Chapter 10
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Chapter 10. Banking and the Management of Financial Institutions. What to Learn ?. How Banking is conducted to earn the highest profits? Why Banks make loans? How they make loans? Assets and Liabilities of a Bank? The Bank Balance Sheet. How Banks make Income?

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Chapter 10

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Chapter 10

Chapter 10

Banking and the Management of Financial Institutions


What to learn

What to Learn ?

  • How Banking is conducted to earn the highest profits?

  • Why Banks make loans?

  • How they make loans?

  • Assets and Liabilities of a Bank?

  • The Bank Balance Sheet.

  • How Banks make Income?

  • Make Foundations to know how Banks Create Money?


The bank balance sheet

The Bank Balance Sheet

Total Assets = Total Liabilities + Capital

Liabilities : Source of Funds

Checkable deposits

Nontransaction deposits (Savings deposits, CDs, Time Deposits)

Borrowings (From Fed as discount loans, corporations, other banks)

Bank capital (Gained by selling Stocks)


The bank balance sheet cont d

The Bank Balance Sheet (cont’d)

Assets : Uses of Obtained Funds

Reserves

Cash items in process of collection


Chapter 10

The Bank Balance Sheet (cont’d)

  • Assets : Uses of Obtained Funds

    • Deposits at other banks

      • In exchange for services such as security purchasing, foreign transaction help, check collection etc…)

    • Securities

      • No STOCK buying. But can buy BONDs such as US government bonds >> Secondary reserves, municipal bonds, other low risk bonds)

    • Loans

      • Primary source of profits .

    • Other assets

      • Other physical assets such as building, computers etc..


Table 1 balance sheet of all commercial banks items as a percentage of the total june 2011

Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2011


Basic banking cash deposit

Basic Banking: Cash Deposit

Opening of a checking account at Bank of America with $100 cash leads to an increase in the bank’s reserves equal to the increase in checkable deposits. The Balance sheet is as follows; (100% Reserve Banking)


Basic banking check deposit

Basic Banking: Check Deposit

  • Opening of a checking account at Bank of America with $100 check from US Bank leads to an increase in the bank’s reserves equal to the increase in checkable deposits. The Balance sheets of both banks are as follows; (100% Reserve Banking)


Basic banking making a profit

Basic Banking: Making a Profit

  • Opening of a checking account at Bank of America with $100 cash. Assume the bank has a 10% reserve Ratio. The Balance sheet of the bank is as follows; (Fractional Reserve Banking)


Chapter 10

Basic Banking: Example

E.g. Prepare the Balance sheet of the US Bank. Use the following information for your answer.


General principles of bank management

General Principles of Bank Management

Liquidity Management

Asset Management


Chapter 10

General Principles of Bank Management

  • Liability Management

  • Capital Adequacy Management


Chapter 10

General Principles of Bank Management

  • Credit Risk

  • Interest-rate Risk


Liquidity management ample excess reserves

Liquidity Management: Ample Excess Reserves

Suppose bank’s required reserves are 10%

If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet


Liquidity management shortfall in reserves

Liquidity Management: Shortfall in Reserves

Reserves are a legal requirement and the shortfall must be eliminated.

Excess reserves are insurance against the costs associated with deposit outflows.

Solution: Borrow from FED, Corporations, other Banks etc… / sell existing securities / Reduce Loans


Liquidity management borrowing

Liquidity Management: Borrowing

Cost incurred is the interest rate paid on the borrowed funds


Liquidity management securities sale

Liquidity Management: Securities Sale

The cost of selling securities is the brokerage and other transaction costs


Liquidity management federal reserve

Liquidity Management: Federal Reserve

Borrowing from the Fed also incurs interest payments based on the discount rate


Liquidity management reduce loans

Liquidity Management: Reduce Loans

Reduction of loans is the most costly way of acquiring reserves.

Calling in loans antagonizes customers.

Other banks may only agree to purchase loans at a substantial discount.


Asset management three goals

Asset Management: Three Goals

1. Seek the highest possible returns on loans and securities.

2. Reduce risk

3. Have adequate liquidity


Asset management four tools

Asset Management: Four Tools

Find borrowers who will pay high interest rates and have low possibility of defaulting.

2. Purchase securities with high returns and low risk.

3. Lower risk by diversifying.

4. Balance need for liquidity against increased returns from less liquid assets.


Liability management

Liability Management

Recent phenomenon due to rise of money center banks.

Expansion of overnight loan markets and new financial instruments (such as negotiable CDs).

Checkable deposits have decreased in importance as source of bank funds


Capital adequacy management

Capital Adequacy Management

Bank capital helps prevent bank failure.

The amount of capital affects return for the owners (equity holders) of the bank.

Regulatory requirement.


Capital adequacy management preventing bank failure

Capital Adequacy Management: Preventing Bank Failure


Capital adequacy management returns to equity holders

Capital Adequacy Management: Returns to Equity Holders


Capital adequacy management safety

Capital Adequacy Management: Safety

Benefits the owners of a bank by making their investment safe.

Costly to owners of a bank because the higher the bank capital, the lower the return on equity.

Choice depends on the state of the economy and levels of confidence.


Managing credit risk

Managing Credit Risk

Screening and Monitoring

Screening.

Specialization in lending.

Monitoring and enforcement of restrictive covenants


Managing credit risk cont d

Managing Credit Risk (cont’d)

Long-term customer relationships.

Loan commitments.

Collateral and compensating balances.

Credit rationing


Managing interest rate risk

Managing Interest-Rate Risk

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


Gap and duration analysis

Gap and Duration Analysis

Basic gap analysis:

(Rate sensitive assets - Rate sensitive liabilities) x  Interest rates = Bank profit

Maturity bucked approach

Measures the gap for several maturity subintervals.

Standardized gap analysis

Accounts for different degrees of rate sensitivity.


Gap and duration analysis cont d

Gap and Duration Analysis (cont’d)

% in market value of security ≈ - percentage point  in interest rate x duration in years.

Uses the weighted average duration of a financial institution’s assets and of its liabilities to see how net worth responds to a change in interest rates.


Off balance sheet activities

Off-Balance-Sheet Activities

Loan sales (secondary loan participation)

Generation of fee income. Examples:

Servicing mortgage-backed securities

Creating SIVs (structured investment vehicles) which can potentially expose banks to risk, as it happened in the global financial crisis


Off balance sheet activities cont d

Off-Balance-Sheet Activities (cont’d)

Trading activities and risk management techniques

Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market and speculation.

Principal-agent problem arises


Off balance sheet activities cont d1

Off-Balance-Sheet Activities (cont’d)

Internal controls to reduce the principal-agent problem

Separation of trading activities and bookkeeping

Limits on exposure

Value-at-risk

Stress testing


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