ECON 3307 Saint Mary University Economics Questions

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Mishkin/Serletis
The Economics
of Money, Banking,
and Financial Markets
Sixth Canadian Edition
Chapter 6
THE RISK AND TERM STRUCTURE
OF INTEREST RATES
Copyright © 2017 Pearson Canada Inc.
Learning Objectives
1. Identify and explain the three factors affecting the risk
structure of interest rates
2. List and explain the three theories of why interest
rates vary across different maturities
Copyright © 2017 Pearson Canada Inc.
6-2
Risk Structure of Interest Rates
• Bond yields differ (sometimes substantially) across
bonds of similar maturity
• Key factors:
– Risk of default
– Liquidity
– Tax considerations
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6-3
Long-Term Bond Yields, 1978-2012
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6-4
Risk Structure of Interest Rates (cont’d)
• Default Risk: probability that the issuer of the bond is
unable or unwilling to make interest payments or pay
off the face value
– Government of Canada bonds are considered default-free
(government can raise taxes or print money to repay)
• Risk Premium: the spread between the interest rates
on bonds with default risk and the interest rates on
(same maturity) Canada bonds
• Credit-rating agencies assess and grade risk
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6-5
Response to an Increase in Default Risk on
Corporate Bonds
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6-6
Bond Ratings by DBRS, Moody’s, Standard and
Poor’s, and Fitch
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6-7
Junk Bonds and Fallen Angels
• Junk bonds – high yielding, high default risk
bonds (rated below BB)
• Fallen angels – investment-grade securities
whose rating have fallen to junk levels
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6-8
Risk Structure of Interest Rates (cont’d)
• Liquidity:
– the ease with which an asset can be converted into cash
• cost of selling a bond
• number of buyers/sellers in a bond market
• Income tax considerations:
– interest payments on municipal bonds are exempt from
federal income taxes
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6-9
Multiple Choice
Three factors explain the risk structure of interest
rates:
(a) liquidity, default risk, and the income tax treatment
of a security
(b) maturity, default risk, and the income tax treatment
of a security.
(c) maturity, liquidity, and the income tax treatment of
a security.
(d) maturity, default risk, and the liquidity of a
security.
(e) maturity, default risk, and inflation.
Copyright © 2017 Pearson Canada Inc.
6-10
Multiple Choice
If the probability of a bond default
increases because corporations begin to
suffer large losses, then the default risk on
corporate bonds will _____ and the
expected return on these bonds will _____.
(a) decrease; increase.
(b) decrease; decrease.
(c) increase; increase.
(d) increase; decrease
Copyright © 2017 Pearson Canada Inc.
6-11
Term Structure of Interest Rates
• Bonds with identical risk, liquidity, and tax
characteristics may have different interest rates
because the time remaining to maturity is different
• Yield Curve: a plot of the yield on bonds with differing
terms to maturity but the same risk, liquidity and tax
considerations
– Upward-sloping: long-term rates are above short-term rates
– Flat: short- and long-term rates are the same
– Inverted: long-term rates are below short-term rates
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6-12
Interest Rates on Government of Canada Bonds
with Different Maturities
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6-13
Facts that the Theory of the Term Structure of
Interest Rates Must Explain
1. Interest rates on bonds of different maturities move
together over time
2. When short-term interest rates are low, yield curves
are more likely to have an upward slope; when shortterm rates are high, yield curves are more likely to
slope downward and be inverted
3. Yield curves almost always slope upward
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6-14
Three Theories to Explain the Three Facts
We will explore three theories:
1. Expectations theory
– explains the first two facts but not the third
2. Segmented markets theory
– explains fact three but not the first two
3. Liquidity premium theory
– combines the two theories to explain all three facts
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6-15
Expectations Theory
• The interest rate on a long-term bond will equal an
average of the short-term interest rates that people
expect to occur over the life of the long-term bond
• Buyers of bonds do not prefer bonds of one maturity
over another; they will not hold any quantity of a bond
