Tackle the question of how human beings recognize and respond to the probabilities they confront. This, ultimately is what risk management and decision making

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Lecture Note set II:

Interest rate risk Measurement & Hedging

Managing Credit risk

Managing Liquidity risk

Loan Evaluation

“…tackle the question of how human beings recognize and respond to the probabilities they confront. This, ultimately is what risk management and decision making are all about and where the balance between measurement and gut becomes the focal point of the whole story”

  • Peter L. Bernstein

Against the Gods: The Remarkable Story of Risk

Part I: Introduction to Interest Rate Risk

Query: Why do banks assume interest rate risk? Do they HAVE to do so?

(yield curve graph)

  1. Observation of interest rate risk: What are its symptoms?

    • Variable net interest income (or net interest margins)

    • Variable MV equity values (when i-rates vary)

(Focus of Analysis: Dollar Gap: Balance Sheet I-Rate Risk Management)

Net Interest Margin (NIM) = (Int Income - Int Expense)

Avg Earning Assets

Or NIM = NII/Earning assets

Dollar Gap = $GAP = ($) Rate Sensitive Assets - ($) Rate Sensitive Liabilities.

Note: the $GAP will be in DOLLAR METRIC (not a percentage).

Generic definition of rate sensitive => instrument matures in 90 days (1 qtr) or less. However, rate sensitivities are often specified for particular periods of time (ie: 0-30 days, 31-60 days, 61-90 days etc.) For example, $GAP61-90 denotes the dollar amount of assets and liabilities that mature in the period of 61 days to 90 days from now.

Other Ratios using the dollar GAP:

  1. Relative Gap ratio = $GAP/Total Assets

  2. Interest rate sensitivity Ratio = $RSA / $RSL

* Note: $GAP Calculations always require the use of book-value figures *

Definition: Basis point = 1/100th of a percentage point. I.e., 100 basis points = 1 percentage point.
Ex: Rates are currently 9%. They are forecast to increase by 30 basis points. What are the new rates expected to be?
(NII) = RSA (i) - RSL(i) = $GAP (i)

GAP formula:

If the change in rates is negative, i.e., rates are decreasing, i should be input as a negative number. The same goes for the remainder of the formulas we will be using in this class that include a “i”.
How is the $GAP formula used?
* Determine a maximum allowable (NII) or (NIM). Then, forecast the change in interest rates for the next period, and try to obtain a $GAP to allow the variability in NII or NIM to be within the desired range. Use the above formula for Change in NII, solving for the maximum desired GAP. (To target change in NIM, simply divide both sides to avg. earning assets.)

Used to measure expected changes in the MV of assets and liabilities, when I-rates change. Is this a superior indicator of the impact of interest rates on s/h wealth relative to changes in NII?
Duration as a measure of interest rate risk
I. Introduction to duration
A) What does duration indicate? Is it an exact or approximate measure?
Answ: Weighted Average Futurity of a cash flow

Duration is most often used to determine the approximate percentage change or dollar change in market value of a fixed cash- flow instrument for a given i- rate change. The answer you will obtain is less accurate for larger changes (up or down) in interest rates.

Other uses:

    • You can use duration in a similar manner as you would beta (for stock portfolios) when measuring interest rate risk of a portfolio of fixed cash-flow instruments. The duration of a portfolio of (bonds/loans) is equal to the weighted average duration of the bonds/loans in that portfolio.

    • If you know the individual D for a set of bonds/loans , you can rank the bonds/loans in order of their interest rate risk (variability when i-rates change.)

QUERY: For a given required rate and coupon rate, does a short-term or long-term bond experience more price variability as interest rates change?


QUERY: For a given maturity, does a discount, par or premium bond experience more price variability as interest rates change?


How to Calculate Duration: The Spreadsheet Method

The following example is used to calculate the duration of a 5-year $1000 bond, with a 6% coupon rate (with interest payments made annually (Not semiannually - as is the usual case). This bond as a current required rate of return of 9%.

