market exposure.
Trading activities introduce other perils as was
discovered by Allied Irish Banks U.S. subsidiary,
AllFirst Bank when a rogue trader successfully
masked large trading losses and fraudulent
activities involving foreign exchange positions
202
Striking growth of off-balance-sheet
activities
Letters of credit
Loan commitments
Derivative positions
Speculative activities using offbalance-sheet items create

considerable risk
203
Technology and Operational Risk

Risk that technology investment fails to
produce anticipated cost savings.
Risk that technology may break down.
CitiBanks ATM network, debit card system
and on-line banking out for two days
Wells Fargo
Bank of New York: Computer system failed
to recognize incoming payment messages
sent via Fedwire although outgoing
payments succeeded
204
Technology and Operational Risk

Operational risk not exclusively
technological
Employee fraud and errors
Losses magnified since they affect
reputation and future potential
Merrill Lynch $100 million penalty
205

Result of exposure to foreign government
which may impose restrictions on repayments
to foreigners.
Often lack usual recourse via court system.
Examples:
Indonesia
Argentina
Malaysia
Russia
Thailand.
South Korea
206

In the event of restrictions, reschedulings, or
outright prohibition of repayments, FIs
remaining bargaining chip is future supply of
loans
Weak position if currency collapsing or
government failing
Role of IMF
Extends aid to troubled banks
Increased moral hazard problem if IMF
bailout expected
207
Liquidity Risk
Risk of being forced to borrow, or sell assets in a very
short period of time.
Low prices result.
May generate runs.
Runs may turn liquidity problem into solvency
problem.
Risk of systematic bank panics.
Example: 1985, Ohio savings institutions insured by
Ohio Deposit Guarantee Fund
Interaction of credit risk and liability risk
Role of FDIC (see Chapter 19)
208
Insolvency Risk
Risk of insufficient capital to offset
sudden decline in value of assets to
liabilities.
Continental Illinois National Bank and
Trust
Original cause may be excessive

interest rate, market, credit, offbalance-sheet, technological, FX,
sovereign, and liquidity risks.
209
Insolvency Risk Management

Net worth
a measure of
of an FIs capital that is equal to the difference
between the market value o its assets and the market value of
its liabilities
Book Value
value of assets and liabilities based on their historical costs
Market value or mark-to-market value basis

balance sheet values
values that reflect current
current rather than
than historical
prices
210
Central Bank & Interest Rate Risk

Federal Reserve Bank: U.S. central bank
Open market operations influence money supply,
inflation, and interest rates
Oct-1979 to Oct-1982, nonborrowed reserves target
regime did not work
Implications of reserves target policy:
Increases importance of measuring and managing
interest rate risk.
Effects of interest rate targeting.
Lessens interest rate risk
Greenspan view: Risk Management
Focus on Federal Funds Rate
Simple announcement of Fed Funds increase,
decrease, or no change.
211
Implications
Emphasizes importance of:
Measurement of exposure
Control mechanisms for direct market
riskand employee created risks
Hedging mechanisms
212
Market Risk
Market risk is the uncertainty resulting from
changes in market prices .
Affected by other risks such as interest rate
risk and FX (foreign exchange) risk
It can be measured over periods as short as
one day.
Usually measured in terms of dollar
exposure amount or as a relative amount
against some benchmark.
213
Market Risk Measurement

Important in terms of:
Management information
Setting limits
Resource allocation (risk/return tradeoff)
Performance evaluation
Regulation
BIS and Fed regulate market risk via capital
requirements leading to potential for overpricing
of risks
Allowances for use of internal models to calculate
capital requirements
214
Tema 6
ANATOMA DE LAS CRISIS
BANCARIAS: LA CRISIS
CREDITICIA DE 2007 Y 2008
(MATERIAL DEL PROFESOR)
Asymmetric information and its

implications
Banking crises
Definition of a banking crisis.
Recent evidence and why we should care.
Sources of banking crises.

