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Chapter 1 Why are financial institutions special? Chapter outline Financial institutions’ specialness FI function as broker FI function as asset transformer Information costs Liquidity and price risk Other special services Other aspects of specialness The transmission of monetary policy Credit allocation Intergenerational wealth transfers or time intermediation Payment services Denomination intermediation Specialness and regulation Safety and soundness regulation Monetary policy regulation Credit allocation regulation Consumer and investor protection regulation Entry regulation The changing dynamics of specialness Trends in Australia Global trends The rise of financial services holding companies The shift away from risk measurement and management and the global financial crisis Appendix 1A: The US sub-prime crisis, the global financial crisis and the failure of financial services institution specialness Appendix 1B: Implementation of monetary policy by the Reserve Bank of Australia Learning objectives 1.1 Understand why financial institutions (FIs) are different from commercial firms (which is why, for example, the failure of a large bank may have more serious effects on the economy than the failure of a large steel or car producer). Learn how financial institutions—especially banks—provide a special set of services to households and firms. Discover why FIs’ very specialness results in increased regulation and regulatory oversight that other corporations do not require, which imposes a regulatory burden on financial institutions. Gain knowledge of how regulation can and does affect the efficiency with which financial institutions produce financial services. Understand how the failure of FIs to perform the specialist functions of risk measurement and management can lead to systemic risk in the domestic and global financial systems. Comprehend the causes of the sub-prime crisis in the US and how this led to the global financial crisis. Overview of chapter The major theme of this book is the measurement and management of the risks of financial institutions (FIs). Although we might categorise or group FIs and label them ‘life insurance companies’, ‘banks’, ‘finance companies’ and so on, the particular risks that they face are more common than different. Specifically, all the FIs described in this chapter (1) hold some assets that are potentially subject to default or credit risk and (2) tend to mismatch the maturities of their balance sheets to a greater or lesser extent and are thus exposed to interest rate risk. Moreover, all are exposed to some type of underwriting risk, whether through the sale of securities or by issuing various types of credit guarantees on or off the balance sheet. Finally, all are exposed to operating cost risks because the production of financial services requires the use of real resources and back-office support systems. This chapter describes the various factors and forces impacting FIs and the specialness of the services they provide. These forces suggest that in the future, FIs that have historically relied on making profits by performing traditional special functions—such as asset transformation and the provision of liquidity services—will need to expand into selling financial services that interface with direct security market transactions, such as asset management, insurance and underwriting services. This is not to say that specialised or niche FIs cannot survive, but rather that only the most efficient FIs will prosper as the competitive value of a specialised FI charter declines. Because of these risks and the special role that FIs in particular play in the financial system, FIs are singled out for special regulatory attention. In this chapter, we first examine questions related to this specialness. In particular, what are the special functions that FIs—both depository institutions (banks, building societies and credit unions) and non-depository institutions (insurance companies, securities brokers, investment banks, finance companies and managed funds)—provide? How do these functions benefit the economy? Second, we investigate what makes some FIs more special than others. Third, we look at how unique and long-lived the special functions of FIs really are. As a part of this discussion, we briefly examine how changes in the way FIs deliver services played a major part in the events leading up to the global financial crisis (GFC), commencing in the late 2000s. A more detailed discussion of the causes of major events during and regulatory and industry changes resulting from the financial crisis is provided in Appendix 1A to the chapter. Appendix 1B describes the way the RBA decides and carries out monetary policy in Australia. Chapter 1 Teaching Suggestions This chapter is very useful to commence any course on financial institutions management or bank management. Or indeed any course which examines regulatory structures and the reasons for them. One way to commence the topic is to ask the question ‘Why are the banks, or more generally, the financial services industry, so heavily regulated?’ One of the answers to this question is the special nature of the financial institutions and the role that they play in the transition of money in the economy—and the transmission of government policy (both fiscal and monetary). A follow-up question could be ‘why do we have a course specifically on the management of banks/FIs—that is, why are they different from other businesses?’ This question allows the development of a discussion of the specific products, the interaction with customers—that is, the facilitation of business through financial transactions, etc., and the role of FIs in enabling business to take place. It also allows for a discussion of the ways that FIs affect the economy as a whole and not just a specific part (such as manufacturing). From here, it is possible to develop a discussion of the economy with and without banks—and the role of intermediation in assisting commerce, and from this develop the discussion of the various functions of FIs which are useful. For example, ask students to think about the different roles that FIs may undertake which assist business activity: Monitoring function Intermediation Liquidity intermediation Currency intermediation Time intermediation Asset intermediation Risk intermediation Transmission of monetary policy and role in funding for fiscal policy through purchase and sale of government bonds Credit allocation mechanisms Payment system and the transmission of payments generally As each of these points arise in the discussion, the lecturer can expand on each and provide examples from their own experience and draw on the experience of students to bring the topic alive. Encouraging students to see the relevance of this discussion to their own lives at this point in the subject will assist you in making the important point about the need for conservative management of FIs—to protect our savings and future financial health and capability—and more generally, to protect the future underlying financial security of the Australian economy. It is important to set the tone for the subject in this introductory lecture, using Chapter 1, as by capturing the imagination of students through their own experience and expression, they will better understand why the identification of risks in FIs is so important, as of course is the management of those risks. From an understanding of the role of FIs’ various functions, and their impact on the economy, it is an easy step to argue why FIs are regulated. You may like to ask some questions about potential scenarios such as: What would happen if you couldn’t withdraw your money from the bank? What would happen if none of the banks would lend to you to buy a house? What would happen if the banks would not lend to small businesses? What would happen if you had to wait two weeks to withdraw your funds? What would happen if you could only withdraw US dollars, and not Australian dollars? What would happen if you could only use cheques and these are only cleared on a weekly basis? What if my bank deposits were not safe? What if all of my bank’s deposits were invested in high risk entrepreneurial activities? Who can open and bank—or what businesses can call themselves a bank? From these types of questions, you can then discover through discussion of the issues involved, the types of regulation that may be useful, so that a set of main types of regulations are identified: Safety—capital and liquidity regulation Monetary policy regulation Credit allocation regulation Consumer protection regulation Investor protection regulation Entry and chartering regulation Throughout the discussion, you should emphasise the risks faced by FIs and the importance of their management. The fact that much of the regulation of FIs is towards the limit on risk taking is a particularly important point. The changing structure and dynamics of the FI firm in the modern global financial markets should also be examined through a discussion of the modern versus the traditional product type FI: that is, now we have FI conglomerates/holding companies which provide all types of financial services, whereas only 30 years ago, we had banks, insurance companies, fund managers, etc., each providing one type of service. The Australian and global trends are telling, and this could lead to a discussion of how the changing structure of FIs may have changed the effectiveness of risk management within these FIs. You may also wish to discuss in more detail the role of this particular issue in the causes and consequences of the global financial crisis of the late 2000s—a great case study, and which is the subject of Appendix 1A. Depending on the subject curriculum, the next chapter covered could be either Chapters 2 and 3 (which describe the institutional characteristics of depository institutions and other FIs) or Chapter 4, which introduces students to the key financial risks faced by FIs. Chapter 2 The financial services industry: depository institutions Chapter outline Banks Size, structure and composition of the industry Balance sheet and trends Bank performance Credit unions and building societies Size, structure and composition of the industry Balance sheet, performance and trends The regulation of Australian depository institutions The key legislation The regulatory agencies Australian prudential supervision framework Overview of the regulation of depository institutions Learning objectives Learn the different types of depository institutions in Australia and how they compete in the same market and face similar risks. Gain an understanding of the major activities of banks and the industry structure. Gain an insight into the balance sheet of banks and the trends in assets, liabilities and capital. Appreciate the key performance ratios of banks and the trends in bank performance. Learn the history of the industry comprising credit unions and building societies and the structure of their industry. Gain an understanding of the changing shape of the market for credit unions and building societies and how they have performed. Appreciate the regulatory framework governing the activities of Australian depository institutions and the key regulatory agencies. Understand the key areas of regulation and the reasons why these areas are targeted for regulation. Appendix 2A Financial statement analysis using a return on equity framework (online) Overview of chapter This chapter provides an overview of the major activities of Australia’s banks, building societies and credit unions. The size, structure and composition of banking and the mutual organisations is covered along with a discussion of recent trends in balance sheet structure and performance. It also describes the regulation of Australian depository institutions (DIs) and the various agencies that regulate them. DIs rely heavily on retail deposits to fund