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Financial Instruments
and Institutions
Accounting and
Disclosure Rules
Second Edition
STEPHEN G. RYAN
John Wiley & Sons, Inc.
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Financial Instruments
and Institutions
Accounting and
Disclosure Rules
Second Edition
STEPHEN G. RYAN
John Wiley & Sons, Inc.
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For John and Arlene, my parents,
and Lisa and Jacob, my life
This book is printed on acid-free paper.

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada.
Wiley Bicentennial Logo: Richard J. Pacifico
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Library of Congress Cataloging-in-Publication Data
Ryan, Stephen G.
Financial instruments and institutions : accounting and disclosure rules /
Stephen G. Ryan. — 2nd ed.
p. cm.
Includes index.
ISBN 978-0-470-04037-9 (cloth)
1. Financial instruments —Accounting. 2. Financial institutions —
Accounting. I. Title.
HF5681.F54R93 2007
657′.76 — dc22
2006036780
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
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Contents
Preface
ix
Acknowledgments
xvii
CHAPTER 1
Financial Instruments and Institutions
1
Main Ingredients of the Analysis of Financial Instruments
Activities and Risks of Financial Institutions
Valuation of Financial Institutions in Practice
4
11
16
CHAPTER 2
Nature and Regulation of Depository Institutions
19
Activities of Depository Institutions
Bank Regulation
Bank Subtypes
Recent Trends
19
22
35
38
CHAPTER 3
Thrifts
45
Financial Statement Structure
Main Risk-Return Trade-Offs and Financial Analysis Issues
46
56
CHAPTER 4
Interest Rate Risk and Net Interest Earnings
63
Views of Interest Rate Risk
Interest Rate Risk Concepts
64
66
iii
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iv
Analysis of Net Interest Earnings
Rate-Volume Analysis
Repricing Gap Disclosures
CONTENTS
78
81
84
CHAPTER 5
Credit Risk and Losses
93
Economics of Credit Risk
Accounts for Loans and Loan Losses
Accounting and Disclosure Rules for Unimpaired Loans
Accounting and Disclosure Rules for Impaired Loans
Loan Portfolio Quality and Loan Loss Reserve Adequacy
Research on Banks’ Loan Loss Reserves
Appendix 5A: SunTrust Banks —After the Restatement
95
97
100
107
110
118
119
CHAPTER 6
Fair Value Accounting for Financial Instruments:
Concepts, Disclosures, and Investment Securities
131
Fair Value Accounting for Financial Instruments
Disclosures of the Fair Value of Financial Instruments
Investment Securities
Appendix 6A: Washington Federal’s Big Gap
133
141
149
158
CHAPTER 7
Mortgage Banks
161
Mortgage Banking Industry, Major Players, and Activities
Financial Statement Structure
Main Risk-Return Trade-Offs and Financial Analysis Issues
Accounting for Fees and Costs
162
167
174
186
CHAPTER 8
Securitizations
189
Why and What?
Securitization Structures
SFAS No. 140
192
196
204
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Contents
Financial Analysis Issues
Empirical Research on Securitizations
Servicing Rights and Prepayment-Sensitive Securities
Appendix 8A: Doral Financial’s Interesting
Interest-Only Strips
v
216
221
222
224
CHAPTER 9
Elements of Structured Finance Transactions
235
Special-Purpose/Variable-Interest Entities
Related Transactions
Hybrid Financial Instruments
Financial Guarantees
Recent SEC Decisions Regarding Structured Finance
Transactions
236
244
248
251
253
CHAPTER 10
Commercial Banks
255
Balance Sheet
Income Statement
Cash Flow Statement
257
261
265
CHAPTER 11
Derivatives and Hedging
269
Derivatives
Hedging
SFAS No. 133 (1998), as Amended
Framework for Assessing Financial Institutions’ Derivatives
and Hedging
272
282
285
308
CHAPTER 12
Market Risk Disclosures
311
Overview of FRR No. 48 (1997)
Tabular Format
Sensitivity Approach
312
315
322
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Value-at-Risk Approach
Comparison of Disclosure Approaches
Effect of SunTrust’s Derivatives and Hedging
on Its Market Risk
Research
Appendix 12A: Bank of America’s Derivatives,
Hedging, and Market Risk
CONTENTS
326
331
332
337
337
CHAPTER 13
Lessors and Lease Accounting
347
Competitive Advantages of Leasing
Lease Structures and Contractual Terms
Lessors’ Risks
Lease Accounting Methods
Analysis Issues Regarding Lease Accounting Methods
Special Lease Transactions
Lessors’ Financial Statements
Lease Disclosures
Possible Future Changes in Lease Accounting
350
352
355
357
366
369
374
379
387
CHAPTER 14
Insurers and Insurance Accounting
389
Products
Risk-Return Trade-Offs
Regulation
Primary Insurance Accounting Standards
Accounting Standards Governing Embedded
Derivatives and Other Life Insurance Policy Features
Financial Statements
Line of Business Disclosures
Other Insurance Accounting Systems
391
396
403
405
421
423
428
429
CHAPTER 15
Property-Casualty Insurers’ Loss Reserve Disclosures
435
Loss Reserve Footnote
438
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Loss Reserve Development Disclosures
Calculating Loss Reserves by Accident Year
Calculating Loss Reserve Revisions by Accident Year
Calculating Claim Payments by Accident Year and Tail
Constructing Accident Year Loss Reserve T Accounts
Property-Casualty Expense Ratios
vii
440
444
446
448
452
453
CHAPTER 16
Reinsurance Accounting and Disclosure
457
Accounting and Analysis Issues
Reinsurance Contracts
Accounting for Reinsurance Contracts
Reinsurance Disclosures and Analysis
Evolution of Financial Reporting for Reinsurance
459
462
472
487
493
Index
497
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Preface
T
his book provides a comprehensive guide to the analysis of financial
instruments and institutions using accounting information and disclosures that are publicly available in financial reports. It is primarily written
for users of financial reports who must confront the complex, voluminous,
and changing nature of financial reporting rules for financial instruments
and institutions. My primary goal is to provide these users with the tools
necessary to construct as coherent a story as possible about how financial
institutions and also nonfinancial firms generate or destroy value using
financial instruments. I show how financial reports provide clues to the construction of such a story through fair value accounting for financial instruments and accompanying estimation sensitivity and risk disclosures that
users can, with focused effort, piece together and interpret in a consistent
and conceptually sound fashion.
Most of the major accounting standards governing financial instruments
and transactions are covered, including those for loans, investment securities, securitizations, the constituent elements of structured finance transactions, derivatives and hedging, leasing, insurance, and reinsurance. Those
instruments and transactions for which the accounting is straightforward are
excluded. The exposition of accounting standards reflects my belief that
users of financial reports do not need to know all of the myriad details of
each standard but rather only the critical features that make or break the
representational faithfulness of financial reports. For example, in securitization accounting, these critical features pertain to the valuation and risk of
retained interests; excess value assigned to risky retained interests has led
to a sizable number of large losses by securitizers of risky assets, such as those
experienced by subprime mortgage banks during the hedge fund crisis in the
second half of 1998. This book hones in on these critical features.
My perspective is that fair value provides the simplest and most natural
measurement basis for financial instruments, especially for financial institutions that hold many instruments with correlated values that hedge or
accentuate risks at the portfolio level. However, I also emphasize that, aside
from securities and other instruments that are publicly traded in liquid
markets, fair value accounting for financial instruments inevitably involves
some degree of subjectivity (and thus possibly intentional bias) and inadvertent error (i.e., random noise) in estimation. I discuss how financial report
users can assess this subjectivity and error using required disclosures of
ix
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PREFACE
estimation sensitivity, interest rate and other market risks, credit risk, and
insurance claims risk. Most of the major required estimation sensitivity and
risk disclosures are covered.
A distinctive aspect of this book is its integrated coverage of financial
reporting for financial instruments and institutions. This coverage reflects
my strong belief that financial reporting and analysis for financial instruments must reflect the economic context of the firms and transactions
involved. I examine six types of financial institutions, which were chosen
either because they reflect specific financial transactions in a clear fashion or
because they have distinctive accounting or disclosure requirements: thrifts,
mortgage banks, commercial banks, lessors, property-casualty insurers, and
life insurers. These financial institutions constitute specific understandable
contexts that are often unusually well described in financial reports because
of risk and other disclosures mandated by industry regulators. These institutions also tend to have more extensive ranges or lengthier histories of
specific financial transactions than nonfinancial firms. For these reasons,
financial institutions provide the best available settings to learn disciplined
analysis of financial instruments. Users of nonfinancial firms’ financial
reports will find learning such disciplined analysis useful in their settings.
WHY I WROTE THE BOOK
In teaching courses on financial instruments and institutions at the Stern
School of Business of New York University over the past 12 years, I have
found that the available treatments of the relevant financial reporting rules
have three weaknesses from the perspective of users of financial reports.
First, the available treatments usually target one of two audiences. Some are
written for preparers of financial statements or practicing accountants, who
naturally are concerned with how to account for specific complex transactions; these treatments tend to be poorly grounded in economic concepts and
overly detailed with respect to implementation issues. Alternatively, some
are written for the generalist student of financial analysis; these treatments
provide little of the context necessary to understand financial transactions
and institutions, discuss the relevant financial reporting rules inadequately
if at all, and apply analytical schemas that invariably have been developed
for nonfinancial transactions and firms. Either approach obscures the nature
and usefulness of the financial report information about financial instruments and institutions from the perspective of users of financial reports. In
contrast, while avoiding needless detail, I provide economically grounded
descriptions of financial transactions and institutions, thorough treatments
of the accounting standards and disclosure rules applying to financial instruments and financial institutions, and many cases drawn from the financial
reports of actual financial institutions.
Second, most of the recently propounded and likely future financial
reporting rules involve some form of fair value accounting for financial
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instruments. The available treatments do not provide sufficient discussion
of the nature, strengths, and weaknesses of fair value accounting for financial report users to be able to evaluate the information provided by these
rules. I provide a strong conceptual treatment of fair value accounting. I
supplement this with numerous cases drawn from actual financial institutions’ financial reports that illustrate when fair value accounting for financial instruments works well and when it is fragile. These cases span the
various types of financial institutions covered in the book, which allows me
to emphasize the common issues that apply across types of institutions.
These common issues arise because financial transactions inherently have
common features, but also because smart financial transaction designers
quickly import innovations developed in other settings. Moreover, the distinctions among various types of financial institutions continue to blur over
time, with the products they offer increasingly competing against each other.
For example, I discuss how the retention of residual risk raises similar financial reporting and analysis issues in securitizations, leasing, and reinsurance.
These features enable diligent readers to develop robust intuitions about fair
value accounting for financial instruments. They also imply that readers interested in a subset of the topics will benefit considerably from reading the
whole book.
Third, the available treatments give insufficient emphasis to the analysis of estimation sensitivity and risk disclosures. These disclosures are a critical complement to fair value accounting for financial instruments, since
they indicate the sensitivity of the fair value of the firm’s financial instruments to changes in risk factors and since assumptions about risk factors are
required to estimate the fair values of financial instruments. Moreover,
financial institutions are in large part and increasingly in the risk management business, and so risk disclosures are absolutely essential to the analysis
of these institutions.
ENRON, SARBANES-OXLEY, AND CHANGES IN
FINANCIAL REPORTING RULES FOR STRUCTURED
FINANCE TRANSACTIONS
The importance and limitations of financial reporting for structured finance
transactions was made apparent by the implosion of Enron, which engaged
in a diverse and complex set of those transactions, many of which were
accounted for properly but some significant examples of which were not.
Enron illustrates how these transactions, even if accounted for properly, can
place considerable stress on financial reporting, especially when they are used
to exploit existing accounting rules to obtain desired outcomes such as
off–balance sheet financing or income management. Enron along with other
accounting scandals such as WorldCom created the political pressure necessary to pass the landmark Sarbanes-Oxley Act of 2002, which has led swiftly
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to many significant changes in financial reporting rules, many of them pertaining to structured finance transactions.
For example, since the passage of Sarbanes-Oxley, the Financial Accounting Standards Board (FASB) has issued significant accounting standards on
derivatives and hedging, special-purpose/variable-interest entities, hybrid
financial instruments, financial asset servicing rights, financial guarantees,
and fair value measurements. The FASB’s agenda includes significant projects
on derivatives disclosures, transfers of financial instruments, liabilities and
equity, leases, insurance risk transfer, and the fair value option. The Securities and Exchange Commission (SEC) has issued comprehensive disclosure
requirements for off–balance sheet financing arrangements as well as a special
report that describes its approach and recommendations regarding accounting-motivated structured finance transactions. The SEC, Department of Justice, Office of the New York State Attorney General, and other regulators
have pursued their enforcement activities with unprecedented resources
and zeal.
This book provides many insights about how structured finance transactions should be accounted for and analyzed using the information provided
in financial reports. It describes the economic substance of and accounting
for some of the most important types of structured finance transactions,
including securitizations, (synthetic) leasing, and (finite) reinsurance as well
as the constituent elements of those transactions including special-purpose
entities, transactions related through netting agreements or by the intent of
the counterparties, hybrid financial instruments, and financial guarantees.
Structured finance transactions often partition the risk and value of underlying financial (and, in the case of leasing, nonfinancial) assets and liabilities nonproportionally; for example, securitizations frequently involve the
value of the securitized financial assets being disproportionately but not
fully transferred to asset-backed security purchasers while the risks of those
assets are disproportionately but not fully retained by issuers. When this is
the case, no single method of accounting for these transactions fully captures their nature, since accounting can describe either the value transfer or
the risk transfer but not both. The critical questions for financial report
users are how the accounting method chosen by the reporting firm does and
does not describe the specific transactions the firm engages in, and, given
the inevitable limitations of the accounting, how the estimation sensitivity
and risk disclosures provided by the firm can be analyzed to address the limitations of the accounting.
In the preface to the first edition of this book, published in the immediate wake of Enron, I expressed concern that Enron might provoke overreactions from accounting standards setters and regulators that would
have detrimental effects on financial reporting for financial instruments
and structured finance transactions. Thankfully, this has not been the case.
In particular, in most of its decisions the FASB has continued on a measured course toward broader fair value accounting for financial instruments.
Although fair values are judgmental for some financial instruments and this
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judgment can be abused, fair value accounting is absolutely necessary to
describe risky financial instruments and structured finance transactions,
especially at the level of portfolios of instruments, which financial institutions by their nature hold. While not all financial instruments currently
should be fair valued and errors in fair valuations will occur even for those
that should, a desirable property of fair value accounting is that it corrects
its mistakes over time, since financial instruments must be revalued each
period based on current market conditions. In this regard, many of Enron’s
problems simply would have taken longer to uncover if its accounting were
not based on fair value.
Moreover, in most of their decisions the FASB and SEC have recognized
that the proper way to deal with the stress placed on financial reporting
rules by structured finance transactions is not to jury-rig accounting standards in a futile attempt to dissuade abuse. Instead, they have worked diligently to develop conceptually sounder accounting standards, to require
enhanced disclosures about the nature and purposes of these transactions,
and to provide legal and regulatory (not accounting) disincentives to engage
in transactions with no business purpose that impair the transparency of
financial reports. For example, this approach is evident in the SEC’s disclosure rule on off–balance sheet financing arrangements and its special report
on structured finance transactions mentioned earlier.
Despite the progress made the FASB, SEC, and other accounting policymakers over the past five years, financial reporting rules for financial instruments and structured finance transactions remain highly limited in many key
respects and so will continue to evolve rapidly over the coming years. Fair
value accounting is required only for a small subset of financial instruments.
Virtually all of the major accounting standards for financial instruments
include bright-line, characteristic-based, or intent-based criteria that require
very different accounting for substantively similar instruments, providing
fertile ground for accounting-motivated structured finance transactions.
Disclosures of financial instruments, while voluminous, are disjointed and
often explained poorly or not at all by management. As a result of these limitations, users of financial reports must expend considerable effort and
make significant assumptions in order to draw conclusions about the reporting firm. This book’s conceptual approach will help financial report users
understand and cope with this evolution in financial reporting rules.
TOPICAL COVERAGE AND STRUCTURE OF THE BOOK
The structure of this book reflects my belief that it is important for users
of financial reports to recognize that the value and risk of financial instruments depends on the economic contexts in which they are embedded. I
use the six types of financial institutions mentioned earlier as the source of
context. The book is organized around these types of financial institutions,
starting with relatively simple institutions and proceeding to related but more
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complicated ones. I describe the activities and risks of each type of financial institution in an economically grounded yet intuitive fashion. Financial
reporting and analysis issues are discussed in the same chapter as or immediately subsequent to the chapter covering the most pertinent type of financial institution. This structure allows readers to progress naturally from
relatively simple financial institutions and associated financial reporting and
analysis issues to related but more complex institutions and issues. For readers interested in a specific topic, however, each chapter (or pair of related
chapters) is written to be as self-contained as possible.
Chapter 1 overviews the financial reporting and analysis of financial
instruments and institutions. Chapter 2 contains useful background material
on the structure and regulation of the two main types of depository institution: thrifts and commercial banks. Chapter 3 describes the activities, risks,
and financial reporting of thrifts, the simplest depository institution, which
primarily take deposits and hold residential mortgage-related assets. Most
of the material in this chapter also applies to commercial banks. Chapters
4 through 6 develop and illustrate the application of financial analyses based
on the accounting for and mandated disclosures of interest rate risk, credit
risk, and fair value of financial instruments, respectively. Chapter 7 describes
the activities, risks, and financial reporting of mortgage banks, which write
similar loans to thrifts, but which securitize or otherwise sell most of their
loans. Chapter 8 explains the financial reporting rules for financial asset securitizations and develops and illustrates the application of financial analyses of
prepayment risk and retained interests from securitizations. Chapter 9 discusses the accounting rules governing various important constituent elements
of structured finance transactions, including special-purpose/variable-interest
entities, transactions related through netting agreements or by the intent of
the counterparties, hybrid financial instruments, and financial guarantees.
