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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

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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
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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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Another Random Scribd Document
with Unrelated Content
The Project Gutenberg eBook of Bee: The
Princess of the Dwarfs
This ebook is for the use of anyone anywhere in the United
States and most other parts of the world at no cost and with
almost no restrictions whatsoever. You may copy it, give it away
or re-use it under the terms of the Project Gutenberg License
included with this ebook or online at www.gutenberg.org. If you
are not located in the United States, you will have to check the
laws of the country where you are located before using this
eBook.

Title: Bee: The Princess of the Dwarfs

Creator: Anatole France

Illustrator: Charles Robinson

Translator: Peter Wright

Release date: December 19, 2016 [eBook #53771]

Language: English

Credits: Produced by Al Haines

*** START OF THE PROJECT GUTENBERG EBOOK BEE: THE

PRINCESS OF THE DWARFS ***
Anatole France
 BEE:
THE PRINCESS
OF THE
DWARFS

BY ANATOLE FRANCE

DONE
INTO ENGLISH BY
PETER WRIGHT

NEW YORK E. P. DUTTON AND COMPANY

J. M. DENT & SONS LTD - LONDON & TORONTO
1920
Title page
 SOLE AGENT FOR SCOTLAND
THE GRANT EDUCATIONAL CO. LTD.
GLASGOW

All rights reserved

Contents headpiece

Contents

Chap.

I. Tells of the News that a White Rose brings to the Countess of the
White Moor

II. How the Loves of Bee of the Clarides and George of the White
Moor began
III. Which deals with Education in General, and that of George in
Particular

IV. Tells how the Duchess took Bee and George to the Hermitage
and of Their Meeting an Hideous Old Woman there

V. Is concerned with what you see from the Keep of the Clarides

VI. Tells how Bee and George went off to the Lake

VII. Shows the Penalty George of the White Moor paid for having
gone near to the Lake where live the Sylphs

VIII. Shows how Bee was taken to the Land of the Dwarfs

IX. Tells faithfully the Welcome given by King Loc to Bee of the
Clarides

X. In which the Wonders of the Kingdom of the Dwarfs are

thoroughly described, as well as the Dolls which were given to Bee

XI. In which the Treasure of King Loc is described as well as possible

XII. In which King Loc proposes

XIII. Tells how Bee saw her Mother and could not kiss Her

XIV. In which the Great Grief that overtook King Loc is seen

XV. Relates the Words of the Learned Nur which gave an

Extraordinary Pleasure to little King Loc

XVI. Tells the Marvellous Adventure of George of the White Moor

XVII. In which King Loc makes a Terrible Journey

XVIII. Tells the Marvellous Meeting that occurred to John, the Master
Tailor, and of the Good Song sung by the Birds of the Grove to the
Duchess

