Financial Institutions Management A Risk Management Approach The McGraw-Hill/Irwin Series in Finance, Insurance and Real Estate Stephen A. Ross Ross, Westerfield, and Jaffe Saunders and Cornett Franco Modigliani Professor of Finance and Corporate Finance Financial Institutions Management: A Economics Sloan School of Management Ninth Edition Risk Management Approach Massachusetts Institute of Technology Ross, Westerfield, Jaffe, and Jordan Seventh Edition Consulting Editor Corporate Finance: Core Principles and Saunders and Cornett FINANCIAL MANAGEMENT Applications Financial Markets and Institutions Third Edition Fourth Edition Adair Ross, Westerfield, and Jordan Excel Applications for Corporate INTERNATIONAL FINANCE Essentials of Corporate Finance Finance Seventh Edition Eun and Resnick First Edition International Financial Management Ross, Westerfield, and Jordan Block, Hirt, and Danielsen Fifth Edition Fundamentals of Corporate Finance Foundations of Financial Management Ninth Edition Kuemmerle Fourteenth Edition Case Studies in International Shefrin Brealey, Myers, and Allen Entrepreneurship: Managing and Behavioral Corporate Finance: Principles of Corporate Finance Financing Ventures in the Global Decisions that Create Value Tenth Edition Economy First Edition First Edition Brealey, Myers, and Allen White Principles of Corporate Finance , Robin Financial Analysis with an Electronic Concise International Corporate Finance Calculator Second Edition First Edition Sixth Edition Brealey, Myers, and Marcus REAL ESTATE Fundamentals of Corporate Finance INVESTMENTS Brueggeman and Fisher Sixth Edition Bodie, Kane, and Marcus Real Estate Finance and Investments Brooks Essentials of Investments Fourteenth Edition FinGame Online 5.0 Eighth Edition Ling and Archer Bruner Bodie, Kane, and Marcus Real Estate Principles: A Value Case Studies in Finance: Managing for Investments Approach Corporate Value Creation Ninth Edition Third Edition Sixth Edition Hirt and Block FINANCIAL PLANNING AND Chew Fundamentals of Investment INSURANCE The New Corporate Finance: Where Management Theory Meets Practice Ninth Edition Allen, Melone, Rosenbloom, and Third Edition Hirschey and Nofsinger Mahoney Retirement Plans: 401(k)s, IRAs, Cornett, Adair, and Nofsinger Investments: Analysis and Behavior and Other Deferred Compensation Finance: Applications and Theory Second Edition Approaches First Edition Jordan and Miller Tenth Edition DeMello Fundamentals of Investments: Altfest Cases in Finance Valuation and Management Personal Financial Planning Second Edition Fifth Edition First Edition Grinblatt (editor) Stewart, Piros, and Heisler Harrington and Niehaus Stephen A. 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Schiff Professor of Finance Salomon Center Stern School of Business New York University Marcia Millon Cornett Professor of Finance Bentley University FINANCIAL INSTITUTIONS MANAGEMENT, A RISK MANAGEMENT APPROACH, SEVENTH EDITION Published by McGraw-Hill, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY 10020. Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Previous editions © 2008, 2006, 2003, 2000, 1997, and 1994. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. 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Library of Congress Cataloging-in-Publication Data Saunders, Anthony, 1949- Financial institutions management : a risk management approach/Anthony Saunders, Marcia Millon Cornett. — 7th ed. p. cm.— (The McGraw-Hill/Irwin series in finance, insurance, and real estate) ISBN 978-0-07-353075-8 (alk. paper) 1. Financial institutions—United States—Management. 2. Risk management—United States. 3. Financial services industry—United States—Management. I. Cornett, Marcia Millon. II. Title. HG181.S33 2011 332.1068—dc22 2010023341 www.mhhe.com To CG. Anthony Saunders To my parents, Tom and Sue. Marcia Millon Cornett About the Authors Anthony Saunders Anthony Saunders is the John M. Schiff Professor of Finance and the former Chair of the Department of Finance at the Stern School of Business at New York University. Professor Saunders received his PhD from the London School of Economics and has taught both undergraduate- and graduate-level courses at NYU since 1978. Throughout his academic career, his teaching and research have specialized in financial institutions and international banking. He has served as a visiting professor all over the world, including INSEAD, the Stockholm School of Economics, and the University of Melbourne. Professor Saunders has held positions on the Board of Academic Consultants of the Federal Reserve Board of Governors as well as the Council of Research Advisors for the Federal National Mortgage Association. In addition, Dr. Saunders has acted as a visiting scholar at the Comptroller of the Currency and at the Federal Reserve Banks of