1. 1 Financial Institutions, Risk Management, and Regulation Dr. Gary Brester MSU Department of Agricultural Economics and Economics AGBE 445 Spring Semester

2. 2 OUTLINE 1.Banking Functions 2. Banking History 3. Banking Regulations 4.Stress Tests 5. Agricultural and Small Banks 6. International Competitiveness

3. 3 OUTLINE 1.Banking Functions 2. Banking History 3. Banking Regulations 4.Stress Tests 5. Agricultural and Small Banks 6. International Competitiveness

4. 4 Disclaimer 1.Banking and bank regulations are complex 2. These regulations are evolving 3. Simplified somewhat for illustration purposes

5. 5 Banking Functions 1.Banks are payment agents a. Facilitate payments through checking accounts b. Other electronic funds transfers 2. Banks are intermediaries a. Facilitate transfer of money between savers and borrowers

6. 6 OUTLINE 1.Banking Functions 2. Banking History 3. Banking Regulations 4.Stress Tests 5. Agricultural and Small Banks 6. International Competitiveness

7. 7 Banking History 1.A banking crisis has occurred approximately every 20 years 2. These crises disrupt financial flows 3. Implications can be minor or severe a.Can have little impacts on individuals b.Or large impacts

8. 8 Safety and Soundness Regulation 1.Adequate liquidity to absorb shocks 2.Capital adequacy to cover all obligations in the case of bank failure 3.Enforced by government agencies a.Office of the Comptroller of the U.S. Treasury b.Securities and Exchange Commission 4. Bank concentration

9. 9 U.S. Bank Concentration Banks Assets ($ Trillion) Total Commercial Bank13.9 JP Morgan 2.44 Bank of America 2.12 Citigroup 1.98 Wells Fargo 1.44 Top 4 Banks7.98 (57%) Top 20 Banks10.6 (76%) Total FDIC Banks = 6,900

10. 10 U.S. Bank Failures Year Number of Failures 2000-2007 (total)26 200825 2009140 2010157 201190 201243 201335 No failures in Montana since 2000

11. 11 OUTLINE 1.Banking Functions 2. Banking History 3. Banking Regulations 4.Stress Tests 5. Agricultural and Small Banks 6. International Competitiveness

12. 12 Regulatory Milestones 1.Basel (I, II, III) a.Since 1983 b.International agreements c.Guide to future domestic regulation 2. Sarbane-Oxley (2002) 3. Dodd-Frank (2010)

13. 13 Basel History 1.Basel agreements have evolved since 1983 2. Capital adequacy for default risk a.Been set at 8% b.Equity must be greater than 8% of some measure of assets c.Modified to include  Off balance sheet assets  Customizable to banks

14. 14 Basel History 3.Considers capital for a.Market risk b.Liquidity risk c.Operations risk 4. Considers the quality of capital 5. Leverage ratio established > 3%

15. 15 OUTLINE 1.Banking Functions 2. Banking History 3. Banking Regulations 4.Stress Tests 5. Agricultural and Small Banks 6. International Competitiveness

16. 16 Capital Sufficiency 1. Loan default 2. Market changes (Mark to Market) 3. Operations failure 4. Measure of capital adequacy a.Risky capital ratio  Equity / Risky Asset Value  Must be greater than 8%

17. 17 Simplified Bank Balance Sheet

18. 18 Basel Standardized Risk Weights Claims on Sovereigns AAA to AA0% A + to A-20% Less than BBB + 50% to 150% Claims on Corporation Including Banks AAA to AA20% A + to A-50% Less than BBB + 100% to 150% Retail Products75% Residential Property35% Commercial Real Estate100% Other Assets100%

19. 19 Basel Standardized Risk Weights 1.All non-real estate agricultural loans a. Set at 100% 2. Agricultural real estate loans a.Generally set at 100% b.But, sometimes reduces to rates closer to home mortgages 3. Must have a risk capital ratio > 8% 4. Leverage ratio (2015) a. LR = Tier 1 Capital/Total Exposure b. > 3%

