Financial Institutions Management : A Risk Management Approach

FINANCIAL INSTITUTIONS MANAGEMENT 4E
Contents in full
Preface
	Intended audience
Acknowledgments
About the authors
New in this edition
Text at a glance
	Proven effective
	Connect support
	Visual progress
Organisation and content
Chapter 1
Why are financial institutions special?
	Introduction
	FINANCIAL INSTITUTIONS’ SPECIALNESS
		FI function as broker
		FI function as asset transformer
		Information costs
			FI role as delegated monitor
			FI role as information producer
		Liquidity and price risk
		Other special services
			Reduced transaction costs
			Maturity intermediation
	OTHER ASPECTS OF SPECIALNESS
		The transmission of monetary policy
		Credit allocation
		Intergenerational wealth transfers or time intermediation
		Payment services
		Denomination intermediation
	SPECIALNESS AND REGULATION
		Regulator structure and coordination
		Preliminary assessment
		Observation
		Role and responsibilities of CFR
		Membership
		Transparency and accountability
		Policy options for consultation
		Formalise the role of the CFR within statute
		Increase CFR membership to include the ACCC, AUSTRAC and the ATO
		Increase the reporting by the CFR
		Safety and soundness regulation
		Monetary policy regulation
		Credit allocation regulation
		Consumer and investor protection regulation
		Entry regulation
	THE CHANGING DYNAMICS OF SPECIALNESS
		Trends in Australia
		Global trends
		The rise of financial services holding companies
	THE SHIFT AWAY FROM RISK MEASUREMENT AND MANAGEMENT AND THE GLOBAL FINANCIAL CRISIS
		Endnotes
Chapter 2
The financial services industry: depository institutions
	Introduction
	BANKS
		Size, structure and composition of the industry
		Balance sheet and trends
			Assets
			Liabilities
			Capital
			Off-balance-sheet activities
		Bank performance
		The ‘too big to fail’ subsidy
		Introduction
		The task
		Summary of results
		Summary of implicit subsidy calculation
		Calculation and key assumptions
		Calculating the credit rating uplift
		Calculating the stock of uninsured liabilities
	CREDIT UNIONS AND BUILDING SOCIETIES
		Size, structure and composition of the industry
		Balance sheet, performance and trends
	THE REGULATION OF AUSTRALIAN DEPOSITORY INSTITUTIONS
		The key legislation
		The regulatory agencies
			Australian Prudential Regulation Authority
			Australian Securities and Investments Commission
			Reserve Bank of Australia
			Council of Financial Regulators
		Australian Prudential Supervision Framework 15
			Supervision outcomes and responses and entity risk assessment 18
		Probability and impact rating system (PAIRS) 20
		APRA’s supervisory oversight and response system (SOARS) 22
			Supervisory activities
			Supporting material and infrastructure and quality assurance within the framework
		Overview of the regulation of depository institutions
			1. Capital adequacy—measurement of capital and risk-adjusted assets and disclosure
			2. Liquidity
			3. Credit quality, large exposures, related organisations, outsourcing and business continuity management
Chapter 3
The financial services industry: other financial institutions
	Introduction
	INSURERS AND FUND MANAGERS
		Life insurance
			Size, structure and composition of the industry
			Ordinary business
			Superannuation business of life insurers
			Balance sheet, performance and trends
			Regulation
			General insurance
			Size, structure and composition of the industry
			Balance sheet, performance and trends
			Loss risk
			Property versus liability
			Severity versus frequency
			Long-tail versus short-tail
			Product inflation versus social inflation
			Reinsurance
			Measuring loss risk
			Expense risk
			Investment yield/return risk
			Regulation
			Superannuation funds
			Size, structure and composition of the industry
			Balance sheet, performance and trends
