Chapter 9 Commercial Banks

Contents Commercial Bank Balance Sheet Commercial Bank Liabilities Commercial Bank Assets Commercial Bank Capital Accounts Commercial Bank Management Liquidity Management Liability Management Capital Management

The Importance of Commercial Banks Savers Borrower Funds Primary claims Funds Primary claims Secondary claims Financial Intermediaries

The Importance of Commercial Banks Depository institutions play a key role in channeling funds from savers (surplus unit) to borrowers (deficit units) Commercial banks dominate among depository institutions. Banks take in funds by accepting _____ Banks use the funds mainly to ______ deposit grant loans

The Importance of Commercial Banks Commercial banks are the oldest and most diversified of all financial intermediaries. Banks are important in the money supply process. Banks create money by lending or buying the securities

The Commercial Bank Balance Sheet Banks earn a profit on the “ spread ” (3%-4%) by obtaining funds at relatively low interest rates and lending at higher interest rates. In recent years, fees have played an increasingly important role in bank profits.

The Commercial Bank Balance Sheet A bank balance sheet is a statement of its assets, liabilities, and net worth at a given point in time. Assets are what it owns. Loan, securities (Investment)  earning assets Liabilities are what it owes. Demand deposit, saving deposit, time deposit

The Commercial Bank Balance Sheet –Net worth (capital accounts, capital) is the difference between its assets and liabilities. Common stocks, retained earning Assets = Liabilities + Net Worth Assets - Liabilities = Net Worth

Figure 9-1

Table 9-1

Commercial Bank Liabilities  Transactions Deposits (checkable deposits)  Non-transaction Deposits  Non-deposit borrowing  Other liabilities

Commercial Bank Liabilities Transactions Deposits (checkable deposits) Demand Deposits: non-interest bearing checking accounts Negotiable Order Of Withdrawal (NOW) Accounts: interest-bearing checking accounts Automatic Transfer Service (ATS) Accounts:Paired accounts with checks on non-interest baring accounts & automatic transfers to it from interest-bearing accounts

Commercial Bank Liabilities Non-Transactions Deposits Passbook Savings Accounts Any amount of funds can be added or withdrawn at any time Small Certificates of Deposit (CDs up to $100,000) There are penalties if withdrawing before maturity (3 months to 5 years)  similar to time deposit in Thailand Money Market Deposit Accounts (MMDAs) Special type of saving account with limited check writing feature (no more than 6 times per month) Negotiable CDs. Large CDs over $100,000

Commercial Bank Liabilities Non-deposit Borrowing Borrowing from the Fed  discount loans, discount window  pay interest at the discount rate Borrowing from other banks ’ excess reserve  overnights loans between bank  federal funds  pay interest at federal fund rate

Commercial Bank Assets  Cash Assets  Loans  Securities  Other Assets

Commercial Bank Assets Most of banks ’ assets are in form of income- earning assets or earning assets (85%) Loan Securities However, banks are subjected to maintains portion of their source of funds (liabilities) in form of non-interest-earning legal reserves Coin and currency in banks Bank ’ s deposit balance at the central bank

Commercial Bank Assets Cash Assets Vault cash - Currency and coins at bank oto meet public ’ s demand oto meet reserve required Deposits with Federal Reserve Bank (central bank) oto meet reserve required oto facilitate check clearing process Deposits with other banks oCorrespondent banking – smaller banks maintain deposits in larger banks in return of services e.g. check collection, investment counsel, and transaction in securities and foreign currency

Commercial Bank Assets Loans Real Estate Loans: collateralized by property (real estate), Ex. Mortgage Securitization – banks bundle many real estate loans into the package and issue the securities based on this package to investors Business Loans:  Regular installment loans  Lines of credit (subject to compensating balance)

Commercial Bank Assets Consumer Loans:  Auto loans  Credit cards  banks get the fee from business accepting the card and also get the interest rate if the cardholders design to pay the minimum balance.  Overdraft arrangement Other Loans:  Federal funds sold Securities Other assets  Building, Land, Equipment

Commercial Bank Capital Accounts Bank capital derives from the issue of bank stock shares and from retained earnings Bank capital provides a cushion that protects a bank's owners from potential bank insolvency –Total assets are less than total liabilities –Negative net worth

Writing Off Bad Loans Bank needs to write off $600,000 for bad loans

Writing Off Bad Loans Immediate write off bad loans can make the bank to face the situation of insolvency. –Close the banks –Find new owners to take over the bank (through Merger & Acquisition) Bank usually (also subject to the regulation) sets aside contingent funds against loan loss in advance  loan loss reserve (Allowance for bad debts)

Commercial Bank Management Commercial banks strive to: –earn solid profits; –maintain extremely low exposure to the possibility of becoming insolvent, and –maintain high liquidity (the ability to immediately meet currency withdrawals) by managing liquidity and capital.

T-Accounts T-accounts are statements of the change in the balance sheet resulting from a given event. –ie. if a customer withdraws $200 in cash from a savings account at the Bank of Medicine Bow.  ie. Clearing a check for $12,000 written by a bank customer

The Importance of Liquidity Banks must have emergency plans to meet large reserve withdrawals, so banks need to hold liquid assets like Treasury bills. If a bank is exposed to large deposit outflows and can obtain reserves only at substantial cost, it could find itself in serious trouble, even if it has a relatively large capital account.

