Financial

Institutions

Management

A Risk Management Approach

Eighth Edition

Anthony Saunders
John M. Schiff Professor of Finance
Salomon Center
Stern School of Business
New York University
Marcia Millon Cornett
Professor of Finance
Bentley University

Mc
Graw
Hill
Education

Contents

PART ONE
INTRODUCTION

Chapter One
Why Are Financial Institutions
Special? 2
Introduction 2
Financial Institutions' Specialness 4
FIs Function as Brokers 5
FIs Function as Asset Transformers 5
Information Costs 6
Liquidity and Price Risk 7
Other Special Services 8
Other Aspects of Specialness 8
The Transmission of Monetary Policy 8
Credit Allocation 9
Intergenerational Wealth Transfers or Time
Intermediation 9
Payment Services 9
Denomination Intermediation 10
Specialness and Regulation 10
Safety and Soundness Regulation 11
Monetary Policy Regulation 13
Credit Allocation Regulation 13
Consumer Protection Regulation 13
Investor Protection Regulation 14
Entry Regulation 14
The Changing Dynamics of Specialness 15
Trends in the United States 15
Global Trends 20
Appendix 1A
The Financial Crisis: The Failure of Financial
Services Institution Specialness
(www.mhhe.com/saunders8e)
Appendix IB
Monetary Policy Tools
(www.mhhe.com/saunders8e)
Chapter Two
Financial Services: Depository
Institutions 25
Introduction 25
Commercial Banks 27
Size, Structure, and Composition of the Industry 28
Balance Sheet and Recent Trends 32

Other Fee-Generating Activities 38

Regulation 39
Industry Performance 44
Savings Institutions 48
Size, Structure, and Composition of the Industry 48
Balance Sheet and Recent Trends 50
Regulation 52
Industry Performance 52
Credit Unions 55
Size, Structure, and Composition of the Industry 55
Balance Sheet and Recent Trends 57
Regulation 59
Industry Performance 59
Global Issues: The Financial Crisis 60
Appendix 2A
Financial Statement Analysis Using a Return on
Equity (ROE) Framework
(www.mhhe.com/saunders8e)
Appendix 2B
Commercial Banks' Financial Statements
and Analysis
(www.mhhe.com/saunders8e)
Appendix 2C
Depository Institutions and Their Regulators
(www.mhhe.com/saunders8e)
Appendix 2D
Technology in Commercial Banking
(www.mhhe.com/saunders8e)
Chapter Three
Financial Services: Finance
Companies 68
Introduction 68
Size, Structure, and Composition of the
Industry 68
Balance Sheet and Recent Trends 72
Assets 72
Liabilities and Equity 77
Industry Performance 78
Regulation 80
Global Issues 82
Chapter Four
Financial Services: Securities Brokerage
and Investment Banking 84
Introduction 84
XV

xvi Contents
Size, Structure, and Composition of the
Industry 86
Balance Sheet and Recent Trends 96
Recent Trends 96
Balance Sheet 99
Regulation 101
Global Issues 104
Chapter Five
Financial Services: Mutual Funds
and Hedge Funds 111
Introduction 111
Size, Structure, and Composition of the Mutual
Fund Industry 112
Historical Trends 112
Different Types of Mutual Funds 115
Mutual Fund Objectives 119
Investor Returns from Mutual Fund Ownership 122
Mutual Fund Costs 125
Balance Sheet and Recent Trends for the Mutual
Fund Industry 128
Money Market Funds 128
Long-Term Funds 130
Regulation of Mutual Funds 131
Global Issues in the Mutual Fund Industry 134
Hedge Funds 136
Types of Hedge Funds 138
Fees on Hedge Funds 142
Offshore Hedge Funds 143
Regulation of Hedge Funds 143
Chapter Six
Financial Services: Insurance

148

Introduction 148
Life Insurance 149
S:ze, Sfrwcfwre, and OomposftWM off/# Wwsfry 149
BaWce 5&eef and Recent Trends 253
Regulation 156
Property-Casualty Insurance 157
S;'zf, Sfrwcfwre, and Conzposz'tzon of f/ze Tndwsfn/ 157
Bo/a;zce 5/zeef and Kecenf Trends 159
Regz/Wz'orz 168
Global Issues 168
Chapter Seven
Risks of Financial Institutions
Introduction 173
Interest Rate Risk 174
Credit Risk 176