XIX. Tells of a little Satin Slipper

XX. In which a Dangerous Adventure is related

XXI. In which All ends well

Looking backward

The Sorrow of Demeter. By Sir G. W. Cox

The King of the Golden Mountain. By the Brothers Grimm

Persephone. By Jean Ingelow

The Writer of the Story of Bee

 Princess Bee

Chapter I headpiece
 BEE
PRINCESS OF THE DWARFS

CHAPTER I
TELLS OF THE NEWS THAT A WHITE ROSE BRINGS
TO THE COUNTESS OF THE WHITE MOOR

Setting on her golden hair a hood spread with pearls and tying
round her waist the widow's girdle, the Countess of the White Moor
entered the chapel where she prayed each day for the soul of her
husband, killed by an Irish giant in single combat.
That day she saw, on the cushion of her praying-stool, a white
rose. At the sight of it she turned pale and her eyes grew dim; she
threw her head back and wrung her hands. For she knew that when
a Countess of the White Moor must die she finds a white rose on her
stool.
Knowing that the time had come for her to leave this world,
where she had been within such a short space of time a wife, a
mother, and a widow, she went to her room, where slept her son
George, guarded by waiting women. He was three years old; his
long eyelashes threw a pretty shade on his cheeks, and his mouth
was like a flower. Seeing how small he was and how young, she
began to cry.
"My little boy," she said in a faint voice, "my dear little boy, you
will never have known me, and I shall never again see myself in
your sweet eyes. Yet I nursed you myself, so as to be really your
mother, and I have refused to marry the greatest knights for your
sake."
She kissed a locket in which was a portrait of herself and a lock
of her hair, and put it round her son's neck. Then a mother's tear fell
on his cheek, and he began to move in his cradle and rub his eyes
with his little fists. But the Countess turned her head away and fled
from the room. Her own eyes were soon to close for ever; how could
they bear to look into those two adorable eyes where the light of
understanding had just begun to dawn?
She had a horse saddled and rode to the castle of the Clarides,
followed by her squire, Freeheart.
The Duchess of the Clarides kissed the Countess of the White
Moor:
"What good chance has brought you here, my dear?"
"It is an evil chance that has brought me; listen, dearest. We
were married within a few years of each other, and we became
widows by a similar misfortune. In these times of chivalry the best
die soonest, and only monks live long. When you became a mother I
had already been one for two years. Your daughter Bee is as
beautiful as day, and nothing can be said against my son George. I
like you and you like me. For I must tell you I have found a white
rose on the cushion of my stool. I am going to die. I leave my son to
you."
The Duchess was aware of the news that the white rose brings
to the ladies of the House of White Moor. She began to cry, and
promised in her tears to bring up Bee and George as sister and
brother, and not to give anything to one without giving half to the
other. Then the two ladies put their arms round each other, and
went to the cradle where little Bee slept under light blue curtains, as
blue as the sky. Without opening her eyes she moved her little arms,
and as she opened her fingers five small pink beams appeared to
come out of each sleeve.
"He will defend her," said the mother of George. "And she will
love him," the mother of Bee answered. "She will love him," a small,
clear voice repeated.
The Duchess recognised it as that of a spirit that had long lived
under the hearthstone.
On her return to her manor the Lady of the White Moor divided
her jewels among her maids, and, having anointed herself with
odorous essences and put on her most beautiful clothes to honour
that body which will rise again on the Day of Judgment, she laid
herself down on the bed and went to sleep for ever.

CHAPTER II
HOW THE LOVES OF BEE OF THE CLARIDES AND
GEORGE OF THE WHITE MOOR BEGAN

The ordinary lot of women is to be more good than beautiful or

more beautiful than good. But the Duchess of Clarides was as good
as she was beautiful, and she was so beautiful that the princes who
had only seen her picture had wished to marry her. To all their
proposals she answered:
"As I have but one soul I will never have but one husband."
 Yet she only wore mourning for five years. Then she put off her
long veil and her black clothes, for she did not like to depress those
around her or to prevent them smiling or being merry in her
presence. Her Duchy included large tracts of land, and lonely moors
covered in all their vast extent with heather; also lakes where
fishermen caught fish, some of which were magical, and mountains,
terrible and lonely, beneath which the dwarfs lived in their
underground kingdom.
In the government of the Clarides she followed the advice of an
old monk who had escaped from Constantinople. His belief in the
wisdom of men was small, for he had seen how brutal and perfidious
they are. He lived shut up in a tower with his birds and his books,
and there he performed his duties as counsellor, acting according to
a very few principles. His rules were: "Not to revive old laws; to give
way to the wishes of the people for fear of rebellion, but to give way
as slowly as possible, because, when one reform is carried out, the
public immediately demand another. Princes are deposed for giving
way too quickly, just as they are for resisting too long."
The Duchess, understanding nothing at all about politics, let him
do as he pleased. She was charitable, and, as she could not like all
men, she was sorry for those unfortunate enough to be wicked. She
helped the unhappy in every possible way, visited the sick, consoled
widows, and provided for orphans.
She brought up her daughter Bee with the most charming
wisdom. She taught this child only to take pleasure in doing good,
consequently she could indulge her to any extent.
This amiable lady kept her promise made to the poor Countess
of the White Moor. She acted as a mother to George and made no
distinction between Bee and him. They grew up together and
George found Bee to his taste, though rather small. One day, when
they were still in their earliest childhood, he came to her and said:
"Will you play with me?"
"I would like to," said Bee.
"We will find some sand and make sand pies," said George.
So they made pies, but as Bee did not make hers very well,
George hit her on the fingers with his spade. Bee uttered the most
piercing shrieks, and the squire, Freeheart, who was walking in the
gardens, said to his young Lord:
"It is not a deed worthy of a Count of the White Moor to beat
young ladies, your Highness."
George's first impulse was to thrust his spade right through the
body of the squire. But as the difficulties of this enterprise seemed
insuperable, he fell back upon an easier course of action, which was
to turn his face against a big tree and weep copiously.
In the meanwhile, Bee took good care to keep her tears flowing
by digging her fists into her eyes; and, in her despair, she flattened
her nose against the trunk of a neighbouring tree. When night
began to cover the earth, George and Bee were still weeping, each
in front of their tree. The Duchess of the Clarides had to take her
daughter with one hand and George with the other to bring them
back to the castle. Their eyes were red, their noses were red, their
cheeks were shiny; their sobs and snuffles were heart-rending. They
ate their supper with a good appetite; then each was put to bed. But
as soon as the candle was blown out they slipped out of bed like
little ghosts and kissed each other shouting with laughter. So the
loves of Bee of the Clarides and George of the White Moor began.
 CHAPTER III
WHICH DEALS WITH EDUCATION IN GENERAL,
AND THAT OF GEORGE IN PARTICULAR

