Financial institutions management a risk management approach 7e saunders solutions manual and test bank

Financial institutions management a risk management approach 7e saunders  solutions manual and test bank

Chapter Two

Financial Services: Depository Institutions

Chapter Outline

Introduction

Commercial Banks

• Size, Structure, and Composition of the Industry
• Balance Sheet and Recent Trends
• Other Fee-Generating Activities
• Regulation
• Industry Performance

Savings Institutions

• Size, Structure, and Composition of the Industry
• Balance Sheet and Recent Trends
• Regulation
• Industry Performance

Credit Unions

• Size, Structure, and Composition of the Industry
• Balance Sheet and Recent Trends
• Regulation
• Industry Performance

Global Issues: The Financial Crisis

Summary

Appendix 2A: Financial Statement Analysis Using a Return on Equity (ROE)

Framework (www.mhhe.com/saunders7e)

Appendix 2B: Commercial Banks’ Financial Statements and Analysis (www.mhhe.com/saunders7e)

Appendix 2C: Depository Institutions and Their Regulators (www.mhhe.com/saunders7e)

Appendix 2D: Technology in Commercial Banking (www.mhhe.com/saunders7e)

Solutions for End-of-Chapter Questions and Problems

1. What are the differences between community banks, regional banks, and money-center banks? Contrast the business activities, location, and markets of each of these bank groups.

Community banks typically have assets under $1 billion and serve consumer and small business customers in local markets. In 2009, 92.4 percent of the banks in the United States were classified as community banks. However, these banks held only 10.5 percent of the assets of the banking industry. In comparison with regional and money-center banks, community banks typically hold a larger percentage of assets in consumer and real estate loans and a smaller percentage of assets in commercial and industrial loans. These banks also rely more heavily on local deposits and less heavily on borrowed and international funds.

Regional banks range in size from several billion dollars to several hundred billion dollars in assets. The banks normally are headquartered in larger regional cities and often have offices and branches in locations throughout large portions of the United States. Although these banks provide lending products to large corporate customers, many of the regional banks have developed sophisticated electronic and branching services to consumer and residential customers. Regional banks utilize retail deposit bases for funding, but also develop relationships with large corporate customers and international money centers.

Money center banks rely heavily on nondeposit or borrowed sources of funds. Some of these banks have no retail branch systems, and most money center banks are major participants in foreign currency markets. These banks compete with the larger regional banks for large commercial loans and with international banks for international commercial loans. Most money center banks have headquarters in New York City.

2. Use the data in Table 2-4 for the banks in the two asset size groups (a) $100 million-$1 billion and (b) over $10 billion to answer the following questions.

a. Why have the ratios for ROA and ROE tended to increase for both groups over the 1990-2006 period and decrease in 2007-2009? Identify and discuss the primary variables that affect ROA and ROE as they relate to these two size groups.

The primary reason for the improvements in ROA and ROE from 1990s through 2006 may be related to the continued strength of the macro economy that allowed banks to operate with reduced bad debts, or loan charge-off problems. In addition, the continued low interest rate environment provided relatively low-cost sources of funds, and a shift toward growth in fee income provided additional sources of revenue in many product lines. Finally, a growing secondary market for loans allowed banks to control the size of the balance sheet by securitizing many assets. You will note some variance in performance in the last three years as the effects of a softer economy and rising interest rates were felt in the financial industry.

In the late 2000s, the U.S. economy experienced its strongest recession since the Great Depression. Commercial banks’ performance deteriorated along with the economy. As mortgage borrowers defaulted on their mortgages, financial institutions that held these “toxic” mortgages and “toxic” credit derivatives (in the form of mortgage backed securities) started announcing huge losses on them. Losses from the falling value of OBS securities reached over $1 trillion worldwide through 2009. The bigger banks held more of these toxic assets and, thus, experienced larger losses in income. As a result, they tended to see lower ROAs and ROEs during this period. Losses resulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown of the world’s financial and economic systems.

b. Why is ROA for the smaller banks generally larger than ROA for the large banks?

