DEPOSITORY INSTITUTIONS: ACTIVITIES AND CHARACTERISTICS - Financial Institutions and Markets by Fabozzi

CHAPTER 3

DEPOSITORY INSTITUTIONS:

ACTIVITIES AND CHARACTERISTICS

ASSET/LIABILITY PROBLEM OF DEPOSITORY INSTITUTIONS

These institutions seek to earn spread income, which is a positive spread or margin between the returns on their assets and the costs of their liabilities. In generating spread income, a depository institution faces several risks. These include credit risk, regulatory risk, and interest rate risk.

Interest Rate Risk

Interest rate risk or funding risk is the mismatching of assets and liabilities in terms of their maturities. For example, this can arise because the deposits are short-term and assets long term. An increase in expected interest rates will reduce the spread between the return on assets and the deposit costs. Floating rate long-term assets can reduce this problem since they make long-term assets behave like short-term funds that match deposit terms to maturity.

Liquidity Concerns

Liquidity concern is the possibility of withdrawal of funds by depositors or insufficient funds available to meet lending needs. It can be handled by: (1) attracting more deposits; (2) borrowing from federal agency or other institution (Federal Funds Market); (3) raising short-term funds in the money market; (4) selling or liquidating securities and other assets. Securities held for the purpose of satisfying net withdrawals and customer loan demands are sometimes referred to as secondary reserves.

COMMERCIAL BANKS

Today, banks are regulated and supervised by several federal and state government entities. At the federal level, supervision is undertaken by the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation. The assets of a bank are insured by the Federal Deposit Insurance Corporation.

As of 2d quarter 2007, 7350 commercial banks were operating in the United States. Only about 25% were national banks, but these held the majority of the bank assets (65%).

Bank Services

Banks provide numerous services and are broadly defined as follows: (1) individual banking; (2) institutional banking; (3) global banking.

Individual banking includes consumer lending, mortgage lending (mortgage banking), credit card financing, brokerage services, student loans, and individual-oriented financial investment services. Institutional banking Institutional banking includes commercial real estate financing, leasing activities, and factoring. Global banking includes corporate financing, capital market and foreign exchange products and services. At one time, some of these activities were restricted by the Glass-Steagall Act. But this statute was repealed by the Gramm-Leach-Bliley Act in November 1999.

Bank Funding

Funds are obtained mainly from three sources: (1) deposits, (2) nondeposit, (3) common stock and retained earnings.

Deposits: There are several types of deposit accounts. Demand deposits (checking) pay no interest and can be withdrawn upon demand. Savings deposits pay interest, typically below market rates, and can be withdrawn upon demand. Time deposits, also called certificates of deposit, have a fixed maturity date and pay either a fixed or floating interest rate. The market for short-term debt obligations is called money market. A money market demand account is designed to compete with money market mutual funds.

Reserve requirements and borrowing in the federal funds market: The reserve ratio is the specified percentage of deposits in non-interest bearing account at one of the 12 Federal Reserve Banks that a bank must maintain. The dollar amount based on the reserve ratio is the required reserve. To determine the reserve, the Federal Reserve has established a two-week period called the deposit computation period. If actual reserves exceed required reserves, the difference is referred to as excess reserves. Banks temporarily short of their required reserves can borrow reserves from banks that have excess reserves. The market where banks can borrow or lend reserves is called the federal funds market. The interest rate charged to borrow funds is called the federal funds rate.

Borrowing at the Fed discount window: The Federal Reserve is the bank of last resort. Banks temporarily short of funds can borrow from the Fed at its discount window. Collateral is needed to borrow, and the Fed sets the criteria for collateral quality. The interest rate that the Fed charges to borrow funds at the discount window is called the discount rate.

Other nondeposit borrowing: Other nondeposit borrowing can be short term in the form of issuing obligations in the money market, or intermediate to long term in the form of issuing securities in the bond market. Banks that raise most of their funds from the domestic and international money markets, relying less on depositors for funds, are called money center banks. A regional bank is one that relies primarily on deposits for funding.

