Module 1 Case Study FINC3370 answers

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University of Texas, San Antonio *

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3370

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Finance

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Apr 3, 2024

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Module 1: Background Information and Risk in Banking Case 50 total points Please show all work on problems (no work shown, no credit given) and give complete answers on concepts. Don’t forget to write your name on the submitted answers. All answers must be HANDWRITTEN and legible and converted into a single file. Upload your completed case to the Case 1 dropbox on d2l. 1) When looking at the balance sheet, what is the main difference on the asset side between a bank and a manufacturing firm? Also, what is the main difference on the liability side? (5 pts) Ans: On the asset side, a manufacturing firms uses mostly real assets like inventory and PP&E while a bank uses mostly financial assets like cash, securities and loans. On the liability side banks tend to have more debt (deposits and other borrowings) than manufacturing firms (current liabilities and long term debt) and less equity. 2) What are the particular differences between the income statements of manufacturing firms and those of banks? (5 pts) Ans: To get to gross profit, manufacturing firms subtracts the cost of inventory sold from sales whereas banks subtract the cost of deposits/borrowings (interest expense) from interest income on assets (securities/loans). They both subtract expenses of running the business but banks offset this with other sources of income (burden= noninterest exp. – noninterest income). The bank also has to deduct an amount based on predicted loan defaults called the provision for loan losses before getting to earnings before taxes. Manufacturing firms subtract interest after expenses (because interest is normally only an expense and not a form of income). 3) Looking at the chart and the bottom of the second page in your notes, comment on 3 trends you notice occurring over the last 70 years of institutions’ share of financial assets. (5 pts) Ans: Depository institutions have a much smaller percentage of financial assets while investment companies and securities firms have a much larger percentage. Insurance firms and finance companies have roughly the same percentage as they have in the past. The dollar value of financial assets has grown substantially from about 300 billion in 1950 to 16 trillion in 2003 and to 90 trillion in 2017. 4) What is the difference between primary and secondary securities? Provide two examples of each. If you want to own primary securities, what types of financial institutions should you contact? If you want to own secondary securities, which institutions do you contact? (5 pts) Ans: Primary securities are issued by the end user of funds whereas secondary securities are issued by financial intermediaries in order to invest in primary securities. To own primary securities such as stocks and bonds you can contact a broker. To own secondary securities (such as mutual fund shares, deposits or pay insurance premiums) you can contact an intermediary such as a mutual fund, bank or insurance company.

5) Explain the three different types of ownership structures for financial institutions specifying how they differ and what specific types of financial institutions tend to use each structure. Be sure to include examples of at least two firms from each type. (5 pts) Ans: Stock firms are owned by stock holders who want the firm to take risk and provide returns. Large banks such as Bank of America and Wells Fargo normally choose this ownership structure. Mutual firms are supposed to be operated on behalf of the customers and are normally insurance companies such as Liberty Mutual and State Farm. These are not publically traded like stock firms. Not for profit firms are operated on behalf of a select group of people that have something in common (called common bond membership). These tend to be credit unions that can give the members lower rates on loans and higher rates on deposits because they do not pay taxes. Two examples would be the Navy Credit Union and East Texas Credit Union. 6). How is default risk measured in a bank’s securities portfolio? How is it measured in the loan portfolio? What problems can a bank encounter if they take too much default risk? (5 pts) Ans: In a portfolio of securities, the risk of default or missed payments is measured by the bond rating assigned to the bond issue. In the loan portfolio default risk is measured by credit scores (FICO) and borrower risks. If the bank takes too much default risk they can lose income, have to set aside a higher PLL and even become insolvent in extreme situations. 7) Use the balance sheet below to answer questions a, b and c. (10 pts) SFA Bank, Inc. Balance Sheet ASSETS Securities (2%, < 1 yr. maturity) $300 mil Loans (4%, 15 yr. maturity) $500 mil TOTAL $800 mil LIABILITIES & EQUITY Demand Deposits (0%, < 1 yr.) $500 mil Fed Funds (1%, < 1 yr.) $200 mil Equity $100 mil TOTAL $800 mil a) What is the bank’s one-year funding gap? What risk is the bank taking? b) What is the bank’s expected net interest income? c) Based on the funding gap, how much would net interest income change if rates rise by 1%? How much would NII change if rates fall by 1% (or 100 basis points)?

Ans: a) 300million – 200million = 100 million funding gap if interest rates decrease NII decreases with a positive funding gap b) Net Interest Income = interest income – interest expense = (2% x 300M) + (4% x 500M) – (1% x 200M) = $24 million c) +1%: 100,000,000 x 1% = 1,000,000 (more income -1%: 100,000,000 x -1% = -1,000,000 (less income) 8) Distinguish between the three different types of interest rate risk banks face. What could possibly benefit a bank and what could possibly hurt a bank with each type? (5 pts) Ans: Price risk: when rates increase, fixed income securities decrease in value and vice versa. This means an increase in rates could decrease asset values and cause a bank to lose equity (hurt) while a decrease in rates could cause assets to increase in value and increase equity (help). Reinvestment risk: when rates increase periodic cash flows are reinvested at a higher rate and vice versa. This means, with a positive funding gap, a rate increase could increase net interest income (benefit) while a rate decrease could reduce net interest income (hurt). This would be the opposite for a negative funding gap. Prepayment risk: When rates decrease customers refinance higher rate loans. This could hurt the bank’s interest income if they are actually holding the loan on their books and refi at a lower rate; however this could benefit the bank if they are not holding the loan because they make closing costs (origination fees) when refinancing the mortgage loan. 9) What types of problems/risks can an international bank headquartered in the US incur when operating in foreign countries? Please explain. (5 pts) Ans: The bank can suffer losses from forward contracts where they agree to sell foreign currencies at a predetermined price in the future if the currency values move in the wrong direction. Also foreign currencies that depreciate against the dollar are worth less dollars when translated for year-end consolidated statements (that value all assets, domestic and international, in dollars). A bank can also suffer if the economy in the foreign country tanks or if the foreign country starts seizing assets of international firms operating in the country. Bonus: Find a recent story (2019 or 2020) of a hack that somehow affected banks and/or consumer credit and include the story in your submitted case pdf file. (5 pts)

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