their activities, although wholesale borrowing and offshore funding are increasingly important sources of funds, particularly for the major banks. Historically, banks have offered a full range of services to both retail and corporate customers and Australia’s major banks concentrate much of their effort in the provision of banking and investment banking services to businesses. Building societies and credit unions, on the other hand, focus on retail business, with loan portfolios dominated by residential mortgage lending. These differences are being eroded due to competitive forces, regulation and changing financial and business technology. Chapter 2 Teaching Suggestions (including some comments on Chapter 3) For simplicity, some lecturers may wish to commence any course on bank/financial institutions’ risk management with this chapter and Chapter 3—which are both descriptive in nature and provide the institutional arrangements and background for the discussion of bank/FI risks and their management. I would strongly recommend against this approach for many reasons, but principally for one. While relatively simple for students new to the study of institutional risks, essentially the discussion of the institutional arrangements is very dry—and not a good way to stimulate students in preparation for the intensive examination of the key issues discussed in the course. Higher level courses may leave this chapter as reading matter only—and not directly covered, but drawn upon during the ensuing discussion of the various risks and their management. If both Chapters 2 and 3 are covered in lectures, then I suggest that they form a part of the introductory lecture where balance sheets of the various FIs can be examined in light of a discussion of either ‘specialness’ or other aspects of the lecture built around the issues in Chapter 1. The start of the lecture is to identify the various services offered by a bank (Tables 2.1A and 2.1B), and relate these to the evolution of banking over the past few decades, and the specialness aspects discussed in Chapter 1. A good way to approach the discussion of the institutional arrangements is to either use the material in the book, or alternatively get copies of a major bank’s latest annual report (say Westpac), and focus on the items in the typical balance sheet and performance reports. From this, you could then ask questions such as: What is the concentration of Australia’s major banks in terms of assets? How profitable are the Australian banks and how does their performance compare with the credit unions and building societies? What is the largest asset type in the Australian bank balance sheet? (Housing loans) Does the concentration of housing loans in the balance sheets of Australian DIs put them at more risk than their international competitors? (This question gives you a chance to commence discussion of the various credit related risks in the balance sheets—that is, credit risk, concentration risk, etc.) At this point, you may also wish to comment on the findings of the Financial System Inquiry 2014 that suggest that the smaller banks are at a disadvantage to the major banks in the housing loan market. (Also look at the Learning from the Financial System Inquiry box in Chapter 2, ‘The too big to fail subsidy’, page 52.) What are the main types of liabilities in the balance sheets? (You can refer this to the ensuing discussion of liquidity risk and interest rate risk.) The issue of capital and its adequacy could be introduced by referring to the Financial System Inquiry Report 2014, which recommended that the major banks hold higher levels of capital than that currently required by APRA. While the discussion of capital and its role is left for Chapter 18, it is important to introduce students to all risks, including survival risk— solvency risk—at this stage, so that they realise the importance of capital and the maintenance of equity value for the DIs. An examination of the performance reports allows a discussion of the ways DIs make their profit, and with this a discussion of interest rate spread and fees. The issue of which is more important for the Australian major banks, other Australian DIs, foreign banks, etc. can also be explored. The risk of interest rate spreads versus fees is also a good discussion point. Again, with the examination of income-earning potential, the risks to earning capacity can be broached. Clearly, the risks are the same as those from the discussion of the balance sheet, but the question about how these risks affect profitability can now be addressed. For example, you could ask: Which income type (interest rate spreads or fees) has the higher risk potential? What risks are inherent in each income type? Finally, Chapter 2 covers the regulation of DIs, and the regulatory agencies. Note that the Australian Prudential Supervision Framework is also covered in Chapter 2 and that this framework is relevant to all APRA regulated institutions—that is, it includes the insurers and superannuation funds which are discussed in Chapter 3. A key discussion point at this juncture is the role of regulation—that is, what is the regulator trying to achieve? Depending on the course content, if it is a bank or DI related course, then the next relevant chapter is Chapter 4 which introduces all the major risks of FIs. If the course has broader coverage of all FIs, then a quick overview of the other FIs (see Chapter 3) is required. However, please remember that the Prudential Supervision Framework discussed in Chapter 2 is relevant to the key institutions covered in Chapter 3. Chapter 3 The financial services industry: other financial institutions Chapter outline Insurers and fund managers Life insurance General insurance Superannuation funds Managed funds and unit trusts Other financial institutions Money market corporations Finance companies Securitisation vehicles Learning objectives 3.1 Learn that despite the apparently diverse nature of activities, other FIs face