Philadelphia and New York. Currently, he is an academic con- sultant for the FDIC. He also held a visiting position in the research department of the International Monetary Fund. He is editor of Financial Markets, Instruments and Institutions . His research has been published in all the major money and bank- ing and finance journals and in several books. In addition, he has authored or coauthored several professional books, the most recent of which is C redit Risk Measurement: New Approaches to Value at Risk and Other Paradigms, 3rd edition, John Wiley and Sons, New York, 2010. In 2008, he was ranked as the most published author in the last 50 years in the top seven journals in finance. Marcia Millon Cornett M arcia Millon Cornett is a Professor of Finance at Bentley University. She received her BS degree in Economics from Knox College in Galesburg, Illinois, and her MBA and PhD degrees in Finance from Indiana University in Bloomington, Indiana. Dr. Cornett has written and published several articles in the areas of bank performance, bank regulation, and corporate finance. Articles authored by Dr. Cornett have appeared in such academic journals as the Journal of Finance, the J ournal of Money, Credit and Banking, the Journal of Financial Economics, Financial Management, and the J ournal of Banking and Finance. In 2008, she was ranked as the 124th most published author in the last 50 years in the top seven journals in finance. Dr. Cornett served as an Associate Editor of Financial Management and is currently an Associate Editor for the Journal of Financial Services Research, FMA Online, the Multinational Finance Journal and the Review of Financial Economics. She has served as a member of the Board of Directors, the Executive Committee, and the Finance Committee of the SIU Credit Union. Dr. Cornett has also taught at the University of Colorado, Boston College, Southern Methodist University, and Southern Illinois University at Carbondale. She is a member of the Financial Management Association, the American Finance Association, and the Western Finance Association. vi Preface T he last 20 years have been dramatic for the financial services industry. In the 1990s and 2000s boundaries between the traditional industry sectors, such as com- mercial banking and investment banking, broke down, and competition became increasingly global in nature. Many forces contributed to this breakdown in inter- industry and intercountry barriers, including financial innovation, technology, taxation, and regulation. Then in 2008–2009, the financial services industry expe- rienced the worst financial crisis since the Great Depression. It is in this context that this book is written. Although the traditional nature of each sector’s product activity is analyzed, a greater emphasis is placed on new areas of activities such as asset securitization, off-balance-sheet banking, international banking, and on changes occurring as a result of the financial crisis. W hen the first edition of this text was released in 1994, it was the first to analyze modern financial institutions management from a risk perspective. Thus, the title, Financial Institutions Management: A Modern Perspective. At that time, traditional texts presented an overview of the industry sector by sector, concentrating on bal- ance sheet presentations and overlooking management decision making and risk management. Over the last seventeen years other texts have followed this change, such that a risk management approach to analyzing modern financial institutions is now well accepted. Thus, the title: Financial Institutions Management: A Risk Management Approach. The seventh edition of this text takes the same innovative approach taken in the first six editions and focuses on managing return and risk in modern financial institutions (FIs). Financial Institutions Management ’s central theme is that the risks faced by FI managers and the methods and markets through which these risks are managed are similar whether an institution is chartered as a commercial bank, a savings bank, an investment bank, or an insurance company. A s in any stockholder-owned corporation, the goal of FI managers should always be to maximize the value of the financial institution. However, pursuit of value maximization does not mean that risk management can be ignored. I ndeed, modern FIs are in the risk management business. As we discuss in this book, in a world of perfect and frictionless capital markets, FIs would not exist and individuals would manage their own financial assets and portfolios. But since real-world financial markets are not perfect, FIs provide the positive function of bearing and managing risk on behalf of their customers through the pooling of risks and the sale of their services as risk specialists. INTENDED AUDIENCE Financial Institutions