1. Chapter 12
Depository Institutions:
Banks and Bank Management

2. Depository Institutions: The Big Questions
Where do commercial banks get their funds and what do they do with them?
How do commercial banks manage their balance sheets?
What risks do banks face?

3. Balance Sheet of Commercial Banks: Assets, Liabilities, and Capital
The balance sheet identity:
Bank Assets = [Bank Liabilities + Bank Capital]
When one side changes, the other side must change as well.
A bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets)

4. Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2014)

5. Liabilities are Sources of Funds
Checkable Deposits: Called transactions deposits, includes all accounts that allow the owner (depositor) to write checks to third parties:
non-interest earning checking accounts (known as - demand deposit accounts because you can demand cash),
Interest earning negotiable orders of withdrawal (NOW) accounts, and
Money-market deposit accounts (MMDAs), which typically pay the most interest among checkable deposit accounts
About 11% of bank source of funds

6. Liabilities – Sources of Funds
Non-transaction Deposits: generally a bank’s highest cost funds.
Banks want deposits which are more stable and predictable and will pay more to attract such funds.
The largest source of funds ~ 58%

7. Liabilities – Sources of Funds
Borrowings:
Banks borrow from:
the Federal Reserve System: discount loans
other banks: Fed funds and repos
corporations: Repos and commercial paper
About 20% of bank source of funds

9. Bank Capital – Source of Funds
Bank Capital: the source of funds supplied by the bank owners,
either through purchase of ownership shares or retained earnings
Bank capital provides a cushion, thus capital levels are important.
About 11% of bank source of funds
A very important topic in bank regulation.

10. Assets are Uses of Funds
Reserves: funds held in accounts with the Fed (vault cash and cash in the ATM machine is included).
Required reserves represent what is required by law - reserve requirement or required reserve ratios.
Any reserves beyond this are called excess reserves.
About 19% of bank assets.

11. Assets – Uses of Funds
Securities: includes U.S. government debt, agency debt, municipal debt, and other (non-equity) securities.
About 19% of assets.
Short-term US Treasury debt (Treasury Bills) is often referred to as secondary reserves because of its high liquidity.
Commercial banks can not hold stock.

12. Assets – Uses of Funds
Loans: business loans, auto loans, and mortgages.
Generally not very liquid.
About 53% of bank assets.
Most banks tend to specialize in either consumer loans or business loans, and even take that as far as loans to specific groups (such as a particular industry).

13. Assets – Uses of Funds
Other Assets: bank buildings, computer systems, and other equipment.

14. Commercial Bank Liability Trend
Checkable Deposits (11%, up from 6% in Dec 2008)
Have declined substantially in importance
Transactions deposits were 61% of bank funds in 1960.
Transactions deposit available on demand

15. Commercial Bank Liability Trend
Nontransaction Deposits (55%)
Borrowing (20%, around 31% in 2008)
Discount loans for the Fed
Reserves from other banks in the Federal Funds Market (unsecured)
Repurchase agreements
Bank Capital (11%)

16. Balance Sheet of Commercial Banks: Changes in Liabilities over time
Transactions deposits were 61% of bank funds in 1960, 6.0% in 2008.
Borrowings provided only 2% of bank funds in 1960, up to 31% in 2008.

17. Balance Sheet of Commercial Banks: Change in Assets over time
Security holdings down from 70% in 1947 to 20% now.
Loans( C&I, real estate, and consumer loans) ~ 50%.

18. Bank Capital and Profitability
Remember that net worth equals assets minus liabilities.
Net worth is referred to as bank capital, or equity capital.
Capital represents the owners’ stake in the bank.
Capital is the cushion banks have against a sudden drop in the value of their assets or an unexpected withdrawal of liabilities.
It provides some insurance against insolvency.

19. Bank Capital and Profitability
An important component of bank capital is loan loss reserves:
an amount the bank sets aside to cover potential losses from defaulted loans.
At some point the bank gives up hope and the loan will be written off - or erased from the balance sheet.
At this point, the loan loss reserve is reduced by the amount of the loan that has defaulted.

20. Bank Capital and Profitability
Data in Table 12.1 shows in Dec. 2015, bank capital was $1.7 trillion.
This was combined with $13.8 trillion of liabilities to purchase $15.5 trillion of assets.
Couple of ways to look at this:
ratio of debt to equity is 8.1 to 1
ratio of equity to assets is about 11%
ratio of assets to equity is 9.11
every $100 is assets was financed with $11 of equity and $89 of debt
This is a substantial amount of leverage.

21. Bank Capital and Profitability
Although that is a substantial amount of leverage, it is nearly 25% below the average commercial bank leverage ratio that prevailed prior to the financial crisis of
Debt-to-equity ratio for nonfinancial business in the U.S. is less than 1 to 1.
Household leverage is roughly 1/3 to 1.

22. Bank Capital and Profitability
Recall from Chapter 5, leverage increases expected return and risk.
Expected return and risk doubles if leverage ratio (ratio of assets-to-equity)increases from 1-to-1 to 2-to-1.
For banks the ratio is 9-to-1.
Risk and return increase by a factor of 9!
Banking is a risky business.