if its expected return is less than that of another bond
with a different maturity
• Bond holders consider bonds with different maturities
to be perfect substitutes
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6-16
Expectations Theory: Example
• Let the current rate on one-year bond be 6%
• You expect the interest rate on a one-year bond to be
8% next year
• Then the expected return for buying two one-year
bonds averages (6% + 8%)/2 = 7%
• The interest rate on a two-year bond must be 7% for
you to be willing to purchase it
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6-17
Expectations Theory (cont’d)
• For an investment of $1
it = today’s interest rate on a one-period bond
iet+1 = interest rate on a one-period bond expected for
next period
i2t = today’s interest rate on the two-period bond
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6-18
Expectations Theory (cont’d)
• Expected return over the two periods from investing $1
in the two-period bond and holding it for two periods
(1 + i2t )(1 + i2t ) ? 1
= 1 + 2i2t + (i2t ) 2 ? 1
= 2i2t + (i2t )
2
Since (i 2t ) 2 is very small the expected return
for holding the two – period for two perids is 2i 2t
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6-19
Expectations Theory (cont’d)
If two one-period bonds are bought with the $1 investment
(1 + it )(1 + ite+1 ) ? 1
1 + it + ite+1 + it (ite+1 ) ? 1
it + ite+1 + it (ite+1 )
it (ite+1 ) is extremely small
Simplifying we get
it + ite+1
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6-20
Expectations Theory (cont’d)
Both bonds will be held only if the expected returns are equal
2i2t = it + ite+1
it + ite+1
i2 t =
2
The two-period rate must equal the average of the two one-period
rates. For bonds with longer maturities:
i nt =
it + i
e
t +1
+i
e
t +2
+ … + i
e
t + ( n ?1)
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the
bond
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6-21
Expectations Theory (cont’d)
• Explains why the term structure of interest rates
changes at different times
• Explains why interest rates on bonds with different
maturities move together over time (fact 1)
• Explains why yield curves tend to slope up when shortterm rates are low and slope down when short-term
rates are high (fact 2)
• Cannot explain why yield curves usually slope upward
(fact 3)
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6-22
Multiple Choice
• According to the expectations theory of the term structure
• (a) the interest rate on long-term bonds will equal an average
of short-term interest rates that people
expect to occur over the life of the long-term bonds.
• (b) interest rates on bonds of different maturities move
together over time.
• (c) buyers of bonds prefer short-term to long-term bonds.
• (d) all of the above.
• (e) only (a) and (b) of the above
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6-23
Multiple Choice
• According to the expectations theory of the term
structure
• (a) when the yield curve is steeply upward sloping,
short-term interest rates are expected to rise in the
future.
• (b) when the yield curve is downward sloping, shortterm interest rates are expected to decline in the
future.
• (c) yield curves should be as equally likely to slope
downward as slope upward.
• (d) all of the above
• (e) only (a) and (b) of the above.
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6-24
Multiple Choice
• Over the next three years, the expected path of 1-year
interest rates is 4, 1, and 1 percent. The
• expectations theory of the term structure predicts that
the current interest rate on 3-year bond is
• (a) 1 percent.
• (b) 2 percent
• (c) 3 percent.
• (d) 4 percent.
• (e) 5 percent.
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6-25
Segmented Markets Theory
• Bonds of different maturities are not substitutes at all
• The interest rate for each bond with a different
maturity is determined by the demand for and supply
of that bond
• Investors have preferences for bonds of one maturity
over another
• If investors generally prefer bonds with shorter
maturities that have less interest-rate risk, then this
explains why yield curves usually slope upward (fact 3)
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6-26
Multiple Choice
• According to the segmented markets theory of the term structure
• (a) the interest rate for each maturity bond is determined by
supply and demand for that maturity bond.
• (b) bonds of one maturity are not substitutes for bonds of other
maturities, therefore, interest rates on bonds of different
maturities do not move together over time.
• (c) investors’ strong preferences for short-term relative to longterm bonds explains why yieldc urves typically slope upward.
• (d) all of the above
• (e) none of the above.
