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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 26
INTEREST RATE RISK
Bank Risk
Interest Rate Risk (Cont.)
Trading Risk
Other Risks
Globalization of Banking
The Future of Banks
Non-depository Institutions
Insurance Companies
Securities Firms
Finance Companies
Government Sponsored Enterprises
Interest-Rate Risk
Gap analysis highlights the gap or difference between the yield on interest sensitive assets and
the yield on interest-sensitive liabilities
Multiplying the gap by the projected change in the interest rate yields the change in the bank's
profit
Gap analysis can be further refined to take account of differences in the maturity of assets and
liabilities
Banks can manage interest-rate risk by matching the interest-rate sensitivity of assets with the
interest-rate sensitivity of liabilities,
Purchase short term securities to match variable rate deposits
Make long term loans at floating rates
But this approach increases credit risk
Trading Risk
Banks today hire traders to actively buy and sell securities, loans, and derivatives using a
portion of the bank's capital in the hope of making additional profits
However, trading such instruments is risky (the price may go down instead of up); this is called
trading risk or market risk
Managing trading risk is a major concern for today's banks, and bank risk managers place limits
on the amount of risk any individual trader is allowed to assume
Banks also need to hold more capital if there is more risk in their portfolio
Other Risks
Banks that operate internationally will face
Foreign exchange risk (the risk from unfavorable moves in the exchange rate)
Sovereign risk (the risk from a government prohibiting the repayment of loans)
Banks manage their foreign exchange risk by attracting deposits denominated in the same
currency as the loans and by using foreign exchange futures and swaps to hedge the risk
Banks manage sovereign risk by diversification, by refusing to do business in a particular
country or set of countries, and by using derivatives to hedge the risk
Banks also face operational risk, the risk that their computer system may fail or that their
buildings may burn down
To manage operational risk the bank must make sure that its computer systems and buildings
are sufficiently robust to withstand potential disasters
The Globalization of Banking
Toward the end of the 20th century, sharp rise in international trade increased the need for
international financial services
Banks can operate in other countries by
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Money & Banking ­ MGT411
VU
Opening a foreign branch,
Offer same services as in home country
Creating an International Banking Facility (IBF)
Accept deposits from and make loans to foreigners outside the country
Creating an Edge Act subsidiary,
Engage in international banking transactions
Purchasing a controlling interest in a foreign bank
Foreign banks can take advantage of similar options.
The growth of international banking has had an economic impact, increasing the competition in
and efficiency of banking markets
A borrower from France, Brazil, Singapore or Pakistan can shop for loan virtually anywhere in
the world, while a depositor seeking the highest return can do the same
This phenomenon has made banking a tougher job
Profits are harder to come by as borrowers and depositors have more options
But overall the improved efficiency of financial system has enhanced growth everywhere
One of the most important aspects of international banking is the Eurodollar market, in which
dollar-denominated deposits in foreign banks are exchanged
The Eurodollar market was created in response to restrictions on the movement of international
capital imposed at the end of World War II with the creation of Bretton Woods system
Today, the Eurodollar market in London is one of the biggest and most important financial
markets in the world,
The interest rate at which banks lend each other Eurodollars (the London Interbank Offered
Rate or LIBOR) is the standard against which many private loan rates are measured
The Future of Banks
Today's banks are bigger, fewer in number and more international than those of the past, and
they offer more services
Financial holding companies are a limited form of universal banks, firms that engage in non-
financial as well as financial activities
Banking, Insurance and securities
The owners and managers of these financial firms cite three reasons to create them:
They are well diversified,
They are large enough to take advantage of economies of scale,
They hope to benefit from economies of scope
Offering many products under the same "brand" name can also reduce costs
Individual firms provide the same services as more traditional intermediaries do
Money market mutual funds provide liquidity
Mortgage brokers help in borrowing for home purchase
Leasing companies provide car, and consumer financing
Discount brokers provide low cost access to financial markets
Thanks to recent technological advances, almost every service traditionally provided by
financial intermediaries can now be produced independently, without the help of a large
organization
Moreover, the production of information to mitigate the problems of adverse selection and
moral hazard has become a business in and of itself
As we survey the financial industry we can discern two opposite trends:
Large firms are working hard to provide one-stop shopping for financial services
Industry is splintering into a host of small firms, each of which serves a very specific purpose
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY