BANKING – THE SCRIPT

Final exam: Week 6-15 (Chapter 7, Chapter 10, Chapter 11, Chapter 12, Chapter 14, Chapter 15,
Chapter 19, Chapter 20) + Teaching materials

WEEK 5: CHAPTER 7, CHAPTER 14, INVESTMENTS ANALYSIS METHODS

+ TEXTBOOK: CHAPTER 7

PRESENTATION: CHAPTER 7: RISK MANAGEMENT FOR CHANGING INTEREST RATES:

ASSET-LIABILITY MANAGEMENT AND DURATION TECHNIQUES

What types of Asset-Liability Management Strategies are there and briefly explain their principle?

The following asset-liability management strategies exist:

1. Asset Management Strategy – control over assets, no control over liabilities,

2. Liability Management Strategy – control over liabilities by changing rates and other terms,
3. Funds Management Strategy – works with both strategies

What is the Price risk?

Price risk: when interest rates rise, the market value of the bond or asset falls.

What is the Reinvestment risk?

When interest rates fall, the coupon payments on the bond are reinvested at lower rates.
What are ‘interest rates’?

Interest rates are the prices of credit. They are demanded by lenders as compensation for the use of
borrowed funds and are expressed in percentage points and basis points (1/100 of a percentage
point).

They can be measured by using YTM or Bank Discount Rate ?

What is the Yield to Maturity (YTM)?

Yield to Maturity is the discount rate that equalizes the current market value of a loan or security
with the expected stream of future income payments that the loan or security will generate.

What is the Bank Discount rate?

Bank discount rate is another popular interest rate measure. It is often quoted on short-term loans
and money market securities (such as Treasury bills).
The DR measure ignores the effect of compounding and is based on a 360-day year.

- Unlike the YTM measures, which assumes a 365-day year and assumes that interest income
is compounded at the calculated YTM
- The DR measure uses the face value of a financial instrument to calculate its yield or rate of
return, which makes calculations easier but is theoretically incorrect
- The purchase price of a financial instrument is a much better base to use in calculating the
instrument’s true rate of return

What are market interest rates?

Market interest rates are a function of:

1. Risk-free real rate of interest and

2. Various risk premiums:
a. Default risk,
b. Inflation risk,
c. Liquidity risk,
d. Call risk,
e. Maturity risk
What is a Yield Curve?

Yield curves are:

- Graphical pictures of the relationship between yields and maturities of securities,

- They are generally created with treasury securities to keep default risk constant,

What are the possible shapes of the Yield Curve?

Shapes of the yield curve:

- Upward: long-term rates are higher than short-term rates – revenues from longer-term
assets will outstrip expenses from shorter-term liabilities. The result will normally be a
positive net interest margin (interest revenues greater than interest expenses) ; financial
institutions that focus on lending fare somewhat better with this slope
- Downward: long-term rates are lower than short-term rates (relatively small or even
negative net interest margin),
- Horizontal: long-term rates and short-term rates are equal (relatively small or even negative
net interest margin)

What is Gap Management?

Gap management is one of the most popular interest rate hedging strategies in use today. These
techniques require management to perform an analysis of the maturities and repricing opportunities
associated with interest-bearing assets and with interest-bearing liabilities.

If management feels its institution is excessively exposed to interest rate risk, it will try to match as
closely as possible the volume of assets that can be repriced as interest rates change with the
volume of liabilities whose rates can also be adjusted with market conditions during the same time
period.
What is IS GAP and how is it measured?

IS GAP is the interest-sensitive gap. There are two ways to measure it:

1. Dollar IS GAP:
a. If interest-sensitive assets (ISA) are $ 150 million and interest-sensitive liabilities (ISL)
are $ 200 million, then
b. The Dollar IS GAP = ISA – ISL = $150 million - $200 million = -$50 million
c. An institution whose Dollar IS GAP is positive is asset sensitive, while a negative
Dollar IS GAP describes a liability-sensitive condition.
2. Relative IS GAP Ratio:
a. A Relative IS GAP greater than 0 means that institution is asset sensitive, while a
negative relative IS GAP describes a liability-sensitive financial firm
 3. Interest Sensitivity Ratio (ISR)
a. An ISR of greater than 1 tells us we are looking at a asset-sensitive institution, while
an ISR less than one points to an liability-sensitive institution.
b. Only if interest-sensitive assets and liabilities are equal is a financial institution
relatively insulated from interest rate risk

What decisions must a management make, considering the gapping methods used today?

All methods require financial managers to make some important decisions:

1. Management must choose

a. the time period during which the net interest margin (NIM) is to be managed to
achieve some desired value and
b. the lengths of sub-periods (“maturity buckets”) into which the planning period is to
be divided
2. Management must choose a target level for the net interest margin
3. If management wishes to increase the NIM, it must either
a. Develop a correct interest rate forecast, or
b. Find ways to reallocate earning assets and liabilities to increase the spread between
interest revenues and interest expenses
4. Management must determine the volume of interest-sensitive assets and interest-sensitive
liabilities it wants the financial firm to hold

What factors influence the NIM (Net-interest margin)?

The net interest margin (NIM) is influenced by multiple factors:

1. Changes in the level of interest rates,

2. Changes in the spread between asset yields and liability costs,
3. Changes in the volume of interest-bearing (earning) assets a financial institution holds as it
expands or shrinks the overall scale of its activities,
4. Changes in the volume of interest-bearing liabilities that are used to fund earning assets as a
financial institution grows or shrinks in size,
 5. Changes in the mix of assets and liabilities that management draws upon as it shifts between
floating and fixed-rate assets and liabilities, between shorter and longer maturity assets and
liabilities and between assets bearing higher versus lower expected yields

How is NII (Net-interest income) calculated?

What is the cumulative gap?

Cumulative gap is the total difference in dollars between those assets and liabilities that can be
repriced over a designated period of time.

It is a useful overall measure of interest rate risk exposure.

How can the change of NII be calculated?

What problems are associated with interest-sensitive GAP Management?

As follows:

- Interest paid on liabilities tend to move faster than interest rates earned on assets,
- The interest rate attached to bank assets and liabilities do not move at the same speed as
market interest rates,
- The point at which some assets and liabilities are repriced is not easy to identify,
- The interest-sensitive gap does not consider the impact of changing interest rates on equity
positions
What is ‘Duration’?

Duration is a value-weighted and time-weighted measure of maturity that considers the timing of all
cash inflows from earnings assets and all cash outflows associated with liabilities.

It measures the average maturity of a promised stream of future cash payments

What is Net Worth (NW) equal to?

The net worth (NW) of any business or household is equal to the value of its assets less the value of
its liabilities:

NW = A – L

As market interest rates change, the value of both a financial institution’s assets and its liabilities will
change, resulting in a change in its net worth.
What does the portfolio theory teach us?

The portfolio theory teaches us that:

- A rise in market rates of interest will cause the market value (price) of both fixed-rate assets
and liabilities to decline
- The longer the maturity of a financial firm’s assets and liabilities, the more they will tend to
decline in market value (price) when market interest rates rise

How can duration be used to stabilize the market value of a financial institution’s net worth?