The Liquidity-Risk Trade-off If bank decides to maintains high liquidity, bank will face less risk If bank decides to maintains low liquidity, bank will face higher risk

The Liquidity-Risk Trade-off  With a reserve requirement of 10%, the bank has no excess reserves.  Its assets are 90% in high return loans and 10% in low return securities.  What if depositors withdraw $20 million?

The Liquidity-Risk Trade-off  If depositors withdraw $20 million, Deposit decreases to $380 million Reserves also decreases to $20 million  However, required reserve ratio is 10%, bank need to maintain reserves at $38 million  bank need to find more reserve for $18 million  Bank has marketable securities (liquid assets) only $10 million that is not enough  bank need to find other funds

The Liquidity-Profitability Trade-off If bank decides to maintains low liquidity, bank will have a change to get higher return If bank decides to maintains high liquidity, bank will get lower return Higher liquidity means bank will hold more excess reserve (no return) and more marketable securities (low return) rather than lending the loan (higher return)

The Liquidity-Profitability Trade-off The bank has $10 million excess reserves. Its assets are split between high return loans & low return securities.

The Liquidity-Profitability Trade-off If depositors withdraw $20 m, then the balance sheet changes – Deposit decrease to $380 million – Reserves decrease to $30 million With 10% required reserve ratio, bank has to maintain $38 million reserve  bank need more $8 million Bank have lots of marketable securities to be liquidated and change to reserve  no problem However, it is less profitable because it has fewer high-return loans.

The Liquidity-Profitability Trade-off If bank decides to maintains low liquidity, bank will face higher risk but have more opportunity to get higher return If bank decides to maintains high liquidity, bank will face lower risk and get lower return

Indicators of Bank Liquidity The ratio of bank loans to total assets –Higher ratio  lower liquidity The ratio of securities to total assets –Higher ratio  higher liquidity The ratio of demand deposit to total bank deposits –Higher ratio  Bank need to maintain more liquidity

Liability Management Banks look for good lending opportunities and then search for the funds to finance these loans. When a large bank finds a profitable lending opportunity, it can: –“ buy ” federal funds; –issue negotiable CDs at whatever interest rate is required to attract funds; –issue repurchase agreements or borrow Eurodollars, or –obtain funds through the commercial paper market.

Liability Management Aggressive liability management can be dangerous, because a bank ’ s assets typically have longer maturities than its liabilities. If interest rates rise sharply, banks can suffer severe losses. Aggressive liability management allows banks to make profitable loans that they would otherwise have to turn down.

Liability Management 3 rd year10 th yearNow Loans Deposit 5% 1% 5% 4% 2 nd year 7% 5%

Capital Management Bank capital provides a financial cushion so that transitory adverse developments will not cause insolvency. Bank capital also protects bank managers and owners from their own mistakes and from various risks: –default risk  borrowers do not pay back their loans –interest-rate risk  when interest rate changes –liquidity risk  depositors will withdraw the fund –Foreign exchange rate risk  when exchange rate change –political or country risk  risk that fund or assets in other countries cannot be mobilized to home country –management risk  employees will engage in activities involving enormous risk (Barings Bank – Nicholas Leeson)

Capital Management Bank capital ratio = higher bank capital ratio –implies a lower risk of insolvency, –but also a lower rate of return. Capital Asset

The Capital Management Tradeoff Earning Total Assets CapitalTotal AssetsCapital = x Return on Equity = ROA * Equity Multiplier Note: A high capital ratio represents a low equity multiplier; A low capital ratio represents a high equity multiplier A trade-off arises between short-run profitability & the risk of insolvency

Capital Management Earning/Capital = Earning/TA x TA/Capital Suppose a bank has net income (earnings) 1m, TA 100m Case 1: a bank has capital = 5m Earning / Capital = ??? Case 2 : a bank has capital = 10m Earning / Capital = ???

Summary Commercial bank raise the funds from accepting deposit and use the funds in granting the loan Bank earn interest rate spread between deposit rate and loan rate and also earn the service fees If bank faces daily shortage in reserve, bank can borrow from Fed at discount rate or borrow from other banks at fed fund rate Loans are most-income-earning assets of the banks Banks are subjected to maintains portion of their source of funds in form of non-interest-earning legal reserves (currency and deposit at Fed)

Summary Smaller banks maintain deposits in larger banks in return of services e.g. check collection, investment counsel, and transaction in securities and foreign currency  Correspondent banking system Bank may bundle many real estate loans into the package and issue the securities based on this package to investors  securitization Bank becomes insolvency if total asset is less than total liability or negative net worth (equity)

Summary If bank decides to maintains low liquidity, bank will face higher risk but have more opportunity to get higher return Aggressive liability management can be dangerous, because a bank ’ s assets typically have longer maturities than its liabilities. If interest rates rise sharply, banks can suffer severe losses. Bank capital provides a cushion that protects a bank's owners from potential bank insolvency higher bank capital ratio, implies a lower risk of insolvency, but also a lower rate of return.