Chapter 9 Banks and Bank Management Depository Institutions:

Chapter 9 Banks and Bank Management Depository Institutions:

Chapter 9 Banks and Bank Management Depository Institutions: The Big Questions Where do commercial banks get their funds and what do they do with them? How do commercial banks manage their balance sheets? What risks do banks face? Balance Sheet of Commercial Banks: Assets, Liabilities, and Capital The balance sheet identity: Bank Assets = [Bank Liabilities + Bank Capital] Uses of bank funds Sources of bank funds

When one side changes, the other side must change as well. A banks balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets) Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2014) 2012 Pearson Prentice Hall. All rights reserved. 17-4 Liabilities are Sources of Funds Checkable Deposits: Called transactions deposits all accounts that allow the owner (depositor) to write checks to third parties: non-interest earning checking accounts (known as demand deposit accounts because funds are due on demand, Interest earning negotiable orders of withdrawal (NOW) accounts (interest earning checking account), and

Money-market deposit accounts (MMDAs), which typically pay the most interest among checkable deposit accounts About 11% of bank source of funds 2012 Pearson Prentice Hall. All rights reserved. 17-5 Liabilities Sources of Funds Non-transaction Deposits: savings type account - generally a banks highest cost funds. Banks want deposits which are more stable and predictable and will pay more to attract such funds. The largest source of funds ~ 58% 2012 Pearson Prentice Hall. All rights reserved.

17-6 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 About 20% of bank source of funds 2012 Pearson Prentice Hall. All rights reserved. 17-7 Repurchase Agreement - Repo Bank Capital Source of Funds Bank Capital: funds supplied by the bank owners either through purchase of ownership shares or retained earnings

Bank capital provides a cushion capital levels are important. About 11% of bank source of funds A very important topic in bank regulation. 2012 Pearson Prentice Hall. All rights reserved. 17-9 Assets are Uses of Funds Reserves: funds held in accounts with the Fed (vault cash and cash in the ATM machine is included). Required reserves represent what is required by law - reserve requirement or required reserve ratios. Any reserves beyond this are called excess reserves.

About 19% of bank assets. 2012 Pearson Prentice Hall. All rights reserved. 17-10 Assets Uses of Funds Securities: includes U.S. government debt, agency debt, municipal debt, and other (nonequity) securities. About 19% of assets. Short-term US Treasury debt (Treasury Bills) is often referred to as secondary reserves because of its high liquidity. Commercial banks in the US may not hold stock. 2012 Pearson Prentice Hall. All rights reserved. 17-11

Assets Uses of Funds Loans: business loans, auto loans, and mortgages, loans to other banks . Generally not very liquid. About 53% of bank assets. Many banks tend to specialize in either consumer loans or business loans. 2012 Pearson Prentice Hall. All rights reserved. 17-12 Assets Uses of Funds Other Assets: bank buildings, computer systems, and other equipment. 2012 Pearson Prentice Hall. All rights reserved. 17-13

Commercial Bank Liability Trend Checkable Deposits have declined substantially in importance were 61% of bank funds in 1960, down to about 11%. Transactions deposit available on demand Balance Sheet of Commercial Banks: Changes in Liabilities over time 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 2012 Pearson Prentice Hall. All rights reserved. 2008. 17-15

Changes in Bank Assets Over Time Security holdings down from 70% in 1947 to 20% now. Loans( C&I, real estate, and consumer loans) ~ 50%. 2012 Pearson Prentice Hall. All rights reserved. 17-16 Bank Capital and Profitability Net worth equals assets minus liabilities referred to as bank capital, or equity capital. Capital represents the owners stake in the bank. Bank capital acts as a cushion against a sudden drop in the value of their assets or an unexpected withdrawal of liabilities. It provides some insurance against insolvency.

12-17 ratio of equity to assets is 11% (equity ratio) ratio of assets to equity is 9.11 (leverage ratio) every $100 is assets was financed with $11 of equity and $89 of debt 12-18 Bank Capital and Profitability Leverage increases expected return and risk.

Expected return and risk double if leverage ratio (ratio of assets-to-equity) increases from 1-to-1 to 2-to-1. For banks the ratio is 9-to-1. Risk and return increase by a factor of 9! Banking is a risky business. 12-19 Why So Much Leverage One explanation - the existence of government guarantees like FDIC deposit insurance. Too big to fail. Government guarantees allow banks to capture the benefits of risk taking without subjecting depositors to potential losses. 12-20 Basic Banking Transactions

Cash Deposit of $100 in First National Bank First National Bank Assets Vault Cash +$100 First National Bank Liabilities Checkable deposits +$100 Assets Reserves

Liabilities +$100 Checkable deposits +$100 The above example presents two ways to record the same transaction. Opening of a checking account leads to an equal increase in the banks reserves. NOTE: vault cash counts as reserves Basic Banking Transactions Check Deposit of $100 into First National Bank that is written on Second National Bank First National Bank (FNB) Assets

Reserves +$100 Second National Bank (SNB) Liabilities Checkable deposits +$100 Assets Reserves -$100 Liabilities

Checkable deposits -$100 FNB gains reserves and SNB loses reserves Basic Banking - Making a Profit First National Bank Assets First National Bank Liabilities Required reserves

+$10 Checkable deposits Excess reserves +$90 +$100 Assets Liabilities Required reserves +$10 Checkable deposits

Loans +$90 +$100 10% Reserve Requirement Bank use excess reserves to make loans or invest in bonds. Makes a profit because it borrows short (at a relatively low interest rate) and lends long (at a relatively high interest rate) General Principles of Bank Management Make profits by: Selling liabilities with one set of characteristics (high liquidity, low risk , small size, low return). [Source of Funds]

Buying assets with a different set of characteristics (low liquidity, high risk ,large size, high return). [Use of Funds] Process known as asset transformation also referred to as maturity transformation. General Principles of Bank Management Managing Risk. Four primary concerns: 1. Liquidity Risk 2. Credit Risk 3. Interest Rate Risk 4. Capital adequacy I do not cover trading risk.

2012 Pearson Prentice Hall. All rights reserved. 17-25 Managing Liquidity Risk Reserves requirement = 10%, Excess reserves = $10 million Deposit outflow = $10 million After the deposit outflow, the bank has excess reserves of $__million. Is there a need to change the balance sheet? 2012 Pearson Prentice Hall. All rights reserved. 17-26 Managing Liquidity Risk Reserves requirement = 10%, Excess reserves = $0 Bank with no excess reserves

Deposit outflow of $10 million With 10% reserve requirement, bank has reserve shortfall of $9 million. 17-27 2012 Pearson Prentice Hall. All rights reserved. Options to Correct the Shortfall in Reserves: Borrow from other banks or corporations. Assets Reserves Liabilities $9M Deposits $90M Loans

$90M Borrowing $9M Securities $10M Bank Capital $10M Other banks - Federal Funds Market Corporations Issue CP or engage in Repo Theres a cost - interest rate paid on the borrowed funds Liquidity Management - Shortfall in Reserves: Borrow from the Fed

Assets Reserves Liabilities $9M Deposits Loans $90M Borrow from Fed Securities $10M Bank Capital $90M $9M $10M Theres a cost - payments to Fed based on the

discount rate Liquidity Management Shortfall in Reserves: Sell Securities Assets Reserves Loans Securities Liabilities $9M Deposits $90M Bank Capital $90M $10M $1M There are costs: transaction costs and possible

capital loss. Liquidity Management: Reduce Loans Assets Reserves Liabilities $9M Deposits Loans $81M Bank Capital Securities $10M $90M $10M

Reduction of loans is the most costly way of acquiring reserves Calling in loans (basically not renewing short-term loans) antagonizes customers Loans are not a liquid asset. Other banks may only agree to purchase loans at a substantial discount 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 Liability Management Managing the sources of funds: from deposits, to CDs, to other debt. 1. Important since 1960s 2. Banks no longer primarily depend on transactions deposits 3. More dependent on non-transactions deposits and borrowing. Growth in borrowing from 2% in 1960 to 31% in 2008. Negotiable CDs at 19% 2012 Pearson Prentice Hall. All rights reserved. 17-33

Bank Capital Management In Dec 2006, commercial bank capital was $0.86 trillion equal to 8.8% of total assets of $9.77 Trillion Leverage = 9.77/0.86 = 11.4 In Dec 2015, commercial bank capital was $1.7 trillion equal to 11% of total assets of $15.5 Trillion Leverage = 15.5/1.7= 9.1 Capital Adequacy Management Bank capital is a cushion that helps prevent bank failure.

As banks write down assets, bank capital takes a hit. Regulators set minimum capital requirements. Capital Adequacy Management Case Study: Borrower defaults on $5 million loan High Bank Capital Assets Low Bank Capital Liabilities Assets Liabilities

Reserves $10M Deposits $90M Reserves $10M Deposits Loans $90M Bank Capital $10M Loans $90M Bank Capital High Bank Capital Assets

$10M Deposits Loans $85M Bank Capital $4M Low Bank Capital Liabilities Reserves $96M Assets $90M Reserves $5M Loans

Liabilities $10M Deposits $96M $85M Bank Capital -$1M Basic Strategies for Managing Capital What can a bank do if bank is holding too little capital (i.e., the capital ratio is too low)? Issue stock to attract new equity capital. Decrease dividends to increase retained earnings which adds to equity capital. Reduce assets or slow asset growth (retire debt)

Bank Capital and Profitability There are several measures of bank profitability. 1. Return on assets (ROA) ROA is the banks net profit left after taxes divided by the banks total assets. ROA = It is a measure of how efficiently a banks uses its assets. However, it is less important to bank owners than the return on their own investment. Bank Capital and Profitability 2. The banks return to its owners is measured by the return on equity (ROE). This is the banks net profit after taxes divided by the banks capital. ROE = ROA and ROE are related to leverage.

Multiplying ROA by this ratio yields ROE. Capital Adequacy Management: Return to Equity Holders Return on Assets: net profit after taxes per dollar of assets net profit after taxes ROA = assets Return on Equity: net profit after taxes per dollar of equity capital net profit after taxes ROE = equity capital Relationship between ROA and ROE is expressed by the Equity Multiplier: the amount of assets per dollar of equity capital EM = Assets Equity Capital

net profit after taxes net profit after taxes assets equity capital assets equity capital ROE = ROA EM Capital Adequacy Management There is a tradeoff between safety (high capital) and ROE If Equity Capital => EM => ROE Prudent to hold equity capital. Unfortunately, banks arent very prudent. 2012 Pearson Prentice Hall. All rights reserved.

17-41 Equity Multiplier and Capital Ratio Total Assets CapitalRatio Equity Capital EM Assets Equity Capital 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 Bank Profitability ROA is typically 1.2 to 1.3% ROE is 10 to 12 times ROA. Lets take a look:

https://www2.fdic.gov/qbp/2014dec/cb1.html Leverage of Various Financial Institutions prior to Financial Crisis Assets Liabilities $Trillion $Trillion Equity $Trillion Leverage Assets/Equity

Commercial Banks 10.8 9.7 1.1 9.8(10.2%) Savings Inst. 1.91 1.68 .23

8.4(11.9%) .66 .09 8.4(11.9%) 5.23 .17 31.7 Credit Unions 0.75 Investment Banks 5.4

GSEs Overall 1.63 20.5 (1/31.7) = 3.15% 1.56 18.8 .067 1.7 24.7(4.0%) 12.2(8.2%) Suppose banks are required to maintain a capital ratio of 10%.

Assume times are good and loan portfolio increases by $1. National Capital Bank January Assets Cash $10 Loans/Securities $90 Total $100 Liabilities Debt Equity Capital Total $90 $10 $100

National Capital Bank June Assets Cash $10 Loans/Securities $91 Total $101 10% Liabilities Debt $90 Equity Capital $11 capital ratio is 10.89% > National Capital Bank December

Assets Cash $10 Loans $100 Total $110 Liabilities Debt Equity Capital Total $99 $11 $110 The mechanism works in reverse when times are bad.

Loan portfolio decreases by $1: De-leveraging the balance sheet National Capital Bank - January Assets Liabilities Cash $10 Debt $90 Loans/Securities $90 Capital $10 Total $100 Total $100 National Capital Bank June Assets Liabilities

Cash $10 Debt $90 Loans/Securities $89 Capital $9 Total $99 Total $99 capital ratio is 9.09% < 10% National Capital Bank December Assets Cash $10 Loans/Securities $80

Total $90 Liabilities Debt Capital Total $81 $9 $90 Banks do not have to de-leverage if they can raise more equity capital and pay off some debt National Capital Bank June Assets Cash

$10 Loans/Securities $89 Total $99 $99.0 capital ratio is = 10% Liabilities Debt Capital Total $89.1 $9.9 How a Capital Crunch Caused a Credit Crunch in 2008 Housing bust led to large bank losses Value of assets reduced.

The losses reduced bank capital. Banks required to rebuild capital a capital crunch! Banks had two option: (1) raise new capital or (2)reduce lending Which option? 2012 Pearson Prentice Hall. All rights reserved. 17-48 Managing Interest Rate Risk In addition to the borrow/short - lend/long mismatch, banks also have a mismatch between assets and liabilities that are interestrate 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)

Managing Interest Rate Risk What happens if interest rate rise? Deposit rates tied to flexible short-term interest rates rise. Loan revenues based on fixed interest rate remain fixed. Profits fall. Interest-Rate Risk Simple Gap Analysis First National Bank Assets Rate-sensitive

assets(RSA) Liabilities $20M Rate-sensitive liabilities (RSL) Variable-rate and short-term loans Variable-rate CDs Short-term securities Money market deposit accounts Fixed-rate assets $80M Fixed-rate liabilities

Reserves Checkable deposits Long-term loans Savings deposits Long-term securities Long-term CDs $50M $50M Equity capital

If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits Interest Rate Risk: Gap Analysis Basic Gap Analysis bank profits = (RSA RSL) x interest rate We will not cover duration! Managing Interest-Rate Risk Basis Gap Analysis GAP = rate-sensitive assets rate-sensitive liabilities = $20

$50 = $30 million When i 5%: 1. Income on assets = .05 $20m = +$1 million 2. Costs of liabilities = .05 $50m = +$2.5 million 3. Profits = $1m $2.5m = -$1.5m Profits = i GAP = .05 (GAP) = .05 ($20 - $50) = .05 x -$30 =-$1.5 Off-Balance-Sheet Activities 1. Loan sales 2. Fee income from

Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit 3. Trading Activities and Risk Management Techniques Financial futures and options Foreign exchange trading Interest rate swaps All these activities involve risk and potential conflicts 2012 Pearson Prentice Hall. All rights reserved. 17-54

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