Financial

Institutions

Management

A Risk Management Approach Ninth Edition

Anthony Saunders
John M. Schiff Professor of Finance
Solomon Center
Stern School of Business
New York University

Marcia Millon Cornett

Robert A. and Julia E. Doran
Professor of Finance
Bentiey University

Mc
Graw
Hill
Education
Contents

PART ONE Size, Structure, and Composition ofthe Irtdustry 29

Balance Sheet and Recent Trends 33
INTRODUCTION 1
Other Fee-Generating Activities 39
Regulation 40
Chapter One
Industry Performance 46
Why Are Financial Institutions Savings Institutions 49
Special! 2 Size, Structure, and Composition of the Industry 49
Introduction 2 Balance Sheet and Recent Trends 51
Financial Institutions' Specialness 4 Regulation 53
FIs Function as Brokers 5 Industry Performance 53
FIs Function as Asset Transformers 5 Credit Unions 55
Information Costs 6 Size, Structure, and Composition ofthe Industry 57
Liquidity and Price Risk 7 Balance Sheet and Recent Trends 58
Other Special Services 8 Regulation 60
Other Aspects of Specialness 8 Industry Performance 60
The Transmission of Monetary Policy 9 Global Issues: The Financial Crisis 62
Credit Allocation 9 Summary 64
Intergenerational Wealth Transfers or Time Appendix 2A
Intermediation 9 Financial Statement Analysis Using a Return
Payment Services 10 on Equity (ROE) Framework 69
Denomination Intermediation 10 (www.mhhe.com/saunders9e)
Specialness and Regulation 10 Appendix 2B
Safety and Soundness Regulation 11 Commercial Banks' Financial Statements
Monetary Policy Regulation 13 and Analysis 69
Credit Allocation Regulation 13 (www.mhhe.com/saunders9e)
Consumer Protection Regulation 14 Appendix 2C
Investor Protection Regulation 14 Depository Institutions and Their Regulators 69
Entry Regulation 15 (www.mhhe.com/saunders9e)
The Changing Dynamics of Specialness 15 Appendix 2D
Trends in the United States 15 Technology in Commercial Banking 69
Global Trends 21 (www.mhhe.com/saunders9e)
Summary 22
Appendix 1A Chapter Three
The Financial Crisis: The Failure of
Financial Services: Finance
Financial Services Institution Specialness 25
Companies 70
(www.mhhe.com/saunders9e)
Appendix 1B Introduction 70
Monetary Policy Tools 25 Size, Structure, and Composition of the
(www.mhhe.com/saunders9e) Industry 70
Balance Sheet and Recent Trends 74
Chapter Two Assets 74
Financial Services: Depository Liabilities and Equity 79
Institutions 26 Industry Performance 80
Regulation 82
Introduction 26 Global Issues 84
Commercial Banks 28 Summary 84

