They provide a range of services to companies when they are exporting goods and services. Companies can enter into a variety of contracts with banks that are designed to hedge risks they face relating to foreign exchange, commodity prices, interest rates, and other market variables. These contracts will be discussed in later chapters. Even risks related to the weather can be hedged.
Banks undertake securities research and offer “buy,” “sell,” and “hold” recommendations on individual stocks. They offer brokerage services (discount and full service). They offer trust services where they are prepared to manage portfolios of assets for clients. They have economics departments that consider macroeconomic trends and actions likely to be taken by central banks. These departments produce forecasts on interest rates, exchange rates, commodity prices, and other variables. Banks offer a range of mutual funds and in some cases have their own hedge funds. Increasingly banks are offering insurance products.
The investment banking arm of a bank has complete freedom to underwrite securities for governments and corporations. It can provide advice to corporations on mergers and acquisitions and other topics relating to corporate finance.
How are the conflicts of interest outlined in Section 2.6 handled? There are internal barriers known as Chinese walls. These internal barriers prohibit the transfer of information from one part of the bank to another when this is not in the best interests of one or more of the bank's customers. There have been some well-publicized violations of conflict-of-interest rules by large banks. These have led to hefty fines and lawsuits. Top management has a big incentive to enforce Chinese walls. This is not only because of the fines and lawsuits. A bank's reputation is its most valuable asset. The adverse publicity associated with conflict-of-interest violations can lead to a loss of confidence in the bank and business being lost in many different areas.
Accounting
It is appropriate at this point to provide a brief discussion of how a bank calculates a profit or loss from its many diverse activities. Activities that generate fees, such as most investment banking activities, are straightforward. Accrual accounting rules similar to those that would be used by any other business apply.
For other banking activities, there is an important distinction between the “banking book” and the “trading book.” As its name implies, the trading book includes all the assets and liabilities the bank has as a result of its trading operations. The values of these assets and liabilities are marked to market daily. This means that the value of the book is adjusted daily to reflect changes in market prices. If a bank trader buys an asset for $100 on one day and the price falls to $60 the next day, the bank records an immediate loss of $40 – even if it has no intention of selling the asset in the immediate future. Sometimes it is not easy to estimate the value of a contract that has been entered into because there are no market prices for similar transactions. For example, there might be a lack of liquidity in the market or it might be the case that the transaction is a complex nonstandard derivative that does not trade sufficiently frequently for benchmark market prices to be available. Banks are nevertheless expected to come up with a market price in these circumstances. Often a model has to be assumed. The process of coming up with a “market price” is then sometimes termed marking to model. (Chapter 25 discusses model risk and accounting issues further.)
The banking book includes loans made to corporations and individuals. These are not marked to market. If a borrower is up-to-date on principal and interest payments on a loan, the loan is recorded in the bank's books at the principal amount owed plus accrued interest. If payments due from the borrower are more than 90 days past due, the loan is usually classified as a non-performing loan. The bank does not then accrue interest on the loan when calculating its profit. When problems with the loan become more serious and it becomes likely that principal will not be repaid, the loan is classified as a loan loss.
A bank creates a reserve for loan losses. This is a charge against the income statement for an estimate of the loan losses that will be incurred. Periodically the reserve is increased or decreased. A bank can smooth out its income from one year to the next by overestimating reserves in good years and underestimating them in bad years. Actual loan losses are charged against reserves. Occasionally, as described in Business Snapshot 2.3, a bank resorts to artificial ways of avoiding the recognition of loan losses.
BUSINESS SNAPSHOT 2.3
How to Keep Loans Performing
When a borrower is experiencing financial difficulties and is unable to make interest and principal payments as they become due, it is sometimes tempting to lend more money to the borrower so that the payments on the old loans can be kept up to date. This is an accounting game, sometimes referred to debt rescheduling. It allows interest on the loans to be accrued and avoids (or at least defers) the recognition of loan losses.
In the 1970s, banks in the United States and other countries lent huge amounts of money to Eastern European, Latin American, and other less developed countries (LDCs). Some of the loans were made to help countries develop their infrastructure, but others were less justifiable (e.g., one was to finance the coronation of a ruler in Africa). Sometimes the money found its way into the pockets of dictators. For example, the Marcos family in the Philippines allegedly transferred billions of dollars into its own bank accounts.
In the early 1980s, many LDCs were unable to service their loans. One option for them was debt repudiation, but a more attractive alternative was debt rescheduling. In effect, this leads to the interest on the loans being capitalized and bank funding requirements for the loans to increase. Well-informed LDCs were aware of the desire of banks to keep their LDC loans performing so that profits looked strong. They were therefore in a strong negotiating position as their loans became 90 days overdue and banks were close to having to produce their quarterly financial statements.
In 1987, Citicorp (now Citigroup) took the lead in refusing to reschedule LDC debt and increased its loan loss reserves by $3 billion in recognition of expected losses on the debt. Other banks with large LDC exposures followed suit.
The Originate-to-Distribute Model
DLC, the small hypothetical bank we looked at in Tables 2.2 to 2.4, took deposits and used them to finance loans. An alternative approach is known as the originate-to-distribute model. This involves the bank originating but not keeping loans. Portfolios of loans are packaged into tranches which are then sold to investors.
The originate-to-distribute model has been used in the U.S. mortgage market for many years. In order to increase the liquidity of the U.S. mortgage market and facilitate the growth of home ownership, three government sponsored entities have been created: the Government National Mortgage Association (GNMA) or “Ginnie Mae,” the Federal National Mortgage Association (FNMA) or “Fannie Mae,” and the Federal Home Loan Mortgage Corporation (FHLMC) or “Freddie Mac.” These agencies buy pools of mortgages from banks and other mortgage originators, guarantee the timely repayment of interest and principal, and then package the cash flow streams and sell them to investors. The investors typically take what is known as prepayment risk. This is the risk that interest rates will decrease and mortgages will be paid off earlier than expected. However, they do not take any credit risk because the mortgages are guaranteed by GNMA, FNMA, or FHLMC. In 1999, FNMA and FHLMC started to guarantee subprime loans and as a result ran into serious financial difficulties.3
The originate-to-distribute model has been used for many types of bank lending including student loans, commercial loans, commercial mortgages, residential mortgages, and credit card receivables. In many cases there is no guarantee that payment will be made so that it is the investors that bear the credit risk when the loans are packaged and sold.
The originate-to-distribute
