Module 6.1

Question 1

Background on Savings Institutions (1 of 2)

Answer 1

Ownership of Savings Institutions  Savings institutions are classified as either stock owned or mutual (owned by  Because of the difference in owner control, stock owned institutions are more susceptible to unfriendly takeovers.  Some SIs have been acquired by commercial banks that wanted to diversify their operations.

Question 2

Regulation of Savings Institutions

Answer 2

Deposit Insurance The insuring agency for SIs is the Deposit Insurance Fund (DIF), which is administered by the FDIC and insures deposits. The insurable limit is presently $250,000.  Regulatory Assessment of Savings Institutions Regulators conduct periodic on site examinations of SIs using the CAMELS rating system in a manner similar to commercial banks.  Deregulation of Services In recent years, SIs have been granted more flexibility to diversify the products and services they provide.

Question 3

Sources and Uses of Funds (1 of 5)

Answer 3

Deposits Savings institutions obtain most of their funds from a variety of savings and time deposits, including passbook savings, retail certificates of deposit (CDs), and money market deposit accounts (MMDAs).  Borrowed Funds Can borrow in the federal funds market, through repurchase agreements (repos), or at the Federal Reserve.  Capital Primarily composed of retained earnings and funds obtained from issuing stock.

Question 4

Uses of Funds

Answer 4

Cash To satisfy reserve requirements and accommodate withdrawal requests.  Mortgages The primary asset of SIs.  Mortgage Backed Securities Some savings institutions purchase mortgage backed securities.  Other Securities Savings institutions invest in Treasury bonds and corporate bonds which provide liquidity.  Consumer and Commercial Loans Can reduce their heavy exposure to mortgage loans.

Question 5

Other Uses of Funds

Answer 5

Savings institutions can provide temporary financing to other institutions through the use of repurchase agreements.  They can lend funds on a short term basis through the federal funds market.  Both methods allow them to efficiently use funds that they will have available for only a short period of time.

Question 6

Balance Sheet of Savings Institutions

Answer 6

The sources of funds represent liabilities or equity of an SI, while the uses of funds represent assets.  Each SI determines its own composition of liabilities and assets, which determines its specific operations.

Question 7

Balance Sheet of Ashland Savings as of
June 30, 2016

Answer 7

Question 8

How Savings Institutions Finance
Economic Growth

Answer 8

Question 9

Interaction with Other Financial Institutions

Answer 9

When SIs obtain and use funds, they commonly interact
with other financial institutions. (Exhibit 21.3)
Participation in Financial Markets
When SIs perform their various functions, they rely on
various financial markets, as summarized in Exhibit 21.4.

Question 10

Interactions between Savings Institutions
and Other Financial Institutions

Answer 10

Question 11

Participation of Savings Institutions in
Financial Markets

Answer 11

Question 12

Valuation of a Savings Institution (1 of 3)

Answer 12

Factors That Affect Cash Flows

Change in Economic Growth

Economic growth can enhance an SI’s cash flows by
increasing household demand for consumer loans or
mortgage loans and reducing loan defaults.

Demand for other financial services (such as real estate and
insurance services) tends to be higher during periods of
strong economic growth.

Change in the Risk Free Interest Rate

An SI’s cash flows may be inversely related to interest rate
movements.

Question 13

Change in Industry Conditions

Answer 13

Savings institutions are exposed to industry conditions such
as regulatory constraints, technology, and competition.

If regulatory constraints are reduced, the expected cash
flows of some SIs should increase.

Question 14

Change in Management Abilities

Answer 14

An SI has control over the composition of its managers and
its organizational structure.

Its managers attempt to make internal decisions that will
capitalize on the external forces (economic growth, interest
rates, regulatory constraints).

Question 15

Factors That Affect the Required Rate of Return

Answer 15

Change in the risk free rate
An increase in the risk
free rate results in a higher return
required by investors. High inflation, economic growth, and
a high budget deficit place upward pressure on interest rates,
whereas money supply growth places downward pressure
on interest rates.

Change in the Risk Premium
If the risk premium on an SI rises, so will the required rate
of return by investors who invest in the SI. (Exhibit 21.5)

Question 16

Framework for Valuing a Savings
Institution

Answer 16

Question 17

Exposure to Risk (1 of 2)

Answer 17

Liquidity Risk

Since SIs commonly use short term liabilities to finance
long term assets, they depend on additional deposits to
accommodate withdrawal requests.

