BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS Chapter 9 – EC311 Susanto

© 2004 Pearson Addison-Wesley. All rights reserved 9-2 The Bank Balance Sheet

Analysis of balance sheets A balance sheet has two sides: Asset side (what the bank owns; uses of funds) Liabilities side (what the bank owes; sources of funds) Total assets = total liabilities + capital Banks make profits by charging an interest rate on their assets that exceeds the interest rate that they pay on their liabilities (thus, interest rate spread)

Bank liabilities Checkable Deposits Deposits in bank accounts that allow their owners to write checks to third parties; include: –Demand deposits = checking accounts that pay no interest. –Negotiable Order of Withdrawal (NOW) accounts = checking accounts that pay interest. –Money Market Deposit Accounts (MMDAs) = high-yielding deposit accounts that allow limited check-writing privileges. Payable on demand: if the depositor withdraws or writes a check, the bank must pay immediately. Lowest-cost source of funds, since depositors are willing to accept a lower interest rate in exchange for the convenience of writing checks, but the services are costly to maintain.

Bank liabilities Nontransaction Deposits Owners cannot write checks on them. Pay higher interest rates than checkable deposits. Include: –Savings deposits: funds can be withdrawn, without penalty, at any time. –Small (under $100,000) time deposits (certificates of deposit or CDs) = have a fixed maturity, with penalty for early withdrawal. –Large (over $100,000) time deposits (CDs) = also have a fixed maturity date, but they are negotiable, meaning that they can be resold in a secondary market [typically bought by corporations or other banks].

Bank liabilities Borrowings Include: –Borrowings from the Federal Reserve = discount loans. –Borrowings from other banks = federal funds. –Borrowings from non-bank corporations = repurchase agreements. –Borrowings of Eurodollars = deposits denominated in U.S. dollars in foreign banks or foreign branches of U.S. banks. Bank Capital A cushion against a drop in the value of the bank’s assets, since the bank becomes insolvent (bankrupt) if the value of its assets falls below the value of its liabilities (i.e., it owes more than it can repay). Raised by selling new equity (stock) or from retained earnings.

Bank assets Reserves, include: –The bank’s deposits at the Federal Reserve. –Vault cash = currency that is physically held by the bank. Reserves do not pay interest. Required reserves: –By law, the bank must hold a certain fraction (10%) of every dollar of checkable deposits (more precisely, demand deposits and NOW accounts) it receives as reserves. Excess reserves = additional reserves held by the bank to meet its customers’ requests for withdrawals. Total reserves = required reserves + excess reserves. –Required reserves = Required reserves ratio x Total deposits

Bank assets Cash Items in the Process of Collection A check that had been deposited at the bank, but not yet collected from the check writer’s bank, is a cash item in the process of collection. Deposits at Other Banks Many small banks hold deposits at larger banks in return for services (check collection and help with securities purchases). –This relationship between large and small banks is called correspondent banking, and is less important today than in was years ago, when check collection and securities transactions were considerably more difficult.

Bank assets Securities, include: –US government and US government agency securities. –State and local government (municipal) securities. By law, banks can only hold debt instruments; they cannot own equities. Because they are default-free and highly liquid, a bank’s holdings of short-term US government securities (Treasury bills) are sometimes called “secondary reserves.” Loans, include: –Commercial and industrial loans. –Real estate loans (mortgages). –Consumer loans. –Interbank loans.

Bank assets Securities, include: –US government and US government agency securities. –State and local government (municipal) securities. By law, banks can only hold debt instruments; they cannot own equities. Because they are default-free and highly liquid, a bank’s holdings of short-term US government securities (Treasury bills) are sometimes called “secondary reserves.” Loans, include: –Commercial and industrial loans. –Real estate loans (mortgages). –Consumer loans. –Interbank loans.