Regulatory responses
Strengthening regulation and supervision.
Reforming the financial safety net (deposit

insurance and lender of last resort).
216
Asymmetric Information
and its Implications
Definition
Information is asymmetric when one party to an

economic relationship or transaction has less
information about it than the other party or
parties.
Pervasive role in financial markets.
Lenders often do not know the riskiness of the

borrower applying for a loan;
Lenders may not be able to observe whether

the borrower will invest in a safe or risky
project.
218
The very existence of financial institutions can

be explained on asymmetric-information
grounds.
Reason: financial intermediaries
specialize in gathering and analyzing information about borrowers and their

investment projects.
They thereby attenuate the incidence of

information asymmetries.
From this perspective, they act as

delegated monitors.
219
General Implications
Adverse selection. If the price of insurance

against a particular contingency is fixed
independently of the characteristics of the
behavior of the insured, individuals at greater
risk will choose to insure.
Moral hazard. After a contract comes into
effect, insured agents have an incentive to
change their behavior in ways that adversely
affect the interests of the insurer.
220
Free-rider problems. An agent that collects

infor-mation about a particular risk may be
unable to prevent other agents from using that
information (e.g. deposit insurance institution
that is unable to price risk accurately).
Rational herding. Agents may choose to
disregard their own information and instead
react to information on the decisions taken by
other agents (information externalities).
221
Principal-agent and monitoring problems.

A principal may be unable to observe perfectly
the actions of the agent to whom a certain
activity or responsibility is delegated.
Examples:
Bank shareholders may not perfectly

observe investment decisions taken by
managers;
regulators may not be able to determine the

exact degree of riskiness of loans made by
banks.
222
Implications for the credit market
Adverse selection ensures that a

disproportionate number of bad projects
are presented for financing.
Borrowers are induced to choose projects for
which the probability of default is higher,
because riskier projects are associated with
higher expected returns.
May lead to credit rationing; see Stiglitz and
Weiss (1981).
Banks may be tempted to engage in overly
risky lending activities in the presence of
deposit insurance.
223
Banking Crises
Definition of a Banking Crisis
Problematic, no standard definition:

Example: (Detragiache, Demirguc-Kunt (1998a)).
A distress episode is a crisis when
Ratio of nonperforming loans to total bank loans
exceeded 10%.
Cost of the rescue operation (or bailout) was at
least 2% of GDP.
Episode involved a large-scale

nationalization of banks (and possibly other
institutions).
Extensive bank runs took place or
emergency measures (deposit freezes,
prolonged bank holidays, or generalized
deposit guarantees) were enacted by the
government.
226
Problems
Information on nonperforming loans: often not

reliable and timely. Evergreening problem.
Cost of rescue operations is often difficult to
measure due to the importance of quasi-fiscal
costs, contingent liabilities, and restructuring
costs.
Liquidity provided at below-market interest

rates (quasi-fiscal effect).
Promise to bail out ailing banks provides an

implicit subsidy.
227
Estimating the net costs of banking sector restructuring

is difficult; requires assumptions about
amount of liquidity support;
present and future incidence of nonperforming loans

and their recovery rate.
Estimates are often calculated on a gross basis; leads
to overestimation by excluding (Hawkins and Turner
(1999))
future proceeds from reprivatization;
loan recovery;
repayment of the liquidity assistance provided by the

government.
228
Run or event criterion: A crisis can indeed,

in some cases, be dated that way.
Problems
Runs are often short lived.
Dramatic events rarely represent either the
beginning, or the end, of the crisis.
In most cases insolvency problems were
already present and worsening; event itself is
merely the point at which underlying problems
are revealed (either to the regulator or the
public).
229
Subprime Mortgage Crisis
230
Background Introduction
What is Subprime lending? the practice of making loans to
borrowers who do not qualify for the best market interest
rate because of their deficient credit history or inability to
prove they could for the loans they are applying.
Subprime loan involves high risks.
--housing market
--a combination of high interest rates, bad credit history and
murky financial situations associated with the applicants.
231
Causes of the Crisis

Many factors created the crisis, but the most immediate
causes were a rising interest rate environment which caused
people with adjustable rate mortgages (ARM) to see
significant increases in their mortgage payments, and
declining property values as the national real estate market
finally began making corrections (Housing bubble bursts).
232
Role of Mortgage lenders

--Incomplete lending procedure. For example, Many of the
sub-prime loans did not even require that borrowers
document the income listed on their loan application with a
pay stub. some of the lending probably involved actual
fraudulence where people misstated their income and
qualifications.
--adjustable-rate mortgages (ARM); interest-only
adjustable-rate mortgages
233
Role of Subprime borrowershomeowners