Capital Requirements for Banks

Commercial banks are typically highly leveraged, i.e., equity constitutes a small fraction (about 8%) of the bank’s assets. The organization that plays the primary role in establishing risk and management guidelines for banks throughout the world is the Basel Committee on Banking Supervision. The capital requirements that resulted from other guidelines published by the Basel Committee are called the risk-based capital requirements. In July 1988, the Basel Committee released its first guidelines, the Capital Accord of 1988, commonly called Basel I Framework. In June 2004, comprehensive amendments, Basel II Framework, were published to improve on the rules as set forth in the Basel I Framework by bringing risk-based capital requirements more in line with the underlying risks to which banks are exposed.

Credit risk and risk-based capital requirements: The risk-based capital guidelines attempt to recognize credit risk by segmenting and weighting requirements. First, capital is categorized as Tier 1 and Tier 2 capital. Tier 1 is the core capital. Tier 2 is the supplementary capital. Second, the guidelines establish a credit risk weight for all assets.

SAVINGS AND LOAN ASSOCIATIONS

S&Ls originated to gather savings and pool depositor funds to finance home mortgages. They are either mutually owned (by the depositor themselves) or stockholder-owned (thereby making the depositors creditors of the firm). They are state or federally chartered, and they are regulated by the Office of Thrift Supervision (OTS). As in the case of banks, their deposits are insured, but by the Savings Association Insurance Fund (run by the FDIC). Traditionally, most S&L assets have been in home mortgages, the long-term nature of which insulated the S&Ls from interest rate risk for many years. Since the early 1980s, however, they have made several other types of loans and investments to some degree they compete with banks. Their funding has traditionally come from several forms of savings accounts, such as NOW, MMDA, and time deposits. Deregulation in the 1980s forced higher funding costs upon them.

Assets

Traditionally, the only assets in which S&Ls were allowed to invest have been mortgages, mortgage-backed securities, and US government securities. S&Ls became one of the major buyers of junk bonds. Under FIRREA, S&Ls are no longer permitted to invest new money in junk bonds.

Funding

Deregulation expanded the types of accounts that may be offered by S&Ls: negotiable order of withdrawal (NOW) accounts, and money deposit accounts (MMDA). S&Ls can raise funds from the money market. They can borrow in the federal funds market and have access to the Fed’s discount window. They also can borrow from the Federal Home Loan Banks. These borrowings are called advances, which can be short term or longterm in maturity.

Regulation

Federal S&Ls are chartered under the provisions of the Home Owners Loan Act of 1933. Federally chartered S&Ls are supervised by the Office of Thrift Supervisor. The Depository Institutions Deregulation and Monetary Control Act of 1980 deregulated interest rates on deposit accounts. It also expanded the Fed’s control over the money supply by imposing deposit reserve requirements on S&Ls. Subsequent legislation not only granted thrifts the right to offer money market demand accounts, but also broadened the types of assets in which S&Ls could invest. Permission to raise funds in the money market and the bond market was granted by the Federal Home Loan Board in 1975.

There are two sets of capital adequacy standards for S&Ls as for banks. The risk-based capital guidelines are similar to those for banks. Instead of two tiers of capital, there are three: Tier 1 (tangible capital), Tier 2 (core capital), and Tier 3 (supplementary capital). As with commercial banks, there are risk-based requirements based on interest rate risk.

The S&L Crisis

During the 1980’s, many savings and loans failed or became technically insolvent. Deposit insurance funds ran dry and federal help was needed to clean up the mess and help the depositors. Several factors contributed to the crisis, but the following causes were most apparent:

1.      Disintermediation: as short-term interest rates rose in the money market depositors withdrew their low-yield funds for higher-yield market investments such as MMDAs. Because of interest rate restrictions the S&Ls could not compete for such funds.

2.      Deregulation in the early 1980s lifted interest also rate restrictions, allowing S&Ls to compete in the marketplace for short-term funds. But their long-term asset structure its predominantly fixed-rate returns limited the cost increases for liabilities that S&Ls could afford. Moreover, after years of being in a safe market niche of home mortgages S&Ls suddenly found they had to compete directly with banks for funds and asset allocations. Many such savings institutions were simply not up to the task.

