Management of Financial Institutions
1.As a senior loan officer at Joshua Bankcorp you have the following loan applications waiting for review. The bank uses Altman’s Z score, default probabilities, mortality rates and RAROC to assess loan acceptability. The bank’s cost of equity (the RAROC benchmark) is 9 percent. The bank’s loan policy states that the maximum probability of default for loans by type is as follow:
|Loan Type and Maturity||Maximum Allowable Default Probability|
[Note: In all of the following 4 loan applications (a through d), you have to identify whether you accept or reject the loan applications and why?]
- An AAA-rated, one-year C&I loan from a firm with a liquidity ratio of 2.15, a debt-to-asset ratio of 45 percent, volatility in earnings of 0.13, and a profit margin of 12 percent. Joshua Bankcorp uses a linear probability model to evaluate AAA-rated loans as follows:
PD = –0.08X1 + 0.15X2 +1.2X3 – 0.45 X4
Where, X1= Liquidity ratio; X2=Debt-to-asset ratio; X3=Volatility in earnings; X4= Profit Margin
PD = –0.08(2.15) + 0.15(.45) +1.2(.13) – 0.45(.12)
PD= -.175+.0675+.156-.054= -.0055
- An AA-rated, one-year C&I loan from a firm with the following financial statement information (in millions of dollars):
|Assets||Liabilities and Equity|
|Cash Accounts receivables Inventory Plant & Equipment||$ 40 120 210 1,100||Accounts payable Notes payable Accruals Long-term debt Equity (retained earnings = $200)||$ 55 60 70 550 735|
|Total Assets||$1,470||Total liabilities and equity||$1,470|
Also assume sales = $1,250 million, cost of goods sold = $930 million, and the market value of equity is equal to 2.2 times the book value of equity. Joshua Bankcorp uses the Altman’s Z-scoremodel to evaluate AA-rated loans.
- An A-rated corporate loan with a maturity of three years. A-rated corporate loans are evaluated using the mortality rate approach. A schedule of historical defaults (annual and cumulative) experienced by the bank on it’s A-rated corporate loans is as follows:
|Years after Issuance|
|Loan Type A-rated Corporate loans Annual default Cumulative default||1 year||2 years||3 years||4 years|
|0.10% 0.10||0.25% 0.325||0.40% 0.595||0.65% 1.858|
Loan not acceptable
- A $2 million, 5-year loan to BBB-rated corporation in the computer parts industry. Joshua Bankcorp uses a RAROC model and charges a servicing fee of 75 basis points. The duration of the loan is 4.5 years. The cost of funds for the bank is 8 percent. Based on four years of historical data, the bank has estimated the maximum change in the risk premium on the computer parts industry to be approximately 5.5%. The current market rate for loans in this industry is 10%.
4.5 x 2 / 75 = 9/75
2.As a senior loan officer at Marisa Financial Corp, you have a loan application from a firm in the biotech industry. While the loan has been approved on the basis of an individual loan, you must evaluate the loan based on its impact on the risk of the overall loan portfolio. The Marisa Financial Corp uses the following three methods to assess its loan portfolio risk. Should Marisa Financial Corp. grant this loan based on the following 3 criteria and why or why not?
- Concentration Limits – The Marisa Financial Corp currently has lent an amount equal to 40 percent of its capital to the biotech industry and does not lend to a firm in any sector that generates losses in excess of 2 percent of capital. The average historical losses in the biotech industry total 5 percent.
Losses less than industry 5%
lend a loan
- Loan Volume-based Model – National and Marisa Financial Corp’s loan portfolio allocations are as follows.
Allocation of Loan Portfolios in Different Sectors (%)
|Sectors||NationalMarisa Financial Corp|
|Real Estate||50% 45%|
Marisa Financial does not want to deviate from the national average by more than 12.25 percent.
