1. Chapter 9, 4 th edition Chapter 10, 3 rd edition Banking and the Management of Financial Institutions

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. © 2012 Pearson Prentice Hall. All rights reserved. 17-3 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2011

5. © 2012 Pearson Prentice Hall. All rights reserved. 17-4 Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2014)

6. Liabilities – Sources of Funds  Checkable Deposits: Referred to as transactions deposits, includes all accounts that allow the owner (depositor) to write checks to third parties; ─Include non-interest earning checking accounts (known as - demand deposit accounts), ─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

7. 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.  Also the largest source of funds ~ 58%

8. 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

10. 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  Currently a very important topic in bank regulation

11. Assets – Uses of Funds  Reserves: funds held in account 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.

12. 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 Treasury debt (Treasury Bills) is often referred to as secondary reserves because of its high liquidity.

13. 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).

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

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

16. Commercial Bank Liability Trend Nontransaction Deposits (55%) Borrowing (23%, around 31% in 2008)  Discount loans for the Fed  Reserves from other banks in the Federal Funds Market (unsecured)  Repurchase agreements Bank Capital (12%)

17. © 2012 Pearson Prentice Hall. All rights reserved. 17-16 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.

18. Balance Sheet of Commercial Banks: Changes in Assets over time 1947-2006 Securities Down Secondary Markets, Increased Liquidity Security holdings down from 70% in 1947 to 19% in 2014. Loans( C&I, mortgage, and consumer loans) over 50%.

19. Basic Banking Transaction Cash Deposit of $100 in First National Bank The above example presents 2 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 First National Bank AssetsLiabilitiesAssetsLiabilities Vault Cash +$100Checkable deposits +$100Reserves+$100Checkable deposits +$100

20. First National BankSecond National Bank AssetsLiabilitiesAssetsLiabilities Reserves+$100Checkable deposits +$100Reserves-$100Checkable deposits -$100 Basic Banking Transaction Check Deposit of $100 into FNB written on SNB FNB gains reserves and SNB loses reserves

21. Basic Banking - Making a Profit 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) First National Bank AssetsLiabilitiesAssetsLiabilities Required reserves +$10Checkable deposits +$100Required reserves +$10Checkable deposits +$100 Excess reserves +$90Loans+$90

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

23. General Principles of Bank Management 1.Liquidity management 2.Asset management ─Managing credit risk ─Managing interest-rate risk 3.Liability management 4.Managing capital adequacy How does a bank manage its assets and liabilities. Four primary concerns:

24. Principles of Bank Management Liquidity Management Reserves requirement = 10%, Excess reserves = $10 million  With 10% reserve requirement, bank has excess reserves of $1 million: no changes needed in balance sheet Deposit outflow = $10 million

25. Liquidity Management  With 10% reserve requirement, bank has $9 million reserve shortfall No excess reserves - Deposit outflow of $10 million

26. Liquidity Management - Shortfall in Reserves: Borrow from other banks or corporations. Other banks - Federal Funds Market Corporations - CP or Repo There’s a cost - interest rate paid on the borrowed funds AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrowing$9M Securities$10MBank Capital$10M

27. Liquidity Management: Borrow from the Fed There’s a cost - payments to Fed based on the discount rate AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrow from Fed$9M Securities$10MBank Capital$10M

28. Liquidity Management: Sell Securities There are costs: transaction costs and possible capital loss. AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBank Capital$10M Securities$1M

29. Liquidity Management: Reduce Loans Reduction of loans is the most costly way of acquiring reserves  Calling in loans (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 AssetsLiabilities Reserves$9MDeposits$90M Loans$81MBank Capital$10M Securities$10M

30. Asset Management  Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk. 1.Get borrowers with low default risk, paying high interest rates 2.Buy securities with high return, low risk 3.Diversified portfolio 4.Manage liquidity

31. 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

32. Liability Management  Managing the source of funds: from deposits, to CDs, to other debt. 1.Important since 1960s 2.No longer primarily depend on deposits 3.More dependent on non-transactions deposits and borrowing. ─ Growth in borrowing from 2% in 1960 to 31% in 2008. ─ Negotiable CDs at 19%

33. Bank Capital (Equity) Assets – Liabilities = Net Worth Called Bank Capital.  The value of the bank to its owners. In Jan 2007, commercial bank capital was $860 billion equal to 8.8% of total assets of $9.77 Trillion) June 2011 bank capital at 12% of assets

34. Capital Adequacy Management Bank capital is a cushion that helps prevent bank failure.  As banks write down assets, bank capital takes a hit. Regulatory requirement – regulators set minimum capital requirements.

35. Capital Adequacy Management High Capital bank has a 10% capital ratio. Low Capital bank has a 4% capital ratio.

36. Capital Adequacy Management: Preventing Bank Failure When Assets Decline 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 Scenario: Borrower defaults on $5 million loan and minimum capital requirement is 5%.

