Recap 03A -- Interest-Rate Essentials

Recap 03A -- Interest-Rate Essentials - FINS 5550 / FINS...

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FINS 5550 / FINS 3650 — International Banking Topic 3A Recap To date, in the 27 hours you have spent on course readings, you should have read the Basel Capital Accord in its entirety, and read the Basel II and Basel II accords selectively. You should also have reviewed Australian Prudential Standards 110 and 111. Maturity Transformation and Interest-Rate Risk Banks make money through maturity, liquidity, and credit transformation. The first of these — maturity transformation — entails interest-rate risk. As mentioned last week, often a banking crisis is triggered by a crisis of a different sort. Most of the time it is a credit crisis (like the way credit problems in sub-prime residential mortgage loans triggered the GFC). But the U.S. savings-and-loan crisis of the late 1980s and early 1990s was triggered by interest-rate risk. The U.S. Savings and Loan Crisis In a nutshell, U.S. savings and loan associations (S&Ls) were required to hold 90% of their assets in residential mortgage loans, which were generally 30-year fixed-rate loans. At the same time, roughly 90% of their liabilities were 30-day time deposits, or savings accounts. While funding 30-year assets with 30-day liabilities seems reckless, it actually wasn’t so. Because ever since 1933, Regulation Q (promulgated under the Federal Reserve Act) capped the interest which could be paid on demand and time deposits (chequing and savings accounts). S&Ls could pay up to 5.25% per annum on savings accounts, while commercial banks were topped out at 5.00% pa . Thus S&Ls enjoyed a very stable source of funds: Even though savings accounts could be depleted quickly, there was really no place for depositors to go. In the late 1970s, when U.S. inflation was in double digits and short-term paper was yielding upwards of 15% pa , the investment banking community won approval to offer cash-management accounts to retail investors. In 1980, the limit on the rates payable by S&Ls was dropped. Individuals drew down on their savings accounts to open CMAs; S&Ls needed to replenish their funding, so they issued certificates of deposits into the capital markets, where they were snapped up by — cash management trusts. Suddenly, holding 30-year mortgage loans yielding 8% was no longer a safe business. The S&Ls tried to trade their way out. They sought, and were given, the freedom to branch out from residential lending, and they piled into commercial lending. Where they promptly lost billions of dollars. In all, 747 S&Ls failed (out of 3,234), and the total cost was eventually placed at over $160 billion, of which approximately $125 billion was picked up by the U.S. taxpayer.
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This note was uploaded on 09/19/2011 for the course FINS 3650 taught by Professor Arnold during the Three '11 term at University of New South Wales.

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Recap 03A -- Interest-Rate Essentials - FINS 5550 / FINS...

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