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FIN701 - Ch1,7,10-12,13,14,17-20,26,27

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Ryerson University
FIN 701
Patricia Mc Graw

Ch1 – Why FI’s are special FI 4 Pillars – chartered banks, trust companies, insurance companies, & investment dealers Universal bank – FI permitted by regulators to offer full range of financial services All FIs  Hold some assets potential to default/credit risk  Mismatch maturities of balance sheet assets & liabilities = interest rate risk  Liability withdrawal or liquidity risk; some underwriting risk Without FI’s: low level of fund flows - Information costs, Less liquidity, Substantial price risk, Monitoring cost Functions of FI’s  Brokerage function – act as agent for investors (encourages higher rate of savings, reduce costs)  Asset transformation – purchase primary securities by selling financial claims to households  Primary securities – financial claims (bank debt) used to invest in real assets  Secondary securities – financial claims (debt such as deposits) Roles of FIs in Cost Reduction Information costs  Investors exposed to agency costs o delegated monitor – collect info & invest on behalf of smaller agents; utilize info to create new products & continuously update information pool o information producer – monitor power & control, reduce info asymmetry between borrowers & lenders (source & users of funds in economy) Specialness in Provision of Services by FI’s  Information costs – economies of scale reduce costs for FI’s to screen & monitor borrowers  Liquidity & price risk – secondary claims (bonds/equity) issued by FIs have less price risk. FI’s can diversify risks  Reduced transaction costs – since purchase assets in large amounts  Maturity intermediation – FI’s can better bear risk of mismatched maturities of asset/liability  Transmission of monetary supply – through Bank of Canada, target overnight rate  Credit allocation – to specific areas of need eg. Home mortgages, farming, small business  Intergenerational transfers or time intermediation  Payment services (Canadian payments association)  Denomination intermediation – small investors can buy shares in money market mutual funds, purchase pieces of assets normally sold only in large denominations, benefit return & low risk Specialness and Regulation  Special services provided by FIs in general  Institution-specific functions, credit allocation, payment services  Negative externalities arise if services not provided – action by one party has adverse effect on some third party not part of transaction Regulations of FIs  Protect sources & users of savings o Redlining – banker refuse to make loans to residents living inside geographic boundaries (discriminate)  Primary role: ensure soundness of system as whole; regulation is not costless, is net regulatory burden Regulation 1. Safety & soundness regulation o Increase diversification, minimum capital requirements, guaranty funds, monitor & suerveillance 2. Monetary policy regulation 3. Credit allocation regulation 4. Consumer protection regulation 5. Investor protection regulation 6. Entry regulation Payment Services provided by FI’s: cheque clearing & wire transfer services Reduce net regulatory burden: acquire mutual funds, expanded their asset & pension fund management businesses, increased security for underwriting, generate fee income Financial products to become efficient alternatives to FI’s: can replace FI’s in delivery of products that:  Have standardized terms  Serve large # of customers  Sufficiently understood for investors to be comfortable in assessing their prices Ch7 – Risks of FI’s 6 Basic Contracts Non-contingent (2): hold stock (asset) long; sell stock (asset) short Contingent (4): Buy call, sell call, buy put, sell put Enterprise risk management (10) – identification of & management of risk exposure that determines success/failure of organization 1. Interest rate risk – when maturities of assets & liabilities mismatched 2. Market risk – from assets & liabilities in FI’s trading book due to changes in interest rates, exchange rates, & other prices 3. Credit risk – promised cash flows from loans & securities held by FI’s may not be paid in full 4. Off-balance-sheet risk – activities related to FI’s contingent assets & liabilities held off BS 5. Foreign exchange risk – exchange rate change affect value of FI’s assets & liabilities denominated in non-domestic currencies 6. Country/sovereign risk – repayments to foreign lenders/investors interrupted due to restrictions, intervention, or interference from foreign governments 7. Technology risk – when technological investments do not produce anticipated cost savings 8. Operational risk – existing technology, auditing, monitoring & other support systems may malfunction/break down 9. Liquidity risk – sudden surge in liability withdrawals may require FI to liquidate assets in very short period of time, & @ less than fair market values 10. Insolvency risk – may not have enough capital to offset sudden decline in value of its assets Interest Rate Risk – mismatch maturities of assets & liabilities Asset transformation – FI buys primary securities/assets & issue (& sell) secondary securities/liabilities to fund asset purchases  primary securities have different maturity & liquidity characteristics from the secondary securities FI’s sell  Eg. Bank buys medium/long term bonds and makes medium term loans raised by issuing short term deposits  Interest rate risk occurs since prices & reinvestment income characteristics of long-term assets react differently to changes in market interest rates than prices & interest expense of short term deposits Refinancing risk – cost of rolling over or reborrowing funds will rise above returns being earned on asset investments. When asset maturity LONGER than