Tema 3 – Liabilities side operations

Deposits: A deposit is a contract or transaction that involves the transfer of money to a bank account. 

1. Demand deposits: normal deposit for frequent access to funds on demand. More liquid, less costly.

• Current accounts i.e., a deposit account meant neither for the purpose of earning interest nor for the purpose of savings, but for convenience of the business or personal client. 

• Money market accounts: less liquid, offers higher interest i.e., an interest-bearing deposit account based on current interest rates in the money markets. Typically offers a relatively high rate of interest and requires a higher minimum balance to earn interest or avoid 

• Savings accounts: less liquid, offers lower interest.These accounts let customers set aside a portion of their liquid assets while earning a monetary return. Withdrawals are unlimited but occasionally costly and more time-consuming

2. Time deposits: They canmot be withdrawn for certain time unless a penalty is paid. In general, the longer the term the better the yield. Less liquid, more costly.

Interbank loans– are liabilities side operations under which banks raise money shortterm on the interbank lending market. The interbank lending market is a global network used by financial institutions to trade currencies and other currency derivatives directly between themselvesThe goal of interbank lending markets is to provide support to the fractional reserve banking model by giving banks more flexibility in managing liquidity efficiently and satisfy regulations such as reserve requirements. 

Repos – securities sold under agreement to repurchase Repurchase agreements (Repos) are liabilities side operations under which banks use some of their (financial) assets to raise short-term funding. 

Bonds – Fixed income marketable securities-are liabilities side operations under which banks raise medium-to long-term funds from investors in debt capital markets

Covered Bonds i.e., a credit enhanced bond collateralized by a dedicated pool of assets, which provides security against default and reinvestment risks. • Mortgage Bonds (secured by the pledge of specific mortgages) • Public Sector Bonds (secured by the pledge of specific loans) • Contingent Convertible Bonds i.e., a hybrid security that converts into a specified number of shares of common stock of the issuer whenever a trigger condition occurs (usually when the capitalization of the bank falls below some minimum 

Tema 5.3 – Credit Derivative

Credit derivatives are two sided contracts that enable the buyer and the seller  to transfer the credit risk of an underlying position.•They are traded over-the-counter credit risk as a commodity•The counterparty that transfers credit risk (i.e. the protection buyer) seeks protection from potential losses that can be incurred due to adverse credit

 events on a position.Credit events (i.e. bankruptcy, failure to pay, restructuring) result in a payment from the protection seller to the protection buyer and the termination of the contract.•The counterparty to which credit risk is transferred (i.e. the protection seller) seek exposure to credit risk to realize gains on the basis of its credit views (i.e. expectations oncredit quality)

Definition:  under a Credit Default Swap (CDS) the protection buyer pays a premium to the protection seller and gets the right to either receive from the latter a default payment equal to the loss incurred (i.e. Cash Settlement: par value – recovery value) or to transfer to the latter a deliverable obligation at par value (i.e. Physical settlement) if the reference entity becomes insolvent within the period specified in the contract. 

What are credit derivatives used for?1)Credit risk diversification and management-To hold a credit portfolio with the desired risk return profile -To reduce/increase the exposure of the current credit portfolio with respect to a given sector or region, by buying/selling protection against those sectors or regions-To gain, based on credit views, a new credit risk exposure to some sector or region, by selling protection 2)Efficient capital allocation-To improve the return on absorbed capital for a given level of credit risk3)Credit capacity enhancement-Having excess credit capacity is costly and inefficient, credit derivatives allow to gain short- to-medium term exposure to a broader set of customers, sectors and regions. 4)Regulatory capital optimization-To free up regulatory capital by buying protection or to employ capital by selling  protection 5)Cost of funding reduction-To take positions on credit risk independent of the cost of funding6)Bank-customer relationships-To get rid of a customer credit risk without breaching the relation with the customer or to free up capital to provide additional financings7)Synthetic securitizations and “tailor made” operations-To get rid of credit risks while keeping assets on balance sheet (e.g. synthetic securitization)  

How are credit derivatives priced? Premium is quoted as an annual percentage in b.p. on the contract’s notional value. -Transition matrices: they report the probability for a reference entity belonging to a given rating class to migrate to a different class in a given period-Probabilities of default and their covariances -Contingent claim analysis (Option pricing theory)-Market approach: term structure of credit spreads, survival analysis-Ratings based approach-Recovery rates in the event of default (trading prices approach or discounted cash flow approach)

Tema 2 – The Economics of Banking

Depositary institutions

Depository institutions Commercial banks: Commercial banks: a bank that accepts deposits and makes consumer, commercial and real estate loans. • More diversified in terms of assets and liabilities, but the actual compositions strongly depend on size • Interest spread income + fee income from off balance sheet activities • Highly leveraged: i.e., little equity compared with total assets • Regulator requires a minimum level of equity capital to act as a buffer against losses from on-and off balance sheet activities • Subject to annual stress tests, to assess capitalization • Shorter maturity structure of liabilities • Depending on the type of clients they serve they can be further classified as: • Retail Banks • Corporate Banks • Business / Wholesale Banks

