Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 10 Banking and the Management of Financial Institutions

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Objectives we examine in this chapter how banking is conducted to earn the highest profits possible –How and why banks make loans, –How they acquire funds and manage their assets and liabilities (debts), and –How they earn income. Although we focus on commercial banking, many of the same principles are applicable to other types of financial intermediation

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Table 1 Balance Sheet of All Commercial Banks (as a percentage of the total, December 2008)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet A bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets). Banks obtain funds by borrowing and by issuing other liabilities such as deposits. They then use these funds to acquire assets such as securities and loans. Banks make profits by charging an interest rate on their holdings of securities and loans that is higher than the expenses on their liabilities.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet Liabilities (sources of funds) A bank acquires funds by issuing liabilities. Liabilities are: A: Transaction Deposits. Checkable Deposits: bank accounts that allow the owner of the account to write checks to third parties they include 1.Demand Deposits (non-interest-bearing), 2.Interest-bearing NOW (negotiable order of withdrawal) accounts. 3.money market deposit accounts MMDAs (similar to money market mutual funds), they are not subject to reserve requirements.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet They were the most important source of bank funds (over 60% of bank liabilities in Checkable deposits and money market deposit accounts are payable on demand.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet B Non-transaction Deposits. The primary source of bank funds (56% of bank liabilities in Table 1). Owners cannot write checks on non-transaction deposits, but the interest rates are usually higher than those on checkable deposits. There are two basic types of these deposits: savings accounts: In these accounts funds can be added or withdrawn at any time, transactions and interest payments are recorded in a monthly statement or in a small book.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet Time deposits: have a fixed maturity length, ranging from several months to over five years. Have substantial penalties for early withdrawal (the forfeiture of several months’ interest). Less liquid for the depositor than passbook savings, Earn higher interest rates, and are a more costly source of funds for banks. They are either in Small-denomination (less than ) or large denomination (CDs, ore negotiable CDs).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet C. Borrowings: could be: Loans from the Central bank (discount loans (also known as advances)). Overnight loans in the federal funds market from other U.S. banks and financial institutions. Loans from parent companies (bank holding companies), Loan arrangements with corporations (such as repurchase agreements, or Eurodollars)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet D. Bank Capital. the difference between total assets and liabilities. The funds are raised by selling new equity (stock) or from retained earnings. Bank capital is a cushion against a drop in the value of its assets, which could force the bank into insolvency (having liabilities in excess of assets, meaning that the bank can be forced into liquidation).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet Assets (uses of funds) A. Reserves. Reserves are deposits in the central bank plus vault cash stored in bank vaults overnight). banks hold reserves for two reasons: First, they are required to do so (minimum required reserves), e.g., a 10% required reserve ratio. Second banks hold additional reserves, called excess reserves (the most liquid of all bank assets), to meet its obligations when funds are withdrawn.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet B. Cash Items in Process of Collection. Checks deposited in the bank which are claims on other Banks that will be paid within a few days. C. Deposits at Other Banks (correspondent banking). Held by small banks in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions, and help with securities purchases. D. Securities. Are entirely debt instruments (banks are not allowed to hold stocks)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet securities can be classified into three categories: 1.government and agency securities, 2.state and local government securities, 3.other securities. Government and agency securities are the most liquid. Because of their high liquidity, short-term U.S. government securities are called secondary reserves.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Bank Balance Sheet E. Loans. liabilities for the individual or corporation receiving it, but an asset for a bank, because it provides income to the bank. Note: –Loans are typically less liquid than other assets. –Loans also have a higher probability of default than other assets. Because of the lack of liquidity and higher default risk. –The bank earns its highest return on loans. F. Other Assets. The physical capital (bank buildings, computers, and other equipment) owned by banks.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Basic Banking: Cash Deposit Suppose that X opened a checking account in the first national bank using a $ 100 note. This leads to an increase in the bank’s reserves equal to the increase in checkable deposits (section A). Since vault cash is a part of the bank’s reserves, we can rewrite the T-account as in section B. A B First National Bank AssetsLiabilitiesAssetsLiabilities Vault Cash +$100Checkable deposits +$100Reserves+$100Checkable deposits +$100