Real estate 95%
Grant loan to commercial and real estate sector not to the consumer sector
- Loan Loss Ratio-based Model – Based on regression analysis on historical loan losses, the Marisa Financial Corp estimates the following loan loss ratio models:
XC&I = 0.001 + 0.85XL; and
Xcon = 0.003 + 0.65XL
where XC&I = loss rate in the commercial sector, Xcon = loss rate in the consumer (household) sector, and XL = loss rate for its total loan portfolio. Marisa Financial Corp’s total increase in the loan loss ratio is expected to be 12 percent next year.
No loan to be granted
3.Bank of Marconi has the following balance sheet (in millions).
|Assets||Liabilities and Equity|
|Total assets||$130||Total liabilities and equity||$130|
Bank of Marconi’s securities portfolio includes $16 million in T-bills and $10 million in GNMA (Government National Mortgage Association) securities. Bank of Marconihas a $20 million line of credit to borrow in the repo market and $5 million in excess cash reserves (above reserve requirements) with the Fed. Bank of Marconicurrently has borrowed $22 million in Fed funds and $18 million from the Fed discount window to meet seasonal demands.
- What is the Bank of Marconi’s total available (sources of) liquidity? What is the Bank of Marconi’s current total uses of liquidity? What is the net liquidity of Bank of Marconi?
Net Liquidity=9-75= -64
- Calculate the financing gap of Bank of Marconi. What is its financing requirement?
- Bank of
Marconiexpects a net deposit drain of $20 million. Show the Bank of Marconi‘s balance sheet if the following conditions occur:
- Bank of Marconipurchases liabilities to offset this expected drain.
The liabilities would decrease which would encourage the injection of fresh equity
- The stored liquidity management method is used to meet the expected drain (Bank of Marconidoes not want the cash balance to fall below $5 million, and securities can be sold at their fair value).
If securities are drawn out it can be seen that the sales should be of $87(95+4-11)
4. Suppose Bank Kevin, a U.S. Financial Institution (FI) has the following assets and liabilities:
|$500 million||$1,000 million|
|U.S. loans (one year)||U.S. CDs (one year)|
|in dollars||in dollars|
$300 million equivalent
U.K. loans (one year)
(loans made in pounds)
$200 million equivalent
Turkish loans (one year)
(loans made in Turkish lira)
The promised one-year U.S. CD rate is 4 percent, to be paid in dollars at the end of the year; the one-year, default risk–free loans in the United States (U.S.) are yielding 6 percent; default risk– free one-year loans are yielding 8 percent in the United Kingdom (U.K.); and default risk–free one-year loans are yielding 10 percent in Turkey. The exchange rate of dollars for pounds at the beginning of the year is $1.6/£1, and the exchange rate of dollars for Turkish lira at the beginning of the year is $0.5533/TRY1.
- Calculate the dollar proceeds from Bank Kevin’s loan portfolio at the end of the year, the return on Bank Kevin’s loan portfolio, and the net interest margin for Bank Kevin if the spot foreign exchange rate has not changed over the year.
- Calculate the dollar proceeds from Bank Kevin’s loan portfolio at the end of the year, the return on Bank Kevin’s loan portfolio, and the net interest margin for Bank Kevin if the pound spot foreign exchange rate falls to $1.45/£1 and the lira spot foreign exchange rate falls to $0.52/TRY1 over the year.
- Calculate the dollar proceeds from Bank Kevin’s loan portfolio at the end of the year, the return on Bank Kevin’s loan portfolio, and the net interest margin for Bank Kevin if the pound spot foreign exchange rate rises to $1.70/£1 and the lira spot foreign exchange rate rises to $0.58/TRY1 over the year.
5. Blake and George (BG) Bankcorp wants to obtain the DEAR on its trading portfolio. The portfolio consists of the following securities.
- BG Bankcorp has a $1 million position in a six-year zero bonds with a face value of $1,543,302. The bond is trading at a yield to maturity of 7.50 percent. The historical mean change in daily yields is 0.0 percent, and the standard deviation is 22 basis points.
- BG Bankcorp also holds a 12-year zero bond with a face value of $1,000,000. The bond is trading at a yield to maturity of 6.75 percent. The price volatility if the potential adverse move in yields is 65 basis points.
