Copyright  2011 Pearson Canada Inc Chapter 13 Banking and the Management of Financial Institutions

Copyright  2011 Pearson Canada Inc Assets Cash reserves Deposits at Other Banks Cash Items in Process of Collection Securities Loans Fixed and Other Assets

Copyright  2011 Pearson Canada Inc Liabilities I Demand and Notice Deposits Fixed – Term Deposits Borrowings –Overdraft loans (advances) –Settlement balances Bank capital

Copyright  2011 Pearson Canada Inc The Bank Balance Sheet

Copyright  2011 Pearson Canada Inc Basic Banking—Making a Profit Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics The bank borrows short and lends long The primary deposit has no effect on the money supply, but the secondary deposit increases the money supply. First Bank AssetsLiabilitiesAssetsLiabilities Desired reserves +$10Chequable deposits +$100Desired reserves +$10Chequable deposits +$100 Excess reserves +$90Loans+$90Chequable deposits +$90

Copyright  2011 Pearson Canada Inc Bank Management Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk

Copyright  2011 Pearson Canada Inc Liquidity Management and the Role of Reserves If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet AssetsLiabilitiesAssetsLiabilities Reserves$20MDeposits$100MReserves$10MDeposits$90M Loans$80MBank Capital $10MLoans$80MBank Capital$10M Securities$10MSecurities$10M with deposit outflow of $10 million ↓

Copyright  2011 Pearson Canada Inc Liquidity Management: Shortfall in Reserves Reserves are now short of the desired amount and the shortfall must be eliminated Excess reserves are insurance against the costs associated with deposit outflows AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$100MReserves$0Deposits$90M Loans$90MBank Capital $10MLoans$90MBank Capital$10M Securities$10MSecurities$10M with deposit outflow of $10 million ↓

Copyright  2011 Pearson Canada Inc Liquidity Management: Borrowing Cost incurred is the interest rate paid on the borrowed funds AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrowing$9M Securities$10MBank Capital$10M Borrowing $9 million from other banks

Copyright  2011 Pearson Canada Inc Liquidity Management: Securities Sale The cost of selling securities is the brokerage and other transaction costs AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBank Capital$10M Securities$1M Can meet shortfall by reducing loans by $9 million

Copyright  2011 Pearson Canada Inc Liquidity Management: Bank of Canada Advances Borrowing from the Bank of Canada also incurs interest payments based on the discount rate AssetsLiabilities Reserves$9MDeposits$90M Loans$90MAdvance Bank of Canada $9M Securities$10MBank Capital$10M Borrow $9 million from the Bank of Canada

Copyright  2011 Pearson Canada Inc Liquidity Management: Reduce Loans Reduction of loans is the most costly way of acquiring reserves Calling in loans antagonizes customers Other banks may only agree to purchase loans at a substantial discount AssetsLiabilities Reserves$9MDeposits$90M Loans$81MBank Capital$10M Securities$10M

Copyright  2011 Pearson Canada Inc Asset Management: Three Goals Seek the highest possible returns on loans and securities Reduce risk Have adequate liquidity

Copyright  2011 Pearson Canada Inc Asset Management: Four Tools Find borrowers who will pay high interest rates and have low possibility of defaulting Purchase securities with high returns and low risk Lower risk by diversifying Balance need for liquidity against increased returns from less liquid assets

Copyright  2011 Pearson Canada Inc Liability Management Recent phenomenon due to rise of money center banks Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) Checkable deposits have decreased in importance as source of bank funds

Copyright  2011 Pearson Canada Inc Capital Adequacy Management Bank capital helps prevent bank failure The amount of capital affects return for the owners (equity holders) of the bank Regulatory requirement

Copyright  2011 Pearson Canada Inc Capital Adequacy Management: Returns to Equity Holders

Copyright  2011 Pearson Canada Inc Principles for Managing Credit Risk Screening and Monitoring –Screening –Specialization in Lending –Monitoring and Enforcement of Restrictive Covenants Long-term Customer relationships Loan Commitments Collateral and Compensating Balances Credit Rationing

Copyright  2011 Pearson Canada Inc Interest Rate Risk If a financial institution has more interest rate sensitive liabilities than interest rate sensitive assets, a rise in interest rates will reduce the net interest margin and income If a financial institution has more interest rate sensitive assets than interest rate sensitive liabilities, a rise in interest rates will raise the net interest margin and income

Copyright  2011 Pearson Canada Inc Gap Analysis The Gap is the difference between interest rate sensitive liabilities and interest rate sensitive assets GAP = rate-sensitive assets – rate-sensitive liabilities GAP = RSA - RSL A change in the interest rate (Δi) will change bank income (  depending on the Gap  Income = GAP   i

Copyright  2011 Pearson Canada Inc Owners and managers care not only about the change in interest rates on income but also on net worth of the institution Duration Analysis examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates Duration Analysis I

Copyright  2011 Pearson Canada Inc %ΔP = - DUR GAP x [Δi/(1+i)] Where: P is the market value %ΔP = (P t+1 – P t )/P DUR GAP = duration gap i = interest rate Duration Analysis II

Copyright  2011 Pearson Canada Inc The Duration Gap can be calculated as: DUR gap = DUR a – (L/A x DUR L ) Where: DUR a = average duration of assets L = market value of liabilities A = market value of assets DUR L = average duration of liabilities Duration Analysis III

Copyright  2011 Pearson Canada Inc The impact of the interest rate change on net worth (NW) as a percentage of assets can be calculated via: Δ NW/A = -DUR gap x Δi/(1+i) Where: DUR gap = duration gap Δi = interest rate change i = interest rate Duration Analysis IV