risk exposures similar to those faced by DIs. Gain an understanding of the structure, characteristics and regulation of life insurers and their products. Learn about the general insurance industry and an understanding of its products. Appreciate the importance of superannuation in the Australian financial system. Learn that many superannuation and life insurance products are managed funds. Gain an appreciation of the role that managed funds, money market corporations, finance companies and securitisation vehicles and their products play in the Australian financial markets and their structure and regulation. Overview of chapter The RBA describes the three main types of financial institution (FI) in Australia as: depository institutions (DIs) (discussed in Chapter 2); insurers and fund managers; and non-DI financial institutions. Insurers cover both general and life insurance. The funds management industry is dominated by the superannuation funds and also includes cash management trusts, unit trusts, common funds and friendly societies. The non-DI financial institutions are made up of money market companies, finance companies and securitisation vehicles. In this chapter, we outline the key features of the other FIs by concentrating on (1) the size, structure and composition of the industries in which they operate; (2) balance sheets and recent trends; and (3) regulations. Although we categorise or group FIs and label them ‘life insurance companies’, ‘general insurance companies’ and so on, in fact the risks that they face are more common than different. Specifically, all the FIs described in this chapter hold some assets that are potentially subject to default or credit risk, tend to mismatch the maturities of their balance sheets to a greater or lesser extent, and are thus exposed to interest rate risk. Moreover, all are exposed to some degree of saver withdrawal or liquidity risk, depending on the type of claims sold to liability holders. In addition, most are exposed to some type of underwriting risk whether through the sale of insurance, the sale of securities or issuing various types of credit guarantees on or off the balance sheet. Finally, all are exposed to operating cost risks because the production of financial services requires the use of real resources and back-office support systems. Note that many of the FI groups we discuss in this chapter make up parts of FI conglomerates which cover banking, insurance and funds management. In the remaining chapters we introduce the risks of FIs, and later examine the ways that FI managers measure and manage the inventory of risks identified in our discussion of Australian FIs to produce the best return–risk trade-off for shareholders in an increasingly competitive and contestable market environment. Chapter 3 Teaching Suggestions (Also see teaching suggestions for Chapter 2) Please read the teaching suggestions for Chapter 2 prior to the following, as many of those relate directly to this chapter also. Like Chapter 2, this chapter covers institutional material, which provides a background to the discussion of the risks of FIs which follow in later chapters. The way to approach the material in this chapter depends in part on the type of course which you are taking. For example, if a bank management course, then I would suggest a direction which relates and compares the information in this chapter with that of the banks; but if a financial institutions course, then more complete coverage of the institutional material. For bank management course If your course fundamentally relates to banks and bank risk, then I would use the material in this chapter to answer the following types of questions: By how much do the banks dominate the sector and what proportion of total FI assets, profitability, etc. are held by banks? A comparison of the key risks of each type of institution. Do Australia’s major banks have insurance companies, superannuation and fund management activities, finance companies, etc. in their conglomerates, and if so, how large are these relative to the sector as a whole? The point here is that the banks dominate in most areas of financial institution activity, and this is not always obvious as the names don’t tend to indicate the associations. For example, Westpac Bank includes in its group: St George Bank, Bank West, Bank of Melbourne and BT Funds Management. You could also discuss the size and the potential growth of the superannuation fund sector, and how these funds are always looking for suitable investments. Another point to cover in this regard is the discussion pre-, post- and during the Murray Inquiry 2014 about the need for banks to review their deposit strategies and develop new products which may satisfy longer term investors like the superannuation funds. This could do a number of things to improve bank liquidity and funding strategies—for example, it could lengthen bank liabilities, and reduce the reliance on offshore funding. The risks of insurance are often thought to be very different to those of banks, and in many cases they are. However, general insurance risk is a good way to describe the way in which banks should manage their operational risk measurement and management—and especially as operational risk is an important part of capital management (as operational risk makes up a component of capital adequacy regulation). One key operational risk which has been the subject of a great deal of political discussion, inquiry, media coverage and public debate has been the issue of ‘financial advice’. Much of the media coverage related the issue directly to bank management. Look for the various media coverage or ask students to search for this—relating in particular to Commonwealth Bank and Macquarie Bank. The reputational damage to the banks, despite it being outside their normal ‘banking functions’, is worth discussing. Such an issue is a good one to show students how: (a) bank conglomerates are impacted by the activities of their