--With the assumption that housing prices would continue
to increase, many subprime borrowers are encouraged to
obtain ARM.
--Difficult to refinance due to declining property values.
Role of Regulators
--In response to a concern that lending environment was too
easy or say, not properly regulated, the House and Senate
are both considering making some new bills to regulate
lending practices.
234
Part III- The countrywide influence and the

corresponding reactions
Drastic fluctuation in stock market--investors began to
worry about whether the Subprime crisis will turn into a
global economic one.
Many investment banks, mortgage lenders, real estate
investment trusts and hedge funds suffered significant
losses as a result of mortgage payment defaults or mortgage
asset devaluation.
--New Century Finance; American Home Mortgage
--Merrill Lynch;Citigroup
235
The recession of housing market and the

continually increased oil prices will slow down the
step of economic growth rate of the U.S.
236
Subprime Mortgage Crisis
Sharp rise in home foreclosures in late 2006

Only 9% in 1996, 13% in 1999, 20% in 2006
$1.3 Trillion subprime mortgage as of March 2007
The delinquency rate had risen to 21% by 2008
Subprime Borrowers
For poor credit history
Limited income
Subprime Lenders
Greater risks
High returns
237
New Model of Mortgage

Lending
Source: BBC News
238

The Housing Downturn
Excess supply of home inventory

Sales volume of new homes dropped
Reduced market prices (10.4% 12/06-12/07)
Increasing foreclosure rates
Borrowers
Difficulties in re-financing
Begin to default on loans
Walk away from properties
Fraudulent misrepresentations
239

Financial Institutions
Attraction from high returns
Offered high-risk loan and incentives
Believes that will pass on the risk to others
Securitization
Mortgage backed securities
Risk readily transferred to other investors
From 54% in 2001 to 75% in 2006
240

Government and Regulators
Community Reinvestment Act, encourages the

development of the subprime debacle
Glass-Steagall Act contributes to the subprime crisis
(FDIC back up)
Central banks
Less concerned with avoiding asset bubbles

React after bubbles burst to minimize the impact
No determination on monetary policy
Institutions risk more because of Feds rescue
241
Direct Impacts of the Crisis

Stock Market
08/15/07 Dow Jones had dropped below 13,000 from

Julys 14000
First 3 weeks of 08, the Dow Jones Industrial Average
fell 9%
1/18/08 Dow Jones/0.5%, S&P 500/0.6%, and
NASDAQ/0.3%
01/21/08 (black Monday) the worlds biggest falls since
Sept. 11, 2001
242

Financial Institutions Bankruptcy
New Century Financial (USA) Apr. 2, 2007

American Home Mortgage (USA) Aug. 6, 2007
Sentinel management Group (USA) Aug. 17, 2007
Ameriquest (USA) Aug. 31, 2007
NetBank (USA) Sept. 30, 2007
Terra Securities (Norway) Nov. 28, 2007
American Freedom Mortgage Inc. (USA) Jan. 30, 2007
243

Financial Institutions Write-Downs
Citigroup (USA) - $24.1 bln

Merrill Lynch (USA) - $22.5 bln
UBS AG (Switzerland) - $16.7 bln
Morgan Stanley (USA) - $10.3
Credit Agricole (France) - $4.8 bln
HSBC (United Kingdom) - $3.4 bln
Bank of America (USA) - $5.28 bln
CIBC (Canada) 3.2 bln
Deutsche Bank (Germany) - $3.1 bln
By 02/19/08 losses or write-downs > U.S. $150 bln

Be expected exceeding $200 - $400 bln
244
Domestic Impacts of the

Crisis
Home Owners
Housing prices down 10.4% in Dec. 07 vs. year-ago

Sales of new homes dropped by 26.4% in 07 vs. 06
By Jan. 2008, the inventory of unsold new homes stood
at 9.8 months, the highest level since 1981.
Two million families will be evicted from their homes
Minorities
Disproportionate level of foreclosures in minority

46% Hispanics, 55% blacks got higher cost loans
245
Domestic Impacts of the

Crisis
Economy Condition
Recession
Low GDP growth rate
Business close out or lose money (banks, builders etc.)
Weak financial market
Low consumer spending
Lose jobs
Other credit markets
Credit card
Car loan
246
Global Impacts of the Crisis

