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Chapter 10

Chapter 10. Banking and Bank Management. Chapter 9 ALTERNATE 8TH EDITION. Depository Institutions: The Big Questions. Where do banks get their funds and what do they do with them? How do commercial banks manage their balance sheets? What risks do banks face?.

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Chapter 10

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  1. Chapter 10 Banking and Bank Management Chapter 9 ALTERNATE 8TH EDITION

  2. Depository Institutions: The Big Questions • Where do 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. Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2011

  5. Balance Sheet of All Commercial Banks (items as a percentage of the total, December 2008)

  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

  7. Liabilities – Sources of Funds Non-transactionDeposits: 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.

  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

  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.

  10. 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 under required reserve ratios. Any reserves beyond this are called excess reserves.

  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 Treasury debt is often referred to as secondary reserves because of its high liquidity.

  12. Assets – Uses of Funds Loans: business loans, auto loans, and mortgages. Generally not very liquid. 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 (10%, 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.

  15. 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%, up from 10% in 2008)

  16. Balance Sheet of Commercial Banks:Changes in Assets (use of funds)over time 1947-2006 Securities Down Secondary Markets, Increased Liquidity Security holdings down from 70% in 1947 to less than 20% in 2011. Loans( C&I, mortgage, and consumer loans) over 50%.

  17. The Balance Sheet of Commercial Banks – Sources of Funds • 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. 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 increase in the bank’s reserves equal to the increase in checkable deposits(NOTE: vault cash counts as reserves)

  19. Check Deposit of $100 into FNB written on SNB FNB gains reserves and SNB loses reserves

  20. Basic Banking - Making a Profit • 10% Reserve Requirement • Banks use excess reserves to make loans or invest in bonds. • The bank makes a profit because it borrows short and lends long

  21. 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

  22. General Principles of Bank Management How does a bank manage its assets and liabilities. Four primary concerns: • Liquidity management • Asset management • Managing credit risk • Managing interest-rate risk • Liability management • Managing capital adequacy

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

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

  25. 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

  26. Liquidity Management: Borrow from the Fed • Incur interest cost - payments to Fed based on the discount rate

  27. Liquidity Management: Sell Securities • There are costs: transaction costs and possible capital loss.

  28. 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 • Not a liquid asset, other banks may only agree to purchase loans at a substantial discount

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

  30. 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

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

  32. 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 million, 8.8% of assets ($9.77 Billion) • June 2011 bank capital at 12% of assets

  33. 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.

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

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

  36. Capital Adequacy Management: Return to Equity Holders

  37. Capital Adequacy Management If Equity Capital ↑ =>EM ↓ => ROE ↓ Tradeoff between safety (high capital) and ROE Banks also hold capital to meet capital requirements

  38. Strategies for Managing Capital What should a bank manager do if she feels the bank is holding too much capital? • Buy or retire stock • Increase dividends to reduce retained earnings • Increase asset growth via debt (like CDs)

  39. Strategies for Managing Capital Reverse these strategies if bank is holding too little capital? • Issue stock • Decrease dividends to increase retained earnings • Slow asset growth (retire debt)

  40. Equity Multiplier and Capital Ratio • This 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

  41. Bank Profitability ROA is typically 1.2 to 1.3% ROE is 10 to 12 times ROA. Let’s take a look: http://www2.fdic.gov/qbp/2013dec/cb1.html

  42. Bank Capital • 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 debt/equity = 10 to 1 historically. Highly leveraged. Now about 8 to 1. • Non-financial corporation about 1 to 1. • Ratio of Assets/Equity = 12.5/1.5 = 8.33 (down from over 11) • Note: Government guarantees contributes to banks ability to hold so much debt.

  43. Leverage of Various Financial Institutions prior to Financial Crisis

  44. Suppose banks are required to maintain a capital ratio of 10%. Assume times are good and loan portfolio increases by $1. National Capital Bank – Sheet 1 Assets Liabilities Cash $10 Debt $90 Loans/Securities $90 Equity Capital $10 Total $100 Total $100 National Capital Bank – Sheet 2 Assets Liabilities Cash $10 Debt $90 Loans/Securities $91 Equity Capital $11 Total $101 capital ratio is 10.89% > 10% National Capital Bank – Sheet 3 Assets Liabilities Cash $10 Debt $99 Loans $100 Equity Capital $11 Total $110 Total $110

  45. The mechanism works in reverse when times are not so good. Loan portfolio decreases by $1. De-leveraging the balance sheet National Capital Bank - Sheet 1 Assets Liabilities Cash $10 Debt $90 Loans/Securities $90 Capital $10 National Capital Bank – Sheet 2 Assets Liabilities Cash $10 Debt $90 Loans/Securities $89 Capital $9 capital ratio is 9.09% < 10% National Capital Bank – Sheet 3 Assets Liabilities Cash $10 Debt $81 Loans/Securities $80 Capital $9 Total $90 Total $90

  46. 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). The losses reduced bank capital.

  47. How a Capital Crunch Caused a Credit Crunch in 2008 • Banks were forced to either (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?

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

  49. Managing Interest Rate Risk • Also, banks have 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) • What happens if interest rate rise? • Deposit costs based on flexible short-term interest rates rise. • Loan revenues based on fixedinterest rate remain fixed. • Profit reduction

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