Management: A Risk Management Approach is aimed at upper- level undergraduate and MBA audiences. Occasionally there are more technical sections that are marked with a footnote. T hese sections may be included or dropped from the chapter reading, depending on the rigor of the course, without harming the con- tinuity of the chapters. vii viii Preface MAIN FEATURES Throughout the text, special features have been integrated to encourage student interaction with the text and to aid in absorbing the material. Some of these fea- tures include: • In-chapter Internet Exercises and references, which detail instructions for accessing important recent financial data online. • International material highlights, which call out material relating to global issues. • In-chapter Examples, which provide numerical demonstrations of the analytics described in various chapters. • Bold key terms and marginal glossary, which highlight and define the main terms and concepts throughout the chapter. • In-chapter Concept Questions, which allow students to test themselves on the main concepts within each major chapter section. • Notable Events from the Financial Crisis, Industry Perspectives, and Technology in the News boxes, which demonstrate the application of chapter material to real current events. ORGANIZATION Since our focus is on return and risk and the sources of that return and risk, this book relates ways in which the managers of modern FIs can expand return with a managed level of risk to achieve the best, or most favorable, return-risk outcome for FI owners. C hapter 1 introduces the special functions of FIs and takes an analytical look at how financial intermediation benefits today’s economy. Chapters 2 through 6 provide an overview describing the key balance sheet and regulatory features of the major sectors of the U.S. financial services industry. We discuss depository institutions in Chapter 2, insurance institutions in Chapter 3, securities firms and investment banks in Chapter 4, mutual funds and hedge funds in Chapter 5, and finance companies in Chapter 6. In Chapter 7 we preview the risk measurement and management sections with an overview of the risks facing a modern FI. We divide the chapters on risk measurement and management into two sections: mea- suring risk and managing risk. In Chapters 8 and 9 we start the risk measurement section by investigating the net interest margin as a source of profitability and risk, with a focus on the effects of interest rate volatility and the mismatching of asset and liability durations on FI risk exposure. In Chapter 10 we analyze market risk, a risk that results when FIs actively trade bonds, equities, and foreign currencies. In Chapter 11 we look at the measurement of credit risk on individual loans and bonds and how this risk adversely impacts an FI’s profits through losses and provisions against the loan and debt security portfolio. In Chapter 12 we look at the risk of loan (asset) portfolios and the effects of loan concentrations on risk exposure. Modern FIs do more than generate returns and bear risk through traditional maturity mismatching and credit extensions. They also are increasingly engaging in off-balance-sheet activities to generate fee income (Chapter 13) pursuing Preface ix foreign exchange activities and overseas financial investments (Chapter 14), engaging in sovereign lending and securities activities (Chapter 15), and making technological investments to reduce costs (Chapter 16). Each of these has implications for the size and variability of an FI’s profits and/or revenues. In addition, as a by-product of the provision of their interest rate and credit intermediation services, FIs face liquidity risk. We analyze the special nature of this risk in Chapter 17. I n Chapter 18 we begin the risk management section by looking at ways in which FIs can insulate themselves from liquidity risk. In Chapter 19 we look at the key role deposit insurance and other guaranty schemes play in reducing liquid- ity risk. At the core of FI risk insulation is the size and adequacy of the owners’ capital or equity investment in the FI, which is the focus of Chapter 20. Chapter 21 analyzes how and why product and geographic diversification—both domestic and international—can improve an FI’s return-risk performance and the impact of regulation on the diversification opportunity set. Chapters 22 through 26 review various new markets and instruments that have been innovated or engineered to allow FIs to better manage three important types of risk: interest rate risk, credit risk, and foreign exchange risk. These markets and instruments and their strategic use by FIs include futures and forwards (Chapter 22); options, caps, floors, and collars (Chapter 23); swaps (Chapter 24); loan sales (Chapter 25); and securitiza- tion (Chapter 