BK7 - MANA130107 Bank Management 1 Lecture Seven Liquidity...

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Unformatted text preview: MANA130107 Bank Management 1 Lecture Seven Liquidity and Reserve Management (chap 11 ) Topics in Commercial Bank Management MANA130107 Bank Management 2 Liquidity and Reserve Management ¡ Topics covered in this lecture ¢ Demand and supply of liquidity ¢ Approach to meet liquidity requirements ¢ Estimation of liquidity need ¢ Reserve management MANA130107 Bank Management 3 Credit Default Swaps ¡ An example ¢ Bank A pays default premium x BP until default ¢ Bank B pays agreed notional amount on default (relative to some threshold: number of bad loan or amount of loss) ¢ Bank B takes over credit risk from A ¢ Bank A can factor the cost of CDS into the loan and then remove credit risk of the customer Bank A Bank B Pay CDS Premium Credit event payments IF default Borrower Loan IR and Principal Payment MANA130107 Bank Management 4 Credit Linked Notes ¡ What is a CLN? ¢ Instrument fuses together a normal debt instrument with a credit option to give borrower greater repayment flexibility ¢ A CLN essentially transfers credit risk from the note issuer to the bond investors. ¢ An example Bank A extends a $1 million loan to a Steel Company and issues a CLN with same principal amount tied to the value of the loan. If a credit event occurs, Bank A’s repayment obligation on the note will decrease to some extend to offset its loss on the loan. MANA130107 Bank Management 5 Collateralized Debt Obligations ¡ What is a CDO? ¢ A CDO contains pools of high-yield financial instruments (such as corporate bonds, loans and stocks) contributed by businesses ¢ Notes (Claims) of varying grades are sold to investors seeing income from pooled assets ¢ The asset-backed claims sold are divided into tranches similar to Collateralized Mortgage Obligations ¢ The most risky tranche offers the highest return while the least risky tranche offers the lowest return ¢ The challenging part lies in the proper estimation of CDO’s real credit ratings when some of the underlying assets go bad MANA130107 Bank Management 6 A Bank Run in 2003 ¡ Abacus Federal Savings Bank, with assets of $282 million and operations across New York, New Jersey and Pennsylvania. ¡ During the third week of April, it lost $30 million, or 13 percent, of deposits in a 4-day run on branches in New York City and Philadelphia. ¡ The run followed an announcement that Carol Lim, a branch manager, had been fired on suspicion of embezzlement. Some depositors were alarmed that funds entrusted to Lim did not end up in accounts and, therefore, might not be insured. ¡ In the end, Abacus weathered the run, with a few tense moments as the thrift faced the possibility that a short-term funding squeeze could escalate into a solvency problem ¢ So, Banks rely on public confidence, which may quickly be eroded by negative news. A loss of public confidence then leads to “ liquidity ” crisis. MANA130107 Bank Management 7 Liquidity ¡ What is a liquid bank?...
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This note was uploaded on 10/17/2011 for the course FINANCE CFA 201 taught by Professor Leo during the Spring '09 term at Fudan University.

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BK7 - MANA130107 Bank Management 1 Lecture Seven Liquidity...

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