Derivatives, Portfolio Composition and Bank Holding Company Interest Rate Risk Exposure

This paper examines the role played by derivatives in determining the interest rate sensitivity of bank holding companies' (BHCs') common stock, controlling for the influence of on-balance sheet activities and other bank-specific characteristics. The major result of the analysis suggests that derivatives have played a significant role in shaping banks' interest rate risk exposures in recent years. For the typical bank holding company in the sample, increases in the use of interest rate derivatives corresponded to greater interest rate risk exposure during the 1991-94 period. This relationship is particularly strong for bank holding companies that serve as derivatives dealers and for smaller, enduser BHCs. During earlier years, however, there is no significant relationship between the extent of derivatives activities and interest rate risk exposure. There are two plausible interpretations of the relationship between interest rate derivative activity and interest rate risk exposure in the latter part of the sample period: one interpretation suggests that derivatives tend to enhance interest rate risk exposure for the typical BHC in the sample, while the other suggests that derivatives may be used to partially offset high interest rate risk exposures arising from other activities. The analysis provides support for the first of these two interpretations. This paper was presented at the Financial Institutions Center's October 1996 conference on "

What market risk capital reporting tells us about bank risk

This paper was presented at the conference "Economic Statistics: New Needs for the Twenty-First Century," cosponsored by the Federal Reserve Bank of New York, the Conference on Research in Income and Wealth, and the National Association for Business Economics, July 11, 2002. In recent years, financial market supervisors and the financial services industry have increasingly emphasized the role of public disclosure in ensuring the efficient and prudent operation of financial institutions. This article examines the market risk capital figures reported to bank regulators by U.S. bank holding companies with large trading operations to assess the extent to which such disclosure provides market participants with meaningful information about risk. It argues that when one looks across banks, market risk capital figures provide little additional information about the extent of an institution's market risk exposure beyond what is conveyed by simply knowing the relative size of its trading account. In contrast, when one examines individual banks over time, these figures appear to provide information not available from other data in regulatory reports. These findings suggest that market risk capital figures are most useful for tracking changes in individual banks' market risk exposures over time.Bank capital ; Risk ; Bank holding companies ; Financial services industry - Law and legislation

The challenges of risk management in diversified financial companies

In recent years, financial institutions and their supervisors have placed increased emphasis on the importance of measuring and managing risk on a firmwide basis—a coordinated process referred to as consolidated risk management. Although the benefits of this type of risk management are widely acknowledged, few if any financial firms have fully developed systems in place today, suggesting that significant obstacles have led them to manage risk in a more segmented fashion. In this article, the authors examine the economic rationale behind consolidated risk management. Their goal is to detail some of the key issues that supervisors and practitioners have confronted in assessing and developing consolidated risk management systems. In doing so, the authors clarify why implementing consolidated risk management involves significant conceptual and practical difficulties. They also suggest areas in which additional research could help resolve some of these difficulties.Risk management ; Financial institutions ; Bank supervision

Supervisory information and the frequency of bank examinations

Bank supervisors need timely and reliable information about the financial condition and risk profile of banks. A key source of this information is the on-site, full-scope bank examination. This article evaluates the frequency with which supervisors examine banks by assessing the decay rate of the private supervisory information gathered during examinations. The analysis suggests that this information ceases to provide a useful picture of a bank's current condition after six to twelve quarters. The decay rate appears to be faster in years when the banking industry experiences financial difficulties, and it is significantly faster for troubled banks than for healthy ones. Thus, the analysis suggests that the annual examination frequency currently mandated by law is reasonable, particularly during times of financial stress for the banking industry.Bank supervision ; Banking law