Duration Calculation: Spreadsheet Method:



disc CF /

weight x


cash flow

cash flow
































price ^

Duration ^

Duration Formula:

Formula for (approximate) change in value (price) when i-rates change

PART III: Using D to measures and control balance-sheet interest-rate risk exposure

* Note: Duration Calculations always require the use of market value figures *

A = assets

L = liabilities

Duration Gap = DGAP = DA – L/A x DL

DA = weighted average duration of the assets

DL = weighted average duration of the liabilities

Definition: “Short-funded”: Will a short-funded institution have a positive or negative DGAP? Will a short-funded institution have a positive or negative $GAP?

Example of Balance Sheet Risk Measurement
A Numerical Example

Bank TWO:

ASSETS $ amt rate D

LIAB AND EQUITY $ amt rate D

Commer loan




NOW Accts




Auto loans








Cash Advances




Long-term Debt




Fixed rate mortg












TOTAL Debt + eq


Example: weighted-average calculations
rate calculation
Duration calculation:
rate calculation

Duration calculation:


$A = -D x [∆i/(1+i)] x $Apre-rate change

$L = -D x [∆i/(1+i)] x $L pre-rate change


An Application of Duration:
The bank manager is ULTIMATELY concerned with interest rate changes and their impact on the market value of the bank's equity. (Note: Changes in the MV of the bank's equity is observable in the stock price)
We can use Duration theory and MACAULAYS Duration to calculate approximate changes in the market values of a bank's assets and a bank's liabilities when interest rates change. We can use the DURATION GAP to calculate the approximate change in the MV of a bank's equity directly.

Assets= ∆ A =

i x –DA x $A

(1 + iA)
∆ Liabilities = ∆ L =

i x –DL x $L

(1 + iL)
E = ∆ Equity = ∆ A - ∆ L
E / $A = -DGAP x (i) / (1+iA)
Or ∆ E = -DGAP x (i) / (1+iA) x $A
Using the spreadsheet for Bank Two, calculate:

a. The change in the MV of liabilities if interest rates increase by 150 basis points.

b. The change in the MV of assets if interest rates increase 150 basis points.

c. Change in the MV of equity if interest rates increase by 150 basis points.

d. Redo a-c for an interest rate decrease of 300 basis points.

On your own: Another example

Change in interest rates: 200 basis point decline.

Asset duration = 3 years.

Liabilities' duration= 1.5 years.
Market values:
total assets = $1000 , rate = 10%

total liabilities = $900, rate = 8%

total equity = $100

a) Calculate the change in the MV of assets.

b) Calculate the change in the MV of the liabilities
c) Calculate the change in the MV of the equity two ways: first, use data from a and b above, and second, use the DGAP formula.
QUERY: How can we alter the bank’s DGAP?

Macro Hedging using Duration

Immunized Portfolios, or DGAP management:
Query: In times of (highly volatile / relatively stable) interest rates, banks should target a DGAP that is smaller in absolute value.

Creating an Immunized Balance Sheet (Example)

An "Immunized" portfolio is one where the MV of equity is unaffected by i-rate changes.. (RELATE to the formula for a change in equity value above)

assets Liabilities & OE

amt Dur. amt Dur.

Loans 500 1.2 Time deps 520 4.1

treasuries 500 4.5 CDs 380 1.3

equities 100 ---

You are asked to determine which accounts should be increased / decreased if interest rates become volatile to totally eliminate the bank's exposure to interest rate risk. Determine the exact amounts of balance sheet items that would immunize this bank. The overall bank size should remain constant.

a) Intuitive, easy to calculate.

b) Examines i-rate risk exposure for a given period of time – which can be of interest to managers.


a) Doesn't consider the timing of cash flows. (I.e., consider two 10 year assets: Asset "A" has a cash flow of $100 in one year and $1000 in ten years. Asset "B" has a cash flow of $1000 in one year, and $100 ten years from now. They both have a maturity of 10 years. Clearly asset B is safer for the recipient of the cash flows. As interest rates increase, the cash flow in 10 years will be discounted at increasingly greater factor. The cash flow in year 1 can be reinvested sooner at the new, higher rate.)