Small banks historically have benefited from a larger spread between the cost of funds and the rate on assets, each of which is caused by the less severe competition in the localized markets. In addition, small banks have been able to control credit risk more efficiently and to operate with less overhead expense than large banks.

c. Why is the ratio for ROE consistently larger for the large bank group?

ROE is defined as net income divided by total equity, or ROA times the ratio of assets to equity. Because large banks typically operate with less equity per dollar of assets, net income per dollar of equity is larger.

d. Using the information on ROE decomposition in Appendix 2A, calculate the ratio of equity to total assets for each of the two bank groups for the period 1990-2009. Why has there been such dramatic change in the values over this time period, and why is there a difference in the size of the ratio for the two groups?

ROE = ROA x (Total Assets/Equity)

Therefore, (Equity/Total Assets) = ROA/ROE

	$100 million - $1 Billion		Over $10 Billion
Year	ROE	ROA	TA/Equity	Equity/TA		ROE	ROA	TA/Equity	Equity/TA
1990	9.95%	0.78%	12.76	7.84%		6.68%	0.38%	17.58	5.69%
1995	13.48%	1.25%	10.78	9.27%		15.60%	1.10%	14.18	7.05%
1996	13.63%	1.29%	10.57	9.46%		14.93%	1.10%	13.57	7.37%
1997	14.50%	1.39%	10.43	9.59%		15.32%	1.18%	12.98	7.70%
1998	13.57%	1.31%	10.36	9.65%		13.82%	1.08%	12.80	7.81%
1999	14.24%	1.34%	10.63	9.41%		15.97%	1.28%	12.48	8.02%
2000	13.56%	1.28%	10.59	9.44%		14.42%	1.16%	12.43	8.04%
2001	12.24%	1.20%	10.20	9.80%		13.43%	1.13%	11.88	8.41%
2003	12.80%	1.27%	10.08	9.92%		16.37%	1.42%	11.53	8.67%
2006	12.20%	1.24%	9.84	10.16%		13.40%	1.35%	9.93	10.07%
2007	10.34%	1.06%	9.75	10.25%		9.22%	0.92%	10.02	9.98%
2008	3.68%	0.38%	9.68	10.32%		1.70%	0.16%	10.62	9.41%
2009	1.16%	0.12%	9.67	10.34%		1.36%	0.14%	9.71	10.29%

The growth in the equity to total assets ratio has occurred primarily because of the increased profitability of the entire banking industry and (particularly during the financial crisis) the encouragement of regulators to increase the amount of equity financing in the banks. Increased fee income, reduced loan loss reserves, and a low, stable interest rate environment have produced the increased profitability which in turn has allowed banks to increase equity through retained earnings.

Smaller banks tend to have a higher equity ratio because they have more limited asset growth opportunities, generally have less diverse sources of funds, and historically have had greater profitability than larger banks.

3. What factors have caused the decrease in loan volume relative to other assets on the balance sheets of commercial banks? How has each of these factors been related to the change and development of the financial services industry during the 1990s and 2000s? What strategic changes have banks implemented to deal with changes in the financial services environment?

Corporations have utilized the commercial paper markets with increased frequency rather than borrow from banks. In addition, many banks have sold loan packages directly into the capital markets (securitization) as a method to reduce balance sheet risks and to improve liquidity. Finally, the decrease in loan volume during the early 1990s and 2000s was due in part to the short recession in 2001 and the much stronger recession and financial crisis in 2007-2009.

As deregulation of the financial services industry continued during the 1990s, the position of banks as the primary financial services provider continued to erode. Banks of all sizes have increased the use of off-balance sheet activities in an effort to generate additional fee income. Letters of credit, futures, options, swaps and other derivative products are not reflected on the balance sheet, but do provide fee income for the banks.

4. What are the major uses of funds for commercial banks in the United States? What are the primary risks to a bank caused by each use of funds? Which of the risks is most critical to the continuing operation of the bank?

