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Banking in the US

Banking in the US. All Banks in the US are Chartered. National Banks: Comptroller of the Currency State Banks: State Authorities Savings & Loans: Office of Thrift Supervision Credit Union: National Credit Union Administration. Federal Reserve Membership.

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Banking in the US

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  1. Banking in the US

  2. All Banks in the US are Chartered • National Banks: Comptroller of the Currency • State Banks: State Authorities • Savings & Loans: Office of Thrift Supervision • Credit Union: National Credit Union Administration

  3. Federal Reserve Membership • National Banks are Required to be members of the Federal Reserve System (Membership is optional for state banks) • Federal Reserve members are required to purchase stock in the federal reserve system. • Federal Reserve members provide input to the election of Federal Reserve Board Members • The Federal Reserve provides emergency loans (discount window) to all banks. • The Federal Reserve provides check clearing services

  4. Federal Deposit Insurance • FDIC insured banks are charged 0-27 cents per $100 of eligible deposits. • All deposits up to $100,000 are insured by the FDIC. • Federal reserve members are required to purchase deposit insurance.

  5. Bank Supervision/Regulation National BanksState Banks (Fed Members) Federal Reserve Federal Reserve OCC State Authority FDIC FDIC State Banks (FDIC)State Banks(Non-FDIC) FDIC State Authority State Authority

  6. Banks, like any other business, exist to earn profits • Banks accept deposits and then use those funds to create loans • Profit = Loans(rl)-Deposits(rs)

  7. An Example • Suppose that you raise $10 in initial equity to start a bank. You use this initial equity to by T-Bills.

  8. Assets Reserves: Securities: $10M Loans Consumer: Commercial/Industrial: Real Estate: Other: Liabilities Transaction Deposits Checking: Savings: Non-Transaction Deposits: Loans: Equity: $10M An Example

  9. An Example • Suppose that you raise $10 in initial equity to start a bank. • You collect $10M in checking accounts and $20M in savings accounts. Checking accounts earn no interest, savings accounts pay 2% annually.

  10. Assets Reserves: $30M Securities: $10M Loans Consumer: Commercial: Real Estate: Other: Liabilities Transaction Deposits Checking (0%): $10M Savings (2%): $20M Non-Transaction Deposits: Loans: Equity: $10M An Example

  11. An Example • Suppose that you raise $10 in initial equity to start a bank. • You collect $10M in checking accounts and $20M in savings accounts. Checking accounts earn no interest, savings accounts pay 2% annually. • The Federal Reserve requires you keep at least 5% in your vault ($1.5M) • The remainder you loan out and buy T-Bills

  12. Assets Reserves: $2M Securities (3%): $15M Loans Consumer: Commercial (7%): $20M Real Estate (8%): $3M Other: Liabilities Transaction Deposits Checking (0%): $10M Savings (2%): $20M Non-Transaction Deposits: Loans: Equity: $10M An Example

  13. An Example • Your Profit after the first year will be: (.03)$15M + (.07)$20M + (.08)$3M (Interest Income) • (.02) $20M (Interest Cost) • $1,690,000

  14. An Example • Suppose that $1M was withdrawn from checking accounts

  15. Assets Cash Reserves: $1M Securities (3%): $15M Loans Consumer: Commercial (7%): $20M Real Estate (8%): $3M Other: Liabilities Transaction Deposits Checking (0%): $9M Savings (2%): $20M Non-Transaction Deposits: Loans: Equity: $10M An Example

  16. An Example • Suppose that $1M was withdrawn from checking accounts • Your cash balances are now below the required 5% of deposits ($1.450,000). What do you do?