Chapter 10 describes the financial reporting of commercial banks, which
do everything that thrifts and mortgage banks do but are more involved with
derivatives, hedging, and risk management activities. Chapter 11 explains
the financial reporting rules for derivatives and hedging and develops a
schema for the financial analysis of financial institutions’ derivatives and
hedging. Chapter 12 describes market risk disclosures and illustrates their
critical importance in applying that schema. Chapter 13 describes the activities, risks, and distinct financial reporting of lessors, which compete with
commercial banks for certain types of commercial lending. This chapter
also develops and applies financial analyses of lessors. Chapter 14 describes
activities, risks, and distinct financial reporting of property-casualty and life
insurers, which provide different sorts of risk management services from
commercial banks. This chapter also develops and applies financial analyses
of these insurers. Chapter 15 describes property-casualty insurers’ loss reserve
disclosures and develops and illustrates financial analyses using those disclosures. Chapter 16 describes the accounting and disclosures by ceding
insurers for reinsurance, focusing on retroactive and finite reinsurance.
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SIGNIFICANT CHANGES FROM THE FIRST EDITION
The most significant changes from the first edition are the inclusion of new
chapters on constituent elements of structured finance transactions (Chapter 9) and reinsurance (Chapter 16). Although these topics were covered
briefly in the first edition, events occurring since the publication of the first
edition made it clear that these topics demand fuller treatments. This is
especially apparent in the case of finite reinsurance transactions currently
receiving intense scrutiny from the SEC and other regulators. Both of these
chapters contain comprehensive yet accessible treatments of their topics that
are not available elsewhere.
All of the other chapters have been improved in their exposition and
updated for the many significant changes in financial reporting rules, regulation, and economic conditions that have occurred since the publication of
the first edition, only a portion of which have been mentioned. Although
the conceptual approach taken is the same as in the first edition, readers of
the first edition will find that the new edition serves as a decidedly superior reference guide.
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Acknowledgments
W
hen I began teaching a course on the analysis of financial institutions
at the Stern School of Business in 1995, I was fortunate to inherit the
materials and videotapes of the prior instructor, Gerald White, a gift that
has influenced this book in many ways. Tom Linsmeier provided me with
his materials on derivatives and hedging and wrote a valuable review of the
first edition of this book, and he continues to provide insightful answers to
obscure questions about the application of hedge accounting in practice.
I have been fortunate to have coauthors who have shared their understanding of financial institutions’ financial reporting with me. My mentor
Bill Beaver first involved me in research on banks’ loss reserving in 1985.
This led to a series of papers with Chi-Chun Liu and Jim Wahlen. Jim introduced me to Kathy Petroni, who taught me much of what I know about
property-casualty insurers in our project together. I have learned about
financial reporting in general and financial instruments in particular from
my many interactions with the members and staff of the Financial Accounting Standards Board and my colleagues on the American Accounting Association’s Financial Accounting Standards Committee and the Financial
Accounting Standards Advisory Council, especially Jim Leisenring, Dennis
Monson, Katherine Schipper, and Cathy Schrand. The book has also benefited from my interactions with many other accounting academics and practitioners, including Anne Beatty, Jeff Callen, Jack Ciesielski, Tom Frecka,
Dov Fried, Dan Gode, Lisa Koonce, Doron Nissim, Mohan Venkatachalam,
and Patricia Walters.
I am fortunate to have had hundreds of students at the Stern School with
whom I shared my ideas as they developed, who have provided suggestions
about or caught errors in my original draft chapters or in the first edition
of this book, and who have alerted me to recent developments. Particularly
notable contributions have been made by Andrew Henckler and Robert
Young. I also appreciate the financial support of the Stern School, Dean
Thomas Cooley, and Robert Stovall, who endowed my faculty fellowship.
I appreciate the capable editorial services of Sheck Cho, my executive
editor, at John Wiley & Sons. Sheck kept me moving on the second edition
of this book, which took longer than either he or I expected.
My parents believed strongly in the importance of education, and they
sacrificed considerably to provide their six children with good ones. More
important, they instilled in me the desire to learn a little more every day,
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ACKNOWLEDGMENTS
and the many improvements in the second edition of this book reflect the
gradual accumulation of knowledge over the five years since the publication
of the first edition.
Day in and day out, I come home from work to find my dear and tenacious wife, Lisa, helping our one and only son, Jacob, with his schoolwork,
which yields satisfactions and frustrations for both of them, while I get to
read to Jacob before bed, a pure pleasure for both of us. I wish for Jacob the
never-ending love of learning, in work and play, that my parents gave me,
and for Lisa the knowledge that she carries on, nobly, a family tradition.
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CHAPTER
1
Financial Instruments
and Institutions
F
inancial reporting for financial instruments and institutions is undergoing
a period of unprecedented change and salience for financial analysis. In
the past decade, the Financial Accounting Standards Board (FASB), the primary
accounting standards setter in the United States, has issued major standards
on derivatives and hedging, transfers of financial instruments including securitizations, servicing of financial assets, consolidation of special-purpose/
variable interest entities, hybrid financial instruments, financial guarantees,
and fair value measurements. These standards reflect the FASB’s attempts
to address the limitations of prior accounting and disclosure rules that
provided the settings for the huge losses recorded by firms that ineffectively
hedged using derivatives during the interest rate run-up in 1994 or that held
residual or subordinated interests from securitizations during the hedge fund
crisis of 1998. They also reflect its attempts to improve the transparency
of financial reporting for accounting-motivated structured finance transactions that provided much of the impetus for the Sarbanes-Oxley Act of
2002. During this period, the Securities and Exchange Commission (SEC)
developed extensive disclosure requirements for market risk and off–balance
sheet financing arrangements for much the same reasons.
This change will carry on for the foreseeable future, with the FASB’s agenda
including projects on the fair value option for financial instruments, transfers and servicing of financial instruments, liabilities and equity, leases, insurance risk transfer, and derivatives disclosures. All indications are that the FASB
will continue to proceed on a measured course toward fair value accounting for almost all financial instruments as well as enhanced disclosures. This
course should improve financial reporting both by providing more accurate,
timely, and relevant information about individual financial instruments and
by eliminating differences in the accounting for different types of financial
instruments. While different accounting methods for different types of financial instruments may have been appropriate historically, such differences are
increasingly arbitrary and yield noncomparability both across a given financial institution’s financial statement line items and across different types of
1
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FINANCIAL INSTRUMENTS AND INSTITUTIONS
financial institutions’ financial statements, thereby providing fertile ground
for accounting-motivated transactions.
The development of financial reporting rules for financial instruments
just described has provided users of financial reports with substantial new
information about how firms generate or destroy value using these instruments. Considerable understanding and diligence are necessary for users of
financial reports to identify and analyze this information fully, however, for
several reasons. First, current accounting for financial instruments reflects
a “mixed attribute” model, with some instruments recognized at fair value
while others (most, in fact) are recognized at amortized cost. This model
obscures the economics of natural hedges in which the two sides of the hedge
are recognized using different valuation attributes, yielding excess volatility
in owners’ equity and net income. For example, commercial banks often hold
investment securities recognized at fair value that are natural hedges of deposits
or debt recognized at amortized cost. Although financial report users can address
this problem using required footnote disclosures of the fair values of all financial instruments, these disclosures are invariably poorly integrated with the
other information in the report, forcing users to perform this integration.
Second, fair value accounting, while preferable to amortized cost accounting, does not constitute a complete description of financial instruments. For
financial instruments other than securities and other instruments that are
publicly traded in liquid markets, estimated fair values typically include nontrivial subjectivity (and thus potential bias) and inadvertent error (i.e., random
noise). Estimation subjectivity and error are of particular concern for financial instruments that are highly sensitive to valuation assumptions, such as
residual or subordinated interests from securitizations and derivatives. Thus,
the fair values of financial instruments need to be supplemented with information about their sensitivity to valuation assumptions. Relatedly, financial
instruments can be risky and financial transactions often involve complex
partitioning of risk among various parties. Thus, the fair values of financial
instruments need to be analyzed jointly with information about their market
and nonmarket risks. Although financial reports do contain some information in this regard, the quality, comparability across firms, and integration
of this information are again poor, forcing users to rework and integrate this
information.
Finally, current financial reporting for financial instruments and structured finance transactions is complex. Much of this complexity is unnecessary and should be reduced as the FASB develops a conceptually sound
and coherent set of financial instruments standards, but some of it is an
inevitable result of economically justified complexity in the instruments
and transactions and the FASB’s desire to describe that complexity through
accounting. The only way for users to deal with this problem is to understand the economics of instruments and transactions and how accounting does
and does not capture those economics in as complete and robust a fashion
as possible.
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3
The primary purpose of this book is to provide users with the tools to
do this, in particular, to exploit fully the various sources of information about
the fair values and risks of financial instruments provided in financial reports
in order to construct the most coherent possible story about how firms generate or destroy value using financial instruments. In serving this purpose, the
focus is on financial institutions, which provide the best available settings
in which to learn disciplined analysis of financial instruments for two reasons:
1.
The value and risk of the financial instruments held by a firm depend on
the economic context of the firm and the correlations among the individual instruments. Financial institutions constitute specific understandable contexts that primarily involve financial instruments or transactions.
Moreover, financial institutions frequently are required by industry regulators to provide extensive risk disclosures, which supply information
about the correlations among the instruments.
2.
Financial institutions generally have more extensive ranges and lengthier histories of specific financial transactions than nonfinancial firms,
and so are more likely to have experienced the significant issues that
apply to those transactions. For example, readers interested in securitizations of trade receivables by nonfinancial firms will find that the cases
of mortgage banks’ securitizations of residential mortgages discussed in
Chapter 8 generalize to their concerns, since these cases clearly indicate
the conditions under which securitization accounting works well and under
which it is fragile.
The remainder of this chapter provides important perspectives and terminology regarding financial instruments and institutions. The first section
explains the five main ingredients involved in using financial report information
to construct the most coherent possible story about how firms generate or
destroy value using financial instruments. As discussed, the two most important ingredients are fair value accounting for financial instruments and
disclosures of the estimation sensitivity and risk of these instruments. The
third ingredient pertains to financial transactions, such as securitizations,
leasing, and reinsurance, in which the value and risk of underlying financial
instruments are partitioned among various parties. Although the simplest
and most flexible way to view these transactions is using a fair value partitioning (financial components) perspective, in cases of disproportionate risk
retention by the firm under consideration, users need to temper this with
a risk partitioning perspective. The fourth ingredient is the evaluation of
individual financial instruments and portfolios of those instruments on both
gross and net bases, because the market and credit risks of the instrument or
portfolio may offset in part but not entirely, and because different risks may
offset to different extents (e.g., market risks generally are easier to offset
than credit risks). The final ingredient is that financial transactions are financial, even though in many cases, such as leasing and traditional insurance,
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FINANCIAL INSTRUMENTS AND INSTITUTIONS
these transactions are treated as operating under current financial reporting
rules. These five ingredients are applied repeatedly in the various financial
analyses described in this book.
The second section describes the various activities and risks of financial
institutions. Financial report users need to recognize that historically distinct
types of financial institutions increasingly perform the same or similar activities, and so it is most important to distinguish institutions based on the
activities and risks in which they engage. In the last section, the valuation of
financial institutions in practice is discussed.
MAIN INGREDIENTS OF THE ANALYSIS
OF FINANCIAL INSTRUMENTS
Fair Value Accounting
This section explains why and how fair value accounting describes individual
financial instruments and especially portfolios of those instruments —which
constitute the primary rights and obligations of most financial institutions —
better than amortized cost accounting. Definitions for financial instruments,
fair value accounting, and amortized cost accounting that are used throughout the book are also provided.
The term “financial instruments” as defined by the FASB and as used
in this book includes financial assets and liabilities but not the firm’s own
equity. The firm’s own equity is a financial instrument, of course, just not
one for which direct fair valuation generally is contemplated. Financial assets
are contractual claims to receive cash or another financial instrument on
favorable terms or ownership interests in another firm. Financial liabilities
are contractual claims to pay cash or another financial instrument on unfavorable terms.
Fair value is the price that would be received to sell a financial asset or
to transfer a financial liability in an orderly transaction between market participants at the measurement date, and so it reflects current expectations of
the cash flows and priced risks of the financial instrument. Fair values can
be estimated either by observing the market prices for the financial instrument or similar instruments or by using an accepted valuation model with
observable market or unobservable firm-supplied inputs.
Full fair value accounting involves three aspects. On the balance sheet,
it involves recognition of financial instruments at fair value. In the United
States, this aspect of fair value accounting currently is required only for trading and available-for-sale securities, derivatives, hedged items in designated
effective fair value hedges, and the financial inventory of broker-dealers.
(Certain items, such as hybrid financial instruments and rights to service
financial assets, may be accounted for using full fair value accounting under
fair value options for those items. Certain other items, such as financial guarantees, must be recognized at fair value at inception but not subsequently.)
On the income statement, full fair value accounting involves the recognition
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5
of unrealized gains and losses on financial instruments in net income in the
period they occur, which often is prior to their realization through the sale
or repurchase of the instruments. This aspect of fair value accounting currently is required in the United States only for trading securities, derivatives other than those involved in effective cash flow hedges, hedged items
under fair value hedges, and the financial inventory of broker-dealers. In
particular, this aspect is not required for available-for-sale securities or derivatives involved in effective cash flow hedges, despite the fact that they are
recognized at fair value on the balance sheet. Also on the income statement,
full fair value accounting involves calculating interest revenue or expense
as the fair value of the financial instrument times the applicable current
market interest rate during the period. This aspect of fair value accounting
is not required for any financial instrument under current financial reporting rules in the United States. Interest usually is calculated on an amortized
cost basis; when it is not, it is combined with gains and losses, and the total
change in the value of the financial instrument is reported on a single line on
the income statement, as is often the case for trading securities, derivatives,
and the financial inventory of broker-dealers.
Fair value accounting for financial instruments is increasingly feasible
for two reasons:
1.
The markets for financial instruments have become much richer over time.
For example, risky assets that previously were difficult to trade, such
as commercial loans, now can be securitized.
2.
Financial theory, such as options pricing, has developed and been applied
successfully in many contexts by practitioners.
The fair value of most financial instruments now can be estimated with a
reasonable degree of precision either through observation of the market
prices of similar instruments or through the use of accepted valuation models.
For financial instruments that currently cannot be fair valued with a reasonable degree of precision, the proper mind-set is not that amortized cost is
unconditionally preferable to fair value accounting but rather that markets
or valuation models simply need more time to develop sufficiently for those
instruments to be fair valued.
Unlike nonfinancial firms, financial institutions typically hold sizable
portfolios of financial instruments. These instruments often have correlated
values — that is, they hedge or accentuate risks at the portfolio level. Full
fair value accounting for all of the financial instruments in a portfolio is the
simplest and most robust way to account for these correlations. In particular, gains and losses on effective hedges of one financial instrument by another
will offset in net income. In contrast, gains and losses on ineffective hedges
or speculative positions will not so offset.
The alternative to fair value accounting, amortized cost accounting, uses
expectations of cash flows and priced risks determined at initiation to account
for financial instruments throughout their life. Amortized cost accounting has three undesirable features compared to fair value accounting. First,
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amortized cost accounting uses old information and so provides untimely
measures of the value of financial instruments on the balance sheet. This
untimeliness resolves only as financial instruments amortize or when they
are sold or repurchased.
Second, since financial institutions typically hold portfolios of financial
instruments initiated at different times, amortized cost accounting provides
measures of the values of these instruments that reflect expectations of cash
flows and priced risks at different times. This yields noncomparability problems on both balance sheet and income statement. For example, net interest
income for a commercial bank may include interest revenue that is based
on older interest rates than those reflected in interest expense; if so, net interest income does not reflect the bank’s interest rate spread at any point in
time, and so it is likely to be a poor predictor of future net interest income.
Admittedly, hedge accounting may mitigate these limitations of amortized
cost accounting, but hedge accounting is more complex and less transparent
than fair value accounting for all financial instruments. Moreover, hedge
accounting applied to specific hedging relationships within a portfolio, as
is required in most cases under current accounting rules, need not capture
the effects of hedging at the portfolio level.
Third, amortized cost accounting provides firms with the ability to manipulate net income through realizing gains or losses on the sale of financial assets
or repurchase of financial liabilities. This is particularly easy for financial
institutions to do, since they usually hold numerous sets of matched positions, with one side of each matched position likely having appreciated and
the other side likely having depreciated. For all three reasons, amortized cost
provides a poor basis for accounting for financial instruments and institutions, especially given the existence of increasingly complex and sensitive
financial instruments whose values are subject to rapidly changing information and market prices for risk.
Advocates of amortized cost accounting for financial instruments by financial institutions usually make two related arguments on its behalf:
1.
2.
The managers of financial institutions do not manage the fair values of
financial instruments, since these values reflect changes in interest rates
and other market prices that are outside their control. Instead they manage investment and financing decisions that yield income on financial
assets that is expected to exceed the expense associated with financing
those instruments over their whole lives.
These managers conceptualize financial institutions’ risk not as the variability of their value over short periods but rather as the variability of
their net income or cash flows over long periods.
Neither of these arguments makes much sense for most financial institutions. The current interest rates and other market prices embedded in the
fair values of financial instruments are empirically better predictors of
future market prices than are the differentially old market prices embedded
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in amortized costs. Thus, the managers of financial institutions who do not
pay attention to the current fair values of their financial instruments are likely
to find that they are unable to generate income or cash flow going forward.
As discussed, most financial institutions hold portfolios of financial instruments, and these instruments usually trade in reasonably liquid markets. If
financial institutions require liquidity, they usually can sell their financial
assets. In this regard, fair value is the best available estimate of the sales price
of assets and thus of financial institutions’ liquidity. More generally, value
variability, not income or cash flow variability, is clearly the right risk concept
for all but the most illiquid financial institutions.
While preferable to amortized cost accounting, fair value accounting does
not provide a full description of financial instruments. Three general threats
to the economic descriptiveness of fair value accounting exist.
