© 2008 Pearson Education Canada9.1 Chapter 9 Banking and the Management of Financial Institutions

© 2008 Pearson Education Canada9.2 The Bank Balance Sheet

© 2008 Pearson Education Canada9.3Liabilities Demand and Notice Deposits Fixed – Term Deposits Borrowings Bank capital

© 2008 Pearson Education Canada9.4Assets Cash reserves Deposits at Other Banks Cash Items in Process of Collection Securities Loans Fixed and Other Assets

© 2008 Pearson Education Canada9.5 Basic Banking—Cash Deposit Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in chequable deposits First Bank AssetsLiabilitiesAssetsLiabilities Vault Cash +$100Chequable deposits +$100Reserves+$100Chequable deposits +$100

© 2008 Pearson Education Canada9.6 Basic Banking—Cheque Deposit First BankSecond Bank AssetsLiabilitiesAssetsLiabilities Reserves+$100Chequable deposits +$100Reserves-$100Chequable deposits -$100 First Bank AssetsLiabilities Cash items in process of collection +$100Chequable deposits +$100

© 2008 Pearson Education Canada9.7 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 First Bank AssetsLiabilitiesAssetsLiabilities Desired reserves +$100Chequable deposits +$100Desired reserves +$10Chequable deposits +$100 Excess reserves +$90Loans+$90

© 2008 Pearson Education Canada9.8 Bank Management Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk

© 2008 Pearson Education Canada9.9 Liquidity Management: Ample Excess 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

© 2008 Pearson Education Canada9.10 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

© 2008 Pearson Education Canada9.11 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

© 2008 Pearson Education Canada9.12 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

© 2008 Pearson Education Canada9.13 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

© 2008 Pearson Education Canada9.14 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

© 2008 Pearson Education Canada9.15 Asset Management: Three Goals Seek the highest possible returns on loans and securities Reduce risk Have adequate liquidity

© 2008 Pearson Education Canada9.16 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

© 2008 Pearson Education Canada9.17 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

© 2008 Pearson Education Canada9.18 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

© 2008 Pearson Education Canada9.19 Capital Adequacy Management: Preventing Bank Failure High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$90MBank Capital$10MLoans$90MBank Capital$4M High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$85MBank Capital$5MLoans$85MBank Capital-$1M

© 2008 Pearson Education Canada9.20 Capital Adequacy Management: Returns to Equity Holders

© 2008 Pearson Education Canada9.21 Capital Adequacy Management: Safety Benefits the owners of a bank by making their investment safe Costly to owners of a bank because the higher the bank capital, the lower the return on equity Choice depends on the state of the economy and levels of confidence Bank capital requirement

© 2008 Pearson Education Canada9.22 Strategies for Lowering Bank Capital 1.Buying back some of Bank’s stock 2.Pay out higher dividend to shareholders 3.Acquire new funds and increase assets

© 2008 Pearson Education Canada9.23 Strategies for Raising Bank Capital 1.Issue more common stock 2.Reducing dividend to shareholders 3.Issue fewer loans or sell securities and use proceeds to reduce liabilities

© 2008 Pearson Education Canada9.24 Off-Balance-Sheet Activities Loan sales (secondary loan participation) Generation of fee income Trading activities and risk management techniques –Futures, options, interest-rate swaps, foreign exchange –Speculation

© 2008 Pearson Education Canada9.25 Off-Balance-Sheet Activities (Cont’d) Trading activities and risk management techniques (continued) –Principal-agent problem –Internal Controls Separation of trading activities and bookkeeping Limits on exposure Value-at-risk Stress testing

© 2008 Pearson Education Canada9.26 Measuring Bank Performance

© 2008 Pearson Education Canada9.27 Measuring Bank Performance (Cont’d) Operating Income Operating Expenses Net Operating Income Net Income

© 2008 Pearson Education Canada9.28 Measuring Bank Performance (Cont’d) ROA = net income/assets ROE = net income/equity capital NIM = (interest income-interest expenses)/assets