Saving banks : depository institutions that specialize in residential mortgages mostly backed by short term deposits • They originate with the goal to serve the borrowing needs of retail customers in response to commercial banks concentration on corporations • Regulator sets a floor on the minimum holding of mortgages or mortgage-backed securities • Saving deposits are the predominant source of funds • Can be established as mutual organizations in which depositors are also the owners of the bank In Spain: Cajas de Ahorro • Controlled by private foundations with a social goal, that reinvest a substantial part of the profits on social projects • Localized activity targeted towards households and SMEs 

Credit unions: Nonprofit depository institutions, owned by members with a common bond, specializing in small consumer loans • The primary objective is to satisfy the depository and lending needs of their members • High concentration of small consumer loans and small amounts of mortgages • No common stocks are issued, members are legally the owners • Member savings deposits are the predominant source of funds • Any earnings from lending activity are tax exempt and are used to pay higher rates on member deposits, to charge lower rates on member loans, or to finance projects to the benefit of the cooperative.

Investment banks do not transform the securities issued by the net users of funds into claims more attractive to the net suppliers of funds, but they rather serve as brokers intermediating between suppliers and users of funds by: • Originating, structuring, and executing (e.g., underwriting, roadshow and book building) public and private placement of debt and equity securities in primary money and capital markets • ECM (e.g., IPOs, SEOs, ABB, PP), DCM (IG, HY, ABS, PP) • Assisting trading of securities in secondary markets • Brokerage, market-making, research • Advising on corporate finance activities and shareholder relations • M&As, joint ventures, leveraged buyouts, takeover defenses, divestitures, spin-offs, loan syndication and corporate restructurings • Investing and lending (proprietary) and asset management (money market funds, pension funds, hedge funds, private equity funds, etc.) The investment bank business model: • More short term and liquid assets • Income is derived from commissions and fees • Extremely leveraged capital structure • Repurchase agreements as predominant source of funds (no deposits) • Continuous refinancing of interbank loans • Less stringent regulation and supervision • Global operations, organized in a 3D matrix (area, industry, product) • Basic Materials, Healthcare, Communication, Energy, Financial Institutions, Financial Sponsors, Industrials, Power and Utilities, Real Estate, Consumer Products and Retail, Technology and Services, Transportation. 

Shadow Banking– non-bank financial service firms performing banking services. They facilitate the creation of credit across the global financial system. It consists of lenders, brokers and other credit intermediaries who fall outside the traditional regulated banking. It is generally unregulated (as they do not accept traditional deposits) and not subject to the same kinds of risk, liquidity and capital restrictions as traditional banks are. They have played a major role in the expansion of housing credit in the 2008 financial crisis. Shadow banking arose as innovators in financial markets who were able to finance lending for real estate and other purposes. 

Which factors contribute to the rising importance of shadow Banks?  1) Strict banking regulation -> Higher burdens in credit access (credit crunch) -> A new set of entities enter in the credit market  Stronger capital requirements: Capital/Risk Weighted Assets  Banks need to keep higher capital to lend to risky borrowers. Therefore, they ration credit. 2) Regulatory arbitrage -> Highly complex and restrictive banking norms -> Non-banks with lighter regulations satisfy the credit demand. 3) Shadow banks better satisfy some customers -> Non-bank lenders (p. ej. Quicken Loans, P2P)

 Drawbacks • Lack of disclosure and information about the value of your assets. • Unclear ownership and management structures in shadow banks. • Little regulatory or supervisory (as they do not take deposits) oversight compared with the one applied to traditional banks. • A virtual absence of capital to absorb losses or cash for redemptions, and lack of access to formal liquidity support to prevent “liquidations” or forced sales of assets. • Growth of shadow banking in countries with tightening of banking regulation -> They promote shadow activities -> Growing, opaque and unstable sector -> Cause of the next great financial crisis? • High interconnection: The bankruptcy of a shadow bank can generate a cascading effect of losses in other shadow banks without the possibility of controlling or monitoring risks ex-ante

A bank guarantee is the bank’s obligation to pay the beneficiary of the guarantee the amount specified in the letter of guarantee, if the guaranteed obligation is not fulfilled.1)The claims submitted under a letter of guarantee are paid by the bank on demand.2)It is used to essentially insure a 

buyer or seller from loss or damage due to non performance by the other party in a contract.