By equating asset and liquidity durations, management can balance the average maturity of
expected cash inflows from assets with the average maturity of expected cash outflows associated
with liabilities.

Thus, duration analysis can be used to stabilize, or immunize, the market value of financial
institution’s net worth.

Why is Duration important as a risk-management tool?

The important feature of duration from risk-management point of view is that it measures the
sensitivity of the market value of financial instruments to changes in interest rates.

The percentage change in the market price of an asset or a liability is equal to its duration times the
relative change in interest rates attached to that particular asset or liability.
What is ‘Convexity’?

Convexity refers to the presence of a nonlinear relationship between changes in an asset’s price and
changes in market interest rates.

It captures the relationship between an asset’s change in price and its change in yield or interest
rate. It is a number designed to aid portfolio managers in measuring and controlling the market risk
in a portfolio of assets.

Convexity increases with the duration of an asset. It tells us that the rate of change in any interest-
bearing asset’s price (market value) for a given change in interest rate varies according to the
prevailing level of interest rates.
 SHOULD PRACTICE THE PROBLEMS IN THIS
PRESENTATION
What are the limitations of duration gap management?

The limitations of duration gap management:

- Finding assets and liabilities of the same duration can be difficult,

- Some assets and liabilities may have patterns of cash flows that are not well defined,
- Customer prepayments may distort the expected cash flows in duration,
- Customer defaults may distort the expected cash flows in duration,
- Convexity can cause problems

PRESENTATION: CHAPTER 14: INVESTMENT BANKING, INSURANCE, AND OTHER

SOURCES OF FEE INCOME
List some examples of fee income a bank can earn.

Revenues derived from charging customers for the particular services they use:

- Monthly service charges on transaction accounts,

- Commissions for providing insurance coverage for homes and businesses,
- Membership fees for accepting and using a particular credit or debit card,
- Fees for providing financial advice to individuals and corporations,
- “Swipe fees” at the point of sale

Why are financial firms optioning out to generate more fee income?

Several motives:

- A desire to supplement traditional sources of funds (such as deposits) when these sources
are inadequate,
- An attempt to lower production costs by offering multiple services using the same facilities
and resources (economies of scope),
- An effort to offset higher production costs by asking customer to absorb a larger share of the
cost of both old and new financial services,
- A desire to reduce overall risk to the financial-service provider’s cash flow by finding new
sources of revenue not highly correlated with revenues from sale of traditional services,
- A goal to promote cross-selling of traditional and new services in order to further enhance
revenue and net income

What are the Key Investment Banking Services?

Key investment banking services:

- Security underwriting:
o The purchase for resale of new stocks, bonds, and other financial instruments in the
money and capital markets on behalf of clients who need to raise new money,
o One of the most profitable underwriting services – initial public offerings (IPOs)
- Leveraged buyouts (LBOs)
 o Involve the acquisition of a company, usually by a small group of investors, and
typically are funded by large amounts of debt,
- Recently, many investment banks jumped into the hedge fund business

What services are provided by investment banks (IBs)? Who are their principal clients?

The primary role of investment bankers is to serve as financial advisers to corporations,

governments and other large institutions.

Investment banks perform the following services:

1. Securities underwriting,
2. Advising clients regarding M&As,
3. Creating and trading in derivatives,
4. Brokering loan sales,
5. Setting up special purpose entities,
6. Stock and bond trading,
7. Currency and commodity trading,
8. Issuing credit and liquidity enhancements, and
9. Developing business plans

What advantages do commercial banks with investment banking affiliates appear to have over
competitors that do not offer investment banking services? Possible disadvantages?

Advantages:

1. IB services complement traditional lending services, allowing commercial banking firms to

offer both conventional loans and securities to clients seeking to raise new funds,
2. Economies in information gather about clients,

Disadvantage:

1. IB services are highly sensitive to fluctuations in the economy,

2. Increase of the risk exposure of the commercial bank

What sorts of problems can investment banker assist his client with?

Examples of client questions that investment bankers can assist in answering:

- Should we (the investment bank’s clients) attempt to raise new capital? If so, how much,
where, and how do we go about this fund-raising task?
- Should our company enter new market areas at home or abroad? If so, how can we best
accomplish this market-expansion strategy?
- Does our company need to acquire or merge with other firms? Which firms and how? And
when is the best time to do so?
- Should we sell our company to another firm? If so, what is our company worth? And how do
we find the right buyer?

Describe mutual fund investment products.

Mutual fund investment products are one of the most popular of the investment products. Each
share in a mutual fund permits an investor to receive a pro rata share of any dividends or other
forms of income generated by a pool of stocks, bonds, or other securities the fund holds.
If a mutual fund is liquidated, each investor receives a portion of the net asset value (NAV) of the
fund after its liabilities are paid off, based on the number of shares each investor holds.

Describe Annuity Investment Products.

Annuities are a hedge against living too long and outlasting one’s savings. Fixed annuities promise a
customer who contributes a lump-sum of savings a fixed rate of return over the life of the annuity
contract.

Variable annuities allow investors to invest a lump-sum of money in a basket of stocks, mutual
funds, or other investments under a tax-deferred agreement, but there may be no promise of a
guaranteed rate of return.

Recently a new type of annuity contract has appeared, the equity-index annuity. It combines the
features of both fixed and variable annuities.

One advantage for financial firms selling this service is that annuities often carry substantial annual
fees. One significant disadvantage with annuities sold through depository institutions is they
typically compete with selling deposits.

What is ‘Convergence’?

Convergence is a strategic move which entails a merger between two or more different industry
types.

One possible benefit is the relatively low correlation that may exist between cash flows or revenues
generated by the sale of traditional industry products versus the sale of non-traditional products.

What are the benefits of financial-services diversification:

As follows:

- Relatively low correlation that may exist between cash flows or revenues generated by the
sale of traditional industry products versus the sale of non-traditional products. This means
that the portfolio including both of these products may be able to stabilize combined cash
flows and profitability. The risk of failure might also be reduced.
- Economies of scale and economies of scope

What is Economies of scope?

Economies of scope refer to a situation in which the joint costs of producing two or more services in
one firm are less than combined cost of producing each of these services through separate firms.

PRESENTATION: INVESTMENT ANALYSIS METHODS – EVALUATION MODELS AND

ASSET MANAGEMENT OF INVESTMENTS

What methods of investment analysis exist?

As follows:

- Payback period,
- Discounted payback period,
- Net present value,
- IRR (Internal Rate of Return),
 - Index of Profitability (PI),
- Crietrion of annuities

KOMPLETIRAJ AKO TI SE BUDE DALO

WEEK 6: CHAPTER 11, CHAPTER 11_1 + TEXTBOOK: CHAPTER 11

PRESENTATION: CHAPTER 11: LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES

AND POLICIES

When is a financial firm liquid?

A financial firm is considered to be “liquid” if it has ready access to immediately spendable funds at
reasonable cost at precisely the time those funds are needed.

This suggests that a liquid financial firm either has:

- The right amount of immediately spendable funds on hand when they are required,
- They can raise liquid funds in timely fashion by borrowing or selling assets

Explain the Demand for and Supply of Liquidity.