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6-27
Liquidity Premium Theory
• The interest rate on a long-term bond will equal an
average of short-term interest rates expected to occur
over the life of the long-term bond plus a liquidity
premium that responds to supply and demand
conditions for that bond
– Liquidity premium also referred to as a term premium
• Bonds of different maturities are partial (not perfect)
substitutes
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6-28
Liquidity Premium Theory
i nt =
it + ite+1 + ite+ 2 + … + ite+ (n ?1)
n
+ l nt
• where lnt is the liquidity premium for the n-period bond
at time t
• lnt is always positive and increases with the term to
maturity
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6-29
Preferred Habitat Theory
• Closely related to the liquidity premium theory
• Investors have a preference for bonds of one maturity
over another
• They will be willing to buy bonds of different maturities
only if they earn a somewhat higher expected return
• Investors are likely to prefer short-term bonds over
longer-term bonds
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6-30
The Relationship Between the Liquidity Premium
(Preferred Habitat) and Expectations Theory
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6-31
Liquidity Premium and Preferred Habitat
Theories (cont’d)
• Interest rates on different bonds move together
– Explained by first term in the equation
• Yield curves slope upward when short-term rates are
low and downward when short-term rates are high
– Explained by the liquidity premium term in the first case and
by a low expected average in the second case
• Yield curves typically slope upward
– Explained by a larger liquidity premium as the term to
maturity lengthens
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6-32
Yield Curves and the Market’s Expectations of
Future Short-Term Interest Rates
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6-33
Yield Curves for Government of Canada Bonds
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6-34
Multiple Choice
According to the liquidity premium theory of the term
structure
(a) the interest rate on long-term bonds will equal an average
of short-term interest rates that people expect to occur over
the life of the long-term bonds plus a term premium.
(b) buyers of bonds may prefer bonds of one maturity over
another, yet interest rates on bonds of different maturities
move together over time.
(c) even with a positive term premium, if future short-term
interest rates are expected to fall significantly, then the yield
curve will be downward sloping.
(d) all of the above
(e) only (a) and (b) of the above.
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6-35
Multiple Choice
If 1-year interest rates for the next five years are
expected to be 4, 2, 5, 4, and 5 percent, and the 5year term premium is 1 percent, then the 5-year
bond rate will be
(a) 1 percent.
(b) 2 percent.
(c) 3 percent.
(d) 4 percent.
(e) 5 percent
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6-36
Multiple Choice
If the yield curve has a mild upward slope, the
liquidity premium theory (assuming a mild
preference for shorter-term bonds) indicates that the
market is predicting
(a) a rise in short-term interest rates in the near future
and a decline further out in the future.
(b) constant short-term interest rates in the near future
and further out in the future
(c) a decline in short-term interest rates in the near future
and a rise further out in the future.
(d) a decline in short-term interest rates in the near future
and an even steeper decline further out in the future.
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6-37
Mishkin/Serletis
The Economics
of Money, Banking,
and Financial Markets
Sixth Canadian Edition
Chapter 12
BANKING AND
THE MANAGEMENT OF FINANCIAL
INSTITUTIONS
Copyright © 2017 Pearson Canada Inc.
Learning Objectives
1. Summarize the features of a bank balance sheet
2. Apply changes to a bank’s assets and liabilities on a Taccount
3. Identify the ways in which banks can manage their
assets and liabilities to maximize profit
4. List the ways in which banks deal with credit risk
5. Apply gap analysis and duration analysis, and identify
interest-rate risk
6. Summarize the types of off-balance sheet activities
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12-2
The Bank Balance Sheet
• A bank’s balance sheet lists its assets and liabilities
• As the name implies, it balances:
Total Assets = Liabilities + Capital
• Liabilities are the sources of bank funds
• Assets are the uses of bank funds
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12-3
Liabilities
• Banks acquire funds by issuing (selling) liabilities
• Demand and Notice Deposits
– Typically the lowest-cost source of funds
• Fixed-Term Deposits (or CDs)
• Borrowings
– Overdraft loans (advances)
– Settlement balances
• Bank Capital
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12-4
Assets
• Reserves
– Settlement balances (deposits at the Bank of Canada) plus
