Money, Banking, and Financial Markets : Econ. 212

1. Money, Banking, and Financial Markets : Econ. 212 Stephen G. Cecchetti: Chapter 12 Depository Institutions: Banks and Bank Management

2. The Balance Sheet of Commercial Banks Assets: Uses of Funds • The asset side of a bank’s balance sheet includes cash, securities, loans, and all other assets (which includes mostly buildings and equipment). • Cash Items: The three types of cash assets are • reserves (which includes cash in the bank’s vault as well as its deposits at the central bank –Federal reserve in USA); • cash items in the process of collections (uncollected funds the bank expects to receive-checks); • and the balances ofaccounts that banks hold at other banks (correspondent banking).

3. Securities: The second largest component of bank assets; in USA these include U.S. Treasury securities and state and local government bonds. Securities are sometimes called secondary reserves because they are highly liquid and can be sold quickly if the bank needs cash. • Loans: The primary asset of modern commercial banks; includes: • business loans (commercial and industrial loans), • real estate loans, • consumer loans, • inter-bank loans, and • loans for the purchase of other securities. • The primary difference among the various types of depository institutions is in the composition of their loan portfolios.

4. Liabilities: Sources of Funds • Banks need funds to finance their operations; they get them from different savers and from borrowing in the financial markets. • Deposits: There are two types of deposit accounts, transactionsdeposits (checkable deposits) and non-transactions deposits. • Checkable deposits (or transactions deposits): A typical bank will offer 6 or more types of checking accounts. In recent decades these deposits have declinedbecause these accounts pay low interest rates and financial innovations that relaxed the barriers between transactions and non-transaction deposits.

5. Non-transactions Deposits: These include • savings • time deposits • Non-transactions deposits account for nearly two-thirds of all commercial bank liabilities. • Certificates of deposit can be small ($100,000 or less) or large (more than $100,000), and the large ones can be bought and sold in financial markets. • Borrowings: The second most important source of bank funds; banks borrow from • The Central Bank (discount loans) • Other banks • Banks can also borrow by using a repurchase agreement or REPO, which is a short-term collateralized loan in which a security is exchanged for cash, with the agreement that the parties will reverse the transaction on a specific future date (might be as soon as the next day).

6. Bank Capital and Profitability • The net worth of banks is called bank capital; it is the owners’ stake in the bank. Capital is the cushion that banks have against a sudden drop in the value of their assets or an unexpected withdrawal of liabilities. • An important component of bank capital is loan loss reserves, the bank sets aside to cover potential losses from defaulted loans.

7. Bank Profitability • There are several basic measures of bank profitability: • return on assets (after tax net profit divided by its total assets) and • return on equity (after tax net profit divided by its capital). • Net interest income is another measure of profitability; it is the difference between the interest the bank pays and what it receives. Net interest income can also be expressed as a percentage of total assets; that is called net interest margin, or the bank’s interest rate spread. Net interest margin is an indicator of future profitability as well as currentprofitability.

8. Off-Balance-Sheet Activities • Banks engage in these activities in order to generate fee income; these activities include • providing trusted customers with lines of credit. • Letters of credit are another important off-balance-sheet activity; they guarantee that a customer will be able to make a promised payment. In so doing, the bank, in exchange for a fee, substitutes its own guarantee for that of the customer and enables a transaction to go forward. • A standby letter of credit is a form of insurance; the bank promises that it will repay the lender should the borrower default. • Off-balance-sheet activities create risk for financial institutions and so have come under increasing scrutiny in recent years.

9. Bank Risk: Where It Comes from and What to Do About It • Liquidity Risk • Liquidity risk is the risk of a sudden demand for fundsand it can come from both sides of a bank’s balance sheet (deposit withdrawal on one side and the funds needed for its off-balance sheet activities on the liabilities side). • If a bank cannot meet customers’ requests for immediate funds it runs the risk of failure; even with a positive net worth, illiquidity can drive a bank out of business. • One way to manage liquidity risk is to hold sufficient excess reserves (beyond the required reserves mandated by the Central Bank) to accommodate customers’ withdrawals. However, this is expensive (interest is foregone).

10. Two other ways to manage liquidity risk are adjusting assets or adjusting liabilities. • A bank can adjust its assets by selling a portionof its securities portfolio, or by selling some of its loans, or by refusing to renewa customer loan that has come due. • Banks do not like to meet their deposit outflows by contracting the asset side of the balance sheet because doing so shrinks the size of the bank. • Banks can use liability management to obtain additional funds by: • borrowing from the Central Bank • borrowing from another bank, or by • attracting additional deposits (by issuing large CDs).

11. Case 1: holding sufficient excess reserves.- Given the following balance sheet of bank X. - If RRR = 10%. This bank will be holding 5 million excess reserves. - If this bank suffers a deposit outflow of 5. the bank will still be holding excess reserves.