Loans and investment securities continue to be the primary assets of the banking industry. Commercial loans are relatively more important for the larger banks, while consumer, small business loans, and residential mortgages are more important for small banks. Each of these types of loans creates credit, and to varying extents, liquidity risks for the banks. The security portfolio normally is a source of liquidity and interest rate risk, especially with the increased use of various types of mortgage-backed securities and structured notes. In certain environments, each of these risks can create operational and performance problems for a bank.

5. What are the major sources of funds for commercial banks in the United States? How is the landscape for these funds changing and why?

The primary sources of funds are deposits and borrowed funds. Small banks rely more heavily on transaction, savings, and retail time deposits, while large banks tend to utilize large, negotiable time deposits and nondeposit liabilities such as federal funds and repurchase agreements. The supply of nontransaction deposits is shrinking, because of the increased use by small savers of higher-yielding money market mutual funds,

6. What are the three major segments of deposit funding? How are these segments changing over time? Why? What strategic impact do these changes have on the profitable operation of a bank?

Transaction accounts include deposits that do not pay interest and NOW accounts that pay interest. Retail savings accounts include passbook savings accounts and small, nonnegotiable time deposits. Large time deposits include negotiable certificates of deposits that can be resold in the secondary market. The importance of transaction and retail accounts is shrinking due to the direct investment in money market mutual funds by individual investors. The changes in the deposit markets coincide with the efforts to constrain the growth on the asset side of the balance sheet.

7. How does the liability maturity structure of a bank’s balance sheet compare with the maturity structure of the asset portfolio? What risks are created or intensified by these differences?

Deposit and nondeposit liabilities tend to have shorter maturities than assets such as loans. The maturity mismatch creates varying degrees of interest rate risk and liquidity risk.

8. The following balance sheet accounts (in millions of dollars) have been taken from the annual report for a U.S. bank. Arrange the accounts in balance sheet order and determine the value of total assets. Based on the balance sheet structure, would you classify this bank as a community bank, regional bank, or a money center bank?

	Assets				Liabilities and Equity
	Cash		$ 2,660		Demand deposits	$ 5,939
	Fed funds sold	110		NOW accounts	12,816
	Investment securities	5,334		Savings deposits	3,292
	Net loans		29,981		Certificates of deposit	9,853
	Intangible assets	758		Other time deposits	2,333
	Other assets	1,633		Short-term borrowing	2,080
	Premises		1,078		Other liabilities	778
	Total assets	$41,554		Long-term debt	1,191
					Equity			3,272
					Total liability and equity	$41,554

This bank has funded the assets primarily with transaction and savings deposits. The certificates of deposit could be either retail or corporate (negotiable). The bank has very little (~5 percent) borrowed funds. On the asset side, about 72 percent of total assets is in the loan portfolio, but there is no information about the type of loans. The bank actually is a small regional bank with $41.5 billion in assets, but the asset structure could easily be a community bank if the numbers were denominated in millions, e.g., $41.5 million in assets.

9. What types of activities are normally classified as off-balance-sheet (OBS) activities?

Off-balance-sheet activities include the issuance of guarantees that may be called into play at a future time, and the commitment to lend at a future time if the borrower desires.

a. How does an OBS activity move onto the balance sheet as an asset or liability?

The activity becomes an asset or a liability upon the occurrence of a contingent event, which may not be in the control of the bank. In most cases, the other party involved with the original agreement will call upon the bank to honor its original commitment.

b. What are the benefits of OBS activities to a bank?

The initial benefit is the fee that the bank charges when making the commitment. If the bank is required to honor the commitment, the normal interest rate structure will apply to the commitment as it moves onto the balance sheet. Since the initial commitment does not appear on the balance sheet, the bank avoids the need to fund the asset with either deposits or equity. Thus, the bank avoids possible additional reserve requirement balances and deposit insurance premiums, while improving the earnings stream of the bank.

c. What are the risks of OBS activities to a bank?