Demands for Liquidity:

- Customer deposit withdrawals,

- Credit requests from quality loan customers,
- Repayment of non-deposit borrowings,
- Operating expenses and taxes,
- Payment of stockholder dividends

Supplies of Liquid Funds:

- Incoming customer deposits,

- Revenues from the sale of nondeposit services,
- Customer loan repayments,
- Sales of bank assets,
- Borrowings from the money market
What is the essence of liquidity management problems for financial institutions?

The essence of liquidity management problems for financial institutions:

1. Rarely are demands for liquidity equal to the supply of liquidity at any particular moment in
time.
a. The financial firm must continually deal with either a liquidity deficit or a liquidity
surplus
2. There is a trade-off between liquidity and profitability
a. The more resources are tied up in readiness to meet demands for liquidity, the
lower is that financial firms’ expected profitability (other factors held constant)

List the reasons why financial firms often face significant liquidity problems.

As follows:

- Imbalances between maturity dates of their assets and liabilities,

- High proportion of liabilities (especially demand deposits and money market borrowings) are
subject to immediate repayment,
- Sensitivity to changes in interest rates:
o May affect customer demand for deposits,
o May affect customer demand for loans
- Central role in the payment process, reputation and public confidence in the system

Identify strategies for liquidity management.

As follows:

- Asset Liquidity Management or Asset Conversion Strategy:

o This strategy calls for storing liquidity in the form of liquid assets (T-bills, fed funds
loans, CDs, etc.) and selling them when liquidity is needed
- Borrowed Liquidity or Liability Management Strategy
o This strategy calls for the bank to purchase or borrow from the money market to
cover all of its liquidity neds
- Balance Liquidity Strategy
o The combined use of liquid asset holdings (Asset Management) and borrowed
liquidity (Liability Management) to meet liquidity needs
What Guidelines should liquidity managers follow to ensure the company liquidity?

As follows:

- Keep track of all fund-using and fund-raising departments,

- Know in advance withdrawals by the biggest credit or deposit customers,
- Priorities and objectives for liquidity management should be clear,
- Liquidity needs must be evaluated on a continuing basis

What approaches are used for estimation of liquidity needs?

As follows:

- Sources and Uses of Funds Approach

o Loans and deposits must be forecast for a given liquidity planning period,
o The estimated change in loans and deposits must be calculated for the same
planning period,
o The liquidity manager must estimate the bank’s net liquid funds by comparing the
estimated change in loans to the estimated change in deposits
- Structure of Funds Approach
o A Bank’s deposits and Other Sources of Funds Divided into Categories
o Liquidity manager set aside liquid funds according to some operating rule
- Liquidity Indicator Approach
o Cash position indicator,
o Liquid securities indicator,
o Net federal funds and REPO agreements position,
o Capacity ratio,
o Pledged securities ratio,
o Hot money ratio,
o Deposit brokerage index,
o Core deposit ratio,
o Deposit composition ratio,
o Loan commitments ratio
- The Ultimate Standard for Assessing Liquidity
o Liquidity managers should closely monitor the following market signals:
 Public confidence,
 Stock price behaviour,
 Risk premiums on CDs and other borrowings,
 Loss sales of assets,
 Meeting commitments to credit customers,
 Borrowings from the central bank

When is financial institution adequately liquid?

A financial institution is adequately liquid when:

- It has adequate cash available,

- Precisely when cash is needed
- At a reasonable cost

Why do financial firms face significant liquidity management problems?

Due to:

1. Maturity mismatch (imbalance of maturity dates) between assets and liabilities,

2. The sensitivity of changes of their assets and liabilities values towards market interest rate
movement, and
3. The central role in the payments process

How does the sources and uses of funds approach help a manager estimate a financial institution’s
need for liquidity?

The sources and uses of funds approach estimates future deposit inflows and estimated outflows of
funds associated with expected loan demand and calculates the net difference between these items
in each planning period.

When sources and uses of liquidity do not match, there is a liquidity gap, measured by the size of the
difference between sources and uses of funds, and it can be:

- Positive (sources of liquidity have higher value than uses of liquidity, and
- Negative (sources of liquidity have lower value than uses of liquidity)

What steps are needed to carry out the structure of funds approach to liquidity management?

As follows:

1. The sources of funds are divided into categories based on their estimated probability of
being withdrawn,
2. Liquidity manager estimates net liquid funds, considering some operating rules for those
categories

What is liquidity indicator approach to liquidity management?

The liquidity indicator approach is the estimation of liquidity needs based upon experience and
industry averages. It uses tell-tale financial ratios whose changes over time may reflect the changing
liquidity position of the financial institution.

What are ‘legal reserves’?

Legal reserves are those assets that law and central bank regulation say must be held during a
particular time period.
What is a ‘Sweep Account’?

A sweep account is a contractual account between a bank and a customer that permits the bank to
move funds out of the customer’s checking account overnight in order to generate higher returns for
the customer and lower reserve requirements for the bank. Two types:

- Retail Sweep
- Business Sweep

What factors affect the choice of different sources of reserves?

In choosing which source of reserves to draw upon to cover a legal reserve deficit, managers must
carefully consider several aspects of their institution’s need for liquid funds:

1. Immediacy of need,
2. Duration of need,
3. Access to the market for liquid funds,
4. Relative costs and risks of alternative sources of funds,
5. The interest rate outlook,
6. Outlook for central bank monetary policy,
7. Rules and regulations applicable to a liquidity source

CHAPTER 11/12: MANAGING AND PRICING DEPOSIT SERVICES

What are the two key issues that every bank or other depository institution must deal with in
managing the public’s deposits?
As follows:

- Where can funds be raised at the lowest possible cost?, and

- How can management ensure that the institution always has enough deposits to support the
volume of loans and other investment and services the public demands?

What are some of the major types of deposits?

As follows:

- Transaction deposits,
- Non-transaction deposits,
- Interest bearing deposits,
- Non-interest bearing deposits,
- Retirement savings deposits

What are transaction deposits?

Transaction deposits are also known as demand deposits. They are one of the oldest services offered
by a bank. The service provider has to honor any withdrawal by the customer and is most commonly
used in online banking with cellphone.

There are two types of transaction deposits:

- Interest bearing transaction deposits:

o Negotiable Order of Withdrawal (NOW) accounts,
o Money Market Deposit Account (MMDA), and
o Super NOW (SNOW)
- Non-interest bearing transaction deposits:
o They are the most volatile type of deposits, and
o Are majorly held by businesses

What types of non-transaction deposits exist?

As follows:

- Passport saving account,

- Time deposit,
- Certificate of Deposit (CD), and
- Statement saving deposit

List some characteristics of non-transaction deposits.

As follows:

- They are long-term,

- They have higher interest rates than transaction deposits,
- For a bank, they are easier to process and manage

Why are core deposits important?

The reasons:

- They are not highly sensitive to the market interest rates,

- They can be withdrawn immediately but often have long maturities,
 - They are the least expensive source of funds

Describe the essential differences between the following deposit pricing methods in use today:
cost plus pricing, conditional pricing, and relationship pricing.

Cost-plus pricing model price of a product (deposit account) assumes the determination of the price
by adding operating expense, overhead, and planned margin.

