Chapter 9

1. Chapter 9 The Banking Firm and the Management of Financial Institutions g Dr. Reyadh Faras

2. Commercial banks are the most important financial intermediaries in the economy, so it is important to understand how they operate, and understand bank management. THE BANK BALANCE SHEET • To understand how a bank operates, we first examine a commercial bank's balance sheet, where: Total Assets = Total Liabilities + Capital   Dr. Reyadh Faras

3. ميزانية البنك التجاري (Balance Sheet) Dr. Reyadh Faras

4. The Bank Balance Sheet Dr. Reyadh Faras

5. BANK LIABILITIES (Sources of Funds, Sources of costs) 1. Checkable Deposits (11%) Are bank accounts that allow owner of the account to write checks to third parties. They include: a. Demand deposits (non-interest-bearing checking) b. Negotiable Order of Withdrawal (NOW) accounts (interest-bearing checking) c. Money market deposit accounts (MMDAs) - money market mutual funds. Dr. Reyadh Faras

6. Checkable deposits are payable on demand, you can write a check for any amount, including your entire balance. • Checkable deposits are lowest cost source of funds for a bank, sometimes zero (demand deposits). • Because people like the liquidity of checking accounts, they are willing to forego interest for convenience of checks. Dr. Reyadh Faras

7. 2. Nontransaction Deposits (52%) Account owner is not allowed to write checks, but receives interest rates higher than checkable deposits. a. Savings accounts: Funds can be added or withdrawn from the account. b. Time Deposit Accounts: • Fixed maturity from several months to 10 years. • Higher interest rates than saving accounts. • Has penalties for early withdrawal. • Less liquid. • More costly source of funds for the bank. Dr. Reyadh Faras

8. Interest Rates on KD Time Deposits (%) Dr. Reyadh Faras

9. 3. Borrowings (29%) a. From other banks (interbank Market) b. From the central bank (discount Window) c. From parent companies (bank holding companies) d. From corporations (repurchase agreements) e. From foreign banks (Eurodollar deposits) f. Issue debt instruments (Commercial Papers, Bonds) Dr. Reyadh Faras

10. 4. Bank capital (Net Worth) (8%) • Net worth is the difference between total assets and liabilities. • Consists of stocks and retained earnings. • Bank capital is a cushion against a drop in the value of assets, to protect against bankruptcy (insolvency). Dr. Reyadh Faras

11. BANK ASSETS(Uses of Funds, Sources of income): Banks use their deposits to acquire income-earning assets, to make profits, by earning more interest on assets than they pay out on liabilities. 1. Reserves (1%): • Consists of deposits kept on account at the central bank  plus cash held at the bank. • Some reserves are required by the central bank and others are voluntary. Dr. Reyadh Faras

12. Required Reserves:banks are required to hold a percentage of certain deposits in an account at the central bank. • Excess reserves: in addition to required reserves, banks hold extra reserves for increased liquidity (to meet demand for cash withdrawals and check clearing). Dr. Reyadh Faras

13. The Required Reserve Ratio Over Time (%) Dr. Reyadh Faras

14. The Required Reserve Ratio Around the World Dr. Reyadh Faras

15. Required and Excess Reserves in the US: 2007- 2009 Dr. Reyadh Faras

16. 2. Cash Items in Process of Collection Funds from checks written on other banks but are not yet collected (received) from the other bank. 3. Deposits at Other Banks Many (small) banks hold deposits at other (larger) banks to use them in getting a number of services such as: check collection, foreign exchange transactions, and buying securities. Dr. Reyadh Faras

17. 4. Securities (22%): • An important source of income to banks. • Made up entirely of government debt instruments because commercial banks are not allowed to own stocks. • Short term securities are highly liquid, thus are called secondary reserves. Dr. Reyadh Faras

