FINM3006 w3

Banks have set aside more cash than needed for bank losses. 2-3 years earnings bump. During a crisis banks agree to suspend default clauses on derivatives transactions.Bank A writes bank B a credit default swap on some other entity (Bank C) in return it gets a premium from bank B. "in event C defaults, I pay you blabla dollars" Bank Z also has exposure to bank C so enters in CDS. Suppose something happens and C heads into insolvency-> triggers CDS swaps so Bank A needs to pay CDS payment to B and Z. Even though bank A may have been healthy at the time, if there are multiple commitments then bank A might also head into insolvency. There may be another bank, bank D which is in a totally different country but has written CDS for exposure to bank A to some other entity-> bank Y to get a premium. And now the insolvency that lead to bank A insolvency will trigger Bank D. The idea is we stop this whole system for a while and see what happens.

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If you want to use ratios properly, you should look at multiple ratios and compare ratios across firms. DuPont Analysis-> breaking down return on equity. Regulators usually look at the inverse of the ratios and gives you idea of how much bankruptcy risk the institution faces.ROA-> NPM (how you handle costs, the higher the ratio, the smaller the expenses) AU (how much revenue you can generate from assets)CBA over time-> group's ability to web the GFC in robust fashion is due to continued sustained ROE. Higher loan impairments (bad and non performing) and also prudent decision to increase group's capital base. They did two things during crisis-> there was fall from crisis and increase in equity. ROA, you see similar trend as in ROE (dip in 2009). Note that asset base hasn't increased that much-> growth has been slow

There are other important income ratios (interest income ratio) and non interest income ratio. If you look at the spread it tells you interest income relative to asset and interest income relative to liabilities-> profitability per dollar that's transferred from deposits into assets. Banks business is to borrow short and lend long and they make the spread. If you don't have market prices then you can find average interest rate. In crisis this traditional line of business broke down. When your yield curve is flat then the spread is zero and traiditonal spread is less profitable. One of the things that came out of that is securitisation and rising house prices allowed for yield attached to subprime risk. I think a higher spread is better

Example- 25% If you ever use this ratios you need to look across firms over time to get a good picture about what's happening-> need to know what's going into the components of these ratios and be weary of net income (see what they're doing with provisions)

Risks in banking- We know banks are risky and taking risks is usually rewarded and economies and governments want banks to take risks but taking excessive risk means it won't take much for banks to fail. Going to focus on risks that come out of the asset transformation process-Asset transformation and liquidity creation (transformation of illiquid assets e.g. real estate into very liquid liabilities e.g. deposits) This is the key role gives rise to interest rate risk (mismatch of maturities/duration) this is also maturity transformation and the mismatch gives rise to interest rate risk, market risk (risk associated with trading and trading activity; volcker rule that prohibits propriety trading, if rule is implemented it works then this is expected to be reduced liquidity risk (enter market to refinance and you can't so you need to unwind assets), insolvency/bankruptcy risk because they're making loans it gives rise to credit risk (people you lend to won't pay you back) off balance sheet risk can occur if you've issued too many commitments.Other main function is delegated monitor role. If the central bank pushes money into the system but the banks hoard that money and don't lend monetary policy doesn't work

Interest rate risk comes from mismatch of assets and liabilities mismatch, loans are very long term and if they're demand deposits approximately zero years. There are two sources of interest rate riskCash flow riskMarket value riskThe solution is to match securities (30 loans, 30 liabilities) (very short term liabilities, very short term assets) but this is inconsistent with asset transformation role. So not idea solution. The idea of changing interest rates affecting cash flow risk. you can be short funded (like banks). This means maturity of liabilities is much less than maturity of asset base- funding long term assets with short term liabilities. The problem with financing a long term asset with a short term liability- what happens when liability becomes due? (you have to refinance) SO if you're using the same liability you will have to refinance over time of asset but every time you go to refinance  interest rates could change. If interest rates fall it's good, but if they rise then you lose. This is how it affects cash flows. 

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