of 14 %. Another investment has a mean return of 12 % and a standard deviation of return of 20 %. The correlation between the returns is 0.3. Produce a chart similar to Figure 1.2 showing alternative risk-return combinations from the two investments.
16. The expected return on the market is 12 % and the risk-free rate is 7 %. The standard deviation of the return on the market is 15 %. One investor creates a portfolio on the efficient frontier with an expected return of 10 %. Another creates a portfolio on the efficient frontier with an expected return of 20 %. What is the standard deviation of the return on each of the two portfolios?
17. A bank estimates that its profit next year is normally distributed with a mean of 0.8 % of assets and the standard deviation of 2 % of assets. How much equity (as a percentage of assets) does the company need to be (a) 99 % sure that it will have a positive equity at the end of the year and (b) 99.9 % sure that it will have positive equity at the end of the year? Ignore taxes.
18. A portfolio manager has maintained an actively managed portfolio with a beta of 0.2. During the last year, the risk-free rate was 5 % and major equity indices performed very badly, providing returns of about −30 %. The portfolio manager produced a return of −10 % and claims that in the circumstances it was good. Discuss this claim.
PART One
Financial Institutions and Their Trading
CHAPTER 2
Banks
The word “bank” originates from the Italian word “banco.” This is a desk or bench, covered by a green tablecloth, that was used several hundred years ago by Florentine bankers. The traditional role of banks has been to take deposits and make loans. The interest charged on the loans is greater than the interest paid on deposits. The difference between the two has to cover administrative costs and loan losses (i.e., losses when borrowers fail to make the agreed payments of interest and principal), while providing a satisfactory return on equity.
Today, most large banks engage in both commercial and investment banking. Commercial banking involves, among other things, the deposit-taking and lending activities we have just mentioned. Investment banking is concerned with assisting companies in raising debt and equity, and providing advice on mergers and acquisitions, major corporate restructurings, and other corporate finance decisions. Large banks are also often involved in securities trading (e.g., by providing brokerage services).
Commercial banking can be classified as retail banking or wholesale banking. Retail banking, as its name implies, involves taking relatively small deposits from private individuals or small businesses and making relatively small loans to them. Wholesale banking involves the provision of banking services to medium and large corporate clients, fund managers, and other financial institutions. Both loans and deposits are much larger in wholesale banking than in retail banking. Sometimes banks fund their lending by borrowing in financial markets themselves.
Typically the spread between the cost of funds and the lending rate is smaller for wholesale banking than for retail banking. However, this tends to be offset by lower costs. (When a certain dollar amount of wholesale lending is compared to the same dollar amount of retail lending, the expected loan losses and administrative costs are usually much less.) Banks that are heavily involved in wholesale banking and may fund their lending by borrowing in financial markets are referred to as money center banks.
This chapter will review how commercial and investment banking have evolved in the United States over the last hundred years. It will take a first look at the way the banks are regulated, the nature of the risks facing the banks, and the key role of capital in providing a cushion against losses.
2.1 COMMERCIAL BANKING
Commercial banking in virtually all countries has been subject to a great deal of regulation. This is because most national governments consider it important that individuals and companies have confidence in the banking system. Among the issues addressed by regulation is the capital that banks must keep, the activities they are allowed to engage in, deposit insurance, and the extent to which mergers and foreign ownership are allowed. The nature of bank regulation during the twentieth century has influenced the structure of commercial banking in different countries. To illustrate this, we consider the case of the United States.
The United States is unusual in that it has a large number of banks (5,809 in 2014). This leads to a relatively complicated payment system compared with those of other countries with fewer banks. There are a few large money center banks such as Citigroup and JPMorgan Chase. There are several hundred regional banks that engage in a mixture of wholesale and retail banking, and several thousand community banks that specialize in retail banking.
Table 2.1 summarizes the size distribution of banks in the United States in 1984 and 2014. The number of banks declined by over 50 % between the two dates. In 2014, there were fewer small community banks and more large banks than in 1984. Although there were only 91 banks (1.6 % of the total) with assets of $10 billion or more in 2014, they accounted for over 80 % of the assets in the U.S. banking system.
TABLE 2.1 Bank Concentration in the United States in 1984 and 2014
Source: FDIC Quarterly Banking Profile, www.fdic.gov.
The structure of banking in the United States is largely a result of regulatory restrictions on interstate banking. At the beginning of the twentieth century, most U.S. banks had a single branch from which they served customers. During the early part of the twentieth century, many of these banks expanded by opening more branches in order to serve their customers better. This ran into opposition from two quarters. First, small banks that still had only a single branch were concerned that they would lose market share. Second, large money center banks were concerned that the multibranch banks would be able to offer check-clearing and other payment services and erode the profits that they themselves made from offering these services. As a result, there was pressure to control the extent to which community banks could expand. Several states passed laws restricting the ability of banks to open more than one branch within a state.
The McFadden Act was passed in 1927 and amended in 1933. This act had the effect of restricting all banks from opening branches in more than one state. This restriction applied to nationally chartered as well as to state-chartered banks. One way of getting round the McFadden Act was to establish a multibank holding company. This is a company that acquires more than one bank as a subsidiary. By 1956, there were 47 multibank holding companies. This led to the Douglas Amendment to the Bank Holding Company Act. This did not allow a multibank holding company to acquire a bank in a state that prohibited out-of-state acquisitions. However, acquisitions prior to 1956 were grandfathered (that is, multibank holding companies did not have to dispose of acquisitions made prior to 1956).
Banks are creative in finding ways around regulations – particularly when it is profitable for them to do so. After 1956, one approach was to form a one-bank holding company. This is a holding company with just one bank as a subsidiary and a number of nonbank subsidiaries in different states from the bank. The nonbank subsidiaries offered financial services such as consumer finance, data processing, and leasing and were able to create a presence for the bank in other states.
The 1970 Bank Holding Companies Act restricted the activities of one-bank holding companies. They were only allowed to engage in activities that were closely related to banking, and acquisitions by them were subject to approval by the Federal Reserve. They had to divest themselves of acquisitions that did not conform to the act.
After 1970, the interstate
