Saudi Electronic University Accounting of Financial Institutions Questions

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Q1. Explain in more detail how do Commercial banks resemble securities firms and explain the special nature for structures of their financial statements.
Q2. List and explain methods financial institutions may disclose their exposure to each type of market risk and explain Value-at-risk approach

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Chapter 12
Market Risk Disclosures
This chapter has two complementary purpose.
▪ First, it describes the market risk disclosures
required under Securities and Exchange
Commission (SEC) Financial Reporting Release
(FRR) NO. 48.
▪ Second, this chapter demonstrate how these
market risk disclosure allow users of financial
reports to evaluate how financial institutions’
derivatives and hedging affect their market risk.
Market Risk Disclosures
Overview of FRR No. 48 (1997)
The SEC issued FRR NO. 48 (1997) to address the concern
that the market and other risks of firms’ derivatives were not
well understood by firm’ management or transparently
presented in their financial reports.
FRR No. 48 (1997) disclosure requirements apply to
derivatives that must settle financially, to commodity
derivatives that by custom settle financially, and to most
nonderivative financial instruments, although leases,
insurance contracts, and various other financial instruments
are exempted.
FRR No. 48 (1997) defines risk as the “possibility of loss, not
gain”. Possibility of loss is one-sided notion of risk that
translates into overall risk (variance) only when the returns on
the item under consideration are distributed symmetrically.
Derivatives and other financial instruments that are or include
options are particularly likely to exhibit asymmetric return
distributions.
FRR No. 48 “Requires that market risk disclosures be made
once a year in firms’ Form 10-K filings.”
➢ A Significant limitations of market risk disclosures made
under FRR NO. 48 (1997) is that
❖ They need not be comparable across firms
❖ Exposures for a given firm
❖ Time for four reasons.
First, firms may define loss in terms of reduction of value,
earnings or cash flow, and the three definitions of loss are
not identical and can be inconsistent.
Second, firms may disclose their exposure to each type of
market risk using any of these, viz. tabular format,
sensitivity approach, value at risk approach.
▪ Third, the period over which loss is measured
in the sensitivity and VaR approaches varies
across firms and across different risks for a
given firm.
▪ Fourth, the size of the market price movements
in the sensitivity approach and the confidence
level used in the VaR approach vary across
firms.
Market Risk Disclosures
• Tabular format
➢ “Requires that fair values and information sufficient to
estimate the expected cash flows over each of the
next five years and beyond five years be disclosed for
derivatives and other financial instruments grouped
based on common characteristics for each market risk.
Users of financial reports should be aware that this
information is not always tabulated in the same way by
different firms, and so it is critical to read their textual
discussions of the construction of the tables.
▪ The information necessary to estimate the cash flows in
the six time intervals depends on the type of financial
instrument. For example, for fixed –rate debt instruments,
this information includes the expected principal payment
and the weighted-average historical interest rate that
applies to the principal paid in each of the intervals. For
floating–rate debt instruments, this information includes
the expected principal payment and the applicable
weighted-average estimated forward interest rate in each
of the intervals.
Market Risk Disclosures
• Tabular format
➢ Estimating repricing gap
❖ According to the text, three steps are involved in
estimating the repricing gap using tabular format
disclosures of interest rate risk.
1. Treat fixed-rate financial investments as a set of
zero-coupon instruments with repricing intervals
that correspond to the timing of principal cash
flows in the tabular format disclosure.
Market Risk Disclosures
2. Treat floating-rate financial instruments as
repricing within the next year, unless there is
reason to believe these instruments reprice
more slowly.
3. Treat derivatives as the closest available
portfolio of cash instruments, and apply steps
1 and 2.
Market Risk Disclosures
➢ Estimating duration❖ Duration determines the change in the value of a financial
instrument, portfolio, or firm to a small change in a flat yield curve.
According to the text, three steps in estimating duration using
tabular format disclosures
1. Estimate the expected cash flows in each interval for each
type of fixed-rate financial instrument.
2. Unless there is reason to believe otherwise, assume that
floating-rate financial instruments pay off in full in the 0- to 1-year
interval and that payment of principal and half a year’s accrued
interest occurs halfway through the interval.
3. Treat derivatives as the closest available portfolio of cash
instruments and apply steps 1 and 2.
Expected cash flows determined in steps 1-3 can be used to
estimate duration.
Market Risk Disclosures
➢ Strengths and Weaknesses of Tabular Format
❖ Strength-It provides unprocessed and disaggregated
data.
▪ Used to assess market risk on an ex ante basis
▪ Used to estimate market risk on ex post effect of
changes in market prices.
❖ Two main weaknesses for tabular format
▪ Static portrayal of firms’ exposures
▪ Does not clearly indicate the covariances across
different exposures or market risks.
Market Risk Disclosures
• Sensitivity approach
➢ “Requires that the firm provide an estimate of loss of
value, earnings, or cash flow caused by a specific
adverse movement in each market price or rate.”
➢ “Firm can choose the size of the movement, although
it should be at least 10% of the current market price
or rate.”
➢ Most common form of market risk disclosure.
Market Risk Disclosures
➢ Strengths and weaknesses
❖ Strength
▪ Simplicity and ease of interpretation compared
to the tabular format.
❖ Weakness
▪ “May not provide users of financial reports with
a good sense for complex or nonlinear
exposures.”
Market Risk Disclosures
• Value-at-risk approach
➢ “Requires that the firm provide an estimate of the
loss of value, earnings, or cash flow that is expected
to result with a specified probability over a specified
time interval for each market risk.”