1.
2.
3.
When estimates are required to calculate fair values, as usually is the case
for financial instruments other than securities that are publicly traded
in liquid markets, a degree of subjectivity and noise is inevitably involved.
This degree varies substantially across types of financial instruments, and
financial instruments do exist for which fair value accounting is more
problematic than amortized cost accounting.
Fair value estimation errors are effectively leveraged in transactions such
as risky asset securitizations in which a low-risk claim to underlying
financial instruments is transferred to another party while a risky residual
or subordinated claim is retained. The fair value assigned to the retained
risky claim typically includes most or all of the estimation error in the
fair value of the underlying financial instruments.
Even for financial institutions, it is unlikely that all their economic assets
and liabilities are or will ever be fair valued, either because of estimation
difficulties or because some of these assets and liabilities are real, intangible, or do not meet criteria for accounting recognition. If so, fair value
accounting will not capture the value of all economic assets and liabilities of financial institutions, which will yield nondescriptive volatility
in owners’ equity and net income when these exposures hedge each other.
The first two limitations of fair value accounting are mitigated by its selfcorrecting nature, however, since fair values must be reestimated each period.
This situation is in marked contrast to the predetermined nature of amortized cost values. The third limitation will be mitigated in the future by the
expansion of fair value accounting to a broader set of financial instruments.
All three limitations can be addressed through appropriate disclosures, as
discussed in the next section.
Estimation Sensitivity and Risk Disclosures
Subjectivity and noise in estimating fair values, even when leveraged through
the retention of risky residual claims, can be mitigated through clear disclosure
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of estimation assumptions and the sensitivity of fair values to those assumptions. For example, estimation sensitivity disclosures are required for retained
interests in securitizations under Statement of Financial Accounting Standards (SFAS) No. 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities (2000).1 Unfortunately, these disclosures tend to follow boilerplate presentations that do not clearly reflect the
economics of retained interests. For example, the effects of changes in interest
rate and prepayment assumptions on prepayment-sensitive residual interests typically are disclosed separately and independently, even though interest
rate decreases drive prepayment increases.
Fair values are point estimates of the current value of financial instruments. Realized values can differ substantially from estimated values, especially
for risky financial instruments such as residual or subordinated interests from
securitizations and derivatives. Thus, fair values should be analyzed jointly
with market, credit, and other risk disclosures. Risk disclosures are required
under various FASB standards and SEC rules. In addition, for financial institutions, industry regulators often require additional risk disclosures.
A key aspect of this book is its emphasis on the importance of joint analysis of fair value accounting and estimation sensitivity and risk disclosures
to construct the most coherent story possible about how firms generate or
destroy value using financial instruments. This analysis invariably involves
piecing together and consistently interpreting information from various places
in the financial reports of financial institutions. Although burdensome, this
analysis often provides a very different perspective on a financial institution’s
activities from what is conveyed in the financial statements or in management’s discussion and analysis (MD&A). For example, it is not difficult to
find financial institutions that properly apply hedge accounting to specific
hedging relationships and that smooth their net income as a result but that
are antihedging or substantially overhedging their aggregate exposures.
Unfortunately, clear discussions of the effect of hedging on aggregate exposures in financial reports are infrequent for all but the simplest financial
institutions.
Limitations arising from fair valuation of less than all assets and liabilities can be mitigated through separate presentation of unrealized gains and
losses on the income statement and through management discussion of the
existence of economic hedges of non–fair-valued exposures. In this respect,
fair value accounting prods the managements of financial institutions to explain
their economic exposures better than does amortized cost accounting.
Fair Value versus Risk Partitioning
Perspectives on Financial Transactions
Many financial transactions, such as securitizations, leasing, and reinsurance,
involve partitioning the fair value and risks of underlying financial instruments (or, in the case of leasing, real assets) among various parties. A financial
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components perspective, in which the claims to the underlying financial
instruments are accounted for based on their (relative) fair values, is the
simplest and most flexible way to describe these transactions. This perspective has two conceptually desirable features. First, this perspective is “history
independent,” meaning that the accounting at a given time is based on the
rights and obligations held by each party at that time, not on the history of
transactions that gave rise to those rights and obligations. History independence is critical to attaining comparable accounting for structured finance
transactions, because these transactions can be structured in a literally infinite variety of ways that yield the same allocation of rights and obligations
to the parties. Second, this perspective is also consistent with fair value accounting for financial instruments.
A financial components perspective is adopted in SFAS No. 140, which
governs securitizations. It has not yet been applied broadly to financial transactions, although it may be applied more broadly in the future. For example,
the FASB decided in July 2006 to comprehensively reconsider lease accounting, and it is likely to begin its reconsideration with the proposal of the G4 1
Group of Accounting Standards Setters (the standards setters of Australia,
Canada, New Zealand, the United Kingdom, the United States, and, as an
observer, the International Accounting Standards Committee) to apply a
financial components perspective to leases in its special report Leases:
Implementation of a New Approach (2000).2 In its liabilities and equity and
its risk transfer projects, the FASB is considering bifurcation of instruments
with characteristics of liabilities and equity and (re)insurance contracts into
components.
While a financial components perspective has desirable attributes, users
of financial reports should be aware that it is not the only meaningful way
to describe these types of transactions. A risk-partitioning perspective is also
important in cases of disproportionate risk retention. It is possible to transfer most of the fair value of underlying financial instruments while retaining
most of the risk. The breakdown of securitization accounting for subprime
mortgage banks and other securitizers of risky financial assets during the
hedge fund crisis in the second half of 1998 occurred in large part because
these issuers sold most of the fair value of the underlying financial assets
while retaining most of the risk.
Gross and Net Evaluation
Financial instruments exhibit both market (e.g., interest rate, exchange rate,
and commodity price) and nonmarket (e.g., credit, performance, and insurance) risks. Individual financial instruments and portfolios of financial
instruments may need to be evaluated on both gross and net bases, because
the risks of the constituent elements of an instrument or portfolio may offset
in part but not entirely and because offsetting is more likely to occur for market
risks than for nonmarket risks. A gross evaluation considers the constituent
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elements of a financial instrument or portfolio separately, without taking into
account any offsetting of the elements. Conversely, a net evaluation considers the instrument or portfolio after the effect of offsetting.
Specifically, the market risks of financial instruments usually are relatively easily offset across the instruments in a portfolio. For example, a bank
can offset the interest rate risk of a fixed-rate loan asset by engaging in either
a fixed-rate deposit liability or a receive floating-pay fixed interest rate swap.
Because of this ability to offset market risks, for a portfolio of financial instruments these risks usually are best evaluated net.
In contrast, the nonmarket risks of financial instruments are relatively
hard to offset across instruments. For example, a bank cannot offset the credit
risk on a loan asset, which reflects the borrower’s creditworthiness, with a
deposit liability that reflects the bank’s own creditworthiness. Although credit
derivatives markets are developing to offset credit risks, these markets remain
smaller and less liquid than the markets to offset market risk. Even when
credit derivatives are available and used to offset credit risks, they rarely
do so fully because of contractual features, such as the “cheapest to deliver”
option. Because of this difficulty in offsetting, the nonmarket risks of a portfolio of financial instruments are often best evaluated gross. A number of
exceptions to this rule exist, however; for example, the credit risk of a portfolio of financial instruments subject to a close-out or novation netting agreement is best evaluated net.
Structured finance transactions that include multiple legs raise the gross
and net evaluation issue in a similar fashion as portfolios of financial instruments. The market risks of the various legs of the transaction are more likely
to offset than are their nonmarket risks.
In contrast, individual derivative financial instruments raise the gross
and net evaluation issue in mirror-image fashion to portfolios of financial
instruments. Derivatives generally can be thought of as a long position in
one financial instrument and a short position in another financial instrument, with the two positions settling net. For example, a receive floating-pay
fixed interest rate swap is a floating-rate asset and a fixed-rate liability that
settle net. Insofar as derivatives settle net, their credit risks are best evaluated at the net level of the derivative, not the gross level of the offsetting
positions within the derivative. In contrast, the market risk of derivatives
typically reflects only one of the gross positions within them. For example,
the interest rate risk of a receive floating-pay fixed interest rate swap reflects
only the fixed-rate liability. Hence, the market risks of derivatives are best
evaluated at the gross level of the positions within the derivative.
Financial Transactions Are Financial
It is evident that financial transactions should be classified and measured as
such in financial reports. Unfortunately, many financial transactions, such
as operating leases and traditional insurance, are treated as operating under
current accounting standards. Relatedly, by requiring different accounting
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based on bright-line criteria, characteristics of instruments, or the intent of
management, the accounting standards governing financial instruments yield
dramatic differences in the accounting for economically similar financial
instruments. A nontrivial benefit of adopting fair value accounting for all
financial instruments is that it would make transparent the common financial nature of these transactions and of the institutions that engage in them.