George grew up in this castle next to Bee, whom he called sister in

the way of friendship, though he knew she was not so.
He had masters to teach him fencing, riding, swimming,
gymnastics, dancing, hunting, falconry, tennis and generally all the
arts. He even had a writing master, an old clerk, humble in his ways,
but inwardly proud, who taught him various styles of handwriting.
The more beautiful the style was, the more difficult it was to read.
George found little pleasure, and consequently little benefit, either in
the lessons of this old clerk or in those of an old monk who gave
grammatical instruction, using the most barbarous terminology.
George could not make out why he should take the trouble to learn
a tongue he could talk by nature, which is called the mother tongue.
The only person he liked being with was the squire, Freeheart,
who, having sought adventures all over the world, knew the customs
of men and of beasts, described all sorts of countries, and composed
songs he did not know how to write down. Freeheart was the only
master who taught George anything, because he was the only one
who liked him, and affectionate lessons are the only good lessons.
But the two pedants, the writing master and the grammatical
master, who hated each other with all their heart, united in a
common hatred of the old squire, whom they accused of inebriety.
 It was true that Freeheart was rather too fond of going to the
tavern called the Tin-jug. There he forgot his cares and composed
his songs. He was certainly in the wrong.
Homer composed songs even better than Freeheart, and Homer
only drank spring water. As to troubles, everybody has them, and it
is not drinking wine but giving happiness to others that effaces
them.
But Freeheart was an old man grown grey in the wars, loyal and
meritorious, and the two masters ought to have hidden his
weakness instead of reporting them with exaggeration to the
Duchess.
"Freeheart is a drunkard," said the writing master, "and when he
comes back from the tavern called the Tin-jug, he describes in the
road large S's as he walks. I may say that this is the only letter he
has ever shaped, for this drunkard is an ignoramus, your Grace."
The grammatical master added:
"As he staggers along he sings songs that offend against every
rule and follow no received form; he is totally ignorant of
synecdoche, your Grace."
The Duchess had a natural dislike of meanness and tale-
bearing. She did what all of us would have done in the same
situation: she disregarded them at first, but as they kept on
repeating their reports she ended by believing them and determined
to remove Freeheart. However, to make his exile honourable she
sent him to Rome to get the blessing of the Pope. What made this
journey so long to the Squire Freeheart was the large number of
taverns, haunted by musicians, which lay between the Duchy of the
Clarides and the papal city. The story will show how soon the
Duchess was to regret she had deprived the two children of their
most reliable protector.

