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CAPITAL MARKETS

CAPITAL MARKETS. BSC/BBA III Winter Semester 2010 Lahore School of Economics. Chapter 3 Depository Institutions. Depository Institutions Learning Objectives. What is a depository institution? How a DI generates income? What is the Asset/Liability problem for DI’s? What is Funding Risk?

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CAPITAL MARKETS

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  1. CAPITAL MARKETS BSC/BBA III Winter Semester 2010 Lahore School of Economics

  2. Chapter 3Depository Institutions

  3. Depository InstitutionsLearning Objectives • What is a depository institution? • How a DI generates income? • What is the Asset/Liability problem for DI’s? • What is Funding Risk? • What are DI’s funding sources? • What are Reserve Requirements?

  4. Depository Institutions? Include:

  5. Depository Institutions? Include: • Institutions that take deposits Deposits represent Liabilities (debt) for DI’s Include: • Banks • Savings & Loan institutions • Credit Unions

  6. How do DI’s make money? 3 ways:

  7. How do DI’s make money? 3 ways: • Loans Make direct loans to entities • Securities investments Investing in securities & holding portfolios • Fees Charged to their customers

  8. Importance of DI’s? Heavily regulated because:

  9. Importance of DI’s? Heavily regulated because: • Their role in financial system a) Creating the financial playing field • Principal means of making payments a) Individuals & Businesses use for payments • Vehicle for Govt monetary policy a) MP implemented through banking system

  10. Special Privileges • Access to Federal Deposit Insurance • Provision of liquidity in emergencies • Govt has interest in DI’s stability & survival…

  11. Asset-Liability Management 2 Main problems: • Funding Risk • Liquidity Risk

  12. Asset-Liability Management Funding Risk: Illustrate using 100MM, 7% 1 & 10 yrs • Use of Spreads(DI’s make money) Difference between bid/ask or charging premiums • Gaps Open positions created due to duration differences • Interest rate exposure Funding activity resulting in interest rate risk

  13. Asset-Liability Management Opportunities:

  14. Asset-Liability Management Opportunities: • Interest Rate view Managers who have expectations of interest rate changes will seek to profit from funding! • If Interest rates rise What position should you have? • If interest rates fall What position should you have?

  15. Asset-Liability Management Opportunities: • Interest Rate view Managers who have expectations of interest rate changes will seek to profit from funding! • If Interest rates rise DI will benefit if it has borrowed long & lent short because when interest rates will rise its cost will remain unchanged but will be able to lend at a higher rate! • If interest rates fall DI will benefit if it has borrowed short & lent long!

  16. Asset-Liability Management Threats of positioning:

  17. Asset-Liability Management Threats of positioning: • Adverse financial consequences If expectations are not realized, Huge losses can occur • No one can predict interest rates consistently Highly risky • Becomes same as gambling Long run losses highly likely

  18. Asset-Liability Management Main goal of Mgmt:

  19. Asset-Liability Management Main goal of Mgmt: • Try Locking in the spread • Minimize interest rate exposure • Various financial instruments used to manage risk

  20. Asset-Liability Management Main goal of Mgmt: • Try Locking in the spread (By not trying to bet on interest rate movements, focus should solely be on earning from the spread not on interest rate movements) • Minimize interest rate exposure (By investing in assets & Liabilities of similar maturity ranges) • Various financial instruments used to manage risk (Examples include interest rate options, swaps & forwards)

  21. Liquidity Concerns of DI’s? Balancing two activities?

  22. Liquidity Concerns of DI’s? Balancing two activities: • Satisfy Withdrawals of customers (Liquidity Concerns) Liquidity required • Provide Loans to customers (Earnings)

  23. Liquidity Concerns of DI’s? 4 ways to solve liquidity issues?

  24. Liquidity Concerns of DI’s? 4 ways to solve liquidity issues: • Attract deposits • Borrowing from Federal Agency or other Financial Institutions (using security collateral) • Sell Securities on hand • Raise Funds in Money Markets

  25. Liquidity Concerns of DI’s? Increase Borrowing using securities: • Discount window borrowing at Fed

  26. Liquidity Concerns of DI’s? Sell securities it owns: • DI must invest in ST, liquid securities with little Price Risk and keep these in its inventory • E.g: stocks?... No, Bonds? …. No • Solution: ?

