Week-9 Bank Regulation Money and Banking Econ 311 Tuesdays 7 - 9:45 Instructor: Thomas L. Thomas Capital Adequacy Management Bank capital helps prevent bank failure The amount of capital affects return for the owners (equity holders) of the bank Regulatory requirement – Regulatory Capital – Tier 1 and Tier 2 Basle Rules Economic Capital - What is this 2 Capital Adequacy Management: Returns to Equity Holders 3 Traditional Economic Capital Value-At-Risk (VaR) View Frequency of Occurrence / Probability Mean/Average Expected Losses (m) Unexpected Losses @ 99.9% confidence Level (s) Economic Capital Reserves Value-at-Risk VAR Before we can develop adequate credit stress testing we need to understand the differences between traditional credit loss measures and what stress tests incorporate. Aside form standard concentration and coverage analysis, a standard portfolio credit risk analysis typically employs a Value-at-Risk view. Credit risk in this view generally follows a positive skewed distribution (by definition one cannot have negative defaults and thus a normal distribution is not applicable). Reserves ALLL generally cover average expected losses over a horizon. In reality these are usually allocated to general reserves since most ALLL have two components: general reserves and specific reserves for known credits that are detraining. Economic capital functions as a cushion against unexpected loss up to some confidence level. In this case 99.9% or a single “A” rating is the regulatory standard (once every 10,000 years) In addition to a loss cushion economic capital represents the amount of the firm’s equity that is at risk which requires a return sufficient to cover the associated risk. The shape of the curve or tail will then reflect the underlying credit risk of the portfolio or product. However this view has some assumptions that can miss important risk elements. The distribution is generally based on one variable PD in this case and does necessarily fully account for other correlated factors that when combined either change the tail or increase the likelihood of default. Second, while the event may be rare, this methodology does not tell how severe or the magnitude of the event when it occurs beyond the confidence level prescribed for economic capital. 4 Old Measure: New Ones RAROC - Risk Adjusted Return on Capital EVA - Economic Value Added. Hurdle Rate – What is it. How is it measured? 5 Time Line of the Early History of Commercial Banking in the United States 6 Historical Development of the Banking System Bank of North America chartered in 1782 Controversy over the chartering of banks. National Bank Act of 1863 creates a new banking system of federally chartered banks Office of the Comptroller of the Currency Dual banking system Federal Reserve System is created in 1913. 7 Asymmetric Information and Financial.

1. Week-9 Bank Regulation
Money and Banking Econ 311
Tuesdays 7 - 9:45
Instructor: Thomas L. Thomas
Capital Adequacy Management
Bank capital helps prevent bank failure
The amount of capital affects return for the owners (equity
holders) of the bank
Regulatory requirement – Regulatory Capital – Tier 1 and Tier 2
Basle Rules
Economic Capital - What is this

2. 2
Capital Adequacy Management:
Returns to Equity Holders
3
Traditional Economic Capital Value-At-Risk (VaR) View

3. Frequency of Occurrence / Probability
Mean/Average Expected Losses (m)
Unexpected Losses @ 99.9% confidence Level (s)
Economic Capital
Reserves
Value-at-Risk
VAR
Before we can develop adequate credit stress testing we need to
understand the differences between traditional credit loss
measures and what stress tests incorporate.
Aside form standard concentration and coverage analysis, a
standard portfolio credit risk analysis typically employs a
Value-at-Risk view.
Credit risk in this view generally follows a positive skewed
distribution (by definition one cannot have negative defaults
and thus a normal distribution is not applicable).
Reserves ALLL generally cover average expected losses over a
horizon. In reality these are usually allocated to general
reserves since most ALLL have two components: general
reserves and specific reserves for known credits that are
detraining.
Economic capital functions as a cushion against unexpected loss
up to some confidence level. In this case 99.9% or a single “A”
rating is the regulatory standard (once every 10,000 years)

4. In addition to a loss cushion economic capital represents the
amount of the firm’s equity that is at risk which requires a
return sufficient to cover the associated risk.
The shape of the curve or tail will then reflect the underlying
credit risk of the portfolio or product.
However this view has some assumptions that can miss
important risk elements.
The distribution is generally based on one variable PD in this
case and does necessarily fully account for other correlated
factors that when combined either change the tail or increase
the likelihood of default.
Second, while the event may be rare, this methodology does not
tell how severe or the magnitude of the event when it occurs
beyond the confidence level prescribed for economic capital.
4
Old Measure: New Ones
RAROC - Risk Adjusted Return on Capital
EVA - Economic Value Added.
Hurdle Rate – What is it. How is it measured?

5. 5
Time Line of the Early History of Commercial Banking in the
United States
6
Historical Development of the Banking System
Bank of North America chartered in 1782
Controversy over the chartering of banks.
National Bank Act of 1863 creates a new banking system of
federally chartered banks
Office of the Comptroller of the Currency
Dual banking system
Federal Reserve System is created in 1913.

6. 7
Asymmetric Information and Financial Regulation
Bank panics and the need for deposit insurance:
FDIC: short circuits bank failures and contagion effect.
Payoff method.
Purchase and assumption method (typically more costly for the
FDIC).
Other form of government safety net:
Lending from the central bank to troubled institutions (lender of
last resort).
Example TARP Funds Form of Purchase Assumption.
8
Bank Share of Total Nonfinancial Borrowing, 1960–2011
Source: Federal Reserve Flow of Funds;

7. www.federalreserve.gov/releases/z1/Current/z1.pdf. Flow of
Funds Accounts; Federal Reserve Bulletin.
9
Financial Innovation and the Decline of Traditional Banking
(cont’d)
Decline in cost advantages in acquiring funds (liabilities)
Rising inflation led to rise in interest rates and
disintermediation
Low-cost source of funds, checkable deposits, declined in
importance
Decline in income advantages on uses of funds (assets)
Information technology has decreased need for banks to finance
short-term credit needs or to issue loans
Information technology has lowered transaction costs for other
financial institutions, increasing competition
What are banks, credit unions and thrifts main competitive
advantage today?

8. 10
Financial Innovation and the Decline of Traditional Banking
As a source of funds for borrowers, market share has fallen
Commercial banks’ share of total financial intermediary assets
has fallen
In 1970 banks accounted for 40% of non-financial financing
By 2011 Banks accounted for only 25%.
Thrifts declined from 20% of market share to less than 3%
today.
No decline in overall profitability
Increase in income from off-balance-sheet activities
11

9. Size Distribution of Insured Commercial Banks, March 30, 2011
12
Ten Largest U.S. Banks,
December 30, 2010
13
Banks’ Responses
Expand into new and riskier areas of lending
Commercial real estate loans
Corporate takeovers and leveraged buyouts
Pursue off-balance-sheet activities
Non-interest income
Concerns about risk

10. Examples include repos, interest rate and currency swaps,
futures, CDOs, credit default swaps
14
Banks’ Responses
15

11. If a credit event occurs, the CDS contract is terminated and the
termination “payment” takes place in one of two forms:
•Physical settlement is the first where the protection buyer
presents the defaulted asset to the protection seller to obtain the
“termination payment.” If physical settlement is required, the
termination payment becomes the full face value of the
reference asset. In this scenario, the protection seller tries to
obtain some type of recovery from the underlying asset.
•Cash settlement is the second option. In this case the
protection buyer keeps the asset. However the termination
payment is the difference between the reference asset’s insured
notional value, and predetermined recovery value. Obviously
correctly determining the recovery value is key to this
calculation. Consequently, the reference asset’s current market
value, and its recovery value after default, are normally
assessed by an independent assessor.
•The Recovery Rate in either settlement then becomes a primary
driver in LGD and consequently the accuracy of expected losses
and capital calculations.
CDS

12. Bank Consolidation and Nationwide Banking
The number of banks has declined over the last 25 years
Bank failures and consolidation.
Deregulation: Riegle-Neal Interstate Banking and Branching
Efficiency Act f 1994.
Economies of scale and scope from information technology.
Results may be not only a smaller number of banks but a shift in
assets to much larger banks.
17
Benefits and Costs of Bank Consolidation
Benefits
Increased competition, driving inefficient banks out
of business
Increased efficiency also from economies of scale and scope
Lower probability of bank failure from more diversified
portfolios
Costs
Elimination of community banks may lead to less lending to