If new deposits are not sufficient, they can obtain funds
through repurchase agreements or borrow funds in the
federal funds market.
Credit Risk

Because mortgages represent the primary asset, they
are the main reason for credit risk at SIs.
18

Question 18

Interest Rate Risk

Answer 18

Some SIs rely on short term deposits as sources of
funds and use most of their funds to provide fixed rate
mortgages.

The spread between interest revenue and interest
expenses narrows when interest rates increase, which
reduces their profitability.

Measurement of Interest Rate Risk

SIs measure the gap between rate sensitive assets and rate
sensitive liabilities to determine their exposure to interest rate
risk. (Exhibit 21.6)

Question 19

Duration Schedule for Tucson Savings
Institution (Dollar Amounts are in Thousands)

Answer 19

Question 20

Management of Interest Rate Risk (1 of 2)

Answer 20

Adjustable
Rate Mortgages

Adjustable rate mortgages enable SIs to maintain a more
stable spread between interest revenue and interest expenses.

While ARMs reduce the risks of SIs, they expose consumers
to interest rate risk.
Interest Rate Futures Contracts

An interest rate futures contract allows for the purchase of a
specific amount of a debt security for a specified price at a
future point in time.

Some SIs use Treasury bond futures contracts because the
cash flow characteristics of Treasury bonds resemble those of
fixed rate mortgages.

Question 21

Interest Rate Swaps

Answer 21

Allows an SI to swap fixed rate payments (an outflow) for
variable rate payments (an inflow).
Conclusions about Managing Interest Rate Risk

Although these strategies are useful, it is virtually impossible
to eliminate the risk completely.

Potential prepayment of mortgages.

Question 22

Exposure of Saving Institutions to Crises (1 of 6)

Answer 22

Savings Institution Crisis in the Late 1980s

One reason for the crisis of the late 1980s was an
increase in interest rates

Those SIs that had provided long term mortgages were
adversely affected because the interest they earned on
assets remained constant while the interest they paid on
liabilities increased.

Many SIs experienced a cash flow deficiency as a result
of their loan losses, as the inflows from loan repayments
were not sufficient to cover depositor withdrawals.

Question 23

Savings Institution Crisis in the Late 1980s

Answer 23

Fraud Many SIs experienced financial problems because
of various fraudulent activities.

Provisions of the FIRREA

The Financial Institutions Reform, Recovery, and Enforcement
Act (FIRREA) was enacted in 1989.

FIRREA increased penalties for officers of SIs and other financial
institutions convicted of fraud, revised the regulation of SIs, and
raised the capital requirements for SIs.

Allowed commercial banks to acquire SIs.

The Resolution Trust Corporation (RTC ) was formed to deal
with insolvent SIs. The RTC liquidated the assets of the insolvent
SIs and reimbursed depositors or sold the SIs to other financial
institutions.

Question 24

Credit Crisis of 2008
2009

Answer 24

Several subprime lenders went bankrupt

Many SIs invested heavily in mortgage backed securities
without recognizing the credit risk of these securities.

Notable Failures during the Credit Crisis

Countrywide Financial used an aggressive strategy to
approve subprime mortgages. Many of these loans defaulted
in 2007. In January 2008, Countrywide Financial was
acquired by Bank of America.

IndyMac suffered major losses on its $32 billion portfolio
of mortgages.

In September 2008, Washington Mutual became the largest
depository institution ever to fail in the United States.

Question 25

Reform in Response to the Credit Crisis

Answer 25

The Financial Reform Act was implemented in 2010.  Mortgage Origination Requires that savings institutions and other financial institutions granting mortgages to verify the income, job status, and credit history of mortgage applicants before approving mortgage applications  Sales of Mortgage Backed Securities Requires that savings institutions and other financial institutions that sell mortgage backed securities to retain 5% of the portfolio unless the portfolio meets specific standards that reflect low risk.

Question 26

Reform in Response to the Credit Crisis

Answer 26

Financial Stability Oversight Council Responsible for identifying risks to financial stability in the United States and makes regulatory recommendations to regulators that could reduce systemic risk, whereby the financial problems of savings institutions or other financial institutions spreads  Orderly Liquidation Assigned specific regulators the authority to determine whether any particular financial institution should be liquidated.

