The Banking Firm zPurpose of Chapter -- Introduction to basic operations of the individual bank. zFour types of Banks yCommercial Banks ySavings and Loans ySavings Banks yCredit Unions

The Bank’s Balance Sheet Assets Liabilities + Equity zAssets -- Market value of items in your possession. zLiabilities -- Amounts owed to other parties. zEquity = Assets - Liabilities

Working With Assets, Liabilities, and Equity zNote: Definition of equity implies: Assets = Liabilities + Equity (Balance sheets balance!).

A Balance Sheet Example  Consider a house that you buy worth $120,000. You take out a mortgage of $100,000. Assets Liabilities + Equity House $120,000 Mortgage $100,000 Equity $20,000

The Bank’s Major Liabilities and Equity (1) Checkable Deposits (D) yIncludes Demand Deposits, Negotiable Order of Withdrawal (NOW) Acounts, Automatic Transfer of Savings (ATS) Accounts. yNot a major source of funds for banks

(2) Nontransactions Deposits (T) yIncludes Savings Deposits, and Small and Large Time Deposits (Negotiable CDs) yMajor source of funds for banks -- higher interest rate (cost), but less frequency/more predictability of withdrawal

(3) Borrowings (BORR) -- Funds borrowed by banks, usually to meet reserve requirements yEurodollars yRepurchase Agreements Issued yFederal Funds borrowed yDiscount Window Borrowings

(4) Equity (or Equity Capital) (E) yE = Total Assets - Total Liabilities yIncreases with bank profits, decreases with bank losses yEquity-Asset Ratio = (Equity/Total Assets) -- measure of bank’s health

The Bank’s Major Assets (1) Reserves (R) -- vault cash of banks plus deposits at the Federal Reserve yInterest earning, but interest rate less than loan rates yPurpose: to back up withdrawals from customer deposits yHow much reserves to hold? Profit versus safety

Reserve Requirements: The “Minimum Safety Level” zFederal Reserve: issues reserve ratios on checkable deposits (r D ) and savings and time deposits (r T ) with the provision that, at any time R > r D D + r T T

Decomposition of Reserves zRequired Reserves (RR), RR = r D D + r T T zExcess Reserves (ER), ER = R - RR zEquivalent Ways to Express Reserve Requirement R  RR, or ER  0

Other Assets (2) Cash items in the Process of Collection -- uncleared checks (3) Deposits at Other Banks (Correspondent Banking)

(4) Securities Holdings (B) yHoldings of Bonds, holding stock is not allowed yRevenue source for banks yShort-term bonds -- “secondary reserves” yHoldings include Negotiable CDs of other banks yLong-term bonds -- can enjoy conveniences of bonds

(5) Loans yOther major revenue source yLess liquid than bonds. For the most part, the bank must hold them until maturity yHigher default risk than bonds

(5) Loans, Continued yPreferred to bonds as a revenue source for banks. -- Inconveniences imply higher interest rate -- Personal aspect, tradition of banking (US).

Distinction Between Types of Banks (Loans) zCommercial Banks -- “Full Service Banks”, any type of loan zSavings and Loans -- primarily consumer mortgages zSavings Banks -- primarily consumer mortgages and consumer loans zCredit Unions -- primarily consumer loans (different tax treatment as well)

Fundamental Balance Sheet Rule zAny customer withdrawal from any of their deposits (checkable deposits or savings and time deposits) must be met with an equal decrease in reserves.

An Example: Customer Withdrawal zCustomer withdraws $200 from their savings deposit (T) at Chase Chase  R - $200  T - $200

New Customer Deposits zExample: Customer deposits $300 in their checkable deposit (D) Chase  R + $300  D + $300

Banks as Financial Intermediaries zFinancial Intermediary -- An institution that borrows from lenders, then loans to borrowers. zTakes advantage of institutional fact of life -- lenders want to “lend small”, but borrowers want to “borrow large”.

An Example -- The Bank Increasing Its Profits zYou make a $1000 mortgage payment to Chase, $800 is interest and $200 is payment to principal. Interest paid on deposits: $300 to holders of savings and time deposits (T) and $50 to holders of checkable deposits (D).

Balance Sheet Description Chase  R + $1000  D + $50  L - $200  T + $300  E + $450 zBank Profit (  E) = $800 - $350 = $450

A Banking Philosophy: Liability Management zLiability Management -- Seek loan demand, then finance it by issuing CDs, or borrowing if under reserve requirements. zAggressive, profit-oriented policy, followed mainly by large banks.

Liability Management: Evidence zNegotiable CDs have become the primary source of bank funds. zMore bank borrowing (more outlets to borrow as well). zAggregate excess reserves are generally close to zero. zGreater percentage of loans in asset portfolio (less liquid, more default risk than bonds).

The Bank’s Nightmares zFinancial intermediaries have inherent fundamental instabilities. zThe bank can only reduce their probability of occurrence and the impact if they do occur. zBank regulation and regulatory agencies seek as well to reduce the probability of occurrence or reduce the impact to the bank when they happen (next chapter).

Nightmare # 1 -- Disintermediation zDisintermediation -- The systematic withdrawal of customer funds, which can create a minor or major liquidity crisis. zAdverse effect of minor case: bank slips below reserve requirement.

The Bank Run: The Most Dramatic Case zConsider the following balance sheet situation (r D = 0.10, r T = 0.05). Chase R $500 D $2000 L $6500 T $6000 Bonds $2000 E $1000 Customers want 50% of D and 50% of T (HELP!!).

Ways to Reduce Adverse Effects: Disintermediation zSeek sufficient liquidity in asset portfolio zIncrease excess reserves for anticipated unusual withdrawals zBe competitive zUse borrowing sources, when needed

Nightmare #2 -- Interest Rate Risk zInterest Rate Risk -- Increases in interest rates (cost of funds) that the bank cannot pass on to its existing loans. zCreates reduced profits or even losses on existing loans zMost risky -- fixed rate mortgages (Savings and Loans!).

Ways to Reduce Interest Rate Risk zReduce the gap in maturity between assets and liabilities -- Promote shorter term loans -- Promote longer-term deposits zSeek other sources of income/profits (“off the balance sheet” banking)

Nightmare #3 -- Loan Default zLoan Default -- Borrower fails to repay loan zDeclaring bankruptcy -- chapter 7 (consumers sell assets for discharge of debts), as opposed to chapter 13 (debtor arranges plan to repay debt). zMost frequent for consumers – credit card balances (unsecured) zDefault on mortgages – secured loans, but could be a problem for banks if housing prices have fallen significantly.

Example: Loan Default zConsider the following balance sheet situation (r D = 0.10, r T = 0.05). Chase R $500 D $2000 L $6500 T $6000 Bonds $2000 E $1000 Equity-Asset Ratio = (1000/9000) = 11.1%

The Balance Sheet After a Loan Default z$500 loan default. Chase R $500 D $2000 L $6000 T $6000 Bonds $2000 E $500 Equity-Asset Ratio = (500/8500) = 5.6%

Ways to Reduce Adverse Effects of Loan Default zScreening/Collateral zKnowing clientele zPortfolio Diversification zSeek to maintain sufficiently large equity-asset ratio

A Preview of the Next Chapter zBank regulation – how regulatory agencies regulate the banking system. zWins and losses – US banking in the postwar period, with recent developments and current issues