For example, lessors that primarily engage in operating leases appear
to be capital asset management companies under current accounting rules,
with rent revenue and depreciation expense dominating their income statements. This is despite the fact that these lessors often lease long-lived equipment or real estate under long-term contracts that are clearly primarily financing
arrangements expected to generate an interest rate spread for the lessor. This
financial nature would be far more apparent if the economic lease receivables
arising in these transactions were recognized as such on the balance sheet,
with the economic interest revenue on these receivables recognized as such
on the income statement.
ACTIVITIES AND RISKS OF FINANCIAL INSTITUTIONS
Each of the financial institutions discussed in this book could be divided into
subtypes that perform different activities. Moreover, due to deregulation,
mergers and acquisitions, internal diversification, and new product development, many financial institutions have expanded the set of activities that
they perform so that these activities overlap with those provided by other
institutions. For example, some property-casualty (re)insurers now offer
products that allow firms to hedge business and accounting risks in much
the same way as the financial derivatives offered by securities firms and commercial banks. Thus, usually the best way to characterize and distinguish
financial institutions is through descriptions of the sets of activities they
perform and the risk-return trade-offs these activities involve, not through
their historical distinct types.
This section describes nine nonmutually exclusive activities performed
by financial institutions. The first four activities — funds aggregation, trading and investment, yield curve speculation, and risk management — apply
to many types of financial institutions and are of broad economic importance. These activities are examined in detail, focusing on the risk-return
trade-offs that they yield. The remaining five activities pertain to sources
of fee income important for specific types of financial institutions, and so
these activities are discussed more briefly. This set of activities, while fairly
comprehensive, is by no means exhaustive. Moreover, some of these activities are complementary, while others are not.
Funds Aggregation
Many types of financial institutions raise funds from many relatively small
depositors, investors, or other customers that they reinvest in larger chunks.
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Examples of funds aggregators include thrifts and commercial banks with
retail branch networks, life insurers offering annuities, and mutual funds.
The funds raised may be very liquid, as is the case with most deposits, or
less so, as is the case with most annuities. When the funds they raise are more
liquid than their assets, funds aggregators are exposed to liquidity risk, for
which they should earn an interest rate spread.
Funds aggregators exist to exploit some form of economy of scale in
investing. Sources of economies of scale include transactions costs that fall
in percentage terms with trade size, the sizable up-front costs of performing financial research, the expanded investment opportunity set available
to larger investors, and the greater ability of larger investors to diversify
investments. Some funds aggregators invest on their own accounts and provide
a contractually specified return to their providers of funds (e.g., commercial banks), while others invest directly on behalf of their providers of funds
(e.g., mutual funds). When they invest on their own account, funds aggregators attempt to generate income by earning more on their assets than the
cost (including noninterest costs) of the funds they raise. When they invest
directly on behalf of the providers of funds, funds aggregators earn fees that
may be contingent on investment returns. These investment activities are
described in more detail in the sections “Trading and Investment” and “Other
Sources of Fee Income.” Funds aggregators must maintain their stock of funds
for their earnings to persist. This can be difficult because of the many investment opportunities available to providers of funds. For example, aside from
the period of artificially low interest rates from 2001 to 2004 that has now
ended, thrifts and commercial banks have found it increasingly difficult over
time to raise core deposits, because of the increasing availability of liquid
market-rate alternatives.
Funds aggregators that invest on their own account are strongly affected
by their abilities to earn high returns on their assets and to attract low-cost
funds. Since they transact with many small sources of funds, funds aggregators are usually also strongly affected by their ability to process transactions
in a cost-efficient manner.
Trading and Investment
Financial institutions often trade or invest in financial assets on their own
accounts. A financial institution usually holds a trading portfolio because it
believes it has some advantage over its trading partners in valuing financial
instruments that will yield trading gains. It also may hold a trading portfolio
to facilitate or as a result of its other activities. For example, derivatives
dealers hold trading portfolios of derivatives.
Financial institutions invest in financial assets to generate investment
income. Financial institutions other than the yield curve speculators discussed
in the next section usually try to match the timing of the cash flows of their
financial assets and liabilities to mitigate interest rate risk. For example, insurers usually match the timing of payoffs of their financial assets to those on
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their claim liabilities. In the absence of perfect matching of financial assets
and liabilities, trading and investment portfolios are subject to the same sort
of interest rate risks as yield curve speculators.
The performance of financial institutions that invest is strongly affected
by their ability to screen potential investments in order to accept credit risk
only when it is desirable to do so.
Yield Curve Speculation
The values of fixed-rate (and imperfectly floating-rate) financial instruments
are sensitive to changes in the appropriate interest rates. The value of a fixedrate financial instrument varies inversely with interest rates, with the absolute
magnitude of the value change rising with the financial instrument’s duration, a measure of the weighted-average time to the cash flows or next repricing of the instrument. Increases in the appropriate interest rates yield losses
on financial assets and gains on financial liabilities. Decreases in the appropriate interest rates yield gains on financial assets and losses on financial
liabilities.
A yield curve is a function relating the yields to maturity (internal rates
of return) on financial instruments with comparable noninterest rate risks
and cash flow configurations to the maturities of the instruments. For example, Treasury notes and bonds are essentially credit riskless and pay coupons
during their terms and face values at maturity; their yields can be plotted
meaningfully against their maturities on a single yield curve. In stable economic times, interest rates tend to rise with maturity, so the yield curve tends
to slope upward. The yield curve can move up or down and change slope or
shape, however, subject to changes in current economic conditions and the
market’s expectations about future economic conditions. Financial institutions speculate on the yield curve when they invest in financial assets with
durations different from those of their financial liabilities. There are various
approaches to speculating on the yield curve that expose the financial institution to different types of interest rate risk.
The simplest and historically most common approach is to invest in longterm assets using funds provided by short-term liabilities. Since the yield curve
tends to slope upward, this approach tends to yield a positive interest rate
spread. In fact, prior to the mid-1970s, the yield curve sloped upward so
reliably that virtually all thrifts and commercial banks as well as many other
types of financial institutions employed this approach, which barely constituted speculation.
Changes in the level, slope, and shape of the yield curve strongly affect
the value of financial institutions speculating on an upward-sloping yield
curve by holding long-term financial assets and short-term financial liabilities. For example, these institutions benefit when the yield curve falls by a
constant amount over its whole range (a parallel downward shift), because
they gain more on their long-term assets than they lose on their short-term
liabilities. The opposite is true for a parallel upward shift in the yield curve.
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Financial institutions speculating on an upward-sloping yield curve bear more
interest rate risk when the mismatch between the duration of their financial assets and liabilities is larger and when movements in the yield curve
are more variable. In this regard, movements in the yield curve have been
much more variable since the mid-1970s than they were before.
Upward-sloping yield curve speculators, especially thrifts, suffered large
losses when the yield curve rose at various points in the mid-1970s, the late
1970s through early 1980s, and 1994. Reflecting this experience, upwardsloping yield curve speculators are now less common and, insofar as they
remain, are typically less aggressive. They have been aided in this evolution
by the rise of the loan syndication, securitization, and derivatives markets
over the past few decades, which allow financial institutions to sell off longterm, fixed-rate assets and to hedge their remaining exposures more easily.
Financial institutions that now speculate on an upward-sloping yield curve
to a lesser extent now typically attempt to make up for the lost income by
charging fees for performing services or processing transactions, or by generating gains on the sale or securitization of their assets. These activities
are discussed in the section “Other Sources of Fee Income.”
More elaborate approaches to speculating on the yield curve employed
by some financial institutions are to exploit the existing shape of the yield
curve or to bet on changes in the level, slope, or shape of the yield curve.
These approaches are subject to interest rate risk in complex ways that are
discussed in Chapter 4.
Risk Management
Risk managers adjust the risk exposures of their clients, usually— but by no
means always — downward. They may do this by absorbing the risk themselves and diversifying across clients and time (e.g., insurers may hold the
insurance they write) or by transferring the risk to a third party (e.g., a reinsurer or counterparty in a derivatives transaction). The primary examples
of risk managers are insurers, but commercial banks and securities firms offer
derivative securities and other products to manage risks, and virtually any
financial instrument issued or purchased by a financial institution modifies
its counterparty’s risk exposure to some extent. For example, firms that securitize financial assets and hold residual or subordinated securities and lessors
that hold the rights to the residual value of leased assets absorb these risks
for the purchasers of senior asset-backed securities and lessees, respectively.
Recently developed “alternative risk transfer” products, such as catastrophe
bonds and credit derivatives that pay off on discrete events, increasingly blur
the distinction between insurance and other financial instruments.
Risk managers attempt to generate income by charging a premium for
absorbing risk. Assuming competitive markets, this risk premium should fall
with the risk manager’s ability to diversify the risk. For example, in life insurance, mortality risk is generally diversifiable, since it is uncorrelated across
insured individuals in the absence of an epidemic or catastrophe that causes
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Activities and Risks of Financial Institutions
15
the death of a large number of people. In contrast, hurricane insurance in
Florida is much harder to diversify, since a single hurricane results in many
highly correlated claims, and climactic conditions yield no major hurricanes
hitting Florida in most years, while several have hit in certain years. Hence,
the risk premium should be considerably lower for life insurance than for
hurricane insurance in Florida.