Investors will be very cautious to act
Lack confidence in stock/bound market
Consumer spending will slowdown
Lack of cash or unwilling to spend
World economy may slip into recession
U.S. economy condition will affect global economy
GDP growth will be low
Lose businesses
Lose jobs
Economy slow down
247
Global Impacts of the Crisis

Financial market
May take long time to recover
Unemployment rate may be high
Slow economy increase unemployment rate
Exports will decrease in China, Korea, Taiwan
GDP growth heavily depends on export
248
Government and Central Banks

Actions
08/2007, President Bush announced Hope New Alliance

02/13/08, President signed a tax rebates of $168 bln
09/18/07, the Fed dropped rate point
10/31/07, point cut by Fed
12/11/07, point cut by Fed
01/22/08 the Fed slashed the rate by 3/4 points to 3.5%
01/30/08 another cut of 1/2 points to 3%
Central Banks have pumped billions of dollars to banks
Central Banks of the world have done the same thing
249
Tema 7
LAS REDES DE SEGURIDAD, LOS
SEGUROS DE DEPSITOS Y LOS
INCENTIVOS DE LA BANCA
INTERNACIONAL
LECTURA DE REFERENCIA: CARB ET

AL. 2008. EN PRENSA
Banking Crises: Regulatory Responses
Information disclosure.
Strengthening regulation and supervision.
Reforming the financial safety net (deposit
insurance and lender of last resort).
251
Information disclosure
Transparency (e.g. improvements in standards for

data dissemination): viewed as important to crisis
prevention.
Can help markets to improve their pricing of risk,
prevent the buildup of imbalances, and force
policymakers to take timely action to address
vulnerabilities.
However: information disclosure is not a cure-all.
Information is noisy and can be misinterpreted;
perverse effect: bank runs.
252
Strengthening regulation and supervision
Current consensus: bank supervision needs to be

strengthened before financial liberalization.
Objectives: ensure adequate internal controls and
procedures, avoid concentrated patterns of credit or
market risk exposure...
enforce accounting principles and disclosure
requirements...
impose stricter asset classification and provisioning
practices that reduce the scope for delay in recognizing
bad loans, and encourage banks to make adequate
provisions against loan losses.
253
Also: improve incentives for supervisors. Risks of

forbearance (leaving insolvent banks in operation) and
regulatory capture: create moral hazard, regulation
becomes ineffective.
October 1997: Basle Committee on Banking Supervision
released 25 core principles for effective banking
supervision that cover
licensing structure,
prudential regulations and requirements,
methods for on-site and off-site banking supervision,
information requirements,
prerogatives of supervisors.
254
Prudential regulations aimed at containing risks associated

with capital flows:
Limits on banks open net foreign currency positions

(difference between unhedged foreign-currency assets
and liabilities).
Limits on exposure to volatility in equity and real-estate

markets
would help to insulate the banking system from

bubbles associated with large capital inflows
and help to avoid excessive concentration of credit risk.
255
Discourage excessive exposures of domestic firms and

(indirectly banks) by taxing short-term capital inflows (e.g.
Chile).
Impose marginal reserve requirements on deposits
(higher as the maturity of deposits shortens); help to
insulate the banking system from exposure to the risks of

abrupt reversals in capital flows;
prevent a credit boom driven by a surge in bank deposits

(ensures a gradual expansion of banks' loan portfolios).
Attractive goal when capital inflows take mostly the form of
short-term bank deposits.
256
Problems
measures could result in some degree of disintermediation of

capital inflows;
they do not discriminate between weak (or undercapitalized)

banks and strong banks, whose behavior is less risky and
credit assessment capacity is strong.
Inadequate supervision: second-best argument for maintaining
restrictions on capital flows, imposing limits on lending growth, or
to proceed more gradually with financial liberalization.
257
Financial safety nets
Deposit insurance and lender of last resort.

As with any form of insurance, they both tend to
exacerbate the problem of moral hazard:
If banks know (or believe) that they will be

rescued in case of liquidity problems, they will
have fewer incentives to manage their
portfolios prudently.
If depositors are insured against loss, they will

have limited incentives to monitor the
soundness of the institutions with which they
place their funds.
258
Financial safety nets--Deposit insurance
Benefits
If depositors' funds are guaranteed, borrowers

need not worry about bank soundness.
May eliminate costly runs (Diamond-Dybvig).