Securitization is the transformation of an illiquid asset into a security (i.e. an asset backed security).+The lender sells or assigns certain loans to a special purpose vehicle (SPV),that issues debt (ABS) to investors to finance the transfer +The SPV is legally insulated from the originator(s) of the loans +Credit quality of the loans is enhanced, ABS are reviewed by rating agencies +Benefits (and risks) are divided up among investors on a pro-rata basis-A security is tradable, and therefore more liquid than the underlying loans.Securitization of assets can lower risk, add liquidity, improve economic efficiency. Sometimes, assets are worth more off the balance sheet than on it.

What are the reasons why banks embark on securitization? 1)Fundraising: to get new liquidity to provide new credit (that generate new fees) or to repay liabilities.2)To improve the ROA by getting rid of assets that absorb much capital but offer low returns.3)To lower their average cost of capital4)To improve their capitalization ratios

The goal is toidentify an homogeneous pool of assets with a definite risk profile,offering stable and frequent cash flow payments.Type of assets

•Mortgages, residential or commercial (MBS, RMBS or CMBS)

• Loans, performing and nonperforming (CLO) or bonds (CBO)

• Credit derivatives,i.e. swaps (CSO)

• Credit card receivables

They should be Suitability of assets: the pool of assets should be large and homogeneous •enough to facilitate statistical analysis •historically stable in terms of defaults, delinquencies, prepayment, etc. •sufficiently diversified•of basic credit quality standards, evaluated and approved by rating agencies or specialized financial guaranty companies •composed only of transferable and unencumbered assets

What are the risks involved?Cash flow waterfall•Risk and return profiles of tranche securities-Notes/securities issued can be subdivided into graduated slices to attract a diverse range of investors with different risk and return requirements-These tranches are sold separately to investors

-Tranches can pay a fixed or floating-rate to investors and interest and principal are allocated to the tranches in accordance to their seniority

Major sources of risk

Credit risk (i.e. default rate on loans increase)               • Liquidity risk (i.e. loans cash flows are not coincident with ABS flows)           • Interest rate (Ir) / Currency risk

Basis risk (i.e. interest rates on loans fall below ABS ones)•Interest rate / currency risk                 • Prepayment risk (i.e. underlying asset is callable)

Risk mitigation

• Pre-securitization Assets to be included in the pool are selected and packaged with the objective to make the corresponding ABS attractive for outside investors•Screening of assets prior to securitization, subject to: maximum outstanding principal amount…

• Credit enhancements Securitized assets are qualitatively transformed in order to cater the preferences of investors with different risk-return profiles. ABS are structured to obtain higher credit ratings than either the originator or the underlying pool of assets.

                  – Internal: isolation from the originator, tranche subordination, cash collateral account, excess spread, overcollateralization, replacement of assets              

                  – External: third party credit guarantees

• Cash flow restructuring Derivative contracts are signed with outside counterparties in order to hedge risks related to shifts in interest rates of exchange rates

            – Interest rate swaps: to protect investors in ABSs from the risk an increase in market interest rates reduces the excess spread for the SPV

            – Currency swaps: to protect the investors in ABSs from the risk a change in the exchange rates reduces the excess spread for the SPV

Cash inflows from securitized assets can only be used to service debt. But the cash flow waterfall structure is characterized by two phases:

:1) The revolving period: Only interest are paid on ABSIt is the initial period in which the originating bank is allowed to transfers its assets to the SPV up to the maximum nominal amount and according to the established eligibility criteria. In this period the bank is also allowed to replenish the initial pool to the extent that the underlying assets are amortizing.        2) The amortization period: Both principal and interest are paid on ABSIt is the period in which the pool of assets naturally amortizes, and no further replenishments can be made by the originating bank.It can be anticipated if an “early amortization” trigger event occurs.

An activity is an off-balance sheet asset/liability if when a contingent event occurs, the asset/liability moves onto the asset/liability side of the balance sheet or an income/expense is realized on the income statementBy moving assets off balance sheet banks•Earn additional fee income to complement declining margins on loans•Improve capitalization coefficients and avoid regulatory costs 

Tema 4 -Loan Syndicate.

Group of banks that is formed to jointly provide large and ad-hoc financing for the realization of a project. Why indicate? 1) To share risk of a large loan. 2) To create a network between banks

Bank roles:

1) Mandated Lead Arranger (MLA): main actor, designs the operation with the borrower and invites all other banks.            2) Co – Lead Arranger: they will find banks willing to participate to the loan together with the MLA.                  3) Participants.

4)Documentation Bank: organizes the finance documentation                  5) Agent bank: bank that acts as representative of the syndicate

Traditionally MlA’s have used 2 strategies:

1) Single stage syndication: MLA alone underwrites the loan and directly allocates portions of it to other banks in the syndicate.

2) Dual stage syndication: MLA and Co-Lead Arrangers jointly underwrite the loan and then allocate portions of it to other banks participating in the syndicate.