26). CHANGES IN THIS EDITION Each chapter in this edition has been revised thoroughly to reflect the most up-to-date information available. End-of-chapter questions and problem mate- rial have also been expanded and updated to provide a complete selection of testing material. The following are some of the new features of this revision: • Discussion of the financial crisis has been added throughout the book. Virtually every chapter includes new material detailing how the financial crisis affected risk management in financial institutions. • Appendix 1A now describes events leading up to the financial crisis, events occurring at the peak of the crisis, and events associated with the aftermath of the financial crisis, including changes to financial institutions, the impact on U.S. and world economies, federal financial and fiscal rescue efforts, and pro- posed regulatory changes. • Appendix 2A has been added that describes the process of financial ratio analy- sis for financial institutions. • Early chapters include discussions of major firms that have been lost or dramatically altered as a result of the financial crisis, e.g., the failure of Bear Stearns, Lehman Brothers, and AIG, the conversion of Goldman Sachs, Morgan Stanley, GMAC, and CIT Group to bank holding companies, the failure of the Reserve Primary Money Market Fund, and the failure of CIT Group. • The early chapters include discussions of the current state of the various seg- ments of the financial institutions industry. • Major changes proposed for the regulation of financial institutions are included where appropriate throughout the book. x Preface • Chapter 5 includes a discussion of major scandals in some hedge funds, includ- ing Bernard L. Madoff Investment Securities and Galleon Group LLC. • Integrated Minicases have been added to Chapters 9, 10, 12, and 22. • New boxes highlighting “Notable Events from the Financial Crisis” have been added to chapters throughout the book. • Chapter 17 includes a discussion of the liquidity crisis experienced by financial institutions during the financial crisis. • Chapter 19 includes a discussion of new deposit insurance coverage and pre- mium rules as well as the FDIC’s attempts to deal with the liquidity crisis. • Chapter 20 includes a discussion of the TARP Capital Purchase Program and stress tests on the major commercial banks in 2009. • Chapters 21 and 22 in the previous editions of the text have been combined so that product and geographic expansion are viewed as part of an overall expan- sion strategy for financial institutions rather than as independent activities. • Chapters 22 through 26 each include a discussion of the role of derivative securities in the financial crisis, including the roles of swaps (especially credit default swaps), collateralized mortgage, and collateralized debt obligations. • Chapter 26 includes a new section on special purpose entities (SPEs) and struc- tured investment vehicles (SIVs), as well as the federal government takeover of Fannie Mae and Freddie Mac. • Tables and figures in all chapters have been revised to include the most recently available data. We have retained and updated these features: • The risk approach of F inancial Institutions Management has been retained, keep- ing the first section of the text as an introduction and the last two sections as a risk measurement and risk management summary, respectively. • W e again present a detailed look at what is new in each of the different sec- tors of the financial institutions industry in the first six chapters of the text. We have highlighted the continued international coverage with a global issues icon throughout the text. • Chapter 16 includes material on electronic technology and the Internet’s impact on financial services. Technological changes occurring over the last two decades have changed the way financial institutions offer services to customers, both domestically and overseas. The effect of technology is also referenced in other chapters where relevant. • Coverage of Credit Risk models (including newer models, such as KMV, CreditMetrics, and CreditRisk ⫹ ) remains in the text. • Coverage in the “Product and Geographic Expansion” chapter explores the increased inroads of banks into the insurance field, the move toward nation- wide banking (in the United States), and the rapid growth of foreign banks and other intermediaries in the United States. • Numerous highlighted in-chapter Examples remain in the chapters. • Internet references remain throughout each chapter as well as at the end of each chapter, and Internet questions are found after the end-of-chapter questions. • An extensive problem set, including Web exercises, can be found at the end of each chapter that allows students to practice a variety of skills using the same data or set of circumstances.