Copyright © 2002 Pearson Education, Inc.

Chapter 13 The Business of Banking Copyright © 2002 Pearson Education, Inc.

How Banks Earn Profits A balance sheet lists assets, liabilities, and net worth. Bank liabilities are the funds the bank acquires from savers. Bank assets are the uses of acquired funds. Bank net worth is the difference between assets and liabilities. 1. A balance sheet lists the uses of acquired funds, assets; the source of acquired funds, liabilities; and the difference between the two, net worth. 2. Bank liabilities are the funds the bank acquires from savers. 3. Bank assets are the uses of acquired funds. 4. Bank net worth, or equity capital, is the difference between the value of assets and the value of liabilities. Copyright © 2002 Pearson Education, Inc. 2

Table 13.1 Balance Sheet of U.S. Commercial Banks, 2000 Copyright © 2002 Pearson Education, Inc.

Bank Liabilities and Net Worth Checkable deposits Nontransaction deposits Borrowings Net worth 1. Banks offer savers checkable deposits, accounts that grant a depositor the right to write checks. 2. To attract funds from depositors who want to earn interest on their funds, banks offer nontransactions deposits, such as savings accounts, money market deposit accounts, and certificates of deposit. 3. In the United States federal deposit insurance provides government guarantees for account balances up to $100,000. 4. Borrowings, or nondeposit liabilities, include short-term loans in the federal funds market, loans from a bank’s foreign branches or other subsidiaries or affiliates, repurchase agreements, and loans from the Federal Reserve System (known as discount loans). Copyright © 2002 Pearson Education, Inc. 4

Bank Assets Cash Items Securities Loans Other Assets 1. The most liquid asset held by banks is reserves, which consist of vault cash—cash on hand in the bank or in deposits at other banks—and deposits with the Federal Reserve System. 2. The Fed requires banks to hold some of their deposits as required reserves in the form of vault cash or in reserve accounts at a Federal Reserve bank. 3. Marketable securities are liquid assets that banks trade in securities markets. 4. Two thirds of bank assets are loans. 5. Other bank assets include the equipment and buildings the bank owns and collateral received from borrowers in default. Copyright © 2002 Pearson Education, Inc. 5

Bank Failure Bank failure occurs when a bank cannot pay its depositors and meet its reserve requirements. Bank failure occurs when a bank cannot repay its depositors with enough reserves left to meet its reserve requirements. Copyright © 2002 Pearson Education, Inc. 6

The Relationship Between Banks and Savers Banks provide risk-sharing, liquidity, and information services to depositors. Banks must manage both moral hazard and liquidity problems. Bankers reduce moral hazard by putting capital at risk and threat of withdrawals. Banks use asset and liability management to offset liquidity risk. 1. Banks provide risk-sharing, liquidity, and information services to depositors. 2. Banks must manage both moral hazard and liquidity problems. 3. Checkable deposits meet the liquidity needs of depositors and the threat of deposit withdrawals reduces the moral hazard problem of bankers using their private information to their own advantage. A second way for savers to prevent moral hazard is to insist that bankers and bank shareholders place their capital at risk when the bank makes loans. 4. A bank’s return on equity (ROE) is equal to its return on assets (ROA) times the ratio of the bank’s assets to the bank’s equity capital. 5. Banks need to engage in asset and liability management in order to offset liquidity risk, or the possibility that depositors may collectively withdraw more funds than the bank has on hand. Copyright © 2002 Pearson Education, Inc. 7

Figure 13.1 Bank Intermediary Services The risk-sharing, liquidity, and information services that banks can provide give small savers and firms benefits that they could not otherwise afford. Copyright © 2002 Pearson Education, Inc.

Relationship Between Banks and Borrowers Banks are concerned about credit risk, the risk that borrowers might default. Banks suffer interest rate risk if market interest rate changes cause profits to fluctuate. 1. Banks are concerned about credit risk, the risk that borrowers might default on their loans, which arises because of problems of adverse selection and moral hazard. 2. Banks experience interest rate risk if changes in market interest rates cause bank profits to fluctuate. Copyright © 2002 Pearson Education, Inc. 9

Methods to Reduce Credit Risk Diversification of loans Credit-risk analysis Requiring collateral Credit rationing Restrictive covenants in loan agreements Long-term relationship with the borrower 1. Banks can reduce credit risk by holding a diversified portfolio of loans. 2. Banks can also reduce credit risk by performing credit-risk analysis, in which the bank examines the borrower’s likelihood of repayment and general business conditions that might influence the borrower’s ability to repay the loan. 3. Banks require collateral, or assets pledged to the bank in the event that the borrower defaults. 4. To reduce adverse selection and moral hazard problems banks sometimes practice credit rationing, in which case the size of a borrower’s loan is limited or the borrower is simply not allowed to borrow any amount at the going interest rate. 5. To reduce the costs of moral hazard banks monitor borrowers and place restrictive covenants in loan agreements. 6. One of the best ways for a bank to gather information about a borrower’s prospects or to monitor a borrower’s activities is for the bank to have a long-term relationship with the borrower. Copyright © 2002 Pearson Education, Inc. 10

Methods to Reduce Interest Rate Risk Floating-rate debt Interest rate swap Futures and options contracts 1. To evaluate their exposure to interest rate risk, banks measure the duration of their assets and liabilities, which is the responsiveness of the assets’ or liabilities’ market value to a change in the market interest rate. 2. Banks can reduce the risk of interest rate fluctuations through the use of floating-rate debt, with the loan interest rate being variable. 3. Banks can also reduce their exposure to interest rate (and exchange rate) risk by using swaps, such as an interest rate swap that exchanges the expected future return on one financial instrument for the expected future return on another. 4. Futures and options contracts also offer ways for banks to hedge their exposure to interest rate risk. Copyright © 2002 Pearson Education, Inc. 11

Table 13.2 Exposure to Risk in Banking Contracts Copyright © 2002 Pearson Education, Inc.

Causes of Recent Shifts in Sources and Uses of Funds Interest rates increased, becoming volatile during the 1980s. Prohibitions on the payment of interest on checkable deposits were relaxed. By the 1990s, the interest rates banks could pay depositors were fully deregulated. Three changes account for major recent shifts in banks’ sources and uses for funds. 1. Interest rates increased, becoming volatile during the 1980s. 2. Prohibitions on the payment of interest on checkable deposits were relaxed. 3. By the 1990s, the interest rates banks could pay depositors were fully deregulated. Copyright © 2002 Pearson Education, Inc. 13

Off-Balance-Sheet Lending Off-balance-sheet lending: banks do not hold as assets the loans they make. Examples: standby letter of credit, loan commitment, and loan sale Off-balance-sheet activities have become important in generating banks’ profits. Off-balance-sheet activities have expanded in the United Kingdom and Japan. When banks engage in off-balance-sheet lending they do not hold as assets the loans they make. 1. Banks routinely sell to commercial paper borrowers a standby letter of credit, by which the bank promises to lend the borrower funds to pay off its maturing commercial paper if necessary. 2. In a loan commitment, a bank agrees to provide a borrower with a stated amount of funds during some specified time. 3. A loan sale is a financial contract by which a bank agrees to sell the expected future returns from an underlying bank loan to a third party. 4. Off-balance-sheet activities have become increasingly important in generating banks’ profits, although these activities entail significant risk. 5. Off-balance-sheet banking activities have also been expanding in the United Kingdom and Japan. Copyright © 2002 Pearson Education, Inc. 14