currency physically held by banks (called vault cash)
– Reserve requirements removed in 1994
•
•
•
•
•
Cash Items in Process of Collection
Deposits at Other Banks
Securities
Loans
Other Assets
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12-5
Balance Sheet of All Banks in Canada
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12-6
Basic Banking
• Banks make profits through asset transformation
– Acquire funds of one type, buy assets of another
• Use T-accounts to make the analysis concrete
• Example: Jane Brown open a chequing account with
First National Bank with a $100 deposit
First National Bank
Assets
Vault cash
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Liabilities
+$100
Chequable deposits
+$100
12-7
Basic Banking (cont’d)
• When a bank receives additional deposits, it gains an
equal amount of reserves
– Vault cash are part of the bank’s reserves
First National Bank
Assets
Reserves
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Liabilities
+$100
Chequable deposits
+$100
12-8
Basic Banking (cont’d)
• If Jane had opened her account with a $100 cheque
written on an account at another bank, then
First National Bank
Assets
Liabilities
Cash items in process of
collection
+$100
Chequable deposits
+$100
• Net result: Bank of Canada transfers $100 from one
bank to the other
First National Bank
Assets
Reserves
Second National Bank
Liabilities
+$100
Chequable
deposits
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+$100
Assets
Reserves
Liabilities
-$100
Chequable
deposits
-$100
12-9
Basic Banking: Making a Profit
• If the desired reserve ratio is 10%, then loan out $90
from the initial $100 increase in deposits
– Earn profit from the higher interest rate on the load
First National Bank
Assets
Desired Reserves
Excess Reserves
Liabilities
+$10
+$90
Chequable deposits
+$100
First National Bank
Assets
Desired Reserves
Loans
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Liabilities
+$10
+$90
Chequable deposits
+$100
12-10
Multiple Choice Question
• Which of the following statements are true?
A) A bank’s assets are its sources of funds.
B) A bank’s balance sheet has the property that
total assets equal the sum of total liabilities and
equity capital.
C) A bank’s liabilities are its sources of funds.
D) both B and C of the above are true
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12-11
Multiple Choice Question
• Which of the following are reported as liabilities
on a bank’s balance sheet?
A) Loans
B) Deposits
C) Deposits with other banks
D)Reserves
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12-12
Multiple Choice Question
• When you deposit a $50 bill in Royal Bank,
•
A) its liabilities decrease by $50.
B) its reserves increase by $50.
C) its assets increase by $50.
D) only B and C of the above occur
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12-13
General Principles of Bank Management
•
•
•
•
•
•
Liquidity Management
Asset Management
Liability Management
Capital Adequacy Management
Credit Risk
Interest-rate Risk
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12-14
Liquidity Management: Ample Reserves
with deposit outflow of $10
million
?
First Bank
Assets
First Bank
Liabilities
Reserves
$20M Deposits
Loans
$80M Bank
Capital
$10M
Securities
Assets
$100M
$10M
Liabilities
Reserves
$10M Deposits
$90M
Loans
$80M Bank Capital
$10M
Securities
$10M
• If a bank has ample excess reserves, a deposit outflow
does not necessitate changes in other parts of its
balance sheet
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12-15
Liquidity Management: Shortfall in Reserves
with deposit outflow of $10
million
?
First Bank
Assets
First Bank
Liabilities
Reserves
$10M Deposits
Loans
$90M Bank
Capital
$10M
Securities
Assets
$100M
$10M
Reserves
Liabilities
$0M Deposits
Loans
$90M Bank Capital
Securities
$10M
$90M
$10M
• Reserves are now $0; this is unacceptable
• The shortfall must be dealt with
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12-16
Liquidity Management: Borrowing from other
Banks
First National Bank
Assets
Reserves
Loans
Securities
Liabilities
$9M
$90M
$10M
Deposits
Borrowings from other
banks or corporations
Bank Capital
$90M
$9M
$10M
• Cost is the interest rate paid on the borrowed funds
• Excess reserves are insurance against the costs
associated with deposit outflows
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12-17
Liquidity Management: Securities Sale
First National Bank
Assets
Reserves
Loans
Securities
Liabilities
$9M
$90M
$1M
Deposits
Bank Capital
$90M
$10M
• An alternative to borrowing is selling other assets
• The cost of selling securities is the brokerage and other
transaction costs
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12-18
Liquidity Management: Bank of Canada Advances
First National Bank
Assets
Reserves
Loans
Securities
Liabilities
$9M
$90M
$1M
Deposits
Borrowings from the
Bank of Canada
Bank Capital
$90M
$9M
$10M
• A third option: borrow from the Bank of Canada
• Borrowing from the Bank of Canada also incurs interest