13. small business
Banks expanding into new areas may take increased risks and
fail
18
Separation of the Banking and Other Financial Service
Industries
Erosion of Glass-Steagall Act
Prohibited commercial banks from underwriting corporate
securities or engaging in brokerage activities
Section 20 loophole was allowed by the Federal Reserve
enabling affiliates of approved commercial banks to underwrite
securities as long as the revenue did not exceed a specified
amount
U.S. Supreme Court validated the Fed’s action
in 1988

14. 19
Separation of the Banking and Other Financial Service
Industries (cont’d)
Gramm-Leach-Bliley Financial Services Modernization Act of
1999
Abolishes Glass-Steagall
States regulate insurance activities
SEC keeps oversight of securities activities
Office of the Comptroller of the Currency
regulates bank subsidiaries engaged in
securities underwriting
Federal Reserve oversees bank holding companies

15. 20
Separation of Banking and Other Financial Services Industries
Throughout the World
Universal banking
No separation between banking and securities industries
British-style universal banking
May engage in security underwriting
Separate legal subsidiaries are common
Bank equity holdings of commercial firms are less common
Few combinations of banking and insurance firms
21
Financial Innovation and the Growth of the “Shadow Banking
System”
Financial innovation is driven by the desire
to earn profits
A change in the financial environment will stimulate a search
by financial institutions for innovations that are likely to be

16. profitable
Financial engineering
Remember the Dialectic Process!!!
22
Responses to Changes in Demand Conditions: Interest Rate
Volatility
Adjustable-rate mortgages
Flexible interest rates keep profits high when rates rise
Lower initial interest rates make them attractive to home buyers
Financial Derivatives
Ability to hedge interest rate risk
Payoffs are linked to previously issued (i.e. derived from)
securities.
Interest Rate Swap Example

17. 23
Responses to Changes in Supply Conditions: Information
Technology (cont’d)
Securitization
To transform otherwise illiquid financial assets into marketable
capital market securities.
Securitization played an especially prominent role in the
development of the subprime mortgage market in the mid 2000s.
Structure of special purpose vehicles.
Cash Pass Through
Syndicated loans
24

18. Avoidance of Existing Regulations: Loophole Mining
Reserve requirements act as a tax
on deposits
Restrictions on interest paid on deposits led to
disintermediation – people moving their money out of the
banking system.
Money market mutual funds
Sweep accounts
25
Government Safety Net
Moral Hazard
Depositors do not impose discipline of marketplace.
Financial institutions have an incentive to take on greater risk.
Adverse Selection
Risk-lovers find banking attractive.
Depositors have little reason to monitor financial institutions.

19. 26
Government Safety Net: “Too Big to Fail”
Government provides guarantees of repayment to large
uninsured creditors of the largest financial institutions even
when they are not entitled to this guarantee
Uses the purchase and assumption method
Increases moral hazard incentives for big banks
Larger and more complex financial organizations challenge
regulation
Increased “too big to fail” problem
Extends safety net to new activities, increasing incentives for
risk taking in these areas (as has occurred during the global
financial crisis

20. 27
Restrictions on Asset Holdings
Attempts to restrict financial institutions from too much risk
taking
Bank regulations
Promote diversification – Concentration Management
Prohibit holdings of common stock
Capital requirements
Minimum leverage ratio (for banks)
Minimum Capital levels for Tier1 and Tier 2
Basel Accord: risk-based capital requirements
Regulatory arbitrage
28

21. Capital Requirements
Government-imposed capital requirements are another way of
minimizing moral hazard at financial institutions
There are two forms:
The first type is based on the leverage ratio, the amount of
capital divided by the bank’s total assets.
To be classified as well capitalized, a bank’s leverage ratio
must exceed (Get new leverage ratio)
A lower leverage ratio, especially one below 3%, triggers
increased regulatory restrictions on the bank
The second type is risk-based capital requirements
Financial Supervision: Chartering and Examination
Chartering (screening of proposals to open new financial
institutions) to prevent adverse selection
Examinations (scheduled and unscheduled) to monitor capital
requirements and restrictions on asset holding to prevent moral
hazard
Capital adequacy
Asset quality
Management
Earnings
Liquidity

22. Sensitivity to market risk
CAMAL Reports
Filing periodic ‘call reports’
30
Financial Supervision: Chartering and Examination
CAMEL Ratings 1- 5 (5 being best):
Four elements measured:
Oversight provided by management and board
Policies and limits for all significant risk activities
Quality of measurement and monitoring systems
Internal controls to prevent fraud and abuse
MRAs and recommendations - now common
MIRAs mean trouble.

23. 31
Disclosure Requirements
Requirements to adhere to standard accounting (GAP) principles
and to disclose wide range of information
The Basel 2 accord and the SEC put a particular emphasis on
disclosure requirements
The Sarbanes-Oxley Act of 2002 established the Public
Company Accounting Oversight Board – Board and
Management must sign-off on accuracy.
Mark-to-market (fair-value) accounting
Issues of measurement
Assumes liquidation value on non-liquid assets.

24. 32
Macroprudential Vs. Microprudential Supervision
Before the global financial crisis, the regulatory authorities
engaged in microprudential supervision, which is focused on the
safety and soundness of individual financial institutions.
The global financial crisis has made it clear that there is a need
for macroprudential supervision, which focuses on the safety
and soundness of the financial system in the aggregate.
The Dodd-Frank Bill and Future Regulation
The system of financial regulation is undergoing dramatic
changes after the global financial crisis
Dodd-Frank Wall Street Reform and Consumer Protection Act
of 2010: The most comprehensive financial reform legislation
since the Great Depression
The Dodd-Frank Bill and Future Regulation (cont.’d)
The Dodd-Frank Bill addresses 5 different categories of

25. regulation:
Consumer Protection
Resolution Authority
Systemic Risk Regulation – Systemically important financial
institutions – 19 CCAR banks
Volcker Rule – banks limited on proprietary trading.
Derivatives – limits OTC transactions must be traded on
exchanges and cleared through clearing houses to reduce the
risk of one counterparty going bankrupt ( Use of Margin Calls).
Four Suggested Effective Stress Testing Principals
Principal 1: A banking organization’s stress testing framework
include activities and exercises that are tailored to and
sufficiently capture the banking organization’s exposures,
activities, and risks.
Principal 2: An effective stress testing framework should use
multiple conceptually sound stress testing activities and
approaches.
Principal 3: An effective stress testing framework is forward
looking and flexible.
Principal 4: Stress test should be clear, actionable, well
supported and inform decision making.

26. With respect to these elements, our goal today is to concentrate
and relate these elements to credit risks and credit stress
testing.
Should be applied at various levels of the bank
Product / business Lines
Portfolio and Risk Type
Enterprise Basis
Each should be tailored to the relevant level of aggregation.
Capture critical risk drivers.
Determine internal and external elements that influence risk.
Should capture the interplay among different exposures,
activities, and risks and their combined effects.
By flexible is should be able to readily incorporate changes in
the organization’s on and off-balance sheet activities. In
addition, while stress testing should utilize historical
information, it should look beyond the standard assumptions. It
should carefully consider the incremental and cumulative
affects of stressed conditions. Moreover, in addition to
conducting formal and routine stress tests, it should be flexible
to conduct new or ad hoc stress test in a timely manner.
While it is obvious that stress tests should be well documents
regarding assumptions, methodologies, and results, the most
important fact is they need to be actionable.
Similar to liquidity or contingency planning stress testing
should set similar limits and actions for economic stresses or
scenarios.
36
Responses to Changes in Supply Conditions: Information
Technology
Bank credit and debit cards
Improved computer technology lowers transaction costs
Electronic banking

27. ATM, home banking, ABM and virtual banking
Junk bonds
Commercial paper market
37
Stressed Scenario View
Small Loss Attacks Profits
Medium Loss
Dips into Retained Earnings
Large Loss
Attacks ALLL
Major Loss
Wipes out Economic Capital
Erodes Excess
Capital Encroaching

28. Into Debt
Expected Loss
Economic Capital
Loss Distribution
Loss Buffers
Stressed
Losses
$ Losses
Frequency
Stress Test should reflect losses that impact ALLL and Excess
Capital
99.9% Confidence
Level
Stress analysis tries to fill in the gap by assessing the potential
magnitude of events that fall outside the confidence level
established by a VaR analysis .
In that way it complements but does not replace the standard
VaR analysis.
In this view there are various buffers to cover losses and the
point of the analysis is to estimate the type of stress, event, that
will consume each buffer until the bank is effectively un-
operable.