XV
xvi Contents

Chapter Four Global Issues 172

Financial Services: Securities Firnis Summary 174
and Investment Banks 86
Chapter Seven
Introduction 86 Risks of Financial Institutions 177
Size, Structure, and Composition of the Industry 88
Balance Sheet and Recent Trends 98 Introduction 177
Recent Trends 98 Interest Rate Risk 178
Balance Sheet 102 Credit Risk 180
Regulation 103 Liquidity Risk 182
Global Issues 107 Foreign Exchange Risk 184
Summary 111 Country or Sovereign Risk 186
Market Risk 187
Chapter Five Off Balance-Sheet Risk 188
Technology and Operational Risks 190
Financial Services: Mutual Fund
Insolvency Risk 192
and Hedge Fund Companies 114
Other Risks and the Interaction of Risks 193
Introduction 114 Summary 194
Size, Structure, and Composition
of the Mutual Fund Industry 115 PART TWO
Historical Trends 115
MEASURING RISK 199
Different Types of Mutual Funds 118
Mutual Fund Objectives 123
Chapter Eight
Investor Returns from Mutual Fund Ownership 125
Mutual Fund Costs 129 Interest Rate Risk I 200
Balance Sheet and Recent Trends Introduction 200
for the Mutual Fund Industry 132 The Level and Movement of Interest Rates 201
Money Market Funds 132 The Repricing Model 203
Long-Term Funds 134 Rate-Sensitive Assets 205
Regulation of Mutual Funds 135 Rate-Sensitive Liabilities 206
Global Issues in the Mutual Fund Industry 138 Equal Changes in Rates on RSAs and RSLs 209
Hedge Funds 140 Unequal Changes in Rates on RSAs and RSLs 210
Types of Hedge Funds 141 Weaknesses of the Repricing Model 213
Fees on Hedge Funds 146 Market Value Effects 213
Offshore Hedge Funds 146 Overaggregation 213
Regulation of Hedge Funds 147 The Problem of Runoffs 214
Summary 148 Cash Flows from Off-Balance-Sheet Activities 214
Summary 215
Chapter Six Appendix 8A
Financial Services: Insurance The Maturity Model 224
Companies 151 (www.mhhe.com/saunders9e)
Introduction 151 Appendix 8A
Life Insurance 152 Term Structure of Interest Rates 224
Size, Structure, and Composition of the Industry 152
Balance Sheet and Recent Trends 156 Chapter Nine
Regulation 159 Interest Rate Risk II 231
Property-Casualty Insurance 161 Introduction 231
Size, Structure, and Composition of the Industry 161 Duration: A Simple Introduction 232
Balance Sheet and Recent Trends 163
A General Formula for Duration 234
Regulation 172
The Duration of Interest-Bearing Bonds 236
 Contents xvii

The Duration of Zero-Coupon Bonds 238 Appendix 10B

The Duration ofConsol Bonds (Perpetuities) 238 Black Scholes Option Pricing Model 330
Features of Duration 239 (www.mhhe.com/saunders9e)
Duration and Maturity 239
Duration and Yield 240 Chapter Eleven
Duration and Coupon Interest 240 Credit Risk: Loan Portfolio and
The Economic Meaning of Duration 241 Concentration Risk 331
Semiannual Coupon Bonds 245
Duration and Interest Rate Risk 246 Introduction 331
Duration and Interest Rate Risk Management Simple Models of Loan Concentration Risk 332
on a Single Security 246 Loan Portfolio Diversification and Modern
Duration and Interest Rate Risk Management Portfolio Theory (MPT) 334
on the Whole Balance Sheet of an FI 249 Moody's Analytics Portfolio Manager Model 337
Immunization and Regulatory Considerations 256 Partial Applications of Portfolio Theory 340
DifFiculties in Applying the Duration Model 257 Regulatory Models 344
Duration Matching Can Be Costly 257 Summary 345
Immunization Is a Dynamic Problem 257 Appendix IIA
Large Interest Rate Changes and Convexity 258 CreditMetrics 350
Summary 260 Appendix IIB
Appendix 9A CreditRisk+ 354
The Basics of Bond Valuation 269
(www.mhhe.com/saunders9e) Chapter Twelve
Appendix 9B Liquidity Risk 357
Incorporating Convexity into the
Introduction 357
Duration Model 269
Causes of Liquidity Risk 358
Liquidity Risk at Depository Institutions 359
Chapter Ten
Liability-Side Liquidity Risk 359
Credit Risk: Individual Loan Risk 279 Asset-Side Liquidity Risk 363
Introduction 279 Measuring a DI's Liquidity Risk Exposure 365
Credit Quality Problems 281 New Liquidity Risk Measures Implemented by the Bank
Types of Loans 283 for International Settlements 369
Commercial and Industrial Loans 283 Liquidity Planning 375
Real Bstate Loans 286 Liquidity Risk, Unexpected Deposit Drains, and
Indiuidual (Consumer) Loans 287 Bank Runs 376
Olher Loans 289 Bank Runs, the Discount Window, and
Calculating the Return on a Loan 289 Deposit Insurance 377
The Contractually Promised Return on a Loan 290 Liquidity Risk at Other Types of Financial
The Expected Return on a Loan 293 Institutions 378
Retail Versus Wholesale Credit Decisions 294 Life Insurance Companies 378
Retail 294 Property-Casualty Insurers 379
Wholesale 295 Investment Funds 379
Measurement of Credit Risk 296 Summary 381
Default Risk Models 297 Appendix 12A
Qualitative Models 297 Sources and Uses of Funds Statement,
Quantitative Models 300 J. P. Morgan Chase, March 2015 387
Newer Models of Credit Risk Measurement and Pricing 304 (www.mhhe.com/saunders9e)
Summary 321 Appendix 12B
Appendix 10A Illustrative Template for the LCR 388
Credit Analysis and Loan Underwriting 330
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xviii Contents