liability maturities  Market value = PV of current & future cash flows from that asset/liability  Interest ↑ = discount % ↑ = market value ↓  Interest ↑ = reduce net interest income  Interest ↓ = cost of renewing deposits ↓, interest rate on loan remain same, NII ↑ Reinvestment risk – returns on funds to be reinvested will fall below cost of funds. When asset maturities SHORTER than liability maturities; % ↑ = can reinvest since we earn more  Forced to lend/reinvest money @ lower rates than asset (short maturity)  If receives periodic cash flows, they will also be reinvested @ new lower (or higher) interest %  Cause realized yields on assets to differ from expected yields Market Risk – trading assets & liabilities  Focus on value at risk VaR to determine fluctuation on value (daily earnings at risk DEAR for short term risk)  Role of securitization in changing liquidity of bank assets & liabilities  Market risk minimize by using appropriate hedging techniques such as futures, options, & swaps, and by implementing controls that limit the amount of exposure taken by market makers Commercial Bank books Assets Liabilities Cash, loans, other illiquid assets, Deposits, other illiquid borrowed Banking book premises & equipment funds, capital Long: bonds, commodities, FX, Short: bonds, commodities, FX, Trading book equities, derivatives (off BS items) equities, derivatives (off BS items) Credit Risk – promised CF not paid in full  FI’s that lend money for long periods of time (loans or buying bonds) more susceptible to credit risk than FIs with short investment horizon  Eg. Life insurance companies & depository institutions wait longer time for returns to be realized rather than money market mutual funds & property-casual insurance companies Firm-specific credit risk – likelihood that single asset may deteriorate in quality; risk of default of borrowing firm associated with specific types of project risk taken by that firm  To eliminate, FI can hold a well-diversified portfolio of assets & only face systematic risk o Credit screening, monitor credit extended, dynamic adjustment of credit risk premia, counterparty risk from derivative contracts Systematic credit risk – macroeconomic factors that may increase default risk of all firms in economy Off-Balance-Sheet Risk – affect future shape of FI balance sheet involving creation of contingent assets & liabilities to potential placement on balance sheet; contingent  Letter of credit – credit guarantee issued by FI for fee on which payment is contingent on some future event occurring (eg. Government default, FI pays investors = liability on BS)  Loan commitments  Derivative positions Foreign Exchange Risk – exchange % changes affect value of FI assets & liabilities denominated in non-domestic currencies; if domestic $ strong = foreign $ weak. When convert back to domestic, lose value on foreign assets  Net long in foreign assets – foreign currency denominated assets exceed foreign currency denominated liabilities; FI suffer potential loss if domestic $ strengthens when repayment of assets occur in foreign currency  Net short in foreign assets – foreign currency denominated liabilities exceed foreign currency denominated assets; FI suffer potential loss if domestic $ weakens to foreign currency when repayment of liabilities occur in domestic currency  if Euro depreciate, then CDN stronger, pay back net liability with fewer dollars for Canadian- based FI in Paris Country or Sovereign Risk – repayment to foreigners may be interrupted due to foreign government  In event of collapsing country/currency, lender FI little recourse in situation unless FI able to restructure debt or demonstrate influence over future supply of funds to country in question. Involve significant working relationships with IMF and World Bank  Weak position if currency collapsing/government failing; must remain bargaining future supply of loans Technology Risk – investment in new technology does not generate cost savings expected in expansion of financial services, negative NPV Economies of scale – avg. cost of production decrease with expansion in amount of financial services provided increase Economies of scope – FI able to lower overall costs by producing new products with inputs similar to hose used for other products; cost synergy by producing multiple financial service products  Use data from existing customer databases to assist in providing new service products Operational Risk – existing technology, auditing, monitoring & other support systems malfunction/breakdown; employee fraud or error  Failure of back-room support operations necessary to maintain smooth functioning of operation of FI’s including settlement, clearing & other transaction related activities  If transmittal failure or high-tech fraud affecting any one of FI transactions, cause unravelling of all subsequent transactions Liquidity Risk – sudden surge in liability withdrawals, require FI to liquidate assets in short period of time @ less than fair market prices; forced to borrow/sell assets in short period of time  Normal economic activity = accept new deposits & borrow funds in short term money markets  When liquidity crisis, FI may need to sell assets @ losses to generate cash quickly  Liquidity may turn into solvency problem Insolvency Risk – FI may not have enough capital (shareholders’ equity) to offset sudden decline in value of assets  Involves shortfall of capital in times when operating performance of institution generates accounting losses (from other risks) Net Interest Income = Interest Income – Interest Expense Gains (loss) = (End + CF – Begin) / Begin Ch10 – Market Risk Principles-based regulation – generally accepted management principles that must be met Rules-based regulation – rules applicable to all FIs Marke
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