BANKING REGULATION

FINAL EXAM

No documents allowed Use of calculator permitted

Exercise 1 (6 points)
Suppose BBVA has 2 loans, each of which is due to be repaid one period hence and
whose cash flows are independent and identically distributed random variables. Each loan
will repay $400 to the bank with probability 0.8 and $250 with probability 0.2. However,
while BBVA knows this, prospective investors cannot distinguish BBVA loans portfolio
from that of Bancolombia that has the same number of loans, but each of its loans will
repay $400 to the bank with probability 0.5 and $250 with probability 0.5. The prior
belief of investors is that there is as much chance that BBVA has the higher-valued
portfolio as the lower-valued portfolio. Suppose that BBVA wishes to securitize these
loans and it knows that if it does that without credit enhancement, the cost of
communicating the true value of the portfolio of its loans to investors is 7% of the true
value. Moreover BBVA will earn 2% net profit of the securitized portfolio by originating
and servicing the loans. On the other hand, if BBVA keep the loans until maturity, it
should earn 2% of the true value minus $1.2 of administrative costs.
1- Explore BBVA securitization alternatives (tranching included) (3 points)
2- Assuming that a credit enhancer is available and that the credit enhancer could (at a
negligible cost) determine the true value of the loans portfolio, what sort of credit
enhancement should BBVA purchase? Assume everybody is risk neural and that the
discount rate is zero (2 points)
3- Based on your findings, what is the best securitization design? What does this exercise
tell you about the role played by rating agencies and credit enhancer in the development
of securitization? What is the purpose of tranching? (1 point)

1- Securitizing with communication

True value of the portfolio
2 x (0.8 x 400 + 0.2 x 250) = 740
Market value of the loan portfolio or value perceived by investors:
2 x 0.5 x (0.8 x 400 + 0.2 x 250) + 2 x 0.5 x (0.5 x 400 + 0.5 x 250) =
370 + 325 = 695
With communicating the true value to investors, BBVA needs to pay 7% of the true
value:
BBVA expected payoff: 740 (7% x 740) = 688.2 < 695 without communicating.
There is no gain to communicate.

Is it worth proceeding with the securitization of the portfolio?

Answering this question means comparing the net profits:
With securitization, $695 * 2% = $13.9
Without securitization, $740 * 2% - $1.2 = $13.6
Therefore BBVA should proceed with securitizing the loans portfolio.
2- Creating 2 classes of creditors: junior and senior
BBVA can create 2 classes of bondholders in a senior-subordinated structure or a
junior-subordinated structure . Class A bondholders who receive the first tranche
are entitled to receive $500 in the aggregate. After they are paid off, class B
bondholders are entitled to receive $300 or the residual cash flow, whichever is
smaller. Now since the class A bondholders will receive $500 for sure, regardless of
whether the loan portfolio is high-valued or low-valued (note that this is the lowest
payoff on either portfolio is $250), there is no need for the bank to communicate
information to these bondholders. The price at which the portfolio can be sold is
$500. Since class B bondholders are entitled to receive a max of $300 and the max
total payoff on the loan portfolio is $800, it is apparent that these bondholders are
essentially residual claimants. Thus the true value of the class B bonds must be equal
to the total value of the loan portfolio minus the aggregate vale of the class A bonds
or $740 $500 = $240. Since the market value (perceived value by investors) of the
total loan portfolio is $695 and the market value of the class A bonds is $500, the
market value of the class B bonds should be $695 - $500 = $195. If BBVA now
chooses to communicate the true value of class B bonds to investors, it will be able to
sell these bonds for $240 but the communication cost to the bank is 0.07 x 240 =
$16.8. Thus, its net payoff on securitizing this way will be: $500 + $240 - $16.8 =
$723.2. BBVA net revenue is higher when it uses securitization to partition cash flow
from the loan portfolio into 2 classes with different information sensitivities .
Scenario 2: Securitization with credit enhancer
The best way to structure the credit enhancement is to ask the credit enhancer to pay the
class B bondholders the difference between the promised amount of $400 and the actual
residual cash flow after the class A tranche is paid off. Ignoring the possibility of default
by the credit enhancer, this guarantees that class B bondholders will receive $400,
regardless of the quality of the securitized loan portfolio. Thus no information
communication by the bank is necessary. The question is: how much is BBVA ready to
pay its services?
To answer this question, suppose we label the 2 loans in the portfolio as 1 and 2. Then
there are 4 possible states: (i) both loans pay off $400 with proba 0.8 x 0.8 = 0.64, (ii)
loan 1 pays off $400 and loan 2 pays off $250 with proba 0.8 x 0.2 = 0.16, (iii) loan 1
pays off $250 and loan 2 pays off $400 with proba 0.8 x 0.2 = 0.16, (iv) both loans pay
off $250 with proba 0.2 x 0.2 = 0.04. Now in state (i) the credit enhancer has no
liabilities. In states (ii) and (iii) the total portfolio cash flow is $650 so only $150 is
available to pay off class B bondholders after class A bondholders have been satisfied.
The credit enhancers liability is $150 and the total probability of these 2 states is 0.16 +