			Regulation
			Managed funds and unit trusts
			Size, structure and composition of the industry
			Balance sheet and trends
			Regulation
	OTHER FINANCIAL INSTITUTIONS
		Money market corporations
			Size, structure and composition of the industry
			Balance sheet and trends
			Regulation
			Finance companies
			Size, structure and composition of the industry
			Balance sheet and trends
			Regulation
			Securitisation vehicles
			Size, structure and composition of the industry
			Balance sheet and trends
			Regulation
	SUMMARY
	KEY TERMS
	QUESTIONS AND PROBLEMS
	WEB QUESTIONS
	PERTINENT WEBSITES
	ENDNOTES
Chapter 4
Risks of financial institutions
	Introduction
	INTEREST RATE RISK
	MARKET RISK
	CREDIT RISK
	COUNTRY OR SOVEREIGN RISK
	FOREIGN EXCHANGE RISK
	LIQUIDITY RISK
	OFF-BALANCE-SHEET RISK
	TECHNOLOGY AND OPERATIONAL RISKS
		Technology risk
			Operational risk
	INSOLVENCY RISK
	OTHER RISKS AND THE INTERACTION OF RISKS
	SUMMARY
	KEY TERMS
Chapter 5
Interest rate risk measurement: the repricing model
	Introduction
	THE LEVEL AND MOVEMENT OF INTEREST RATES
	THE REPRICING MODEL
		Rate-sensitive assets
		Rate-sensitive liabilities
		Changes to NII—equal changes in rates on RSAs and RSLs
		Changes to NII—unequal changes in rates on RSAs and RSLs
	WEAKNESSES OF THE REPRICING MODEL
		Market value effects
		Over-aggregation
		The problem of runoffs
		Cash flows from off-balance-sheet activities
	Calculating and using the repricing gap
		Unbiased expectations theory
		Liquidity premium theory
		Market segmentation theory
Chapter 6
Interest rate risk measurement: the duration model
	Introduction
	DURATION: A SIMPLE INTRODUCTION
	A GENERAL FORMULA FOR DURATION
		The duration of interest-bearing bonds
		The duration of a zero-coupon bond
		The duration of a consol bond (perpetuity)
	FEATURES OF DURATION
		Duration and maturity
		Duration and yield
		Duration and coupon interest
	THE ECONOMIC MEANING OF DURATION
		Semi-annual coupon bonds
	USING DURATION TO MEASURE AN FI’s INTEREST RATE RISK
		Duration and immunising future payments
		1. Buy five-year maturity zero-coupon bonds
		2. Buy five-year duration coupon bonds
		Duration and interest rate risk in the whole balance sheet of an FI
			The duration gap for a financial institution
	IMMUNISATION AND REGULATORY CONSIDERATIONS
	DIFFICULTIES OF APPLYING THE DURATION MODEL
		Duration matching can be costly
		Immunisation is a dynamic problem
		Large interest rate changes and convexity
	SUMMARY
	KEY TERMS
	QUESTIONS AND PROBLEMS
	Calculating and using duration gap
	PERTINENT WEBSITES
	ENDNOTES
		Calculation of CX
		The problem of the flat-term structure
		The problem of default risk
		Floating rate loans and bonds
		Demand deposits and savings deposits
		Mortgages and mortage-backed securities
		Futures, options, swaps, caps and other contingent claims
Chapter 7
Managing interest rate risk using off-balance-sheet instruments
	Introduction
	FORWARD AND FUTURES CONTRACTS
		Spot contracts
		Forward contracts
		Futures contracts
	FORWARD CONTRACTS AND HEDGING INTEREST RATE RISK
	HEDGING INTEREST RATE RISK WITH FUTURES CONTRACTS
		Microhedging
		Macrohedging
		Routine hedging versus selective hedging
		Macrohedging with futures
			The risk-minimising futures position
			Short hedge
			On-balance-sheet
			Off-balance-sheet
		The problem of basis risk
	OPTIONS CONTRACTS
		Basic features of options
		Buying a call option on a bond
		Writing a call option on a bond
		Buying a put option on a bond
		Writing a put option on a bond
	WRITING VERSUS BUYING OPTIONS
		Economic reasons for not writing options
		Regulatory reasons for not writing options
		Futures versus options hedging
	THE MECHANICS OF HEDGING A BOND OR BOND PORTFOLIO USING OPTIONSOPTIONS CONTRACTS 15
		Hedging with bond options using the binomial model
	ACTUAL BOND OPTIONS