3.      Faced with rising liability costs, many S&Ls went after high return, high risk assets, such as commercial real estate and junk bonds. Such high default risk projects were undertaken prior to an economic downturn. The result was depressed regions of the Southwest, compounded by the fact that for a number of years, regulators did little to ameliorate the problem. A major and costly bailout occurred in the early 1990s. The Resolution Trust Corporation (RTC) was established in the FIRREA Act of 1989 and assigned the task to sell off the assets of the failed institutions.

SAVINGS BANKS

These financial institutions are similar to S&Ls in some respects. They are either mutually- or stockholder-owned and are either federally- or state-chartered. But their asset portfolio is more diversified given that their origin was primarily as a place for small deposits at a time when banks showed little interest in taking small customer accounts. Yet, residential mortgages now constitute a large part of their portfolio. These institutions have not necessarily been immune from the factors that caused the S&L crisis. But as a group they came out better because they were predominantly on the East Coast and had more diversified asset portfolios.

CREDIT UNIONS

Credit unions are the smallest and newest of the financial depositories. They are either state- or federally-chartered. But they are mutual in organization. They exist for their members’ savings and borrowing needs. The shares (deposits) are insured. Deposits from members are by far their major source of funds, but they can borrow for short-term liquidity needs. Their assets consist primarily of small consumer loans made to their members. Time has been hard on them lately, since their borrowing and lending activities are effectively restricted to their membership bases. But their shorter-term and less risky loan portfolios have helped them to avoid the S&L crisis.

Since 1970, the shares of all federally chartered credit unions have been insured by the National Credit Union Share Insurance Fund (NCUSIF) for up to $100,000 and $250,000 for retirement accounts, the same as for commercial banks. The principal federal regulatory agency is the National Credit Union Administration (NCUA). Playing a role similar to the Fed, the lender of last resort is the Central Liquidity Facility (CLF). Credit unions can make investments in corporate credit unions. Federal and state chartered credit unions are called natural person credit unions because they provide financial services to qualifying members of the general public. Corporate credit unions provide a variety of services only to national person credit unions.

ANSWERS TO QUESTIONS FOR CHAPTER 3

(Questions are in bold print followed by answers.)

1. Explain the ways in which a depository institution can accommodate withdrawal and loan demand.

A depository institution can accommodate loan and withdrawal demands first by having sufficient cash on hand. In addition it can attract more deposits, borrow from the Fed or other banks, and liquidate some of its other assets.

2. Why do you think a debt instrument whose interest rate is changed periodically based on some market interest rate would be more suitable for a depository institution than a long-term debt instrument with a fixed interest rate?

This question refers to asset-liability management by a depository institution. An adjustable rate can eliminate or minimize the mismatch of maturity risk. As interest rates rise, the institution would have to pay more for deposits, but would also receive higher payments from its loan.

3. What is meant by:

a.      individual banking

b.      institutional banking

c.       global banking

a.       Individual banking is retail or consumer banking. Such a bank emphasizes individual deposits, consumer loans and personal financial trust services.

b.      An institutional bank caters more to commercial, industrial and government customers. It issues deposits to them and tries to meet their loan needs.

c.       A global bank encompasses many financial services for both domestic and foreign customers. It is much involved in foreign exchange trading as well as the financial of international trade and investment.

4.

a.      What is the Basel Committee for Bank Supervision?

b.      What do the two frameworks, Basel I and Basel II, published by the Basel Committee for Bank Supervision, address regarding banking?

a.       It is the organization that plays the primary role in establishing risk and management guidelines for banks throughout the world.

b.      The frameworks set forth minimum capital requirements and standards.

5. Explain each of the following:

a.      reserve ratio

b.      required reserves

a.       The reserve ratio is the percentage of deposits a bank must keep in a non-interest-bearing account at the Fed.

b.      Required reserves are the actual dollar amounts based on a given reserve ratio.

