Portfolios, Risks, and Regulation of Financial Firms

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Portfolios, Risks, and Regulation of Financial
Firms

• Week 10 October 26, 2006

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Correlation and Efficiency

• Most financial institutions have levered
  portfolios
• Deposits and loans
• Insurance reserves and investments
• Correlation between cash flows can be positive,
  zero, or negative
• Short-term vs. long-term rate movements
• Deposit costs and lending activity
• Policy loans and cancellations, benefits

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Efficient Portfolios
?
??????
Asset 2 Return
Asset 2
? lt 1
? 1
Asset 1 Return
Asset 1 Liability
?
0
Asset 1 Risk
Asset 2 Risk
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Portfolio Constraints

• Asset regulation/activity regulation
• Capital requirements
• Restrictions on portfolio can
• Lower returns
• Raise risks
• Increase desired leverage

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Constrained Portfolios
Unconstrained and Efficient
r
Constrained (inefficient)
0
?
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Equilibrium and Risks

• Equilibrium
• Short-run and long-run
• Outcomes in equilibrium
• Risk and equilibrium
• Shocks to equilibrium
• Real shocks
• Monetary shocks
• Strategy, equilibrium, and risk

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Macroeconomic Risks

• Current events in financial markets
• Stock market
• Interest rates
• Causes?
• Short-run and long-run implications?
• Policy and demographics
• California industries
• Prospects and opportunities?

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Types of Portfolio Risk

• Holding-period yield risk
• Capital gains risk
• Reinvestment risk
• Market risk
• Credit risk
• Non-payment of principal
• Delayed or reduced payments
• Effect of change is creditworthiness on value
• Operating and liquidity risks

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U.S. Stock Market 1970-2004
Source Haver Data Base
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Monetary Shocks and Rates
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Components of Discount Rates
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Risky Rate Components
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Microeconomic Risks

• Specific market changes in area of specialization
• Technology changes
• Approach management of microeconomic risks
• Diversification
• Barriers to micro-economic risk management
  geography, authorities

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Rationales for Regulation of Financial Services

• Economic activity
• Monetary policy (money creation)
• Credit allocation (disadvantaged sectors)
• Government financing
• Competition (equal opportunity and fairness)
• Asymmetry between providers and users
• Uninsurable (system-wide) risks
• Safety and promoting public confidence

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Types of Financial Firm Regulation

• Chartering, branching, and registration
• Ownership, mergers, acquisitions
• Pricing and product review
• Activity and asset restrictions
• Capital requirements
• Disclosure and examination

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Recent Legislative History - U.S.

• Pre 1980
• DIDAMCA (1980)
• Garn-St Germain Act (1982)
• Competitive Equality Banking Act (1987)
• FIRREA (1989)
• FDICIA (1991)
• Riegle-Neal Banking Act (1994)
• Gramm-Leach-Bliley Act (1999)

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Deposit-Taking Regulation

• Reserve requirements
• Investments
• Prohibited investments (e.g. corporate equity
• Prohibited activities (e.g. real estate
  development)
• Restrictions on allowable investments (25 equity
  to one borrower)
• Examination and reporting
• Capital requirements
• Closure rules (since FDICIA)

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Capital Adequacy

• Capital buffer Buffer Assets - Liabilities
  gt Liabilities Assets - Capital gt
  ?Liabilities ? Assets - ? Capital
• Assessing capital adequacy over time (U.S.)
• ABC
• Leverage
• Risk-based capital

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Overview of Capital Regulation

• Risk adjusted assets
• Basel Agreements we have case (Nov. 20)
• Banks, thrifts, and insurance companies
• Risk weights, on- and off- balance sheet
• Tier 1 and Tier 2
• Value-at-risk (VAR) capital requirements
• Internal models, trading assets 10 or 1
  billion, after January, 1998
• 3 x 10-day 99th percentile risk and benchmarks

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Changes and Risks

• Legal Developments in Federal Reserve Bulletin
• Issues raised
• Strategic importance
• Rationale for regulation
• Systemic risk
• Important discussion

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Holding Company Regulation

• Bank holding companies
• Bank Holding Company Act of 1956
• 1970 amendments
• FIRREA changes
• Non-bank holding companies
• Thrifts
• Insurance companies
• Securities firms

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Holding Companies andGlass-Steagall Act (to 1999)
Federal Reserve Board
OCC, FDIC, or FRB
Non-Bank Holding Company
Bank Holding Company
Commercial Bank
Securities Firm
Insurance Company
Securities Subsidiary (Section 20)
SEC, Exchanges SROs
State Insurance Agencies
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Securities Markets Regulation

• Issuers and investors
• Registration and disclosure
• Investor behavior
• Insider trading
• Market manipulation
• Speculation and margin requirements
• Investors and brokers
• NASD and exchanges

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Securities Firm Regulation

• Registration
• Reporting (FOCUS)
• Capital requirements
• Haircuts
• Self-regulatory organizations
• NYSE
• NASD
• Futures Merchants Association
• Government

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Securities Regulation
Legal Liabilities
SEC Review
Legal Liabilities
Mutual Funds
Issuer
Investor
Exchanges and SROs
Investor
Issuer
Manipulation, Insider Trading
Brokers, Dealers, IBs
Issuer
Investor
Disclosure and Reporting
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Insurance Regulation

• United States vs. Rest of the World
• States and McCarran-Ferguson Act
• National Association of Insurance Commissioners
  (NAIC)
• Ministries of Finance, etc., elsewhere
• Domestic, foreign, alien insurance companies in
  United States
• EEC and 1992
• China, Korea, etc.

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Finale Gramm-Leach- Bliley Act

• Established Financial holding companies
• Insurance
• Securities activities
• Maintained separate of banking and commerce in
  general
• Federal Reserve in umbrella regulator, but
  regulation relies mainly on function regulators,
  state insurance commissioners, SEC, CFTC,

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Banks with Glass-Steagall
Bank Holding Company
Finance Company
Commercial Bank
Discount Broker
Securities Subsidiary (Section 20)
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Financial Holding Company
Financial Holding Company
Investment Bank
Commercial Bank
Insurance Company
Thrift Institution
Asset Management Company
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Taxation and Financial Services

• Taxation of primary sectors
• Housing
• Corporate tax treatment
• Inside build-up
• Retirement products
• Taxation of financial service firms
• Deposit-taking firms
• Insurance firms

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Taxation and charters

• Banks and thrifts
• pre 1986
• Currently
• Grandfathering of municipals
• Credit unions
• Mutual and stock insurance companies
• participation
• Investment companies

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Taxation and Financial Products

• IRA accounts in the 1980s
• Roth accounts in the 1990s
• Education savings 529 and ESAs
• Leasing and the investment tax credit
• Limited partnerships
• Taxation and transaction processing
• Tax treatment of major banks in the 1980s
• Political implications

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Next Week (November 2)

• Read Chapter 19
• Begin thinking about Individual Project 3
• Coordinate with team members on integration of
  individual work into final presentation