The primary risk to OBS activities on the asset side of the bank involves the credit risk of the borrower. In many cases the borrower will not utilize the commitment of the bank until the borrower faces a financial problem that may alter the credit worthiness of the borrower. Moving the OBS activity to the balance sheet may have an additional impact on the interest

rate and foreign exchange risk of the bank. Further, at the very heart of the financial crisis were losses associated with off-balance-sheet mortgage-backed securities created and held by FIs. Losses resulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown of the world’s financial and economic systems.

10. Use the data in Table 2-6 to answer the following questions.

a. What was the average annual growth rate in OBS total commitments over the period from 1992-2009?

$266,993.0 = $10,075.8(1+g)¹⁷ Þ g = 20.11 percent

b. Which categories of contingencies have had the highest annual growth rates?

Category of Contingency or Commitment Growth Rate

Commitments to lend 9.05%

Future and forward contracts 14.30%

Notional amount of credit derivatives 52.82%

Standby contracts and other option contracts 19.07%

Commitments to buy FX, spot, and forward 7.23%

Standby LCs and foreign office guarantees 12.10%

Commercial LCs -1.27%

Participations in acceptances -17.25%

Securities borrowed 14.60%

Notional value of all outstanding swaps 28.39%

Credit derivatives grew at the fastest rate of 52.82 percent, yet they have a relatively low outstanding balance of $12,985.9 billion. The rate of growth in the swaps area has been the second strongest at 28.39 percent, the dollar volume is large at $148,529.4 billion in 2009. Option contracts grew at an annual rate of 19.07 percent with a dollar value outstanding of $30,491.5 billion. Clearly the strongest growth involves derivative areas.

c. What factors are credited for the significant growth in derivative securities activities by banks?

The primary use of derivative products has been in the areas of interest rate, credit, and foreign exchange risk management. As banks and other financial institutions have pursued the use of these instruments, the international financial markets have responded by extending the variations of the products available to the institutions.

11. For each of the following banking organizations, identify which regulatory agencies (OCC, FRB, FDIC, or state banking commission) may have some regulatory supervision responsibility.

(a) State-chartered, nonmember, non-holding company bank.

(b) State-chartered, nonmember holding company bank

(c)

(c) State-chartered member bank

(d) Nationally chartered non-holding company bank.

(e) Nationally chartered holding company bank

	Bank Type	OCC	FRB	FDIC	SB Comm
	(a)			Yes	Yes
	(b)		Yes	Yes	Yes
	(c)		Yes	Yes	Yes
	(d)	Yes	Yes	Yes
	(e)	Yes	Yes	Yes

12. What are the main features of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994? What major impact on commercial banking activity occurred from this legislation?

The main feature of the Riegle-Neal Act of 1994 was the removal of barriers to interstate banking. In September 1995 bank holding companies were allowed to acquire banks in other states. In 1997, banks were allowed to convert out-of-state subsidiaries into branches of a single interstate bank. As a result, consolidations and acquisitions have allowed for the emergence of very large banks with branches across the country.

13. What factors normally are given credit for the revitalization of the banking industry during the decade of the 1990s? How is Internet banking expected to provide benefits in the future?

The most prominent reason was the lengthy economic expansion in both the U.S. and many global economies during the entire decade of the 1990s. This expansion was assisted in the U.S. by low and falling interest rates during the entire period.

The extent of the impact of Internet banking remains unknown. However, the existence of this technology is allowing banks to open markets and develop products that did not exist prior to the Internet. Initial efforts have focused on retail customers more than corporate customers. The trend should continue with the advent of faster, more customer friendly products and services, and the continued technology education of customers.

14. What factors are given credit for the strong performance of commercial banks in the early and mid-2000s?

The lowest interest rates in many decades helped bank performance on both sides of the balance sheet. On the asset side, many consumers continued to refinance homes and purchase new homes, an activity that caused fee income from mortgage lending to increase and remain strong. Meanwhile, the rates banks paid on deposits shrunk to all time lows. In addition, the development and more comfortable use of new financial instruments such as credit derivatives and mortgage backed securities helped banks ease credit risk off the balance sheets. Finally, information technology has helped banks manage their risk more efficiently.