29. The point where losses consume one buffer and move to the
next are called “Stress Points”
The guidance suggests 4 basic tests/methodologies to determine
these stress points.
38
Four Basic Stress Testing Approaches
Sensitivity Analysis - refers to the assessment of exposures,
activities, and risks when certain variables, parameters, and
inputs are “stressed” or “shocked.”
Scenario Analysis - is a type of stress testing which a banking
organization applies historical or hypothetical scenarios to
assess the impact of various events including extreme ones.
Reverse Stress Testing – is a tool that allows a banking
organization to assume a known adverse outcome, such as
suffering a credit loss that breaches a regulatory ratio, and then
deducing the types of events that could lead to that outcome.
Enterprise-wide Stress Testing – involves assessing the impact
of certain specific scenarios to the banking organization as a
whole, particularly on capital and liquidity.
Scenarios usually involve some kind of coherent logical story as
to why certain events, and circumstances are occurring and in
which combination and order as to why they occur such as a
severe recession or failure of a major counterparty. Note, some
additional analysis must be conducted to tie these events or
circumstances to risks elements of the bank. Moreover, stress

30. scenarios should reflect CNB’s unique vulnerabilities to factors
that affect exposures, activities and risks.
Sensitivity analysis differs from scenario analysis in that it
involves changing variables, parameters, or inputs without an
explicit underlying reason or narrative, in order to explore what
occurs under a wide range of inputs at extreme of highly
adverse level. Not there is no assignment of the likely hood of
occurrence. Rather like ALM Rate shocks it help risk managers
determine the range and impact at various levels to income,
losses, liquidity, and capital adequacy.
Enterprise-wide stress testing like scenario analysis involves
robust scenario designs and the effective translation of scenario
into impact measures. This type of testing is designed to help
assess the impact of a full set of risk variables under adverse
circumstances, but should be supplemented with other stress
tests and risk measurement tools given the inherent difficulties
in capturing all the risks and adverse outcomes on a company-
wide basis.
Reverse stress testing may help the bank to identify and
consider scenarios beyond it normal business expectations and
see the impact of severe systemic effects. Note, both the Federal
Reserve Bank and the Basle Bank made some observations
based on the recent stress testing by large banks. Both the
Federal Reserve and the Basel Bank made some significant
observations regarding current stress testing practices. First,
most stress tests did not produce large loss numbers in relation
to the capital buffers going into the recent crisis or their actual
loss experience. In many cases, stress tests relied on historical
relationships. These models assume risks are driven the same
statistical processes that were experience in the past and that
these historical relationships “constituted a good basis for
forecasting the development of future risk.” However, most
stress tests were not designed to capture extreme events or
“even broadly match what actually developed.”
A common theme was the lack of management “buy-in.”
According to Basel risk managers at many banks found it

31. difficult to obtain senior management approval of more severe
scenarios. These scenarios were considered too extreme or
innovative and thus were regarded as implausible. As a result,
both the Basel Bank and the Fed suggest as best practice that
banks simulate shocks that have not previously occurred. In
addition, stress tests should include “severity rages capable of
generating the most damage whether though the size of the loss
or through reputation.” This is often referred to as “Worst Case
Scenario Analysis.”
39
Four Basic Stress Testing Approaches
Source Price Waterhouse Coopers
40
Return on Assets: net profit after taxes per dollar of assets
ROA =
net profit after taxes
assets
Return on Equity: net profit after taxes per dollar of equity
capital

32. ROE =
net profit after taxes
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity
capital
EM =
Assets
Equity Capital
net profit after taxes
equity capital
=
net profit after taxes
assets
×
assets
equity capital
ROE = ROA × EM
Return on Assets: net profit after taxes per dollar of assets
ROA =
net profit after taxes
assets
Return on Equity: net profit after taxes per dollar of equity
capital
ROE =

33. net profit after taxes
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity
capital
EM =
Assets
Equity Capital
net profit after taxes
equity capital
=
net profit after taxes
assets
´
assets
equity capital
ROE = ROA ´ EM
Week-8 Stock Market Rational Expectations and Financial &
Bank Structure Continued
Money and Banking Econ 311
Tuesdays 7 - 9:45
Instructor: Thomas L. Thomas

34. The Bank Balance Sheet (cont’d)
Assets
Reserves
Cash items in process of collection
Deposits at other banks
Securities
Loans
Other assets – give some examples?
2
The Bank Balance Sheet
Liabilities
Checkable deposits
Nontransaction deposits – give some examples
Borrowings
Bank capital
What are core deposits?

35. 3
Table 1 Balance Sheet of All Commercial Banks (items as a
percentage of the total, June 2011
4
Basic Banking: Cash Deposit
Opening of a checking account leads to an increase in the
bank’s reserves equal to the increase in checkable depositsFirst
National BankFirst National
BankAssetsLiabilitiesAssetsLiabilitiesVault

36. Cash+$100Checkable deposits+$100Reserves+$100Checkable
deposits+$100
5
Basic Banking: Check Deposit
First National BankSecond National
BankAssetsLiabilitiesAssetsLiabilitiesReserves+$100Checkable
deposits+$100Reserves-$100Checkable deposits-$100First
National BankAssetsLiabilitiesCash items in process of
collection+$100Checkable
deposits+$100

37. 6
Basic Banking: Making a Profit
Asset transformation: selling liabilities with one set of
characteristics and using the proceeds to buy assets with a
different set of characteristics
The bank borrows short and lends longFirst National BankFirst
National BankAssetsLiabilitiesAssetsLiabilitiesRequired
reserves+$10Checkable deposits+$100Required
reserves+$10Checkable deposits+$100Excess
reserves+$90Loans+$90
7
General Principles of Bank Management
Liquidity Management

38. Asset Management
Liability Management
Capital Adequacy Management
Credit Risk
Interest-rate Risk
8
Liquidity Planning
Three Types:
Tactical
Strategic
Contingency

39. 9
Liquidity Management: Ample Excess Reserves
Suppose bank’s required reserves are 10%
If a bank has ample excess reserves, a deposit outflow does not
necessitate changes in other parts of its balance
sheetAssetsLiabilitiesAssetsLiabilitiesReserves$20MDeposits$1
00MReserves$10MDeposits$90MLoans$80MBank
Capital$10MLoans$80MBank
Capital$10MSecurities$10MSecurities$10M
10

40. Liquidity Management: Shortfall in Reserves
Reserves are a legal requirement and the shortfall must be
eliminated
Excess reserves are insurance against the costs associated with
deposit outflows
So what could a bank
do?AssetsLiabilitiesAssetsLiabilitiesReserves$10MDeposits$10
0MReserves$0Deposits$90MLoans$90MBank
Capital$10MLoans$90MBank
Capital$10MSecurities$10MSecurities$10M
11
Liquidity Management: Borrowing
Cost incurred is the interest rate paid on the borrowed funds
What type borrowing can the bank
do?AssetsLiabilitiesReserves$9MDeposits$90MLoans$90MBorr
owing$9MSecurities$10MBank Capital$10M

41. 12
Liquidity Management: Securities Sale
The cost of selling securities is the brokerage and other
transaction
costsAssetsLiabilitiesReserves$9MDeposits$90MLoans$90MBa
nk Capital$10MSecurities$1M
13
Liquidity Management: Federal Reserve

42. Borrowing from the Fed also incurs interest payments based on
the discount rate
Fed used to be considered the lender of last resort to banks –
this is no longer the case.
(note the Fed is a profit making institution for its
members.)AssetsLiabilitiesReserves$9MDeposits$90MLoans$90
MBorrow from Fed$9MSecurities$10MBank Capital$10M
14
Liquidity Management: Reduce Loans
Reduction of loans is the most costly way of
acquiring reserves
Calling in loans antagonizes customers
Other banks may only agree to purchase loans at a substantial
discountAssetsLiabilitiesReserves$9MDeposits$90MLoans$81M
Bank Capital$10MSecurities$10M

43. 15
Asset Management: Three Goals
1. Seek the highest possible returns on loans and securities
2. Reduce risk Concentration management
3. Active Credit Management
4. Have adequate liquidity (ALLL)
16
Asset Management: Four Tools
1. Find borrowers who will pay high

44. interest rates and have low possibility
of defaulting – Risk Adjusted Pricing
2. Purchase securities with high returns and low risk
3. Lower risk by diversifying
4. Balance need for liquidity against increased returns from less
liquid assets
17
Asset Management: Tools
Screening – Adverse selection in the loan markets requires
lenders screen out bad credits. This requires collecting
information and developing a system to evaluate the risk called
underwriting. Risk ratings and FICO scores are numerical
constructs to evaluate credit risk.
Specialized lending – banks often specialize in lending to
specific groups or firms in particular industries. The more
knowledgeable about the industries they are lending to the
better the bank is able to predict which firms are better credit
risks.
The uses of Monitoring and Restrictive covenants to modify
borrower behavior.