173

Liquidity Risk 178

Foreign Exchange Risk 180
Country or Sovereign Risk 182
Market Risk 183
Off-Balance-Sheet Risk 185
Technology and Operational Risks 186
Insolvency Risk 188
Other Risks and the Interaction of Risks 189
PART TWO
MEASURING RISK
Chapter Eight
Interest Rate Risk I

195

196

Introduction 196
The Level and Movement of Interest Rates 197
The Repricing Model 199
Rate-Sensitive Assets 201
Rate-Sensitive Liabilities 202
Equal Changes in Rates on RSAs and RSLs 204
Unequal Changes in Rates on RSAs and RSLs 205
Weaknesses of the Repricing Model 208
Market Value Effects 208
Ooeraggregafzon 209
The Problem of Runoffs 209
Cash Flows from Off-Balance-Sheet Activities 210
Appendix 8A
The Maturity Model
(www.mhhe.com/saunders8e)
Appendix 8B
Term Structure of Interest Rates 219
Chapter Nine
Interest Rate Risk II

226

Introduction 226
Duration: A Simple Introduction 227
A General Formula for Duration 229
The Duration of Interest-Bearing Bonds 231
TTze Duration of Zcro-OoupoH Bo/zds 233
TTze DwrafioM of Congo/ Bonds (Pi'rpcfwf/cs,) 233
Features of Duration 234
Duration and Maturity 234
Duration and Yield 235
Duration and Coupon Interest 235
The Economic Meaning of Duration 236
SenzzannzW Coupon Bonds 240
Duration and Interest Rate Risk 241
Duration and Interest Rate Risk Management
on a Single Security 241

Contents xvii
Duration and Interest Rate Risk Management on the
Whole Balance Sheet of an FI 244
Immunization and Regulatory
Considerations 251
Difficulties in Applying the Duration
Model 252
Duration Matching Can Be Costly 252
Immunization Is a Dynamic Problem 252
Large Interest Rate Changes and Convexity 253
Appendix 9A
The Basics of Bond Valuation
(www.mhhe.com/saunders8e)
Appendix 9B
Incorporating Convexity into the Duration
Model 264
Chapter Ten
Credit Risk: Individual Loan Risk

274

Introduction 274
Credit Quality Problems 276
Types of Loans 278
Commercial and Industrial Loans 278
Real Estate Loans 280
Individual (Consumer) Loans 282
Other Loans 284
Calculating the Return on a Loan 284
The Contractually Promised Return on a Loan 284
The Expected Return on a Loan 288
Retail versus Wholesale Credit Decisions 289
ReM 289
Wholesale 289
Measurement of Credit Risk 291
Default Risk Models 292
Qualitative Models 292
Quantitative Models 294
Newer Models of Credit Risk Measurement
and Pricing 298
Appendix 10A
Credit Analysis
(www.mhhe.com/saunders8e)
Appendix 10B
Black-Scholes Option Pricing Model
(www.mhhe.com/saunders8e)
Chapter Eleven
Credit Risk: Loan Portfolio
and Concentration Risk 326
Introduction 326
Simple Models of Loan Concentration Risk

326

Loan Portfolio Diversification and Modern

Portfolio Theory (MPT) 328
Moody's Analytics Portfolio Manager Model 331
Partial Applications of Portfolio Theory 335
Regulatory Models 339
Appendix 11A
CreditMetrics 345
Appendix 11B
CreditRisk+ 348
Chapter Twelve
Liquidity Risk 351
Introduction 351
Causes of Liquidity Risk 352
Liquidity Risk at Depository Institutions 352
Liability-Side Liquidity Risk 352
Asset-Side Liquidity Risk 356
Measuring a DI's Liquidity Risk Exposure 358
New Liquidity Risk Measures Implemented by the Bank
for International Settlements 361
Liquidity Risk, Unexpected Deposit Drains, and Bank
Runs 368
Bank Runs, the Discount Window, and Deposit
Insurance 369
Liquidity Risk and Life Insurance Companies 370
Liquidity Risk and Property-Casualty
Insurers 370
Investment Funds 371
Appendix 12A
Sources and Uses of Funds Statement, Bank of
America, March 2012
(www.mhhe.com/saunders8e)
Appendix 12B
Illustrative Template for the LCR 380
Chapter Thirteen
Foreign Exchange Risk

