Chapter 9. The Bank Firm & Bank Management Balance sheet Bank Management Credit Risk Interest Risk Other activities & financial innovation Balance sheet Bank Management Credit Risk Interest Risk Other activities & financial innovation

I. Balance Sheet liabilities ($8.25 trillion)  sources of bank funds assets ($9.1 trillion)  uses of bank funds liabilities ($8.25 trillion)  sources of bank funds assets ($9.1 trillion)  uses of bank funds

LiabilitiesLiabilities deposits ($5.95 trillion, 72%)  checkable deposits  savings deposits  time deposits (CDs) deposits ($5.95 trillion, 72%)  checkable deposits  savings deposits  time deposits (CDs)

borrowed funds  discount loans (Federal Reserve)  federal funds (other banks)  repos  eurodollar loans  commercial paper borrowed funds  discount loans (Federal Reserve)  federal funds (other banks)  repos  eurodollar loans  commercial paper

AssetsAssets cash items (< $1 trillion)  reserves -- required -- excess  deposits at other banks  cash items in collection cash items (< $1 trillion)  reserves -- required -- excess  deposits at other banks  cash items in collection

securities ($1.77 trillion)  debt securities  U.S. gov’t debt  municipal debt loans ($5.35 trillion, 59%)  commercial  real estate  consumer  interbank securities ($1.77 trillion)  debt securities  U.S. gov’t debt  municipal debt loans ($5.35 trillion, 59%)  commercial  real estate  consumer  interbank

Bank capital or net worth = assets - liabilities banks have capital requirement  cushion against bad loan losses or net worth = assets - liabilities banks have capital requirement  cushion against bad loan losses

Using T-accounts show changes in assets & liabilities show how money supply changes show changes in assets & liabilities show how money supply changes

exampleexample I empty Timmy’s piggy bank open a savings account $50 I empty Timmy’s piggy bank open a savings account $50

$50 in cash increases assets $50 in savings increases liabilities $50 in cash increases assets $50 in savings increases liabilities

suppose required reserves are 10% of deposits  required reserve ratio suppose required reserves are 10% of deposits  required reserve ratio

bank lends excess reserves,

II. Bank Management liquidity management  need cash to deal with deposit outflows  but holding cash drags down profits liquidity management  need cash to deal with deposit outflows  but holding cash drags down profits

if too low on cash,  borrow from banks or Fed  sell securities  call in or sell loans all of which are costly if too low on cash,  borrow from banks or Fed  sell securities  call in or sell loans all of which are costly

asset management  maximize returns (profits)  acceptable risk -- diversified loan portfolio  adequate liquidity  regulatory compliance asset management  maximize returns (profits)  acceptable risk -- diversified loan portfolio  adequate liquidity  regulatory compliance

liability management  banks increasingly compete for funds w/ other institutions  banks have more choices in raising funds  money center banks -- large banks -- rely on commercial paper, CDs, federal funds liability management  banks increasingly compete for funds w/ other institutions  banks have more choices in raising funds  money center banks -- large banks -- rely on commercial paper, CDs, federal funds

capital management  protects from insolvency  but capital drags down shareholder return (ROE)  regulations set minimum capital requirements -- as a % of risk-adjusted assets -- increased in credit crunch in ‘90-’91 recession capital management  protects from insolvency  but capital drags down shareholder return (ROE)  regulations set minimum capital requirements -- as a % of risk-adjusted assets -- increased in credit crunch in ‘90-’91 recession

III. Managing Credit Risk loans are primary asset  problems of adverse selection -- BEFORE loan moral hazard -- AFTER loan loans are primary asset  problems of adverse selection -- BEFORE loan moral hazard -- AFTER loan