15. What factors are given credit for the week performance of commercial banks in the late 2000s?

In the late 2000s, the U.S. economy experienced its strongest recession since the Great Depression. Commercial banks’ performance deteriorated along with the economy. Sharply higher loss provisions and a very rare decline in noninterest income were primarily responsible for the lower industry profits. Things got even worse in 2008. Net income for all of 2008 was $10.2 billion, a decline of $89.8 billion (89.8 percent) from 2007. The ROA for the year was 0.13 percent, the lowest since 1987. Almost one in four institutions (23.6 percent) was unprofitable in 2008, and almost two out of every three institutions (62.8 percent) reported lower full-year earnings than in 2007. Total noninterest income was $25.6 billion (11 percent), lower as a result of the industry’s first ever full-year trading loss ($1.8 billion), a $5.8 billion (27.4 percent) decline in securitization income, and a $6.6 billion drop in proceeds from sales of loans, foreclosed properties, and other assets. Net loan and lease charge-offs totaled $38.0 billion in the fourth quarter, an increase of $21.7 billion (132.7 percent) from the fourth quarter of 2007, the highest charge-off rate in the 25 years that institutions have reported quarterly net charge-offs. As the economy improved in the second half of 2009, so did commercial bank performance. While rising loan-loss provisions continued to dominate industry profitability, growth in operating revenues, combined with appreciation in securities values, helped the industry post an aggregate net profit. Noninterest income was $4.0 billion (6.8 percent) higher than 2008 due to net gains on loan sales (up $2.7 billion) and servicing fees (up $1.9 billion). However, the industry was still feeling the effects of the long recession. Provisions for loan and lease losses totaled $62.5 billion, the fourth consecutive quarter that industry provisions had exceeded $60 billion. Net charge-offs continued to rise, for an 11th consecutive quarter.

16. How do the asset and liability structures of a savings institution compare with the asset and liability structures of a commercial bank? How do these structural differences affect the risks and operating performance of a savings institution? What is the QTL test?

The savings institution industry relies on mortgage loans and mortgage-backed securities as the primary assets, while the commercial banking industry has a variety of loan products, including mortgage products. The large amount of longer-term fixed rate assets continues to cause interest rate risk, while the lack of asset diversity exposes the savings institution to credit risk. Savings institutions hold less cash and U.S. Treasury securities than do commercial banks. On the liability side, small time and saving deposits remain as the predominant source of funds for savings institutions, with some reliance on FHLB borrowing. The inability to nurture relationships with the capital markets also creates potential liquidity risk for the savings institution industry.

The acronym QTL stands for Qualified Thrift Lender. The QTL test refers to a minimum amount of mortgage-related assets that a savings institution must hold. The amount currently is 65 percent of total assets.

17. How do savings banks differ from savings associations? Differentiate in terms of risk, operating performance, balance sheet structure, and regulatory responsibility.

The asset structure of savings banks is similar to the asset structure of savings associations with the exception that savings banks are allowed to diversify by holding a larger proportion of corporate stocks and bonds. Savings banks rely more heavily on deposits and thus have a lower level of borrowed funds. Both are regulated at both the state and federal level, with deposits insured by the FDIC’s DIF.

18. What happened in 1979 to cause the failure of many savings institutions during the early 1980s? What was the effect of this change on the operating statements of savings associations?

The Federal Reserve changed its reserve management policy to combat the effects of inflation, a change which caused the interest rates on short-term deposits to increase dramatically more than the rates on long-term mortgages. As a result, for many savings institutions, the marginal cost of funds exceeded the average yield on assets. This caused a negative interest spread for the savings institutions. Further, because savings institutions were constrained by Regulation Q on the amount of interest which could be paid on deposits, they suffered disintermediation, or deposit withdrawals, which led to severe liquidity pressures on the balance sheets.