383

Introduction 383
Foreign Exchange Rates and Transactions 383
Foreign Exchange Rates 383
Foreign Exchange Transactions 384
Sources of Foreign Exchange Risk Exposure 387
Foreign Exchange Rate Volatility and FX Exposure 389
Foreign Currency Trading 390
FX Trading Activities 391
Foreign Asset and Liability Positions 392
The Return and Risk of Foreign Investments 393
Risk and Hedging 395
Multicurrency Foreign Asset-Liability Positions 399

xviii Contents
Interaction of Interest Rates, Inflation,
and Exchange Rates 400
Purchasing Power Parity 401
Interest Rate Parity Theorem 402
Chapter Fourteen
Sovereign Risk 412
Introduction 412
Credit Risk versus Sovereign Risk 416
Debt Repudiation versus Debt
Rescheduling 416
Country Risk Evaluation 418
Outside Evaluation Models 418
Internal Evaluation Models 420
Using Market Data to Measure Risk: The Secondary
Market for LDC and Emerging Market Debt 429
Appendix 14A
Mechanisms for Dealing with Sovereign Risk
Exposure
(www.rnhhe.com/saunders8e)
Chapter Fifteen
Market Risk 438
Introduction 438
Calculating Market Risk Exposure 440
The Risk Metrics Model 441
The Market Risk of Fixed-Income Securities 442
Foreign Exchange 445
Equities 446
Portfolio Aggregation 447
Historic (Back Simulation) Approach 450
The Historic (Back Simulation) Model versus
RiskMetrics 453
The Monte Carlo Simulation Approach 454
Expected Shortfall 458
Regulatory Models: The BIS Standardized
Framework 461
Partial Risk Factor Approach 461
Fuller Risk Factor Approach 462
The BIS Regulations and Large-Bank Internal
Models 465
Chapter Sixteen
Off-Balance-Sheet Risk

474

Introduction 474
Off-Balance-Sheet Activities and FI
Solvency 475

Returns and Risks of Off-Balance-Sheet

Activities 479
Loan Commitments 481
Commercial Letters of Credit and Standby Letters
of Credit 485
Derivative Contracts: Futures, Forwards, Swaps,
and Options 488
Forward Purchases and Sales of When-Issued
Securities 491
Loans Sold 492
Non-Schedule L Off-Balance-Sheet Risks 493
Settlement Risk 493
Affiliate Risk 494
The Role of OBS Activities in Reducing
Risk 495
Appendix 16A
A Letter of Credit Transaction
(www.mhhe.com/saunders8e)
Chapter Seventeen
Technology and Other Operational
Risks 503
Introduction 503
What are the Sources of Operational Risk? 505
Technological Innovation and Profitability 505
The Impact of Technology on Wholesale
and Retail Financial Service Production 508
Wholesale Financial Services 508
Retail Financial Services 509
Advanced Technology Requirements 511
The Effect of Technology on Revenues
and Costs 512
Technology and Revenues 514
Technology and Costs 515
Testing for Economies of Scale and Economies
of Scope 519
The Production Approach 519
The Intermediation Approach 519
Empirical Findings on Cost Economies of Scale
and Scope and Implications for Technology
Expenditures 520
Economies of ScaZe
Scope and X-f nesciences 520
Technology and the Evolution of the Payments
System 522
Risks That Arise in an Electronic Transfer Payment
System 524
Other Operational Risks 529
Regulatory Issues and Technology
and Operational Risks 531

