Chapter 12. Banks and Bank Mgmt. Balance sheet Bank Risks Balance sheet Bank Risks

Bank Balance Sheet Assets: Uses of funds  2007: $10.5 trillion Liabilities: Sources of funds  $9.4 trillion Assets: Uses of funds  2007: $10.5 trillion Liabilities: Sources of funds  $9.4 trillion

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 ($2.4 trillion)  debt securities  U.S. gov’t debt  municipal debt loans ($6.9 trillion, 66% of assets)  commercial  real estate  consumer  interbank securities ($2.4 trillion)  debt securities  U.S. gov’t debt  municipal debt loans ($6.9 trillion, 66% of assets)  commercial  real estate  consumer  interbank

LiabilitiesLiabilities deposits ($6.4 trillion, 68%)  transaction deposits  Nontransaction deposits ($5.9 trillion) Savings CDs (large CDs, >$100,000 can be resold) deposits ($6.4 trillion, 68%)  transaction deposits  Nontransaction deposits ($5.9 trillion) Savings CDs (large CDs, >$100,000 can be resold)

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

Bank capital or net worth = assets – liabilities = $1.1 trillion 10 to 1 leverage! banks have capital requirement  cushion against bad loan losses or net worth = assets – liabilities = $1.1 trillion 10 to 1 leverage! banks have capital requirement  cushion against bad loan losses

Bank capital and profits ROE = net after tax profit bank capital Higher bank capital lowers ROE ROE = net after tax profit bank capital Higher bank capital lowers ROE

Bank risks Liquidity risk Credit risk Interest-rate risk Other  Trading  Foreign currency  sovereignty  operational Liquidity risk Credit risk Interest-rate risk Other  Trading  Foreign currency  sovereignty  operational

Liquidity Risks Risk of running short of cash  need cash to deal with deposit outflows  but holding cash drags down profits Holding too little cash, bank incurs costs of raising additional funds Risk of running short of cash  need cash to deal with deposit outflows  but holding cash drags down profits Holding too little cash, bank incurs costs of raising additional funds

Risk of unpaid loans How to minimize?  Credit risk analysis Credit history, scores  Monitoring, collateral  Diversification Tradeoff with the gains of loan specialization Risk of unpaid loans How to minimize?  Credit risk analysis Credit history, scores  Monitoring, collateral  Diversification Tradeoff with the gains of loan specialization Credit risk

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, savings, checking liabilities  cost of funds goes up with interest rates -- rates on CDs, money market accounts, savings, checking

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  Floating rate loans, swaps 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  Floating rate loans, swaps

Other Risks Trading risk  Securities fluctuate in values  Traders do not personally corver losses  Solution: monitoring, limits Trading risk  Securities fluctuate in values  Traders do not personally corver losses  Solution: monitoring, limits

Foreign exchange risk  Currency fluctuations affect value of foreign assets  Use derivatives to manage Sovereign risk  Governments interfere with currency transfers Foreign exchange risk  Currency fluctuations affect value of foreign assets  Use derivatives to manage Sovereign risk  Governments interfere with currency transfers

Operational risk  Damage to physical/computer infrastructure  Backup systems, geographically dispersed Operational risk  Damage to physical/computer infrastructure  Backup systems, geographically dispersed