45. Collateral – to reduce exposure and modify behavior.
Developing long-term relationships (know your customer) – by
issuing loan commitments (credit lines) tied to some market
rate generally LIBOR over some specified time – maturity.
Finally credit rationing – refusing to make loans to borrowers
deemed to be too risky even though they are willing to pay
higher rates. – Simply put declining a loan – note issues with
fair lending.
18
Commercial Judgmental Credit Ratings

46. Typical 10 Grade Bank Rating System
Risk Grade 7 - Special Mention :Borrowers who exhibit
potential credit weaknesses or downward trends deserving bank
management's close attention. If not checked or corrected, these
trends will weaken the bank's asset or position. While
potentially weak, no loss of principal or interest is presently
envisioned. As a result, special mention assets do not expose
City National Bank to sufficient risk to warrant adverse
classification. Included in special mention assets could be those
borrowers in turnaround situations that are still in progress, as
well as those borrowers previously Pass rated who have shown
deterioration. Typically, start-up companies or those in
deteriorating industries or those with poor and declining market
share in an average industry are candidates. Borrower may be
experiencing temporary operating losses, but still has positive
cash flow. Cash flow may be volatile. Other characteristics
include an element of asset quality or management that is below
average. Management and owners may have limited depth and
back up.
Risk Grade 8 – Substandard: Borrowers with well-defined
weaknesses that jeopardize the orderly liquidation of debt. A
substandard credit is inadequately protected by the current
sound worth and paying capacity of the obligor or by the
collateral pledged, if any. The borrower may exhibit negative
cash flow. Negative or extremely volatile cash flow trends are
expected to continue. Repayment from the borrower of all
contractual principal and interest is in jeopardy, although no
loss of principal is presently envisioned. There is a distinct
possibility that a partial loss of interest and/or principal will
occur if deficiencies are not corrected. Loss potential, while
existing in the aggregate amount of substandard assets, does not
have to exist in individual assets classified substandard.
Management skills are questionable with readily identifiable
voids.

47. Risk Grade 9 – Doubtful: Borrowers classified doubtful have
the weaknesses found in substandard borrowers with the added
provision that the weaknesses make collection or liquidation in
full, on the basis of currently existing facts, conditions, and
values, highly questionable and improbable. Serious problems
exist to the point where partial loss of principal is likely. The
possibility of loss is extremely high, but cannot be determined
because of certain important and reasonably specific pending
factors that may result in strengthening the assets. Pending
factors include proposed merger, acquisition, or liquidation
procedures; capital injection; perfecting liens on additional
collateral; and refinancing plans. Specific reserves are generally
established to provide for these uncertainties. Management has
a demonstrated history of failing to live up to agreements,
unethical or dishonest business practices, bankruptcy, and/or
conviction of criminal charges. Relationship Managers should
attempt to identify loss in the credit whenever possible, thereby
limiting the excessive use of the Doubtful classification.
Risk Grade 10 – Loss: Advances to the borrower are in excess
of the calculated current fair value of the collateral. Borrower is
deemed incapable of repayment of unsecured debt. There is
little or no prospect for near term improvement and no realistic
strengthening action of significance pending. Credits to such
borrowers are considered uncollectible and of such little value
that continuance as active assets of the bank is not warranted.
This classification does not mean that the credits have
absolutely no recovery or salvage value, but rather, it is not
practical or desirable to defer writing off these basically
worthless assets even though partial recovery may be affected in
the future.

48. Expected Credit Loss composed of three items:
Probability of Default (PD)
Exposure at Default = [Outstanding Balance + CCF (Unused
Line)]
Loss Given Default = (1-Recovery Rate)
PD x Exposure X LGD = Expected Loss → ALLL
ALLL = Allowance for Loan and Lease Losses (e.g. Credit
Loss Reserves)
Expected Credit Loss
Liability Management
Recent phenomenon due to rise of money center banks
Expansion of overnight loan markets and new financial
instruments (such as negotiable CDs) have forced banks to pay
higher rates reducing NIM and profit.
Checkable deposits have decreased in importance as source of
bank funds.
As a result banks look closely at managing their funding
sources and interest rate exposure – Note S&L crisis borrowing
short lending long. Thereby focusing on interest rate and
maturity gaps.

49. 22
ALM – Managing Interest rate Risk
Traditional Gap Analysis – RSA – RSL
Refined in three ways (all three methods follow the matching
principal in accounting):
Maturity Bucket Approach – where RSA and RSL are matched
by buckets of similar maturity.
Standardized Gap Analysis – matches maturity and rates
sensitivity by matching fixed vs. variable rate instruments.
Duration Gap – matches interest rate sensitivity of RSA and
RSL so that the weighted duration for RSA is close to RSL
EVE and NII Shock Testing usually +/- 300 basis points in 100
b.p. shocks
Question – measure the maturity for credit lines and deposits
without stated maturities?

50. 23
Capital Adequacy Management
Bank capital helps prevent bank failure
The amount of capital affects return for the owners (equity
holders) of the bank
Regulatory requirement – Regulatory Capital – Tier 1 and Tier 2
Basle Rules
Economic Capital - What is this
24

51. Capital Adequacy Management:
Returns to Equity Holders
25
Traditional Economic Capital Value-At-Risk (VaR) View
Frequency of Occurrence / Probability
Mean/Average Expected Losses (m)
Unexpected Losses @ 99.9% confidence Level (s)
Economic Capital
Reserves

52. Value-at-Risk
VAR
Before we can develop adequate credit stress testing we need to
understand the differences between traditional credit loss
measures and what stress tests incorporate.
Aside form standard concentration and coverage analysis, a
standard portfolio credit risk analysis typically employs a
Value-at-Risk view.
Credit risk in this view generally follows a positive skewed
distribution (by definition one cannot have negative defaults
and thus a normal distribution is not applicable).
Reserves ALLL generally cover average expected losses over a
horizon. In reality these are usually allocated to general
reserves since most ALLL have two components: general
reserves and specific reserves for known credits that are
detraining.
Economic capital functions as a cushion against unexpected loss
up to some confidence level. In this case 99.9% or a single “A”
rating is the regulatory standard (once every 10,000 years)
In addition to a loss cushion economic capital represents the
amount of the firm’s equity that is at risk which requires a
return sufficient to cover the associated risk.
The shape of the curve or tail will then reflect the underlying
credit risk of the portfolio or product.
However this view has some assumptions that can miss
important risk elements.
The distribution is generally based on one variable PD in this
case and does necessarily fully account for other correlated

53. factors that when combined either change the tail or increase
the likelihood of default.
Second, while the event may be rare, this methodology does not
tell how severe or the magnitude of the event when it occurs
beyond the confidence level prescribed for economic capital.
26
Old Measure: New Ones
RAROC - Risk Adjusted Return on Capital
EVA - Economic Value Added.
Hurdle Rate – What is it. How is it measured?
27
Asymmetric Information and Financial Regulation
Bank panics and the need for deposit insurance:
FDIC: short circuits bank failures and contagion effect.
Payoff method.
Purchase and assumption method (typically more costly for the
FDIC).

54. Other form of government safety net:
Lending from the central bank to troubled institutions (lender of
last resort).
Example TARP Funds Form of Purchase Assumption.
28
Government Safety Net
Moral Hazard
Depositors do not impose discipline of marketplace.
Financial institutions have an incentive to take on greater risk.
Adverse Selection
Risk-lovers find banking attractive.
Depositors have little reason to monitor financial institutions.