Contents xix
PART THREE
MANAGING RISK

537

Chapter Eighteen
Liability and Liquidity Management

538

Introduction 538
Liquid Asset Management 538
Monetary Policy Implementation Reasons 539
Taxation Reasons 539
The Composition of the Liquid Asset
Portfolio 540
Return-Risk Trade-Off for Liquid Assets 541
The Liquid Asset Reserve Management Problem for U.S.
Depository Institutions 541
Undershooting/Overshooting of the Reserve
Target 545
Managing Liquid Assets Other than Cash 549
Liability Management 550
Funding Risk and Cost 551
Choice of Liability Structure 552
Demand Deposits 552
Interest-Bearing Checking (NOW) Accounts 553
Passbook Savings 554
Money Market Deposit Accounts (MMDAs) 554
Retail Time Deposits and CDs 555
Wholesale CDs 556
Federal Funds 557
Repurchase Agreements (RPs) 558
Other Borrowings 558
Liquidity and Liability Structures for U.S.
Depository Institutions 560
Liability and Liquidity Risk Management
in Insurance Companies 562
Liability and Liquidity Risk Management
in Other Financial Institutions 562
Appendix ISA
Federal Reserve Requirement Accounting
(www.mhhe.com/saunders8e)
Appendix 18B
Bankers' Acceptances and Commercial Paper as
Sources of Financing
(www.mhhe.com/saunders8e)
Chapter Nineteen
Deposit Insurance and Other
Liability Guarantees 568
Introduction 568
Bank and Thrift Guaranty Funds 569

The Causes of the Depository Fund

Insolvencies 572
The Financial Environment 572
Moral Hazard 573
Panic Prevention versus Moral Hazard 574
Controlling Depository Institution Risk Taking 575
Stockholder Discipline 575
Depositor Discipline 580
Regulatory Discipline 585
Non-U.S. Deposit Insurance Systems 586
The Discount Window 587
Deposit Insurance versus the Discount Window 587
The Discount Window 587
Other Guaranty Programs 590
National Credit Union Administration 590
Property-Casualty and Life Insurance Companies 590
The Securities Investor Protection Corporation 591
The Pension Benefit Guaranty Corporation 593
Appendix 19A
Calculation of Deposit Insurance
Premiums 600
Appendix 19B
FDIC Press Release of Bank Failures
(www.mhhe.com/saunders8e)
Appendix 19C
Deposit Insurance Coverage for Commercial
Banks in Various Countries
(www.mhhe.com/saunders8e)
Chapter Twenty
Capital Adequacy

605

Introduction 605
Capital and Insolvency Risk 606
Capital 606
The Market Value of Capital 607
The Book Value of Capital 608
The Discrepancy between the Market and Book Values
of Equity 609
Arguments against Market Value Accounting 609
Capital Adequacy in the Commercial Banking
and Thrift Industry 611
Capital 617
Credit Risk-Adjusted Assets 618
Calculating Risk-Based Capital Ratios 618
Capital Requirements for Other Financial
Institutions 636
Securities Firms 636
Life Insurance 636
Property-Casualty Insurance 638

xx Contents
Appendix 20A
Internal Ratings-Based Approach to Measuring
Credit Risk-Adjusted Assets 648
Appendix 20B
Methodology Used to Determine G-SIBs'
Capital Surcharge
(www.mhhe.com/saunders8e)
Chapter Twenty-One
Product and Geographic Expansion

651

Introduction 651
Product Diversification 652
Segmentation in the U.S. Financial Services
Industry 653
Commercial and Investment Banking Activities 653
Banking and Insurance 656
Commercial Banking and Commerce 657
Nonbank Financial Service Firms and Banking 658
Nonbank Financial Service Firms and Commerce 660
Activity Restrictions in the United States versus
Other Countries 660
Issues Involved in the Diversification of Product
Offerings 661
Safety and Soundness Concerns 661
Economies of Scale and Scope 663
Conflicts of Interest 664
Deposit Insurance 665
Regulatory Oversight 666
Competition 666
Domestic Geographic Expansion 668
Regulatory Factors Affecting Geographic
Expansion 669
Insurance Companies 669
Thrifts 669
Commercial Banks 669
Cost and Revenue Synergies Affecting
Domestic Geographic Expansion by Merger
and Acquisition 672
Cost Synergies 673
Revenue Synergies 674
Merger Guidelines for Acceptability 674
Other Market- and Firm-Specific Factors Affecting
Domestic Geographic Expansion Decisions 677
Global and International Expansions 678
U.S. Banks Abroad 679
Foreign Banks in the United States 682
Advantages and Disadvantages of International
Expansion 684
Advantages 684
Disadvantages 685

Appendix 21A
EU and G-10 Countries: Regulatory Treatment of
the Mixing of Banking, Securities, and Insurance
Activities and the Mixing of Banking and
Commerce
(www.mhhe.com/saunders8e)
Chapter Twenty-Two
Futures and Forwards

