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Financial
Institutions
Management
A Risk Management Approach

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Preface
The last 35 years have been dramatic for the financial services industry. In the 1990s
and 2000s, boundaries between the traditional industry sectors, such as commercial
banking and investment banking, broke down, and competition became increas-
ingly global in nature. Many forces contributed to this breakdown in interindustry
and intercountry barriers, including financial innovation, technology, taxation, and
regulation. Then in 2008–2009, the financial services industry experienced the worst
financial crisis since the Great Depression. Even into the mid-2010s, the U.S. and
world economies had not fully recovered from this crisis. It is in this context that
this book is written. Although the traditional nature of each sector’s product activity
is analyzed, a greater emphasis is placed on new areas of activities such as asset secu-
ritization, off-balance-sheet banking, international banking, and on changes occurring
as a result of the financial crisis.
When the first edition of this text was released in 1994, it was the first to ana-
lyze modern financial institutions management from a risk perspective—thus, the
title, Financial Institutions Management: A Modern Perspective. At that time, traditional
texts presented an overview of the industry sector by sector, concentrating on bal-
ance sheet presentations and overlooking management decision-making and risk
management. Over the last 20 years, other texts have followed this change, such
that a risk management approach to analyzing modern financial institutions is now
well accepted—thus, the title: Financial Institutions Management: A Risk Management
Approach.
The tenth edition of this text takes the same innovative approach taken in the
first nine editions and focuses on managing return and risk in modern financial insti-
tutions (FIs). Financial Institutions Management’s central theme is that the risks faced
by FI managers and the methods and markets through which these risks are man-
aged are similar whether an institution is chartered as a commercial bank, a savings
bank, an investment bank, or an insurance company.
As in any stockholder-owned corporation, the goal of FI managers should always
be to maximize the value of the financial institution. However, pursuit of value
maximization does not mean that risk management can be ignored.
Indeed, modern FIs are in the risk management business. As we discuss in this
book, in a world of perfect and frictionless capital markets, FIs would not exist and
individuals would manage their own financial assets and portfolios. But since real-
world financial markets are not perfect, FIs provide the positive function of bearing
and managing risk on behalf of their customers through the pooling of risks and the
sale of their services as risk specialists.

INTENDED AUDIENCE
Financial Institutions Management: A Risk Management Approach is aimed at upper-
level undergraduate, MSF, audiences. Occasionally, there are more technical sections.
These sections may be included or dropped from the chapter reading, depending on the
rigor of the course, without harming the continuity of the chapters.

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Preface ix

MAIN FEATURES
Throughout the text, special features have been integrated to encourage student
interaction with the text and to aid in absorbing the material. Some of these features
include:
• In-chapter Internet Exercises and references, which detail instructions for
accessing important recent financial data online.
• International material highlights, which call out material relating to global
issues.
• In-chapter Examples, which provide numerical demonstrations of the analy­tics
described in various chapters.
• Bold key terms and marginal glossary, which highlight and define the main
terms and concepts throughout the chapter.
• In-chapter Concept Questions, which allow students to test themselves on
the main concepts within each major chapter section.
• Industry Perspectives, which demonstrate the application of chapter material
to real current events.

ORGANIZATION
Since our focus is on return and risk and the sources of that return and risk, this
book relates ways in which the managers of modern FIs can expand return with a
managed level of risk to achieve the best, or most favorable, return-risk outcome for
FI owners.
Chapter 1 introduces the special functions of FIs and takes an analytical look at
how financial intermediation benefits today’s economy. Chapters 2 through 6 pro-
vide an overview describing the key balance sheet and regulatory features of the
major sectors of the U.S. financial services industry. We discuss depository institu-
tions in Chapter 2, finance companies in Chapter 3, securities firms and investment
banks in Chapter 4, mutual funds and hedge funds in Chapter 5, and insurance
institutions in Chapter 6. In Chapter 7, we preview the risk measurement and man-
agement sections with an overview of the risks facing a modern FI. We divide the
chapters on risk measurement and management into two sections: measuring risk
and managing risk.
In Chapters 8 and 9, we start the risk measurement section by investigating the
net interest margin as a source of profitability and risk with a focus on the effects of
interest rate volatility and the mismatching of asset and liability durations on FI risk
exposure. In Chapter 10, we look at the measurement of credit risk on individual
loans and bonds and how this risk adversely affects an FI’s profits through losses and
provisions against the loan and debt security portfolio. In Chapter 11, we look at the
risk of loan (asset) portfolios and the effects of loan concentrations on risk exposure.
In addition, as a by-product of the provision of their interest rate and credit interme-
diation services, FIs face liquidity risk. We analyze the special nature of this risk in
Chapter 12.
Modern FIs do more than domestic maturity mismatching and credit extensions.
They also are increasingly engaging in foreign exchange activities and overseas
financial investments (Chapter 13) and engaging in sovereign lending and securities

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x Preface

activities (Chapter 14). In Chapter 15, we analyze market risk, a risk incurred by FIs
in trading assets and liabilities due to changes in interest rates, exchange rates, and
other asset prices.
In addition, modern FIs do more than generate returns and bear risk through
traditional maturity mismatching and credit extensions. They also are increasingly
engaging in off-balance-sheet activities to generate fee income (Chapter 16) and mak-
ing technological investments to reduce costs (Chapter 17). Financial technology, or
fintech, refers to the use of technology to deliver financial solutions in a manner that
competes with traditional financial methods. While similar to technology, fintech is
defined as “technology-enabled innovation in financial services that could result in
new business models, applications, processes, or products with an associated mate-
rial effect on the provision of financial services.” Fintech risk (Chapter 18) involves
the risk that fintech firms could disrupt business of financial services firms in the
form of lost customers and lost revenue. Thus, fintech risk is broader and wider rang-
ing than technology risk. Each of these has implications for the size and variability of
an FI’s profits and/or revenues.
In Chapter 19, we begin the risk management section by looking at ways in which
FIs can insulate themselves from liquidity risk. In Chapter 20, we look at the key role
deposit insurance and other guaranty schemes play in reducing liquidity risk. At the
core of FI risk insulation are the size and adequacy of the owners’ capital or equity
investment in the FI, which is the focus of Chapter 21. Chapter 22 analyzes how and
why product and geographic diversification—both domestic and international—can
improve an FI’s return-risk performance and the impact of regulation on the diver-
sification opportunity set. Chapters 23 through 27 review various new markets and
instruments that have been innovated or engineered to allow FIs to better manage
three important types of risk: interest rate risk, credit risk, and foreign exchange risk.
These markets and instruments and their strategic use by FIs include futures and for-
wards (Chapter 23); options, caps, floors, and collars (Chapter 24); swaps (Chapter 25);
loan sales (Chapter 26); and securitization (Chapter 27).

CHANGES IN THIS EDITION

Each chapter in this edition has been revised thoroughly to reflect the most up-to-
date information available. End-of-chapter questions and problem material have also
been expanded and updated to provide a complete selection of testing material.
The following are some of the new features of this revision:
• A discussion of the rise of fintech firms has been added to Chapters 1, 2, and 7.
• Chapter 2 includes discussions of the revised Volcker Rule as well as the impact
of Brexit on foreign banks.
• Chapter 4 includes new discussions on global IPOs, as well as transitions from
LIBOR to SOFR.
• Chapter 6 includes a new discussion on catastrophe bonds and insured losses
from severe weather events.
• Updates on the major changes proposed for the regulation of financial institutions
are included where appropriate throughout the book.
• Chapters 8 and 9 discuss the Fed’s debate and decision to increase interest rates
since 2015.