23. Bank Capital and Profitability
One explanation for the relatively high degree of leverage in banking is the existence of government guarantees like deposit insurance.
These government guarantees allow banks to capture the benefits of risk taking without subjecting depositors to potential losses.

24. Basic Banking Transactions Cash Deposit of $100 in First National Bank
Assets
Liabilities
Vault Cash
+$100
Checkable deposits
Reserves
The above example presents two ways to record the same transaction.
Opening of a checking account leads to an equal increase in the bank’s reserves.
NOTE: vault cash counts as reserves

25. First National Bank (FNB) Second National Bank (SNB)
Basic Banking Transaction Check Deposit of $100 into First National Bank that is written on Second National Bank
First National Bank (FNB)
Second National Bank (SNB)
Assets
Liabilities
Reserves
+$100
Checkable deposits
-$100
FNB gains reserves and SNB loses reserves

26. Basic Banking - Making a Profit
First National Bank
Assets
Liabilities
Required reserves
+$10
Checkable deposits
+$100
Excess reserves
+$90
Loans
10% Reserve Requirement
Bank use excess reserves to make loans or invest in bonds.
Bank makes a profit because it borrows short (at a relatively low interest rate) and lends long (at a relatively high interest rate)

27. General Principles of Bank Management
The basic operation of a bank -
Make profits by:
Selling liabilities with one set of characteristics (high liquidity, low risk , small size, low return). [Source of Funds]
Buying assets with a different set of characteristics (low liquidity, high risk ,large size, hugh return). [Use of Funds]
Process known as “asset transformation” also referred to as “maturity transformation.”

28. General Principles of Bank Management
Managing Risk. Four primary concerns:
Liquidity Risk
Credit Risk
Interest Rate Risk
Capital adequacy
I do not cover trading risk.

29. Managing Liquidity Risk
Reserves requirement = 10%, Excess reserves = $10 million
Deposit outflow = $10 million
After the deposit outflow, the bank has excess reserves of $__million. Is there a need to change the balance sheet?

30. Managing Liquidity Risk
Reserves requirement = 10%, Excess reserves = $10 million
Bank with no excess reserves -
Deposit outflow of $10 million
With 10% reserve requirement, bank has $9 million reserve shortfall

31. Other banks - Federal Funds Market
Liquidity Management - Shortfall in Reserves: Borrow from other banks or corporations.
Assets
Liabilities
Reserves
$9M
Deposits
$90M
Loans
Borrowing
Securities
$10M
Bank Capital
Other banks - Federal Funds Market
Corporations – Issue CP or engage in Repo
There’s a cost - interest rate paid on the borrowed funds

32. Liquidity Management - Shortfall in Reserves: Borrow from the Fed
Assets
Liabilities
Reserves
$9M
Deposits
$90M
Loans
Borrow from Fed
Securities
$10M
Bank Capital
There’s a cost - payments to Fed based on the discount rate

33. Liquidity Management: Sell Securities
Assets
Liabilities
Reserves
$9M
Deposits
$90M
Loans
Bank Capital
$10M
Securities
$1M
There are costs: transaction costs and possible capital loss.

34. Liquidity Management: Reduce Loans
Assets
Liabilities
Reserves
$9M
Deposits
$90M
Loans
$81M
Bank Capital
$10M
Securities
Reduction of loans is the most costly way of acquiring reserves
Calling in loans (basically not renewing short-term loans) antagonizes customers
Loans are not a liquid asset. Other banks may only agree to purchase loans at a substantial discount

35. Asset Management - Credit Risk: Overcoming Adverse Selection and Moral Hazard
Screening and information collection
Specialization in lending (e.g. energy sector)
Diversification - by industry and geography
Monitoring and enforcement of restrictive covenants
Long-term customer relationships
Collateral and compensating balances

36. Liability Management
Managing the sources of funds: from deposits, to CDs, to other debt.
Important since 1960s
Banks no longer primarily depend on transactions deposits
More dependent on non-transactions deposits and borrowing.
Growth in borrowing from 2% in 1960 to 31% in 2008.
Negotiable CDs at 19%

37. Bank Capital (Equity) Assets – Liabilities = Net Worth
Called Bank Capital.
The value of the bank to its owners.
In Dec 2006, commercial bank capital was $0.86 trillion equal to 8.8% of total assets of $9.77 Trillion
In Dec 2015, commercial bank capital was $1.7 trillion equal to 11% of total assets of $15.5 Trillion

38. Capital Adequacy Management
Bank capital is a cushion that helps prevent bank failure.
As banks write down assets, bank capital takes a hit.
Regulators set minimum capital requirements.