Pitfalls
If deposits are guaranteed, depositors will not

monitor bank quality.
Insolvent banks will continue to operate as long as

government guarantees are credible.
Because they are not liable for doing poorly, banks

may take on riskier loans.
259
Deposit insurance cannot prevent bank runs resulting from a

loss of confidence in the currency, because it generally
does not guarantee the foreign-currency value of deposits.
Mitigating Moral Hazard
Reduce risk to the system by closely monitoring banks'

activities and supervising compliance with regulations.
Limit explicit deposit insurance (coinsurance).
Both insured and insurer are responsible for some loss.

Depositors may lose a certain % of the covered amount (UK)
or bear a specified fraction of the loss at different levels of
coverage (Italy).
260
Limitations
Partial deposit insurance may not

strengthen discipline; de facto treatment of
depositors after bank failures is often more
generous than de jure arrangements.
Small depositors may be too dispersed or

too unsophisticated to exert much pressure
(through deposit withdrawals) on weak
banks.
261
Adjust premiums for risk to induce greater monitoring by

depositors and enhance cautious lending practices.
In practice, however: differences in premium rates across

banks are small.
Evidence
Garcia (1999): survey of the characteristics of explicit

deposit insurance system (DIS) in 68 industrial and
developing countries.
DIS: often introduced in the context of a crisis.
Example: Asia: full guarantee of deposits put in place during

the crisis (Korea, Malaysia).
262
Countries with Explicit Deposit Insurance Systems

Africa
Asia
Cameroon
Central African Republic
Chad
Congo
Equatorial Guinea
Gabon
Kenya
Nigeria
Tanzania
Uganda
Bangladesh
India
Japan
Korea
Marshall Islands
Micronesia
Philippines
Sri Lanka
Taiwan
10
Source: Gillian (1999).
Europe
Austria
Belgium
Bulgaria
Croatia
Czech Rep.
Denmark
Estonia
Finland
France
Germany
Gibraltar
Greece
Hungary
Iceland
Ireland
Italy
Middle
East
Latvia
Bahrain
Lithuania
Lebanon
Luxembourg
Oman
Macedonia
Netherlands
Norway
Poland
Portugal
Romania
Slovak Rep.
Spain
Sweden
Switzerland
Turkey
Ukraine
United Kingdom
32
Western
Hemisphere
Argentina
Brazil
Canada
Chile
Colombia
Dominican Rep.
Ecuador
El Salvador
Jamaica
Mexico
Peru
Trinidad & Tobago
United States
Venezuela
14
263
Coverage levels: vary across countries.

IMF: uses twice per capita income as a rule of thumb to
evaluate coverage levels (other factors: distribution of
deposits by size).
Significant negative relation between per capita income and
DIS coverage ratio. Interpretation: moral hazard is stronger
in developing countries.
Almost one-third of the total use risk-adjusted premiums.
Co-insurance features: more limited.
264
Shift away from voluntary DIS to compulsory schemes

(more than 80% now; 55 out of 68); reduces adverse
selection problems.
DIS now tend to be funded by member institutions, with
access to emergency financing from the government.
Trend toward excluding foreign-currency deposits from
coverage; in Garcias sample, 40% do so.
Many countries that cover foreign-currency deposits pay out
in domestic currency to protect the DIS from exposure to
foreign exchange risk.
265
Ratio of Deposit Coverage to per capita GDP, 1999

Venezuela
Chad
Romania
Central African Republic
J amaica
Cameroon
Greece
Oman
Sri Lanka
Peru
Trinidad and Tobago
Uganda
Tanzania
Norway
United Kingdom
Portugal
Dominican Republic
Gabon
Italy
Bulgaria
India
Average ratios for:

the World - 3.0
Africa - 6.2
Asia - 4.0
Europe - 1.6
Middle East - 3.4
Western Hemisphere - 3.2
Bangladesh
Kenya
Republic of Congo
Brazil
Taiwan
Croatia
Sweden
Spain
Finland
Hungary
Netherlands
Austria
Ireland
Germany
United States
Iceland
Argentina
Denmark
Equatorial Guinea
Chile
Philippines
Belgium
France
Bahrain
El Salvador
Lebanon
Switzerland
Czech Republic
Luxemburg
Colombia
Estonia
Lithuania
Ukrain
Slovak Republic
Poland
Nigeria
Latvia
Canada
M acedonia
Source: Garcia (2000).
12
17
0.5
1.5
266
Impact on banking stability
Limited evidence. Demirguc-Kunt and Detragiache