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Preface xi

• Chapter 10 includes a discussion of the rise of student loan defaults.

• Chapter 13 includes a discussion of the foreign exchange crisis in Turkey. The
Big Mac index used to measure purchasing power parity has also been added to
the chapter.
• Chapter 14 has an added discussion on Venezuela’s hyperinflation crisis.
• Chapter 15 has a new detailed discussion on the revised standardized approach
for market risk.
• Chapter 18 is an entirely new chapter which discusses the evolution on fintech,
changing relationship between banks and fintechs, the types of fintech innova-
tions (e.g., mobile wallets, peer-to-peer payments, digital currencies, business-to-
business payments, digital exchange platforms, blockchain, artificial intelligence,
machine learning, Internet of things, crowdfunding, lending marketplaces, high-
frequency trading, robo-advice), and regulatory approaches to fintech.
• Chapter 21 has significant updates including a new section on the 2017 Basel III
reforms, which includes discussions on the standardized approach for credit risk,
operational risk framework, leverage ratio framework, and output floor.
• Many tables and figures in all chapters have been revised to include the most
recently available data.
• Many EOC problems have been revised or updated.

We have retained and updated these features:

• The risk approach of Financial Institutions Management has been retained, keep-
ing the first section of the text as an introduction and the last two sections as a
risk measurement and risk management summary, respectively.
• We again present a detailed look at what is new in each of the different sectors
of the financial institutions industry in the first six chapters of the text. We have
highlighted the continued international coverage with a global issues icon
throughout the text.
• Chapter 17 includes material on electronic technology and the Internet’s impact
on financial services. Technological changes occurring over the last two decades
have changed the way financial institutions offer services to customers, both
domestically and overseas. The effect of technology is also referenced in other
chapters where relevant.
• Coverage of credit risk models (including newer models, such as Moody’s
Analytics, ­CreditMetrics, and CreditRisk+) remains in the text.
• Coverage in the Product and Geographic Expansion chapter explores the
increased inroads of banks into the insurance field, the move toward nationwide
banking (in the United States), and the rapid growth of foreign banks and other
intermediaries in the United States.
• Numerous highlighted in-chapter Examples remain in the chapters.
• Internet references remain throughout each chapter and Internet questions are
found after the end-of-chapter questions.
• An extensive problem set, including web exercises, can be found at the end
of each chapter that allows students to practice a variety of skills using the same
data or set of circumstances.

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xii Preface

ANCILLARIES
All supplemental materials for both students and instructors can be found on the
McGraw-Hill website for the tenth edition of Financial Institutions Management at
www.mhhe.com/saunders10e. Instructor materials are password protected for
your security.
Print versions are available by request only—if interested, please contact your
McGraw-Hill/Irwin representative. The following supplements are available for the
tenth edition.

For Students
• Multiple-Choice Quizzes for each chapter consist of 10 multiple-choice
questions that reflect key concepts from the text. These quizzes have instant
grading.
• Appendices consist of material that has been removed from previous editions of
the print textbook to allow room for new topics.

For Instructors
• The Test Bank, updated by Leslie Rush, University of Oahu Hawaii–West, offers
multiple-choice and true/false questions that are designed to apply specifically to
this text and this edition’s revisions.
• The Instructor’s Manual, created by author Marcia Millon Cornett, contains
answers to the text’s Questions and Problems at the end of each chapter and
chapter outlines.
• The PowerPoint Presentations, revised by Courtney Baggett, Troy, summarize
the main points of each chapter in a step-by-step fashion. These slideshows can be
edited by instructors to customize presentations.
• The Digital Image Library contains electronic versions of all figures and tables
from the tenth edition of the text.

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Acknowledgments
Finally, we would like to thank the numerous colleagues who assisted with the pre-
vious editions of this book. Of great help were the book reviewers whose painstak-
ing comments and advice guided the text through its eight revisions.
Jack Aber Elyas Elyasiani
Boston University Temple University–Philadelphia
Brian J. Adams Joseph Finnerty
University of Portland University of Illinios
Michael H. Anderson Margaret Forster
University of Massachusetts–Dartmouth University of Notre Dame
Mounther Barakat Jack Clark Francis
University of Houston–Clear Lake Baruch College–CUNY
Sreedhar Bharath James H. Gilkeson
University of Michigan University of Central Florida
Rita Biswas Anurag Gupta
SUNY–Albany Case Western Reserve University
M. E. Bond John H. Hand
University of Memphis Auburn University
Qiang Bu Mahfuzul Haque
Pennsylvania State–Harrisburg Indiana State University–Terre Haute
Yea-Mow Chen Yan He
San Francisco State University San Francisco State University
Robert Chersi Alan C. Hess
Pace University University of Washington–Seattle
Jeffrey A. Clark William Hudson
Florida State University Saint Cloud State University
Robert A. Clark Ray Jackson
Butler University University of Massachusetts–Dartmouth
Ethan Cohen-Cole Kevin Jacques
University of Maryland–College Park Georgetown University and Office of the
S. Steven Cole Comptroller of the Currency
University of North Texas Julapa Jagtiani
James Conover Federal Reserve Bank of Chicago
University of North Texas Craig G. Johnson
Douglas Cook California State University–Hayward
University of Mississippi Deniz Kebabci Tudor
Kenneth Daniels San Francisco State University
Virginia Commonwealth University Elinda Kiss
Paul Ellinger University of Maryland–College Park
University of Illinois Nelson J. Lacey
David Ely University of Massachusetts at Amherst
San Diego State University

xiii

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xiv Acknowledgments

Robert Lamy Kenneth Rhoda

Wake Forest University LaSalle University
Rick LeCompte Tara Rice
Wichita State University Boston College
Andrew Light Stephen Rush
Liberty University University of Connecticut–Storrs
Chunlin Liu Don Sabbarese
University of Nevada–Reno Kennesaw State University
Barry Marchman Daniel Singer
Georgia Institute of Technology Towson University
Patricia C. Matthews Duane Stock
Mount Union College University of Oklahoma–Norman
Robert McLeod Richard Stolz
University of Alabama California State University–Fullerton
Jamie McNutt Michael Toyne
Rutgers–Camden Northeastern State University
Ardavan Mobasheri Haluk Unal
Bernard M. Baruch College–CUNY University of Maryland
Richard Patterson James A. Verbrugge
Indiana University–Bloomington University of Georgia
Joe Peek Hsinrong Wei
University of Kentucky–Lexington Baruch College–CUNY
Roberto Perli Sonya Williams-Stanton
University of Maryland University of Michigan–Ann Arbor
Marcelo Pinheiro Alexander Wilson
George Mason University University of Arizona
Anna Pomeranets Robert Wolf
Florida Atlantic University University of Wisconsin–La Crosse
Rose M. Prasad David Zalewski
Central Michigan University Providence College
Hong Qian Shaorong Zhang
Oakland University Marshall University
Andreas Rauterkus Lina Zhou
University of Alabama–Birmingham Augustana College

We very much appreciate the contributions of the book team at McGraw-­ Hill
Education: Chuck Synovec, Executive Brand Manager; Allison McCabe-Carroll,
­
Senior Product Developer; Trina Mauer, Senior Marketing Manager; and Sherry Kane;
Senior Content Project Manager. We are also grateful to our secretaries and assis-
tants, Robyn Vanterpool, Ingrid Persaud, Anand Srinivasan, Brenda Webb, Rebecca
Roach, and Rhianna Joffrion.
Anthony Saunders
Marcia Millon Cornett
Otgo Erhemjamts