b) Only focuses on a segment of the banks risk exposure at one time (as determined by the definition of "rate sensitive".)

c) Can’t be used to determine an exact change in NII or NIM


a) Measures an institution's overall (comprehensive) interest rate risk exposure.

b) Recognizes timing of cash flows.

c) Can predict changes in equity value


a) Market value calculation of B/S items imperative to calculations.

b) Continuous adjustments (calculations) required.

c) Difficult to calculate. One must determine the required rate of return for all of the assets. If the asset is public ally traded, it can somewhat easily be determined. If the asset is NOT publicly traded (such as commercial loans), the required rate is difficult to determine.

d) Can't be used to determine an exact change in market value. The greater the change in interest rates, the more error in using duration to calculate changes in market value. With the proliferation of computers, it is often optimal to re-discount the future cash flows by the new market interest rate to determine the new market value.

Problems with both DGAP and $GAP

a) Assumes either parallel shifts in yield curves (DGAP) or that the change in rates will affect RSA and RSL by same amount ($GAP)

b) Often difficult to determine the terms for rollover/refinancing/rate-sensitivity. I.e., if the increase in value associated with reinvestment at higher rates exceeds the penalty, some long-term CDs may be withdrawn early. Fixed rate loans may be refinanced at lower rates if i-rates fall. Therefore, a 20-year mtg. may be re-priced at lower rates prior to maturity.

Complete the following Table:




+ $GAP


+ $GAP


- $GAP


- $GAP










Part II: Derivates as a hedge against interest rate risk

Financial Futures Contract:
Characteristics (A review for some):
1) Organized exchanges

2) Very few traders take delivery (less than 1%)

3) Requires a "maintenance margin" and "initial margin" (relatively small) Daily gains/losses credited or deducted from margin account. If the margin falls below the required maintenance margin, the position is automatically closed out.

4) Very few "long" futures participants actually take delivery. An offsetting position is taken immediately prior to expiration.

Topic I: Futures Terminology:
long futures: buy a futures contract. The purchaser takes delivery if an offsetting transaction is not made prior to delivery.

short futures: Sell a futures contract. Must make delivery if an offsetting "buy" transaction is not made prior to delivery. If you don’t have the product to deliver, you will come-up “short.”

QUERY: Are futures contract spot prices always equal to the expected cash (market) price at the time of the contract's expiration, or are the futures prices set by the laws of "supply and demand" for the contracts since fewer than 2% of the contracts actually have delivery of the commodity?

Consider the following possibility relating to a contract of 100 live hogs:
Assume that shortly before a contract's expiration on July 1st, you find that the futures contract to buy or sell 100 live hogs specifies a price of $4000 for the purchase (delivery) of 100 live hogs. However, you know that the going market price is $5000 for 100 live hogs.

Could you make arbitrage profits from this scenario?

What commodities trade on the futures markets?
a) Grains and fruits (wheat, corn, oranges)

b) Livestock (live cattle, hogs)

c) Metals

d) Securities

i) Eurodollar (hedge for currency risk)

ii) T-bills (hedge for i-rate risk)

iii) Stock market indices
Who transacts on the futures markets?
Hedgers and Speculators: Hedgers reduce a risk by taking a position in the futures markets to offset that risk. (Return on the futures markets is negatively correlated with the returns of the item you wish to hedge). Speculators earn returns by "speculating" on mispricing.

Micro vs. Macro Hedging in Banking: A Micro hedge is a hedge of a particular asset or liability. A Macro hedge is a hedge of the entire Balance Sheet's exposure to risk.
Let's examine which side of an interest-rate futures contract a bank might take to hedge the following risks:
The risks in futures market trading:
1) Correlation risk: If the hedged item and the futures contract are not highly correlated (correlation coefficient is not +1 or -1), then there is "basis risk". Risk that price decreases in the hedged item will not be perfectly offset by the futures contract's profits. (I.e. using T-Bond futures to off-set the interest rate risk to mortgages)

2) Credit Risk: Risk that the opposite party in the contract will default. (More probable in forward contracts, since there's no organized exchange to back the contract). Marking to market and clearing organizations help guarantee the integrity of the parties. However the contract may be closed-out early if the opposite party defaults.

