1. Banking and the Management of Financial Institutions
Chapter 9
Banking and the Management of Financial Institutions

2. Preview Chapter 9
Banking plays a major role in moving funds to borrowers with investment opportunities. This allows the economy to run smoothly.
In the US banks supply more than $6 trillion in credit annually.
Banks provide loans to businesses, help finance college, purchase a new car or home and provide us with such services as checking and savings accounts.
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3. Preview Chapter 9
In this chapter we examine how banking is done to earn the highest profits possible; how and why banks make loans, how they get funds, manage their assets and liabilities (debts) and how they earn income.
The focus is on commercial banking because this is the most important financial intermediary activity.
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4. Bank Balance Sheet Total assets = total liabilities+capital
A bank’s balance sheet is a list of its sources of bank funds (liabilities) and uses to which the funds are put (assets)
Banks get funds by borrowing and issuing 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 assets.
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6. Basic Banking
Banks make profits by selling liabilities with one set of characteristics (liquidity, risk, size and return) and using the profits to buy assets with a different set of characteristics. This process is referred to as asset transformation.
For example, David opens a savings account with banker Kevin and Kevin makes a loan to Ann. This is described as “borrow short and lends long”, because the bank makes a long-term loan and funds them by issuing short-dated deposits.
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7. Basic Banking
To make our understanding of the operation of a bank more simple we use a tool called a T-account. A T-account is a simplified balance sheet, with lines in the form of a T, that lists the changes that occur in balance sheet items starting from some initial balance sheet position.
Let’s look at an example:
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8. Basic Banking—Cash Deposit
First National Bank
Assets
Liabilities
Vault Cash
+$100
Checkable deposits
Reserves
Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits
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9. Basic Banking—Check Deposit
First National Bank
Assets
Liabilities
Cash items in process of collection
+$100
Checkable
deposits
First National Bank
Second National Bank
Assets
Liabilities
Reserves
+$100
Checkable deposits
-$100
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10. Check Deposit-Role of the FED
The First National Bank has $100 in cash items in process as it must collect the money from the Second National Bank. It could go directly to the Second Bank for payment but the two banks are different states and it is costly to do so. Instead the First Bank deposits the check in the account at the Fed and the Fed collects the funds from the Second Bank. The result is the Fed transfers $100 of reserves to the First Bank. Thus the balance sheet looks like the T-account on the previous slide.
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11. Basic Banking – Making a Profit
Now that you know how banks gain and lose reserves, we will look at how it makes profits. First, you must know that banks are required to keep a certain fraction of its checkable deposits as required reserves. The required amount is 10%. Since reserves pay no interest, it has no income from the $100 deposit. But servicing the deposit is costly because the bank must keep records, pay tellers, and other costs. The bank is taking a loss! So, it makes a loan and it looks like this: The bank is now making a profit.
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12. Basic Banking—Making a Profit
First National Bank
Assets
Liabilities
Required reserves
+$100
Checkable deposits
Excess reserves
+$90
Loans
Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics
The bank borrows short and lends long
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13. Bank Management Liquidity Management Asset Management
Liability Management
Capital Adequacy Management
Credit Risk
Interest-rate Risk
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14. Liquidity Management: Ample Excess Reserves
Assets
Liabilities
Reserves
$20M
Deposits
$100M
$10M
$90M
Loans
$80M
Bank Capital
Securities
If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet
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15. Liquidity Management: Shortfall in Reserves
Assets
Liabilities
Reserves
$10M
Deposits
$100M $0
$90M
Loans
Bank Capital
Securities
Reserves are a legal requirement and the shortfall must be eliminated
Excess reserves are insurance against the costs associated with deposit outflows
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16. Liquidity Management: Borrowing
Assets
Liabilities
Reserves
$9M
Deposits
$90M
Loans
Borrowing from other banks or corporations
Securities
$10M
Bank Capital
Cost incurred is the interest rate paid on the borrowed funds. First of 4 ways to meet its 10% reserve requirement.
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17. Liquidity Management: Securities Sale
Assets
Liabilities
Reserves
$9M
Deposits
$90M
Loans
Bank Capital
$10M
Securities
$1M
The cost of selling securities is the brokerage and other transaction costs. This is a second way the bank the bank can help cover the deposit outflow.
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18. Liquidity Management: Federal Reserve
Assets
Liabilities
Reserves
$9M
Deposits
$90M
Loans
Borrow from Fed
Securities
$10M
Bank Capital
Borrowing from the Fed also incurs interest payments based on the discount rate. This is a third way the bank can cover deposit outflow.