Bank Operation T-account Analysis: Deposit of $100 cash into First National Bank AssetsLiabilities Vault Cash + $100Checkable Deposits + $100 (=Reserves) Deposit of $100 check into First National Bank AssetsLiabilities Cash items in processCheckable Deposits + $100 of collection + $100 First National BankSecond National Bank AssetsLiabilitiesAssetsLiabilitiesCheckable ReservesDepositsReservesDeposits + $100+ $100– $100– $100 Conclusion: When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount

9-12 Principles of Bank Management 1.Liquidity Management – managing how quickly it can liquidate assets; making sure that the bank has enough cash to cover depositors’ requests for withdrawals (deposit outflows). 2. Asset Management – finding high return and low risk. A. Managing Credit Risk – lending to people who can pay back. B. Managing Interest-rate Risk – making sure that it can pay interest on deposits given the interest it earns on loans 3. Liability Management – acquiring funds at the lowest cost. 4. Capital Adequacy Management – maintaining sufficient capital while still providing decent returns to shareholders.

Liquidity Management Suppose reserve requirement = 10%, Excess reserves = $10 million Assets Liabilities Reserves$20 millionDeposits$100m Loans$80 millionBank Capital$ 10m Securities $10 million Now suppose there is a Deposit outflow of $10 million. What happens?

Liquidity management Assets Liabilities Reserves$10mDeposits$90m Loans$80mBank Capital $10m Securities$10m With 10% reserve requirement, bank still has excess reserves of $1 million: reserve requirement = 0.1* $90m = $9m. By holding ample excess reserves, a bank can cope with a deposit outflow without changing any other part of its balance sheet.

Liquidity Management Now let’s suppose no excess reserves Deposit outflow of $ 10 million Assets Liabilities Reserves$ 0mDeposits$90m Loans$90mBank Capital$10m Securities$10m Notice that the bank’s reserved went down to zero, not enough to cover the required reserves of $9m (by law). *Required reserves is still 10% of $90m, which is $9m.

Liquidity Management Four options available: 1. Borrow from other banks or corporations Assets Liabilities Reserves $9mDeposits $90m Loans$90mBorrowings $9m Securities $10mBank Capital $10m *Cost: interest rates from borrowing If the bank borrows from another bank, it pays the federal funds rate.

Liquidity Management 2. Sell Securities Assets Liabilities Reserves $ 9mDeposits$90m Loans $ 90mBank Capital$10m Securities$ 1m *Cost: brokerage and other transaction costs of selling securities. 3. Borrow from Fed Assets Liabilities Securities $10mBank Capital $10m Reserves $ 9mDeposits $90m Loans$ 90mDiscount Loans $ 9m *Cost: interest rate paid to the Fed (called discount rate).

Liquidity Management 4. Call in or sell off loans Assets Liabilities Reserves$ 9mDeposits$90m Loans$81mBank Capital$10m Securities$10m *This is the costliest way of acquiring reserves Conclusion 1: excess reserves are insurance against above 4 types of costs from deposit outflows Conclusion 2: the higher the cost associated with deposit outflows, the more excess reserves banks are likely to hold

9-19 Asset Management Three goals: 1.Seek the highest possible returns on loans and securities 2.Reduce risk 3.Have adequate liquidity Four Basic Principles: 1. Find borrowers who will pay high interest rates but who are unlikely to default. 2. Find securities with high returns and low risk. 3. Diversify the bank’s asset holdings to minimize risk, offering protection when there are losses in one type of security or one type of loan. 4. Holding some liquid assets, including excess reserves and US Treasury bills (“secondary reserves”).

9-20 Liability Management Important since 1960s – especially since the rise of “money center” banks. Money center bank = A large bank in a major financial center which borrows from and lends to governments, corporations, and other banks. Expansion of overnight loan markets and new financial instruments (such as negotiable CDs). Banks no longer primarily depend on checking deposits. Checkable deposits alone can no longer provide a bank with all of the funds that it needs. Other loan opportunities: borrow or issue CDs to acquire funds

Capital Adequacy Management: Preventing Bank Failure High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$90MBank Capital$10MLoans$90MBank Capital$4M Suppose each bank has to write off $5 million of their housing loan that went bad. High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$85MBank Capital$5MLoans$85MBank Capital-$1M Low capital bank is now insolvent. Bank capital lessens the chance that a bank will become insolvent.