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Brief Contents
PART ONE 13 Foreign Exchange Risk 391
Introduction 1 14 Sovereign Risk 423
1 Why Are Financial Institutions 15 Market Risk 450
Special? 2
16 Off-Balance-Sheet Risk 491
2 Financial Services: Depository
Institutions 26 17 Technology and Other
Operational Risks 518
3 Financial Services: Finance
Companies 70 18 Fintech Risks 550

4 Financial Services: Securities Firms

and Investment Banks 85
PART THREE
Managing Risk 575
5 Financial Services: Mutual Fund
and Hedge Fund Companies 116 19 Liability and Liquidity
Management 576
6 Financial Services: Insurance
Companies 157 20 Deposit Insurance and Other
Liability Guarantees 606
7 Risks of Financial Institutions 184
21 Capital Adequacy 645
PART TWO 22 Product and Geographic
Measuring Risk 207 Expansion 697

8 Interest Rate Risk I 208 23 Futures and Forwards 736

9 Interest Rate Risk II 239 24 Options, Caps, Floors, and Collars 773

10 Credit Risk: Individual Loan Risk 278 25 Swaps 811

11 Credit Risk: Loan Portfolio and 26 Loan Sales 842

Concentration Risk 329 27 Securitization 858
12 Liquidity Risk 356
Index 903

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Contents
PART ONE Balance Sheet and Recent Trends 33
Other Fee-Generating Activities 40
INTRODUCTION 1
Regulation 40
Industry Performance 46
Chapter One
Savings Institutions 49
Why Are Financial Size, Structure, and Composition of the
Institutions Special? 2 Industry 50
Introduction 2 Balance Sheet and Recent Trends 52
Financial Institutions’ Specialness 4 Regulation 53
FIs Function as Brokers 5 Industry Performance 54
FIs Function as Asset Transformers 5 Credit Unions 56
Information Costs 6 Size, Structure, and Composition of the Industry 56
Liquidity and Price Risk 7 Balance Sheet and Recent Trends 58
Other Special Services 7 Regulation 59
Other Aspects of Specialness 8 Industry Performance 59
The Transmission of Monetary Policy 8 Global Financial Performance 61
Credit Allocation 9 Summary 64
Intergenerational Wealth Transfers or Time Appendix 2A
Intermediation 9 Financial Statement Analysis Using a Return on
Payment Services 9 Equity (ROE) Framework 69
Denomination Intermediation 9 (www.mhhe.com/saunders10e)
Specialness and Regulation 10 Appendix 2B
Safety and Soundness Regulation 11 Commercial Banks’ Financial Statements and
Monetary Policy Regulation 12 Analysis 69
Credit Allocation Regulation 13 (www.mhhe.com/saunders10e)
Consumer Protection Regulation 13
Investor Protection Regulation 14 Chapter Three
Entry Regulation 14 Financial Services: Finance
The Changing Dynamics of Specialness 15 Companies 70
Trends in the United States 15
Global Trends 21 Introduction 70
Summary 22 Size, Structure, and Composition of the
Appendix 1A Industry 70
The Financial Crisis: The Failure of Financial Balance Sheet and Recent Trends 74
Services Institution Specialness 25 Assets 74
(www.mhhe.com/saunders10e) Liabilities and Equity 78
Appendix 1B Industry Performance 79
Monetary Policy Tools 25 Regulation 81
(www.mhhe.com/saunders10e) Global Issues 83
Summary 83
Chapter Two
Financial Services: Depository Chapter Four
Institutions 26 Financial Services: Securities Firms
and Investment Banks 85
Introduction 26
Commercial Banks 28 Introduction 85
Size, Structure, and Composition of the Industry 29 Size, Structure, and Composition of the Industry 86
xvi

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Contents xvii

Balance Sheet and Recent Trends 99 Interest Rate Risk 185

Recent Trends 99 Credit Risk 187
Balance Sheet 102 Liquidity Risk 189
Regulation 104 Foreign Exchange Risk 191
Global Issues 109 Country or Sovereign Risk 193
Summary 112 Market Risk 194
Off-Balance-Sheet Risk 195
Chapter Five Technology and Operational Risks 197
Financial Services: Mutual Fund FinTech Risk 198
and Hedge Fund Companies 116 Insolvency Risk 200
Other Risks and the Interaction of
Introduction 116
Risks 200
Size, Structure, and Composition of the Mutual
Summary 201
Fund Industry 117
Historical Trends 117
Different Types of Mutual Funds 119
PART TWO
Mutual Fund Objectives 124
Investor Returns from Mutual Fund Ownership 126 MEASURING RISK 207
Mutual Fund Costs 132
Balance Sheet and Recent Trends for the Mutual Chapter Eight
Fund Industry 136 Interest Rate Risk I 208
Money Market Funds 136 Introduction 208
Long-Term Funds 137 The Level and Movement of Interest Rates 209
Regulation of Mutual Funds 138 The Repricing Model 211
Global Issues in the Mutual Fund Industry 142 Rate-Sensitive Assets 213
Hedge Funds 144 Rate-Sensitive Liabilities 214
Types of Hedge Funds 145 Equal Changes in Rates on RSAs and RSLs 217
Fees on Hedge Funds 151 Unequal Changes in Rates on RSAs and RSLs 218
Offshore Hedge Funds 152 Weaknesses of The Repricing Model 221
Regulation of Hedge Funds 152 Market Value Effects 221
Summary 154 Overaggregation 221
Chapter Six The Problem of Runoffs 222
Cash Flows from Off-Balance-Sheet
Financial Services: Insurance
Activities 222
Companies 157
Summary 223
Introduction 157 Appendix 8A
Life Insurance 158 The Maturity Model 232
Size, Structure, and Composition of the Industry 158 (www.mhhe.com/saunders10e)
Balance Sheet and Recent Trends 162 Appendix 8B
Regulation 165 Term Structure of Interest Rates 232
Property–Casualty Insurance 167
Size, Structure, and Composition of the Industry 167
Balance Sheet and Recent Trends 169 Chapter Nine
Regulation 178 Interest Rate Risk II 239
Global Issues 179 Introduction 239
Summary 181 Duration: A Simple Introduction 240
Chapter Seven A General Formula for Duration 242
The Duration of Interest-Bearing Bonds 244
Risks of Financial Institutions 184
The Duration of Zero-Coupon Bonds 246
Introduction 184 The Duration of Consol Bonds (Perpetuities) 246