0.16 = 0.32. In state (iv), the total portfolio cash flow is $500 so the credit enhancers
liability is $300 with proba 0.04.
Expected value of credit enhancers liability is equal to:
0.16 x 2 x $150 + 0.04 x $300 = 48 + 12 = 60
In a competitive market (with a zero discount rate and risk neutrality) $60 is what BBVA
will have to pay for the credit enhancement. Thus BBVA net pay off will be :
$500
+
$300
60
=
$740
market value of class A bonds + market value of class B bonds - credit enhancement
with credit
enhancement fee
With the credit enhancement the loan portfolio has been made perfectly liquid.
Conclusion : securitization with credit enhancement dominates securitization with
creation of 2 classes of bondholders and communication. Now the question for BBVA is
to find out whether or not there is a credit enhancer ready to endorse the risk for that
price.
3- Securitization with credit enhancement dominates securitization with creation of 2
classes of bondholders and communication. Credit enhancement is the best option
providing it is available in the market. This exercise shows that securitization needs both
rating agencies and credit enhancers to develop extensively. It also shows that tranching
reduced the cost of communication and increases the value of securitized portfolios since
it allows tailoring the risk associated to the portfolio to the risk appetite of the investor.
Short-answer questions
Answer to the questions in the blank space
Question 1 (5 points)
Recall the main principles of deposit-taking banks liquidity management. What have
been the major changes brought by the development of money markets over the last 25
years? Explain to what extent those changes have made banks more sensitive to market
conditions. How do the liquidity ratios (present those ratios) introduced by Basel III
address that question? Justify your answer.
Solution:
Main principles of liquidity management: deposit-taking institutions have a strong
constraint in terms of liquidity management due to deposits that are callable on demand
and due to clearing settlements. Therefore they hold reserves as primary reserves and
short term securities as secondary reserves. Over the last 25 years and due to the growth
of money markets secondary reserves have increased at the expense of primary reserves.
This is especially true in the US where reserves held at the central bank did not earn any
interest rate. Deposit-taking institutions have been increasingly dependent on market
conditions when selling short term securities.
Basel III introduces for the first liquidity ratios at short and long terms as a consequence
of the 2007 crisis that started as a liquidity crisis. The short term ratio is the Liquidity

Coverage Ratio (LCR): stock of highly liquid assets /total net cash outflows over 30 days
must be at least equal to 100% . The long term ratio is the Net Stable Funding Ratio
(NFSR): available stable funding/ required amount of stable funding must be at least
equal to 100%. This last ratio clearly aims at reducing the dependence of banks to money
markets.
Question 2 (5 points)
The Basel requirements regulation is an ongoing process with the last regulation aiming
at improving the previous one. Basel I major weakness was the regulatory arbitrage
practice. Explain. How did Basel II address that question? The 2007 crisis put in light
Basel II shortcomings: what are they and how does Basel III intend remedying to them?
Solution:
The regulatory arbitrage is the result of a discrepancy between the regulatory risk weight
and the economic risk weight as assessed by banks. Basel I introduced a very crude
definition of risk weights that did not correspond to the risk weights as calculated by
banks. Therefore banks had an incentive to select assets which regulatory risk weight was
lower than economic risk weight minimizing the cost of complying with the regulation.
The outcome of Basel I was seen as counterproductive given that banks could end up
with taking on more risk than before. Basel II tried to address that question by refining
the standard approach and allowing banks to use internal rating-based risk weights. Basel
II was essentially a micro-prudential regulation clearly encouraging banks to rely on their
own risk assessment modeling system to assess risk-weights reducing the possibility for
regulatory arbitrage.
Basel II shortcomings put in light by the 2007 crisis are the followings: the insufficiency
of true capital ready to absorb unexpected losses and the procyclicality of the ratio.
Basel III addresses that question by reinforcing the share of pure capital (common
equity and retained earnings) up to 4.5%, adding a conservation buffer that increases
further the core capital up to 7% in the 8% required. Further it imposes a countercyclical
capital buffer set in a range from 0 to 2,5%, the decision being left to national banking
authorities. The principle is the following: banks must build up on their capital position
during flourishing economic conditions over the minimum in order to draw on it during
bad economic times.
Question 3 (4 points)
Explain the rationale for the traditional banking business model originate to hold.
Under that business model, why is asset transformation usually low unless banks decide
to expose themselves to major interest rate risk? Why have banks (big-size ones in
particular) changed for the originate to distribute? What are the limits of this business
model in light of the 2007 crisis? How does Basel III affect it?
Solution:
The traditional banking model is the outcome of fractional reserve banking i.e institutions
that were managing accounts and the payment system started to lend money out of
deposit accounts since they demonstrated some stability. Since deposits are callable on

demand, deposit-taking institutions have always been concerned by setting aside

sufficient reserves to face clearing settlements and deposit outflows. In order to minimize
the risk of being illiquid those banks tended to keep asset transformation low reducing
mismatches between assets and liabilities. They were typically lending at 12-18 months
to businesses. That way they were reducing the risk of having to refinance at a higher rate
than the one earned on the assets side. With the increased competition coming from
financial markets and non bank institutions banks had to defend their market share.
Theyve done so by increasing the mortgage activity. The mortgage activity was not a
traditional bank activity because asset transformation is very high. That change is
explained by the simultaneous recourse to securitization. Securitization allows for high
asset transformation without bearing the consequences in terms of mismatches since
mortgages are bundled into securitized portfolio and sold to investors. Banks are no
longer exposed to interest rate risk despite high asset transformation. The limits put in
light by the 2007 crisis are the followings: when banks originate to distribute, they tend
to screen less their borrowers since they dont hold the risk in their balance sheet.
Moreover banks are dependent on the demand for securitized products. Once the demand
slows down banks have to face high asset transformation since they are unable to sell as
much as before their mortgages. In the 2007 crisis banks had also to cope with the
insolvency of special vehicles in charge of selling securitized portfolios to final investors.
Basel III has two opposite effects on securitization: it clearly increases the cost of
securitizing by increasing the capital charge but at the same time securitization is
promoted by the necessity to lower the average risk-weight of the loans portfolio and to
match the liquidity ratios.