payments based on the discount rate
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12-19
Liquidity Management: Bank of Canada Advances
First National Bank
Assets
Reserves
Loans
Securities
Liabilities
$9M
$81M
$1M
Deposits
Bank Capital
$90M
$10M
• Finally, a bank could reduce (or calling in) its loans
• Reduction of loans is the most costly way of acquiring reserves
• Calling in loans antagonizes customers
• Other banks may only agree to purchase loans at a substantial
discount
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12-20
Asset Management: Three Goals
• To maximize profits, banks must seek the highest
possible returns on loans and securities, reduce risk,
and have adequate liquidity
– Four basic ways to accomplish these goals
1. Find low-risk borrowers that pay high interest rates
2. Purchase securities with high returns and low risk
3. Diversifying their asset holdings
4. Manage liquidity to meet deposit outflow
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12-21
Liability Management
• Prior to the 1960’s liabilities were seen as fixed
– They were mostly zero-interest checkable deposits
– Overnight loans did not exist between banks
• This is a recent phenomenon due to rise of money
center banks
• Expansion of overnight loan markets and new financial
instruments (such as negotiable CDs)
• Checkable deposits have decreased in importance as
source of bank funds
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12-22
Capital Adequacy Management
• Banks have to make decisions about the amount of
capital they need to hold for three reasons:
1. Bank capital helps prevent bank failure
2. The amount of capital affects return for the owners
(equity holders) of the bank
3. Regulatory requirement
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12-23
Capital Adequacy Management: Preventing
Bank Failure
Bank Capital = Total Assets – Liabilities
•When a bank defaults on a loan it lowers assets and bank
capital
•This leads to a lower net worth and in some cases even a
negative net worth
•Insolvent – Negative Net Worth
•Government regulation forces the bank to close
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12-24
Capital Adequacy Management: Preventing
Bank Failure
High Capital Bank
Assets
Low Capital Bank
Liabilities
Assets
Liabilities
Reserves
$10M Deposits
$90M
Reserves
$10M Deposits
Loans
$90M Bank
Capital
$10M
Loans
$90M Bank Capital
$96M
$4M
Imagine $5M of their loads become worthless
High Capital Bank
Assets
Low Capital Bank (now insolvent)
Liabilities
Reserves
$10M Deposits
Loans
$85M Bank
Capital
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Assets
$90M
$5M
Liabilities
Reserves
$10M Deposits
$96M
Loans
$85M Bank Capital
-$1M
12-25
Capital Adequacy Management: Returns to
Equity Holders
Return on Assets: net profit after taxes per dollar of assets
net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital
net profit after taxes
equity capital
Relationship between ROA and ROE is expressed by the
ROE =
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
Equity Capital
net profit after taxes net profit after taxes
assets
=
´
equity capital
assets
equity capital
EM =
ROE = ROA ´ EM
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12-26
Capital Adequacy Management: Safety
• Benefits the owners of a bank by making their
investment safe
• Costly to owners of a bank because the higher the bank
capital, the lower the return on equity
• Choice depends on the state of the economy and levels
of confidence
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12-27
Example: Do Banks Want to Hold Capital
• High Capital Bank:
– $100 Million in Assets and $10 Million in Equity (Bank Capital)
– Equity Multiplier = $100/$10 = 10
• Low Capital Bank
– $100 Million in Assets and $4 Million in Equity
– Equity Multiplier = $100/$4 = 25
• Return on Assets = 2% (each bank ran equally)
– High Capital: ROE = 2% x 10 = 20%
– Low Capital: ROE = 2% x 25 = 50%
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12-28
Strategies for Managing Bank Capital
• How to increase the equity multiplier (reduce
capital):
–
–
–
Buying back some of Bank’s stock
Pay out higher dividend to shareholders
Acquire new funds and increase assets
• How to decrease the equity multiplier (increase
capital):
–
–
–
Issue more common stock
Reducing dividend to shareholders
Issue fewer loans or sell securities and use proceeds to
reduce liabilities
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12-29
Application: How a Capital Crunch Caused a
Credit Crunch During the Global Financial Crisis
• Shortfalls of bank capital led to slower credit growth
– Huge losses for banks from their holdings of securities backed
by residential mortgages
– Losses reduced bank capital
• Banks could not raise much capital on a weak
economy, and had to tighten their lending standards
and reduce lending
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12-30
Multiple Choice
• A bank failure is more likely to occur when
A) a bank holds more government of Canada
securities.