Foreign exchange contracts:
BG Bankcorp has a €2.0 million long trading position in spot euros at the close of business on a particular day. The exchange rate is €0.80/$1, or $1.25/€, at the daily close. Looking back at the daily changes in the exchange rate of the euro to dollars for the past year, BG Bankcorp finds that the volatility or standard deviation (σ) of the spot exchange rate was 55.5 basis points (bps).
BG Bankcorp holds a $2.5 million trading position in stocks that reflect the U.S. stock market index (e.g., the S&P 500). The β = 1. Over the last year, the standard deviation of the stock market index was 175 basis points (bps).
Correlations (ρij) among Assets are given below:
Six-year zero-coupon 12-year zero-coupon €/$ U.S. stock index
|Six-year, zero-coupon – 0.75 -0.2||0.40|
|12-year, zero-coupon – – -0.3||0.45|
|€/$ – – –||0.25|
|U.S. stock index – – –||–|
Calculate the DEAR (Daily Earnings at Risk) of this trading portfolio of BG Bankcorp.
6.Jakob& Jon (J&J) National Bank has issued the following off-balance-sheet items:
- A one-year loan commitment of $1 million with an up-front fee of 40 basis points. The back-end fee on the unused portion of the commitment is 55 basis points. The bank’s base rate on loans is 8 percent, and loans to this customer carry a risk premium of 2 percent. The bank requires a compensating balance on this loan of 10 percent to be placed in demand deposits and must maintain reserve requirements on demand deposits of 8 percent. The customer is expected to draw down 75 percent of the commitment at the beginning of the year.
- A one-year loan commitment of $500,000 with an up-front fee of 25 basis points. The back-end fee on the unused portion of the commitment is 30 basis points. Loans to this customer carry a risk premium of 2.5 percent. The bank will not require a compensating balance on this loan. The customer is expected to draw down 90 percent of the commitment at the beginning of the year.
- A three-month commercial letter of credit on behalf of one of its AA-rated customers who is planning to import $400,000 worth of goods from the Germany. The bank charges an up-front fee of 75 basis points on commercial letters of credit (LC) to AA-rated customers.
- A standby letter of credit (SLC) to one of its A-rated customers who is planning to issue $5 million of 270-day commercial paper for an effective yield of 5 percent. The corporation expects to save 50 basis points on the interest rate by using the SLC. The bank charges an up-front fee of 40 basis points on SLCs to A-rated customers to back the commercial paper issue?
- What up-front fees does the J&J National Bank earn on each of these?
Total upfront fees=10%+25%+75%=110% from this portfolio
- What other income does the J&J National Bank earn on these off-balance-sheet activities?
Brokerage and trading profits are some other profits from these ventures
- Calculate the returns on each of the off-balance-sheet activities assuming that the takedowns on the loan commitments are at the expected percentage and the customers holding the letters of credit do not default on their obligations.
7.The operations department of a major financial institution (Tamim & Rita Bank) is planning to reorganize several of its back-office functions. Its current operating expense is $1.5 million, of which $1 million is for staff expenses. The FI uses a 12 percent cost of capital to evaluate costsaving projects.
- One way of reorganizing is to outsource a portion of Tamim & Rita Bank’s data entry functions. This will require an initial investment of approximately $500,000 after taxes. The Tamim & Rita Bank expects to save $150,000 in annual operating expenses after taxes for the next seven years. Should it undertake this project?
5000000-150000=350000 should be undertaken
- Another option is to automate the entire process by installing new state-of-the-art computers and software. The Tamim & Rita Bank expects to realize more than $500,000 per year in after-tax savings, but the initial investment will be approximately $3 million. In addition, the life of this project is limited to seven years, at which time new computers and software will need to be installed. Using this seven-year planning horizon, should the Tamim & Rita Bank invest in this project? What level of after-tax savings would be necessary to make this plan comparable in value creation to the plan in part (a)?
NPV of the first alternative
Npv(12%,cashflows 1.5 million)=1.05million
NPV of the second alternative
Npv(12%,cashflows 1million)=.93 million
NPV of the Third alternative
Npv(12%,cashflows .5 million)=.32 million