(1999): sample of 61 countries for 1980-97.
Explicit DIS is detrimental to bank stability, when
bank interest rates are deregulated and institutional
environment is weak.
Adverse impact tends to be stronger the larger the
coverage, when the scheme is funded, and where it
is run by the government rather than the private
sector.
Interpretation: unless other safeguards are in
place, DIS induces more risk-taking.
267
Financial safety nets--Lender of last resort
Benefits
Informational asymmetries: make solvent banks

vulnerable to deposit runs and/or inadequate access to
interbank lending in times of crisis.
Domino effect or too big to fail problem (insolvent

bank): potential risk to stability of the financial system as a
whole following the failure of a solvent bank.
Bail out is rational to avoid threats to the entire system.

Absence of a LOLR facility can drive illiquid banks into
insolvency by forcing them to liquidate their assets at fire
sale prices.
268
Pitfalls
Direct financial cost involved in the explicit provision of

funds to insolvent institutions; potential losses.
By insuring banks against the costs of liquidity or solvency

problems, the provision of liquidity may increase moral
hazard. Government guarantees may thus lead to greater
incentives to take on risky loans.
The existence of a LOLR with the ability to print money can

allow inflationary beliefs to become self-fulfilling (Antinolfi,
Huybens, and Keister (2001)).
269
Implications
Central bank needs to weigh the cost of providing capital to

a possibly insolvent bank against the cost of the instability
generated by not doing so.
In practice: difficult.
Constructive ambiguity: may limit moral hazard by

introducing an element of uncertainty into the provision of
LOLR assistance (Enoch, Stella, and Khamis (1997)).
Difficult notion to pin down; encompasses, besides

uncertainty as to whether intervention will occur at all,
uncertainty regarding both its exact timing and the terms
and penalties attached to it.
270
Tema 8
MEDIOS DE PAGO: TARJETAS
BANCARIAS Y MERCADOS
BILATERALES
LECTURA DE REFERENCIA:
ROCHET Y TIROLE, 2003
An Overview
The
Players
The
Programs
Specifics
The
How!
Cardholder
Banks
Corporate
Sponsor
Issuing and
Acquiring
Access Device
(Card, Transponder,
Terminals .)
Rewards
(Points,
coupons)
Merchant
/ POI
Processor
Program
Collateral
(Loyalty supplier,
database, rules)
(setup, statements,
printed materials)
Technology
(Systems, processing, hardware, firmware, Issuing)
272
Electronic Payment Systems

Electronic commerce involves the exchange of
some form of money for goods and services.
Implementation of electronic payment systems
is in its infancy and still evolving.
Electronic payments are far cheaper than the
traditional method of mailing out paper invoices
and then processing payments received.
273

Estimates of the cost of billing one person
vary between $1 and $1.50.
Sending bills and receiving payments over
the Internet promises to drop the
transaction cost to an average of 50 cents
per bill.
Today, four basic ways to pay for purchases
dominate business-to-consumer commerce.
274
275

Electronic cash distribution and payment can
be handled by wallets, smart cards, or
proprietary, limited-use scrip.
Scrip is digital cash minted by a company
instead of by a government.
Companies like Payment Online sell packages
of payment processing services to Web
merchants that accept several types of
payments.
276
Payment Cards
Payment cards are all types of plastic cards that
consumers use to make purchases:
Credit cards
such as a Visa or a MasterCard, has a preset
spending limit based on the users credit limit.
Debit cards
removes the amount of the charge from the
cardholders account and transfers it to the
sellers bank.
Charge cards
such as one from American Express, carries no
preset spending limit.
277
Advantages and Disadvantages

of Payment Cards
Advantages:
Payment cards provide fraud protection.
They have worldwide acceptance.
They are good for online transactions.
Disadvantages:
Payment card service companies charge
merchants per-transaction fees and
monthly processing fees.
278
Payment Acceptance and