37. Capital Adequacy Management: Return to Equity Holders

38. © 2012 Pearson Prentice Hall. All rights reserved. 17-37 Capital Adequacy Management Tradeoff between safety (high capital) and ROE Prudent to hold equity capital. Unfortunately, banks aren’t very prudent. Banks required to hold capital to meet minimum capital requirements imposed by regulators. If Equity Capital ↑ => EM ↓ => ROE ↓

39. © 2012 Pearson Prentice Hall. All rights reserved. 17-38 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)

40. Basic Strategies for Managing Capital What should a bank manager do if she feels the bank is holding too much capital?  Use equity capital to buy or retire stock  Increase dividends to reduce retained earnings  Increase asset growth using debt (like CDs)

41. 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

42. Bank Profitability ROA is typically 1.2 to 1.3% ROE is 10 to 12 times ROA. Let’s take a look: https://www2.fdic.gov/qbp/2014dec/cb1.html

43. Bank Capital Currently, U.S. commercial banks combine about $1.5 trillion in bank capital (equity) with $11.0 trillion of borrowed funds to purchase $12.5 trillion in assets. Ratio of Assets/Equity = 12.5/1.5 = 8.33 (down from over 11) Flip: 1.5/12.5 = 12% Government guarantees contributes to banks ability to hold so much debt.

44. Leverage of Various Financial Institutions prior to Financial Crisis Assets $Trillion Liabilities $Trillion Equity $Trillion Leverage Assets/Equity Commercial Banks 10.89.71.1 9.8(10.2%) Savings Inst. 1.911.68.238.4 (11.9%) Credit Unions 0.75.66.098.4 (11.9%) Investment Banks 5.45.23.1731.7 (1/31.7) = 3.15% GSEs1.631.56.06724.7 (4.0%) Overall20.518.81.712.2 (8.2%)

45. 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 $10 Debt $90 Loans/Securities $90 Equity Capital $10 Total $100 National Capital Bank – December Assets Liabilities Cash $10 Debt $99 Loans $100 Equity Capital $11 Total $110 National Capital Bank – June Assets Liabilities Cash $10 Debt $90 Loans/Securities $91 Equity Capital $11 Total $101 capital ratio is 10.89% > 10%

46. 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 $10 Debt $90 Loans/Securities $90 Capital $10 National Capital Bank – December Assets Liabilities Cash $10 Debt $81 Loans/Securities $80 Capital $9 Total $90 National Capital Bank – June Assets Liabilities Cash $10 Debt $90 Loans/Securities $89 Capital $9 capital ratio is 9.09% < 10%

47. 9-46 Bank does not have to de-leverage if it can raise more equity capital and pay off some debt National Capital Bank – June Assets Liabilities Cash $10 Debt $89.1 Loans/Securities $89 Capital $9.9 capital ratio is = 10%

48. How a Capital Crunch Caused a Credit Crunch in 2008  Housing boom and bust led to large bank losses (including losses on SIVs which had to be recognized on the balance sheet ).  Value of assets reduced.  The losses reduced bank capital.  Banks required to rebuild capital – a capital crunch!

49. How a Capital Crunch Caused a Credit Crunch in 2008  Banks had two option: (1) raise new capital or (2) reduce lending.  Guess which route they chose?  Why would banks be hesitant to raise new capital (equity) during an economic downturn and a financial crisis?

50. Banks Must also Manage Interest-Rate Risk: Bank assets don’t match liabilities Banks “borrow short” and “lend long” Creates a maturity mismatch

51. 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)

52. Managing Interest Rate Risk What happens if interest rate rise?  Deposit cost based on flexible short-term interest rates rise.  Loan revenues based on fixed interest rate remain fixed.  Profit reduction

53. Interest-Rate Risk – Simple Gap Analysis 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(RSA) $20MRate-sensitive liabilities (RSL) $50M Variable-rate and short-term loans Variable-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

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

55. Managing Interest-Rate Risk Basis Gap Analysis GAP= rate-sensitive assets – rate-sensitive liabilities = $20 – $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

56. Off-Balance-Sheet Activities 1.Loan sales 2.Fee income from ─Foreign exchange trades for customers ─Servicing mortgage-backed securities ─Guarantees of debt ─Backup lines of credit 3.Trading Activities and Risk Management Techniques ─Financial futures and options ─Foreign exchange trading ─Interest rate swaps  All these activities involve risk and potential conflicts

57. © 2012 Pearson Prentice Hall. All rights reserved. 17-56 Special Purpose Vehicle Loans All Other Assets Deposits Other Liabilities Capital Bank AssetsLiab. Assets Liab. SPV Cash Loans ABS Investors Cash ABS Converting on-balance sheet assets to a securitized asset: SPV is set up solely for this purpose. It acts as a conduit passing cash flows to investors for a fee. It has no rights to the cash flows and it ceases to exist when the Asset Backed Security (ABS) matures.

58. © 2012 Pearson Prentice Hall. All rights reserved. 17-57 Structured Investment Vehicle Loans All Other Assets Deposits Other Liabilities Capital Bank AssetsLiab. Assets Liab. SIV Cash Loans Commercial Paper Repo Investors Cash ABCP and Repo Converting on-balance sheet assets to a securitized asset: SIV is a structured operating company set up to earn higher returns then its cost of funds. Borrows very short-term and invest long-term. How does this differ from a bank? Huge liquidity risk!