6. Explain each of the following types of deposit accounts:

a.      demand deposit

b.      certificate of deposit

c.       money market demand account

a.       Demand deposits (checking accounts) do not pay interest and can be withdrawn at any time (upon demand).

b.      Certificates of Deposit (CDs) are time deposits which pay a fixed or variable rate of interest over a specified term to maturity. They cannot be withdrawn prior to maturity without a substantial penalty. negotiable CDs (large business deposits) can be traded so that the original owner still obtains liquidity when needed.

c.       Money Market Demand Accounts (MMDAs) are basically demand or checking accounts that pay interest. Minimum amounts must be maintained in these accounts so that at least a 7-day interest can be paid. Since many persons find it not possible to maintain this minimum (usually around $2500) there are still plenty of takers for the non-interest-bearing demand deposits.

7. How did the Glass-Steagall Act impact the operations of a bank?

The Glass-Steagall Act prohibited banks from carrying out certain activities in the securities markets, which are principal investment banking activities. It also prohibited banks from engaging in insurance activities.

8. The following is the book value of the assets of a bank:

Asset	Book Value (in millions)
U.S. Treasury securities	$ 50
Municipal general obligation bonds	50
Residential mortgages	400
Commercial loans	200
Total book value	$700

a.      Calculate the credit risk-weighted assets using the following information:

Asset	Risk Weight
U.S. Treasury securities	0%
Municipal general obligation bonds	20
Residential mortgages	50
Commercial loans	100

b.      What is the minimum core capital requirement?

c.       What is the minimum total capital requirement?

a.       The risk weighted assets would be $410

	BV	Weight	Product
US T Sec.	$50	0%	0
MB	50	20%	10
RM	400	50%	200
CL	200	100%	200
Total	700		410

           

b.      The minimum core capital is $28 million (.04X700) i.e., 4% of book value.

c.       Minimum total capital (core plus supplementary capital) is 32.8 million, .08X410, which is 8% of the risk-weighted assets.

9. In later chapters, we will discuss a measure called duration. Duration is a measure of the sensitivity of an asset or a liability to a change in interest rates. Why would bank management want to know the duration of its assets and liabilities?

a.       Duration is a measure of the approximate change in the value of an asset for a 1% change in interest rates.

b.      If an asset has a duration of 5, then the portfolio’s value will change by approximately 5% if interest rate changes by 100 basis points.

10.

a.      Explain how bank regulators have incorporated interest risk into capital requirements.

b.      Explain how S&L regulators have incorporated interest rate risk into capital requirements.

a.       The FDIC Improvement Act of 1991, required regulators of DI to incorporate interest rate risk into capital requirements. It is based on measuring interest rate sensitivity of the assets and liabilities of the bank.

b.      The OST adopted a regulation that incorporates interest rate risk for S&L. It specifies that if thrift has greater interest rate risk exposure, there would be a deduction of its risk-based capital. The risk is specified as a decline in net profit value as a result of 2% change in market interest rate.

11. When the manager of a bank’s portfolio of securities considers alternative investments, she is also concerned about the risk weight assigned to the security. Why?

The Basel guidelines give weight to the credit risk of various instruments. These weights are 0%, 20%, 50% and 100%. The book value of the asset is multiplied by the credit risk weights to determine the amount of core and supplementary capital that the bank will need to support that asset.

12. You and a friend are discussing the savings and loan crisis. She states that “the whole mess started in the early 1980s.When short-term rates skyrocketed, S&Ls got killed—their spread income went from positive to negative. They were borrowing short and lending long.”

a.      What does she mean by “borrowing short and lending long”?

b.      Are higher or lower interest rates beneficial to an institution that borrows short and lends long?

a.       In this context, borrowing short and lending long refers to the balance sheet structure of S&Ls. Their sources of funds (liabilities) are short-term (mainly deposits) and their uses (assets) are long-term in nature (e.g. residential mortgages).

b.      Since long-term rates tend to be higher than short-term ones, stable interest rates would be the best situation. However, rising interest rates would increase the cost of funds for S&Ls without fully compensating higher returns on assets. Hence a decline in interest rate spread or margin. Thus lower rates, having an opposite effect, would be more beneficial.