Conditional pricing of deposits assumes that a depository sets up a schedule of fees. Customer pays
a low fee or no fee if the deposit balance remains above some minimum level, but faces a higher fee
if the average balance falls below that minimum. Thus, the customer pays a price conditional on how
he or she uses the deposit.

Relationship pricing assumes pricing deposits taking into consideration the number of services
customer uses – customer receives lower fees if they purchase more than one service. Emphasis is
on the creation of customer loyalty, making the customer less sensitive to price changes of other
institutions.

What factors do household depositors rank most highly in choosing a financial firm for their
checking account?

As follows:

- Convenient location,
- Availability of other services,
- Safety,
- Low fees and low minimum balance,
- High deposit interest rates

What factors do household depositors rank most highly in choosing a financial firm for their
savings account?

As follows:

- Familiarity,
- Interest rate paid,
- Transactional convenience,
- Location,
- Availability of Payroll Deduction,
- Fees Charged

What factors do household depositors rank most highly in choosing a financial firm for their
business firms?

As follows:

- Financial health of lending institution,

- Whether bank will be a reliable source of credit in the future,
- Quality of bank officers,
- Whether loans are competitively priced,
- Quality of financial advice given,
- Whether cash management and operations services are provided
What is lifeline banking? What pressures does it impose on the managers of banks and other
financial institutions?

Services for low income customers, should every adult citizen be guaranteed access to certain basic
financial services such as checking accounts and personal loans.

Pressures:

- Possible default on loans,

- Unreliable customers,
- Fees and interest rates too low to support low income customers

What does underbanked and unbaked mean?

Underbanked – having access to some critical services but not others reslay on payday loans, check
cashing firms … to pay their bills

Unbanked – no deposits or loans of any kind

WEEK 7: THE RISK MANAGEMENT PRESENTATIONS

RISK MANAGEMENT: THE PAPER

What is risk management and what does it cover?

Risk management can be defined as a risk insurance function of a bank that covers following
activities:

- Risk exposure identification for all asset categories with the potential loss estimation,
- Risk assessment, which consists of measurement and analysis of previous losses, so that
variables which will influence the future could be assessed,
- Risk control, trying to decrease or eliminate (if possible) risk of loss using every kind of
securing possibilities,
- Risk financing, by making reserves,
- Administrative techniques development and use of risk management knowledge

What are the major risks in banking?

The major banking risks are:

- Credit risk
- Market risk:
o Interest rate risk,
o Currency exchange risk

What are the main goals of risk management in a bank?

Risk management in a bank has two main goals:

- Avoid insolvency of the bank,

- Maximization of a risk-adjusted rate of return on capital (RAROC)
What are the components of a modern concept of central banking risk management?

As follows:

- Adequate evaluation of credit and market risks,

- Collecting payments that represent price of taking risks from users of banks services,
- Distributing collected payments to reserves and banks capital,
- Covering unexpected risks from the capital,
- Forming risk-based capital,
- Managing a risk portfolio,
- Risk monitoring

What can risk management in a bank be?

It can be:

- Qualitative (based on experienced assessment of banks experts – particularly important for

those risk factors that cannot be quantified)
- Quantitative (used for risk factors that can be quantified)

What are the determinants of the maximum amount of loss for a bank?

As follows:

- Risk exposure,
- Standard deviation,
- Level of tolerance (possibility that the loss will break the projected limit)

What is Value at Risk (VAR)?

Value at risk (VAR) is maximum loss that can occur when given level of tolerance – the value of all
risks that the bank is accepting, the maximum amount of the potential loss which a bank can accept
through its business.

What is CAR?

CAR is the adequate quantitative level of capital at risk. It is the ultimate mean of protection against
insolvency for a bank.

What risks is a bank faced with?

As follows:

- Credit risk,
- Liquidity risk,
- Risk of default,
- Foreign exchange risk,
- Country risk,
- Market risk,
- Operational risk

Describe the credit rating system of the bank.

Credit rating system of the bank is based on grading the quality (grades 1-10) (ability to pay back the
loan) of the client (borrower):
 1. Risk Free – for borrowers whose credit ability is extremely good – world class banks and
successful multinational companies
2. Minimum risk – for borrowers whose credit ability is of high quality – large multinational
companies which have regular cash flows and good liquidity management
3. Moderate risk – for borrowers which have good quality of assets, good liquidity, regular cash
flows and good capacity to repay its debt – larger regional or national companies
4. Below average risk – for borrowers whose business performance are weaker than previous
group of borrowers – good regional and very good local companies,
5. Average risk – borrowers with satisfying asset quality and liquidity, good capacity for
repaying the debt and good management in all critical positions, but with possibility to have
lower income in some years,
6. Risk that should be considered – for borrowers showing above average risk of default,
because of the trend of reduced income (lenders usually request loan securitisation)
7. Potential weakness – for borrowers which show potential weakness completing their loan
responsibilities, but there is no loss yet
8. Definite weakness, but without losses – for borrowers who are definitely showing sings of
weaknesses and that those weaknesses will lead to endangerment of the liquidity to repay
the debt, but there were not losses yet
9. Potential loss – for borrowers with this rating is characteristic that they show all kinds of
weaknesses, which will lead to very high probability of default
10. Loss – for borrowers who are proclaimed incompatible to repay debt, and loans given to
these borrowers are considered to be loss for the bank. This does not mean that the client
will absolutely not repay his debt

How is credit ability estimated?

Borrowers credit ability is estimated using 6C analysis:

1. Character – Characteristics of the borrower,

2. Capacity – borrowers capacity to repay the loan,
3. Cash – borrowers ability to repay the principle and interest regularly,
4. Collateral – ways of securing the approved loans,
5. Condition – conditions of approving the loan
6. Control

What forms does the risk of changes in interest rates has?

The risk of changes in interest rates has essentially two forms:

1. Risk basis, which is used to determine the level of interest rates, when the fundamentals
that determine interest rates on loans and obligations are different
2. Risk time periods in which disagreement leads to changes in interest rates. In the present
conditions banks apply three models estimate the interest rate risk:
a. Model re-establishing the value or the revaluation model (repricing model)
b. Maturity model
c. Duration model

Revaluation model is based on the maturity imbalance position on the assets and liabilities,
considering that their values can be reevaluated due to changes in interest rates.
Maturity model is based on changes in market values of bank assets and liabilities arising from
changes in interest rates. The assets and liabilities are not valued by bookkeeping prices but rather
on a market prices (increase in interest rate = reduction of the market value of bank assets and
liabilities).

Duration model measures the weighted average maturity time of assets and liabilities by using the
relative present values of cash flows as weights. This model emphasizes timing of financial terms of
loans and deposits.

What are the reasons for emergence of risks other than of credit and market?

As follows:

- Higher adoption of automated technology,

- Emergence of e-commerce,
- Outsourcing, and
- Mergers/acquisitions/consolidations

How can operational risk be classified?

The bank’s operational risks can be classified into following six exposure classes:

- People,
- Process,
- Management,
- System,
- Business, and
- External

The human factor involves errors arising from insufficient experience, lack of discipline in adhering
established procedures and policies.

The technical factors involves errors that are typical for certain model that is used in a working
process. These errors arise mostly from non-existence of adequate instruments for measuring risk.