➢ VaR approach is statistical and confidence bound.
➢ Confidence bound
❖ Distinguishes normal from abnormal realizations
of risk.
Market Risk Disclosures
• Value-at-risk approach
➢ Three main statistical approaches:
❖ Delta-normal method
▪ “Firm assumes that the return to each of the
financial instruments it holds is distributed
normally, so the returns to all its financial
instruments are linearly related.”
❖ Historical simulation method
▪ “The firm observes the multivariate empirical
distributions of the returns to its exposures
and, through repeated sampling from these
distributions, simulates the distribution of the
returns to its portfolio of exposures.
Market Risk Disclosures
❖ Monte Carlo method
▪ “The firm assumes return distribution that it
believes apply to its various exposures –
most commonly, smooth distributions that
resemble the empirical distributions but
abstract from the idiosyncrasies of the
historical data – and uses these distributions
to simulate the distribution of returns to its
portfolio.”
▪ Strength and Weakness of VaR Approach
Strength- It does not require users of financial reports to
assess the probability of given movements in market
prices or correlations among exposures.
Limitation:
(1) VaR estimates are sensitive to the methods used to
calculate them, in particular, to the length of the prior
period over which variances and covariances are
estimated or empirical distributions are sampled.
(2) Unlike, the tabular format and the sensitivity
approach, VaR does no provided the direction of the
exposure; for example, the firm could be hurt by
increase or decrease in interest rates, and users of
financial reports will not know which from the VaR
disclosures.
Chapter 10
Commercial Banks
Commercial Banks
The commercial banking industry in the United States
comprises a diverse array of financial institutions that
individually and collectively offer a wide range of financial
services.
A primary reason for this diversity is the fact that healthy
commercial banks can create financial holding companies
(FHCs) that engage in any financial activity under the Gramm,
Leach, Bliley Act of 1999 (GLBA).
The health requirement of this Act has not been a constraint on
formation of FHCs by commercial banks, as almost the entire
industry currently is profitable and well capitalized and has been
so for over a decade.
➢ As on November 2006, 641 FHCs remain effective, the vast
majority of which were created by institutions that are primarily
commercial banks.
➢ In addition, frequent mergers and acquisitions involving
commercial banks and other financial institutions have blurred the
boundaries between commercial banking and the other financial
services industries.
➢ Mergers and acquisitions also have dramatically increased
industry concentration. From 1990 to 2005, the number of
commercial banking organizations in the United States decreased
from more than 12000 to less than 8000, and the 10 largest banks’
share of the industry’s assets rose from about 20 % to 50 %.
This chapter provides a sense for commercial banks’ diversity.
Compared to thrifts, larger and more wholesale commercial
banks tend to be more like securities firms in two ways:
First: They focus more on generating fee or other noninterest
income and less on generating interest income.
❖ Although both thrifts and commercial banks earn non
interest income on traditional banking activities such as
deposit servicing, loan origination, trust and asset
management, larger and more wholesale commercial banks
increasingly earn fee income on nontraditional activities
usually conducted by securities firms previously such as
investment banking, financial advisory services, brokerage,
trading (including dealing), and merchant banking.
▪ Second: The largest U.S. commercial banks are extensively
involved with derivatives as dealers, traders and hedgers.
For example, the Bank of International Settlements reports
that over –the-counter (OTC) derivatives with a notional
amount of $ 285 trillion were outstanding in December
2005, while the office of Thrift Supervision reports that $
85 trillion (30%) of this amount was held by the three
largest U.S. commercial Banks – J P Morgan Chase ($ 44
trillion), Bank of America ($ 21 trillion), and ContiGroup
($ 20 trillion)-with an additional $ 9 trillion (3%) being
held by the next 22 largest U.S. commercial banks.
Because of commercial banks’ focus on generating
noninterest income, compared to the balance sheet focus
of the analysis of thrifts, the analysis of commercial
banks places more weight on income or cash flow
statement-based
valuation
approaches.
These
approaches require users of financial reports to assess
the risk and persistence of commercial banks’ various
non interest income streams.
Commercial Banks
• Balance sheet
➢ Balance sheets of commercial banks are
unclassified – no distinction made between current
versus noncurrent accounts.
➢ This reflects liquid nature of financial assets and
liabilities.
➢ Assets and liabilities are listed in order of liquidity
which reflects a combination of intent to order and
term to maturity.
Commercial Banks
• Income statement
➢ “Order of commercial banks’ income statements reflects the
historical primacy of net interest income.”
➢ Interest revenue is at the top of the income statement from
which interest expense is subtracted to yield net interest
income before the provision for loan losses. The provision
for loan losses is subtracted to yield net interest income
after the provision for loan losses. The provision for loan
losses naturally offsets net interest income before the
provision for loan losses, since loans subject to more credit
risk should carry higher interest rates, all else being equal.
At the bottom of the income statement, noninterest income
is added and non interest expenses and tax expenses are
subtracted.
Commercial Banks
• Cash flow statement
➢ “As with thrifts, the distinction among operating,
investing, and financing cash flows is arbitrary on
commercial banks’ cash flow statements, since
most of their cash flows relate to financial
instruments.”
Commercial Banks
• Cash flow statement
➢ “The same cash flow statement classification issue
arise for commercial banks’ trading portfolio.”
➢ “In analyzing a commercial bank, it usually wise to
ignore its cash flow statement classifications and
focus instead on what the cash flow statement
indicates about the banks’ new investments and
sources of funding during the year.

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