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19. 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 but is the fourth way a bank can meet its deposit outflow. Certainly the last option.
Calling in loans antagonizes customers
Other banks may only agree to purchase loans at a substantial discount
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20. Summary of Liquidity Management & Role of Reserves
The previous discussion explains why banks hold excess reserves even though loans and securities earn a higher return.
When a deposit outflow occurs holding excess reserves allows the bank to escape the costs of: 1. borrowing from banks; 2. selling securities; 3. borrowing from the Fed; 4. calling in or selling loans.
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21. Summary of Liquidity Management & Role of Reserves
Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves the bank will want to hold.
Just as you and I want to pay for insurance to protect against losses to say a car or house, so the bank is wiling to pay the cost of holding excess reserves (opportunity cost), to insure against losses due to deposit outflows.
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22. Asset Management: Three Goals
Now we know why a bank has need for liquidity, we look at the strategy the bank has for managing its assets.
Seek the highest possible returns on loans and securities
Reduce risk
Have adequate liquidity
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23. Asset Management: Four Tools
Find borrowers who will pay high interest rates and have low possibility of defaulting. Reduce adverse selection and moral hazard problems.
Purchase securities with high returns and low risk
Lower risk by diversifying
Balance need for liquidity against increased returns from less liquid assets, such as holding securities with a lower return.
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24. Liability Management
Recent phenomenon due to rise of money center banks (large banks in key financial markets, like NY and Chicago) and the federal funds market.
Expansion of overnight loan markets and new financial instruments (such as negotiable CDs)
Checkable deposits have decreased in importance as source of bank funds from 61% of bank liabilities in 1960 to 7% in 2005.
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25. Credit Risk: Overcoming Adverse Selection and Moral Hazard
Screening and information collection
Specialization in lending
Monitoring and enforcement of restrictive covenants
Long-term customer relationships
Loan commitments
Collateral and compensating balances
Credit rationing
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26. Chapter 9 Summary
The balance sheet of commercial banks are a list of sources and uses of bank funds. The banks liabilities are its sources of funds such as checkable deposits. The banks assets are it uses of funds such as reserves, loans & securities.
Banks make profits through asset transformation. They borrow short (accept deposits) and lend long (make loans). As a bank takes in and pays out deposits, it gains and loses reserves.
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27. Chapter 9 Summary
3. Banks will hold more liquid assets that earn lower returns to provide insurance against deposit outflow. Banks manage their assets to maximize profit y seeking the highest return possible while at the same time lowering risk.
Large money center banks handle liability management by seeking out sources of funds by issuing CD’s or actively borrowing from other banks and corporations. Banks manage the amount of capital they hold to prevent bank failure, yet they always want to try and maximize returns to equity holders (shareholders).
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28. Chapter 9 Summary
4. Adverse selection and moral hazard explain the need for many credit risk management principles involving loan activities: screening and monitoring, long-term customer relationships, restrictive covenants and collateral.
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29. Chapter 9 Study questions
(2.) Rank the following bank assets from most to least liquid: a. Commercial loans; b. Securities; c. Reserves; d. Physical capital.
(3.) Using the T-accounts of the First Bank & Second Bank show what happens when Jane writes a $50 check on her account at the First Bank to pay her friend Joe who deposits the check in his account at the second Bank.
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30. Chapter 9 Study questions
3. (4.) What happens to reserves at the First Bank if John withdraws $1000 of cash and Tracy deposits $500 of cash? Use T accounts to explain your answer.
4. (5.) The bank you own has the below balance sheet:
If the bank suffers a deposit outflow of $50 million with a required reserve ratio of on deposits of 10%, what actions must you take to keep your bank from failing?
ASSETS
LIABILITIES
Reserves $ 75 million
Deposits $500 million
Loans $525 million
Bank Capital $100 million
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31. Chapter 9 Study questions
5. (7.) Why has the development of overnight loan markets made it more likely that banks will hold fewer excess reserves?
6. If a deposit outflow of $50 million occurs, which balance sheet would a bank rather have at first, the balance sheet in question 4 or the following balance sheet? Why?
ASSETS
LIABILITIES
Reserves $100 million
Deposits $500 million
Loans $525 million
Bank Capital $100 million
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32. Chapter 9 Study questions
7. (8.) If the bank you own has no excess reserves and a good customer comes in asking for a loan should you turn the customer down, telling him that you have no excess reserves to loan out? Why or why not? What options are available for you to give out the funds your customer needs?
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