Capital Adequacy Management: ROA vs. ROE Terms/formulas ROA = Net profits / Assets ROE = Net profits / Equity Capital EM (equity multiplier) = Assets / Equity ROE = ROA  EM Capital , EM , ROE  ceteris paribus A bank faces a trade-off: By maintaining more capital, it protects itself against a decline in the value of its assets. But by maintaining less capital, it can pay more dividends and thereby provide its shareholders with a better ROI.

9-23 Capital Adequacy Management 1.Bank capital is a cushion that helps prevent bank failure 2.Higher is bank capital, lower is return on equity 3.Tradeoff between safety (high capital) and ROE 4.Banks also hold capital to meet capital requirements 5.Managing Capital: *Note: a shortfall of bank capital is likely to lead to a bank reducing its assets  contraction in lending. *Banks could not raise much capital on a weak economy, and had to tighten their lending standards and reduce lending. To lower amount of capital and increase equity multiplier: A. Buy back bank’s stocks B. Pay out higher dividends C. Increase bank’s assets To increase amount of capital relative to assets: A.Sell/issue stocks B.Reduce dividends C.Make fewer loans

9-24 Managing Credit Risk Solving Asymmetric Information Problems 1. Screening (e.g., application forms, credit ratings) 2. Monitoring and Enforcement of Restrictive Covenants 3.Specialize in Lending (e.g. certain areas, industries) Less diversification, but better information collection and risk assessment 4.Establish Long-Term Customer Relationships Makes screening process easier, lowers monitoring costs 5.Loan Commitment Arrangements A bank’s commitment to provide lines of credit tied to market interest rate 6.Collateral and Compensating Balances Compensation balances: a firm receiving a loan must keep a minimum balance in a checking account at the lending bank 7.Credit Rationing Refusing to make loans even though borrowers are willing to pay the rate

Managing Interest Rate Risk First National Bank Assets Liabilities Rate-sensitive assets$20 mRate-sensitive liabilities $50 m Variable-rate loans Variable-rate CDs Short-term securities MMDAs Fixed-rate assets$80 mFixed-rate liabilities$50 m ReservesCheckable deposits Long-term bondsSavings deposits Long-term securitiesLong-term CDs Equity capital If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce a bank’s profits and a decline in interest rates will increase its profits

9-26 Managing Interest-Rate Risk Gap Analysis: measure the sensitivity of a bank’s profits to changes in interest rates GAP= rate-sensitive assets – rate-sensitive liabilities = $20 – $50 = –$30 million When i  5%: Income on assets = + $1 million (= 5%  $20m) Costs of liabilities = +$2.5 million (= 5%  $50m)  Profits = $1m – $2.5m = –$1.5m = 5%  ($20m – $50m) = 5%  (GAP)  Profits =  i  GAP

9-27 Duration Analysis Duration Analysis: measure the sensitivity of the market value of the bank’s total assets and liabilities to changes in interest rates %  value  –(% point  i)  (DUR) Example: i  5%, duration of bank assets = 3 years, duration of liabilities = 2 years; %  assets = –5%  3 = –15% %  liabilities = –5%  2 = –10% If total assets = $100m and total liabilities = $90m: assets   $15m (-15% x $100m) liabilities  $9m (-10% x $90m) net worth  $6m ((-$15m) – (-$9m))

Strategies to manage interest rate risk 1. Rearrange balance-sheet – happens when possible on loan renewal or by issuing new types of deposit accounts 2. Interest-rate swap – swap rate-insensitive assets for sensitive ones 3. Hedge with financial futures – take a bet out that interest rates do not rise – offsets profit loss.

Off-Balance-Sheet Activities Trading activities that affect bank profits but do not appear on bank balance sheets. 1.Loan sales (secondary loan participation) – selling all or part of cash stream from a specific loan to another intermediary Thereby removing the loan (no longer in the selling bank’s balance sheet) 2.Fee income from providing specialized activities A. Foreign exchange trades for customers B. Servicing mortgage-backed securities (by collecting payments and then paying them out) C. Creating SIVs (Structured investment vehicles) D. Guarantees of debt E. Backup lines of credit (include loan commitment, overdraft privileges, standby letters of credit) 3.Trading Activities Financial futures and options, forex, swaps