13. Consider this headline from the New York Times of March 26, 1933: “Bankers will fight Deposit Guarantees.” In this article, it is stated that bankers argue that deposit guarantees will encourage bad banking. Explain why.

The barrier imposed by Glass-Steagall act was finally destroyed by the Gramm-Leach Bliley Act of 1999. This act modified parts of the BHC Act so as to permit affiliations between banks and insurance underwriters. It created a new financial holding company, which is authorized to engage in underwriting and selling securities. The act preserved the right of state to regulate insurance activities, but prohibits state actions that have would adversely affected bank-affiliated firms from selling insurance on an equal basis with other insurance agents.

14. How did the Gramm-Leach-Bliley Act of 1999 expand the activities permitted by banks?

a.       Deposit insurance provides a safety net and can thus make depositors indifferent to the soundness of the depository recipients of their funds. With depositors exercising little discipline through the cost of deposits, the incentive of some banks owners to control risk-taking accrue to the owners. It becomes a “heads I win, tails you lose” situation.

b.      One the positive side, deposit insurance provides a comfort to depositors and thus attracts depositors to financial institutions. But such insurance carries a moral hazard, it can be costly and, unless premiums are risk-based, it forces the very sound banks to subsidize the very risky ones.

15. The following quotation is from the October 29, 1990 issue of Corporate Financing Week:

Chase Manhattan Bank is preparing its first asset-backed debt issue, becoming the last major consumer bank to plan to access the growing market, Street asset-backed officials

Said…Asset-backed offerings enable banks to remove credit card or other loan receivables from their balance sheets, which helps them comply with capital requirements.

a.      What capital requirements is this article referring to?

b.      Explain why asset securitization reduces capital requirements.

a.       The capital requirements mentioned are risk based capital as specified under the Basel Agreement, which forces banks to hold minimum amounts of equity against risk-based assets.

b.      Securitization effectively eliminates high risk based loans from the balance sheet. The capital requirements in the case of asset securitization are lower than for a straight loan.

16. Comment on this statement: The risk-based guidelines for commercial banks attempt to gauge the interest rate risk associated with a bank’s balance sheet.

This statement is incorrect. The risk-based capital guidelines deal with credit risk, not interest-rate risk, which is the risk of adverse changes of interest rates on the portfolio position.

17.

a.      What is the primary asset in which savings and loan associations invest?

b.      Why were banks in a better position than savings and loan associations to weather rising interest rates?

a.       Savings and Loans invest primarily in residential mortgages.

b.      During 1980's, although banks also suffered from the effects of deregulation and rising interest rates, relatively they were in a better position than S&L association because of their superior asset-liability management.

18. What federal agency regulates the activities of credit unions?

The principal federal regulatory agency is the National Credit Union Administration.  

FINANCIAL INSTITUTIONS, FINANCIAL INTERMEDIARIES, AND ASSET MANAGEMENT FIRMS - Financial Institutions and Markets by Fabozzi

CHAPTER 2

FINANCIAL INSTITUTIONS,

FINANCIAL INTERMEDIARIES,

AND ASSET MANAGEMENT FIRMS

FINANCIAL INSTITUTIONS

Financial institutions perform several important services:

1.      Transforming financial assets acquired through the market and constituting them into a different, and more widely preferable, type of asset, which becomes their liability. This is the function performed by financial intermediaries.

2.      Exchange financial assets for their customers, typically a function of brokers and dealers.

3.      Exchange financial assets for their own account.

4.      Create financial assets for their customers and sell them to other market participants—the underwriter this role.

5.      Give investment advice to others and manage portfolios of customers.

6.      Managing the portfolio of other market participants.

Financial intermediaries including depository institutions, which acquire the bulk of their funds by offering their liabilities to the public mostly in the form of deposits, insurance companies, pension funds, and finance companies.

ROLE OF FINANCIAL INTERMEDIARIES

Intermediaries obtain funds from customers and invest these funds. Such a role is called direct investment. Customers who give their funds to the intermediaries and who thereby hold claims on these institutions are making indirect investments. A commercial bank accepts deposits and uses the proceeds to lend funds. Financial intermediaries, such as investment companies, play a basic role of transforming financial assets which are less desirable for a large part of the public into other financial assets which are broadly preferred by the public. By doing so they provide at least one of the following four economic functions: (1) providing maturity intermediation, (2) reducing risk via diversification, (3) reducing costs of contracting and information process, (4) providing a payment mechanism.