other FI activities (b) operational risks for banks are not just related to strictly bank activities—this may assist in students better understanding APRA’s approach to the measurement of operational risk. While Chapter 2 outlines the regulation framework for APRA supervised FIs, this should be again highlighted in discussion of insurers and superannuation funds. You may then wish to compare the APRA style of supervision and capital adequacy requirements to those of the other FIs which are in general supervised by ASIC. For more general FI courses In this case, I would suggest following the general approach outlined for banks and other DIs in Chapter 2 Teaching Suggestions. Chapter 4 Risks of financial institutions Chapter outline Interest rate risk Market risk Credit risk Country or sovereign risk Foreign exchange risk Liquidity risk Off-balance-sheet risk Technology and operational risks Technology risk Operational risk Insolvency risk Other risks and the interaction of risks Learning objectives 4.1 Learn about the importance of interest rate risk and its impact on FI performance. 4.2 Understand the significance of market risk for FIs. 4.3 Gain an understanding of the influence of credit risk on FIs. 4.4 Discover why country or sovereign risk is a key concern of FI managers. 4.5 Discover the reasons why foreign exchange risk management is necessary for FIs. 4.6 Understand the emphasis placed on liquidity risk management by FIs. 4.7 Learn about the importance of off-balance-sheet risk on FI management. 4.8 Identify the importance of technology and operational risks for FIs. 4.9 Learn the importance of insolvency risk and its relationship to other risks. 4.10 Gain an understanding of the interconnectedness and complexity of the risks facing managers of modern FIs. Overview of chapter This chapter introduces and provides an overview of the 10 major risks faced by modern FIs. They face interest rate risk when their assets and liabilities maturities are mismatched. They incur market risk on their trading assets and liabilities if there are adverse movements in interest rates, exchange rates or other asset prices. They face credit risk or default risk if their clients default on their loans and other obligations. Modern-day FIs also engage in a significant number of off-balance-sheet activities that expose them to off-balance-sheet risks: contingent asset and liability risks. The advent of sophisticated technology and automation exposes FIs to both technological risk and operational risk. If FIs conduct foreign business, they are subject to additional risks, namely foreign exchange and sovereign risks. Liquidity risk is an everyday risk to which an FI is subject, and is the risk of meeting contractual obligations—such as a call on deposit or a drawdown of a loan commitment—which otherwise could result in a serious run on an FI because of excessive withdrawals or problems in refinancing. Finally, insolvency risk occurs when an FI’s capital is insufficient to withstand a relative decline in the value of assets. The effective management of these risks determines the success or failure of a modern FI. The chapters that follow analyse each of these risks in greater detail, beginning with interest rate risk. Chapter 4 Teaching Suggestions This chapter is the ‘real’ introduction to any course covering FI or bank risk management or treasury management, as it introduces students to all the key financial risks faced by FIs. Many of these risks (e.g. interest rate risk, liquidity risk, FX risk, market risk) are managed by the treasury of an FI, and usually the treasury operation will often also manage capital, and the assurance that capital and liquidity regulations are met. There is no special way to approach the topics covered in the chapter. The order of the topics reflects the order of the chapters which follow, commencing with interest rate risk, an everyday risk of FIs, the management of which is critical to the FI’s performance. To commence this topic, you may like to ask the students to identify as many risks as possible—this is a follow-up to any introduction discussion you may have had when covering Chapter 1. One way to approach the teaching of the subject generally is to cover Chapters 1 and 4 at the same time—that is, discuss the specialness aspects of FIs and the associated risks (Chapter 1) and then introduce each of the risks using the material in Chapter 4. Then follow with a discussion of the institutional environment (Chapters 2 and 3). The important aspect of teaching this chapter is to ensure that students understand: The key aspects of each of the risks. The ways the risks impact an FI’s performance. The differences between the risk types. The fact that most risks don’t occur in isolation—that is, there are usually one or two risks impacted by a particular transaction. The ways that management of one risk may actually increase another risk. The way a bank is able to transfer risk from itself to a client with the design of a product—for example, variable rate mortgages transfer interest rate risk to the client. You may wish to identify some simple transactions that a client may undertake and then relate these to risks to the bank. For example: Bank deposit Call risk, and if fixed deposit then interest rate risk Loan of foreign currency FX risk and credit risk, and also possibly sovereign risk Line of credit Credit risk and potentially liquidity risk (if funds called during a liquidity squeeze), and interest rate risk if a fixed rate loan Call option on a bond Credit risk and interest rate risk Transaction settlement systems Operational and technology risks I find that the most effective way to introduce the risks is to make the transactions as simple as possible, and as close to the students’ experiences as possible. So you could discuss the risks by first asking the students to identify a number of transactions, and then asking them to identify the risks inherent in them. Some courses may not