CHAPTER IV
TELLS HOW THE DUCHESS TOOK BEE AND GEORGE
TO THE HERMITAGE AND OF THEIR MEETING
AN HIDEOUS OLD WOMAN THERE

One morning, that of the first Sunday after Easter, the Duchess
issued from the castle on her big chestnut horse, having on her left
George of the White Moor, riding a jet-black pony who had a white
star in the middle of his forehead, and, on her right, Bee, who had a
pink bridle to govern a pony with a cream-coloured coat. They were
going to hear Mass at the Hermitage. Soldiers carrying lances
escorted them, and there was a press of people on the way to
admire them. And really each of the three was very beautiful. The
Duchess looked stately and sweet under her veil spangled with silver
flowers and her loose cloak: the mild splendour of the pearls which
embroidered her headdress was becoming to the face and to the
soul of this beautiful person. Next to her George, with his waving
hair and bright eye, looked quite handsome, and the soft, clear
colour of Bee's face, who was riding on her other side, was a
delicious pleasure to the eye; but nothing was more wonderful than
the flow of her fair hair, bound in a ribbon embroidered with three
golden lilies. It fell down her shoulders like the splendid mantle of
youth and beauty. The good folk looked at her and each said to the
other, "What a pretty young lady!"
The master tailor, old John, lifted his grandson Peter in his arms
to show him Bee, and Peter asked whether she was alive, or
whether she was not really a piece of waxwork. He could not
understand that a creature so white and delicate could belong to the
same species as he, little Peter, did, with his chubby, sunburnt
cheeks and drab rustic smock laced at the back.
While the Duchess received these marks of respect with
kindness, the two children showed the contentment of pride, George
in his flush, Bee in her smile. This is why the Duchess said to them:
"These good people greet us very cheerfully. George, what do
you think of it? And what do you, Bee?"
"That they do well," said Bee.
"And that it is their duty," said George.
"And for what reason is it their duty?" the Duchess asked.
Seeing they gave no answer, she continued:
"I am going to tell you. From father to son, for more than three
hundred years, the dukes of the Clarides, lance in rest, protected
these poor people, who owe it to them that they can reap the
harvest they have sown. For more than three hundred years every
Duchess of the Clarides has spun wool for the poor, visited the sick,
and held their babies over the baptismal font. That is why, children,
you are greeted."
George thought: "The ploughman will have to be protected,"
and Bee: "I will have to spin wool for the poor."
So, conversing and reflecting, they made their way through
meadows enamelled with flowers. A range of blue hills ran its
indented line along the horizon. George stretched out his hand
towards the East.
"Is not that a large shield of steel that I see over there?"
"It is rather a silver buckle as large as the moon," said Bee.
"It is neither a shield of steel nor a silver buckle, children," the
Duchess answered, "but a lake shining in the sun. The face of the
water, that from a distance looks as smooth as a mirror, is broken
into innumerable waves. The banks of this lake that seem to you as
clean as if they were cut out of metal are really covered with reeds,
waving their light plumes, and with irises, whose flower is like a
human eye among drawn swords. Each morning white mists cover
the lake, which shines like armour under the midday sun. But you
must not go near it, for the Sylphs live there who draw travellers
down into their crystal manor."
And now they heard the tinkle of the Hermitage bell.
"Let us get off," said the Duchess, "and go on foot to the
chapel. It was neither on their elephants nor their camels that the
Wise Men of the East approached the Manger."
They heard the Hermit's Mass. An old woman, hideous and in
rags, knelt next to the Duchess, who offered her holy water as they
went out of church, and said:
"Take some, my good woman."
George was astonished.
"Do you not know," said the Duchess, "that you must honour
the poor as the favourites of Jesus Christ? A beggar woman just like
this one held you over the baptismal font with the good Duke of the
Black Rocks, and similarly your little sister Bee had a beggar as a
godfather."
 The old woman, who had guessed the feelings of the little boy,
leaned towards him, leering, and said:
"I wish you the conquest of as many kingdoms as I have lost,
my prince. I have been Queen of the Island of Pearls and of the
Mountains of Gold; every day I had fourteen different kinds of fish
served at my table, and a little blackamoor to carry my train."
"And by what misfortune did you lose your islands and your
mountains, my good woman?" asked the Duchess.
"I offended the dwarfs, who have carried me off from my
States."
"Have the dwarfs so much power?" asked George.
"Living under the earth," the old woman said, "they know the
virtue of stones, fashion metal, and discover springs."
The Duchess:
"And what did you do to vex them, good mother?"
The old woman:
"On a night of December one of them came to me to ask my
permission to prepare a great New Year's supper in the kitchens of
the castle, which were larger than a capitular hall, and furnished
with stew and preserving and frying pans, pipkins, caldrons, boilers,
ovens, gridirons, porringers, dripping-pans, meat screens, fish-
kettles, pastry-moulds, jugs, goblets of gold and silver and of
grained woods, not to speak of the turnspit skilfully wrought of iron,
and the huge black kettle hanging to the pothook. He promised that
nothing should be lost or damaged. I refused his request, and he
withdrew muttering dark threats. Three nights after, which was that
of Christmas, the same dwarf returned to the room in which I was
sleeping; he was accompanied by a multitude of others, who pulled
me from my bed, and carried me off in my nightshirt to an unknown
land.
"This," they said to me on leaving, "this is the punishment of
rich people who will not grant a portion of their treasures to the
industrious and gentle nation of Dwarfs, who fashion gold and cause
the springs to flow."
So spoke the toothless old woman, and the Duchess, having
comforted her with words and money, again took the road to the
Castle with her two children.

CHAPTER V
IS CONCERNED WITH WHAT YOU SEE FROM THE
KEEP OF THE CLARIDES

One day, not long after this, Bee and George, without being seen,
climbed up the stairs of the Keep which rises in the middle of the
castle. On reaching the platform they shouted loudly and clapped
their hands. The view stretched over rolling downs, cultivated and
cut up into small green and brown squares. On the horizon they
could see hills and woods--blue in the distance.
"Little sister," cried George, "little sister, look at the whole
earth."
"It is very big," said Bee.
"My professor," said George, "had taught me that it was big, but
as Gertrude our governess says, seeing is believing."
They walked round the platform.
 "Here is a marvellous thing, little brother," said Bee. "The castle
is in the middle of the whole earth, and we, who are on the Keep,
which is in the middle of the castle, are now in the middle of the
whole world. Ha! ha! ha!"
And really the skyline was around the children like a circle of
which the Keep was the centre.
"We are in the middle of the world. Ha! ha! ha!" George
repeated.
Then both began to think.
"What a pity it is that the world is so big!" said Bee. "You can
lose yourself in it and be separated from your friends."
George shrugged his shoulders.
"How nice it is that the world is so big! You can look for
adventures in it. Bee, when I am grown up I mean to conquer those
mountains which are right at the end of the earth. It is there that
the moon rises. I will catch it as I go along and give it to you, my
Bee."
"That's it," said Bee; "you will give it to me and I will set it in
my hair."
Then they began to look for the places they knew as if on a
map.
"I know perfectly where we are," said Bee (who knew nothing
of the sort), "but I cannot guess what all those little square stones
sown on the side of the hill are."
"Houses!" answered George; "those are houses! Don't you
recognise, little sister, the capital of the Duchy of the Clarides? It is
quite a big town; it has three streets, of which one is paved. We
passed through it last week to go to the Hermitage. Don't you
remember it?"
"And that winding stream?"
"That's the river. Look at the old stone bridge over there."
"The bridge under which we fished for lobsters?"
"The very one, which has in the recess the statue of the
'Headless Woman,' but you cannot see her from here because she is
too small."
"I remember. Why has she no head?"
"Probably because she has lost it."
Without saying whether the explanation satisfied her, Bee kept
her eyes fixed on the distance.
"Little brother, little brother, do you see what is shining near the
blue mountains? It is the lake."
"It's the lake!"
They now remembered what the Duchess had told them of the
lovely and dangerous waters, where the Sylphs had their manor.
"Let us go there," said Bee.
This decision overwhelmed George, who gaped and said:
"The Duchess has forbidden us to go out alone, and how can
we get to this lake, which is at the end of the world?"
"How to get there I really don't know, but you ought to, who
are a man and have a grammar master."
George was stung, and answered that it is possible to be a man,
and even a fine man, without knowing all the roads in the world.
Bee gave him a mincing, disdainful look, made him blush to the tips
of his ears, and said to him primly:
 "I am not the one who promised to conquer the blue mountains
and to unhook the moon. I do not know the road to the lake, but I
will find it; you see!"
"Ha! ha! ha!" said George, trying to laugh.
"You laugh like a booby, sir."
"Bee, boobies neither laugh nor cry."
"If they did they would laugh like you. I will go to the lake
alone. And while I discover the lovely waters where the Sylphs live,
you can stay at the castle all by yourself like a little girl. I will leave
you my tapestry frame and my doll. Please take great care of them,
George; please take great care of them."
George had pride. He felt the shame which Bee put upon him.
With his head down, darkly, he cried in a muffled voice:
"All right! we will go to the lake!"