The impact of supervision on bank performance

Does the intensity of supervision affect quantifiable outcomes at supervised firms? We develop a novel proxy to identify plausibly exogenous variation in the intensity of supervision across large U.S. bank holding companies (BHCs), based on the size rank of a BHC within its Federal Reserve district. We begin by demonstrating that the largest five BHCs in a district receive discontinuously more supervisory time than smaller BHCs in the district, even after controlling for size and a variety of other BHC characteristics. Using a matched sample approach, we find that these "top five" BHCs have lower volatility of accounting earnings and market returns than otherwise similar BHCs. These firms also appear to hold less risky loan portfolios and to engage in more conservative loan loss reserving practices. While their risk is lower, top five BHCs do not experience lower accounting returns or slower asset growth. Given that these firms are subject to similar rules, our results support the idea that supervision has a distinct role as a complement to regulation

Using credit risk models for regulatory capital: issues and options

The authors describe the issues and options that would be associated with the development of regulatory minimum capital standards for credit risk based on banks' internal risk measurement models. Their goal is to provide a sense of the features that an internal-models (IM) approach to regulatory capital would likely incorporate, and to stimulate discussion among financial institutions, supervisors, and other interested parties about the many practical and conceptual issues involved in structuring a workable IM regulatory capital regime for credit risk. The authors focus on three main areas: prudential standards defining the risk estimate to be used in the capital requirements, model standards describing the essential components of a comprehensive credit risk model, and validation techniques that could be used by supervisors and banks to assess model accuracy. The discussion highlights a range of alternatives for each of these areas.Bank capital ; Bank loans ; Risk ; Bank supervision

Parsing the content of bank supervision

We measure bank supervision using the database of supervisory issues, known as matters requiring attention or immediate attention, raised by Federal Reserve examiners to banking organizations. The volume of supervisory issues increases with banks' asset size, especially for the largest and most complex banks, and decreases with profitability and the quality of the loan portfolio. Stressed banks are faster at resolving issues, but all else equal, resolving new issues takes longer the more issues a bank faces, which may suggest capacity constraints in addressing multiple supervisory issues. Using computational linguistic methods on the text of the issue description, we define five categorical issue topics. The subset of issues related to capital levels and loan portfolio are the most consequential in terms of supervisory rating downgrades and are directly related to changes in banks' balance sheet characteristics and profitability. Other issues appear to reflect soft information and are less correlated with bank observables. By categorizing questions asked by analysts at banks' quarterly earnings calls using the same linguistic approach, we find that market monitors raise issues similar to those of supervisors when the issues are related to hard information (such as loan quality or capital) and public supervisory assessment programs

The Return to Retail and the Performance of U.S. Banks

The U.S. banking industry is experiencing a renewed focus on retail banking, a trend often attributed to the stability and profitability of retail activities. This paper examines the impact of banks' retail intensity on performance from 1997 to 2004 by developing three complementary definitions of retail intensity (retail loan share, retail deposit share, and branches per dollar of assets) and comparing these measures with both equity market and accounting measures of performance. We find that an increased focus on retail banking across U.S. banks is linked to significantly lower equity market and accounting returns for all banks but lower volatility for only the largest banking companies. We conclude that retail banking may be a relatively stable activity, but it is also a low-return one

Supervising large, complex financial companies: What do supervisors do?

The Federal Reserve is responsible for the prudential supervision of bank holding companies (BHCs) on a consolidated basis. Prudential supervision involves monitoring and oversight to assess whether these firms are engaged in unsafe or unsound practices, as well as ensuring that firms are taking corrective actions to address such practices. Prudential supervision is interlinked with, but distinct from, regulation, which involves the development and promulgation of the rules under which BHCs and other regulated financial intermediaries operate. This paper describes the Federal Reserve's supervisory approach for large, complex financial companies and how prudential supervisory activities are structured, staffed, and implemented on a day-to-day basis at the Federal Reserve Bank of New York as part of the broader supervisory program of the Federal Reserve System. The goal of the paper is to generate insight for those not involved in supervision into what supervisors do and how they do it. Understanding how prudential supervision works is a critical precursor to determining how to measure its impact and effectiveness