ACT 4220: FINANCIAL

MARKETS & INSTITUTIONS

CHAPTER 21 THRIFT OPERATIONS

EX03243 EX03250 EX03316

THAI TZI MENG CHEW SHIOU LING CHEW BOON WEI
 Background on
Savings
Institutions

Sources and Uses

Summary of Funds

Content

Valuation of a
Credit Unions Savings
Institution

Exposure of
Savings Exposure to
Institutions to
Crises
Risk
Management
of Interest
Rate Risk
 Background on Savings Institutions

 Savings institutions include savings banks and savings and loan

associations (S&Ls)
 S&Ls are the most dominant type
 Both are very similar in their sources and uses of funds

 Ownership
 Most SIs are mutual (owned by depositors)
 Many SIs have shifted their ownership structure from depositors to
shareholders through mutual-to-stock-conversions
 Allow SIs to obtain additional capital by issuing stock
 Provide owners with greater potential to benefit from performance
 Make SIs more susceptible to hostile takeovers
 In an acquisition, both SIs have to be stock-owned
 Merger-conversion
 Background on Savings Institutions

 Ownership (cont’d)
 In an acquisition, both SIs have to be stock-owned
 Merger-conversion
 There are less than half as many SIs today as in 1994
 The total assets of stock SIs have more than doubled
since 1994
 The total assets of mutual SIs have remained steady since
1994
 Background on Savings Institutions
Regulation of savings institutions
• Established by Financial Reform(Dodd-Frank) Act of 2010.
• The Office of the Comptroller of the Currency at supervises mutual
SIs and federal SIs
• The Federal Reserve regulates parent holding companies of SIs
• The Consumer Financial Protection Bureau supervises larger SIs
(with at least $10 billion in assets)
• State-chartered SIs are regulated by their respective state
• Need to satisfy guidelines established by Federal Deposit Insurance
Corporation (FDIC)
Deposit insurance
• provided by the Deposit Insurance Fund (DIF) administered by
FDIC. Insurable limit is currently $250,000
Regulatory assessment of SIs
• Regulators conduct periodic on-site examinations of capital and
risk
• Monitoring is conducted using the CAMELS rating
Deregulation of services
• Recently, SIs have been granted more flexibility to diversify products
and services
 Sources and Uses of Funds
 Sources of Funds
 Deposits
 Passbook savings, retail certificates of deposit (CDs), and money
market deposit accounts (MMDAs)
 Borrowed funds
 SIs can borrow from other depository institutions in the federal funds
market
 SIs can borrow through repurchase agreement (repo)

 SIs can borrow at the Federal Reserve

 Capital
 The capital (net worth) of SIs is composed of retained earnings and
funds obtained from issuing stock
 Sources and Uses of Funds

 Uses of Funds
 Cash
 SIs maintain cash to satisfy reserve requirements and
accommodate withdrawal requests
 Mortgages
 Primary asset of SIs

 Typically have long-term maturities and can be prepaid by

borrowers
 Are mostly for homes or multifamily dwellings

 Are subject to interest rate risk and credit (default) risk

 Mortgage-backed securities
 Return is highly influenced by default rate on the underlying
mortgages
 Sources and Uses of Funds

 Other Securities
 Invest in securities such as Treasury bonds and corporate
bonds
 Provide liquidity
 Consumer and Commercial Loans
 Reduce heavy exposure to mortgage loans
 Reduce their exposure to interest rate risk
 Other Uses of Funds
 Provide temporary financing to other institutions through
use of repos
 Lend funds on a short-term basis through the federal
funds market
 Sources and Uses of Funds

 Balance Sheet of Savings Institutions

 Sources of funds represent liabilities or equity
 Uses of funds represent assets
 Determines its own composition of liabilities and assets, which
determines its specific operations.
 Exhibit 21.1 Balance Sheet of Ashland Savings as of June 30,
2016

10
 Exhibit 21.2 How Savings Institutions Finance Economic
Growth

11
 Exhibit 21.3 Interactions between Savings Institutions and
Other Financial Institutions

12
 Exhibit 21.4 Participation of Savings Institutions in Financial
Markets

13
 Valuation of a Savings Institution

 The value should change in response to changes in its expected

cash flows and to changes in the required rate of return:

V  f E (CF ), k 
 -
 Factors That Affect Cash Flows

E (CF )  f ( ECON, Rf , INDUS, MANAB)

 - ? 
 Valuation of a Savings Institution

 Factors That Affect Cash Flows (Cont’d)

 Change in economic growth
 During periods of strong economic growth:
 Consumer loan and mortgage loan demand is higher
 Loan defaults are reduced
 Change in the risk-free interest rate
 SIs’ cash flows are inversely related to interest rate movements
 SIs rely heavily on short-term deposits

 SIs’ assets commonly have fixed rates

 Change in industry conditions

 SIs are exposed to regulatory constraints, technology, and
competition
 Valuation of a Savings Institution

 Factors That Affect Cash Flows (Cont’d)

 Change in management abilities
 Managers can attempt to make internal decisions that will
capitalize on the external forces that the bank cannot control
 Skillful managers will recognize how to revise the composition of
the SI’s assets and liabilities to capitalize on existing economic or
regulatory conditions
 Valuation of a Savings Institution

 Factors that affect the required rate of return by investors

k  f (R f , RP)
 
 Change in the risk-free rate
 When the risk-free rate increases, so does the return required by
investors
 Change in the risk premium
 When the risk premium increases, so does the return required by
investors
 Exposure to Risk

 Liquidity risk
 SIs commonly use short-term liabilities to finance long-term assets
 If new deposits are not sufficient to cover withdrawal requests, SIs
can experience liquidity problems
 SIs can obtain temporary funds through repurchase agreements or in
the federal funds market
 Alternative way is to sell assets in exchange for cash which will
reduces SI’s size and possibly its earnings

 Credit risk
 Conventional mortgages are the primary source of credit risk
 SIs often carry the risk rather than paying for insurance
 If perform adequate credit analysis on potential borrowers and
geographically diversify mortgage loans, SI should able to maintain a
low degree of risk
 Exhibit 21.5 Framework for Valuing a Savings Institution

19
 Exposure to Risk (Cont’d)

 Interest rate risk

 Some SIs rely heavily on short-term deposits as sources
of funds and use most of their funds to provide fixed-rate
mortgages
 Subject to interest rate risk as liabilities are rate sensitive
(cost is sensitive to changes in market interest rates)
 Measure the gap between their rate-sensitive assets and
rate-sensitive liabilities in order to determine exposure to
interest rate risk
 Exhibit 21.6 Duration Schedule for Tucson Savings Institution
(Dollar Amounts are in Thousands)

21
 Management of Interest Rate Risk

 Adjustable-Rate Mortgages (ARM)

 Tied to market-determined rate
 Periodically adjusted in accordance with formula in
contract
 Enable SIs to maintain more stable spread between
interest revenue and expense
 Reduce impacts of interest rates changes
 Acts as hedging strategy
 Expose consumers to interest rate risk
 Significant impact on household mortgage
payments
 Management of Interest Rate Risk (Cont’d)

 Interest Rate Futures Contracts

 Allows purchase of debt security at specific price in
future
 Seller obligated to sell at that contract price
 Some SIs use Treasury bond futures contract as treasury
bond cash flow resembles fixed-rate mortgages
 Treasury bond offers fixed periodic payments, market value
move inversely to interest rate fluctuation
 SIs can hedge fixed-rate mortgages, benefit from
difference between market value(purchase) and futures
price(sell)
 Offset spread between interests during rising interest rate
 Management of Interest Rate Risk (Cont’d)

 Interest Rate Swaps

 SI swap fixed-rate payments (outflow) for variable-rate
payments (inflow)
 Fixed-rate outflow payments matched against fixed-rate
mortgages to achieve certain spread
 Variable-rate inflow matched against variable cost of funds
 In rising rate environment, fixed-rate outflow remain fixed
while variable-rate inflow increase, partially offset
unfavourable impact of rising interest rate
 Can also reduce favourable impact of declining interest
rate by reducing inflow interest payment but outflow interest
payment remain same
 Management of Interest Rate Risk (Cont’d)

 Conclusion
 Impossible to eliminate interest rate risk completely
 Due to potential prepayment of mortgages

 Homeowner normally pay off mortgages before

maturity
 SIs do not know mortgage actual maturity and cant
match interest rate sensitivity
 Exposure of Savings Institutions to Crisis