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xviii Contents

Features of Duration 247 Appendix 10A

Duration and Maturity 247 Credit Analysis and Loan Underwriting 328
Duration and Yield 248 (www.mhhe.com/saunders10e)
Duration and Coupon Interest 248 Appendix 10B
The Economic Meaning of Duration 249 Black–Scholes Option Pricing Model 328
Semiannual Coupon Bonds 253 (www.mhhe.com/saunders10e)
Duration and Interest Rate Risk 254
Duration and Interest Rate Risk Management Chapter Eleven
on a Single Security 254
Credit Risk: Loan Portfolio and
Duration and Interest Rate Risk Management
on the Whole Balance Sheet of an FI 257
Concentration Risk 329
Immunization and Regulatory Introduction 329
Considerations 264 Simple Models of Loan Concentration
Difficulties in Applying the Duration Risk 330
Model 265 Loan Portfolio Diversification and Modern
Duration Matching Can Be Costly 266 Portfolio Theory (MPT) 333
Immunization Is a Dynamic Problem 266 Moody’s Analytics Portfolio Manager Model 336
Large Interest Rate Changes and Convexity 267 Partial Applications of Portfolio Theory 339
Summary 269 Regulatory Models 343
Appendix 9A Summary 345
The Basics of Bond Valuation 277 Appendix 11A
(www.mhhe.com/saunders10e) CreditMetrics 350
Appendix 9B Appendix 11B
Incorporating Convexity into the Duration CreditRisk+ 353
Model 277
(www.mhhe.com/saunders10e) Chapter Twelve
Liquidity Risk 356
Chapter Ten
Introduction 356
Credit Risk: Individual Loan Risk 278
Causes of Liquidity Risk 357
Introduction 278 Liquidity Risk at Depository
Credit Quality Problems 279 Institutions 358
Types of Loans 282 Liability-Side Liquidity Risk 358
Commercial and Industrial Loans 282 Asset-Side Liquidity Risk 362
Real Estate Loans 284 Measuring a DI’s Liquidity Risk Exposure 364
Individual (Consumer) Loans 286 New Liquidity Risk Measures Implemented by
Other Loans 287 the Bank for International Settlements 366
Calculating the Return on a Loan 288 Liquidity Planning 374
The Contractually Promised Return on a Loan 288 Liquidity Risk, Unexpected Deposit Drains, and Bank
The Expected Return on a Loan 291 Runs 375
Retail Versus Wholesale Credit Decisions 292 Bank Runs, the Discount Window, and Deposit
Retail 292 Insurance 376
Wholesale 293 Liquidity Risk at Other Types of Financial
Measurement of Credit Risk 294 Institutions 377
Default Risk Models 295 Life Insurance Companies 377
Qualitative Models 295 Property–Casualty Insurers 378
Quantitative Models 298 Investment Funds 378
Newer Models of Credit Risk Measurement and Summary 381
Pricing 302 Appendix 12A
Summary 319 Illustrative Template for the LCR 388

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Contents xix

Chapter Thirteen Historic (Back Simulation) Approach 464

Foreign Exchange Risk 391 The Historic (Back Simulation) Model versus
RiskMetrics 467
Introduction 391 The Monte Carlo Simulation Approach 468
Foreign Exchange Rates and Transactions 391 Expected Shortfall 472
Foreign Exchange Rates 391 Regulatory Models: The BIS Standardized
Foreign Exchange Transactions 392 Framework 475
Sources of Foreign Exchange Risk Exposure 395 The BIS Regulations and Large-Bank Internal
Foreign Exchange Rate Volatility and FX Models 481
Exposure 399 Summary 485
Foreign Currency Trading 400
FX Trading Activities 401
Chapter Sixteen
Foreign Asset and Liability Positions 403
The Return and Risk of Foreign Investments 403 Off-Balance-Sheet Risk 491
Risk and Hedging 405 Introduction 491
Multicurrency Foreign Asset–Liability Off-Balance-Sheet Activities and FI
Positions 409 Solvency 492
Interaction of Interest Rates, Inflation, Returns and Risks of Off-Balance-Sheet
and Exchange Rates 410 Activities 496
Purchasing Power Parity 411 Loan Commitments 498
Interest Rate Parity Theorem 413 Commercial Letters of Credit and Standby Letters of
Summary 415 Credit 501
Derivative Contracts: Futures, Forwards, Swaps, and
Chapter Fourteen Options 504
Sovereign Risk 423 Forward Purchases and Sales of When-Issued
Securities 507
Introduction 423
Loans Sold 508
Credit Risk Versus Sovereign Risk 427
Non–schedule L Off-Balance-Sheet
Debt Repudiation versus Debt Rescheduling 429
Risks 509
Country Risk Evaluation 431
Settlement Risk 509
Outside Evaluation Models 431
Affiliate Risk 510
OECD Country Risk Classifications 433
The Role of OBS Activities in Reducing
Internal Evaluation Models 434
Risk 511
Using Market Data to Measure Risk: The Secondary
Summary 513
Market for LDC and Emerging Market Debt 443
Appendix 16A
Summary 445
A Letter of Credit Transaction 517
Appendix 14A
(www.mhhe.com/saunders10e)
Mechanisms for Dealing with Sovereign Risk
Exposure 449
(www.mhhe.com/saunders10e) Chapter Seventeen
Technology and Other Operational
Chapter Fifteen Risks 518
Market Risk 450
Introduction 518
Introduction 450 Sources of Operational Risk 521
Calculating Market Risk Exposure 454 Information Technology (IT) Risks 522
The RiskMetrics Model 455 Strategic Risk of IT 522
The Market Risk of Fixed-Income Securities 456 Cybersecurity Risk 524
Foreign Exchange 459 Technology Vendor and Third-Party Risk 526
Equities 460 Data Management Risk 527
Portfolio Aggregation 461 Risk of Ineffective Risk Management 528

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xx Contents

The Effect of Technology on Revenues and Choice of Liability Structure 590

Costs 529 Demand Deposits 590
Technology and Revenues 530 Interest-Bearing Checking (NOW) Accounts 591
Technology and Costs 531 Passbook Savings 593
Technology and The Evolution of the Payments Money Market Deposit Accounts (MMDAs) 593
System 535 Retail Time Deposits and CDs 594
Risks That Arise in an Electronic Transfer Payment Wholesale CDs 594
System 537 Federal Funds 595
Regulatory Issues and Technology and Operational Repurchase Agreements (RPs) 596
Risks 544 Other Borrowings 597
Summary 547 Liquidity and Liability Structures for U.S.
Depository Institutions 598
Chapter Eighteen Liability and Liquidity Risk Management
Fintech Risks 550 In Insurance Companies 600
Liability and Liquidity Risk Management
Introduction 550 In Other Financial Institutions 601
The Evolution of Fintech 551 Summary 601
Changing Relationship Between Banks and Appendix 19A
Fintechs 555 Federal Reserve Requirement Accounting 605
The Types of Fintech Innovations 557 (www.mhhe.com/saunders10e)
Payments, Clearing, and Settlement Services 558 Appendix 19B
Market Support Services 564 Bankers’ Acceptances and Commercial Paper as
Credit, Deposit, and Capital-Raising Services 570 Sources of Financing 605
Investment Management Services 570 (www.mhhe.com/saunders10e)
Regulatory Approaches to Fintech 571
Fintech Charters and Other Licenses 572
International Regulations 573 Chapter Twenty
Summary 573 Deposit Insurance and Other Liability
Guarantees 606
PART THREE Introduction 606
MANAGING RISK 575 Bank and Thrift Guaranty Funds 607
The Causes of the Depository Fund
Chapter Nineteen Insolvencies 609
The Financial Environment 609
Liability and Liquidity
Moral Hazard 610
Management 576
Panic Prevention versus Moral Hazard 611
Introduction 576 Controlling Depository Institution Risk
Liquid Asset Management 576 Taking 611
Monetary Policy Implementation Reasons 577 Stockholder Discipline 612
Taxation Reasons 577 Depositor Discipline 617
The Composition of the Liquid Asset Regulatory Discipline 622
Portfolio 578 Non-U.S. Deposit Insurance Systems 623
Return-Risk Trade-Off For Liquid Assets 579 The Discount Window 624
The Liquid Asset Reserve Management Problem Deposit Insurance versus the Discount Window 624
for U.S. Depository Institutions 579 The Discount Window 624
Undershooting/Overshooting of the Reserve Other Guaranty Programs 627
Target 584 National Credit Union Administration 627
Managing Liquid Assets Other than Cash 588 Property–Casualty and Life Insurance Companies 627
Liability Management 589 The Securities Investor Protection Corporation 628
Funding Risk and Cost 589 The Pension Benefit Guaranty Corporation 629