3) Marking to market risk: Risk that you may be unable to cover a "margin call".
4) Managerial risk: Risk that management may not understand the futures contract, or may use the futures contract to speculate (double up) risks. Also, risk that the manager might "overhedge" or "underhedge".

Micro Hedges: Hedge of a particular scenario or transaction.

Scenario I: The bank has assets maturing in 3 months, which were funded using 6-month CDs. Hedge:
Scenario II: The bank wishes to hedge against the risk that mortgages will be refinanced.
Scenario III: Bank wishes to hedge against the risk that borrowers will act on their pre-negotiated line of credit at unfavorable rates which were negotiated (fixed) in advance. Hedge:
Scenario IV: The bank anticipates several significant balloon loan repayments (large inflows) in the near future. Hedge:
Scenario V: The bank anticipates several significant deposit inflows. Hedge:

Macro Hedges: Hedges of the balance sheet

If the bank has a POSITIVE DGAP, the bank hedges its balance sheet by going ___________________ in the interest-rate futures market.

If the bank has a NEGATIVE DGAP, the bank hedges its balance sheet by going _____________________ in the interest rate futures market.

If the bank has a POSITIVE $GAP, then the bank hedges its balance sheet by going ___________________ in the interest-rate futures market.

If the bank has a NEGATIVE $GAP, then the bank hedges its balance sheet by going _____________________ in the interest rate futures market.

Derivatives as hedging instruments


By law, banks are restricted to the use of derivatives for hedging-purposes only. However, bank holding companies can take a market (speculative) position in derivatives. Banks can sometimes take a speculative position in derivatives unintentionally by "over-hedging." This is often difficult to observe.

(I) Hedging the $GAP:
Number of contracts= [(V x Mc)/(F x Mf)] b
V= value of cash flow to be hedged ($ GAP POSITION)

Mc = maturity of the cash asset (Period of $ GAP)

Mf = maturity of the futures contract

F = face value of the futures contract (at maturity of T-bill)

b = ratio of variability of the cash market to variability of the futures market

A bank wishes to use 3-mo T-bill futures (Assume FV = 1 mil) to hedge a $48 million positive $GAP over the next 6 months. The number of future contracts to be purchased (assuming a correlation coefficient (b) of 1) is:
[(48 x 6) / (1x3) ] (1) = 96 contracts
(II) Hedging the DGAP:

Dp = Drsa + Df [NfFP/Vrsa]

Dp is the duration of the entire portfolio of assets. You’re trying to achieve this!

Drsa = duration of the rate sensitive assets. Rate sensitive here means that these are the assets that you’re targeting. (They may be all bank assets except for cash and PPE).

Df is the duration of the deliverable securities for the future contract

Nf is the number of future contracts. You’re typically trying to solve for this!

Vrsa is the market value of the rate sensitive assets

FP is the price of the future contract

Let's assume that the goal is to reduce the bank's DA to 0.25 to achieve a 0 DGAP.


Assets ($)

@ 12%

Liabilities ($)

@ 10%










Assume all of the above require only one payment, at maturity (ie: They're 0-coupon instruments). What does this imply about their respective Durations?

D(assets) =

Duration of assets calculation:


cash flow



w x t
























Assume that the assets are funded using 90 day CDs requiring 1 payment at maturity. The CDs are rolled over every quarter. D(liabilities) = .25 years. (HOW DO WE KNOW THIS?)

Assume that the bank wishes to obtain an immunized position. What does this mean? Dp = .25

How many 90 day t-bill futures should they buy or sell, if T-bills are expected to yield 12%?