  27. Liquidity Concerns of DI’s? Sell securities it owns: • DI must invest in ST, liquid securities with little price risk and keep these in its inventory • E.g stocks?... No, Bonds? …. No • Solution: Short term, Money Market instruments like Treasury Bills, Commercial Papers etc

  28. Liquidity Concerns of DI’s? SECONDARY RESERVES? • Securities held by a DI for the purpose of satisfying withdrawals or loans. • Disadvantage? Lower yield % of assets as secondary reserves depends on DI’s risk/return appetite

  29. Liquidity Concerns of DI’s? One more reason for holding liquid assets?

  30. Liquidity Concerns of DI’s? One more reason for holding liquid assets? • To fulfill Govt regulation! • In form of Reserve Requirements (discussed later)

  31. Commercial Banks 3 Main Types of services:

  32. Commercial Banks 3 Main Types of services: • Individual Banking • Institutional Banking • Global Banking

  33. Commercial Banks Individual Banking • Consumer Lending • Residential Mortgage • Credit Card financing • Car & Boat Financing • Brokerage services • Student Loans

  34. Commercial Banks Institutional Banking: • Loans to Corporations • Loans to Insurance companies • Loans to Government • Commercial Financing & Leasing

  35. Commercial Banks Global Banking: • Foreign Exchange products • Capital Markets products • Corporate financing products

  36. Commercial Banks How do Banks raise Funds?

  37. Commercial Banks How do Banks raise Funds? 3 Main Sources of Funds • Deposits • Non-Deposit Borrowing • Common Stock & Retained Earnings

  38. Commercial Banks How do Banks raise Funds? 3 Main Sources of Funds • Deposits (Demand Deposit, Savings Deposit, Time Deposits) • Non-Deposit Borrowing (Borrowing from Federal Reserve through Discount window, Repurchase Agreements, borrowing by the issuance of instruments in the money & bond market) • Common Stock & Retained Earnings

  39. Commercial Banks Reserve Requirement & Borrowing at the Fed Funds Market? • Banks must maintain a %age of deposits with Federal Reserve called Reserve Ratio. • The cash kept with Fed is called Required Reserve.

  40. Reserve Requirement Type of Deposits: • Transaction Deposits • Non-transactions Deposits Reserve Ratios are higher for transaction Deposits relative to non transaction deposits!

  41. Reserve Requirements • Reserve maintenance period 2 Week period where the average of the daily total of each type of deposit is taken to get RR (THR-WED) • Actual Reserves Average Amount of Reserves held at the close of business at the Federal Reserve Bank during each day of a two week reserve maintenance period. • Excess Reserves If bank reserves exceed the RR at the Fed • Fed Funds Market & Fed Funds Banks short of RR borrow from Excess Reserves of other Banks at Fed Funds rate.

  42. Reserve Requirements Fed Discount Window: • Fed is the Banker’s Bank – last resort • Charges DISCOUNT RATE • Collateral Treasury securities, Govt securities etc. • Heavily Discourages its use Will investigate if use becomes frequent

  43. Regulations • Regulation of Interest rates • Geographical Restrictions • Permissible Activities for Commercial Banks • Capital Requirements for Commercial banks

  44. Regulations • Regulation of Interest rates Ceilings imposed on the interest rate that can be paid on Deposit Accounts. • Geographical Restrictions This legislation was intended to prevent large banks from expanding geographically & thereby taking over smaller banking entities, threatening competition. • Permissible Activities for Commercial Banks • Capital Requirements for Commercial banks

  45. Permissible Activities for Commercial Banks • The permissible activities of banks are limited to those that are viewed by the Fed as closely “related to banking”. • Banks can neither underwrite securities & stocks, nor can act as dealers in the secondary market. • Banking act of 1933 Prohibits any depository institution from engaging in the securities business.

  46. Capital Requirements for Commercial Banks • The ratio of equity Capital to total assets is low, typically less than 8% in case of banks. • “Off Balance Sheet Obligations” • Risk Based Capital Requirements

  47. Risk Based Capital Requirements Types of Capital • Tier 1 Capital (Core Capital) It consists basically of common Stockholder’s Equity, Preferred Stock & minority interest in subsidiaries. It is based on book Value of Total Assets. • Tier 2 Capital(Supplemental Capital) It includes loan loss Reserves, Perpetual Debt & hybrid Capital Instruments. It is based on Risk Weighted Assets.

  48. Risk Based Capital Requirements

  49. Risk Based Capital Requirements- Example

  50. Risk Based Capital Requirements- Example

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