Risk managers also attempt to generate income by implicitly or explicitly charging fees. A portion of a property-casualty insurance premium is an
implicit fee for setting up the policy and for expected future claim adjustment
services. Securities firms and commercial banks selling derivative securities
may charge either explicit fees or implicit fees tucked into the interest rates
offered. This fact implies that the financial statement classification of fee income
often depends on whether the fee is explicit or implicit.
As in any high-volume business like insurance, efficiency at obtaining business is important.
Other Sources of Fee Income
Syndication, Securitization, and Reinsurance. Syndication and securitization reverse the investment activities of financial institutions. Syndication
involves splitting individually large financial assets and selling the pieces
to other firms. Securitization involves pooling financial assets with similar
features and selling asset-backed securities that convey rights to specified
portions of the cash flows generated by the pool to investors. Similarly, reinsurance reverses the ceding insurer’s risk management role, with the ceding
insurer paying the reinsurer to assume the obligation to pay claims. Financial institutions that consistently syndicate or securitize their assets or that
reinsure the insurance they write do so to generate fees for originating business and gains on sale without assuming the ongoing risks that business
entails. Such financial institutions are cash flow–oriented businesses that
require continuous origination to maintain their profitability and liquidity.
Market Making and Brokerage. Securities firms and large banks may make
markets in or broker the trading of financial instruments. Market makers
generate income either through a bid-ask spread or through the return on
holding inventory in their trading portfolios. Brokers receive commissions.
Spreads and commissions tend to be largest for new or unique products.
Deal Making. Securities firms and large banks may execute or advise on
various financial deals (e.g., mergers and acquisitions and major security
transactions) and receive commissions. They also may generate trading or
investment income by holding a portion of the securities that are issued or
by offering bridge financing up to the completion of the deal.
Asset Management and Investment Advice. Many financial institutions
manage or provide advice regarding clients’ investments for fees. For example,
thrifts and commercial banks offer trust services. These fees can be fixed,
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FINANCIAL INSTRUMENTS AND INSTITUTIONS
a percentage of assets managed, based on the performance of the portfolio,
or mixtures of these options.
Transactions Processing. The performance of any financial institution with
a high transactions volume depends on its ability to process transactions efficiently in its “back office.” For example, large thrifts, commercial banks, and
securities firms may process millions of transactions in a given day. Some
of these transactions result in explicit fee income. Some financial institutions specialize in performing these processing tasks for other firms for a fee.
Financial institutions that process high volumes of transactions make substantial investments in information technology.
Fee income from different sources can have very different risk and persistence. For example, deals tend to be concentrated in bull markets. Sources
of fee income may be correlated, however, since financial institutions aggressively “cross-sell” their services and so can gain or lose multiple sources
of fee income when a major customer is added or dropped or when the firm
becomes more or less competitive in a given market.
Exhibit 1.1 provides a useful matrix for organizing one’s thinking about
a specific financial institution. The matrix displays financial institutions’ activities horizontally and risks vertically.
VALUATION OF FINANCIAL
INSTITUTIONS IN PRACTICE
The value of financial institutions stems from two sources:
1.
2.
A portfolio of financial instruments that are or will be valued on the
balance sheet at fair value. Most financial instruments are (or quickly
become) commodities in which new investments have approximately zero
net present value.
A set of future streams of noninterest income and expense with various
degrees of risk and persistence. If the firm has market power in a given
area, some of these sources of fee income could reflect positive present
value prospects.
In general, the values of these future fee income streams are not recorded
on the balance sheet.
Reflecting these two streams, most financial analysts adopt a two-pronged
approach to valuing financial institutions. They value:
1.
2.
The institution’s financial instruments using a balance sheet approach
based on fair value
Its future income streams using a discounted cash flow or (residual)
income approach
The relative importance of the two approaches in the valuation of a given
financial institution depends on the types of activities it performs.
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Valuation of Financial Institutions in Practice
EXHIBIT 1.1 Financial Institutions’ Activities and Sources of Risk and Return
Main Activity
Main Source
of Risk
Funds
Trading and Yield Curve
Risk
Fee
and Return Aggregation Investment Speculation Management Generation
Liquidity
risk
Interest rate
risk
Cash flow
risk
Persistence
of income
Cost
effectiveness
This book does not attempt to prescribe how overall valuations for financial institutions should be performed, since history has shown that the market’s approach to these valuations changes over time as financial institutions
and the economy evolve. The specific analyses presented should remain useful
for as long as financial institutions provide the types of services that they
do today.
NOTES
1. All Financial Accounting Standards Board documents are self-published in
Norwalk, CT.
2. Published by the Financial Accounting Standards Board.
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CHAPTER
2
Nature and Regulation of
Depository Institutions
P
rior to the 1990s, depository institutions, which raise funds through
deposits that they invest in loans or securities, were by far the most important type of financial institution in the United States. Depository institutions
were the dominant mechanism for raising and distributing capital in the economy and so were the focal point of the government’s regulation of the financial system and its conduct of monetary policy. Although some activities
of depository institutions have been partly displaced by securities markets
and other financial institutions, their regulation continues to have a strong
influence on the structure and evolution of the financial system. Moreover,
depository institutions remain very important players within that system.
This chapter provides background information about the nature and
regulation of depository institutions in the United States. The first section
describes the activities of the two main types of depository institutions, thrifts
and commercial banks. When it is not necessary to distinguish thrifts and
commercial banks, they are called “banks.” The second section summarizes
the history and current status of bank regulation. This section emphasizes
capital regulation, which is the clearest embodiment of bank regulators’
approach to the risk-concentration issues addressed in this book from the
perspective of financial analysts and other users of financial reports. The
third section defines important subtypes of banks. The final section discusses
recent trends affecting banks.
ACTIVITIES OF DEPOSITORY INSTITUTIONS
Depository institutions are intermediaries between depositors, a specific type
of lender of capital, and borrowers of capital. From the perspective of depositors, depository institutions provide uniquely liquid, convenient, and safe
investments. Most deposits can be withdrawn effectively at will from many
locations. Under the Federal Deposit Insurance Reform Act of 2005, the federal
government currently insures individual accounts up to $100,000 and certain
19
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NATURE AND REGULATION OF DEPOSITORY INSTITUTIONS
retirement accounts up to $250,000, amounts that may be indexed for inflation every five years beginning in 2010. These attributes allow depository
institutions to pay relatively low interest rates on deposits.
From the perspective of borrowers, depository institutions provide an
alternative to the public issuance of securities, which can be costly or cumbersome under certain conditions. The issuance of securities works well when
borrowers are well-known entities that borrow sufficiently large amounts with
long enough lead times and for long enough periods to justify the costs of
such issuance. However, securities issuance is difficult for firms that do not
have histories of financial information or that have relatively uninformative
financial information (e.g., start-ups), because it would be difficult to price
the securities based on public information. Depository institutions can obtain
more detailed information from borrowers, monitor them better, and write
more detailed debt contracts than can the holders of securities. These factors
may justify a depository institution lending in circumstances in which securities issuance would either be infeasible or entail a higher cost of capital.
Depository institutions’ role as intermediaries is summarized in the
schematic balance sheets of borrowers, depository institutions, and depositors depicted in Exhibit 2.1. Depository institutions primarily obtain funds
in the form of deposits. Subject to the reserve and capital requirements
described in the “Bank Regulation” section, depository institutions use these
funds to either make loans or purchase securities. The average size of individual loans or holdings of a type of security typically is considerably larger
than the average size of individual deposits, so depository institutions perform
the funds aggregation role described in Chapter 1, for which they earn an
interest rate spread.
Until recently, depository institutions usually invested in financial assets
with a substantially longer duration than their deposits, and so they also
performed the yield curve speculation role described in Chapter 1, for which
they earned an additional interest rate spread. However, this role subjected
them to interest rate risk that led to large losses when interest rates rose
at various points in the mid-1970s, the late 1970s through early 1980s, and
1994. As a result of these losses, most depository institutions currently perform this role to a much more limited extent, if at all.
EXHIBIT 2.1 Schematic Balance Sheets of Depository Institutions,
Borrowers, and Depositors
Borrowers
Assets
Depository
Institutions
Depositors
Liabilities
Assets
Liabilities
Assets
loans
securities
loans
securities
deposits
deposits
Liabilities
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Activities of Depository Institutions
21
By making capital available for productive activity, depository institutions promote growth in the economy. The ability of depository institutions
to do this depends on the willingness of lenders to hold deposits. In times
of economic uncertainty or when other investments offer better returns,
lenders may withdraw their deposits, forcing depository institutions to reduce
their lending to remain liquid, a process referred to as disintermediation.
During the Great Depression, disintermediation occurred when economic
uncertainty led to runs on and restrained lending by depository institutions.
Milton Friedman and other economists have argued that the Great Depression would have been much less severe if the Federal Reserve and other policymakers had intervened to a greater extent to stop disintermediation and the
shrinkage of the money supply that it caused.