Price of T-bill = 100/(1.12)1/4 = $97.21
.25 = .73 + .25 Nf (97.21)/(3221.50)

Nf = -63.63 so short approx 64 contracts

Other Hedging Instruments
Interest rate options: Call Option to buy or sell a financial contract like t-bills futures, Stock market index futures (etc)

Buy a call
Sell a call

Buy a put

Sell a put

Compare the above to payoffs for future contracts: Note lack of symmetry of call and put payoffs vs. symmetry of futures payoffs.
Which acts more like an "insurance" policy against risk?
Interest Rate Swaps

What is a swap? "You make my interest payments, i'll make yours"

  • According to Beckstrom [1986], the first interest rate swap in the US was completed by the Sallie Mae assoc in 1982. They were a fixed vs. floating rate swap.

  • Most transactions are handled through major investment banks. (Note website listed in text to facilitate swaps) There is a primary and a secondary market for i-rate swaps.

  • Larger, more wholesale oriented banks deal largely in short-term i-rate swaps (3-years or less), and smaller retail-oriented banks deal in long-term swaps. Why?

Why do swaps exist:

    • as a hedging tool to offset volatile interest rates

    • exploit arbitrage conditions in worldwide market for interest rates

B) Swap example: (note: LIBOR= London InterBank Offer Rate, an index rate, similar to the Prime rate.)

BBB Corp

AAA Bank


Funding objective



Fixed rate




Floating rate

Libor + 0.50%

Libor + 0.25%


Arbitrage benefit


BBB Corp prefers a fixed rate, but has a relative advantage to issue floating rate debt. (In other words, even though the cost to BBB Corp is greater for both the floating rate and fixed rate debt, the floating rate debt is less expensive relative to the bank than is the fixed rate debt).

AAA prefers floating rate debt. AAA Bank's cost for both the floating and fixed rate debt is less (on an absolute basis). However, the fixed rate debt of AAA is relatively cheaper when compared to BBB Corporation.
Example of (potentially) divided Profits:
AAA Bank issues fixed rate debt (even though they prefer floating rate debt). BBB Corporation issues floating rate debt, although BBB Corp desires fixed rate debt. In other words, both parties issue the type of debt that is relatively best for them, even though the type of debt issues is not necessarily the type of debt that they desire.
BBB Corp and AAA Bank swap payments. However, the swap is not an "even-up" one-for-one swap. If it were so, AAA Bank would not be pleased with the arrangement, since they could have obtained floating rate debt cheaper than BBB Corporation if they issued it themselves.

Putting some specifics into our example:
BBB Corporation pays AAA Bank's fixed rate of 11.625% plus a 1.5% premium on their fixed rate interest, for a total payment corresponding to 13.125% fixed rate interest.

AAA Bank agrees to pay BBB Corporation Libor + .5% for the floating rate debt.

Let's examine whether AAA Bank and BBB Corp would agree to this arrangement:
BBB Corporation's net benefits:
Net advantage for floating rate swap = 0%. (Ie. BBB Corporation borrows at Libor + .5%. AAA Bank makes their payments on the debt.)

Net advantage for the fixed rate swap = 14% - 13.125 = 0.875%. In other words, BBB Corporation is better off by 0.875% (in total) than if they had borrowed fixed rate themselves! Total advantage to BBB Corporation = 0% + 0.875% = 0.875%

AAA Bank's net benefits:

Net advantage (loss) on floating rate swap = LIBOR + .25% - [LIBOR + .5%] = -.25%. In other words, AAA bank is .25% worse off on the even-up floating rate swap than if they had borrowed floating-rate themselves!

Net advantage on the fixed rate swap = 13.125 - 11.625 = 1.5%. In other words, AAA bank is charging BBB corp 13.125% for a loan that is costing them 11.625%. (AAA Bank "pockets the difference" in the payments.)
Total advantage to AAA Bank = -.25% + 1.5% = 1.25%

So AAA Bank is willing to "lose" .25% on the floating rate swap, if they gain 1.5% on the fixed rate swap!

