Chapter 9

1. Chapter 9 Commercial Banks

2. Contents • Commercial Bank Balance Sheet • Commercial Bank Liabilities • Commercial Bank Assets • Commercial Bank Capital Accounts • Commercial Bank Management • Liquidity Management • Liability Management • Capital Management

3. The Importance of Commercial Banks Primary claims Funds Savers Borrower Flow of Fund Financial Intermediaries Funds Funds Primary claims Secondary claims

4. The Importance of Commercial Banks • Depository institutions play a key role in channeling funds from savers (surplus unit) to borrowers (deficit units) • Commercial banks dominate among depository institutions. • Banks take in funds by accepting _____ • Banks use the funds mainly to ______ deposit grant loans

5. The Importance of Commercial Banks • Commercial banks are the oldest and most diversified of all financial intermediaries. • Banks are important in the money supply process. • Banks create money by lending or buying the securities

6. The Commercial Bank Balance Sheet • Banks earn a profit on the “spread” (3%-4%) by obtaining funds at relatively low interest rates and lending at higher interest rates. • In recent years, fees have played an increasingly important role in bank profits.

7. The Commercial Bank Balance Sheet • A bank balance sheet is a statement of its assets, liabilities, and net worth at a given point in time. • Assetsare what it owns. Loan, securities (Investment)  earning assets • Liabilities are what it owes. Demand deposit, saving deposit, time deposit

8. The Commercial Bank Balance Sheet • Net worth (capital accounts, capital)is the difference between its assets and liabilities. Common stocks, retained earning • Assets = Liabilities + Net Worth • Assets - Liabilities = Net Worth

9. Figure 9-1

10. Table 9-1

11. Commercial Bank Liabilities • Transactions Deposits (checkable deposits) • Non-transaction Deposits • Non-deposit borrowing • Other liabilities

12. Commercial Bank Liabilities • Transactions Deposits (checkable deposits) • Demand Deposits: non-interest bearing checking accounts • Negotiable Order Of Withdrawal (NOW) Accounts: interest-bearing checking accounts • Automatic Transfer Service (ATS) Accounts:Paired accounts with checks on non-interest baring accounts & automatic transfers to it from interest-bearing accounts

13. Commercial Bank Liabilities • Non-Transactions Deposits • Passbook Savings Accounts Any amount of funds can be added or withdrawn at any time • Small Certificates of Deposit (CDs up to $100,000) There are penalties if withdrawing before maturity (3 months to 5 years)  similar to time deposit in Thailand • Money Market Deposit Accounts (MMDAs) Special type of saving account with limited check writing feature (no more than 6 times per month) • Negotiable CDs. Large CDs over $100,000

14. Commercial Bank Liabilities • Non-deposit Borrowing • Borrowing from the Fed  discount loans, discount window  pay interest at the discount rate • Borrowing from other banks’ excess reserve  overnights loans between bank  federal funds  pay interest at federal fund rate

15. Commercial Bank Assets • Cash Assets • Loans • Securities • Other Assets

16. Commercial Bank Assets • Most of banks’ assets are in form of income-earning assets or earning assets (85%) • Loan • Securities • However, banks are subjected to maintains portion of their source of funds (liabilities) in form of non-interest-earning legal reserves • Coin and currency in banks • Bank’s deposit balance at the central bank

17. Commercial Bank Assets • Cash Assets • Vault cash - Currency and coins at bank • to meet public’s demand • to meet reserve required • Deposits with Federal Reserve Bank (central bank) • to meet reserve required • to facilitate check clearing process • Deposits with other banks • Correspondent banking – smaller banks maintain deposits in larger banks in return of services e.g. check collection, investment counsel, and transaction in securities and foreign currency

18. Commercial Bank Assets • Loans • Real Estate Loans: collateralized by property (real estate), Ex. Mortgage Securitization – banks bundle many real estate loans into the package and issue the securities based on this package to investors • Business Loans: • Regular installment loans • Lines of credit (subject to compensating balance)

19. Commercial Bank Assets • Consumer Loans: • Auto loans • Credit cards  banks get the fee from business accepting the card and also get the interest rate if the cardholders design to pay the minimum balance. • Overdraft arrangement • Other Loans: • Federal funds sold • Securities • Other assets  Building, Land, Equipment

20. Commercial Bank Capital Accounts • Bank capital derives from the issue of bank stock shares and from retained earnings • Bank capital provides a cushion that protects a bank's owners from potential bank insolvency • Total assets are less than total liabilities • Negative net worth

21. Writing Off Bad Loans Bank needs to write off $600,000 for bad loans

22. Writing Off Bad Loans • Immediate write off bad loans can make the bank to face the situation of insolvency. • Close the banks • Find new owners to take over the bank (through Merger & Acquisition) • Bank usually (also subject to the regulation) sets aside contingent funds against loan loss in advance  loan loss reserve (Allowance for bad debts)

23. Commercial Bank Management • Commercial banks strive to: • earn solid profits; • maintain extremely low exposure to the possibility of becoming insolvent, and • maintain high liquidity(the ability to immediately meet currency withdrawals) by managing liquidity and capital.

24. T-Accounts • T-accounts are statements of the change in the balance sheet resulting from a given event. • ie. if a customer withdraws $200 in cash from a savings account at the Bank of Medicine Bow. • ie. Clearing a check for $12,000 written by a bank customer

25. The Importance of Liquidity • Banks must have emergency plans to meet large reserve withdrawals, so banks need to hold liquid assets like Treasury bills. • If a bank is exposed to large deposit outflows and can obtain reserves only at substantial cost, it could find itself in serious trouble, even if it has a relatively large capital account.