The factors of procedural actions is expressed through absence of adequate procedures for
reporting, monitoring and decision making, as well as inadequate information processing, control of
those processes, lack in organizational scheme, the absence of incentive to avoid excessive exposure
to risk, etc.

The information technology factors are reflected in fact that information system has certain
disadvantages that are not previously noticed, and which can in a certain moment contribute to the
failure or inopportune reaction to the appearance of certain risks.

What are the causes of operational risk?

Some of the important causes of operational risk are:

- Internal frauds due to employees’ intentional involvement,

- External frauds due mainly to robbery and forgery/falsification of documents,
- Workers compensation claims, violation of employee health and safety rules,
- Misuse of confidential customer information, money-laundering, sale of unatuthorized and
unfamiliar products,
- Damage to physical assets due to terrorism, earthquakes, fires and floods,
 - Business disruption and system failures due to software, power or network problems,
- Execution errors on account of wrong data entry or incomplete legal documentation

What are the Basel 2 Approaches to bank operational risk?

As follows:

- The Basic Indicator Approach: requires the bank’s average annual gross income over the
previous 3 years to be multiplied by a factor, determined for each country, to determine the
capital requirement for operational risk
- The Standardized Approach: goes a step further and separates the income streams into eight
business lines. The capital charge is then estimated as an exposure indicator for each line of
business multiplied by a coefficient.
- The Advanced Measurement Approaches: bank uses its own method to asses its exposure to
operational risk. But to migrate to AMA, a bank must satisfy some strict qualitative and
quantitative standards set by the regulator. Some of the important criteria are:
o Well-developed and well-documented risk management systems fully integrated
into the day-to-day risk management process of the bank,
o A system of regular reporting of operational risk exposures and loss experience to
business unit management and the board of directors,
o Maintaining rigorous procedures for operational risk model development and
independent model validation,
o Capability to track loss data, to each business line, and access external data bases of
loss incidents where appropriate internal data are not available

LIQUIDITY AND RESERVE MANAGEMENT: STRATEGIES AND POLICIES

What is liquidity?

Liquidity is the availability of cash in the amount and at the time needed, at a reasonable cost.

List the supplies of liquid funds.

As follows:

- Incoming customer deposits,

- Revenues from the sale of non-deposit services,
- Customer loan repayments,
- Sales of bank assets,
- Borrowings from the money market

List the demands for liquidity.

As follows:

- Customer deposit withdrawals,

- Credit requests from quality loan customers,
- Repayment of non-deposit borrowings,
- Operating expenses and taxes,
- Payment of stockholder dividends

What is the financial firm’s net liquidity position equal to?

L = Supplies of Liquid Funds – Demands for Liquidity

Why do banks and their competitors face significant liquidity problems?

Reasons:

- Imbalances between maturity dates of their assets and liabilities,

- High proportion of liabilities subject to immediate repayment,
- Sensitivity to changes in interest rates,
- Central role in the payment process

What strategies can liquidity managers adopt?

As follows:

- Asset liquidity management or asset conversion strategy: this strategy calls for storing
liquidity in the form of liquid assets and selling them when liquidity is needed
- Borrowed liquidity or liability – management strategy: this strategy calls for the bank to
purchase or borrow from the money market to cover all of its liquidity needs
- Balanced liquidity strategy: the combined use of liquid asset holdings (asset management)
and borrowed liquidity (liability management) to meet liquidity needs

What are the characteristics of liquid asset?

As follows:

- Must have a ready market so it can be converted to cash quickly,

- Must have a reasonably stable price,
- Must be reversible so an investor can recover original investment with little risk

List some options a bank has for storing liquidity.

As follows:

- Treasury bills,
- FED funds sold to other banks,
- Purchasing securities for resale (Repos),
- Deposits with correspondent banks,
- Municipal Bonds and Notes,
- Federal Agency Securities,
- Negotiable Certificates of Deposits

List some of the costs of asset liquidity management.

As follows:

- Loss of future earnings on assets that must be sold,

- Transaction costs on assets that must be sold,
- Potential capital losses if interest rates are rising,
- May weaken appearance of balance sheet,
- Liquid assets generally have low returns

List some of the sources of borrowed funds.

As follows:
 - Federal funds purchased,
- Selling securities for repurchase (repos),
- Issuing large CDs (greater than $100.000),
- Issuing euro-currency deposits,
- Securing advance from the Federal Home Loan Bank,
- Borrowing reserves from the discount window of the Federal Reserve

What methods may be used for estimating liquidity needs?

As follows:

- Sources and uses of funds approach:

o Loans and deposits must be forecast for a given liquidity planning period,
o The estimated change in loans and deposits must be calculated for the same
planning period,
o The liquidity manager must estimate the bank’s net liquid funds by comparing the
estimated change in loans to the estimated change in deposits
- Structure of funds approach:
o A bank’s deposits and other sources of funds are divided into categories,
o Liquidity manager set aside liquid funds according to some operating rule
- Liquidity indicator approach,
- Signals from the marketplace

List and write the formulas for liquidity indicators.

As follows:

1. Cash position indicator (CASH) = Cash and deposits due from other banks / Total assets,
2. Liquid securities indicator = Government (other securities) / Total assets
3. Net Federal Funds position = (Federal Funds sold – Federal Funds purchased) / Total assets
4. Capacity Ratio = Net loans and leases / Total assets
5. Pledged Securities Ratio ?
6. Hot money ratio ?
7. Deposit Brokerage Index ?
8. Core Deposit Ratio,
9. Deposit Composition Ratio = Demand deposits / Time deposits
10. Loan Commitment Ratio

What market signals of liquidity management exist?

As follows:

- Public confidence,
- Stock price behaviour,
- Risk premiums on CDs,
- Loss sales of assets,
- Meeting commitments to creditors,
- Borrowings from the Central bank

What is money position management?

Money position management is the management of a financial institution’s liquidity position that
requires quick decisions which may have long-run consequences on profitability. A money position
manager is responsible for ensuring that the institution maintains an adequate level of legal
reserves.

What is the primary goal of money position management?

The primary goal of money position management is to ensure that:

- The bank has sufficient legal reserves to meet its reserve requirements as imposed by the
central bank, and
- The bank holds not more than the minimum legal requirement because excess legal reserves
yield no income for the bank

What factors should a money position manager consider in meeting a deficit in a depository
institution’s legal reserve account?

As follows:

- Current and expected future levels of interest rates,

- Projected changes in monetary policy,
- Bank’s growing capacity and current holdings of liquid assets,
- The bank’s forecast of future deposit growth and loan demand,
- The expected size and duration of any liquidity deficits and surpluses,
- Knowledge of the future plans of the bank’s clients

What are legal reserves?

Legal resrves are assets that a CB requires depository institutions to hold as a reserve behind their
deposits or other liabilities.

What is Reserve Maintenance Period?

Reserve Maintenance Period is the period of time over which a bank must hold the required amount
of legal reserves that the law demands.

What is the Reserve Computation Period?

It is the period of time over which a bank calculates its legal reserve requirement.

What factors should be considered when choosing among different sources of reserves?

