Module 6.1 Flashcards
Background on Savings Institutions (1 of 2)
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.
Regulation of Savings Institutions
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.
Sources and Uses of Funds (1 of 5)
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.
Uses of Funds
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.
Other Uses of Funds
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.
Balance Sheet of Savings Institutions
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.
Balance Sheet of Ashland Savings as of
June 30, 2016
How Savings Institutions Finance
Economic Growth
Interaction with Other Financial Institutions
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.
Interactions between Savings Institutions
and Other Financial Institutions
Participation of Savings Institutions in
Financial Markets
Valuation of a Savings Institution (1 of 3)
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.
Change in Industry Conditions
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.
Change in Management Abilities
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).
Factors That Affect the Required Rate of Return
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)
Framework for Valuing a Savings
Institution
Exposure to Risk (1 of 2)
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.
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Interest Rate Risk
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)
Duration Schedule for Tucson Savings
Institution (Dollar Amounts are in Thousands)
Management of Interest Rate Risk (1 of 2)
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.
Interest Rate Swaps
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.
Exposure of Saving Institutions to Crises (1 of 6)
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.
Savings Institution Crisis in the Late 1980s
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.
Credit Crisis of 2008
2009
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.
Reform in Response to the Credit Crisis
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.
Reform in Response to the Credit Crisis
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.
Consumer Financial Protection Bureau
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.
Trading of Derivative Securities
Requires that derivative securities be traded through a
clearinghouse or exchange, rather than over the counter.
Credit Unions (1 of 4)
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.
Deposit Insurance for Credit Unions
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.
Regulatory Assessment of Credit Unions
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).
Credit Union Sources and Uses of Funds
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.
Exposure of Credit Unions to Risk
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.
SUMMARY (1 of 5)
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.
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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.
Savings Institution Valuation
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.
Savings institutions are exposed to credit risk as a result of
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.
SI can reduce risk by….
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.
Final Summary on SI’s
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.