	USING OPTIONS TO HEDGE THE INTEREST RATE RISK OF THE BALANCE SHEET
		Basis risk
	INTEREST RATE SWAPS
		Swap markets
		The generic interest rate swap
		Realised cash flows on an interest rate swap
		Macrohedging with swaps
		Interest rate swaps and credit risk concerns
	SUMMARY
	KEY TERMS
	WEB QUESTIONS
	Hedging interest rate risk with futures versus options
	PERTINENT WEBSITES
	ENDNOTES
Chapter 8
Managing interest rate risk using loan sales and securitisation
	Introduction
	LOAN SALES
		Types of loan sales contracts
		Participations
		Assignments
		Using a loan sale to manage interest rate risk
		Why FIs sell loans
		Reserve requirements
		Fee income
		Capital costs
		Credit risk
		Liquidity risk
		Factors encouraging loan sales growth in the future
		BIS capital requirements
		Market value accounting
		Credit ratings
		Purchase and sale of foreign bank loans
		SECURITISATION
		Converting on-balance-sheet assets to a securitised asset
		The pass-through security
		Interest rate risk: incentives and mechanics of pass-through security creation
		Prepayment risk on pass-through securities
		Refinancing
		Housing turnover
		Good news effects
		Bad news effects
		Prepayment models
		The collateralised mortgage obligation (CMO)
		Creation of CMOs
		Class A, B and C bond buyers
		Class A
		Class B
		Class C
		Other CMO classes
		Class Z
		Class R
		The mortgage-backed bond (MBB)
		Cover pool monitor
		APRA powers
		Club structures
		Can all assets be securitised?
		SUMMARY
	KEY TERMS
	WEB QUESTION
	PERTINENT WEBSITES
	ENDNOTES
Chapter 9
Market risk
	Introduction
	CALCULATING MARKET RISK EXPOSURE
	THE RISKMETRICS MODEL
		The market risk of fixed-income securities
		Foreign exchange
		Equities
		Portfolio aggregation
	THE HISTORIC (BACK SIMULATION) APPROACH
		The historic (back simulation) model versus RiskMetrics
		Approach
		VaR limits
		Back-testing
		Back-testing results
		The Monte Carlo simulation approach 34
		Expected shortfall
		Value at Risk (VaR)
		Expected shortfall
	REGULATORY MODELS: THE BIS STANDARDISED FRAMEWORK
		Partial risk factor approach
		Fuller risk factor approach
		Step 1. Assign each instrument to applicable risk factors
		Step 2. Determine the size of the net risk position in each risk factor
		Step 3. Aggregate overall risk position across risk factors
	THE BIS REGULATIONS AND LARGE BANK INTERNAL MODELS
	SUMMARY
	KEY TERMS
	QUESTIONS AND PROBLEMS
	WEB QUESTION
	Calculating DEAR on an FI’s trading portfolio
	Fixed-income securities
	Foreign exchange contracts
	Equities
	PERTINENT WEBSITES
	ENDNOTES
Chapter 10
Credit risk I: individual loan risk
	Introduction
	CREDIT QUALITY PROBLEMS
		Regulatory use of macroprudential powers
			Observation by FSI
		Policy options for consultation
		Assess the prudential perimeter
		Additional macroprudential powers
	TYPES OF LOANS
		Business loans
		China—Central Bank supports lending to small business
		India—Risk capital firms back small business lenders
		Housing loans
		Consumer or individual loans
		Regulations restricting competition
			Other loans
			Loan defaults
	CALCULATING THE RETURN ON A LOAN
		The contractually promised return on a loan
		LIBOR Interest Rate Probe Escalates: Barclays Agrees to Pay Record Fine;
		The expected return on a loan
	RETAIL VERSUS WHOLESALE CREDIT DECISIONS
		Retail
		Wholesale
	MEASUREMENT OF CREDIT RISK
	DEFAULT RISK MODELS
		Qualitative models
		Borrower-specific factors
		Reputation
		Leverage
		Volatility of earnings
		Collateral
		Market-specific factors
		The business cycle
		The level of interest rates
		Quantitative models
		Credit scoring models
		Linear probability model and logit model
		Linear discriminant models
	NEWER MODELS OF CREDIT RISK MEASUREMENT AND PRICING
		Term structure derivation of credit risk
		Probability of default on a one-period debt instrument
