Chapter 4 Commercial Bank’s Sources and Uses of Funds

1. Chapter 4Commercial Bank’s Sources and Uses of Funds Lecture Objectives 1.To describe the Profit and Loss Account and Balance Sheet of a commercial bank 2.To identify the sources and uses of funds of commercial banks 3.To explain the goals and management strategies of commercial banks 4.To define funds management 5.To review the latest performance of Hong Kong banking sector

2. Commercial Bank’sProfit and Loss Account Interest Income – Interest Expenses = Net Interest Income (Spread)

3. Commercial Bank’sProfit and Loss Account Net Interest Income – Provision for loan losses + Non-interest Income (Fees) – Non-interest Expenses (Overheads) = Income before taxes and investment gain / (loss)

4. Commercial Bank’sBalance Sheet Assets : Cash Amounts due from financial institutions Trade bills Advances and loans to customers Investment Fixed Assets

5. Commercial Bank’sBalance Sheet Liabilities : Amounts due to financial institutions Deposits from customers Certificates of deposits Provisions for loan loss

6. Commercial Bank’sBalance Sheet Shareholders’ Funds : Share capital Reserves

7. Commercial Bank’sSources and Uses of Funds A commercial bank’s main sources of funds come from the customers’ deposits, the issue of certificates of deposit, the share capital contributed by the bank’s shareholders and the reserves from the retained profits.

8. Commercial Bank’sSources and Uses of Funds A commercial bank’s main uses of funds are for lending to customers and investments. But a commercial bank has to keep substantial funds in the form of cash and short-term investments as liquid assets.

9. Commercial Bank’sSources and Uses of Funds The profitability of a commercial bank depends on the composition of its balance sheet and the efficiency of its operation. Nowadays there is a trend to increase the non-interest income because keen competition among commercial banks has decreased the Spread.

10. Commercial Bank’sSources and Uses of Funds It is vital for banks to maintain sufficient cash and near-liquid funds to repay depositors. However, the problem of maintaining assets in the form of cash or near-liquid fund is that the more liquid it is, the lower rate of interest it earns. The highest rates of interest are charged for the most illiquid assets, i.e. advances and loans to business and personal customers.

11. Liquidity (L) versus Profitability (P) L P

12. Goals of a Commercial Bank Increased shareholders’ wealth Maximum net earnings Increased rate of growth Improved services to the public

13. Management of Assets : Maximize yields available Satisfy the liquidity needs and regulations Management of Liabilities : Minimize costs of funds raised Promote the growth in total funds available Commercial Bank’s Financial Management

14. Management of Capital : Minimize the owners’ total investment in the firm Minimize risk exposure Satisfy the government’s regulations Marketing Policies : Identify consumers’ needs Develop new products, pricing and promotion campaigns Expense Control : Increase efficiency in the use of resources New money-saving methods Commercial Bank’s Financial Management

15. Commercial Bank’s Risk Management The focus of the assets and liabilities management of commercial banks is always in the reduction of interest-rate risk, liquidity risk, credit risk and foreign exchange risk.

16. Commercial Bank’s Risk Management Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. A sound basis for evaluating funds management requires understanding the bank, its customer mix, the nature of its assets and liabilities, as well as the economic environment.

17. Liquidity A bank has adequate liquidity when it can obtain sufficient funds, either by increasing liabilities or by converting assets into cash, promptly and at a reasonable cost. Liquidity is met through holding high quality short-term assets (like treasury bills). The price of liquidity is the income not earned from not holding lower quality longer-term assets (like some long-term commercial loans).

18. Interest Rate Risk Management The interest rate risk management is achieved through the asset-liability management of a commercial bank. Management must consider the cost of maintaining liquidity. Changes in money market conditions may cause a deterioration in a bank’s capacity to borrow at a favourable interest rate. Therefore, seasonal and cyclical factors may also cause an increase in loan demand and a decrease in deposits or an increase in deposits and a decrease in loan demand. As a result, the interest rate margins and income may fluctuate.

19. Performance of the Hong Kong banking sector in 2003 The Hong Kong economy was marked by continuing deflation, declining property prices, and historically high unemployment and personal bankruptcies in 2003. The economic conditions were aggravated by the SARS outbreak.

20. Performance of the Hong Kong banking sector in 2003 The declining loan demand resulted in a highly liquid banking sector, with the Hong Kong dollar interest rates dropped to a new low. The one-month HIBOR fell to an annual average of 0.92% and the one-month time deposit rate fell to an annual average of 0.07%. But the best lending rate remained unchanged at 5.00%, resulting in a widening interest rate spreads. The spread between the average best lending rate and the average one-month HIBOR widened to 408 basis points.

21. Performance of the Hong Kong banking sector in 2003 However, the pre-tax operating profits of retail banks increased by 5.3% due to gains in treasury operations (foreign exchange trading), increased income from fees and commissions, and reduced bad debt provisions and operating expenses.

22. Performance of the Hong Kong banking sector in 2003 Retail banks’ total lending fell modestly by 0.6% and property lending decreased by 2% in 2003. The holding of negotiable debt instruments excluding negotiable certificate of deposits, by retail banks grew by 13.3% in 2003. The increase was largely in corporate debt instruments and floating rate notes denominated in foreign currencies.

23. Performance of the Hong Kong banking sector in 2003 The liquidity of retail banks remained high and the loan-to-deposit ratio dipped to 49.6%. But the asset quality of banks improved in 2003 as the classified and non-performing loan ratios dropped to 3.91% and 3.16% respectively.

24. Tutorial Study the Balance Sheet: All Authorized Institutions. 1.What are the largest items in the Liabilities and Assets ? 2.Discuss the characteristics of the sources and uses of funds of the authorized institutions in Hong Kong.

25. Tutorial Study the Profit and Loss Accounts and Balance Sheets of the Hongkong and Shanghai Banking Corporation Ltd., Standard Chartered Bank Ltd. and Bank of China Hong Kong Ltd. for the year 2003, compare their strengths and weaknesses.

26. Performance of the Hong Kong Banking Sector in 2003

27. Liabilities Deposits from customers Capital, Reserves and other liabilities Amount due to Authorized Institutions in Hong Kong Assets Loans and advances to customers Government bills, notes and bonds Amount due from Authorized Institutions in Hong Kong The largest items of liabilities and assets

28. Sources and Uses of Funds of Authorized Institutions in Hong Kong The financial intermediation functions prevail. The main source of fund is customers’ deposits and the main use of fund is loans and advances to customers. The HKD deposits are concentrated in a few big banks like HSBC, Hang Seng Bank, Bank of China, Standard Chartered Bank, etc. Other banks have to borrow HKD funds from the big banks through the interbank market. Therefore, Amount due to AIs and and Amount due from AIs are also important source and use of funds.

29. Sources and Uses of Funds of Authorized Institutions in Hong Kong Capital and reserves are important sources of fund. The traditional practice is for banks in Hong Kong to reserve a larger portion of the profits as reserves for future business expansion. Government bills, notes and bonds are high quality short-term assets which the banks hold to earn interest while at the same time to maintain liquidity, because the investment can be converted into cash quickly.

30. Compare the Profit and Loss Accounts of HSBC, SC and BOC for the Year 2003 (HKD’million)

31. Compare the Profit and Loss Accounts of HSBC, SC and BOC for the Year 2003 (% of Total Income)

32. Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (HKD’million)

33. Compare the Balance Sheets of HSBC, SC and BEA for the Year 2003 (HKD’million)

34. Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (HKD’million)

35. Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (%)

36. Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (%)