CAPITAL MARKETS BSC/BBA III Winter Semester 2010 Lahore School of Economics

Chapter 3 Depository Institutions

Depository Institutions Learning Objectives What is a depository institution? How a DI generates income? What is the Asset/Liability problem for DI’s? What is Funding Risk? What are DI’s funding sources? What are Reserve Requirements?

Depository Institutions? Include:

Depository Institutions? Include: Institutions that take deposits Deposits represent Liabilities (debt) for DI’s Include: Banks Savings & Loan institutions Credit Unions

How do DI’s make money? 3 ways:

How do DI’s make money? 3 ways: Loans Make direct loans to entities Securities investments Investing in securities & holding portfolios Fees Charged to their customers

Importance of DI’s? Heavily regulated because:

Importance of DI’s? Heavily regulated because: Their role in financial system a) Creating the financial playing field Principal means of making payments a) Individuals & Businesses use for payments Vehicle for Govt monetary policy a) MP implemented through banking system

Special Privileges Access to Federal Deposit Insurance Provision of liquidity in emergencies Govt has interest in DI’s stability & survival…

Asset-Liability Management 2 Main problems: Funding Risk Liquidity Risk

Asset-Liability Management Funding Risk: Illustrate using 100MM, 7% 1 & 10 yrs Use of Spreads (DI’s make money) Difference between bid/ask or charging premiums Gaps Open positions created due to duration differences Interest rate exposure Funding activity resulting in interest rate risk

Asset-Liability Management Opportunities:

Asset-Liability Management Opportunities: Interest Rate view Managers who have expectations of interest rate changes will seek to profit from funding! If Interest rates rise What position should you have? If interest rates fall What position should you have?

Asset-Liability Management Opportunities: Interest Rate view Managers who have expectations of interest rate changes will seek to profit from funding! If Interest rates rise DI will benefit if it has borrowed long & lent short because when interest rates will rise its cost will remain unchanged but will be able to lend at a higher rate! If interest rates fall DI will benefit if it has borrowed short & lent long!

Asset-Liability Management Threats of positioning:

Asset-Liability Management Threats of positioning: Adverse financial consequences If expectations are not realized, Huge losses can occur No one can predict interest rates consistently Highly risky Becomes same as gambling Long run losses highly likely

Asset-Liability Management Main goal of Mgmt:

Asset-Liability Management Main goal of Mgmt: Try Locking in the spread Minimize interest rate exposure Various financial instruments used to manage risk

Asset-Liability Management Main goal of Mgmt: Try Locking in the spread (By not trying to bet on interest rate movements, focus should solely be on earning from the spread not on interest rate movements) Minimize interest rate exposure (By investing in assets & Liabilities of similar maturity ranges) Various financial instruments used to manage risk (Examples include interest rate options, swaps & forwards)

Liquidity Concerns of DI’s? Balancing two activities?

Liquidity Concerns of DI’s? Balancing two activities: Satisfy Withdrawals of customers (Liquidity Concerns) Liquidity required Provide Loans to customers (Earnings)

Liquidity Concerns of DI’s? 4 ways to solve liquidity issues?

Liquidity Concerns of DI’s? 4 ways to solve liquidity issues: Attract deposits Borrowing from Federal Agency or other Financial Institutions (using security collateral) Sell Securities on hand Raise Funds in Money Markets

Liquidity Concerns of DI’s? Increase Borrowing using securities: Discount window borrowing at Fed

Liquidity Concerns of DI’s? Sell securities it owns: DI must invest in ST, liquid securities with little Price Risk and keep these in its inventory E.g: stocks?... No, Bonds? …. No Solution: ?

Liquidity Concerns of DI’s? Sell securities it owns: DI must invest in ST, liquid securities with little price risk and keep these in its inventory E.g stocks?... No, Bonds? …. No Solution: Short term, Money Market instruments like Treasury Bills, Commercial Papers etc

Liquidity Concerns of DI’s? SECONDARY RESERVES? Securities held by a DI for the purpose of satisfying withdrawals or loans. Disadvantage? Lower yield % of assets as secondary reserves depends on DI’s risk/return appetite

Liquidity Concerns of DI’s? One more reason for holding liquid assets?