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Contents xxi

Summary 631 Segmentation in the U.S. Financial Services

Appendix 20A Industry 699
Calculation of Deposit Insurance Premiums 636 Commercial and Investment Banking Activities 699
Appendix 20B Banking and Insurance 702
Press Release 644 Commercial Banking and Commerce 703
(www.mhhe.com/saunders10e) Nonbank Financial Service Firms and Banking 703
Appendix 20C Nonbank Financial Service Firms and
Deposit Insurance Coverage for Commercial Banks Commerce 705
in Various Countries 644 Activity Restrictions in the United States Versus
(www.mhhe.com/saunders10e) Other Countries 706
Issues Involved in the Diversification of Product
Chapter Twenty-One Offerings 707
Capital Adequacy 645 Safety and Soundness Concerns 707
Economies of Scale and Scope 709
Introduction 645
Conflicts of Interest 710
Capital and Insolvency Risk 647
Deposit Insurance 712
Capital 647
Regulatory Oversight 712
The Market Value of Capital 648
Competition 713
The Book Value of Capital 649
Domestic Geographic Expansion 714
The Discrepancy between the Market and Book Values
Regulatory Factors Affecting Geographic
of Equity 649
Expansion 715
Arguments Against Market Value Accounting 650
Insurance Companies 715
Capital Adequacy in the Commercial Banking
Thrifts 715
and Thrift Industry 652
Commercial Banks 715
Credit Risk and Risk-Based Capital 654
Cost And Revenue Synergies Affecting
Capital 657
Domestic Geographic Expansion by Merger and
Risk–Weighted Assets 659
Acquisition 718
Interest Rate Risk, Market Risk, and Risk-Based
Cost Synergies 719
Capital 672
Revenue Synergies 720
Operational Risk and Risk-Based Capital 673
Merger Guidelines for Acceptability 720
Basel III Reforms 675
Other Market- and Firm-Specific Factors
​​
Capital Requirements for Other Financial
Affecting Domestic Geographic Expansion
Institutions 680
Decisions 723
Securities Firms 680
Global and International Expansions 724
Life Insurance 681
U.S. Banks Abroad 725
Property–Casualty Insurance 683
Foreign Banks in the United States 728
Summary 685
Advantages and Disadvantages of International
Appendix 21A
Expansion 730
Internal Ratings-Based Approach to Measuring
Advantages 731
Risk-Weighted Assets 693
Disadvantages 731
Appendix 21B
Summary 732
Methodology Used to Determine G-SIBs’ Capital
Surcharge 696
(www.mhhe.com/saunders10e) Chapter Twenty-Three
Futures and Forwards 736
Chapter Twenty-Two
Introduction 736
Product and Geographic
Forward and Futures Contracts 738
Expansion 697
Spot Contracts 738
Introduction 697 Forward Contracts 738
Product Diversification 698 Futures Contracts 740

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xxii Contents

Forward Contracts and Hedging Interest Rate Collars 800

Risk 741 Caps, Floors, Collars, and Credit Risk 803
Hedging Interest Rate Risk with Futures Summary 803
Contracts 742 Appendix 24A
Microhedging 742 Microhedging with Options 810
Macrohedging 743 (www.mhhe.com/saunders10e)
Routine Hedging versus Selective Hedging 743
Macrohedging with Futures 744
Chapter Twenty-Five
The Problem of Basis Risk 751 Swaps 811
Hedging Foreign Exchange Risk 753 Introduction 811
Forwards 753 Swap Markets 812
Futures 754 Interest Rate Swaps 813
Estimating the Hedge Ratio 757 Realized Cash Flows on an Interest Rate Swap 817
Hedging Credit Risk with Futures and Macrohedging with Swaps 818
Forwards 760 Currency Swaps 821
Credit Forward Contracts and Credit Risk Hedging 761 Fixed-Fixed Currency Swaps 821
Futures Contracts and Catastrophe Risk 763 Fixed-Floating Currency Swaps 823
Regulation of Derivative Securities 763 Credit Swaps 824
Summary 765 Total Return Swaps 826
Appendix 23A Pure Credit Swaps 828
Microhedging with Futures 772 CDS Indexes 828
(www.mhhe.com/saunders10e) Swaps And Credit Risk Concerns 829
Netting and Swaps 830
Chapter Twenty-Four Payment Flows Are Interest, Not Principal 831
Options, Caps, Floors, and Collars 773 Standby Letters of Credit 831
Introduction 773 Libor Transition 831
Basic Features of Options 773 Summary 833
Buying a Call Option on a Bond 774 Appendix 25A
Writing a Call Option on a Bond 775 Setting Rates on an Interest Rate Swap 838
Buying a Put Option on a Bond 776 Chapter Twenty-Six
Writing a Put Option on a Bond 776
Writing Versus Buying Options 777
Loan Sales 842
Economic Reasons for Not Writing Options 777 Introduction 842
Regulatory Reasons 779 The Bank Loan Sales Market 843
Futures versus Options Hedging 779 Definition of a Loan Sale 843
The Mechanics of Hedging A Bond or Bond Types of Loan Sales 843
Portfolio 780 Types of Loan Sales Contracts 845
Hedging with Bond Options Using the Binomial Trends in Loan Sales 846
Model 781 The Buyers and the Sellers 847
Actual Bond Options 785 Why Banks and Other FIs Sell Loans 853
Using Options to Hedge Interest Rate Risk Reserve Requirements 853
on The Balance Sheet 787 Fee Income 853
Using Options to Hedge Foreign Exchange Capital Costs 853
Risk 792 Liquidity Risk 853
Hedging Credit Risk with Options 793 Factors Affecting Loan Sales Growth 854
Hedging Catastrophe Risk with Call Spread Access to the Commercial Paper Market 854
Options 794 Customer Relationship Effects 854
Caps, Floors, and Collars 795 Legal Concerns 854
Caps 796 BIS Capital Requirements 855
Floors 799 Market Value Accounting 855

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Contents xxiii

Asset Brokerage and Loan Trading 855 Prepayment Models 874

Government Loan Sales 855 Government Sponsorship and Oversight of FNMA
Credit Ratings 855 and Freddie Mac 882
Purchase and Sale of Foreign Bank Loans 855 The Collateralized Mortgage Obligation (CMO) 885
Summary 856 Creation of CMOs 885
Class A, B, and C Bond Buyers 888
Chapter Twenty-Seven Other CMO Classes 888
Securitization 858 The Mortgage-Backed Bond (MBB) or Covered
Bond 889
Introduction 858 Innovations In Securitization 891
Mechanisms Used to Convert On-Balance-Sheet Mortgage Pass-Through Strips 891
Assets to A Securitized Asset 859 Securitization of Other Assets 894
The Pass-Through Security 862 Can All Assets Be Securitized? 895
GNMA 863 Summary 897
FNMA 863 Appendix 27A
FHLMC 864 Fannie Mae and Freddie Mac Balance Sheets 902
The Incentives and Mechanics of Pass-Through (www.mhhe.com/saunders10e)
Security Creation 864
Prepayment Risk on Pass-Through Securities 869 Index 903