Total "arbitrage" benefits for both parties = .875% + 1.25% = 2.125%


A credit derivative is an OTC derivative designed to transfer credit risk from one party to another. By synthetically creating or eliminating credit exposures, they allow institutions to more effectively manage credit risks. Credit derivatives take many forms. Three basic structures include:

credit default swap: Two parties enter into an agreement whereby one party pays the other a fixed periodic coupon for the specified life of the agreement. The other party makes no payments unless a specified credit event occurs. Credit events are typically defined to include a material default, bankruptcy or debt restructuring for a specified reference asset. If such a credit event occurs, the party makes a payment to the first party, and the swap then terminates. The size of the payment is usually linked to the decline in the reference asset's market value following the credit event.

total return swap: Two parties enter an agreement whereby they swap periodic payment over the specified life of the agreement. One party makes payments based upon the total return—coupons plus capital gains or losses—of a specified reference asset. The other makes fixed or floating payments as with a vanilla interest rate swap. Both parties' payments are based upon the same notional amount. The reference asset can be almost any asset, index or basket of assets.

credit linked note: A debt instrument is bundled with an embedded credit derivative. In exchange for a higher yield on the note, investors accept exposure to a specified credit event. For example, a note might provide for principal repayment to be reduced below par in the event that a reference asset defaults prior to the maturity of the note.

The fundamental difference between a credit default swap and a total return swap is the fact that the credit default swap provides protection against specific credit events. The total return swap provides protection against loss of value irrespective of cause—a default, market sentiment causing credit spreads to widen, etc.

Most credit derivatives entail two sources of credit exposure: one from the reference asset and the other from possible default by the counterparty to the transaction.

Source: Riskglossery.com

IO/PO Mortgage Splits

Interest-only / principal only mortgage splits:
(Also see loan amortization spreadsheets)
Case I

Example: $100,000, 15-year mortgage, @12%

monthly payment = ________________
First payment's interest = $1,000

First payment's principal = ________________

Second payment's interest = ___________

Second payment's principal = ______________

If interest rates increased, would borrowers choose to make extra payments toward principal? (Prepay?)
If interest rates decline, would borrowers choose to make extra payments toward principal? (Prepay?)

Assume borrowers choose to pay an extra $300 per month.

Case II
First payment's interest: $1,000

First payment's principal= _____________

Second month's interest = _____________

Second month's principal = ___________

Third month's interest = ___________

Third month's principal = __________

If we (for this time only) ignore time value of money and sum the total amount paid toward principal over time, what will our figure be?________________ Does this figure differ depending on whether we prepay or not?
In which case will we receive the money sooner?
If we compare the interest payments for each month in cases I and II, in which case will the interest figures be higher? Will this ALWAYS be true over time? Will the sum (ignoring TVM) of the interest payments differ over time for Case I vs. Case II?

Which instrument, an I/O or a P/O will increase in value as interest rates decline? Which will decline in value when interest rates decline?

Part III: Liquidity Risk Management

  1. Estimate fund needs using predictions based on economic conditions, competitive conditions etc. [Estimate demand for loans vs. supply of deposits, sources vs uses of funds]

Sources of funds: [decrease/increase] in loans. [decrease/increase] in deposits

  • Low interest rates make it difficult to attract deposits, but loan demand is high

  • Periods of Economic expansion puts pressure on banks to supply funds.

  1. Meet liquidity needs through …

  1. Asset Management (using near cash assets (funds sold to other banks…money market securities) converting assets to cash – securitization.) small banks use this method more often

  1. Liability Management (meeting needs through borrowings, fed funds, purchased CDs, repurchase agreements etc). large banks use this method more often. Note, ability to obtain uninsured debt largely a function of solvency.

Tradeoffs: Near-cash assets are lower earning than other assets. Purchased liabilities generally uninsured. These could subject the bank to a bank run.

Estimated Sources and Uses of Funds:
Uses: Loan demand increases when….

  1. The economy grows at a fast pace

  2. Regional economic growth is strong

Sources: Deposit growth is influenced by:

  1. Economic conditions

(If i-rates are very high, corporate treasurers move funds out of demand deposits. On the other hand, if i-rates are very low, depositors are motivated to seek higher yields.)