B) a bank suffers large deposit outflows.
C) bank holds less equity capital.
D)both B and C of the above
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12-31
Multiple Choice
• The amount of assets per dollar of equity capital
is called the
A) equity multiplier.
B) asset ratio.
C) equity ratio.
D) multiplier
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12-32
Managing Credit Risk
• A major component of many financial institutions
business is making loans
• To make profits, these firms must make successful
loans that are paid back in full
• The concepts of moral hazard and adverse selection
are useful in explaining the risks faced when making
loans
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12-33
Managing Credit Risk: Adverse Selection
• Adverse selection is a problem in loan markets because
bad credit risks (those likely to default) are the one
which usually line up for loans
• Those who are most likely to produce an adverse
outcome are the most likely to be selected
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12-34
Managing Credit Risk: Moral Hazard
• Moral hazard is a problem in loan markets because
borrowers may have incentives to engage in activities
that are undesirable from the lenders point of view
• Once a borrower has obtained a loan, they are more
likely invest in high-risk investment projects that might
bring high rates of return if successful
• The high risk, however, makes it less likely the loan will
be repaid
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12-35
Managing Credit Risk (cont’d)
• To be profitable, lending firms must overcome adverse
selection and moral hazard problems
• Attempts by the lending institutions to solve the
problems explains a number of principles for managing
risk
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12-36
Managing Credit Risk (cont’d)
• Screening and Monitoring
– Screening
– Specialization in Lending
– Monitoring and Enforcement of Restrictive Covenants
• Long-term customer relationships
• Loan commitments
• Collateral and compensating balances
• Credit rationing
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12-37
Interest Rate Risk
• If a financial institution has more interest rate sensitive
liabilities than interest rate sensitive assets, a rise in
interest rates will reduce the net interest margin and
income
• If a financial institution has more interest rate sensitive
assets than interest rate sensitive liabilities, a rise in
interest rates will raise the net interest margin and
income
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12-38
Managing Interest Rate Risk
First National Bank
Assets
Rate-sensitive assets
Liabilities
$20M Rate-sensitive liabilities
$50M
Variable-rate and short-term loans
Variable-rate CDs
Short-term securities
Money market deposit accounts
Fixed-rate assets
$80M Fixed-rate liabilities
Reserves
Checkable deposits
Long-term loans
Savings deposits
Long-term securities
Long-term CDs
$50M
Equity capital
• If a bank has more rate-sensitive liabilities than assets, a rise in
interest rates will reduce bank profits; a decline in interest rates
will raise bank profits
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12-39
Income Gap Analysis
• We can measure sensitivity of profits to interest rate
changes using gap analysis
• The “gap” is the difference between interest rate
sensitive liabilities and interest rate sensitive assets
GAP = rate-sensitive assets – rate-sensitive liabilities
GAP = RSL – RSA
• A change in the interest rate (?i) will change bank
income (?I) depending on the Gap
?Income = GAP ? ?i
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12-40
Income Gap Analysis
Basic Gap Analysis:
(rate-sensitive assets ? rate sensitive liabilities)
? ? interest rates = ? in bank profits
($20 – $50) x .05 = -$1.5 million
Maturity Bucket Approach measures the gap for several maturity subintervals
Standardized Gap Analysis accounts for differing degrees of rate sensitivity
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12-41
Interest Rate Risk
• What happens when the interest increases by 5%?