Chapter Thirteen Regulatory Models: The BIS Standardized

Framework 473
Foreign Exchange Risk 391
Partial Risk Factor Approach 474
Introduction 391 The BIS Regulations and Large-Bank Internal
Foreign Exchange Rates and Transactions 391 Models 477
Foreign Exchange Rates 391 Summary 479
Foreign Exchange Transactions 392
Sources of Foreign Exchange Risk Exposure 395 Chapter Sixteen
Foreign Exchange Rate Volatility and FX Exposure 399 Off Balance Sheet Risk 485
Foreign Currency Trading 400
FX Trading Activities 401 Introduction 485
Foreign Asset and Liability Positions 403 Off-Balance-Sheet Activities and FI Solvency 486
The Return and Risk of Foreign Investments 403 Returns and Risks of Off-Balance-Sheet Activities 490
Risk and Hedging 405 Loan Commitments 493
Multicurrency Foreign Asset-Liability Positions 409 Commercial Letters of Credit and Standby Letters
Interaction of Interest Rates, Inflation, of Credit 496
And Exchange Rates 410 Derivative Contracts: Futures, Forwards, Swaps,
Purchasing Power Parity 411 and Options 499
Interest Rate Parity Theorem 412 Forward Purchases and Sales of When-Issued Securities 502
Summary 414 Loans Sold 503
Non-Schedule L Off-Balance-Sheet Risks 504
Chapter Fourteen Settlement Risk 504
Sovereign Risk 422 Affüiate Risk 505
The Role of OBS Activities in Reducing Risk 506
Introduction 422
Summary 508
Credit Risk Versus Sovereign Risk 426
Appendix 16A
Debt Repudiation Versus Debt Rescheduling 428
A Letter of Credit Transaction 512
Country Risk Evaluation 429
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Outside Evaluation Models 430
OECD Country Risk Classifications 431
Chapter Seventeen
Internal Evaluation Models 433
Using Market Data to Measure Risk: The Secondary Technology and Other
Market for LDC and Emerging Market Debt 442 Operational Risks 513
Summary 444 Introduction 513
Appendix 14A What Are the Sources of Operational Risk? 516
Mechanisms for Dealing with Sovereign Technological Innovation and Profitabiiity 516
Risk Exposure 448 The Impact of Technology on Wholesale and Retail
(www.mhhe.com/saunders9e) Financial Service Production 519
Chapter Fifteen Wholesale Financial Services 519
Retail Financial Services 520
Market Risk 449
Advanced Technology Requirements 522
Introduction 449 The Effect of Technology on Revenues and Costs 523
Calculating Market Risk Exposure 453 Technology and Revenues 525
The RiskMetrics Model 453 Technology and Costs 525
The Market Risk of Fixed-lncome Securities 454 Technology and the Evolution of the Payments
Foreign Exchange 457 System 530
Equities 458 Risks That Arise in an Electronic Transfer
Portfolio Aggregation 459 Payment System 533
Historie (Back Simulation) Approach 462 Other Operational Risks 538
The Historie (Back Simulation) Model versus RiskMetrics 465 Regulatory Issues and Technology and
The Monte Carlo Simulation Approach 466 Operational Risks 540
Expected Shortfall 470 Summary 542
 Contents xix