As follows:

- Immediacy of bank’s needs,

- Duration of bank’s needs,
- Bank’s access to market for liquid funds,
- Relative costs and risks of alternatives,
- Interest rate outlook,
- Outlook for Central Bank monetary policy,
- Regulations applicable for liquidity sources

What is a Sweep Account?

Sweep account is a contractual account between bank and customer that permits the bank to move
funds out of a customer’s checking account overnight in order to generate higher returns for the
customer and lower reserve requirements for the bank.
What is Customer Relationship Doctrine?

It is a philosophy which states that management should strive to meet all good loans that walk in the
door in order to build lasting customer relationships.

WEEK 9: CHAPTER 15, INTERNATIONAL PAYMENT SYSTEM

What tasks capital performs?

As follows:

- Provides a cushion against the risk of failure,

- Provides funds to help institutions get started,
- Promotes public confidence,
- Provides funds for growth,
- Regulator of growth,
- Regulatory tool to limit risk exposure

What are the links between capital and risk exposure among financial-service providers?

Capital functions as a cushion to absorb losses until management can correct the problems
generating those losses.

Institutions face many different kinds of risk:

1. Crime risk,
2. Interest-rate risk,
3. Credit risk
4. Liquidity risk
5. Exchange risk
6. Operational risk

Capital represents the ultimate line of defence against these risks when all other defences fail.

What tools can management use as defence against risks?

As follows:

- Quality management,
- Diversification:
o Geographic, and
o Portfolio,
- Deposit insurance,
- Owners’ Capital

List some of the types of capital in use.

As follows:

- Common stock,
- Preferred stock,
- Surplus,
 - Undivided profits,
- Equity reserves,
- Subordinate debentures,
- Minority interest in consolidated subsidiaries,
- Equity commitment notes

What reasons exist that can justify capital regulation?

Reasons for capital regulation:

- To limit risk of failures,

- To preserve public confidence,
- To limit losses to the government and other institution arising from deposit insurance claims

What are the most popular financial ratios regulators use to assess the adequacy of bank capital
today?

As follows:

- Capital to assets,
- Equity capital to assets,
- Total capital to risk assets,
- Primary (core capital) to total assets (permanent capital = core capital, in a manner of
saying)
- Primary (core capital) to risk-adjusted assets
- Secondary (supplementary capital) to total assets
- Secondary (supplementary capital) to risk-adjusted assets

Why was Basel Agreement signed?

Reasons:

- Designed to keep capital positions strong,

- Designed to reduce inequalities in capital requirements among different countries,
- Designed to promote fair competition,
- Designed to catch up with recent changes in financial services and financial innovation

According to Basel I, what is included in Tier 1 (Core) Capital?

As follows:

- Common stock and surplus,

- Undivided profits (retained earnings),
- Qualifying noncumulative perpetual preferred stock,
- Minority interest in the equity accounts of consolidated subsidiaries,
- Selected identifiable intangible assets less goodwill and other intangible assets

According to Basel I, what belongs to Tier 2 (Supplemental) Capital?

As follows:

- Allowance (reserves) for loan and lease losses,

- Subordinated debt capital instruments,
 - Mandatory convertible debt,
- Intermediate-term preferred stock,
- Cumulative perpetual preferred stock with unpaid dividends, and
- Equity notes and other long-term capital instruments that combine both debt and equity
features

According to Basel I, when does a bank qualify as adequately capitalized?

In order for a bank to qualify as adequately capitalized, it must have:

1. A ratio of core capital (Tier 1) to total risk-weighted assets of at least 4%

2. A ratio of total capital (Tier 1 + Tier 2) to total risk-weighted assets of at least 8%, with the
amount of Tier 2 capital limited to 100% of Tier 1 capital.

What changes in the regulation of bank capital were brought into being by the Basel Agreement?
What is Basel I? Basel II?

The Basel Agreement created a set of rules on International Bank Capital Standards, which are
followed by regulatory agencies charged with setting minimum capital requirements and assessment
of the capital adequacy of the financial firms they regulate.

Basel I is the first of the three Basel agreements. Its content elaborates on three topics, also known
as the pillars of the Basel I agreement:

1. Minimum capital requirements,

2. Supervisory review process,
3. Market discipline requirements

The highlight of Basel I was the introduction of the classification of capital into two tiers:

1. Tier 1 (Core capital),

2. Tier 2 (Supplemental capital)

However, the agreement had multiple drawbacks including:

1. Focus on a single risk measure,

2. The framework was not flexible, and was created to fit a financial institution regardless of
the conditions and risks associated with it,
3. Operational risk was not considered

Weaknesses in Basel I led to a Basel II agreement to be gradually phased in. It was focused on solving
the previously listed drawbacks of Basel I:

- It was gave more emphasis on banks internal methodologies, supervisory review and market
discipline,
- It provided flexibility and menu of approaches, along with incentives for better risk
management
- It introduced approaches for credit risk and operational risk in addition to market risk
introduced earlier
- More risk sensitivity

Explain the importance of the concepts of internal risk assessment, VaR, and market discipline.
Internal risk assessment refers to an innovation in Basel II which allows banks to measure their own
risk exposure and determine how much capital they needed to meet that exposure. These
measurement are subject to review by the regulators to ensure they are reasonable.

The VaR (Value at Risk) model is one of the model’s used to determine a bank’s risk exposure. It
measures the price or market risk of a portfolio of assets whose value may decline due to adverse
movements in the financial markets or interest rates.

Market discipline refers to the market determining the bank’s risk exposure. The market’s collective
actions of buying and selling bank’s securities (like subordinate debt) in the financial market provide
an independent assessment of the bank’s financial condition. Since such debt is not guaranteed, the
buyers of such securities would be very vigilant about the bank’s financial condition.

What is VaR model?

VaR or Value at Risk model is a statistical framework for measuring a bank portfolio’s exposure to
changes in market prices or market rates over a given time period, subject to a given probability

What are the limitations and challenges of VaR and Internal modelling?

As follows:

- VaR estimates and internal modelling are not perfect:

o Inaccurate VaR estimates can expose a bank to excessive risk so that its capital
position may turn out not to be large enough to cover actual losses the bank faces,
o The portfolios of the largest banks are so complex with thousands of risk factors it
may be impossible to consistently forecast VaRs accurately
- Promote “backtesting”,
- Even if an individual bank is a good forecaster, there may still be trouble due to systemic risk

What were the drawbacks of Basel I that forced the introduction of Basel II?

As follows:

- Capital arbitrage:
o Instead of making banks less risky, parts of Basel I seemed to encourage banks to
become more risky
- Basel I represented a “one size fits all” approach to capital regulation
o It failed to recognize that no two banks are alike in terms of their risk profiles

Basel II set up a system in which capital requirements would be more sensitive to risk and protect
aginst more types of risk than Basel I

What are the pillars of Basel II?

