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The Money Rate for the Wholesale Bank
The opportunity cost of funds for a loan portfolio depends on those factors that affect its systematic risk: duration, the sensitivity of its value to changes in interest rates, and the portion of its credit or default risk that cannot be diversified away. Diversifiable credit risk does not affect the opportunity cost of funds; rather, it is reflected in the computation of the expected cash flow to the loan portfolio. Suppose we are
Exhibit 21.14 Expected Payouts for a Low-Quality Loan
Year Cumulative default rate Promised payments Assumptions
1 1 200 1,000 lent at year 0
2 2 200 When the loan defaults,
j 5 200 nothing can be recovered
4 10 200
5 20 1,200
evaluating the opportunity cost of capital for the low-quality loan in Exhibit 21.14. We lend $1,000 in return for promised payments of $200 per year plus repayment of the principal, $1,000, at the end of the fifth year. The promised yield to maturity is 20 percent. However, the cumulative default rate rises each year until only 80 percent of loans of this type reach maturity. Actual cumulative default rates on five- to nine-year-old portfolios of original issue junk bonds were between 19 and 26 percent.3 We need to figure out the expected yield to maturity, and do this by finding the rate that equates the expected cash flow with the amount we lend out.
SI QUO - "<S21X)> I -98($200) | .95($200) | .9<$200) | .8($1,200)
The expected yield, y, is about 15.8 percent, or 420 basis points lower than the promised yield.
Once the difference between the expected and promised yields has been clarified, you need to decide what money rate to charge the wholesale bank for borrowing from the treasury. If cash-flow estimates forecast charge-offs, then the money rate should be the expected yield for loan portfolios of equivalent credit risk and duration. Alternately, if expected charge-offs are not computed (and by default, all payments are assumed to be made as promised), then the money rate should be the promised yield to maturity for loan portfolios of equivalent credit risk and duration.
A commonly used source of data for yields on loan portfolios of equivalent credit risk and duration is market prices of publicly traded debt issues. Be skeptical when drawing comparisons, because the covenants on publicly held debt issues are often different from bank debt covenants. As a result, a
3 P. Asquith, D. Mullins Jr., and E. Wolff, ''Original Issue High Yield Bonds: Aging Analysis of Defaults, Exchanges, and Calls," Journal of Finance, vol. 44, no. 4 (1989), pp. 923-952.
direct comparison of yields may be inappropriate unless they are adjusted for the effect of differences in covenants.
As with the retail bank, the dominant consideration is that the equity for all of the pieces of the bank should equal the total bank equity. We recommend that book equity in the wholesale bank be determined as a percentage of its external assets (usually equal to total assets).
Cost of Equity
The cost of equity for the wholesale bank will be less than for the bank as a whole because each loan portfolio is match-funded with a money rate that accounts for both credit risk and interest-rate (duration) risk and the ratio of equity to total assets will be close to the regulatory requirement. Business risk is the primary risk left in the wholesale bank after match-funding. Hence, its cost of equity will be close to the unlevered cost of capital for the entire bank.
Treasury and Headquarters
The bank treasury borrows from the retail bank and lends to the wholesale bank. It also handles the bank's trading business and is responsible for centralized risk management. To organize our discussion of these issues, we cover, in turn, the mismatch problem, centralized risk management, the cost of equity, and the shared-cost problem. We will not discuss the treasury's capital structure except to say that, as before, equity will be allocated to the treasury based on the amount of external assets it holds.
Mismatch Profits and Losses
The philosophy that we have adopted is to match-fund the retail and wholesale banks as closely as possible for credit and interest-rate (duration) risk. The business reason for doing so is to provide business-unit managers with guidelines that lead directly to positive net present value decisions. For example, a loan officer must earn an all-in rate (fees plus interest) that exceeds a money rate that is adjusted for credit and duration risk. To the extent that the risk and duration of deposits is less than for loans, the treasury unit will record a mismatch profit. We have already illustrated, in Exhibit
21.6 and the accompanying discussion, that mismatch profits can be illusory. Recall that the key to handling mismatch gains or losses is to build a good cash flow forecast that takes into account the way spreads are forecasted to evolve with changing interest-rate environments; the inflow of funds from loans being paid off and the outflow of funds at new rates as new loans are made; the substitution between interest-bearing and non-interest-bearing deposits as interest-rate environments change, and the portion of mismatch profits that are sustainable because forward rates tend to be higher than their corresponding realized rates.