55. 29
Government Safety Net: “Too Big to Fail”
Government provides guarantees of repayment to large
uninsured creditors of the largest financial institutions even
when they are not entitled to this guarantee
Uses the purchase and assumption method
Increases moral hazard incentives for big banks
Larger and more complex financial organizations challenge
regulation
Increased “too big to fail” problem
Extends safety net to new activities, increasing incentives for
risk taking in these areas (as has occurred during the global
financial crisis

56. 30
Restrictions on Asset Holdings
Attempts to restrict financial institutions from too much risk
taking
Bank regulations
Promote diversification – Concentration Managment
Prohibit holdings of common stock
Capital requirements
Minimum leverage ratio (for banks)
Minimum Capital levels for Tier1 and Tier 2
Basel Accord: risk-based capital requirements
Regulatory arbitrage
31
Capital Requirements
Government-imposed capital requirements are another way of
minimizing moral hazard at financial institutions
There are two forms:

57. The first type is based on the leverage ratio, the amount of
capital divided by the bank’s total assets.
To be classified as well capitalized, a bank’s leverage ratio
must exceed (Get new leverage ratio)
A lower leverage ratio, especially one below 3%, triggers
increased regulatory restrictions on the bank
The second type is risk-based capital requirements
Financial Supervision: Chartering and Examination
Chartering (screening of proposals to open new financial
institutions) to prevent adverse selection
Examinations (scheduled and unscheduled) to monitor capital
requirements and restrictions on asset holding to prevent moral
hazard
Capital adequacy
Asset quality
Management
Earnings
Liquidity
Sensitivity to market risk
CAMAL Reports
Filing periodic ‘call reports’

58. 33
Financial Supervision: Chartering and Examination
CAMEL Ratings 1- 5 (5 being best):
Four elements measured:
Oversight provided by management and board
Policies and limits for all significant risk activities
Quality of measurement and monitoring systems
Internal controls to prevent fraud and abuse
MRAs and recommendations - now comon
MIRAs mean trouble.

59. 34
Disclosure Requirements
Requirements to adhere to standard accounting (GAP) principles
and to disclose wide range of information
The Basel 2 accord and the SEC put a particular emphasis on
disclosure requirements
The Sarbanes-Oxley Act of 2002 established the Public
Company Accounting Oversight Board – Board and
Management must sign-off on accuracy.
Mark-to-market (fair-value) accounting
Issues of measurement
Assumes liquidation value on non-liquid assets.
35
Restrictions on Competition
Justified as increased competition can also increase moral

60. hazard incentives to take on more risk.
Branching restrictions (eliminated in 1994)
Glass-Steagall Act (repeated in 1999)
Disadvantages
Higher consumer charges
Decreased efficiency
36
Macroprudential Vs. Microprudential Supervision
Before the global financial crisis, the regulatory authorities
engaged in microprudential supervision, which is focused on the
safety and soundness of individual financial institutions.
The global financial crisis has made it clear that there is a need
for macroprudential supervision, which focuses on the safety
and soundness of the financial system in the aggregate.

61. The Dodd-Frank Bill and Future Regulation
The system of financial regulation is undergoing dramatic
changes after the global financial crisis
Dodd-Frank Wall Street Reform and Consumer Protection Act
of 2010: The most comprehensive financial reform legislation
since the Great Depression
The Dodd-Frank Bill and Future Regulation (cont’d)
The Dodd-Frank Bill addresses 5 different categories of
regulation:
Consumer Protection
Resolution Authority
Systemic Risk Regulation – Systemically important financial
institutions – 19 CCAR banks
Volcker Rule – banks limited on proprietary trading.
Derivatives – limits OTC transactions must be traded on
exchanges and cleared through clearing houses to reduce the
risk of one counterparty going bankrupt ( Use of Margin Calls).

62. Four Suggested Effective Stress Testing Principals
Principal 1: A banking organization’s stress testing framework
include activities and exercises that are tailored to and
sufficiently capture the banking organization’s exposures,
activities, and risks.
Principal 2: An effective stress testing framework should use
multiple conceptually sound stress testing activities and
approaches.
Principal 3: An effective stress testing framework is forward
looking and flexible.
Principal 4: Stress test should be clear, actionable, well
supported and inform decision making.
With respect to these elements, our goal today is to concentrate
and relate these elements to credit risks and credit stress
testing.
Should be applied at various levels of the bank
Product / business Lines
Portfolio and Risk Type
Enterprise Basis
Each should be tailored to the relevant level of aggregation.
Capture critical risk drivers.
Determine internal and external elements that influence risk.
Should capture the interplay among different exposures,
activities, and risks and their combined effects.
By flexible is should be able to readily incorporate changes in
the organization’s on and off-balance sheet activities. In

63. addition, while stress testing should utilize historical
information, it should look beyond the standard assumptions. It
should carefully consider the incremental and cumulative
affects of stressed conditions. Moreover, in addition to
conducting formal and routine stress tests, it should be flexible
to conduct new or ad hoc stress test in a timely manner.
While it is obvious that stress tests should be well documents
regarding assumptions, methodologies, and results, the most
important fact is they need to be actionable.
Similar to liquidity or contingency planning stress testing
should set similar limits and actions for economic stresses or
scenarios.
40
Stressed Scenario View
Small Loss Attacks Profits
Medium Loss
Dips into Retained Earnings
Large Loss
Attacks ALLL
Major Loss
Wipes out Economic Capital
Erodes Excess
Capital Encroaching
Into Debt
Expected Loss
Economic Capital

64. Loss Distribution
Loss Buffers
Stressed
Losses
$ Losses
Frequency
Stress Test should reflect losses that impact ALLL and Excess
Capital
99.9% Confidence
Level
Stress analysis tries to fill in the gap by assessing the potential
magnitude of events that fall outside the confidence level
established by a VaR analysis .
In that way it complements but does not replace the standard
VaR analysis.
In this view there are various buffers to cover losses and the
point of the analysis is to estimate the type of stress, event, that
will consume each buffer until the bank is effectively un-
operable.
The point where losses consume one buffer and move to the
next are called “Stress Points”
The guidance suggests 4 basic tests/methodologies to determine
these stress points.
41

65. Four Basic Stress Testing Approaches
Sensitivity Analysis - refers to the assessment of exposures,
activities, and risks when certain variables, parameters, and
inputs are “stressed” or “shocked.”
Scenario Analysis - is a type of stress testing which a banking
organization applies historical or hypothetical scenarios to
assess the impact of various events including extreme ones.
Reverse Stress Testing – is a tool that allows a banking
organization to assume a known adverse outcome, such as
suffering a credit loss that breaches a regulatory ratio, and then
deducing the types of events that could lead to that outcome.
Enterprise-wide Stress Testing – involves assessing the impact
of certain specific scenarios to the banking organization as a
whole, particularly on capital and liquidity.
Scenarios usually involve some kind of coherent logical story as
to why certain events, and circumstances are occurring and in
which combination and order as to why they occur such as a
severe recession or failure of a major counterparty. Note, some
additional analysis must be conducted to tie these events or
circumstances to risks elements of the bank. Moreover, stress
scenarios should reflect CNB’s unique vulnerabilities to factors
that affect exposures, activities and risks.
Sensitivity analysis differs from scenario analysis in that it
involves changing variables, parameters, or inputs without an
explicit underlying reason or narrative, in order to explore what
occurs under a wide range of inputs at extreme of highly

66. adverse level. Not there is no assignment of the likely hood of
occurrence. Rather like ALM Rate shocks it help risk managers
determine the range and impact at various levels to income,
losses, liquidity, and capital adequacy.
Enterprise-wide stress testing like scenario analysis involves
robust scenario designs and the effective translation of scenario
into impact measures. This type of testing is designed to help
assess the impact of a full set of risk variables under adverse
circumstances, but should be supplemented with other stress
tests and risk measurement tools given the inherent difficulties
in capturing all the risks and adverse outcomes on a company-
wide basis.
Reverse stress testing may help the bank to identify and
consider scenarios beyond it normal business expectations and
see the impact of severe systemic effects. Note, both the Federal
Reserve Bank and the Basle Bank made some observations
based on the recent stress testing by large banks. Both the
Federal Reserve and the Basel Bank made some significant
observations regarding current stress testing practices. First,
most stress tests did not produce large loss numbers in relation
to the capital buffers going into the recent crisis or their actual
loss experience. In many cases, stress tests relied on historical
relationships. These models assume risks are driven the same
statistical processes that were experience in the past and that
these historical relationships “constituted a good basis for
forecasting the development of future risk.” However, most
stress tests were not designed to capture extreme events or
“even broadly match what actually developed.”
A common theme was the lack of management “buy-in.”
According to Basel risk managers at many banks found it
difficult to obtain senior management approval of more severe
scenarios. These scenarios were considered too extreme or
innovative and thus were regarded as implausible. As a result,
both the Basel Bank and the Fed suggest as best practice that
banks simulate shocks that have not previously occurred. In
addition, stress tests should include “severity rages capable of