Pillars of Basel II:

1. Minimum capital requirements for each bank based on its own:

a. Estimated risk exposure from credit,
b. Market and
c. Operational risks
2. Supervisory review of each bank’s:
a. Risk-assessment procedures and
b. The adequacy of its capital to ensure they are ‘reasonable’
 3. Greater public disclosure of each bank’s true financial condition so that market discipline
could become more powerful force compelling excessively risky banks to lower their risk
exposure

A difference between Basel I and Basel II:

- Under Basel I, minimum capital requirements remained the same for most types of loans
regardless of credit rating
- Under Basel II, minimum capital requirements were designed to vary significantly with
credit quality

What problems are associated with the implementation of Basel II?

As follows:

- Basel II was not perfect:

o Some forms of risk had no generally accepted measurement scale (operational risk)
- How do we add up the different forms of risk exposure in order to get an accurate picture of
bank’s total risk exposure?
- What should we do about the business cycle
- Some have expressed concern about improving regulator competence

What is the Key issue in Basel III?

The key issue in Basel III: Determining the volume and mix of capital the world’s leading banks
should maintain if their troubled assets generate massive losses.

What is Prompt Corrective Action and what tool is used for its implementation?

Prompt Corrective Action or PCA is used when an insured depository institution’s capital falls below
acceptable levels.

U.S. bank regulators created capital-adquacy categories for implementing PCA:

1. Well capitalized,
2. Adequately capitalized,
3. Undercapitalized,
4. Significantly undercapitalized,
5. Critically undercapitalized

How can a firm raise external capital?

It has several options:

1. Selling common stock,

2. Selling preferred stock,
3. Issuing debt capital,
4. Selling assets,
5. Leasing facilities,
6. Swapping stock for debt securities

What steps should be part of any plan for meeting a long-range need for capital?

As follows:
 1. Develop an overall financial plan,
2. Determine the amount of capital that is appropriate given the goals, planned service
offerings, acceptable risk exposure, and government regulations
3. Determine how much capital can be generated internally
4. Evaluate and choose the source of external capital best suited to the institution’s needs and
goals

What is ICGR?

ICGR or Internal Capital Growth Rate is a ratio of retained earningsto the equity capital of the firm. IT
shows that if we want to increase internally generated capital, we must increase earnings, increase
the earnings retention ratio, or both.

It indicates how fast a firm can allow its assets to grow and still keep its capital-to-asset ratio fixed. IF
the assets grow by a percentage above the ICGR, there is a possibility of capital-to-assets ratio to
rail. If it falls far enough, the regulatory authorities may insist that capital be increased.

What factors should management consider in choosing among the various sources of external
capital?

As follows:

- Impact each source would have on returns on stockholders, measured by EPS,

- Institution’s risk exposure,
- The impact on control by existing stockholders,
- The state of the market for the assets or securities being sold, and
- Regulatory framework

PRESENTATION: INTERNATIONAL PAYMENT SYSTEM

What types of payment systems exist?

As follows:

- Cash payment,
- Non-cash payment,
- Electronic transfer of money

What are the main focuses of electronic money development?

As follows:

- Being able to use it through a wider range of hardware such as secured credit cards,
- Linked bank accounts that would generally be used over an internet means, for exchange
with a secure micropayment systems such as in large corporations

List some of the instruments of international payment system.

As follows:

- Documentary letter of credit,

- Orders,
 - Documentary collection,
- Payment by checks,
- International letter of credit

WEEK 10: ELECTRONIC BANKING, CAHPTER 10 AND CHAPTER 14

PAPER: ELECTRONIC BANKING

What is E-banking?

E-banking is defined as the automated delivery of new and traditional banking products and services
directly to customers through electronic, interactive communication channels.

What is EFT and what is it used for?

EFT or Electronic fund transfer uses computer and electronic technology in place of checks and other
paper transactions. EFTs are initiated through devices like cards or codes that let you, or those you
authorize, access your account.

You can use electronic funds transfer to:

- Have your pay-check deposited directly into your bank or credit union checking account,
- Withdraw money from your checking account from an ATM machine with a personal
identification number (PIN), at your convenience, day or night
- Instruct your bank or credit union to automatically pay certain monthly bills from your
account, such as your loan or your mortgage payment
- Have the bank or credit union transfer funds each month from your checking account to
your mutual fund account
- Have your government social security benefits check or your tax refund deposited directly
into your checking account,
- Buy groceries, gasoline and other purchases at the point-of-sale, using a check card rather
than cash, credit or a personal check
- Use a smart card with a prepaid amount of money embedded in it for use
- Use your computer and personal finance software to coordinate your total personal financial
management process

List some of the common EFT services.

As follows:

- ATMs (Automated teller machines): electronic terminals that let you bank almost virtually
any time
- Direct deposit: lets you authorize specific deposits – like pay-checks, social security checks
and other benefits – to your account on a regular basis
- Pay-by-Phone System: lets you call your financial institution with instructions to pay certain
bills or to transfer funds between accounts
- PC banking or internet banking: lets you handle many banking transactions using your PC
- Debit Card Purchase or Payment Transactions: let you make purchases or payments with a
debit card, which also may be your ATM card
 - Electronic Check Conversion: converts a paper check into an electronic payment in a store or
when a company gets your check in the mail

What is electronic currency and what are its types?

Digital (electronic) currency refers to any exchange of money that takes place electronically through
a secured network.

There are four primary types of electronic money instruments:

- Electronic fund transfers,

- Payment cards,
- Internet payments, and
- Mobile payments

What types of electronic terminals are used for EFTs?

As follows:

- Computer,
- A credit, debit or prepaid card,
- An ATM,
- A Point-of-sale (POS) device,
- A smartphone

How are payment cards classified?

Payment cards are classified according to the level of restrictions and benefits granted to the holder
by the card issuer:

1. Credit cards,
2. Debit cards
3. Prepaid cards

All three card types allow holders to make purchases in store or online and to withdraw cash at an
ATM. Credit and debit cards are tied to a bank account and provide more flexibility in terms of
spendable amounts, though many require a positive credit history.

Prepaid cards, in contrast, do not require a bank account or a positive credit records, but most be
preloaded with funds before use.

What are the primary differences between Prepaid, Debit and Credit Cards?

The differences between these three types of cards can be observed from four categories:

- When the bank charges the client for service performed (Prepaid card: pay-before, Debit
card: pay now, Credit card: pay later,
- Does the bank consider the clients credit history (P: No ; D: Yes; C: Yes)
- Is the card connected to the client’s bank account (P: No ; D: Yes ; C: Yes)
- Is the bank granting credit to the cardholder (P: No ; D: No ; C: Yes)

What types of prepaid cards exist?

As follows:

- Stored Value Cards,

 - Reloadable Prepaid Cards,
- Gift Cards

List some of the advantages of Electronic banking.

There are several advantages of electronic banking:

- Very convenient,
- Unlimited service day and night
- No time constraint
- Easy to access via PC
- Easy way of payment
- Smart
- Higher Interest rate
- Easy transaction
- Both efficient and effective

List the disadvantages of Electronic banking.

Some of the disadvantages of internet banking include:

- Slow processing of the conducted financial transaction,

- Learning curve issue: banking online, especially in locating the sites, may be complicated
and hard to find
- Bank site changes: whenever the bank site changes, the bank will require the client to re-
enter his information and other related data agin
- The trust aspect: online banking should be entered very carefully if you wish to enjoy your
financial life

What types of risks are associated with electronic banking?