Banks gather information screening  adverse selection  credit history (FICO score)  industry specialization in lending -- become experts in screening, -- but lack of diversification increase risk of assets screening  adverse selection  credit history (FICO score)  industry specialization in lending -- become experts in screening, -- but lack of diversification increase risk of assets

monitoring  moral hazard  monitor borrow after loan -- restrictive covenants -- enforce agreements monitoring  moral hazard  monitor borrow after loan -- restrictive covenants -- enforce agreements

example of monitoring  mortgage escrow account -- banks collects monthly insurance, tax payments from homeowner -- ensures that owner pays taxes, insurance example of monitoring  mortgage escrow account -- banks collects monthly insurance, tax payments from homeowner -- ensures that owner pays taxes, insurance

long-term customers  less screening & monitoring  encouraged with better terms long-term customers  less screening & monitoring  encouraged with better terms

collateral  protects bank from loss  adverse selection -- discourages certain borrowers  moral hazard -- discourages borrower risk- taking, since borrower is risking property collateral  protects bank from loss  adverse selection -- discourages certain borrowers  moral hazard -- discourages borrower risk- taking, since borrower is risking property

credit rationing  riskier borrowers would be willing to pay high rates  good borrowers won’t  so banks will not lend to certain borrowers at ANY rate or only small amounts credit rationing  riskier borrowers would be willing to pay high rates  good borrowers won’t  so banks will not lend to certain borrowers at ANY rate or only small amounts

IV. Managing Interest Rate Risk changes in interest rates affect BOTH assets and liabilities assets  changes VALUE  changes the amount of interest income  depends on whether LT or ST changes in interest rates affect BOTH assets and liabilities assets  changes VALUE  changes the amount of interest income  depends on whether LT or ST

liabilities  cost of funds goes up with interest rates -- rates on CDs, money market accounts very sensitive -- rates on savings, checking not as sensitive liabilities  cost of funds goes up with interest rates -- rates on CDs, money market accounts very sensitive -- rates on savings, checking not as sensitive

overall impact rising interest rates  asset income will go up  cost of funds will go up total impact depends on  amount of rate-sensitive assets vs. rate-sensitive liabilities rising interest rates  asset income will go up  cost of funds will go up total impact depends on  amount of rate-sensitive assets vs. rate-sensitive liabilities

banks typically borrow short-term and lend long-term so rate sensitive liabilities > rate sensitive assets so as interest rates rise  costs increase faster than income  bank profits fall  banks must manage interest rate risk banks typically borrow short-term and lend long-term so rate sensitive liabilities > rate sensitive assets so as interest rates rise  costs increase faster than income  bank profits fall  banks must manage interest rate risk

V. Other Bank Activities Off-balance sheet loan sales  secondary market  frees up capital to make more loans Off-balance sheet loan sales  secondary market  frees up capital to make more loans

fee income  growing portion of bank profits  ATM, service fees  guarantee fees  makes banks less dependent on spread between deposit & lending rates fee income  growing portion of bank profits  ATM, service fees  guarantee fees  makes banks less dependent on spread between deposit & lending rates

risk management  trading derivative securities  introduces new risks -- possible to lose LOTS of money in a short period of time -- traders make unauthorized trades risk management  trading derivative securities  introduces new risks -- possible to lose LOTS of money in a short period of time -- traders make unauthorized trades

VI. Financial Innovation new types of assets, new activities why?  changing demand conditions  changing supply conditions  regulatory avoidance new types of assets, new activities why?  changing demand conditions  changing supply conditions  regulatory avoidance

demanddemand interest rate volatility (and risk) increase in 1970s  banks demand new products to manage the risk  ARM reduces bank interest rate risk interest rate volatility (and risk) increase in 1970s  banks demand new products to manage the risk  ARM reduces bank interest rate risk

supplysupply banks supplying new services cost of financial transactions have fallen with new technologies  ATMs  credit/debit cards  internet banking banks supplying new services cost of financial transactions have fallen with new technologies  ATMs  credit/debit cards  internet banking

regulationregulation avoiding reserve requirements  minimize liabilities subject to requirement  eurodollars  commercial paper avoiding reserve requirements  minimize liabilities subject to requirement  eurodollars  commercial paper