cover all of the risks in detail, understandable given the short time of a semester. For example, if it is a treasury management course, then you may not cover credit risk and sovereign risk in as much detail. Or if it is a bank management course which is a part of a more general finance program in which international finance is covered in another subject, you may choose not to cover FX risk. However, despite these changes in the lectures to follow, I would strongly suggest that you introduce all of the risks outlined in Chapter 4 and explain to students why or why they are not covered in your particular course. Chapter 5 Interest rate risk: the repricing model Chapter outline The level and movement of interest rates The repricing model Rate-sensitive assets Rate-sensitive liabilities Changes to NII—equal changes in rates on RSAs and RSLs Changes to NII—unequal changes in rates on RSAs and RSLs Weaknesses of the repricing model Market value effects Over-aggregation The problem of runoffs Cash flows from off-balance-sheet activities Appendix 5A: Maturity model (found at the book website) Appendix 5B: Term structure of interest rates Learning objectives 5.1 Appreciate the influence that the RBA has on interest rates and why this is the case. 5.2 Learn that at the heart of interest rate risk is the tendency of many modern FIs to mismatch the maturities of their assets and liabilities (for example, banks normally use short-term deposits to fund long-term loans) and that this mismatching can give rise to significant interest rate exposure and insolvency risk. 5.3 Learn the repricing model, repricing gaps and their use in measuring interest rate risk. 5.4 Gain an understanding of rate-sensitive assets and rate-sensitive liabilities. 5.5 Learn the weaknesses of the repricing model. 5.6 Gain an understanding of the problems caused by measuring interest rate risk exposure by looking only at the maturity mismatch. 5.7 Gain an understanding of the theory behind term structure of interest rates. Overview of chapter The second part of the book covering the measurement and management of FI risks commences with this chapter. This chapter opens with a discussion of the Reserve Bank of Australia’s (RBA) monetary policy as this also influences an FI’s interest rate risk. We discuss the RBA’s monetary policy objective to maintain inflation in a targeted range, and its management of monetary policy through movements in the target cash rate. The chapter then introduces the first of three methods of measuring an FI’s interest rate exposure: the repricing model. The other methods are the maturity model which is found in Appendix 5A, and the duration model which is the subject of Chapter 6. The repricing model is the simplest of the interest rate measurement models, and measures interest rate risk by examining the difference, or gap, between an FI’s rate-sensitive assets and rate-sensitive liabilities to measure interest rate risk. Because of its use of book values, the repricing model concentrates on the net interest income effects of rate changes and ignores any market value effects. In addition, the model ignores important cash flow issues associated with over-aggregation, runoffs and off-balance-sheet activities. As such, the model does not provide an accurate picture of an FI’s interest rate risk exposure. More complete measures of interest rate risk are provided by duration and the duration gap model examined in Chapter 6. In addition, Appendix 5A compares and contrasts the repricing model with the market value-based maturity model. While the maturity model is not used by FIs, it was one of the first attempts to incorporate the impact of interest rate movements on an FI’s total market value, rather than NII only. In Appendix 5B, the term structure of interest rates is examined for those students requiring a review of this important introductory finance topic. Chapter 5 Teaching Suggestions The first risk to be examined by the book in detail is interest rate risk. There are four chapters covering this risk, as well as being supported by 10 appendices. Interest rate risk is an important topic both because it is a common, everyday risk of banks, but also because its measurement and management is a fundamental part of the normal management of FIs. It is usually a treasury function—that is, the interest rate risk management is centralised—as for most risks. Some of the techniques involved in both the management and measurement are quite difficult, and may not be suited to all courses. An important lesson in the management of interest rate risk is that it is most effective if undertaken for the balance sheet for the FI as a whole. It is ineffective if IRR management is undertaken in bits—that is, retail bank, business bank, institutional bank, etc.—as each part of the organisation may be making IRR decisions which counter each other. Hence, the risk must be managed across the bank as a whole. Having said this, the repricing model which is the subject of Chapter 5 is not difficult and is a good introduction to interest rate risk, where it is found, how it can be estimated, and what FIs can do to minimise it. There is nothing particularly technically difficult with the mathematics in this chapter. This is not the case for Chapter 6 or Appendix 5A, and while the maturity model may be excluded from any course and referred to for academic interest only, the duration model should be covered for at least two reasons. First, because banks and other FIs use the duration model more often than repricing; and second, as it forms the basis for the measurement of interest rate risk for capital regulatory purposes. With this introduction, I suggest that you commence the topic interest rate risk by examining the volatility of interest rates and the impact that such changes will have on the management of deposits and loans. For example, you could enter into a discussion of the following: If banks issued only fixed-rate loans, what would happen