 Savings Institutions Crisis in the Late 1980s

 Due to increase in interest rates cause decline in
interest income
 Many loan defaults due to saving institutions having
little expertise in assess ability to repay loan
 Saving institutions experience cash flow deficiency &
depositors withdraw savings
 Fraud: lack of oversight cause manager serve own
interest
 FIRREA (Financial Institutions Reform, Recovery, and
Enhancement Act) increase penalty for fraud
 Exposure of Savings Institutions to Crisis

 Credit crisis 2008-2009

 Home price plummeted, value of home less than its
mortgage balance
 Saving institutions sold subprime loans to
institutional investors in secondary market, but still
exposed to credit crisis due to decline in level of
mortgage originations
 Same adverse effects like crisis in 1980s
 Exposure of Savings Institutions to Crisis

 Reform in Response to the Credit Crisis

 Mortgage Origination: require institutions to verify
income, job status and credit history of applicants before
approving (strengthen standard)

 Sales of Mortgage-Backed Securities: require to retain

5% of portfolio unless meet standard of low risk, force to
maintain stake in mortgage portfolio that they sell

 Financial Stability Oversight Board: identify risk to

financial stability in US, make regulatory recommendation to
reduce systemic risk, ie. risk of financial problem may spread.
Council can recommend rules for institutions perceived to be
too large & complex
Exposure of Savings Institutions to Crisis

 Orderly Liquidation: assigned specific regulators with

authority determine whether particular financial institutions
should be liquidated, help to limit losses due to failing
financial institution

 Consumer Financial Protection Bureau: regulate various

consumer financial products and services offered by
institutions

 Trading of Derivative Securities: required to trade

derivative securities via exchange/clearinghouse, allow for
more standardized structure about margins and collateral with
more transparency in prices
 Credit Unions

 Ownership of Credit Unions

 Stock owned by depositor as credit unions do not
issue stock
 Credit unions are non-profit organization, income
not taxed
 Accumulated earnings used to offer higher deposit
rates or reduce loan rates
 Credit Unions

 Advantages and Disadvantages of Credit Unions

 Advantages: offer higher deposit rates, lower fees on
checking accounts, lower required minimum balance, lower
loan rate as profit not taxed and not required to achieve
shareholders’ required return

 Disadvantages: employees no incentive to efficiently

manage operations, may not have funds to invest in new
technology heavily, may not able to offer latest innovation,
limits its ability to diversify

 Credit unions overcome disadvantages by merging,

diversify products and services
 Credit Unions

 Deposit Insurance for Credit Unions

 Insured by National Credit Union Share Insurance
Fund (NCUSIF), which sets aside a portion of funds as
reserves to cover expenses due to failures

 Regulatory Assessment of Credit Unions

 Federal: supervised, regulated by National Credit Union
Administration (NCUA)
 State-chartered: regulated by respective states
 NCUA examiners derive financial ratio from
semiannual financial report completed by CU to
identify potential problems requiring attention
 Credit Unions

 Credit Union Sources of Funds

 Deposits: obtain most funds from share deposits by
members, most CUs also offer checkable accounts i.e. share
drafts which pay interest and allow to write unlimited checks

 Borrowed Funds: if CU needs funds temporarily, may

borrow from Central Liquidity Facility (CLF), acting as lender
accommodate seasonal funding & specialized needs

 Capital: primary source is from retained earnings, capital

ratio higher than other institutions as CUs use conservative
management.
 Credit Unions

 Credit Union Uses of Funds

 Loans to members
 Buy government and agency securities maintain liquidity

 Exposure of Credit Unions to Risk

 Liquidity Risk of Credit Unions: borrow from Central Liquidity
Facility resolve liquidity problem in short run, CUs have less ability to
generate deposits quickly as its market is restricted to those qualify as
members

 Credit Risk of Credit Unions: primarily from personal loans to

members, most loans are secured so less loss if default. CUs suffer loss
due to late payments or default on mortgages and home-equity loans

 Interest Rate Risk of Credit Unions: asset portfolio rate sensitive as

have short / intermediate maturity, CUs less exposure to interest rate
risk than savings institutions as spread between interest revenue and
expense stable over time