The Banking Firm and Bank Management Chapter Fifteen The Banking Firm and Bank Management

The Bank Balance Sheet Flow of funds (tab down to commercial banks) http://www.osfi-bsif.gc.ca Copyright © 2004 Pearson Education Canada Inc.

Bank Operation T-account Analysis: Deposit of $100 cash into First Bank Copyright © 2004 Pearson Education Canada Inc.

Bank Operation Deposit of $100 cheque Conclusion: When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount Copyright © 2004 Pearson Education Canada Inc.

Principles of Bank Management Liquidity management Asset management Managing credit risk Managing interest-rate risk Liability management Managing capital adequacy Copyright © 2004 Pearson Education Canada Inc.

Principles of Bank Management Copyright © 2004 Pearson Education Canada Inc.

Principles of Bank Management With a 10% desired reserve ratio, bank still has excess reserves of $1 million: no changes needed in balance sheet Copyright © 2004 Pearson Education Canada Inc.

Liquidity Management With a 10% desired reserve ratio, bank has $9 million reserve shortfall Copyright © 2004 Pearson Education Canada Inc.

Liquidity Management Copyright © 2004 Pearson Education Canada Inc.

Liquidity Management Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows Copyright © 2004 Pearson Education Canada Inc.

Asset and Liability Management Asset Management Get borrowers with low default risk, paying high interest rates Buy securities with high return, low risk Diversify Manage liquidity Liability Management Important since 1960s No longer primarily depend on deposits When see loan opportunities, borrow or issue CDs to acquire funds Copyright © 2004 Pearson Education Canada Inc.

Capital Adequacy Management Bank capital is a cushion that prevents bank failure Higher is bank capital, lower is return on equity ROA = Net Profits/Assets ROE = Net Profits/Equity Capital EM = Assets/Equity Capital ROE = ROA  EM Capital , EM , ROE  Copyright © 2004 Pearson Education Canada Inc.

Capital Adequacy Management (cont.) Tradeoff between safety (high capital) and ROE Banks also hold capital to meet capital requirements Strategies for Managing Capital Sell or retire stock Change dividends to change retained earnings Change asset growth Copyright © 2004 Pearson Education Canada Inc.

Off-Balance-Sheet Activities Fee income from Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit Financial futures and options Foreign exchange trading Interest rate swaps Loan sales All these activities involve risk Copyright © 2004 Pearson Education Canada Inc.

Banks' Income Statement Copyright © 2004 Pearson Education Canada Inc.

Measures of Bank Performance ROA = Net Profits/ Assets ROE = Net Profits/ Equity Capital NIM = [Interest Income - Interest Expenses]/ Assets Copyright © 2004 Pearson Education Canada Inc.

Financial Innovation Innovation is result of search for profits Response to Changes in Demand Major change is huge increase in interest-rate risk starting in 1960s Example: Variable-Rate Mortgages Response to Changes in Supply Major change is improvement in computer technology Increases ability to collect information Lowers transactions costs Examples Bank Credit Cards Electronic Banking Facilities Copyright © 2004 Pearson Education Canada Inc.

Avoidance of Existing Regulations Regulations Behind Financial Innovation Reserve requirements Tax on deposits = D  rD Deposit-rate ceilings in the United States (Reg Q) As i , loophole mine to escape reserve requirement tax and deposit-rate ceilings Copyright © 2004 Pearson Education Canada Inc.

Avoidance of Existing Regulations Examples Eurodollars Bank Commercial Paper Sweep Accounts and Overnight Repos Copyright © 2004 Pearson Education Canada Inc.

Profiting from Canada Strips Copyright © 2004 Pearson Education Canada Inc.