Liquidity Concerns of DI’s? One more reason for holding liquid assets? To fulfill Govt regulation! In form of Reserve Requirements (discussed later)

Commercial Banks 3 Main Types of services:

Individual Banking Institutional Banking Global Banking Commercial Banks

Individual Banking Consumer Lending Residential Mortgage Credit Card financing Car & Boat Financing Brokerage services Student Loans Commercial Banks

Institutional Banking: Loans to Corporations Loans to Insurance companies Loans to Government Commercial Financing & Leasing Commercial Banks

Global Banking: Foreign Exchange products Capital Markets products Corporate financing products Commercial Banks

How do Banks raise Funds? Commercial Banks

How do Banks raise Funds? 3 Main Sources of Funds Deposits Non-Deposit Borrowing Common Stock & Retained Earnings Commercial Banks

How do Banks raise Funds? 3 Main Sources of Funds Deposits (Demand Deposit, Savings Deposit, Time Deposits) Non-Deposit Borrowing (Borrowing from Federal Reserve through Discount window, Repurchase Agreements, borrowing by the issuance of instruments in the money & bond market) Common Stock & Retained Earnings Commercial Banks

Reserve Requirement & Borrowing at the Fed Funds Market? Banks must maintain a %age of deposits with Federal Reserve called Reserve Ratio. The cash kept with Fed is called Required Reserve. Commercial Banks

Reserve Requirement Type of Deposits: Transaction Deposits Non-transactions Deposits Reserve Ratios are higher for transaction Deposits relative to non transaction deposits !

Reserve Requirements Reserve maintenance period 2 Week period where the average of the daily total of each type of deposit is taken to get RR (THR-WED) Actual Reserves Average Amount of Reserves held at the close of business at the Federal Reserve Bank during each day of a two week reserve maintenance period. Excess Reserves If bank reserves exceed the RR at the Fed Fed Funds Market & Fed Funds Banks short of RR borrow from Excess Reserves of other Banks at Fed Funds rate.

Fed Discount Window: Fed is the Banker’s Bank – last resort Charges DISCOUNT RATE Collateral Treasury securities, Govt securities etc. Heavily Discourages its use Will investigate if use becomes frequent Reserve Requirements

Regulations Regulation of Interest rates Geographical Restrictions Permissible Activities for Commercial Banks Capital Requirements for Commercial banks

Regulations Regulation of Interest rates Ceilings imposed on the interest rate that can be paid on Deposit Accounts. Geographical Restrictions This legislation was intended to prevent large banks from expanding geographically & thereby taking over smaller banking entities, threatening competition. Permissible Activities for Commercial Banks Capital Requirements for Commercial banks

Permissible Activities for Commercial Banks The permissible activities of banks are limited to those that are viewed by the Fed as closely “related to banking”. Banks can neither underwrite securities & stocks, nor can act as dealers in the secondary market. Banking act of 1933 Prohibits any depository institution from engaging in the securities business.

Capital Requirements for Commercial Banks The ratio of equity Capital to total assets is low, typically less than 8% in case of banks. “Off Balance Sheet Obligations” Risk Based Capital Requirements

Types of Capital Tier 1 Capital (Core Capital) It consists basically of common Stockholder’s Equity, Preferred Stock & minority interest in subsidiaries. It is based on book Value of Total Assets. Tier 2 Capital (Supplemental Capital) It includes loan loss Reserves, Perpetual Debt & hybrid Capital Instruments. It is based on Risk Weighted Assets.

Risk Based Capital Requirements Risk WeightExamples of Assets included 0% U.S Treasury Securities, MBS issued by GNMA 20% Municipal general Obligation bonds, MBS issued by Govt. Associations 50% Municipal Revenue Bonds, Residential Mortgages 100% Commercial loans & mortgages, Corporate Bonds.

Risk Based Capital Requirements- Example AssetBook Value (in millions) US Treasury Securities100 Municipal General Obligation Bonds 100 Residential Mortgages500 Commercial Loans300 Total Book Value1000

Risk Based Capital Requirements- Example AssetBook ValueRisk WeightProduct US Treasury Security1000%0 Municipal Bonds10020%20 Residential Mortgages 50050%250 Commercial Loans300100%300 Risk Weighted Assets 570

Risk Based Capital Requirements- Example Risk Weighted Assets = 570 million Minimum Core Capital Requirement (Tier 1) = 4% of Total assets = 4% of $1000 million = $ 40 Million Minimum Total Capital = 8% of Risk Weighted Assets = 8% of $570 = $ 45.6 Million Minimum Supplemental Capital Requirement (Tier 2) = 45.6 – 40 = $5.6 Million

Depository Institutions Summary What is a depository institution? How a DI generates income? What is the Asset/Liability problem for DI’s? What is Funding Risk? What are DI’s funding sources? What are Reserve Requirements?

Assignment # 1 Q1: The following is the book value of the assets of a bank: AssetBook Value (in millions) US Treasury Securities$50 MGBO50 Residential Mortgages400 Commercial Loans200 Total Book Value700

Assignment # 1 a) Calculate the risk weighted Assets b) What is the minimal Core Capital Requirement? c) What is the minimum total Capital Requirement? AssetRisk Weights US Treasury Securities0% MGBO20% Residential Mortgages50% Commercial Loans100%

Assignment # 1 Q2: What is meant by individual Banking? Institutional Banking? Global Banking? Q3: Explain: Reserve Ratio, Required Reserves, Excess Reserves. Q4: Are higher or lower interest rates beneficial to institutions that borrow short & lend long? Explain!

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