to their profitability if interest rates rose? If interest rates are rising would banks prefer to raise call deposits only from customers, or fixed-rate deposits? How should a bank act if the RBA increases/decreases the cash rate? That is, what changes should banks make to their deposit and loan products? Why should they make these changes? You may have started this discussion in the introduction to FI risks (Chapter 4), but it is worth taking this further at this point so that students understand the importance of minimising the risk of changing interest rates, and how critical this is. Before introducing the repricing model specifically, I suggest that you look at a hypothetical balance sheet of a bank such as that shown in Table 5.2, and examine the nature of rate sensitivity and repricing. I have found it better to do this prior to the introduction of the model itself, so that students fully appreciate these fundamental issues before you examine the gap model itself. With the knowledge of interest rate sensitivity of assets and liabilities, and the fact that repricing does not equal maturity, you should then easily explain the model and the gaps—both simple and cumulative. Another point worth mentioning at this stage is the fact that the number of gap periods will be determined by the volatility of interest rates. For example, in the 1980s when interest rates were highly volatile, banks had many more gap periods and especially in the short end, for example: 1 day 1–7 days 8–14 days 15–31 days etc. The reason for this is that the use of the repricing model is to identify risks—and as rates were changing rapidly from day to day, then management of the short end was more critical than the longer end (where in such circumstances gaps were usually matched). From the examination of gaps, then you could introduce a discussion of the impact on the net interest income of the bank if there are any gaps. Here, you may wish to start with an examination of the impact on first assets and then liabilities, and then bring the two together. Use Table 5.3 to help explain the impact on NII under the circumstances when interest rates on assets and liabilities change by the same amount. Then move to the more complex situation when the change is not the same—see Table 5.5 which shows a great deal of uncertainty. However, the mathematics is simple for any finance student and so each possibility should be covered. In all cases, use actual examples—which you may also draw from the book—as this will help reinforce the lessons. You should complete the discussion of the repricing model by examining the weaknesses. As the course is probably an advanced finance course, students should be able to determine some of the problems with the model and the fact that it relies on book values and not market values. The discussion of weaknesses is a good introduction to the discussion of the duration model. In the 1980s and early 1990s, banks knew about the duration model, but didn’t have the computational power to use it. In such circumstances, the repricing model was used—even though it was known to be imprecise. How times have changed! Note that there is an integrated mini-case at the end of this chapter which provides students with practice in measuring the various gaps and in using the repricing model to protect an FI against interest rate movements. Chapter 6 Interest rate risk measurement: the duration model Chapter outline Duration: a simple introduction A general formula for duration The duration of interest-bearing bonds The duration of a zero-coupon bond The duration of a consol bond (perpetuity) Features of duration Duration and maturity Duration and yield Duration and coupon interest The economic meaning of duration Semi-annual coupon bonds Using duration to measure an FI’s interest rate risk Duration and immunising future payments Duration and interest rate risk in the whole balance sheet of an FI Immunisation and regulatory considerations Difficulties of applying the duration model Duration matching can be costly Immunisation is a dynamic problem Large interest rate changes and convexity Appendix 6A: Bond valuation (found at the book website) Appendix 6B: Incorporating convexity into the duration model Learning objectives 6.1 Learn to calculate duration and appreciate that it is a more complete measure of an asset or liability’s interest rate sensitivity than maturity. 6.2 Identify the relationship of duration to maturity, yield and coupon interest rates. 6.3 Gain an understanding of the economic meaning of duration. 6.4 Learn about the Macaulay Duration Model and how this and the duration gap are used to measure an FI’s interest rate risk exposure. 6.5 Appreciate how duration can be used to maintain a particular leverage ratio. 6.6 Understand some of the problems of applying the Macaulay Duration Model to real-world FIs. 6.7 Learn about convexity and its use as a superior measure of interest rate risk. Overview of chapter As mentioned in Chapter 5, a weakness of the repricing model is its reliance on book values. The recording of market values by comparison means that assets or liabilities are revalued to reflect current market conditions. That is, marking to market, implied by the market value accounting method, reflects economic reality or the true values of assets and liabilities if the FI’s portfolio were to be liquidated at today’s securities’ prices rather than at the prices when the assets and liabilities were originally purchased or sold. In this chapter, we also examine the measurement of interest rate risk, and present a market value based model—the duration model, a model which explicitly takes into account the impact of interest rate changes on market values of assets and liabilities. Duration is an important and useful measure of interest rate risk which is incorporated into risk measurement models by many Australian banks. The chapter commences with an explanation of the concept of duration and the basic arithmetic