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Part One
Introduction
1. Why Are Financial Institutions Special? 2
2. Financial Services: Depository Institutions 26
3. Financial Services: Finance Companies 70
4. Financial Services: Securities Firms and Investment Banks 85
5. Financial Services: Mutual Fund and Hedge Fund Companies 116
6. Financial Services: Insurance Companies 157
7. Risks of Financial Institutions 184

sau13820_ch01_001-025.indd 1 09/23/19 11:26 AM

Another random document with
no related content on Scribd:
boxes and trays full of little glass eyes, and glue pots and bits of wax
and bits of leather, and a small red pipkin for melting wax, and
another for melting India rubber, and a broken teacup for varnish,
and several tiny, round bladders, and tiny, tin boxes, all full of things
very precious to Mr. Sprat in his business.
All the family worked at doll-making, and were very industrious. Mr.
Sprat was of course the great manager and doer of most things, and
always the finisher, but Mrs. Sprat was also clever in her department,
which was entirely that of the eyes. She either painted the eyes, or
else, for the superior class of dolls, fitted in the glass ones. She,
moreover, always painted the eyebrows, and was so used to it, that
she could make exactly the same sort of arch when it was late in the
evening and nearly dark, before candles were lighted. The eldest
boy painted hair, or fitted and glued hair on to the heads of the best
dolls. The second boy fitted half legs and arms together, by pegs at
the joints. The little girl did nothing but paint rosy cheeks and lips,
which she always did very nicely, though sometimes she made them
rather too red, and looking as if very hot, or blushing extremely.
Now Mr. Sprat was very ingenious and clever in his business as a
doll-maker. He was able to make dolls of various kinds, even of wax,
or of a sort of composition; and sometimes he did make a few of
such materials; but his usual business was to make jointed dolls—
dolls that could move their legs and arms in many positions—and
these were of course made of wood. Of this latter material I was
manufactured.
The first thing I recollect of myself was a kind of a pegging, and
pushing, and scraping, and twisting, and tapping down at both sides
of me, above and below. These latter operations were the fitting on
of my legs and arms. Then I passed into the hands of the most
gentle of all the Sprat family, and felt something delightfully warm
laid upon my cheeks and mouth. It was the little girl, who was
painting me a pair of rosy cheeks and lips; and her face, as she bent
over me, was the first object of life that my eyes distinctly saw. The
face was a smiling one, and as I looked up at it I tried to smile too,
but I felt some hard material over the outside of my face, which my
smile did not seem able to get through, so I do not think the little girl
perceived it.
 I Was So Frightened! I Thought He Would Break Something
Off Me!
But the last thing done to me was by Mr. Sprat himself, whose funny,
white face and round eyes I could now see. He turned me about and
about in his hands, examining and trying my legs and arms, which
he moved backwards and forwards, and up and down, to my great
terror, and fixed my limbs in various attitudes. I was so frightened! I
thought he would break something off me. However, nothing
happened, and when he was satisfied that I was a complete doll in
all parts, he hung me up on a line that ran along the room overhead,
extending from one wall to the other, and near to the two beams that
also extended from wall to wall. I hung upon the line to dry, in
company with many other dolls, both boys and girls, but mostly girls.
The tops of the beams were also covered with dolls, all of whom, like
those on the lines, were waiting there till their paint or varnish had
properly dried and hardened. I passed the time in observing what
was going on in the room under my line, and also the contents of the
room, not forgetting my numerous little companions, who were
smiling and staring, or sleeping, round about me.
Mr. Sprat was a doll-maker only; he never made doll’s clothes. He
said that was not work for an artist like him. So in about a week,
when I was properly dry, and the varnish of my complexion
thoroughly hardened and like enamel, Mr. Sprat took me down—
examined me all over for the last time—and then, nodding his head
to himself several times, with a face of seriousness and satisfaction,
as much as to say, ‘You are a doll fit in all respects for the most
polished society,’—he handed me to his wife, who wrapped me up in
silver paper, all but the head, and laying me in a basket among nine
others, papered up in the same way, she carried me off to a large
doll-shop not far from the corner of New Turnstile in High Holborn.
 CHAPTER II
MY FIRST MAMMA