PART THREE Moral Hazard 580

MANAGING RISK 545
Chapter Eighteen
Liability and Liquidity Management
Introduction 546
Liquid Asset Management 546
Monetary Policy Implementation Reasons 547
Taxation Reasons 547
The Compositum of the Liquid Asset Portfolio 548
Return-Risk Trade-Off for Liquid Assets 549
The Liquid Asset Reserve Management Problem
for U.S. Depository Institutions 549
Undershooting/Overshooting of the Reserve Target 554
Managing Liquid Assets Other than Cash 558
Liability Management 559
Funding Risk and Cost 559
Choice of Liability Structure 560
Demand Deposits 560
Interest-Bearing Checking (NOW) Accounts 561
Passbook Savings 563
Money Market Deposit Accounts (MMDAs) 563
Retail Time Deposits and CDs 564
Wholesale CDs 564
Federal Funds 565
Repurchase Agreements (RPs) 566
Other Borrowings 567
Liquidity and Liability Structures for U.S.
Depository Institutions 568
Liability and Liquidity Risk Management
In Insurance Companies 570
Liability and Liquidity Risk Management
In Other Financial Institutions 571
Summary 571
Appendix IBA
Federal Reserve Requirement Accounting 575
(www.mhhe.com/saunders9e)
Appendix 18B
Bankers' Acceptances and Commercial Paper as
Sources of Financing 575
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Chapter Nineteen
Deposit Insurance and Other
Liability Guarantees 576
Introduction 576
Bank and Thrift Guaranty Funds 577
The Ganses of the Depository Fund Insolvencies
The Financial Environment 579
Panic Prevention Versus Moral Hazard 581
Controlling Depository Institution Risk
Taking 581
546 Stockholder Discipline 582
Depositor Discipline 587
Regulatory Discipline 592
Non-U.S. Deposit Insurance Systems 593
The Discount Window 594
Deposit Insurance versus the Discount Window 594
The Discount Window 594
Other Guaranty Programs 597
National Credit Union Administration 597
Property-Casualty and Life Insurance
Companies 597
The Securities Investor Protection Corporation 598
The Pension Benefit Guaranty Corporation 599
Summary 601
Appendix 19A
Calculation of Deposit Insurance Premiums 606
Appendix 19B
FDIC Press Release of Bank Failures 611
(www.mhhe.com/saunders9e)
Appendix 19C
Deposit Insurance Coverage for Commercial Banks
in Various Countries 611
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Chapter Twenty
Capital Adequacy 612
Introduction 612
Capital and Insolvency Risk 613
Capital 613
The Market Value of Capital 615
The Book Value of Capital 616
The Discrepancy between the Market and Book Values
ofEquity 616
Arguments against Market Value Accounting 617
Capital Adequacy in the Commercial Banking
And Thrift Industry 619
Capital 624
Credit Risk-Adjusted Assets 624
Calculating Risk-Based Capital Ratios 625
Capital Requirements for Other Financial
Institutions 643
Securities Firms 643
Life Insurance 644
579 Property-Casualty Insurance 646
Summary 648
xx Contents
Appendix 20A
Internal Ratings-Based Approach to Measuring
Credit Risk Adjusted Assets 656
Appendix 2 OB
Methodology Used to Determine G-SIBs'
Capital Surcharge 658
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Chapter Twenty-One
Product and Geographie Expansion
Introduction 659
Product Diversification 660
Segmentation in the U.S. Financial Services
Industry 661
Commercial and Investment Banking Activities 661
Banking and Insurance 664
Commercial Banking and Commerce 665
Nonbank Financial Service Firms and Banking 665
Nonbank Financial Service Firms and Commerce 667
Activity Restrictions in the United States
Versus Other Countries 668
Issues Involved in the Diversification
of Product Offerings 668
Safety and Soundness Concems 669
Economies of Scale and Scope 671
Conflicts of Interest 671
Deposit Insurance 673
Regulatorg Oversight 673
Competition 674
Domestic Geographie Expansion 675
Regulatory Factors Affecting Geographie
Expansion 676
Insurance Companies 676
Thri/ts 677
Commercial Banks 677
Cost and Revenue Synergies Affecting
Domestic Geographie Expansion by Merger and
Acquisition 680
Cost Synergies 680
Revenue Synergies 681
Merger Guidelines for Acceptability 682
Other Market- and Firm-Specific Factors Affecting
Domestic Geographie Expansion Decisions 685
Global and International Expansions 685
U.S. Banks Abroad 686
Foreign Banks in the United States 690
Advantages and Disadvantages of
International Expansion 692
Advantages 692
Disadvantages 693
Summary 694
Chapter Twenty-Two
Futures and Forwards 698
Introduction 698
Forward and Futures Contracts 700
Spot Contracts 700
Forward Contracts 700
Futures Contracts 702
Forward Contracts and Hedging Interest
659 Rate Risk 703
Hedging Interest Rate Risk with Futures
Contracts 704
Microhedging 704
Macrohedging 705
Routine Hedging versus Selective Hedging 705
Macrohedging with Futures 706
The Problem of Basis Risk 713
Hedging Foreign Exchange Risk 715
Forwards 715
Futures 716
Estimating the Hedge Ratio 719
Hedging Credit Risk with Futures and Forwards 722
Credit Forward Contracts and Credit Risk
Hedging 723
Futures Contracts and Catastrophe Risk 725
Regulation of Derivative Securities 725
Summary 727
Appendix 22A
Microhedging with Futures 734
(www.mhhe.com/saunders9e)
Chapter Twenty-Three
Options, Caps, Floors, and Collars 735
Introduction 735
Basic Features of Options 735
Buying a Call Option on a Bond 736
Writing a Call Option on a Bond 737
Buying a Put Option on a Bond 738
Writing a Put Option on a Bond 738
Writing Versus Buying Options 739
Economic Reasons for Not Writing Options 739
Regulatory Reasons 741
Futures versus Options Hedging 741
The Mechanics of Hedging a Bond or Bond
Portfolio 742
Hedging with Bond Options Using the Binomial
Model 743
Actual Bond Options 747
Using Options to Hedge Interest Rate Risk
On The Balance Sheet 749
Using Options to Hedge Foreign Exchange Risk 754
 Contents xxi