18. 5. Loans (66%): Most bank profits come from Loans.  A loan is a liability for the borrower but an asset for the bank because it generates income. Loan Types: a. Commercial loans to businesses b. Real estate loans (mortgages, home improvement loans) c. Consumer loans (Cars, furniture) d. Interbank loans (overnight loans to other banks through the interbank market) Dr. Reyadh Faras

19. Loans are less liquid than other assets because they are tied up for the length of the loan. • Loans are also more risky, have higher default risk than securities. • Because loans are more risky and less liquid, they earn more interest for banks. 6. Other Assets (7%): • Buildings, office equipment, computer systems, etc. Dr. Reyadh Faras

20. Summarized Balance Sheet Dr. Reyadh Faras

21. BASIC OPERATION OF A BANK • Asset Transformation: • Banks make profits by selling liabilities with one set of characteristics (liquidity, risk, and return) and buying assets with different set of characteristics. Example: A savings deposit (liability) can be used by the bank to make a loan (asset). • The bank borrows short-term and lends long-term. Dr. Reyadh Faras

22. Characteristics of Assets and Liabilities Dr. Reyadh Faras

23. Weighted Averages Interest Rates on Loans and Deposits in Kuwait (%) Dr. Reyadh Faras

24. The process of asset transformation and providing services (e.g. check clearing, credit analysis) is similar to the production process by firms. • If the bank produces at low cost and earns higher return on its assets, then it makes profit, vice versa. • A tool used in analyzing bank operation is the T-account: a simplified balance sheet that lists only changes occurring in balance sheet items from a transaction. Dr. Reyadh Faras

25. Example 1 • 1. A person opens a checking account at “First National Bank (FNB)” with $100 in cash. This shows up as a liability on the bank balance sheet. • If the bank keeps the $100 as cash, this raises the bank assets (vault cash). First National Bank Dr. Reyadh Faras

26. Since the cash is part of the bank’s reserves, we can rewrite the T-account as follows: First National Bank Result:opening a checking account with cash increases the bank’s reserves equal to the increase in checkable deposits. Dr. Reyadh Faras

27. Example 2 2. If a person opens a checking account with a $100 check written on her account at another bank “Second National Bank (SNB).” • FNB is owed $100 by SNB. This asset for FNB appears in its T-account as cash items in process of collection. • FNB deposits the check in its account at the central bank who transfers $100 of reserves from SNB to FNB. Dr. Reyadh Faras

28. First National Bank The final balance sheet positions of the two banks are as follows: First National Bank Dr. Reyadh Faras

29. Second National Bank Result: when opening a checking account with a check, the bank receiving the deposit gains reserves equal to the amount of the check, while the bank on which the check is written loses reserves by the same amount. Dr. Reyadh Faras

30. Making profit • If FNB receives a $100 checkable deposit. • If the required reserve ratio is 10%. • The required reserves are $_____, and the excess reserves are $_____. The T-account becomes: First National Bank Dr. Reyadh Faras

31. If the FNB decides not to hold excess reserves, it makes a loan of $____ (Why not $100?), the T-account becomes: First National Bank If the bank charges 10% on loans, managing each account costs $3, paying 5% interest on each account. What’s the bank's profit from the two transactions? Profit = Dr. Reyadh Faras

32. Gulf Bank Income Statement (2007, million KDs) Dr. Reyadh Faras

33. Continue…Income Statement Dr. Reyadh Faras

34. GENERAL PRINCIPLES OF BANK MANAGEMENT 1. Liquidity Management: Maintaining enough liquid assets to meet obligations to depositors and to the central bank. 2. Asset Management: Managing assets to achieve diversification and minimize rate of default and interest rate risk. 3. Liability Management: Acquire funds at the lowest possible cost. 4. Capital Adequacy Management: Maintaining the appropriate capital (net worth) to meet central bank regulations and prevent bank failure. Dr. Reyadh Faras

35. FIRST: LIQUIDITY MANAGEMENT Management of bank reserves. Two concerns: 1) excess reserves and 2) insufficient reserves. Example (1): Bank holds excess reserves Assume the bank's initial balance sheet is as follows: First National Bank Dr. Reyadh Faras