19. How did the two pieces of regulatory legislation─the DIDMCA in 1980 and the DIA in 1982─change the operating profitability of savings institutions in the early 1980s? What impact did these pieces of legislation ultimately have on the risk posture of the savings institution industry? How did the FSLIC react to this change in operating performance and risk?

The two pieces of legislation allowed savings institutions to offer new deposit accounts, such as NOW accounts and money market deposit accounts, in an effort to reduce the net withdrawal flow of deposits from the institutions. In effect this action was an attempt to reduce the liquidity problem. In addition, savings institutions were allowed to offer adjustable-rate mortgages and a limited amount of commercial and consumer loans in an attempt to improve the profitability performance of the industry. Although many savings institutions were safer, more diversified, and more profitable, the FSLIC did not foreclose many of the savings institutions which were insolvent. Nor did the FSLIC change its policy of assessing higher insurance premiums on companies that remained in high risk categories. Thus, many savings institutions failed, which caused the FSLIC to eventually become insolvent.

20. How did the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 reverse some of the key features of earlier legislation?

FIRREA rescinded some of the expanded thrift lending powers of the DIDMCA of 1980 and the Garn-St Germain Act of 1982 by instituting the qualified thrift lender (QTL) test that requires

that all thrifts must hold portfolios that are comprised primarily of mortgages or mortgage products such as mortgage-backed securities. The Act also required thrifts to divest their portfolios of junk bonds by 1994, and it replaced the FSLIC with a new thrift deposit insurance fund, the Savings Association Insurance Fund, which was managed by the FDIC.

The FDICA of 1991 amended the DIDMCA of 1980 by introducing risk-based deposit insurance premiums in 1993 to reduce excess risk-taking. FDICA also provided for the implementation of a policy of prompt corrective actions (PCA) that allows regulators to close banks more quickly in cases where insolvency is imminent. Thus, the ill-advised policy of regulatory forbearance should be curbed. Finally, the Act amended the International Banking Act of 1978 by expanding the regulatory oversight powers over foreign banks.

21. What is the “common bond” membership qualification under which credit unions have been formed and operated? How does this qualification affect the operational objective of a credit union?

The common bond policy allows anyone who meets a specific membership requirement to become a member of the credit union. The requirement normally is tied to a place of employment or residence. Because the common bond policy has been loosely interpreted, implementation has allowed credit union membership and assets to grow at a rate that exceeds similar growth in the commercial banking industry. Since credit unions are mutual organizations where the members are owners, employees essentially use saving deposits to make loans to other employees who need funds.

22. What are the operating advantages of credit unions that have caused concern among commercial bankers? What has been the response of the Credit Union National Association to the banks’ criticisms?

Credit unions are tax-exempt organizations that often are provided office space by employers at no cost. As a result, because noninterest operating costs are very low, credit unions can lend money at lower rates and pay higher rates on savings deposits than can commercial banks. CUNA has responded saying that the cost to tax payers from the tax-exempt status is replaced by the additional social good created by the benefits to the members.

23. How does the asset structure of credit unions compare with the asset structure of commercial banks and savings institutions? Refer to Tables 2-5, 2-9, and 2-12 to formulate your answer.

The relative proportions of credit union assets are more similar to commercial banks than savings institutions, with 25 percent in investment securities and 60 percent in loans. However, nonmortgage loans of credit unions are predominantly consumer loans. On the liability side of the balance sheet, credit unions differ from banks in that they have less reliance on large time deposits and they differ from savings institutions in that they have virtually no borrowings from any source. The primary sources of funds for credit unions are transaction and small time and savings accounts.

24. Compare and contrast the performance of the worldwide depository institutions with those of major foreign countries during the financial crisis.