I arrived safe at the doll-shop, and Mrs. Sprat took me out of the
basket with her finger and thumb, keeping all her other fingers
spread out, for fear of soiling my silver paper.
‘Place all these dolls on the shelf in the back parlor,’ said the master
of the shop. ‘I have no room yet for them in the window.’ As I was
carried to the shelf, I caught a glimpse of the shop-window! What a
bright and confused sensation it gave me! Everything seemed so
light and merry and numerous! And then, through all this crowd of
many shapes and colors, packed and piled and hanging up in the
window, I saw the crowds of large walking people passing outside in
the world, which was as yet perfectly unknown to me! Oh, how I
longed to be placed in the shop-window! I felt I should learn things
so fast, if I could only see them. But I was placed in a dark box,
among a number of other dolls, for a long time, and when I was
taken out I was laid upon my back upon a high shelf, with my rosy
cheeks and blue eyes turned towards the ceiling.
Yet I cannot say that the time I passed on this shelf was by any
means lost or wasted. I thought of all I had seen in Mr. Sprat’s room,
and all I had heard them talk about, which gave me many very
strange and serious thoughts about the people who lived in the world
only for the purpose, as I supposed, of buying dolls. The
conversation of Mr. Sprat with his family made me very naturally
think this; and in truth I have never since been quite able to fancy but
that the principal business of mankind was that of buying and selling
dolls and toys. What I heard the master of the shop in Holborn often
say helped to fix this early impression on my mind.
But the means by which I learned very much of other things and
other thoughts was by hearing the master’s little girl Emmy read
aloud to her elder sister. Emmy read all sorts of pretty books, every
word of which I eagerly listened to, and felt so much interested, and
so delighted, and so anxious and curious to hear more. She read
pretty stories of little boys and girls, and affectionate mammas and
aunts, and kind old nurses, and birds in the fields and woods, and
flowers in the gardens and hedges; and then such beautiful fairy
tales; and also pretty stories in verse; all of which gave me great
pleasure, and were indeed my earliest education. There was the
lovely book called ‘Birds and Flowers,’ by Mary Howitt; the nice
stories about ‘Willie,’ by Mrs. Marcett; the delightful little books of
Mrs. Harriet Myrtle,—in which I did so like to hear about old Mr.
Dove, the village carpenter, and little Mary, and the account of May
Day, and the Day in the Woods,—and besides other books, there
was oh! such a story-book called ‘The Good-natured Bear!’ But I
never heard any stories about dolls, and what they thought, or what
happened to them! This rather disappointed me. Living at a doll-
shop, and hearing the daughter of the master of such a wonderful
shop reading so often, I naturally expected to have heard more
about dolls than any other creatures! However, on the whole, I was
very well contented, and should have been perfectly happy if they
would only have hung me up in the shop-window! What I wanted
was to be placed in the bright window, and to look into the
astonishing street!
Soon after this, however, by a fortunate accident, I was moved to an
upright position with my back against a doll’s cradle, so that I could
look down into the room below, and see what was going on there.
How long I remained upon the shelf I do not know, but it seemed like
years to me, and I learned a great deal.
One afternoon Emmy had been reading to her sister as usual, but
this time the story had been about a great Emperor in France, who,
once upon a time, had a great many soldiers to play with, and whose
name was Napoleon Bonaparte. The master himself listened to this,
and as he walked thoughtfully up and down from the back room to
the shop in front, he made himself a cocked hat of brown paper, and
put it upon his head, with the corners pointing to each shoulder.
Emmy continued to read, and the master continued thoughtfully
walking up and down with his hands behind him, one hand holding
the other.
But presently, and when his walk had led him into the front shop,
where I could not see him, the shop-bell rang and Emmy ceased
reading. A boy had come in, and the following dialogue took place.
‘If you please, sir,’ said the voice of the boy, ‘do you want a nice
Twelfth-cake?’
‘Not particularly,’ answered the master, ‘but I have no objection to
one.’
‘What will you give for it, sir?’ said the boy.
‘That is quite another question,’ answered the master; ‘go about your
business. I am extremely engaged.’
‘I do not want any money for it, sir,’ said the boy.
‘What do you mean by that, my little captain?’ said the master.
‘Why, sir,’ said the boy, ‘if you please, I want a nice doll for my sister,
and I will give you this large Twelfth-cake that I have in paper here
for a good doll.’
‘Let me see the cake,’ said the master. ‘So, how did you get this
cake?’
‘My grandfather is a pastry-cook, sir,’ answered the boy, ‘and my
sister and I live with him. I went to-day to take home seven Twelfth-
cakes. But the family at one house had all gone away out of the
country, and locked up the house, and forgotten to send for the cake;
and grandfather told me that I and my sister might have it.’
‘What is your name?’
‘Thomas Plummy, sir; and I live in Bishopsgate street, near the
Flower Pot.’
‘Very well, Thomas Plummy; you may choose any doll you fancy out
of that case.’
Here some time elapsed; and while the boy was choosing, the
master continued his slow walk to and fro from one room to the
other, with the brown paper cocked hat, which he had forgotten to
take off, still upon his head. It was so very light that he did not feel it,
and did not know it was there. At last the boy declared he did not like
any of the dolls in the case, and so went from one case to another,
always refusing those the master offered him; and when he did
choose one himself, the master said it was too expensive. Presently
the master said he had another box full of good dolls in the back
room, and in he came, looking so grave in his cocked hat, and
beginning to open a long wooden box. But the boy had followed him
to the door, and peeping in, suddenly called out, ‘There, sir! that one!
that is the doll for my cake!’ and he pointed his little brown finger up
at me.
‘Aha!’ said the master, ‘that one is also too expensive; I cannot let
you have that.’
However, he took me down, and while the boy was looking at me
with evident satisfaction, as if his mind was quite made up, the
master got a knife and pushed the point of it into the side of the
cake, just to see if it was as good inside as it seemed to be on the
outside. During all this time he never once recollected that he had
got on the brown paper cocked hat.
‘Now,’ said the master, taking me out of the boy’s hand, and holding
me at arm’s length, ‘you must give me the cake and two shillings
besides for this doll. This is a young lady of a very superior make, is
this doll. Made by one of the first makers. The celebrated Sprat, the
only maker, I may say, of this kind of jointed dolls. See! all the joints
move—all work in the proper way; up and down, backwards and
forwards, any way you please. See what lovely blue eyes; what rosy
cheeks and lips; and what a complexion on the neck, face, hands,
and arms! The hair is also of the most beautiful kind of delicate light-
brown curl that can possibly be found. You never before saw such a
doll, nor any of your relations. It is something, I can tell you, to have
such a doll in a family; and if you were to buy her, she would cost
you a matter of twelve shillings!’
‘Sir,’ said he, ‘this is a Twelfth-cake of very superior make. If the
young lady who sits reading there was only to taste it, she would say
so too. It was made by my grandfather himself, who is known to be
one of the first makers in all Bishopsgate street; I may say the very
first. There is no better in all the world. You see how heavy it is; what
a quantity of plums, currants, butter, sugar, and orange and lemon-
peel there is in it, besides brandy and caraway comfits. See! what a
beautiful frost-work of white sugar there is all over the top and sides!
See, too, what characters there are, and made in sugar of all colors!
Kings and queens in their robes, and lions and dogs, and Jem Crow,
and Swiss cottages in winter, and railway carriages, and girls with
tambourines, and a village steeple with a cow looking in at the porch;
and all these standing or walking, or dancing upon white sugar,
surrounded with curling twists and true lover’s knots in pink and
green citron, with damson cheese and black currant paste between.
You never saw such a cake before, sir, and I’m sure none of your
family ever smelt any cake at all like it. It’s quite a nosegay for
Queen Victoria herself; and if you were to buy it at grandfather’s
shop, you would have to pay fifteen shillings and more for it.’
‘Thomas Plummy!’ said the master, looking very earnestly at the boy;
‘Thomas Plummy! take the doll, and give me the cake. I only hope it
may prove half as good as you say. And it is my opinion that, if you,
Thomas Plummy, should not happen to be sent to New South Wales
to bake brown bread, you may some day or other come to be Lord
Mayor of London.’
‘Thank you, sir,’ said the boy. ‘How many Abernethy biscuits will you
take for your cocked hat?’
The master instantly put his hand up to his head, looking so
confused and vexed, and the boy ran laughing out of the shop. At the
door he was met by his sister, who had been waiting to receive me in
her arms: and they both ran home, the little girl hugging me close to
her bosom, and the boy laughing so much at the affair of the cocked
hat that he could hardly speak a word all the way.
 CHAPTER III
TWELFTH-NIGHT

