Business Finance 726, Steve Young Final Exam Review

7/29/2019 Business Finance 726, Steve Young Final Exam Review

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Final Exam Review

Chapter 13

Off Balance Sheet Risk

- Poses an uncertainty- The value of these assets and how much they are leveraged. It is not clear and can impact

investors

Contingent Assets

- An item or activity that, when a contingent event occurs, moves onto the balance side of thebalance sheet

Contingent Assets and Liabilities

- Assets and liabilities off the balance sheet that potentially can produce positive or negativefuture cash flows for an FI

Contingent Liability

- An item or activity that, when a contingent even occurs, moves onto the liability side of thebalance sheet

Loan commitment agreements

- A contractual commitment to make a loan up to a stated amount at a given interest rate inthe future

- A contractual commitment by an FI to lend to a firm a certain maximum amount at giveninterest rate terms

- Defines the length of time over which the borrower has the option to take down this loanTake down risk (TYCO)

- ??The risk that the borrower will take down the loan at an interest rate that is below that ofthe market and the issuer will have to relay the funds to the borrower??

- In February 2002, Tyco International unexpectedly drew down $14.4 billion in credit linesfrom bans such as Bank of America and J. P. Morgan Chase after being shut out of the

commercial paper market when investors began to doubt its accounting practices.

- To some extent, at least, the back-end fee on unused amounts is designed to createincentives for the borrower to take down lines in full to avoid paying this fee. However, in

actuality, many lines are only partially drawn upon.

Commercial letters of credit

- Contingent guarantees sold by an FI to underwrite the trade or commercial performance ofthe buyer of the guaranty

- In economic terms, the FI that sells the Letter of Credit (LC) is selling insurance against thefrequency or severity of some particular future occurrence. Further, similar to the different


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lines of insurance sold by property-casualty insurers, LC contracts differ as to the severity

and frequency of their risk exposures

- The FIs role is to provide a formal guaranty that payment for goods shipped or sold will beforthcoming regardless of whether the buyer of the goods defaults on payment.

Chapter 16

Sources of operational risk

- Employee risk: human error and/or internal fraudo employee turnover; key personnel risk; fraud risk; error; rogue trading; money

laundering; confidentiality breach

- Technology risk: Failure or deteriorating systemso programming error; model risk; mark-to-market error; management information; IT

systems outage; telecommunications failure; technology provider failure;

contingency planning

- Customer risk: contractual disputeso contractual disagreement; dissatisfaction; default

- Capital Asset risk: destruction by fire or other natural catastropheo safety; security; operating costs; fire/flood

- External risk: external fraudo taxation risk; legal risk; war; collapse of markets; reputation risk; relationship risk

Float

- The interval between the deposit of a check and when funds become available for depositoruse; that is, the time it takes a check to clear at a bank

Chapter 17

Fire-sale price

- The price received for an asset that has to be liquidated (sold) immediately- The price an asset holder must accept for the immediate sale may be far less than it would

receive with a longer horizon over which to negotiate a sale

- Threatens the solvency of an FIPurchased liquidity management (in red)

- An adjustment to a deposit drain that occurs on the liability side of the balance sheet- Federal funds market or repo market- Managing the liability side preserves asset side of balance sheet- Borrowed funds likely at higher rates than interest paid on deposits- Deposits are insured- Regulatory concerns: growth of wholesale funds and the potential for serious problems in

credit crunch


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Stored liquidity management (in red)

- An adjustment to a deposit drain that occurs on the asset side of the balance sheet- Liquidate assets

o In absence of reserve requirements, banks tent to hold reserves. E.g., in U.K.reserves 1% or more. Downside: opportunity cost of reserves

o Decreases size of balance sheeto Requires holding excess non-interest-bearing assetso Combine purchased and stored liquidity management

Bank runs

- A sudden and unexpected increase in deposit withdrawals form a Depository Institution- Can arise due to concern about banks solvency- Demand preferences are on a first come first served basis

o Depositors place in line mattersPro rata distribution on investment funds

- in proportion distribution of funds- Funds distributed to investors according to the amount invested in the company- Asset losses will be shared on a pro rata basis so there is no advantage to being first in line

Managing liquidity on basis of assets (selling) or maintaining balance sheet on basis of liabilities

Chapter 19

Moral hazard

- The loss exposure faced by an insurer when the provision of insurance encourages theinsured to take more risks

- With deposit insurance, a highly leverage bank whose debt holders need not monitor theDis (borrowers) actions has a strong incentive to undertake excessively risky investment

decisions, such as in its loan-generating activities

Capital forbearance

- Regulators policy of allowing an FI to continue operating even when its capital funds arefully depleted

Prompt corrective action

- When banks are in trouble, regulators do this- Mandatory actions that have to be taken by regulators as a DIs capital ratio falls


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The Too Big to Fail doctrine

- Bear Stearns and Lehman Brotherso Bear Stearns was bailed out by the governmento Lehman Brothers was allowed to crash and burn

- Too Big to Fail Banks Banks that are viewed by regulators as being too big to be closed andliquidated without imposing a systemic risk to the banking and financial system

Discount window from the FED

- Central bank lender of last resort facility- For example, suppose a DI has an unexpected deposit drain close to the end of a reserve

requirement period and cannot meet its reserve target. It can seek to borrow from the

central banks discount window facility

Chapter 20

Net worth (shareholders equity) of the bank

- A measure of an FIs capital that is equal to the difference between the market value of itsassets and the market value of its liabilities

Mark-to-Market

- Allowing balance sheet values to reflect current rather than historical prices- Marking the balance sheet items to their current prices

Basel Agreements

- The requirement to impose risk-based capital ratios on banks in major industrializedcountries- Basel I basic Basel agreement from the Bank of International Settlements

o Explicitly incorporated the different credit risks of assets (both on and off balancesheet) into capital adequacy measures.