Quickly after it hit the U.S., the financial crisis spread worldwide. As the crisis started, banks worldwide saw losses driven by their portfolios of structured finance products and securitized exposures to the subprime mortgage market. Losses were magnified by illiquidity in the markets for those instruments. As with U.S. banks, this led to substantial losses in their marked to market valuations. In Europe, the general picture of bank performance in 2008 was similar to that in the U.S. That is, net income fell sharply at all banks. The largest banks in the Netherlands, Switzerland and the United Kingdom had net losses for the year. Banks in Ireland, Spain and the United Kingdom were especially hard hit as they had large investments in mortgages and mortgage-backed securities. Because they focused on the domestic retail banking, French and Italian banks were less affected by losses on mortgage-backed securities. Continental European banks, in contrast to UK banks, partially cushioned losses through an increase in their net interest margins.

A number of European banks averted outright bankruptcy thanks to direct support from the central banks and national governments. During the last week of September and first week of October 2008, the German government guaranteed all consumer bank deposits and arranged a bailout of Hypo Real Estate, the country’s second largest commercial property lender. The United Kingdom nationalized mortgage lender Bradford & Bingley (the country’s eighth largest mortgage lender) and raised deposit guarantees from $62,220 to $88,890 per account. Ireland guaranteed deposits and debt of its six major financial institutions. Iceland rescued its third largest bank with a $860 million purchase of 75 percent of the banks stock and a few days later seized the country’s entire banking system. The Netherlands, Belgium, and Luxembourg central governments together agreed to inject $16.37 billion into Fortis NV (Europe’s first ever cross-border financial services company) to keep it afloat. The central bank in India stepped in to stop a run on the country’s second largest bank ICICI Bank, by promising to pump in cash. Central banks in Asia injected cash into their banking systems as banks’ reluctance to lend to each other led the Hong Kong Monetary Authority to inject liquidity into its banking system after rumors led to a run on Bank of East Asia Ltd. South Korean authorities offered loans and debt guarantees to help small and midsize businesses with short term funding. The United Kingdom, Belgium, Canada, Italy, and Ireland were just a few of the countries to pass an economic stimulus plan and/or bank bailout plan. The Bank of England lowered its target interest rate to a record low of 1 percent hoping to help the British economy out of a recession. The Bank of Canada, Bank of Japan, and Swiss National Bank also lowered their main interest rate to 1 percent or below. All of these actions were a result of the spread of the U.S. financial market crisis to world financial markets.

The worldwide economic slowdown experienced in the later stages of the crisis meant that bank losses became more closely connected to macroeconomic performance. Countries across the world saw companies scrambling for credit and cutting their growth plans. Additionally, consumers worldwide reduced their spending. Even China’s booming economy slowed faster than had been predicted, from 10.1 percent in the second quarter of 2008 to 9 percent in the third quarter. This was the first time since 2002 that China’s growth was below 10 percent and dimmed hopes that

Chinese demand could help keep world economies going. In late October, the global crisis hit the Persian Gulf as Kuwait’s central bank intervened to rescue Gulf Bank, the first bank rescue in the oil rich Gulf. Until this time, the area had been relatively immune to the world financial crisis. However, plummeting oil prices (which had dropped over 50 percent between July and October) left the area’s economies vulnerable. In this period, the majority of bank losses were more directly linked to a surge in borrower defaults and to anticipated defaults as evidenced by the increase in the amount and relative importance of loan loss provision expenses.

International banks’ balance sheets continued to shrink during the first half of 2009 (although at a much slower pace than in the preceding six months) and, as in the U.S., began to recover in the latter half of the year. In the fall of 2009, a steady stream of mostly positive macroeconomic news reassured investors that the global economy had turned around, but investor confidence remained fragile. For example, in late November 2009, security prices worldwide dropped sharply as investors reacted to news that government-owned Dubai World had asked for a delay in some payments on its debt. Bank performance continued to be driven to a significant degree by ongoing and expected policy stimulus and in particular by expansionary monetary policy. Although the outlook remained uncertain, there were clear signs that the global economy had begun to recover.