CHAPTER VI
TELLS HOW BEE AND GEORGE WENT OFF TO
THE LAKE

Next day, after lunch, when the Duchess had retired to her room,
George took Bee by the hand.
"Come along," he said to her.
"Where?"
"Hush!"
They went down the stairs and crossed the courts. When they
had passed the gate Bee asked a second time where they were
going.
"To the lake," George answered decisively.
The mouth of the stupefied Miss Bee gaped. Was it sensible to
go that distance, and in satin slippers? For her slippers were of satin.
"We must go there, and we need not be sensible."
Such was the lofty answer given by George to Bee. She had put
him to shame, and now she pretended to be astonished. It was now
his turn to refer her disdainfully to her doll. Girls goad a man into
adventures, and then draw back. Her behaviour was disgraceful. She
might stay behind, but he would go himself.
She took him by the arm. He pushed her away. She flung
herself round the neck of her brother.
"Little brother!" she said sobbing, "I will follow you."
Her repentance was complete, and it moved him.
"Come along," he said, "but do not let us go by the town, we
might be seen. We had better follow the ramparts and reach the
high road by a short cut."
They went holding each other by the hand. George explained
the scheme he had drawn up.
"We will follow the road we took to go to the Hermitage; we are
certain to see it as we saw it last time, and then we will go straight
to it across the field in a bee-line."
In a bee-line is a pretty country way of saying a straight line,
but the name of the little maid occurring quaintly in the idiom made
them laugh.
Bee picked flowers growing by the ditch: flowers of the mallow
and the mullein, asters and oxeyes, making a posy of them; the
flowers faded visibly in her little hands, and they looked pitiful when
Bee crossed the stone bridge. As she did not know what to do with
her posy, the idea occurred to her of throwing them in the water to
refresh them, but she preferred to give them to the "Headless
Woman."
She asked George to lift her in his arms to make her tall
enough, and she placed her handful of country flowers in the folded
hands of the old stone figure.
At a distance she turned her head and saw a dove on the
shoulder of the statue.
They walked some time, and Bee said:
"I am thirsty."
"So am I," said George, "but the river is far behind us, and I can
see neither stream nor spring."
"The sun is so hot, it must have drunk them all up; what shall
we do?"
Thus they talked and complained, when they saw a
countrywoman with a basket full of fruit.
"Cherries," cried George. "What a pity it is that I have no money
to buy any!"
"I have some money," said Bee.
She drew out of her pocket a purse with five pieces of gold in it,
and addressed the country-woman.
"Good woman," she said, "will you give me as many cherries as
my dress can carry."
As she spoke she held out the skirt of her frock with both
hands. The countrywoman threw two or three handfuls of cherries
into it. Bee took the fold of her skirt in one hand and with the other
held out a piece of gold to the woman and said:
 "Is that enough, that?"
The countrywoman seized the piece of gold, which would have
been a high price for all the cherries in the basket, with the tree on
which they had grown, and the orchard in which the tree was
planted, and she cunningly answered:
"That will do to oblige you, my little Princess."
"Then," replied Bee, "put some more cherries in my brother's
hat, and I will give you another gold piece."
This was done and the countrywoman pursued her way,
thinking of the old stocking under the mattress in which she was to
hide her two pieces of gold. And the two children went on their road
eating the cherries, and throwing the stones to the right and the
left. George looked for cherries held together in pairs by the stalk to
make earrings of them for his sister, and he laughed to see the
beautiful vermeil-coloured twin fruit swinging on the cheek of Bee.
A pebble checked their joyful progress. It had stuck in the
slipper of Bee, who began to limp. At each hop she took her gold
curls waved on her cheeks, and limping thus, she went and sat
down. There her brother, kneeling at her feet, took off her satin
slipper; he shook it, and a little white pebble rolled out.
Then looking at her feet, she said:
"Little brother, when we go again to the lake, we will put on
boots."
The sun had by now declined in the radiant sky. A breath of
wind fanned the necks and the cheeks of the young travellers who
boldly, and with fresh alacrity, pursued their travels. To walk more
easily, they held each other by the hand and sang, and they laughed
to see their two black shadows, likewise united, moving in front of
them. They sang:

Marian the maid,

Demure and staid,
Went riding to the mill,
She placed her load
Of corn, and rode
Upon her donkey Bill.

But Bee stops. She cries:

"I have lost my slipper, my satin slipper."
And it was as she said. The silk bows of the little slipper had got
loose as she walked, and it lay all dusty in the road.
Then she looked behind her, and seeing the towers of the castle
swimming in the distant mist, she felt a pang, and tears came into
her eyes.
"The wolves will eat us," she said, "and our mother will never
see us again, and she will die of grief."
But George brought her slipper to her and said:
"When the castle bell rings for supper, we will be back at the
Clarides. Forward!"

The miller tight,

With flour white,
Stood close under the mill,
And fair and free.
 Cried, "To that tree
Tie up your donkey Bill."

"The lake, Bee, look: the lake, the lake, the lake."
"Yes, George, the lake!"
George cried hurrah! and threw his hat in the air. Bee was too
well behaved to throw up her coif in the same fashion. But taking off
her slipper which barely held, she threw it over her head to show
her joy. There it was, the lake, at the bottom of the valley the slopes
of which ran round the silvery waters, holding them as in a cup of
foliage and flowers. There it was, calm and clear, and a shiver still
ran over the ruffled grasses of its banks. But the two children could
not discover any road in the thickets to take them to this lovely
mere. As they searched, their legs were bitten by geese, who were
followed by a little girl, dressed in a sheepskin, with a switch in her
hand. George asked her what she was called.
"Gill."
"Well, Gill, how do you go to the lake?"
"I don't go."
"Why?"
"Because."
"But if you did go?"
"If I did go, there would be a road, and I would take the road."
There was no answer to be given to the goose-girl.
"All right," said George, "we will certainly find a path in the
wood further on."
 "We will pick nuts there," said Bee, "and eat them, for I am
hungry. We must, when we come again to the lake, bring a bag full
of things good to eat."
George:
"We will do as you say, little sister. I now approve the plan of
the squire Freeheart, who, when he set out for Rome, took with him
a ham for hunger and a demijohn for thirst. But we must hurry, for it
seems to me it is getting late, though I do not know the time."
"Shepherdesses know it by looking at the sun," said Bee; "but I
am not a shepherdess. Yet it seems to me that this sun, which was
above our heads when we started, is now over there, far behind the
town and the land of the Clarides. I wish I knew whether this is the
case every day, and what it means."
While they thus observed the sun a cloud of dust rose on the
road, and they saw horsemen, who moved towards them at full
gallop and whose armour glittered. The children were very
frightened and went and hid in the underwoods. They are robbers,
or rather ogres, they thought. But really they were men-at-arms sent
by the Duchess of Clarides to search for the two little adventurers.
The two little adventurers found a narrow path in the
underwood which was not a lover's path, for two could not walk side
by side holding each other by the hand, as lovers do. Further, the
footprints were not human. Only a track made by a multitude of little
hoofed feet was visible.
"These are the footprints of elves," said Bee.
"Or roedeer," said George.
The problem is as yet unsolved. But what is certain is that the
path led by an easy descent to the edge of the lake, which now
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