Maturity Intermediation

The customer (depositor) often wants only a short-term claim, which the intermediary can turn into a claim on long-term assets. In other words, the intermediary is willing and able to handle the liquidity risk more readily than the customer. This is called maturity intermediation.

Risk Reduction Via Diversification

By pooling funds from many customers the financial intermediary can better achieve diversification of its portfolio than its customers.

Reduced Costs of Contracting and Information Processing

Financial institutions provide expert analysis, better data access, and loan enforcement. Costs of writing loan contracts are referred to as contracting costs. Also there are information processing costs. They also benefit from economies of scale.

Providing a Payments Mechanism

Financial depositories provide a payment mechanism, e.g. checking accounts, credit cards, certainty debt cards, and electronic transfers of funds.

OVERVIEW OF ASSET/LIABILITY MANAGEMENT FOR FINANCIAL INSTITUTIONS

All intermediaries face asset/liability management problems. The nature of the liabilities dictates the investment strategy a financial institution will pursue.

Nature of Liabilities

The liabilities of a financial institution mean the amount and time of the cash outlays that must be made to satisfy the contractual terms of the obligations issued. These liabilities can be categorized into four types.

Type I Liabilities: Both amounts of cash outflows and timing are known, e.g., fixed-rate certificates of deposit and guaranteed investment contracts. The former are among liabilities of financial depositories. Life insurance companies offer the latter.

Type II Liabilities: Cash outflows are known, but timing is not, e.g. life insurance policies.

Type III Liabilities: Cash outflows are not known, but timing is known, e.g. floating-rate certificates of deposit.

Type IV Liabilities: Neither cash outflows nor timing are known, e.g., auto or home insurance policies.

Liquidity Concerns

Due to different degrees of certainty about timing and outlay, some institutions must have deposits more cash on hand or accessible in order to satisfy their obligations, e.g. the offering of demand means customers can obtain whatever amount of their funds whenever they wishplays . The greater the concern over liquidity, the fewer less-liquid investments an intermediary can hold.

CONCERNS OF REGULATORS

The risks of a financial institution are: credit, settlement, market, liquidity, operational, and legal.

Credit risk is the risk that the obligor of a financial instrument held by a financial institution will fail to fulfill its obligation. Settlement risk is the risk that when there is a settlement of a trade or obligation, the transfer fails to take place. Counterparty risk is the risk that a counterparty fails to satisfy its obligation.

Liquidity risk in the context of settlement risk means that the counterparty can eventually meet its obligations, but not at the due date. Liquidity risk has two forms. Market liquidity risk is the risk that a financial institution is unable to transact in a financial instrument at a price near its market value. Funding liquidity risk is the risk that the financial institution will be unable to obtain funding to obtain cash flow necessary to satisfy its obligations.

Market risk is the risk of a financial institution’s economic well being that results from an adverse movement in the market price of the asset it owns or the level or the volatility of market prices. There are measures that can be used to gauge this risk. One such measure endorsed by bank regulators is value-at-risk.

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The definition of operational risk includes legal risk. This is the risk of loss resulting from failure to comply with laws as well as prudent ethical standards and contractual obligations. Sources of operation risk include: employees, business process, relationships, technology, and external factors.

ASSET MANAGEMENT FIRMS

Asset management firms manage the funds of individuals, businesses, endowments and foundations, and state and local governments. Types of funds managed by asset management firms include regulated investment companies, insurance company funds, pension funds, and hedge funds. Asset management firms are ranked based on assets under management. These firms receive compensation primarily from management fees charged based on the market value of the assets managed for clients. Also, they are increasingly adopting performance-based management fees for other types of accounts.

Hedge Funds

There is not a single definition of hedge fund. There are several characteristics.

1.      The word “hedge” is misleading. Many funds do not hedge risk at all, but engage in highly risk, leveraged transactions.