26. The Liquidity-Risk Trade-off • If bank decides to maintains high liquidity, bank will face less risk • If bank decides to maintains low liquidity, bank will face higher risk

27. The Liquidity-Risk Trade-off • With a reserve requirement of 10%, the bank has no excess reserves. • Its assets are 90% in high return loans and 10% in low return securities. • What if depositors withdraw $20 million?

28. The Liquidity-Risk Trade-off • If depositors withdraw $20 million, • Deposit decreases to $380 million • Reserves also decreases to $20 million • However, required reserve ratio is 10%, bank need to maintain reserves at $38 million  bank need to find more reserve for $18 million • Bank has marketable securities (liquid assets) only $10 million that is not enough  bank need to find other funds

29. The Liquidity-Profitability Trade-off • If bank decides to maintains low liquidity, bank will have a change to get higher return • If bank decides to maintains high liquidity, bank will get lower return • Higher liquidity means bank will hold more excess reserve (no return) and more marketable securities (low return) rather than lending the loan (higher return)

30. The Liquidity-Profitability Trade-off • The bank has $10 million excess reserves. • Its assets are split between high return loans & low return securities.

31. The Liquidity-Profitability Trade-off • If depositors withdraw $20 m, then the balance sheet changes • Deposit decrease to $380 million • Reserves decrease to $30 million • With 10% required reserve ratio, bank has to maintain $38 million reserve  bank need more $8 million • Bank have lots of marketable securities to be liquidated and change to reserve  no problem • However, it is less profitable because it has fewer high-return loans.

32. The Liquidity-Profitability Trade-off • If bank decides to maintains low liquidity, bank will face higher risk but have more opportunity to get higher return • If bank decides to maintains high liquidity, bank will face lower risk and get lower return

33. Indicators of Bank Liquidity • The ratio of bank loans to total assets • Higher ratio  lower liquidity • The ratio of securities to total assets • Higher ratio  higher liquidity • The ratio of demand deposit to total bank deposits • Higher ratio  Bank need to maintain more liquidity

34. Liability Management • Banks look for good lending opportunities and then search for the funds to finance these loans. • When a large bank finds a profitable lending opportunity, it can: • “buy” federal funds; • issue negotiable CDs at whatever interest rate is required to attract funds; • issue repurchase agreements or borrow Eurodollars, or • obtain funds through the commercial paper market.

35. Liability Management • Aggressive liability management can be dangerous, because a bank’s assets typically have longer maturities than its liabilities. • If interest rates rise sharply, banks can suffer severe losses. • Aggressive liability management allows banks to make profitable loans that they would otherwise have to turn down.

36. Liability Management Loans 5% 5% 5% Now 2nd year 3rd year 10th year 7% 4% 1% Deposit

37. Capital Management • Bank capital provides a financial cushion so that transitory adverse developments will not cause insolvency. • Bank capital also protects bank managers and owners from their own mistakes and from various risks: • default risk  borrowers do not pay back their loans • interest-rate risk  when interest rate changes • liquidity risk  depositors will withdraw the fund • Foreign exchange rate risk  when exchange rate change • political or country risk  risk that fund or assets in other countries cannot be mobilized to home country • management risk  employees will engage in activities involving enormous risk (Barings Bank – Nicholas Leeson)

38. Capital Management • Bank capital ratio = • higher bank capital ratio • implies a lower risk of insolvency, • but also a lower rate of return. Capital Asset

39. The Capital Management Tradeoff Earning Earning Total Assets x = Capital Total Assets Capital Return on Equity = ROA * Equity Multiplier Note: A high capital ratio represents a low equity multiplier; A low capital ratio represents a high equity multiplier A trade-off arises between short-run profitability & the risk of insolvency

40. Capital Management Earning/Capital = Earning/TA x TA/Capital Suppose a bank has net income (earnings) 1m, TA 100m Case 1: a bank has capital = 5m Earning / Capital = ??? Case 2 : a bank has capital = 10m Earning / Capital = ???

41. Summary • Commercial bank raise the funds from accepting deposit and use the funds in granting the loan • Bank earn interest rate spread between deposit rate and loan rate and also earn the service fees • If bank faces daily shortage in reserve, bank can borrow from Fed at discount rate or borrow from other banks at fed fund rate • Loans are most-income-earning assets of the banks • Banks are subjected to maintains portion of their source of funds in form of non-interest-earning legal reserves (currency and deposit at Fed)

42. Summary • Smaller banks maintain deposits in larger banks in return of services e.g. check collection, investment counsel, and transaction in securities and foreign currency  Correspondent banking system • Bank may bundle many real estate loans into the package and issue the securities based on this package to investors  securitization • Bank becomes insolvency if total asset is less than total liability or negative net worth (equity)

43. Summary • If bank decides to maintains low liquidity, bank will face higher risk but have more opportunity to get higher return • Aggressive liability management can be dangerous, because a bank’s assets typically have longer maturities than its liabilities. If interest rates rise sharply, banks can suffer severe losses. • Bank capital provides a cushion that protects a bank's owners from potential bank insolvency • higher bank capital ratio, implies a lower risk of insolvency, but also a lower rate of return.