Hedging Credit Risk with Options 755 Fee Income 814

Hedging Catastrophe Risk with Call Spread Capital Costs 814
Options 756 Liquidity Risk 814
Caps, Floors, and Collars 757 Factors Affecting Loan Sales Growth 814
Caps 758 Access to the Commercial Paper Market 814
Floors 761 Customer Relationship Effects 815
Collars 762 Legal Concerns 815
Caps, Floors, Collars, and Credit Risk 765 BIS Capital Requirements 815
Summary 765 Market Value Accounting 815
Appendix 23A Asset Brokerage and Loan Trading 816
Microhedging with Options 772 Government Loan Sales 816
(www.mhhe.com/saunders9e) Credit Ratings 816
Purchase and Sale of Foreign Bank Loans 816
Chapter Twenty-Four Summary 817
Swaps 773
Chapter Twenty-Six
Introduction 773
Securitization 819
Swap Markets 774
Interest Rate Swaps 775 Introduction 819
Realized Cash Flows on an Interest Rate Swap 779 Mechanisms Used to Convert On-Balance-Sheet
Macrohedging with Swaps 780 Assets to a Securitized Asset 820
Currency Swaps 783 The Pass-Through Security 823
Fixed-Fixed Currency Swaps 783 GNMA 824
Fixed-Floating Currency Swaps 785 FNMA 824
Credit Swaps 786 FHLMC 825
Total Return Swaps 788 The Incentives and Mechanics of Pass-Through
Pure Credit Swaps 790 Security Creation 825
CDS Indexes 790 Prepayment Risk on Pass-Through Securities 831
Swaps and Credit Risk Concerns 791 Prepayment Models 835
Netting and Swaps 792 Government Sponsorship and Oversight of FNMA
Payment Flows Are Interest, Not Principal 793 and Freddie Mac 843
Standby Letters of Credit 793 The Collateralized Mortgage Obligation (CMO) 845
Summary 793 Creation of CMOs 846
Appendix 24A Class A, B, and C Bond Buyers 848
Setting Rates on an Interest Rate Swap 799 Other CMO Classes 848
The Mortgage-Backed Bond (MBB) or Covered
Chapter Twenty-Five Bond 849
Loan Sales 803 Innovations in Securitization 851
Mortgage Pass-Through Strips 851
Introduction 803 Securitization of Other Assets 854
The Bank Loan Sales Market 804 Can All Assets Be Securitized? 855
Definition of a Loan Sale 804 Summary 857
Types of Loan Sales 804 Appendix 26A
Types of Loan Sales Contracts 806 Fannie Mae and Freddie Mac Balance Sheets 862
Trends in Loan Sales 807 (www.mhhe.com/saunders9e)
The Buyers and the Seilers 808
Why Banks and Other FIs Seil Loans 813 INDEX 863
Reserve Requirements 813