2.      Hedge funds use a wide range of trading strategies and techniques to earn a superior return. These strategies include: leverage, short selling, arbitrage, and risk control.

3.      Hedge funds operate in all of the financial markets: cash markets for stocks, bonds, and currencies and the derivatives markets.

4.      The management fee structure for hedge funds is a combination of a fixed fee based on the market value of assets managed plus a share of the positive return.

5.      Investors are interested in the absolute return generated by the asset manager, not the relative return. Absolute return is simply the return realized. Relative return is the difference between the absolute return and the return on some benchmark or index.

Types of hedge funds: There are various ways to categorize the different types of hedge funds.

1.   A market directional hedge fund is one in which the asset manager retains some exposure to systemic risk.

2.   A corporate restructuring hedge fund is one in which the asset manager positions the portfolio to capitalize on the anticipated impact of a significant corporate event. These funds include: (1) hedge funds that invest in the securities of a corporation that is either in bankruptcy or is highly likely in the opinion of the asset manager to be forced into bankruptcy; (2) hedge funds that focus on merger arbitrage, (3) hedge funds that seek to capitalize on other types of broader sets of events impacting a corporation.

3.   A convergence trading hedge fund uses a strategy to take advantage of misalignment of prices or yields, an arbitrage strategy. Technically, arbitrage means riskless profit. Some strategies used by hedge funds do not really involve no risk, but instead low risk strategies of price misalignments.

4.   An opportunistic hedge fund is one that has a broad mandate to invest in any area that it sees opportunities for abnormal returns. These include fund of funds, and global macro hedge funds that invest opportunistically on macroeconomic considerations in any world market.

Concerns with hedge funds in financial markets: There is concern that the risk of a severe financial crisis due to the activities and investment strategies of hedge funds, most notably the use of excess leverage. The best known example is the collapse of Long-Term Capital Management in September 1998. Most recently, in June 2007, there was the collapse of two hedge funds sponsored by Bear Stearns. Obviously, subsequent market develops in 2008 relate to the concern with hedge fund activities in financial markets.

ANSWERS TO QUESTIONS FOR CHAPTER 2

(Questions are in bold print followed by answers.)

1. Why is the holding of a claim on a financial intermediary by an investor considered an indirect investment in another entity?

An individual’s account at a financial intermediary is a direct claim on that intermediary. In turn, the intermediary pools individual accounts and lends to a firm. As a result, the intermediary has a direct contractual claim on that firm for the expected cash flows. Since the individual’s funds have in essence been passed through the intermediary to the firm, the individual has an indirect claim on the firm. Two separate contracts exist. Should the individual lend to the firm without the help of an intermediary, he then has a direct claim.

2. The Insightful Management Company sells financial advice to investors. This is the only service provided by the company. Is this company a financial intermediary? Explain your answer.

Strictly speaking, the Insightful Management Company is not a financial intermediary, because it lacks the function of deposit taking and creating liabilities.

3. Explain how a financial intermediary reduces the cost of contracting and information processing.

Financial intermediaries can reduce the cost of contracting by its professional staff because investing funds is their normal business. The use of such expertise and economies of scale in contracting about financial assets benefits both the intermediary as well as the borrower of funds. Risk can be reduced through diversification and taking advantage of fund expertise.

4. “All financial intermediaries provide the same economic functions. Therefore, the same investment strategy should be used in the management of all financial intermediaries.” Indicate whether or not you agree or disagree with this statement.

Disagree. Although each financial intermediary more or less provides the same economic functions, each has a different asset-liability management problem. Therefore, same investment strategy will not work.

5. A bank issues an obligation to depositors in which it agrees to pay 8% guaranteed for one year. With the funds it obtains, the bank can invest in a wide range of financial assets. What is the risk if the bank uses the funds to invest in common stock?

Practically, it is not a valid statement as banks are not allowed to hold stocks. The bank has a funding risk. On the liability side, amount of cash outlay and timing are known with certainty (Type I). However, on the asset side, both factors are unknown. Thus, there is liquidity risk and price risk.