		Probability of default on a multi-period debt instrument
		Mortality-rate derivation of credit risk
		RAROC models
		Using duration to estimate loan risk
		Using loan default rates to estimate loan risk
		Option models of default risk 35
		Theoretical framework
		The borrower’s payoff from loans
		The debt holder’s payoff from loans
		Applying the option valuation model to the calculation of default risk premiums
		The Moody’s Analytics option model and expected default frequency
	SUMMARY
	KEY TERMS
	WEB QUESTIONS
	Loan analysis
	PERTINENT WEBSITES
Chapter 11
Credit risk II: loan portfolio and concentration risk
	Introduction
	SIMPLE MODELS OF LOAN CONCENTRATION RISK
	LOAN PORTFOLIO DIVERSIFICATION AND MODERN PORTFOLIO THEORY (MPT)
		Moody’s Analytics Portfolio manager model
			Return on the loan (Ri )
			Risk of the loan (σ i )
			Correlation (ρ ij )
		Partial applications of portfolio theory
			Loan volume-based models
			Loan loss ratio–based models
	REGULATORY MODELS
	USE OF DERIVATIVES TO HEDGE CREDIT RISK
		Credit forward contracts and credit risk hedging
			Futures contracts and catastrophe risk
		Hedging credit risk with options
			Hedging catastrophe risk with call spread options
		Credit swaps
			Total return swaps
			Pure credit swaps
			CDS indices
		Swaps and credit risk concerns
			Netting and swaps
			Payment flows are interest and not principal
			Standby letters of credit
	USE OF LOAN SALES AND SECURITISATION TO MANAGE CREDIT RISK
		Loan sales
		Asset securitisation
		Removal of credit risk
		Reduction of concentration risk
		Maintenance of customer relationships
		Capital adequacy regulations
		Moral hazard issues
Chapter 12
Sovereign risk
	Introduction
	CREDIT RISK VERSUS SOVEREIGN RISK
	DEBT REPUDIATION VERSUS DEBT RESCHEDULING
	COUNTRY RISK EVALUATION
		Outside evaluation models
			The Euromoney Country Risk Index
			The Economist Intelligence Unit
			The Institutional Investor index
		Internal evaluation models
			Statistical models
		The debt service ratio (DSR)
		The import ratio (IR)
		Investment ratio (INVR)
		Variance of export revenue (VAREX)
		Domestic money supply growth (MG)
			Problems with statistical CRA models
		Measurement of key variables
		Population groups
		Political risk factors
		Portfolio aspects
		Incentive aspects
		Borrowers
		Benefits
		Costs
		Lenders (FIs)
		Benefits
		Costs
		Stability
	USING MARKET DATA TO MEASURE RISK: THE SECONDARY MARKET FOR LDC AND EMERGING MARKET DEBT
		The structure of the market
		Sellers
		Buyers
		The early market for sovereign debt
		Today’s market for sovereign debt
		Sovereign bonds
		Performing loans
		Non-performing loans
		Growing stability in Europe
		Continuing downward trend in the financial sector
		Correlation of S&P ratings and corporate defaults
		The sovereign debt crisis continues to be felt
Chapter 13
Foreign exchange risk
	Introduction
	FOREIGN EXCHANGE RATES AND TRANSACTIONS
		Foreign exchange rates
		Foreign exchange transactions
	SOURCES OF FOREIGN EXCHANGE RISK EXPOSURE
		Foreign exchange rate volatility and FX exposure
	FOREIGN CURRENCY TRADING
		FX trading activities
	INTERACTION OF INTEREST RATES, INFLATION AND EXCHANGE RATES
		Purchasing power parity
		Interest rate parity
	FOREIGN ASSET AND LIABILITY POSITIONS
		The return and risk of foreign investments
		Risk and hedging
	ON-BALANCE-SHEET HEDGING
	MANAGING FX RISK USING DERIVATIVE INSTRUMENTS
		Hedging with forwards
		Hedging with futures
		Estimating the hedge ratio 9
		Using options to hedge FX risk
		Using currency swaps to hedge FX risk
			Fixed–fixed currency swaps
			Fixed–floating currency swaps
	MULTICURRENCY FOREIGN ASSET–LIABILITY POSITIONS
	KEY TERMS
	QUESTIONS AND PROBLEMS
	WEB QUESTION
	PERTINENT WEBSITES
	ENDNOTES
Chapter 14
Liquidity risk
	Introduction
	CAUSES OF LIQUIDITY RISK
	LIQUIDITY RISK AT DEPOSITORY INSTITUTIONS