20. 20 Basel Standardized Risk Weights 5.Tier 1 Capital a. Common stock b.Retained earnings c.Preferred non-accumulating stock d.No conflicts of interest 6. Total Exposure a.All risky assets (weights > 0) b.No risk weighting

21. 21 Simplified Total Exposure 1.Total exposure = 97 million 2. Tier 1 Capital = 8 million 3. Leverage ratio = 8/97 = 8.2% 4. Assume that one-half of the equity did not qualify as Tier 1 capital a. LR = 4/97 = 4%

22. 22 Effects of Declining Loan Quality 1.Suppose that $3.5 million of a bank’s housing loans could go into default 2. Must put $3.5 million into the Loss Reserve category

23. 23 Loan Defaults Balance Sheet

24. 24 Loan Defaults Balance Sheet

25. 25 Agriculture and Risk Weights 1.Agriculture loan defaults are low 2. Agriculture returns correlations a. Low with respect to other sectors b. High within agriculture 3. IRB models usually decrease risk weights for agricultural loans if a. A bank is not heavily concentrated in agriculture

26. 26 Internal Risk Based Models 1.Alternative to standardized risk weights 2. IRB is used to customize risk weights for individual banks 3. This can substantially lower risk weights a. Sometimes by as much as 12% 4. Risk weights decline as a.Probability of defaults decline b.Default correlations are reduced

27. 27 Comparing Two Banks Capital Ratio Target10% ROA4% Interest Paid Rate3.5% Bank ItemAB Capital10 Risky Capital100 Risk Weight25% 60% Total Assets400166.67 Return on Assets over Operations16 6.67 Interest Paid13.65 5.48 Net Return2.35 1.18 ROE23.5% 11.8%

28. 28 Mark to Market 1.Suppose that home interest rates increase from 3% to 4% 2. Even if home mortgage rates have been fixed at 3% a. The value of the bank’s home mortgages declines 3. Assume an average maturity of 12 years a. The value of mortgages declines from 40 million to 37.71 million

29. 29 Mark to Market Balance Sheet

30. 30 Mark to Market on Loans 1. Usually the interest rates on loans and bonds move together a. But not always 2. If rates on bonds decline a. Bond value increases b. Equity declines

31. 31 Mark to Market Risk Mitigation 1. Sell loans into the secondary market 2. Use complex risk instruments a. Match variable and fixed interest rates on bonds and loans b. Match maturities on bonds and loans 3. Use credit swaps and other derivatives

32. 32 Future Regulations 1. Consider diversification strategies of loan portfolios 2. Make adjustments for bank size 3. More IRB customization using mathematically complex models a. Stress testing b. Value at risk c. Migration models d. Interest rate spread models

33. 33 OUTLINE 1.Banking Functions 2. Banking History 3. Banking Regulations 4.Stress Tests 5. Agricultural and Small Banks 6. International Competitiveness

34. 34 Agriculture and Risk Weights 1.Agriculture loan defaults are low 2. Agriculture returns correlations a. Low with respect to other sectors b. High within agriculture 3. IRB models usually decrease risk weights for agricultural loans if a. A bank is not heavily concentrated in agriculture

35. 35 Small Bank Challenges 1. Personnel capable of IRB analysis a. Scarce and expensive 2. Access to secondary markets are more difficult because of small size 3. Credit swaps are often not accessible 4. Loan portfolios are usually concentrated

36. 36 OUTLINE 1.Banking Functions 2. Banking History 3. Banking Regulations 4.Stress Tests 5. Agricultural and Small Banks 6. International Competitiveness

37. 37 International Comparisons ItemU.S. Developing Countries Risk free interest rate includes inflation (LIBOR or U.S. T-bill based) 2.5% Bank margin3.3%4.8% Inflation or currency risk01.5% Default risk0.5%4.0% Political and Judicial risk05.0% Commercial farmer interest rate6.3% 17.8%

38. 38 Credit Impediments: Developing Countries 1. Property rights a. Not well-established or defined b. Not useful for collateral  Unable to recover c. Real estate is often not merchandisable 2. Lack of stable, uniform, and enforceable business rules of law

39. 39 QUESTIONS