6. Look at Table 2-1 again. Match the types of liabilities to these four assets that an individual might have:

a.      car insurance policy

b.      variable-rate certificate of deposit

c.       fixed-rate certificate of deposit

d.      a life insurance policy that allows the holder’s beneficiary to receive $100,000 when the holder dies; however, if the death is accidental, the beneficiary will receive $150,000

a.       Car insurance: neither the time nor the amount of payoffs are certain, which is Type IV liability

b.      Variable rate certificates of deposit: times of payments are certain, the amounts are not, which is Type II liability.

c.       Fixed-rate certificate of deposit: both times of payments and cash outflows are known, which is Type I liability.

d.      Life insurance policy: time of payout is not known, but the amount is certain, which is Type III liability.

7. Each year, millions of American investors pour billions of dollars into investment companies, which use those dollars to buy the common stock of other companies. What do the investment companies offer investors who prefer to invest in the investment companies rather than buying the common stock of these other companies directly?

In investing funds with the investment companies, investors are reducing their risk via diversification and the cost of contracting and information. These companies also provide liquidity to the investor.

8. In March 1996, the Committee on Payment and Settlement Systems of the Bank for International Settlements published a report entitled “Settlement Risk in Foreign Exchange Transactions” that offers a practical approach that banks can employ when dealing with settlement risk. What is meant by settlement risk?

Counterparty risk is that risk that a counterparty to a transaction cannot fulfill its obligation. It is related to settlement risk in that counterparty party risk bears on the question of whether settlement can take place or not.  

9. The following appeared in the Federal Reserve Bank of San Francisco’s Economic Letter, January 25, 2002:

Financial institutions are in the business of risk management and reallocation, and they have developed sophisticated risk management systems to carry out these tasks. The basic components of a risk management system are identifying and defining the risks the firm is exposed to, assessing their magnitude, mitigating them using a variety of procedures, and setting aside capital for potential losses. Over the past twenty years or so, financial institutions have been using economic modeling in earnest to assist them in these tasks. For example, the development of empirical models of financial volatility led to increased modeling of market risk, which is the risk arising from the fluctuations of financial asset prices. In the area of credit risk, models have recently been developed for large-scale credit risk management purposes.

   Yet, not all of the risks faced by financial institutions can be so easily categorized and modeled. For example, the risks of electrical failures or employee fraud do not lend themselves as readily to modeling.

What type of risk is the above quotation referring to?

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.  

10. What is the source of income for an asset management firm?

The sources of income are a fee based on assets under management, and sometimes a performance fee based on returns that meet certain benchmarks or targets.

11. What is meant by a performance-based management fee and what is the basis for determining performance in such an arrangement?

Performance based management fees are typically seen in hedge funds. Increasingly, they are also used by managers of asset management firms. These fees are fees based on performance that meet specified criteria.

12. a. Why is the term hedge to describe “hedge funds” misleading?

b. Where is the term hedge fund described in the U.S. securities laws?

a.       Hedge denotes hedging risk. Many hedge funds, however, do not use hedge as a strategy, and these funds take significant risk in their attempt to achieve abnormal returns.

b.      The term is not described in US securities laws, and hedge funds are not regulated by the SEC.

13. How does the management structure of an asset manager of a hedge fund differ from that of an asset manager of a mutual fund?

Asset management firms are compensated by a fee on asset under management. Hedge funds are compensated by a combination of assets under management and a performance fees. Clearly, investment strategies of these firms will be different since hedge funds seek to generate abnormal returns.

14. Some hedge funds will refer to their strategies as “arbitrage strategies.” Why would this be misleading?

Arbitrage means riskless profit. These opportunities are few and fleeting. Hedge funds take great risk. The arbitrage typically taken is where there is a disparity between the risk and the return, such as pricing disparities across markets.

15. What is meant by a convergence traded hedge fund?

A convergence trading hedge fund uses a strategy to take advantage of misalignment of prices or yields.

16. What was the major recommendation regarding hedge funds of the President’s Working Group on Financial Markets?

The major recommendation was that commercial banks and investment banks that lend to hedge funds improve their credit risk management practices.