– Assets: $20 million are interest rate sensitive
– Assets increase by $20 x .05 = $1 million
– Liabilities: $50 million are interest rate sensitive
– Liabilities increase by $50 x .05 = $2.5 million
• The impact of the 5% change is
– $1 million less $2.5 million or -$1.5 million
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12-42
Duration Analysis
• Owners and managers care not only about the change
in interest rates on income but also on net worth of the
institution
• Duration Analysis examines the sensitivity of the
market value of the financial institution’s net worth to
changes in interest rates
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12-43
Duration Analysis (cont’d)
%?P = – DUR x [?i/(1+i)]
Where:
P is the market value of a security
%?P = (Pt+1 – Pt)/P
DUR = duration
i = interest rate
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12-44
Interest Rate Risk: Duration Analysis
• Assume
– The banks average assets holdings are 3 years and liability holdings
are 2 years
– The banks has $100 million in assets and $90 million in liabilities
• Suppose interest rates increase by 5% ( increased from 10% to 15%)
– The market value of assets falls by 13.64% (-3 *5%/1.1%) years)
or $13.64 million ( Assets now 100-13.64 =86.36)
– The market value of liabilities falls by 9.09% (-2 * 5%/1.1%) years)
or $ 8.18 million ( Liabilities now 90- 8.18 = 81.82)
• Net worth
– Before: $100 – $90 = $10 million
– Now: $86.36 – $81.82 = $4.54 million
– Change in new worth is 10- 4.54 = 5.46
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12-45
Interest Rate Risk: Duration Analysis
The Duration Gap can be calculated as:
DURgap = Dura – (L/A x DURL)
Where:
Dura = average duration of assets
L = market value of liabilities
A = market value of assets
Durl = average duration of liabilities
DURgap = 3 – 90/100*2
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=1.2
12-46
Interest Rate Risk: Duration Analysis
The impact of the interest rate change on net worth (NW) as a
percentage of assets can be calculated via:
? NW/A = -Durgap x ?i/(1+i)
Where:
DURgap = duration gap
?i = interest rate change
i = interest rate
? NW/A = -1.2 * 5%/1.1% = 5.45
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12-47
Off-Balance-Sheet Activities
• Off-balance sheet activities affect profits but do not
appear on bank balance sheets
• Loan sales (secondary loan participation)
• Generation of fee income
• Trading activities and risk management techniques
– Futures, options, interest-rate swaps, foreign exchange
– Speculation
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Off-Balance-Sheet Activities (cont’d)
• May create principal-agent problems
– Traders have incentive to take big bets at high risk (if trades
lead to profit, they are rewarded, while loses born by firm)
• Internal controls to reduce the principal-agent problem
–
–
–
–
Separation of trading activities and bookkeeping
Limits on exposure
Value-at-risk
Stress testing
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Strategies to Manage Interest-rate Risk
1. Rearrange balance-sheet
2. Interest-rate swaps
3. Hedge with financial futures/options
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12-50
Mishkin/Serletis
The Economics
of Money, Banking,
and Financial Markets
Sixth Canadian Edition
Chapter 14
CENTRAL BANKS AND THE BANK OF
CANADA
Copyright © 2017 Pearson Canada Inc.
Learning Objectives
1. Recognize the historical context of the development
of the Bank of Canada
2. Describe the key features and functions of the Bank of
Canada and assess its degree of independence
3. Summarize the arguments for and against the
independence of the Bank of Canada
4. Identify the ways in which the theory of bureaucratic
behaviour can help explain central bank actions
5. Discuss the structure and independence of other
major central banks around the world
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2014 Pearson Canada Inc.
14-2
1-2
Comparison of Central Banks
Bank of Canada
Federal Reserve
European Central Bank
Established in 1935
Established in 1913
Established in 1999
Regional office in 5
cities: Halifax, Vancouver,
Federal Reserve
Banks In 12 states
In 17 countries Euro
area currency
Board of Directors
“15”
Board of Governors
“7”
Executive Board 6
Governing Council
“5”
FOMC “12”
Governing Council “19”
Instrument in
dependence
Goal and Instrument Instrument and political
independence
independence
Calgary, Montreal, Toronto
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2014 Pearson Canada Inc.
14-3
1-3
15 –
Origins of the Bank of Canada
• The Bank was created by the Bank of Canada Act in
1934 and started operations in 1935
• Initially the Bank was a private institution but was
nationalized in 1938, so is now a national institution
with headquarters in Ottawa
• Unlike a private bank that operates in pursuit of profit,
the Bank of Canada is responsible for the country’s
monetary policy and for the regulation of Canada’s
deposit-based financial institutions
Copyright © 2017