67. generating the most damage whether though the size of the loss
or through reputation.” This is often referred to as “Worst Case
Scenario Analysis.”
42
Four Basic Stress Testing Approaches
Source Price Waterhouse Coopers
43
When a bank receives
additional deposits, it
gains an equal amount of reserves;
when it loses deposits,
it loses an equal amount of reserves
When a bank receives
additional deposits, it
gains an equal amount of reserves;
when it loses deposits,
it loses an equal amount of reserves

68. Moody's
Standard
& Poor's
FitchCredit worthiness
AaaAAAAAAAn obligor has EXTREMELY STRONG capacity
to meet its financial commitments.
Aa1AA+AA+
Aa2AAAA
Aa3AA-AA-
A1A+A+
A2AA
A3A-A-
Baa1BBB+BBB+
Baa2BBBBBB
Baa3BBB-BBB-
Ba1BB+BB+
Ba2BBBB
Ba3BB-BB-
B1B+B+
B2BB
B3B-B-
CaaCCCCCC
An obligor is CURRENTLY VULNERABLE, and is dependent
upon favourable business, financial, and
economic conditions to meet its financial commitments.
CaCCCCAn obligor is CURRENTLY HIGHLY-VULNERABLE.
CC
The obligor is CURRENTLY HIGHLY-VULNERABLE to
nonpayment. May be used where a bankruptcy
petition has been filed.
CDD
An obligor has failed to pay one or more of its financial
obligations (rated or unrated) when it
became due.
SDRD
This rating is assigned when the agency believes that the

69. obligor has selectively defaulted on a
specific issue or class of obligations but it will continue to meet
its payment obligations on other
issues or classes of obligations in a timely manner.
NRNRNRNo rating has been requested, or there is insufficient
information on which to base a rating.
Source: Moody's, Standard & Poor's and Fitch Rating Agencies
An obligor has VERY STRONG capacity to meet its financial
commitments. It differs from the highest
rated obligors only in small degree.
An obligor has STRONG capacity to meet its financial
commitments but is somewhat more
susceptible to the adverse effects of changes in circumstances
and economic conditions than obligors
in higher-rated categories.
An obligor has ADEQUATE capacity to meet its financial
commitments. However, adverse economic
conditions or changing circumstances are more likely to lead to
a weakened capacity of the obligor to
meet its financial commitments.
An obligor is LESS VULNERABLE in the near term than other
lower-rated obligors. However, it faces
major ongoing uncertainties and exposure to adverse business,
financial, or economic conditions
which could lead to the obligor's inadequate capacity to meet its
financial commitments.
An obligor is MORE VULNERABLE than the obligors rated
'BB', but the obligor currently has the
capacity to meet its financial commitments. Adverse business,
financial, or economic conditions will
likely impair the obligor's capacity or willingness to meet its
financial commitments.
Pass Ratings (Levels 1 - 6)
1Highest quality
2Excellent quality
3Good quality

70. 4 Average quality
5 Acceptable quality
6 Minimum acceptable quality
Non-Pass Ratings (Levels 7-10)
7Special Mention
8Substandard
9Doubtful
10Loss
Return on Assets: net profit after taxes per dollar of assets
ROA =
net profit after taxes
assets
Return on Equity: net profit after taxes per dollar of equity
capital
ROE =
net profit after taxes
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity
capital
EM =
Assets
Equity Capital
net profit after taxes
equity capital

71. =
net profit after taxes
assets
×
assets
equity capital
ROE = ROA × EM
Return on Assets: net profit after taxes per dollar of assets
ROA =
net profit after taxes
assets
Return on Equity: net profit after taxes per dollar of equity
capital
ROE =
net profit after taxes
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity
capital
EM =
Assets
Equity Capital
net profit after taxes
equity capital
=
net profit after taxes
assets
´
assets
equity capital
ROE = ROA ´ EM

72. Week-7 Economic Analysis of Financial Structure & Bank
Failures
Money and Banking Econ 311
Instructor: Thomas L. Thomas
Stocks are not the most important external funding source for
companies: Between 1970 -2000 only accounted for 11%.
Marketable debt and securities (bonds) are not the most
important source of external funding: 32% over the same period.
Only large, well established corporations have access to the
securities market to finance their activities.
Financial Intermediaries like banks are the most used source for
external finance accounting for 56% in the US and up to 70% in
Europe.
The financial system is among the most regulated sectors in the
economy.
Basic Facts

73. Asymmetric Information: Adverse Selection and Moral Hazard
Adverse selection occurs before the transaction
Adverse selection is a problem created when there is
asymmetric information before a transaction occurs. It occurs
when borrowers who are most likely to default are the ones
most actively seeking to obtain loans and are thus selected.
Moral hazard arises after the transaction
Moral hazard in the financial markets is the risk or hazard that
the borrower might engage in activities that are undesirable
(immoral) from the lenders point of view.
Moral hazard can also occur from the lending perspective where
management engages in activities that benefit themselves at the
expense of the owners shareholders.
Agency theory analyses how asymmetric information problems
affect economic behavior
3

74. How Moral Hazard Affects the Choice Between Debt and Equity
Contracts
Called the Principal-Agent Problem
Principal: less information (stockholder)
Agent: more information (manager)
Separation of ownership and control
of the firm
Managers pursue personal benefits and power rather than the
profitability of the firm– this is called the separation theorem
All of this applies to what phenomenon?
4
The Lemons Problem: How Adverse Selection Influences
Financial Structure
If quality cannot be assessed, the buyer is willing to pay at most
a price that reflects the average quality
Sellers of good quality items will not want to sell at the price
for average quality

75. The buyer will decide not to buy at all because all that is left in
the market is poor quality items
Similar problems are exhibited in the bond market – Often
buyers cannot distinguish good firms with high expected profits
and low risk against firms with low expected profit and high
risks.
If owners of a good firm have better info on their firm’s
performance they will be unwilling to sell stock at an average
market price.
The only firms that will be willing to sell at an average market
price are high risk low profit firms where the average price is
higher than the company’s actual stock value.
Since investors are not stupid and will not want to purchase
poor performing stocks they will decide to not to purchase
anything thereby retarding the market.
5
Tools to help solve the problem
One solution to reduce asymmetric information is by supplying
more information and details about individuals and firms
seeking financing –

76. Private companies like Standard and Poor’s and Moody’s
Investment services specialize in selling such information.
However this does not completely solve the problem. A free-
rider problem occurs when people who take advantage of the
private information without paying for it (how do they do this).
The free rider – problem prevents the private market from
producing enough information to eliminate asymmetry. One
way is for the government to release information to help
investors distinguish good and bad firms. SEC Filings and
GAAP accounting are examples.
What are some examples ?
Note discloser agreements do not always work as some still
cheat – give an example?
6
Financial Intermediation
Just like used car dealers become experts at looking at a used
car and determining its value – financial intermediaries are
experts at producing information about firms and individuals
who want to borrow money.
An important element is a bank’s ability to profit from

77. information it produces by not making it public thereby
eliminating the free rider problem.
Banks also exhibit economies of scale thereby reducing
transaction costs (give some examples).
Banks also spread risk though diversification.
7
Tools to Help Solve Moral Hazard in Debt Contracts
Monitoring and Enforcement of Restrictive Covenants
Discourage undesirable behavior
Encourage desirable behavior
Keep collateral valuable
Provide information

78. 8
Covenants discourage undesirable behavior – they can be
designed to keep the borrower from engaging in risky behavior.
Covenants encourage desirable behavior – for example cash
flow covenants encourage borrowers to engage in activities that
maintain sufficient cash flow to pay debt.
Covenants keep collateral valuable – a covenant to monitor
collateral and keep in good condition (like rental property)
protects the lender against loss.
Convents provide information – generally require borrowers to
provide financial information in the form of quarterly
accounting reports. (Still some moral hazard – why)
Financial Covenants & Moral Hazard
Studies by AMIR SUFI of he University of Chicago Graduate
School of Business suggest that banks provide credit lines that
are contingent on maintenance of cash flow.
Coverage covenants, are the most common financial covenant
(70%) which are written on a measure of cash flow divided by
interest, debt service, or fixed charge expense.
Reductions in cash flow lead to covenant violations, which in