		Liability-side liquidity risk
		Deposits
			Purchased liquidity management
			Stored liquidity management
		Asset-side liquidity risk
		Measuring a depository institution’s liquidity exposure
			Sources and uses of liquidity
			Peer group ratio comparisons
			Liquidity index
			Financing gap and the financing requirement
			New liquidity risk measures implemented by the BIS
			Maturity ladder/scenario analysis
			Other liquidity risk control measures
		Liquidity planning
		Liquidity risk, unexpected deposit drains and bank runs
			Deposit drains and bank run liquidity risk
		Bank runs, the discount window and deposit guarantees
		Liquidity and financial system stability
			Reserve Bank role in maintaining financial system stability
	LIQUIDITY RISK IN OTHER FINANCIAL INSTITUTIONS
		Life insurance companies
		General insurers
		Managed funds
	SUMMARY
	KEY TERMS
	QUESTIONS AND PROBLEMS
	WEB QUESTION
	PERTINENT WEBSITES
	ENDNOTES
Chapter 15
Liability and liquidity management
	Introduction
	LIQUID ASSET MANAGEMENT
		Monetary policy implementation reasons
		Taxation reasons
	THE COMPOSITION OF THE LIQUID ASSET PORTFOLIO
	RETURN–RISK TRADE-OFF FOR LIQUID ASSETS
		The liquid asset reserve management problem for depository institutions
		Management of exchange settlement funds
			Payment settlement
			RBA liquidity facilities
		Liquidity management as a knife-edge management problem
	LIABILITY MANAGEMENT
		Funding risk and cost
	CHOICE OF LIABILITY STRUCTURE
	DEPOSIT LIABILITIES
		Cheque account and other demand deposits
			Withdrawal risk
			Costs
		Savings accounts
			Withdrawal risk
			Costs
		Cash management/investment savings accounts
			Withdrawal risk
			Costs
		Fixed-term deposits
			Withdrawal risk
			Costs
		Negotiable certificates of deposit (NCDs)
			Withdrawal risk
			Costs
	NON-DEPOSIT LIABILITIES
		Interbank funds
			Withdrawal risk
			Costs
		Repurchase agreements (Repos)
			Withdrawal risk
			Costs
		Covered bonds
			Withdrawal risk
			Costs
		Other borrowings
			Bank accepted bills (BAB)
			Commercial bills or non-bank bills
			Commercial paper or promissory notes
			Subordinated debt, medium-term notes and long-term borrowings
	LIQUIDITY REGULATION
		Liquidity management framework
		Contingency funding plan
		Minimum quantitative requirements
		LCR regime ADIs
			The LCR requirement
			The ‘name crisis’ scenario (phased out 31 December 2014)
			The ‘going concern’ scenario
			Stress testing
		MLH regime ADIs
		Net stable funding ratio (NSFR)
		Improved global liquidity?
	DEPOSITOR PROTECTION AND DEPOSIT GUARANTEES
		Australian depositor protection mechanisms
			Financial Claims Scheme 33
			Guarantee Scheme for Large Deposits and Wholesale Funding
			Financial Claims Scheme—Policyholders Compensation Facility
	SUMMARY
	KEY TERMS
	QUESTIONS AND PROBLEMS
	WEB QUESTIONS
	PERTINENT WEBSITES
	ENDNOTES
Chapter 16
Off-balance-sheet risk
	Introduction
	OBS ACTIVITIES AND FI SOLVENCY
	RETURNS AND RISKS OF OBS ACTIVITIES
		Loan commitments
			Interest rate risk
			Draw-down risk
			Credit risk
			Aggregate funding risk
		Documentary letters of credit and standby letters of credit
			Documentary letters of credit
			Standby letters of credit
			Risks associated with letters of credit
		Derivative contracts: futures, forwards, swaps and options
		Why the economy needs risk management products, like derivatives
			Credit risk concerns with derivative securities
		Forward purchases and sales of when-issued securities
			Risks associated with when-issued securities
		Loans sold
			Risks associated with loan sales
	THE ROLE OF OBS ACTIVITIES IN REDUCING RISK
	SUMMARY
	KEY TERMS
	QUESTIONS AND PROBLEMS
	WEB QUESTION
	Calculating income on OBS activities
	PERTINENT WEBSITES
	ENDNOTES
Chapter 17
Technology and other operational risks
	Introduction
	WHAT ARE THE SOURCES OF OPERATIONAL RISK?