Question 27

Consumer Financial Protection Bureau

Answer 27

Responsible for regulating various consumer finance products and services that are offered by savings institutions and other financial institutions, such as online accounts and credit cards.

Question 28

Trading of Derivative Securities

Answer 28

Requires that derivative securities be traded through a clearinghouse or exchange, rather than over the counter.

Question 29

Credit Unions (1 of 4)

Answer 29

Nonprofit organizations composed of members with a common bond, such as an affiliation with a particular labor union, church, university, or even residential area. Ownership of Credit Unions  Technically owned by the depositors.  CUs can be federally or state chartered. Advantages and Disadvantages of CUs  Not taxed.  Noninterest expenses are relatively low because their office and furniture are often donated or provided at a very low cost through the affiliation of their members.  Employees may not have incentive to manage efficiently.

Question 30

Deposit Insurance for Credit Unions

Answer 30

About 90% of CUs are insured by the National Credit Union Share Insurance Fund (NCUSIF).  CUs typically pay an annual insurance premium of about one tenth of 1% of share deposits.

Question 31

Regulatory Assessment of Credit Unions

Answer 31

Federal CUs are supervised and regulated by the National Credit Union Administration (NCUA), while state chartered CUs are regulated by their respective states.  Examiners classify each CU into a specific risk category, ranging from Code 1 (low risk) to Code 5 (high risk).

Question 32

Credit Union Sources and Uses of Funds

Answer 32

Credit Union Sources of Funds  Deposits Credit unions obtain most of their funds from share deposits by members.  Borrowed Funds A CU can borrow from other CUs or from the Central Liquidity Facility (CLF).  Capital Like other depository institutions, CUs maintain capital. Their primary source of capital is retained earnings. Credit Union Uses of Funds  Use the majority of their funds for loans to members.  Purchase government and agency securities to maintain adequate liquidity.

Question 33

Exposure of Credit Unions to Risk

Answer 33

Liquidity Risk of Credit Unions If a CU experiences an unanticipated wave of withdrawals without an offsetting amount of new deposits, it could become illiquid.  Credit Risk of Credit Unions Because CUs concentrate on personal loans to their members, their exposure to credit (default) risk is primarily derived from those loans.  Interest Rate Risk of Credit Unions Loans have short or intermediate maturities, so their asset portfolios are rate sensitive.

Question 34

SUMMARY (1 of 5)

Answer 34

Savings institutions are classified as either stock owned or mutual. They are regulated by the Comptroller of the Currency and the Federal Reserve. Their deposits are insured by the Deposit Insurance Fund, which is administered by the Federal Deposit Insurance Corporation. ■ The main sources of funds for SIs are deposits and borrowed funds. The main uses of funds for SIs are mortgages, mortgage backed securities, and other securities.

Question 35

Savings Institution Valuation

Answer 35

The valuation of an SI is a function of its expected cash flows and the required return by its investors. The expected cash flows are influenced by economic growth, interest rate movements, regulatory constraints, and the abilities of the institution’s managers. The required rate of return is influenced by the prevailing risk free rate and the risk premium. The risk premium is lower when economic conditions are strong.

Question 36

Savings institutions are exposed to credit risk as a result of

Answer 36

Savings institutions are exposed to credit risk as a result of their heavy concentration in mortgages, mortgage backed securities, and other securities. They attempt to diversify their investments to reduce credit risk. Savings institutions are highly susceptible to interest rate risk because their asset portfolios are typically less rate sensitive than their liability portfolios to interest rate movements.

Question 37

SI can reduce risk by....

Answer 37

Savings institutions can reduce their interest rate risk by using adjustable rate mortgages instead of fixed rate mortgages so that the rate sensitivity of their assets is more similar to that of their liabilities. Alternatively, they can sell interest rate futures contracts, which would generate gains if interest rates increase. Third, they can engage in interest rate swaps in which they swap fixed rates for floating rates, which would generate gains if interest rates rise.

Question 38

Final Summary on SI's

Answer 38

In the late 1980s, many SIs made very risky loans and investments and experienced heavy losses from loan defaults, adverse interest rate movements, and fraud. In the 2004 2006 period, many SIs pursued aggressive mortgage lending strategies, which led to major problems during the credit crisis of 2008 2009.  Credit unions obtain most of their funds from share deposits by members. They use the majority of their funds for personal loans to members and therefore are exposed to credit risk.