39. Capital Adequacy Management
Scenario: Borrower defaults on $5 million loan
High Bank Capital
Low Bank Capital
Assets
Liabilities
Reserves
$10M
Deposits
$90M
$96M
Loans
Bank Capital
$4M
$85M
$5M
-$1M

40. Basic Strategies for Managing Capital
What should a bank manager do if she feels the bank is holding too little capital (i.e., the capital ratio is too low)?
Issue stock to attract new capital
Decrease dividends to increase retained earnings which adds to equity
Slow asset growth (retire debt)

41. Capital Adequacy Management: Return to Equity Holders

42. Capital Adequacy Management
Tradeoff between safety (high capital) and ROE Prudent to hold equity capital. Unfortunately, banks aren’t very prudent.
If Equity Capital ↑ => EM ↓ => ROE ↓

43. Equity Multiplier and Capital Ratio
EM is actually a measure of leverage
EM = 10, means $1 of equity supports $10 in assets. The bank borrows $9.
EM = 25, means $1 of equity supports $25 in assets. The bank borrows $24.
EM is the inverse of the capital ratio

44. Bank Profitability ROA is typically 1.2 to 1.3%
ROE is 10 to 12 times ROA.
Let’s take a look:

45. Leverage of Various Financial Institutions prior to Financial Crisis
Assets
$Trillion
Liabilities
Equity
Leverage
Assets/Equity
Commercial Banks
10.8
9.7
1.1
9.8(10.2%)
Savings Inst.
1.91
1.68
.23
8.4(11.9%)
Credit Unions
0.75
.66
.09
Investment Banks
5.4
5.23
.17
31.7
(1/31.7) = 3.15%
GSEs
1.63
1.56
.067
24.7(4.0%)
Overall
20.5
18.8
1.7
12.2(8.2%)

46. Loans/Securities $90 Equity Capital $10 Total $100 Total $100
Suppose banks are required to maintain a capital ratio of 10%. Assume times are good and loan portfolio increases by $1.
National Capital Bank – January
Assets Liabilities
Cash $ Debt $90
Loans/Securities $ Equity Capital $10
Total $ Total $100
National Capital Bank – June
Assets Liabilities
Cash $ Debt $90
Loans/Securities $ Equity Capital $11
Total $ capital ratio is 10.89% > 10%
National Capital Bank – December
Assets Liabilities
Cash $ Debt $99
Loans $ Equity Capital $11
Total $ Total $110

47. Loans/Securities $80 Capital $9 Total $90 Total $90
The mechanism works in reverse when times are bad. Loan portfolio decreases by $1. De-leveraging the balance sheet
National Capital Bank - January
Assets Liabilities
Cash $ Debt $90
Loans/Securities $ Capital $10
Total $ Total $100
National Capital Bank – June
Assets Liabilities
Cash $10 Debt $90
Loans/Securities $89 Capital $9
Total $ Total $99
capital ratio is 9.09% < 10%
National Capital Bank – December
Assets Liabilities
Cash $ Debt $81
Loans/Securities $80 Capital $9
Total $ Total $90

48. National Capital Bank – June
Banks do not have to de-leverage if they can raise more equity capital and pay off some debt
National Capital Bank – June
Assets Liabilities
Cash $ Debt $89.1
Loans/Securities $ Capital $9.9
Total $ Total $99
capital ratio is = 10%

49. How a Capital Crunch Caused a Credit Crunch in 2008
Housing bust led to large bank losses
Value of assets reduced.
The losses reduced bank capital.
Banks required to rebuild capital – a capital crunch!
Banks had two option: (1) raise new capital, or
(2) reduce lending.
Which option?

50. Managing Interest Rate Risk
In addition to the borrow/short - lend/long mismatch, banks also have a mismatch between assets and liabilities that are interest-rate sensitive and non-interest rate sensitive.
For example,
deposit rates tied to market rates (interest rate sensitive cost)
long-term fixed rate loan ( Non-interest rate sensitive income)

51. Managing Interest Rate Risk
What happens if interest rate rise?
Deposit rates tied to flexible short-term interest rates rise.
Loan revenues based on fixed interest rate remain fixed.
Profits fall.

52. Interest-Rate Risk – Simple Gap Analysis
First National Bank
Assets
Liabilities
Rate-sensitive assets(RSA)
$20M
Rate-sensitive liabilities (RSL)
$50M
Variable-rate and short-term loans
Variable-rate CDs
Short-term securities
Money market deposit accounts
Fixed-rate assets
$80M
Fixed-rate liabilities
Reserves
Checkable deposits
Long-term loans
Savings deposits
Long-term securities
Long-term CDs
Equity capital
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

53. Interest Rate Risk: Gap Analysis
Basic Gap Analysis
(RSA – RSL) x Δ interest rate = Δ bank profits

54. Managing Interest-Rate Risk
Basis Gap Analysis
GAP = rate-sensitive assets – rate-sensitive liabilities
= $ – $50 = –$30 million
When i  5%:
1. Income on assets = + $1 million
(= 5%  $20m)
2. Costs of liabilities = +$2.5 million
(= 5%  $50m)
3. Profits = $1m – $2.5m = –$1.5m
= 5%  (GAP) = 5%  ($20 - $50) = .05x -$30 =-$1.5
4. Profits = i  GAP

55. Off-Balance-Sheet Activities
Loan sales
Fee income from
Foreign exchange trades for customers
Servicing mortgage-backed securities
Guarantees of debt
Backup lines of credit
Trading Activities and Risk Management Techniques
Financial futures and options
Foreign exchange trading
Interest rate swaps
All these activities involve risk and potential conflicts