Chapter Fifteen The Banking Firm and Bank Management

Slide 15–3 The Bank Balance Sheet Flow of funds (tab down to commercial banks)

Slide 15–4 Bank Operation T-account Analysis: –Deposit of $100 cash into First National Bank

Slide 15–5 Bank Operation Deposit of $100 check Conclusion: When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount

Slide 15–6 Principles of Bank Management 1.Liquidity management 2.Asset management –Managing credit risk –Managing interest-rate risk 3.Liability management 4.Managing capital adequacy

Slide 15–7 Principles of Bank Management

Slide 15–8 Principles of Bank Management With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet

Slide 15–9 Liquidity Management With 10% reserve requirement, bank has $9 million reserve shortfall

Slide 15–10 Liquidity Management

Slide 15–11 Liquidity Management Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows

Slide 15–12 Asset and Liability Management Asset Management 1.Get borrowers with low default risk, paying high interest rates 2.Buy securities with high return, low risk 3.Diversify 4.Manage liquidity Liability Management 1.Important since 1960s 2.No longer primarily depend on deposits 3.When see loan opportunities, borrow or issue CDs to acquire funds

Slide 15–13 Capital Adequacy Management 1.Bank capital is a cushion that prevents bank failure 2.Higher is bank capital, lower is return on equity –ROA = Net Profits/Assets –ROE = Net Profits/Equity Capital –EM = Assets/Equity Capital –ROE = ROA  EM –Capital , EM , ROE 

Slide 15–14 Capital Adequacy Management (cont.) 3.Tradeoff between safety (high capital) and ROE 4.Banks also hold capital to meet capital requirements 5.Strategies for Managing Capital –Sell or retire stock –Change dividends to change retained earnings –Change asset growth

Slide 15–15 Off-Balance-Sheet Activities 1.Fee income from –Foreign exchange trades for customers –Servicing mortgage-backed securities –Guarantees of debt –Backup lines of credit 2.Financial futures and options 3.Foreign exchange trading 4.Interest rate swaps 5.Loan sales All these activities involve risk

Banks' Income Statement

Slide 15–17 Measures of Bank Performance ROA = Net Profits/ Assets ROE = Net Profits/ Equity Capital NIM = [Interest Income - Interest Expenses]/ Assets

Slide 15–18 Financial Innovation Innovation is result of search for profits Response to Changes in Demand –Major change is huge increase in interest-rate risk starting in 1960s –Example: Adjustable-Rate Mortgages Response to Changes in Supply –Major change is improvement in computer technology 1.Increases ability to collect information 2.Lowers transactions costs –Examples 1.Bank Credit Cards 2.Electronic Banking Facilities

Slide 15–19 Avoidance of Existing Regulations Regulations Behind Financial Innovation 1.Reserve requirements Tax on deposits = I  r D 2.Deposit-rate ceilings (Reg Q) As i , loophole mine to escape reserve requirement tax and deposit-rate ceilings

Slide 15–20 Avoidance of Existing Regulations Examples 1.Eurodollars 2.Bank Commercial Paper 3.NOW Accounts 4.ATS Accounts 5.Sweep Accounts and Overnight RPs 6.Money Market Mutual Funds

Slide 15–21 Profiting from Treasury Strips