needed to calculate the duration of an asset or liability. It then presents the economic meaning of duration—that is, the measurement of the average life of the asset or liability and the use of duration as a measure of interest sensitivity or interest elasticity. From here, the chapter shows how duration and the duration gap are more accurate measures of an FI’s interest rate exposure than the repricing model presented in Chapter 5. Unlike the repricing model, the duration gap considers market values, the timing of cash flows and the maturity distributions of an FI’s assets and liabilities. Next, the chapter explores how duration can immunise or protect an FI against interest rate risk. The chapter concludes with an examination of some problems in applying the duration measure to real-world FIs, and in Appendix 6B, a possible solution using convexity models to the more advanced issues associated with these problems is presented. Appendix 6A discusses bond pricing, providing a revision of this important topic for students who may need this. Chapter 6 Teaching Suggestions This chapter is packed full of topics of significant interest to any banker who is interested in risk management and fully understanding the nature of the types of assets and liabilities in a bank balance sheet. If your course is part of a finance program, then your students may have already studied duration, and in this case, I would suggest you use the introduction to duration as a revision exercise only. However, the use of duration to build the duration model to measure interest rate sensitivity/elasticity of an FI balance sheet is important for all aspiring banking and FI managers. The chapter is technical and involves some mathematics which in general is pretty simple. For students of finance, the maths is probably OK, but for more general students, I would suggest that some results are just summarised. Let me explain some of the key areas further. 1. A general formula for duration (page 174 The basic arithmetic in calculating duration should not present a problem for any student. However, the general formula for duration (Macaulay Duration) for a fixed-income security looks difficult and may frighten students without a strong mathematics background. Rather than using mathematical symbols, the formula could be described as follows: for each individual cash flow of a security, multiply its present value by its duration (i.e. remember that the duration of a single cash flow is its time to maturity). Add all these products together—and this is the numerator of the duration calculation. Divide this sum of the products by the present value of the security. If students are unsure of the way to calculate the present value of a bond, then use Appendix 6A (an online appendix) to support their learning or to provide a basis of revision if necessary. Then ask students to compute the duration of a number of different bonds using the examples 6.1 and 6.2 to reinforce the simple calculation. I would strongly encourage that you use the tabular approach in calculating duration—easy for students to use in a website, and easy to see the actual calculation (and simplicity of it). 2. The economic meaning of duration (page 179) The ‘proof’ of the formula for interest elasticity may not be necessary for students to know. However, the resulting formula is necessary to assist their understanding in using duration to manage interest rate risk. If the proof is not covered, then refer interested students to the mathematics in the book—to satisfy their curiosity—as smart students will want to know where the formula comes from. Once again reinforce their learning and understanding by asking students to do a number of calculations of interest elasticity and modified duration. 3. Duration and interest rate risk in the whole balance sheet of an FI (page 187) Similarly, the ‘proof’ of the equation for the change in equity resulting from a change in interest rates is available for any course wishing to cover this. However, many courses will simply advise students that ‘it can be found that …’ and then provide the formula only. If your approach is the latter, then I would suggest that you refer students to the ‘proof’ in the book so that student curiosity is satisfied. The resulting equation is relatively simply, and again, the best way to reinforce the relationships is to go through examples in lectures as well as providing the students with an opportunity to practise. Having completed the sections of the chapter covering the more technical issues, and resulting equations, a discussion of how to use the various formulas in managing interest rate risk then follows. In particular, you should ensure that students understand that the way to use the duration model depends on the particular objective of the FI. That is, if the objective is to immunise any change in equity (i.e. market value of equity), then the balance sheet should be structured so that DA = kDL However, if the objective is to immunise the net worth ratio (i.e. to set the change in (E/A) to zero), then the FI manager needs to set DA = DL The discussion of the difficulties in applying the duration model are relatively straightforward, and each of the points are important. For those courses which take students to a higher level, and for treasury management courses, the issue of convexity should be discussed, and if time permits, then refer to Appendix 6B which is in the book at the end of the chapter, and discusses the process of incorporating convexity into the duration model. Note also that there is an integrated mini case at the end of this chapter which covers the measurement of duration, the duration gap and gives students an opportunity to use the duration model to immunise a bank against interest rate risk. Instructor Manual for Financial Institutions Management Anthony Saunders, Marcia Cornett, Patricia McGraw 9780070979796, 9780071051590

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