Disintermediation also occurred in a milder form during the mid-1970s
and the late 1970s through early 1980s, when interest rates spiked but banks
were constrained by Federal Reserve Regulation Q from raising the interest rates they offered on deposits. The possibility of disintermediation is less
of a concern now, because the Federal Reserve focuses on maintaining liquidity in the economy, interest rate ceilings have been eliminated, and a variety
of new lending institutions (e.g., finance companies) and market sources of
financing (e.g., commercial paper and financial asset securitization) have arisen.
Thrifts include savings and loan associations, savings banks, and credit
unions. Credit unions are not examined in this chapter, because they are
nonprofit cooperatives, typically rather small, and regulated differently from
other thrifts. Thrifts’ major activities are to take deposits from households
and to make residential mortgages. Savings banks typically engage in a broader
variety of investment and borrowing activities than do savings and loans.
Thrifts are required by the qualified thrift lender (QTL) provision of
the Financial Institutions Reform, Recovery, and Enforcement Act of 1989
(FIRREA) to hold at least 65% of their assets in qualified thrift investments
(QTIs). Qualified thrift investments used to be defined only as residential
mortgage-related assets, but the definition has been broadened over time to
include educational loans, credit card loans, small business loans, and various other items. Certain additional assets are considered QTIs to the extent
that they collectively constitute less than 20% of assets. One of these additional assets is thrifts’ investments in service corporation subsidiaries, which
are counted as QTIs as long as the subsidiary holds 80% of its assets in QTIs.
Commercial banks typically engage in a much wider set of investment
and borrowing arrangements than do thrifts. In particular, they hold a much
larger proportion of commercial and industrial loans, and they finance these
loans through many sources other than household deposits. The capital
acquired from these sources usually reflects market interest rates and is
referred to as managed liabilities. Commercial banks also provide a broader
variety of financial services than thrifts, such as financial advice, risk management, trading, market making, and securities underwriting.
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NATURE AND REGULATION OF DEPOSITORY INSTITUTIONS
Due to deregulation and increasing competition, the distinctions among
thrifts, commercial banks, and other financial institutions are gradually disappearing. An important regulatory change in this regard is the creation of
financial holding companies under the Financial Services Modernization Act
of 1999, invariably referred to as the Gramm, Leach, Bliley Act (GLBA).
Under GLBA, healthy depository institutions are allowed either to own
or to be affiliated through financial holding companies with any other financial institution, although not with nonfinancial firms. Unitary thrift holding
companies that had been affiliated with nonfinancial firms prior to GLBA
are allowed to maintain these affiliations, however. As of November 2006,
641 financial holding companies have been created and remain effective.
BANK REGULATION
This section discusses bank chartering, regulatory supervision, and branching. In the “Reserve Requirements” and “Capital Requirements” sections,
the two main types of “safety and soundness” regulation of banks, reserve
and capital requirements, respectively, are described. Users of financial reports
must assess banks’ current and expected future reserve and capital levels,
because these levels affect the ability of banks to grow. The “Regulatory
Cycles” section summarizes the historically cyclical path of bank regulation
and recent deregulatory trends.
Chartering, Regulatory Supervision, and Branching
The regulation of banks is a complex patchwork that reflects both historical accident and bureaucratic politics. Many academics and others have
argued that a simpler, nonoverlapping system of regulation would be more
efficient, to little effect so far.
Both thrifts and commercial banks can be either state or federally chartered, in what is referred to as the dual banking system. Federal charters
are granted by the Comptroller of the Currency (COC) for commercial banks
and by the Office of Thrift Supervision (OTS) for thrifts. Both the COC and
OTS are branches of the Treasury Department. Appropriate state authorities
grant state charters.
The Federal Deposit Insurance Corporation (FDIC) regulates any financial institution for which it provides deposit insurance. Regulatory examinations and other general regulation are performed by: the COC for federally
chartered commercial banks; the Federal Reserve and state authorities for
state-chartered commercial banks; the OTS and FDIC for federally chartered thrifts; and the OTS, FDIC, and state authorities for state-chartered
thrifts. The Federal Reserve acts as the umbrella regulator for bank and financial holding companies, which means it must coordinate with functional
regulators of their subsidiaries. The extent of this coordination has been
increased by GLBA, and it is working out successfully so far.
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Bank Regulation
23
Foreign banks operating in the United States generally are subject to the
same regulation as domestic banks. They are also subject to regulation at
the holding company level by the Federal Reserve under Regulation K, which
applies to U.S. banks operating abroad as well.
State authorities determine the ability of banks to branch within a state.
Most, if not all, states now allow unlimited intrastate branching.
Reserve Requirements
Under reserve requirements, banks must hold vault cash or noninterestbearing deposits with the Federal Reserve as a percentage of their transaction deposits (interest- and noninterest-bearing checking accounts). For 2007,
this percentage is 0% for the first $8.5 million of transaction deposits, 3%
for transaction deposits between $8.5 million and $45.8 million, and 10%
thereafter. The primary intent of reserve requirements is to ensure that banks
have access to enough cash to meet the foreseeable demands of depositors
and thus to prevent bank runs. Historically, reserves were required at higher
rates and for a broader set of deposits.
For banks with deposits over $207.7 million (which are required to report
weekly to bank regulators), reserve requirements must be met on average
over two-week reserve maintenance periods. Sometimes banks have to
scrounge for reserves on the last days of the period. To meet reserve requirements, larger banks usually borrow in the federal funds market, which involves
short-term (usually one-day) uncollateralized borrowing and lending between
financial institutions. When a bank’s credit risk is an issue, it can borrow
in the collateralized securities repurchase market instead. Smaller banks usually
borrow from one of the 12 Federal Home Loan Banks (FHLBs), which they
jointly own along with some insurance companies. The FHLBs have access
to low-cost funding due to their size.
Banks also may borrow at the discount window of the Federal Reserve
under three distinct lending programs described in its Regulation A: primary,
secondary, and seasonal. The primary program is available to all generally
sound banks, but the Federal Reserve sets the primary rate 1% higher than
its target federal funds rate to dissuade discount window borrowing by banks
that can access other markets. The secondary program is available to banks
for which a timely return to market financing is foreseeable and for the
orderly resolution of failing banks; the secondary rate is set .5% above the
primary rate. The seasonal program is available to banks that have recurring intrayear fluctuations in funding needs; the seasonal rate usually is set
close to the target federal funds rate.
Larger banks tend to purchase (borrow) reserves and smaller banks tend
to sell (lend) reserves. The Federal Reserve sets a target for the federal funds
rate to achieve macroeconomic goals, lowering the rate in depressed or potentially deflationary times and raising the rate in boom or potentially inflationary
times. For example, the target federal funds rate is 5.25% in November 2006,
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NATURE AND REGULATION OF DEPOSITORY INSTITUTIONS
having been raised by the Federal Reserve in 17 separate .25% increments
from a very low 1% level in June 2004 as the economy improved over this
period. The Federal Reserve has various tools at its disposal to keep the actual
federal funds rate near the target rate. The most important of these are open
market purchases and sales of government securities, which influence the
amount of funds available in the economy. The actual federal funds rate can
fluctuate considerably around the target in the last days of reserve maintenance periods when there are imbalances in the demand and supply for federal
funds.
Capital Requirements
Under regulatory capital requirements, banks must maintain various measures of equity above certain percentages of corresponding measures of assets.
The intent of capital requirements is to ensure that banks are and will remain
solvent, so that they are able to pay off their liabilities as they come due.
Currently there are three main capital ratios for which requirements
exist:
1.
2.
3.
The leverage ratio
The Tier 1 risk-based capital ratio
The total risk-based capital ratio
The leverage ratio pertains solely to banks’ credit risk. The risk-based capital ratios pertain to banks’ credit risk and for banks with significant market
risk, as measured by their trading assets plus trading liabilities exceeding $1
billion or 10% of total assets, to their market risk.
As will be discussed, the two risk-based capital ratios will change in January 2008 when U.S. bank regulators begin the four-year phase-in period
for the Basel II Capital Accord (Basel II) for a small set of large banks and
refine existing capital requirements for other banks. The leverage ratio will
not be affected by Basel II.
This section first describes current capital requirements, and then describes
the expected changes in those requirements resulting from the adoption of
Basel II. Users of financial reports should understand these capital requirements, because they indicate bank regulators’ main concerns regarding risks
banks undertake, and these concerns are similar in many respects to those
of users.
Leverage Ratio. The leverage ratio is based on a measure of equity called
“Tier 1” capital. Tier 1 capital equals common equity with these adjustments:

Minus other comprehensive income associated with unrealized gains and
losses on available-for-sale securities under SFAS No. 115, Accounting
for Certain Investments in Marketable Securities (1993), and effective
cash flow hedges under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (1998).
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Bank Regulation

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Plus minority interest and noncumulative perpetual preferred stock.
Plus qualifying cumulative perpetual preferred stock, including trust
preferred securities issued by unconsolidated special purpose entities that
are accounted for under generally accepted accounting principles (GAAP)
as subordinated debt of the bank. This item is subject to a limit of 25%
of the sum of common stock, minority interests, and noncumulative and
qualifying cumulative perpetual preferred stock for most banks, but it
is subject to a tighter limit of 15% of this sum for internationally active
banks with greater than $250 billio…
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