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Basic Banking: Check Deposit First National BankSecond National Bank AssetsLiabilitiesAssetsLiabilities Reserves+$100Checkable deposits +$100Reserves-$100Checkable deposits -$100 First National Bank AssetsLiabilities Cash items in process of collection+$100Checkable deposits+$100 Suppose that X opened his account using a check written on the Second National Bank. Note that when a bank receives additional deposits, it gains an equal amount of reserves, when it loses deposits it loses an equal amount of reserves.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Basic Banking: Making a Profit the bank is obliged to keep a required reserve ratio of 10%, the First National Bank’s T-account is shown in section A. to make a profit, the bank must use all or part of the $90 of excess reserves. Let us assume that the bank makes loans of the $ 90. The First National Bank T account will be as shown in section B. AB First National Bank AssetsLiabilities AssetsLiabilities Required reserves +$10Checkable deposits +$100Required reserves +$10Checkable deposits +$100 Excess reserves +$90Loans+$90

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Bank Management Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Liquidity Management: Ample Excess Reserves Suppose bank’s required reserves are 10%. Given the banks T account in A. If the bank suffers a deposit outflow of $10M, See section B. Note that if a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet AB AssetsLiabilitiesAssetsLiabilities Reserves$20MDeposits$100MReserves$10MDeposits$90M Loans$80MBank Capital $10MLoans$80MBank Capital$10M Securities$10MSecurities$10M

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Liquidity Management: Shortfall in Reserves Suppose that RR=10%. Given the banks T account in A. If the bank suffers a deposit outflow of $10M, See section B. Reserves are zero. Note that Reserves are a legal requirement 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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Liquidity Management: Borrowing Options to deal with reserve shortfall: (1) borrowing from other banks or corporations, (2) selling securities, (3) borrowing from the Fed, or (4) calling in or selling off loans. 1. Borrowing. The bank will borrow 9 M. Cost incurred is the interest rate paid on the borrowed funds AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrowing$9M Securities$10MBank Capital$10M

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Liquidity Management: Securities Sale Suppose that the bank sold $9M securities to help cover the deposit outflow and deposit the proceeds with the Fed, resulting in the following balance sheet. The cost of selling securities is the brokerage and other transaction costs. AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBank Capital$10M Securities$1M

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Liquidity Management: Federal Reserve Borrowing from the Central bank $9M. The cost associated with discount loans is the interest rate that must be paid to the Central bank (called the discount rate). AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrow from Fed$9M Securities$10MBank Capital$10M

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Asset Management: Three Goals The basic strategy a bank pursues in managing its assets is to maximize its profits, reduce risk, and make adequate provisions for liquidity. Banks accomplish these three goals in four basic ways. –First, banks try to find borrowers who will pay high interest rates and are unlikely to default on their loans. Typically, banks are conservative in their loan policies. –Second, banks try to purchase securities with high returns and low risk.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Asset Management: Three Goals –Third, banks must attempt to lower risk by diversifying. They accomplish this by purchasing different types of assets (short- and long-term, Treasury, and municipal bonds) and approving many types of loans to a number of customers. –Fourth, the bank must manage the liquidity of its assets so that it can satisfy its reserve requirements without bearing huge costs.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Capital Adequacy Management Banks have to make decisions about capital they need to hold for three reasons. –First, bank capital helps to prevent bank failure, a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors and so goes out of business. –Second, the amount of capital affects returns for the owners (equity holders) of the bank. –Third, a minimum amount of bank capital (bank capital requirements) is required by regulatory authorities.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Capital Adequacy Management: Preventing Bank Failure How Bank Capital Helps Prevent Bank Failure. consider two banks with identical balance sheets, except that one has a ratio of capital to assets of10% while other has a ratio of 4%. Suppose that both banks find that $5 million of their loans became worthless later. When these bad loans are written off (valued at zero), the total value of assets declines by $5 million, and so bank capital, which equals total assets minus liabilities, also declines by $5 million. The balance sheets of the two banks now look like this

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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 A bank maintains bank capital to lessen the chance that it will become insolvent.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Capital Adequacy Management: Returns to Equity Holders The return on assets (ROA), the net profit after taxes per dollar of assets. This measures how efficiently the bank is run: ROA=net profit after taxes/assets Return on equity (ROE), is the net profit after taxes per dollar of equity (bank) capital. This measures how well the owners are doing on their investment: ROE=net profit after taxes/equity capital There is a direct relationship between ROA and ROE. This relationship is determined by the so- called equity multiplier (EM).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Capital Adequacy Management: Returns to Equity Holders EM=assets/equity capital Note that: net profit after taxes/equity capital= net profit after taxes/assets × assets/equity capital Which yields: ROE = ROA × EM

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Trade-off Between Safety and Returns to Equity Holders. bank capital has benefits in that it makes owner’s investment safer by reducing the likelihood of bankruptcy. costs of bank capital are: the higher it is, the lower will be the return on equity for a given return on assets. Choice depends on the state of the economy and levels of confidence

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Capital Adequacy Management: Bank Capital Requirements. Banks also hold capital because they are required to do so by regulatory authorities. Because of the high costs of holding capital, bank managers often want to hold less bank capital relative to assets than is required by the regulatory authorities. In this case, the amount of bank capital is determined by the bank capital requirements. In Kuwait the minimum capital/assets ratio is 12%.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Managing Credit Risk: Overcoming Adverse Selection and Moral Hazard Screening and Monitoring 1.Screening Lenders must collect reliable information about the borrowers. Information include: company’s profits and losses (income) and its assets and liabilities, and evaluation of the likely future success of the business. the company’s future plans, how the loan will be used, and the competition in the industry.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Managing Credit Risk: Overcoming Adverse Selection and Moral Hazard 2.Specialization in Lending. A bank often specializes in lending to local firms or to firms in particular industries. It is easier for the bank to collect information about local firms and determine their creditworthiness. By concentrating lending on firms in specific industries, the bank becomes more knowledgeable about these industries and is therefore better able to predict which firms will be able to make timely payments on their debt.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Managing Credit Risk: Overcoming Adverse Selection and Moral Hazard 3.Monitoring and Enforcement of Restrictive Covenants. To reduce moral hazard, lenders should write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Managing Credit Risk: Overcoming Adverse Selection and Moral Hazard Long-Term Customer Relationships Long-term relationships benefit the customers as well as the bank. A firm with a previous relationship will find it easier to obtain a loan at a low interest rate The bank has an easier time determining if the prospective borrower is a good credit risk and incurs fewer costs in monitoring the borrower. Long-term customer relationships reduce the costs of information collection and make it easier to screen out bad credit risks.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Managing Credit Risk: Overcoming Adverse Selection and Moral Hazard Loan Commitments A loan commitment is a bank’s commitment to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate. provisions in the loan commitment agreement require that the firm continually supply the bank with information about the firm’s income, asset and liability position, business activities, and so on.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Managing Credit Risk: Overcoming Adverse Selection and Moral Hazard Collateral and Compensating Balances Collateral: which is property promised to the lender as compensation if the borrower defaults, lessens the consequences of adverse selection because it reduces the lender’s losses in the case of a loan default. Compensating balances: A firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Interest-Rate Risk If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits First National Bank AssetsLiabilities Rate-sensitive assets$20MRate-sensitive liabilities$50M Variable-rate and short-term loansVariable-rate CDs Short-term securitiesMoney market deposit accounts Fixed-rate assets$80MFixed-rate liabilities$50M ReservesCheckable deposits Long-term loansSavings deposits Long-term securitiesLong-term CDs Equity capital

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Interest Rate Risk: Gap Analysis Basic gap analysis: (rate sensitive assets - rate sensitive liabilities) x  interest rates =  in bank profit Maturity bucked approach –Measures the gap for several maturity subintervals. Standardized gap analysis –Accounts for different degrees of rate sensitivity.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Interest Rate Risk: Duration Analysis %  in market value of security  - percentage point  in interest rate x duration in years. Uses the weighted average duration of a financial institution’s assets and of its liabilities to see how net worth responds to a change in interest rates.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Off-Balance-Sheet Activities Loan sales (secondary loan participation) Generation of fee income. Examples: –Servicing mortgage-backed securities. –Creating SIVs (structured investment vehicles) which can potentially expose banks to risk, as it happened in the subprime financial crisis of

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Off-Balance-Sheet Activities Trading activities and risk management techniques –Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market and speculation. –Principal-agent problem arises

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Off-Balance-Sheet Activities Internal controls to reduce the principal-agent problem –Separation of trading activities and bookkeeping –Limits on exposure –Value-at-risk –Stress testing