As follows:

- Security risk,
- Credit risk:
o Anyone can apply for a loan,
o There is no physical meeting between the client and the banker,
o It is difficult to verify collateral
- Transaction risk
- Reputational risk

WEEK 12: CHAPTER 19: MERGERS AND ACQUISITIONS

PRESENTATION: ACQUISITION AND MERGERS IN FINANCIAL-SERVICES MANAGEMENT

List some of the causes of the trend of mergers.

As follows:

- Intense competition,
- Deregulation,
 - The search for the optimal size financial-services organization,

List some of the Motives Behind the Rapid Growth of Financial-Service Mergers.

Mergers usually occur because

- The stockholders involved expect to increase their wealth or reduce their risk exposure,
- Management expects to gain:
o Higher salaries and employee benefits,
o Greater job security, or
o Greater prestige from managing a larger firm
- Both stockholders and management may reap benefits from a merger
- Profit potential: if the acquiring organization has more skilful management than the firm it
acquires, revenues and earnings may rise
- Risk reduction: the lower risk may arise because:
o Mergers increase the overall size and prestige of an organization,
o Open up new markets with different economic characteristics from markets already
served
o Make possible the offering of new services whose cash flows are different in timing
from cash flows generated by existing services
- Rescue of Failing Institutions

MISLIM DA JE DO OVDJE NAJBOLJE IZ PITANJA

….

NAUČITI: SLIDE 25
What are the principal characteristics of the institution targeted for merger, that are examined by
the potential acquirer?

The principal characteristics of the targeted institution that are examined by the potential acquirer
fall into six broad categories:

1. The firm’s history, ownership and management

2. The condition of its balance sheet
3. The firm’s track record of growth and operating performance
4. The condition of its income statement and cash flow
5. The condition and prospects of the local economy served by the targeted institution
6. The competitive structure of the market in which the firm operates (as indicated by any
barriers to entry, market shares, and degree of market concentration)

What are the additional factors that potential acquirer might consider?

As follows:

1. The comparative management styles of the merging organizations

2. The principal customers the targeted institution serves
3. Current personnel and employee benefits
4. Compatibility of accounting and management information systems among the merging
companies
5. Condition of the targeted institution’s physical assets
6. Ownership and earnings dilution before and after the proposed merger
What is the Herfindahl-Hirschman Index (HHI)?

HHI or Herfindahl-Hirshcman Index is a summary measure of market concentration. It is the sum of

the squared market share for all banks in a specific market area

Considering the HHI index, what types of market concentration are there?

Under the Depratment of Justice Guidelines, the market can be:

1. Un-concentrated: if a market has a post-merger HHI below 1.000 points (no review
required),
2. Moderately concentrated: if a market has a post-merger HHI is 1.000 to 1.800 points and a
change of HHI because of the merger is less than 100 points (no review required, unless
change in the HHI is greater than 100 points)
3. Highly concentrated: if a market has a post-merger HHI above 1.800 points and the post-
merger change in the HHI exceeds 50 points (usuallyno further review, unless the change in
the HHI is greater than 50 points):
a. If the change in the HHI is greater than 100 points, significant competitive issues will
be raised and a suit to block the proposed merger may be filed

What factors might have a negative influence on a merger?

A variety of factors often get in the way:

- Poor management,
- Mismatch of corporate cultures and styles,
- Excessive prices paid by the acquirer for the acquired firm,
- Failure to take into account the customer’s feelings and concerns,
- Lack of strategic “fit” between the combining companies

What steps should be taken if one wishes to improve the chances for a desirable merger outcome?

As follows:

1. Acquirer must start by evaluating its own financial condition,

2. Must have detailed analysis of possible new markets,
3. Must establish a realistic price for target firm
4. After merger, combined team must direct progress towards consolidation
5. Must establish communication between senior management and all employees
6. Must create communication channels for customers and employees to understand why
merger took place
7. Should create customer advisory panels to evaluate and comment on merged bank’s image
and products
What is the financial and economic impact of acquisitions and mergers?

As follows:

- Merger-active financial companies tend to grow faster than nonmerging firms

- Generally, acquiring financial firms, on average, are no more profitable than the firms they
buy:
o This suggests that management of the acquiring firm hopes to buy into success
- Acquired companies are often significantly less profitable than the firms they compete with
- Acquirers pay sizable premiums for target firms:
o Thus, stockholders of acquired companies often gain a financial advantage, while
acquirers often wind up with mixed results

WEEK 14: CHAPTER 20: INTERNATIONAL BANKING AND THE FUTURE

OF BANKING AND FINANCIAL SERVICES

PRESENTATION: INTERNATIONAL BANKING AND THE FUTURE OF BANKING AND

FINANCIAL SERVICES

List some of the goals of international banking regulation.

As follows:

- Protecting the Safety of Depositor Funds,

- Promoting Stable Growth in Money and Credit,
- Foreign Exchange Controls,
- Restrict the Outflow of Scarce Capital,
- Protect Domestic Financial Institutions and Markets from Foreign Competition

List some of the key customer services offered by international banks.

As follows:

- Supplying foreign currencies to customers,

- Hedging against foreign currency risk,
- Security underwriting for corporations,
- Hedging against interest rate risk,
- Supplying long- and short-term credit and credit guarantees,
- Payments and cash management services,
- Savings or thrift instruments,
- Foreign marketing assistance for customers

List some of the challenges for international banks in foreign market.

As follows:

- Growing customer use of securities market to raise funds in a more volatile and risky world,
- Developing better methods for assessing risk in international lending
- Adjusting to new market opportunities created by deregulation and new international
agreements
What solutions to troubled international loans exist?

Troubled international loans:

- May be restructure,
- Can be sold in the secondary market,
- Can be written off:
o Either a portion or in its entirety

List some of the international loan risk evaluation systems.

As follows:

1. The Checklist Approach,

2. The Delphi Method,
3. Advanced Statistical Methods,
4. Published Country-Risk Indicators:
a. Euromoney Magazine,
b. Institutional Investor Index,
c. International Country Risk Guide

What new opportunities can be exploited by banks?

As follows:

- Opportunities created by the North American Free Trade Agreement (NAFTA) and the
Central American Free Trade Agreement (CAFTA)
- Opportunities in the expanding European community,
- Opportunities in Asia as barriers erode

List some of the traits of the future of banking and financial services.

As follows:

- Convergence,
- Consolidation,
- Survival of Community Financial-Service Institutions,
- Reaching the Mass Media,
- Invasion by Industrial and Retailing Companies,
- The Wal-Mart Challenge,
- Fighting the Ultimate Survival in a Global Financial System

PRESENTATION: OFFSHORE BANKING

What is an offshore bank and what are the benefits it provides to its clients?

An offshore bank is a bank located outside the country of residence of the depositor, typically in a
low tax jurisdiction.

The advantages it provides to its clients are:

1. Greater privacy,
2. Low or no taxation (i.e. tax havens)
 3. Easy access to deposits (at least in terms of regulation)
4. Protection against political or financial instability

What is the purpose of offshore banking.

The purpose of offshore banking:

1. Tax Evasion,
2. Secrecy,
3. Political Stability,
4. Wealth Management Services and Expertise