79. turn lead to a restriction in the availability of a line of credit.
when a firm violates a covenant, it loses access to a substantial
portion of its line of credit.
In terms of magnitudes, a covenant violation is associated with
a 15 to 30% drop in the availability of both total and unused
lines of credit.
Financial Covenants Reduce Exposure
Collateral is a prevalent feature of debt contracts for both
households and business.
Collateral is property that is pledged to the lender to guarantee
payment in the event of default. Collateralized debt is called a
secured transaction. (Note the importance of seniority)
Debt that is not guaranteed with collateral like a credit card is
called unsecured transaction.
The primary sources of repayment is three fold – What are they?
Collateral
Expected Credit Loss composed of three items:
Probability of Default (PD)

80. Exposure at Default = [Outstanding Balance + CCF (Unused
Line)]
Loss Given Default = (1-Recovery Rate)
PD x Exposure X LGD = Expected Loss → ALLL
ALLL = Allowance for Loan and Lease Losses (e.g. Credit
Loss Reserves)
Expected Credit Loss
What is a Financial Crisis?
A financial crisis occurs when there is a particularly large
disruption to information flows in financial markets, with the
result that financial frictions increase sharply and financial
markets stop functioning
Asset Markets Effects on Balance Sheets
Stock market decline
Decreases net worth of corporations.
Unanticipated decline in the price level
Liabilities increase in real terms and net worth decreases.
Unanticipated decline in the value of the domestic currency
Increases debt denominated in foreign currencies and decreases
net worth.
Asset write-downs.

81. 13
Factors Causing Financial Crises
Deterioration in Financial Institutions’ Balance Sheets
Decline in lending.
Banking Crisis
Loss of information production and disintermediation.
Increases in Uncertainty
Decrease in lending.
Factors Causing Financial Crises (cont’d)

82. Increases in Interest Rates
Increases adverse selection problem
Increases need for external funds and therefore adverse
selection and moral hazard.
Government Fiscal Imbalances
Create fears of default on government debt.
Investors might pull their money out of the country.
Dynamics of Financial Crises in Advanced Economies
Stage One: Initiation of Financial Crisis
Mismanagement of financial liberalization/innovation
Asset price boom and bust
Spikes in interest rates
Increase in uncertainty
Stage two: Banking Crisis
Stage three: Debt Deflation

83. Dynamics of Financial Crises in Advanced Economies
Stage two: Banking Crisis
Deteriorating Balance Sheets and tougher lead some financial
institution’s net worth to a negative position.
Unable to pay depositors and creditors can lead to a bank panic
in which multiple banks fail.
Moreover uncertainty about the health of the banking system
can lead to bank runs on good as well as bad banks leading
called contagion – why
With fewer banks information about the creditworthiness of
borrowers disappears increasing adverse selection and moral
hazard deepening the financial crisis.
Dynamics of Financial Crises in Advanced Economies

84. Stage three: Debt Deflation
If the economic downturn leads to a sharp decline in the
aggregate price level it can short-circuit the a recovery.
This is called debt deflation where a substantial unanticipated
decline in the price level sets in leading to a further
deterioration in a firm’s net worth because of the increase in
the burden of debt.
Due to the decline in the net worth of borrowers from a drop in
price levels causes an increase in adverse selection and moral
hazard problems facing lenders.
Bank Failures of the 1980s and 1990s
The distinguishing feature of the history of banking in the
1980s was the extraordinary upsurge in the number of bank
failures. Between 1980 and 1994 more than 1,600 banks insured
by the Federal Deposit Insurance Corporation (FDIC) were
closed or received FDIC financial assistance far more than in
any other period since the advent of federal deposit insurance in
the 1930s

85. Common Characteristics 80s & 90S Bank Failures
1. Each followed a period of rapid expansion; in most cases,
cyclical forces were accentuated by external factors.
2. In all four recessions, speculative activity was evident.
.Expert. opinion often gave support to overly optimistic
expectations.
3. In all four cases there were wide swings in real estate
activity, and these contributed to the severity of the regional
recessions.
4. Commercial real estate markets in particular deserve
attention because boom and bust activity in these markets was
one of the main causes of losses at both failed and surviving
banks.
Common Characteristics 80s & 90S Bank Failures
Yet on the eve of the 1980s most banks gave few obvious signs
that the competitive environment was becoming more

86. demanding or that serious troubles lay ahead.
At banks with less than $100 million in assets (the vast majority
of banks), net returns on assets (ROA) rose during the late
1970s and averaged approximately 1.1 percent in 1980.a level
that would not be reached again until 1993.
Large banks, however, showed clearer signs of weakness. In
1980 ROA and equity/assets ratios were much lower for banks
with more than $1 billion in assets than for small banks and
were also well below the large-bank levels they would reach in
the early 1990s.
For the 25 largest bank holding companies in the late 1970s and
early 1980s, the market value of capital decreased relative to
and fell below its book value, suggesting that to investors, the
franchise value of large banks was declining.
Common Characteristics 80s & 90S Bank Failures
This relationship between the number of bank failures and
regional boom-and-bust patterns of economic activity is
illustrated by the data in the attached tables.
Bank failure rates were generally high in states where, in the
five years preceding state recessions, real personal income grew
faster than it did for the nation as a whole.

87. Week-6 Stock Market, Rational Expectations and Financial
Structure
Money and Banking Econ 311
Tuesdays 7 - 9:45
Instructor: Thomas L. Thomas
Common Stock is the principal way that corporations raise
equity capital
Stockholders those who own stock – own an interest in the
corporation proportional to the shares they own.
The most important rights are the right to vote and to be a
residual claimant of al the funds flowing into the firm (cash
flows). (What do we mean by residual)
Dividends are payments made periodically (usually quarterly to
the stockholders (shareholders).
Stock

88. A basic principal of finance is that the value of any investment
is found by computing the present value of all cash flows that
the investment will generate over its life. (How do we measure
a corporation’s life from an investor’s point of view?)
Similar to the net present value formula in chapter 4 the
discounted cash flows on equity consists of one dividend
payments and the final sales price.
=
Where P0 = the current price of the stock at the present
Div1 = dividend paid at the end of year 1
= the required return on an equity investment
P1 = the price of the stock at the end of the period or the
predicted sales price of the stock
Example assume the current price for a share of stock is $50.
Also assume that the required return is 12% the dividend is
$0.16 and the forecasted sales price is $60.00
= = $0.14 + $53.57 = $53.71
Would you buy the stock?
One Period Valuation

89. The Generalized Dividend Valuation Model
4
The Gordon Growth Model

90. 5
The Required Return (k)
Depends on
the risk-free rate (rf),
the return on the market (rm), and
the stock's beta.
6
Relationship Between Risk and Required Return
2.0
1.5
1.0
0.5
20
15
10
5
k=3.5% +(10% - 3.5%)ß

91. B
A
Required Return (%)
Risk ß
1.8
0.8
8.7
15.2
Substitution of Cash Flow for Earnings and Dividends
Emphasis on firm’s ability to generate cash
May be applied when firm does not pay a dividend
8

92. How the Market Sets Prices
The price is set by the buyer willing to pay the highest price
The market price will be set by the buyer who can take best
advantage of the asset
Superior information about an asset can increase its value by
reducing its perceived risk
Information is important for individuals to value each asset.
When new information is released about a firm, expectations
and prices change.
Market participants constantly receive information and revise
their expectations, so stock prices change frequently
9
Application: The Global Financial Crisis and the Stock Market
Financial crisis that started in August 2007 led to one of the
worst bear markets in 50 years.
Downward revision of growth prospects: ↓g.
Increased uncertainty: ↑ke
Gordon model predicts a drop in stock prices.
Explain why the formula suggests a drop in prices?

93. The Theory of Rational Expectations
Adaptive expectations:
Expectations are formed from past experience only.
Changes in expectations will occur slowly over time as data
changes.
However, people use more than just past data to form their
expectations and sometimes change their expectations quickly.
Expectations will be identical to optimal forecasts using all
available information
Even though a rational expectation equals the optimal forecast
using all available information, a prediction based on it may not
always be perfectly accurate
It takes too much effort to make the expectation the best guess
possible
Best guess will not be accurate because predictor is unaware of
some relevant information
This is due to What???????