Deposit Liquidity Management
Estimate deposit sources of funds graphically:
$ deps

Structure of deposits method : Estimate $ amount of deposits, multiply by probability of withdrawal in a given timeframe (ie One quarter).



Prob of withdrawal






$ 1.8

Other transaction



$ 6.0

Small time & svgs deps




Large time deposits



$ 2.0



Core Deposits: Stable funds provided by loyal customers…not interest-rate sensitive (demand, time < 100K, MMDA, NOW.)
Large-donomination liabilities Large deposits, interest-rate sensitive, pose great liquidity risk.
Funding liquidity risk: transactions in futures market may require cash to cover “margin” calls. Gains are obtained when position in closed-out. Banks that invest heavily in the derivatives markets can have more difficulty managing their liquidity.

Market liquidity risk: Volatile securities markets can cause temporary lack of liquidity in securities positions held by banks.
Asset Liquidity Management

Why rely on assets for liquidity?

  • May be “cheaper” than purchased CDs

  • If bank is judged unsound (risky) by financial markets, liabilities may be unavailable

(note: In addition to liquidity needs, gov't securities reduce the need for equity capital relative to loans)

Highly Liquid Assets:
Primary Reserves: Cash requirements imposed by regulators for banks to hold a given amount of cash in their vaults & on deposit at the FED

Reserve Requirements

Type of liability


Percentage of liabilities

Effective date

Net transaction accounts 1

     $0 to $7.0 million 2



     More than $7.0 million to $47.6 million 3



     More than $47.6 million




Nonpersonal time deposits




Eurocurrency liabilities



 Required reserves must be held in the form of vault cash and, if vault cash is insufficient, also in the form of a deposit maintained with a Federal Reserve Bank. An institution that is a member of the Federal Reserve System must hold that deposit directly with a Reserve Bank; an institution that is not a member of the System can maintain that deposit directly with a Reserve Bank or with another institution in a pass-through relationship. Reserve requirements are imposed on commercial banks, savings banks, savings and loan associations, credit unions, U.S. branches and agencies of foreign banks, Edge corporations, and agreement corporations.

Total transaction accounts consists of demand deposits, automatic transfer service (ATS) accounts, NOW accounts, share draft accounts, & telephone or preauthorized transfer accounts.

Asset Liquidity: (most to least liquid)
1) Money Market instruments: T-bills, Federal Agency securities, Repurchase agreements,* Fed funds, commercial paper.

* Securities are purchased (sold) under agreement to resell (repurchase). May have a set maturity date (usu. less than 3 mos.) Usually t-bills pledged as collateral.

2) Other Government Securities
3) Securitizable Loans
4) Commercial Loans

Historical lessons in liquidity risk:
I) Bank of New England, focused loans in one geographic area and one type in the 1980s - commercial real estate loans.
II) First Bank of Browning Mo., experience a deposit run when local workers were paid a day early, and cashed their checks to follow the Browning Indians to an out of town basketball tournament.
III) Continental Ill: Although located near Chicago, obtained uninsured liabilities & pursued high risk lending strategy

Part IV: Commercial Lending
Risk quantification: Credit Example:
EL (basis pts) = PD(%) x LGD (%)

Probability of default x loss given default

EL ($) = PD x LDG x EAD

EAD = $ exposure at default

Default probabilities can be determined from:
1) Historical default experience

2) Mapping to external default information
Portfolio credit factors: loan correlations; loan concentrations

Types of loans:
Wholesale banking: Focus on loans to business and corporations
Retail Banking: Focus on loans to individuals
Real Estate loans - largest component of loan portfolio, followed by commercial loans

Other sources of loans to businesses: commercial paper, life insurance cos, junk bonds, commercial finance cos.

Bank loans are used largely by: farmers, small businesses, medium size businesses.
Trend: Banks target particular industries where loan officer has expertise. Benefits in assessing risk correctly, but can be a disadvantage in diversification of the loan portfolio.

Benefits to bank borrowing vs. direct finance (bonds/commercial paper)

  1. Banks are more willing to forbear

  • What do banks do to "forbear"?