Processing
Open and closed loop systems will accept
and process payment cards.
A merchant bank or acquiring bank is a
bank that does business with merchants
who want to accept payment cards.
Software packaged with your electronic
commerce software can handle payment
card processing automatically.
279
Payment Acceptance and

Processing
280
PAYMENT SYSTEMS ARE TWO-SIDED

MARKETS
-Card payment systems provide joint services to two
users: the cardholder and the merchant.
-Even if surcharging is allowed, merchants are reluctant
to do it.
-Thus it is important to send the correct price signal to
the cardholder, who has the last word about the means
of payment.
-We have a Two-Sided Market because the price
structure matters.
281
OTHER TWO-SIDED MARKETS
Platform
Buyers
readers/viewers
players
computer users
consumers
Sellers
newspapers, TV operators
video consoles
operating systems
shopping malls
advertisers
game developers
Software
developers
shops
For all these platforms, finding the appropriate business

model (price structure) is vital.
282
OTHER TWO-SIDED MARKETS
Price structure is often skewed in two-sided markets:

Video consoles are subsidized by platforms
(extract revenue from developers)
Some TV channels and newspapers are free for
readers (only advertisers pay)
Most shopping malls subsidize buyers (free
parking)
This does not mean that prices should be regulated.
Also, traditional competition policy analysis (excessive
prices, predation) does not apply.
283
THE ROLE OF INTERCHANGE FEES
- In proprietary systems (AMEX, Diners Club) the price

structure is chosen by the network.
- In four-party systems, payment services are provided
jointly by two providers: the issuer and the acquirer.
- The interchange fee is a transfer between the two
providers that sets the rule for allocating the total cost
of the card payment between these two providers.
284
THE ROLE OF INTERCHANGE FEES

Prices and costs in a four-party system (system fees and costs
neglected)
Thus decreasing a implies : cost decrease for acquirers

and revenue decrease (cost increase) for issuers
285

Financial Institutions

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Financial Institutions

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GESTIN BANCARIA

Master en Banca y Finanzas

Santiago Carb Valverde

Santiago Carb Valverde

Why study Financial Markets and

Overview of Financial Markets

Primary Markets versus

Money Markets versus Capital

Money Market Instruments Outstanding,

Capital Market Instruments Outstanding,

Foreign Exchange Markets

Flow of Funds in a World without

Example: A firm sells shares directly to investors without going

Flow of Funds in a world with

Services Performed by Financial

Services Provided by FIs

Services Provided by FIs Benefiting

Risks Faced by Financial Institutions

Globalization of Financial Markets

Factors Leading to Significant Growth in

(LECTURA DE REFERENCIA: ALLEN Y

Why Are Financial

Financial Structure Puzzles: a

Lemons Problem in Stock and Bond

More Solutions to Financial

Role of FIs in Cost Reduction

Services Performed by FIs

Services Provided by FIs

Safety and soundness regulation

Trends in the United States

(LECTURA DE REFERENCIA: HUMPHREY

IO theory predicts a correspondence between the

As contestability increases in a market, the

Although the SCP hypothesis of a positive relationship

Some empirical studies have even tested and rejected the

Although price to marginal costs indicators are not

The definition of the mark-up and the

with j y j y and j 1,..., m

where p is the price of the bank product; C(yj,

where the mark-up of price over marginal cost ([p

The mark-up is used to compute the Lerner index,

Table 1: Bank Interest Cost Efficiency--DFA, 1992-2001

Table 2: Bank Operating Cost Efficiency--DFA, 1992-2001

Table 3: Bank Interest Cost Efficiency--DEA, 1992-2001

Table 4: Bank Operating Cost Efficiency--DEA, 1992-2001

Existen, al menos, tres dimensiones

(MATERIAL DEL PROFESOR)

It is the ability to foretell what is going to happen

Sir Winston Churchill

What are Financial

Transparent, Transluscent and Opaque FIs

What Services Do FIs Provide?

FIs are the most regulated of

Monetary Policy Regulation

Credit Allocation Regulation (eg., mortgages)

Investor Protection Regulation

Features Common to Most FIs

Overview of Depository Institutions

Size, structure and composition

Specialness of Depository FIs

Other outputs of depository FIs

By 2003, products and services

Size of Depository FIs