- Basel IIo Pillar 1: calculation of regulatory minimum capital requirements

Credit risk: both on and off balance sheet Market Risk: (Standardized v. Internal Ratings-Based Approach) Operational Risk: (Basic Indicator v. Standardized v. Advanced Measurement

Approach)

o Pillar 2: regulatory supervisory review so as to complement and enforce minimumcapital requirements calculated under Pillar 1

Specifies importance of regulatory reviewo Pillar 3: requirements on rules for disclosure of capital structure, risk exposures, and

capital adequacy so as to increase FI transparency and enhance market/investor

discipline

Specifies detailed guidance on disclosure of capital structure, risk exposureand capital adequacy of banks


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Tier 1 Capital

- Primary or core capital- Closely linked to the banks book value of equity, reflecting the concept of the core capital

contribution of a banks owners

- Basically includes the book value of common equity plus an amount of perpetual(nonmaturing) preferred stock plus minority equity interests held by the bank

Tier 2 Capital

- Supplementary capital- Broad array of secondary capital resources- Includes a banks loan loss reserves up to a maximum of 1.25% of the risk-adjusted assets

plus various convertible and subordinated debt instruments with maximum caps

Chapter 27

Securitization

- The packaging and selling of loans and other assets backed by securitiesPrepayment risk

- The investor pays off more of the principle earlier often causing a refinancing of thesecuritization at a lower interest rate

IO Strip

- A bond sold to investors whose cash flows reflect the monthly interest payments receivedfrom a pool of mortgages

- Negative Duration: relationship in which the price of a bond increases or decreases as yieldsincrease or decrease

Chapter 4

Investment banking and securities firms

- Involves the raising of debt and equity securities for corporations or governments- Includes the origination, underwriting, and placement of securities in money and capital

markets for corporate or government issuers

IPOs

- An initial, or first time, public offering of debt or equity by a corporation- Goal is to raise capital for the company

The Chinese Wall

- Separate private and public functions to prevent information from crossing


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- Private areas of the bank deal with insider information that may not be publicly disclosed- An information barrier implemented within a firm to separate and isolate persons who

make investment decisions from persons who are privy to undisclosed material information

which may influence those decisions

Chapter 22

In Market Merger

- A merger of two or more companies that deal with the same banking and in the same areaMarket Extension Merger

- A merger of two or more companies that deal in different types of banking and could be indifferent areas also

Chapter 20 Maybe

Depositor transfer Resolution Method

Short Answer Topics

JP Morgan had a loan commitment to TYCO, what kind of risk did they have with respect to thisloan commitment (in detail)? How could they have mitigated that risk?

o Risks

Off Balance Sheet Risk Take down risk In February 2002, Tyco International unexpectedly drew down $14.4 billion in

credit lines from bans such as Bank of America and J. P. Morgan Chase after

being shut out of the commercial paper market when investors began to doubt

its accounting practices.

o Mitigate the risk Insert certain language into the loan commitment agreement Material Adverse Clause

Put into the agreement language that can nullify the agreement shouldthe financials of either company dramatically change

Chase and Chemical Case: Which company was in a weaker negotiating position and why?o Chase

Chemical was better capitalized Chases market to book value was less than Chemical (87% v. 94.72%) Chemicals efficiency ratio (63%) is less than Chases efficiency ratio (66.33%)

Less is better, like in golf scores


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What is a bank run? What are some possible clauses of a bank run? What feature of a demanddeposit contract contributes to a bank run?

o A sudden and unexpected increase in deposit withdrawals form a Depository Institutiono Can arise due to concern about banks solvencyo Who gets their money: first come first served

How does moral hazard relate to financial institutions and the recent financial crisis? What isthe too big to fail doctrine and how did it evolve?

o Moral hazard occurs when banks take a higher risk in an investment because their fundsare backed by such institutions as the FDIC

o If people feel like they are insulated from the possibility of negative effects, they aremore likely to act rashly and make more risky investments

o Too Big to Fail exacerbates this moral hazard because big banks can make these riskyinvestments and if they fail, they will be bailed out by the government and will get all

their money back that they lost on the failed investment

o How did it evolve? What is one of the most important trends in investment banking over the last 20 years?

o Starting to invest their own equity in their own balance sheet???? Goldman Sachs and Paulson: Abacus 2007how did they get into trouble in connection to this

trend?

o They have raised tremendous capital, with huge balance sheets?????o Got in trouble by building a failing financial product and selling it to investors while

Paulson & Co. hedged against Abacus by buying credit default swaps

Private equity firms: How do PEFs create value to their investors with respect to the buyouts ofother companies?

o Increase earningso Multiple expansiono Delever: pay down the debt that you borrowed

Securitization: What has been the effect of securitization on the asset portfolios of financialinstitutions?

o In old days, held on balance sheeto Now, they sell them and get liquidity which comes with fees that they earno Allows for an overall greater expansion

Boston Chicken IPO: What did Merrill do well in the transaction for Boston Chicken? What didthey do poorly? Who was Merrills client?

o Well: closed the dealo Poorly: mispriced the IPO, undervalued $20 v. the actual market price at nearly $48o Client: institutional investors that they were selling to, and Boston

Business Finance 726, Steve Young Final Exam Review

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