	TECHNOLOGICAL INNOVATION AND PROFITABILITY
	THE IMPACT OF TECHNOLOGY ON WHOLESALE AND RETAIL FINANCIAL SERVICE PRODUCTION
		Wholesale financial services
		Retail financial services
		Advanced technology requirements
	THE EFFECT OF TECHNOLOGY ON REVENUES AND COSTS
		Technology and revenues
		Technology and costs
			Economies of scale
			Economies of scope
	TESTING FOR ECONOMIES OF SCALE AND ECONOMIES OF SCOPE
		The production approach
		The intermediation approach
	EMPIRICAL FINDINGS ON COST ECONOMIES OF SCALE AND SCOPE AND IMPLICATIONS FOR TECHNOLOGY EXPENDITURES
		Economies of scale and scope and X-inefficiencies
	TECHNOLOGY AND THE PAYMENTS SYSTEM
		Trends in retail payments
		Trends in high-value payments
		Risks that arise in an electronic payment system
			RTGS and daylight overdraft risk
			Crime and fraud risk
			Regulatory risk
			Tax avoidance
			Competition risk
	OTHER OPERATIONAL RISKS
	REGULATORY ISSUES AND TECHNOLOGY AND OPERATIONAL RISKS
		Operational risk and FI insolvency
		Consumer protection
	SUMMARY
	KEY TERMS
	QUESTIONS AND PROBLEMS
	WEB QUESTIONS
	PERTINENT WEBSITES
	ENDNOTES
Chapter 18
Capital management and adequacy
	Introduction
	CAPITAL AND INSOLVENCY RISK
		Capital
		The market value of capital
		The book value of capital
		The discrepancy between the market and book values of equity
		Arguments against market value accounting
	CAPITAL MANAGEMENT
	REGULATION OF CAPITAL OF AUSTRALIAN DIs
		Observation
		Capital requirements
		Country implementation of Basel III
		Calibrate the prudential framework
		International comparability of Australia’s prudential requirements
		Basel accords: The evolution of DI capital regulation
			Three-pillar framework
			The third Basel accord: Basel III
	PILLAR 1: CAPITAL ADEQUACY
		Measurement of regulatory capital
			Tier 1 (going concern) capital
			Common equity Tier 1
			Additional Tier 1 capital
			Tier 2 (gone concern) capital
			Capital adequacy ratios
		Measuring risk-adjusted assets
			Measurement of credit-risk-adjusted assets
			On-balance-sheet activities
			Off-balance-sheet activities
			Calculating the total credit-risk-adjusted assets
			Credit derivatives in the banking book
			Operational risk and risk-based capital
			Standardised approach to calculating operational risk capital charge
			Advanced measurement approaches to operational risk capital charge
			Market risk capital charge
			Non-traded interest rate risk capital charge
			Risk capital charge for securitisation credit risk
			Covered bonds and capital adequacy
		Calculating the capital adequacy ratios
		Leverage ratio
		Capital buffers
	PILLAR 2: DI RISK ASSESSMENT AND SUPERVISION
	PILLAR 3: CAPITAL AND RISK DISCLOSURE
	SUMMARY
	KEY TERMS
	QUESTIONS AND PROBLEMS
	WEB QUESTIONS
	PERTINENT WEBSITES
	ENDNOTES
	APPENDIX 18A
	Market risk capital charge for interest rate risk using the standardised approach
	APPENDIX 18B
	Criticisms of the risk-based capital ratio
		Risk weights
		Risk weights based on external credit rating agencies
		Capital ratios
		Portfolio aspects
		DI specialness
		Other risks
		Competition
		Leverage ratio
		Slower growth and higher lending costs resulting from additional costs of regulation
Glossary
Index
	A
	B
	C
	D
	E
	F
	G
	H
	I
	J
	K
	L
	M
	N
	O
	P
	Q
	R
	S
	T
	U
	V
	W
	X
	Y
	Z