36. If required reserve ratio is 10%, the required reserves are: _____. But since the bank's total reserves are ______, the excess reserves are _____. • If depositors withdraw $10 million, the bank's balance sheet becomes: First National Bank Dr. Reyadh Faras

37. The bank lost $_____of deposits and $_____of reserves. The required reserves declined from $______ to $______ (Why?). • Excess reserved declined from $______ to $______ (why?) • Result: If a bank has excess reserves, a decline in its deposits does not necessitate (leads to) changes in other parts of its balance sheet (Except:___ & ___) Dr. Reyadh Faras

38. Example (2): Bank holds no excess reserves Assume the bank's initial balance sheet is as follows: First National Bank If depositors withdraw $10 million, the bank's balance sheet becomes: First National Bank Dr. Reyadh Faras

39. The bank lost $____of deposits and $____of reserves. Total reserves declined from $______ to $_______. Required reserves should be $______, but the bank has $_____ reserves (is there a problem?) What do we mean by a problem? 1. 2. To get funds to meet reserve requirements, the bank has four options: Dr. Reyadh Faras

40. 1. Borrow from other banks (from the __________market), or from corporations. In this case the balance sheet becomes: First National Bank The cost of this option is the amount of interest paid on the loans. Dr. Reyadh Faras

41. 2. Sell securities Sell securities and deposit the revenues with the central bank, the balance sheet becomes: First National Bank Selling securities has brokerage costs, they are low for government securities because they are very liquid, but may be high for other securities. Dr. Reyadh Faras

42. 3. Borrow from the central bank Borrow from the C.B., the balance sheet is: First National Bank Two costs: A.The amount of interest paid on the loan. B. Indirect Costs: 1) The C.B. discourages too much borrowing, 2) the C.B. carefully examines the bank, and 3) the C.B. may close the discount window. Dr. Reyadh Faras

43. 4. Reducing Loans The bank can reduce loans in two ways: 1) don't renew short term loans and 2) sell loans to other banks and deposit the revenues with the C.B. The balance sheet become: First National Bank Dr. Reyadh Faras

44. This is the costliest way because: 1) Not renewing loans discourages future business with borrowers. 2) Selling loans may require banks to sell them at lower value to encourage other banks to buy them (why?). 3) The bank will forego potential interest on loans. General Result: 1) Excess reserves are insurance against the costs associated with deposit outflows. 2) The higher the costs to provide required reserves, the more excess reserves banks will want to hold. Dr. Reyadh Faras

45. SECOND: ASSET MANAGEMENT Banks manage their assets to maximize profits by: 1. Assess creditworthiness of potential borrowers to avoid costly defaults. (Banks usually conservative, default rate is low) 2. Buying securities with high returns and low risks. 3. Diversify assets: • Securities: Short term (T-bills) and long term (Government bonds) • Loan portfolio (commercial, industrial, consumer, real estate). Dr. Reyadh Faras

46. Kuwait’s Banks: Assets (Million KDs) Dr. Reyadh Faras

47. Maturity and the Volatility of Bond Returns Dr. Reyadh Faras

48. 4. Manage assets to ensure liquidity by holding sufficient liquid assets in case of large deposit outflows. • For example, T-Bills are so safe and liquid that they are considered "secondary reserves."  • The bank has to balance liquidity (cash) against increased earnings from less liquid assets (loans). Dr. Reyadh Faras

49. Capital Adequacy Management Banks choose the amount of capital they hold for three reasons: 1. It Helps Prevent Bank Failure: Bank failure occurs when a bank cannot satisfy its obligations to pay its depositors and creditors and so goes out of business. Example Consider two banks, one with low capital to assets ratio and the other high ratio. Dr. Reyadh Faras

50. High Capital Bank Low Capital Bank Dr. Reyadh Faras