691

Introduction 691
Forward and Futures Contracts 693
Spot Contracts 693
Forward Contracts 693
Futures Contracts 694
Forward Contracts and Hedging Interest Rate
Risk 695
Hedging Interest Rate Risk with Futures
Contracts 697
Microhedging 697
Macrohedging 697
Routine Hedging versus Selective Hedging 698
Macrohedging with Futures 698
The Problem of Basis Risk 706
Hedging Foreign Exchange Risk 708
Forwards 708
Futures 708
Estimating the Hedge Ratio 712
Hedging Credit Risk with Futures
and Forwards 715
Credit Forward Contracts and Credit Risk
Hedging 716
Futures Contracts and Catastrophe Risk 718
Regulation of Derivative Securities 718
Appendix 22A
Microhedging with Futures
(www.mhhe.com/saunders8e)
Chapter Twenty-Three
Options, Caps, Floors, and Collars

728

Introduction 728
Basic Features of Options 728
Buying a Call Option on a Bond 729
Writing a Call Option on a Bond 730
Buying a Put Option on a Bond 731
Writing a Put Option on a Bond 731
Writing versus Buying Options 732
Economic Reasonsfor Not Writing Options 732
Regulatory Reasons 734
Futures versus Options Hedging 734

Contents xxi
The Mechanics of Hedging a Bond or
Bond Portfolio 735
Hedging with Bond Options Using the Binomial
Model 736
Actual Bond Options 740
Using Options to Hedge Interest Rate Risk
on the Balance Sheet 742
Using Options to Hedge Foreign Exchange
Risk 747
Hedging Credit Risk with Options 748
Hedging Catastrophe Risk with Call
Spread Options 749
Caps, Floors, and Collars 750
Caps 751
Floors 754
Collars 755
Caps, Floors, Collars, and Credit Risk 758
Appendix 23A
Microhedging with Options
(www.mhhe.com/saunders8e)
Chapter Twenty-Four
Swaps 766
Introduction 766
Swap Markets 767
Interest Rate Swaps 768
Realized Cash Flows on an Interest Rate Swap 772
Macrohedging with Swaps 773
Currency Swaps 776
Fixed-Fixed Currency Swaps 776
Fixed-Floating Currency Swaps 778
Credit Swaps 779
Total Return Swaps 781
Pure Credit Swaps 783
CDS Indexes 783
Swaps and Credit Risk Concerns 784
Netting and Swaps 786
Payment Flows Are Interest and Not Principal 786
Standby Letters of Credit 786
Appendix 24A
Setting Rates on an Interest Rate Swap 792
Chapter Twenty-Five
Loan Sales 796
Introduction 796
The Bank Loan Sales Market 797
Definition of a Loan Sale 797
Types of Loan Sales 797
Types of Loan Sales Contracts 799

Trends in Loan Sales 800

The Buyers and the Sellers 801
Why Banks and Other FIs Sell Loans
Reserve Requirements 806
Fee Income 807
Capital Costs 807
Liquidity Risk 807
Factors Affecting Loan Sales Growth
Access to the Commercial Paper Market
Customer Relationship Effects 808
Legal Concerns 808
BIS Capital Requirements 808
Market Value Accounting 808
Asset Brokerage and Loan Trading 809
Government Loan Sales 809
Credit Ratings 809
Purchase and Sale of Foreign Bank Loans

806

807
807

809

Chapter Twenty-Six
Securitization 812
Introduction 812
Mechanisms Used to Convert On-Balance-Sheet
Assets to a Securitized Asset 813
The Pass-Through Security 816
GNMA 817
FNMA 817
FHLMC 818
The Incentives and Mechanics of Pass-Through
Security Creation 818
Prepayment Risk on Pass-Through Securities 824
Prepayment Models 828
Government Sponsorship and Oversight of FNMA
and Freddie Mac 836
The Collateralized Mortgage Obligation
(CMO) 838
Creation of CMOs 839
Class A, B, and C Bond Buyers 841
Other CMO Classes 841
The Mortgage-Backed Bond (MBB) or
Covered Bond 842
Innovations in Securitization 844
Mortgage Pass-Through Strips 844
Securitization of Other Assets 847
Can All Assets Be Securitized? 848
Appendix 26A
Fannie Mae and Freddie Mac Balance
Sheets
(www.mhhe.com/saunders8e)
INDEX

856