  • Why are banks more willing than bondholders to "forbear"

  • When should a banker forbear / when shouldn't the banker "forbear"?

  1. Banks are more discrete about loan's use

* When is discretion important? When is it not?

Credit Analysis Basics:

  1. What risks are inherent in the operations of the firm?

  1. What have managers done to reduce these risks (if anything)?

  1. What can a lender do to control its own risk in supplying funds?

5 c's of Lending

  1. Character: Borrower's honesty

  1. Capital (Why is capital important?)

  1. Capacity to repay. Business my have identifiable cash flow

  1. Conditions: Economic and Industry environment

  1. Collateral: If "perfected" bank has superior claim to an asset w.r.t. other lenders

5 C's of Bad Credit Symptoms:

  1. Complacency (things will be OK in future, if they were OK in the past)

  1. Carelessness

  1. Poor Communication

  1. Contingencies: Does borrow identify downside risks, and have plans to deal with such problems

  1. Competition: Don't make a loan just so that the bank "down the street" doesn't get to make it.

The Credit Decision

Made individually, by independent underwriting department OR by committee. The larger the loan, the higher up in the organization the decision will be made.

Loan Terminology:

  1. Position Limits: Maximum allowable credit exposure of any single borrower, industry or geographic location

* Large loans may be obtained through "loan participations" by banks.

  1. Risk rating loans: Grade loans on default likelihood and amount of loss. May be subjective or quantitative. Banks may have a model for this (for retail loans - rely on credit rating agencies.)

  1. Loan Covenants: Requirements the borrower must meet during the life of the loan - made to protect the lender. May be "positive" or "negative" in nature.

4) Credit Review: Monitoring of the performance of existing loans, and the handling of problem loans

Evaluating Commercial Loan Requests in more detail:

Character of the Borrower:
Indications of problems: Problems meeting past loan obligations, lack of references, overdrawn accounts/bounced checks, integrity in dealing with suppliers and customers, lawsuits filed etc.
Problem signs:
  • Borrower made recent key changes to financial aspects of the firm

  • Borrower makes frequent requests for credit (failure to plan ahead)

  • Bad Hygiene (can signal alcoholism, drug use, gambling, legal problems)

Use of loan proceeds:
Why does the firm need cash?

  • Seasonal and permanent WC needs (changes in CA - CL) (what can cause these changes?)

  • Purchase of depreciable assets (PPE), acquisition of other firms, extraordinary expenses?

  • Is firm borrowing to pay off other debts?

  • Does the firm have pro-forma income statement and balance sheets. To the best of your knowledge, are their projections realistic? Does the firm have a cash budget?

How much do they need?

  • Loaning too much can be just as bad as loaning too little.

Methods to generate loans:

  1. Buy them

  1. Solicit them (Actively seek them by visiting prospective customers)

  1. Make "Commitments" -Agreement between bank and borrower to make a loan under certain conditions. These include letters of credit and standby letters of credit.

  1. Refinancing

  1. Loan brokers - Sell loans to banks and other lenders

  1. Customer requests

Two problems in lending:

Asymmetric Information: Borrower knows more than seller

Moral Hazard: Borrower takes actions to harm the lender.

Know Your Customer: Example: A bank made a one-year $800,000 loan to a Panamanian Corp, collateralized with a 1.1 million home owned by the corporation. After the loan was made, the gov't discovered that the Panamanian Corp was owned by an illegal drug trafficker. The gov't seized the 1.1 million property, claiming they had reason to believe that the property was purchased with drug money.

Property that has been purchased with laundered money is subject to government seizure and forfeiture, even if it serves as collateral for a bank loan.
If the bank is an "innocent" lien holder, the court may "pardon" the property. However the bank must PROVE that it had no knowledge of the illegal activity that led to the forfeiture. In the above case, the court ruled that the bank was "willfully blind" to a number of obvious facts. The bank did not know the purpose of the loan, or how it would be repaid, when this corporation's sole asset was a vacant property.

{Handout: Management of Small Business Succession}

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