94. Formal Statement of the Theory
12
Rationale Behind the Theory
The incentives for equating expectations with optimal forecasts
are especially strong in financial markets. In these markets,
people with better forecasts of the future get rich.
The application of the theory of rational expectations to
financial markets (where it is called the efficient market
hypothesis or the theory of efficient capital markets) is thus

95. particularly useful
Implications of the Theory
If there is a change in the way a variable moves, the way in
which expectations of the variable are formed will change as
well
Changes in the conduct of monetary policy (e.g. target the
federal funds rate)
The forecast errors of expectations will, on average, be zero and
cannot be predicted ahead of time.
14
The Efficient Market Hypothesis:
Rational Expectations in Financial Markets

96. 15
The Holding Period Return (HPR)
The percentage earned on an investment during a period of time
HPR = P1 + D - P0
P0
16

97. The Efficient Market Hypothesis: Rational Expectations in
Financial Markets (cont’d)
At the beginning of the period, we know Pt and C.
Pt+1 is unknown and we must form an expectation of it.
The expected return then is
Expectations of future prices are equal to optimal forecasts
using all currently available information so
Supply and Demand analysis states Re will equal the
equilibrium return R*, so Rof = R*
How Valuable are Published Reports by Investment Advisors?
Information in newspapers and in the published reports of
investment advisers is readily available to many market
participants and is already reflected in market prices

98. So acting on this information will not yield abnormally high
returns, on average
The empirical evidence for the most part confirms that
recommendations from investment advisers cannot help us
outperform the general market
Efficient Market Prescription for the Investor
Recommendations from investment advisors cannot help us
outperform the market
A hot tip is probably information already contained in the price
of the stock
Stock prices respond to announcements only when the
information is new and unexpected
A “buy and hold” strategy is the most sensible strategy for the
small investor
Why the Efficient Market Hypothesis Does Not Imply that
Financial Markets are Efficient
Some financial economists believe all prices are always correct

99. and reflect market fundamentals (items that have a direct impact
on future income streams of the securities) and so financial
markets are efficient
However, prices in markets like the stock market are
unpredictable- This casts serious doubt on the stronger view
that financial markets are efficient
The Efficient Market Hypothesis
Hard to beat the market on a risk-adjusted basis consistently
Earning a higher return is not necessarily outperforming the
market.
Considering risk is also important.
21
Assumptions Concerning Efficient Markets
Large number of competing participants

100. Information is readily available.
Transaction costs are small.
22
Random Walk
Another term for efficient markets
Does not imply security prices are randomly determined.
Implies day-to-day price changes are random
23

101. Random Walk
Successive prices changes are independent.
Today's price does not forecast tomorrow's price.
Current price embodies all known information.
24
Random Walk
New information must be random
IF NOT
An opportunity to earn an excess return would exist
25
Undervaluation and Overvaluation
Undervaluation

102. drives prices up
returns decline
Overvaluation
drives prices down
returns increase
26
Rationale Behind the Hypothesis
27

103. Undervaluation and Overvaluation
28
Random Walk
Prices change quickly to new information.
By the time most investors know the information, the price
change has already occurred.
29
Degree of Market Efficiency
The forms of the efficient market hypothesis:
the weak form
the semi-strong form
the strong form

104. 30
The Weak Form
Studying past price and volume data will not lead to superior
investment results.
While the weak form suggests that using price data will not
produce superior results, using financial analysis may produce
superior returns.
31
The Semi-Strong Form
Studying economic and accounting data will not lead to superior
investment returns.
Studying inside information may lead to superior returns.

105. 32
The Strong Form
Using inside information will not lead to superior investment
returns.
33
Anomalies
Empirical results generally support:
the weak form, and
the semi-strong form.
Possible exceptions to the efficient market hypothesis, called
anomalies, appear to exist.

106. 34
Anomalies and Returns
Empirical evidence of the existence of an anomaly does not
mean the individual can take advantage of the anomaly.
The anomaly can still exist and the market be effectively
efficient from the individual investor's perspective.
35
Implications of Efficient Markets
Security prices embody known information.
The playing field is level.
Specifying financial goals may be more important than seeking
undervalued stocks.
36

107. Implications of Efficient Markets
Other markets may not be efficient.
Importance of reducing transactions costs: the argument for a
buy-and-hold strategy
37
Implications of Efficient Markets
Security prices embody known information.
The playing field is level.
Specifying financial goals may be more important than seeking
undervalued stocks.
38
Implications of Efficient Markets

108. Other markets may not be efficient.
Importance of reducing transactions costs: the argument for a
buy-and-hold strategy
39
Behavioral Finance
The lack of short selling (causing over-priced stocks) may be
explained by loss aversion
The large trading volume may be explained by investor
overconfidence
Stock market bubbles may be explained by overconfidence and
social contagion

109. 40
12
0
12
0
0
1
The value of stock today is the present
value of all future cash flows
...
(1)(1)(1)(1)
If is far in the future, it will not a
ffect
(1)
The price of the
nn
nn
eeee
n
t
t
t
e
DP
DD
P
kkkk
PP
D
P
k
¥
=
=++++
++++

110. =
+
å
stock is determined only by the present
value of
the future dividend stream
P0 =
D0 (1+ g )
(ke − g )
=
D1
(ke − g )
D0 = the most recent dividend paid
g = the expected constant growth rate in dividends
ke = the required return on an investment in equity
Dividends are assumed to continue growing at a constant rate
forever
The growth rate is assumed to be less than the required return
on equity
P
0
=
D
0
(1+g)
(k
e

111. -g)
=
D
1
(k
e
-g)
D
0
= the most recent dividend paid
g = the expected constant growth rate in dividends
k
e
= the required return on an investment in equity
Dividends are assumed to continue growing at a constant rate
forever
The growth rate is assumed to be less than the required return
on equity
expectation of the variable that is bei
ng forecast
= optimal forecast using all available
information
eof
e
of
XX
X
X
=
=
1
Recall
The rate of return from holding a securi
ty equals the sum of the capital
gain on the security, plus any cash paym
ents divided by the

112. initial purchase price of the security.
= the r
tt
t
PPC
R
P
R
+
-+
=
1
ate of return on the security
= price of the security at time + 1, t
he end of the holding period
= price of the security at time , the b
eginning of the holding period
= cash payment (coupon
t
t
Pt
Pt
C
+
or dividend) made during the holding per
iod
t
t
e
t
e
P
C
P
P
R

113. +
-
=
+
1
of
e
of
t
e
t
R
R
P
P
=
Þ
=
+
+
1
1
Rof > R* ⇒ Pt ↑⇒ R
of ↓
Rof < R* ⇒ Pt ↓⇒ R
of ↑
until
Rof = R*
In an efficient market, all unexploited profit opportunities will
be eliminated

114. R
of
>R
*
ÞP
t
-ÞR
of
¯
R
of
<R
*
ÞP
t
¯ÞR
of
-
until
R
of
=R
*
In an efficient market, all unexploited profit opportunities will
be eliminated
1 SEQ CHAPTER h r 1Volcano Research Assignment
Due: March 26, 2015
No Late Research Projects will be accepted!
YOU MUST FOLLOW ALL DIRECTIONS ON THIS
INSTRUCTION SHEET TO EARN POINTS FOR THIS

115. ASSIGNMENT (40 total points available)
Pick any two active (erupted within the last 50 years) volcanoes
anywhere in the world to research. Please make sure your two
choices are in different parts of the world. Please do not choose
Mt. St. Helens, Kileaua, or Mt. Etna.
The following information must be included in your report for
each volcano:
Pt value
Name
2
Location (country, latitude and longitude)
1
Elevation
1
Date of last eruption
2
Why does it exist? (hot spot, convergence plate boundary,
divergent plate boundary, etc.)
3
Facts about its recent eruption history, include some interesting
or unusual activity.
2
Type of eruption that usually occurs (Hawaiian, Strombolian,

116. Vulcanian, or Plinian)
2
Type of volcano (shield, stratovolcano, cinder cone)
2
Type of lava that is usually erupted from the volcano (basalt,
andesite, rhyolite)
1
A location map for the volcano
1
At least one image of the volcano (photograph, satellite image,
etc.)
3
List of references, include the URL and the last date you
accessed the website.
20 total points available for each volcano
Please note that you will not earn any points if this volcano is
not an active one!
You may write this report in list form or paragraph form. I
prefer list form.
The following websites have some great information you might
check out or at least will give you a place to start.
http://volcano.und.edu/
http://volcanoes.usgs.gov/
You must also reference the material you use in your report,
which should include the URL and the date you last accessed
the website.