That evening little Ellen Plummy begged to go to bed earlier than

usual. She took me with her, and I had the great happiness of
passing the whole night in the arms of my first mamma.
The next morning, however, was the day before Twelfth-day, and
there were so many preparations to be made, and so many things to
do in the house, that the pastry-cook required the help of everybody
who could do anything at all; so he desired Ellen to put me in a box
till Twelfth-night was over, because he wanted her to sort small
cakes, and mix sugar-plums of different colors, and pile up sticks of
barley sugar, and arrange artificial flowers, and stick bits of holly with
red berries into cakes for the upper shelves of his shop-window.
I was, therefore, placed in a dark box in the bedroom, and lay there
thinking.
After I had gone over in my mind all that I had at present seen and
heard since I was a doll, I began to wonder how long this
confinement in the dark box would continue. The morning seemed
so very long. But twice my little mamma, Ellen, came creeping softly
upstairs, and ran and opened the box—took me out, gave me a kiss,
put me in again, shut the lid of the box, and downstairs she softly
tripped back, to continue her work. The afternoon was also terribly
long, and I saw nothing of mamma till about six in the evening, when
she came and took me out, and embraced me, and said, ‘Oh, you
dear doll! I shall come to put you to bed!’ and away she ran again.
About nine o’clock mamma came and took me out of my box. She
had contrived to find time in the course of the day to make, in a very
hasty manner, a little night-gown and night-cap for me, which she
immediately put on me, and then took me to bed with her as before.
Next morning was Twelfth-day, and I was again placed in the dark
box. Ellen had so much to do, that all this day she was quite unable
to come even once to take a peep at me. Oh, how long the dark day
was! and how tired I felt of it! However, I was obliged to be as patient
as I could and tried to amuse myself with my own thoughts and
recollections.
I called to mind the poor, dusky room where I was manufactured and
born, with its three beds upon the floor on one side, and the long
work-bench at the other, and all the strange shadows of the dolls
upon the walls by candle-light; dozens of funny shadows cast from
the dolls that hung upon the lines or stood upon the beams. And
when the candle was moved about, these shadows danced. I also
recollected many conversations that had taken place between the
celebrated Mr. Sprat and his wife, when the children were asleep
and the candle was out, as to how they should be able to afford an
apple-pie for dinner next Sunday week, which was the little man’s
birthday. Then I recollected the many cold dark nights, and days
almost as dull, which I had passed in the box at the doll-shop,
before, by a lucky accident, I was moved to an upright position on
the top of the shelf. After that I went over in my mind all the pretty
stories and other books that had been read by Emmy in the shop.
This made me happier; yet I could not forget the many dark days and
nights in the box. Nor did I consider my present condition better, and
felt sadly impatient at being thus shut up in a small box, and quite
alone besides, without another doll to whisper a word to.
I had just begun to get very sad when suddenly I heard the sound of
little feet tripping over the floor; the lid of my box was opened, and I
saw a beautiful fairy standing over me! I was taken out by a pair of
soft warm hands, and who should it be but my mamma, dressed all
in white, with silver bracelets, and roses in her hair, and a bit of most
beautiful violet tinsel stuck upon the breast of her frock! ‘Come!’ cried
she, clasping me in her arms, ‘come downstairs with me, you
poppet! you shall come with me, Maria, and see Twelfth-night.’
Out of the room she ran with me, and downstairs! The staircase was
all lighted with gas! I was going to see Twelfth-night! And I had that
instant been christened, and my name was Maria Poppet! Oh, how
delighted I felt! I tried to jump out of my mamma’s arms, I was so
pleased—but I could not; and this was fortunate, because perhaps I
could not have jumped back again. But I felt so happy!
She ran straight with me into the very shop itself—the fine front shop
with all the cakes! How shall I describe it? How shall I tell the effect it
had upon me? Oh, it is impossible. I fainted away.
When I came to my senses I found that my mamma had placed me
upright between two tall, round glass jars, one full of glittering barley-
sugar sticks twisted, and the other full of large sugar-plums of all
colors; and I was close behind the counter where she stood to serve.
I saw nothing else distinctly, my eyes were so dazzled, and so
indeed were all my senses. Amidst a blaze of gas, crowded with
immense cakes, the round, white sugar island of each being covered
with its extraordinary inhabitants, there was the front window in all its
glory! Scenes in eastern countries, with elephants and dromedaries
and great palm trees (the names of all which my mamma told me
afterwards), and negro people and tigers sitting under orange trees;
and scenes in northern countries, where all is snow and frost and tall
rocks of ice, and bears walking round broken ships; and scenes in
delightful countries, where the weather is so beautiful, and where
people play guitars and sing all day and half the night, too, in groves
and gardens; and scenes in many parts of England, where the fields
are so very green, and the daisies and buttercups in such thousands
and thousands; and wonderful scenes in no country ever yet
discovered, but which were all once to be seen in fairyland, if
anybody could find them; these and many more things were all upon
the tops of the large cakes in the lower part of the window, together
with sprigs of holly, oh, so full of bright red berries!—and here and
there shining blanc-mange and jellies in the shape of baskets of fruit
and flowers, and three round glass bowls full of gold and silver fish,
who constantly moved round, staring, with their noses pushing
against the glass, in imitation of a crowd of children outside the
shop-window, who were all staring and pushing their noses against
the glass in just the same way. There was a shelf which ran across
the middle of the window, close to the front, and this was also thick
with cakes of a smaller sort, and all covered with Twelfth-night
characters, in colored sugar; but what they were it was impossible to
see for the glitter of the beautiful barley-sugar sticks that were piled
up in round glass jars, across and across, and standing between the
cakes. There were also cakes on a top shelf, near the top of the
window, but here scarcely anything could be seen for the blaze of
the gas.
 The Old Gentleman, Pastry-Cook, and Great Cake-Maker
Himself!
In the shop itself there was continually a crowd coming in to buy
cakes or other things, for the counter was also covered with
delightful wonders, and the old gentleman pastry-cook and great
cake-maker himself walked about in the middle of the shop, dressed
in his best, with a large red rose in the button-hole of his coat,
smiling and rubbing his hands together, and chatting with all the
children that came in, and sometimes going to the door and giving a
handful of sugar-plums to children outside who had no money to buy
anything. But behind the counter there were his grown-up niece, and
the pretty girl who served in the shop, and his grand-daughter, who
was my mamma; and all of these were dressed in white muslin, with
borders of lace and bright ribbons. His niece, however, was the most
like a princess, for she had a blue satin turban on, with feathers
hanging down over one side, and a silk scarf with gold fringe edges,
and a red cornelian necklace, with beads as large as turnip radishes.
I bore all this extraordinary scene as long as I could, until at last, out
of too much happiness, I was unable to endure it any longer, and
then something happened to me. I felt my eyes twink and twitch and
wink, and feel a little sore; and without knowing it, or knowing
anything, except that I was in a state of the most indescribable
happiness, I fell fast asleep.
 CHAPTER IV
THE LITTLE MILLINERS

My life at the pastry-cook’s passed in a very pleasant manner; but

not because of the cakes or pastry. For, in the first place, every night
was not like Twelfth-night; and as for the pastry, though I was
delighted to see it for some time, and to notice how much it was
admired and longed for, yet, in the course of a few weeks, I had seen
so many little girls and boys make themselves unwell by eating too
many raspberry tarts and cheesecakes, that I almost ceased to take
any further interest in those things. My eyes were constantly
employed in observing the different people who came in and out, or
passed by the door and window; my ears were constantly attentive
to all that was said; and my mind was busily engaged in thinking
over all I had seen, and all I had heard, both spoken and read from
books, ever since I was a doll. By these means I advanced my
education very much, because my memory became stronger by
practice, and my understanding was improved by this habit of
thinking over everything to myself. I believe no doll ever lived who
was more anxious to learn and know about all sorts of things—good,
pretty, or wonderful—than I was.
I soon had an opportunity of seeing a very different set of things from
the cakes, and tarts, and buns, and sugar-plums. We left our abode
at the pastry-cook’s. Ellen Plummy was sent to be a milliner to her
aunt, who employed a great number of girls in making ladies’
dresses. Ellen was only seven years old, and she cried at leaving
her kind grandfather’s; but he kissed her, and told her he knew it
would be best for her, so she dried her eyes and tried to look
cheerful; and her brother Thomas carried her little grey box. She
carried me herself in her arms.
Her Aunt Sharpshins was a very tall, thin, pale-faced woman, who
was always dressed in a long gown made close up to the throat, of
the color of old nankeen, with a faded bed-furniture pattern round the
hem at the bottom. She had a nose like a parrot’s beak, and always
spoke through it. She kept fifteen little milliner girls in the house, who
were her apprentices, and obliged to work as long as she pleased.
The youngest was about ten years of age; her name was Nanny
Bell, and she and my mamma Ellen became great friends directly.
Now this tall Aunt Sharpshins, with the parrot’s nose, made her
fifteen little milliners all work together in the same room, all seated
upon small chairs without backs, so that they could not lean
backwards to rest themselves. And she made them work the whole
day, from six o’clock in the morning till eight o’clock at night, with
only about half an hour’s rest at one o’clock, when they were all
called downstairs to dinner in the back parlor of the house. Some of
the poor girls often cried, or fell asleep and tumbled off their chairs,
they were so tired. If this misfortune happened to them, Mrs.
Sharpshins used to give them only bread and water for dinner; and
sometimes she was so cruel as even to give them a loud slap on the
shoulders.
One day my mamma Ellen and Nanny Bell were sitting alone
together in the back parlor after dinner, to talk a little, as Aunt
Sharpshins had gone out to take some dresses home. ‘Ah,’ said
Ellen, ‘I do so wish to go back to my grandfather’s, he was such a
kind pastry-cook; and my brother Tom was so very fond of me
always. I am so sorry to be a milliner; and although my aunt says I
am to be her partner, perhaps, when I grow up, yet I do not like it.’
‘But then,’ said Nanny Bell, ‘you would be much kinder to all of us
than your aunt is. You would not make us work so long every day,
would you? and have so little rest, would you, Ellen? and such poor,
cold dinners, with not enough either—now, would you?’
‘That I would not!’ exclaimed Ellen, giving me a toss in the air with
both hands, ‘that I would not! You should only work as long as I
worked myself; and when I was tired, then I should know that all of
you must be tired, and I should say, “Now let’s go downstairs, and
have each a large slice of cake.” Then, in the evening, as soon as it
was dark, and we began to feel our eyes sore with looking at the