12. Case 2: holding insufficient excess reserves.- Given the following balance sheet of bank Y. - If RRR = 10%. This bank will be holding no excess reserves. - If this bank suffers a deposit outflow of 5. the bank will have a liquidity shortage of 5 million

15. Credit Risk • This is the risk that loans will not be repaid and it can be managed through diversification and credit-risk analysis. • Diversificationcan be difficult for banks, especially those that focus on certain kinds of lending. • Credit-risk analysis produces information that is very similar to the bond-rating systems and is done using a combination of statistical models and information specific to the loan applicant. • Lending is plagued by adverse selection and moral hazard, and financial institutions use a variety of methods to mitigate these problems.

16. Interest-Rate Risk • The two sides of a bank’s balance sheet often do not match up because liabilities tend to be short-term while assets tend to be long-term; this creates interest-rate risk. • In order to manage interest-rate risk, the bank must determine how sensitive its balance sheet is to a change in interest rates; gap analysis highlights the gap or difference between the yield on interest sensitive assets and the yield on interest-sensitive liabilities. • Multiplying the gap by the projected change in the interest rate yields thechange in the bank’s profit. • Gap analysis can be further refined to take account of differences in the maturity of assets and liabilities.

18. Banks can manage interest-rate risk by matchingthe interest-rate sensitivity of assets with the interest-rate sensitivity of liabilities, but this approach increases credit risk. • Bankers can use derivatives, like interest-rate swaps, to manage interest-rate risk. • Trading Risk • Banks today hire traders to actively buy and sell securities, loans, and derivatives using a portion of the bank’s capital in the hope of making additional profits. • However, trading such instruments is risky (the price may go down instead of up); this is called trading risk or market risk.

19. Managing trading risk is a major concern for today’s banks, and bank risk managers place limits on the amount of risk any individual trader is allowed to assume. • Banks also need to hold more capital if there is more risk in their portfolio. • Other Risks • Banks that operate internationally will face foreign exchange risk(the risk from unfavorable moves in the exchange rate) and sovereign risk (the risk from a government prohibiting the repayment of loans). • Banks manage their foreign exchange risk by attracting deposits denominated in the same currency as the loans and by using foreign exchange futures and swaps to hedge the risk.

20. Banks manage sovereign risk by diversification, by refusing to do business in a particular country or set of countries, and by using derivatives to hedge the risk. • Banks also face operational risk, the risk that their computer system may fail or that their buildings may burn down. • To manage operational risk the bank must make sure that its computer systems and buildings are sufficiently robust to withstand potential disasters.

21. Lessons of Chapter 12 • Bank assets equal bank liabilities plus bank capital. • Bank assets are the uses for bank funds. • They include reserves, securities, and loans. • Over the years, securities have become less important and mortgages more important as a use for bank funds. • Banks liabilities are the sources of bank funds. • They include transactions and nontransactions deposits, as well as borrowings from other banks. • Over the years, transactions deposits have become increasingly less important as a source of bank funds. • Bank capital is the contribution of the bank’s owners; it acts as a cushion against a fall in the value of the bank’s assets or a withdrawal of its liabilities. • Banks make a profit for their owners. Measures of a bank’s profitability include return on assets (ROA), return on equity (ROE), net interest income, and net interest margin. • Banks’ off-balance-sheet activities have become increasingly important in recent years. They include: • loan commitments, which are lines of credit that firms can use whenever necessary. • letters of credit, which are guarantees that a customer will make a promised payment.

22. Banks face several types of risk in day-to-day business. They include: • Liquidity risk – the risk that customers will demand cash immediately • Liability-side liquidity risk arises from deposit withdrawals. • Asset-side liquidity risk arises from the use of loan commitments to borrow. • Banks can manage liquidity risk by adjusting either their assets or their liabilities. • Credit risk – the risk that customers will not repay their loans. Banks can manage credit risk by: • diversifying their loan portfolios. • using statistical models to analyze borrowers’ creditworthiness. • monitoring borrowers to ensure that they use borrowed funds properly. • Interest-rate risk – the risk that a movement in interest rates will change the value of the bank’s assets more than the value of its liabilities. • When a bank lends long and borrows short, increases in interest rates will drive down the bank’s profits. • Banks use a variety of tools, such as gap analysis, to assess the sensitivity of their balance sheets to a change in interest rates. • Banks manage interest-rate risk by matching the maturity of their assets and liabilities and using derivatives like interest-rate swaps. • Trading risk – the risk that traders who work for the bank will create losses on the bank’s own account. Banks can manage this risk using complex statistical models. • Other risks banks face include foreign exchange risk, sovereign risk, and operational risk.

23. Key Terms • capital gain capital loss • Consol current yield • default risk holding period return • inflation risk inflation-indexed bonds • interest-rate risk investment horizon • Perpetuity pure discount bond • stripped bond tax incentive • U.S. Treasury bill (T-bill) yield to maturity • yield on a discount basis zero-coupon bond