Risk Management and Financial Institutions. Hull John C.

Model

      DLC, the small hypothetical bank we looked at in Tables 2.2 to 2.4, took deposits and used them to finance loans. An alternative approach is known as the originate-to-distribute model. This involves the bank originating but not keeping loans. Portfolios of loans are packaged into tranches which are then sold to investors.

      The originate-to-distribute model has been used in the U.S. mortgage market for many years. In order to increase the liquidity of the U.S. mortgage market and facilitate the growth of home ownership, three government sponsored entities have been created: the Government National Mortgage Association (GNMA) or “Ginnie Mae,” the Federal National Mortgage Association (FNMA) or “Fannie Mae,” and the Federal Home Loan Mortgage Corporation (FHLMC) or “Freddie Mac.” These agencies buy pools of mortgages from banks and other mortgage originators, guarantee the timely repayment of interest and principal, and then package the cash flow streams and sell them to investors. The investors typically take what is known as prepayment risk. This is the risk that interest rates will decrease and mortgages will be paid off earlier than expected. However, they do not take any credit risk because the mortgages are guaranteed by GNMA, FNMA, or FHLMC. In 1999, FNMA and FHLMC started to guarantee subprime loans and as a result ran into serious financial difficulties.3

      The originate-to-distribute model has been used for many types of bank lending including student loans, commercial loans, commercial mortgages, residential mortgages, and credit card receivables. In many cases there is no guarantee that payment will be made so that it is the investors that bear the credit risk when the loans are packaged and sold.

      The originate-to-distribute model is also termed securitization because securities are created from cash flow streams originated by the bank. It is an attractive model for banks. By securitizing its loans it gets them off the balance sheet and frees up funds to enable it to make more loans. It also frees up capital that can be used to cover risks being taken elsewhere in the bank. (This is particularly attractive if the bank feels that the capital required by regulators for a loan is too high.) A bank earns a fee for originating a loan and a further fee if it services the loan after it has been sold.

      As we will explain in Chapter 6, the originate-to-distribute model got out of control during the 2000 to 2006 period. Banks relaxed their mortgage lending standards and the credit quality of the instruments being originated declined sharply. This led to a severe credit crisis and a period during which the originate-to-distribute model could not be used by banks because investors had lost confidence in the securities that had been created.

      2.8 THE RISKS FACING BANKS

      A bank's operations give rise to many risks. Much of the rest of this book is devoted to considering these risks in detail.

      Central bank regulators require banks to hold capital for the risks they are bearing. In 1988, international standards were developed for the determination of this capital. These standards and the way they have evolved since 1988 are discussed in Chapters 15, 16, and 17. Capital is now required for three types of risk: credit risk, market risk, and operational risk.

      Credit risk is the risk that counterparties in loan transactions and derivatives transactions will default. This has traditionally been the greatest risk facing a bank and is usually the one for which the most regulatory capital is required. Market risk arises primarily from the bank's trading operations. It is the risk relating to the possibility that instruments in the bank's trading book will decline in value. Operational risk, which is often considered to be the biggest risk facing banks, is the risk that losses are made because internal systems fail to work as they are supposed to or because of external events. The time horizon used by regulators for considering losses from credit risks and operational risks is one year, whereas the time horizon for considering losses from market risks is usually much shorter. The objective of regulators is to keep the total capital of a bank sufficiently high that the chance of a bank failure is very low. For example, in the case of credit risk and operational risk, the capital is chosen so that the chance of unexpected losses exceeding the capital in a year is 0.1 %.

      In addition to calculating regulatory capital, most large banks have systems in place for calculating what is termed economic capital (see Chapter 26). This is the capital that the bank, using its own models rather than those prescribed by regulators, thinks it needs. Economic capital is often less than regulatory capital. However, banks have no choice but to maintain their capital above the regulatory capital level. The form the capital can take (equity, subordinated debt, etc.) is prescribed by regulators. To avoid having to raise capital at short notice, banks try to keep their capital comfortably above the regulatory minimum.

      When banks announced huge losses on their subprime mortgage portfolios in 2007 and 2008, many had to raise new equity capital in a hurry. Sovereign wealth funds, which are investment funds controlled by the government of a country, have provided some of this capital. For example, Citigroup, which reported losses in the region of $40 billion, raised $7.5 billion in equity from the Abu Dhabi Investment Authority in November 2007 and $14.5 billion from investors that included the governments of Singapore and Kuwait in January 2008. Later, Citigroup and many other banks required capital injections from their own governments to survive.

      SUMMARY

      Banks are complex global organizations engaged in many different types of activities. Today, the world's large banks are engaged in taking deposits, making loans, underwriting securities, trading, providing brokerage services, providing fiduciary services, advising on a range of corporate finance issues, offering mutual funds, providing services to hedge funds, and so on. There are potential conflicts of interest and banks develop internal rules to avoid them. It is important that senior managers are vigilant in ensuring that employees obey these rules. The cost in terms of reputation, lawsuits, and fines from inappropriate behavior where one client (or the bank) is advantaged at the expense of another client can be very large.

      There are now international agreements on the regulation of banks. This means that the capital banks are required to keep for the risks they are bearing does not vary too much from one country to another. Many countries have guaranty programs that protect small depositors from losses arising from bank failures. This has the effect of maintaining confidence in the banking system and avoiding mass withdrawals of deposits when there is negative news (or perhaps just a rumor) about problems faced by a particular bank.

      FURTHER READING

      Saunders, A., and M. M. Cornett. Financial Institutions Management: A Risk Management Approach. 8th ed. New York: McGraw-Hill, 2013.

      PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)

      1. How did concentration in the U.S. banking system change between 1984 and 2014?

      2. What government policies led to the large number of small community banks in the United States?

      3. What risks does a bank take if it funds long-term loans with short-term deposits?

      4. Suppose that an out-of-control trader working for DLC bank (see Tables 2.2 and 2.3) loses $7 million trading foreign exchange. What do you think would happen?

      5. What is meant by net interest income?

      6. Which items on the income statement of DLC bank in Section 2.2 are most likely to be affected by (a) credit risk, (b) market risk, and (c) operational risk?

      7. Explain the terms “private placement” and “public offering.” What is the difference between “best efforts” and “firm commitment” for a public offering?

      8. The bidders in a Dutch auction are as follows:

      The number of shares being auctioned is 150,000. What is the price paid by investors? How many shares does each investor receive?

      9. What is the attraction of a Dutch auction over the normal procedure for an IPO? In what ways was Google's IPO different