  17. An Example • Suppose that $1M was withdrawn from checking accounts • Your cash balances are now below the required 5% of deposits ($1,450,000). What do you do? • Recall a loan • Borrow from another bank (federal funds market) • Borrow from the federal reserve (discount window) • Sell some securities

  18. Assets Cash Reserves: $6M Securities (3%): $15M Loans Consumer: Commercial (7%): $20M Real Estate (8%): $3M Other: Liabilities Transaction Deposits Checking (0%): $9M Savings (2%): $20M Non-Transaction Deposits: Loans: $5M Equity: $10M An Example

  19. Equity Capital • Net Worth (Equity Capital) is the difference between a bank’s assets and liabilities • Banks are required to maintain a minimum capital adequacy (equity capital >4% of risk weighted assets)

  20. Asset Risk Weight Cash and equivalents 0 Government securities 0 Interbank loans 0.2 Mortgage loans 0.5 Ordinary loans 1.0 Standby letters of credit 1.0 Risk weighted assets

  21. Asset Risk Weight Cash and equivalents: $6M 0 * 6 = 0 Government securities: $15M 0 * 5 = 0 Interbank loans 0.2 Mortgage loans: $8M 0.5 * 8 = $4M Ordinary loans: $20M 1.0 * 20 = $20M Standby letters of credit 1.0 Risk weighted assets 4% of $24M ($960,000) is your required equity

  22. An Example • Suppose a $10M commercial loan defaults

  23. Assets Cash Reserves: $6M Securities (3%): $15M Loans Consumer: Commercial (7%): $10M Real Estate (8%): $3M Other: Liabilities Transaction Deposits Checking (0%): $9M Savings (2%): $20M Non-Transaction Deposits: Loans: $5M Equity: $0M An Example

  24. An Example • Suppose a $10M commercial loan defaults • What do you do now?

  25. An Example • Suppose a $10M commercial loan defaults • What do you do now? • You need to raise equity or shut down!

  26. Bank Profitability • Return on Assets = After Tax Profits/Total Assets • Return to Equity = After Tax Profits/Equity Capital • ROE = ROA*(Assets/Equity Capital)

  27. Company A Assets = 100 Profits = 10 Debt = 20 Equity = 80_________ ROA = 10% ROE = 12.5% Company B Assets = 100 Profits = 10 Debt = 80 Equity = 20_________ ROA = 10% ROE = 50% ROE vs. ROA

  28. Equity Capital to Assets

  29. Return on Assets

  30. Return on Equity

  31. Key issues in Banking • Managing informational problems (moral hazard, adverse selection) • Managing Liquidity • Managing interest rate risk

  32. Asymmetric Information Between Banks & Borrowers • Diversification • Credit Scoring • Collateral • Rationing (Credit Limits) • Restrictive Covenants & Monitoring • Personal Relationships

  33. Asymmetric Information Between Banks & Savers • FDIC and Government Regulation • Checkable Deposits as a commitment device • Capital Adequacy Management

  34. Managing Liquidity • Banks don’t like holding cash because it pays no interest, however a bank must always be able to meet the cash requirements of its demand deposits • This can be handled through excess reserves, active participation in the federal funds market or through asset & liability management

  35. Interest Rate Risk • A bank’s assets and liabilities are comprised of payments made or received over time. Therefore, their value depends on the interest rate.

  36. Present Value • Given some interest rate, the present value of $X to be paid in N years is: PV = $X/(1+i)^N

  37. An Example • Suppose you have a $10,000 loan with an annual interest rate equal to 5%. You agree to pay off the loan in three annual payments.

  38. An Example • Suppose you have a $10,000 loan with an annual interest rate equal to 5%. You agree to pay off the loan in three annual payments. P/(1.05) + P/(1.05)^2 + P/(1.05)^3 = ?

  39. An Example • Suppose you have a $10,000 loan with an annual interest rate equal to 5%. You agree to pay off the loan in three annual payments. P/(1.05) + P/(1.05)^2 + P/(1.05)^3 = $10,000 P = $3,671

  40. An Example • Suppose you have a $10,000 loan with an annual interest rate equal to 5%. You agree to pay off the loan in three annual payments of $3,671. If the current rate of interest is 7%, what is the present value of this payment stream? PV = $3,671/(1.07) + $3,671/(1.07)^2 + $3,671/(1.07)^3 = $3,430 + $3,206 + $2,996 = $9,632

  41. An Example • The loan originally had a value of $10,000 (when the market interest rate was 5%). • A 2% rise in the interest rate caused the value of the loan to drop to $9,632 (a 4% decrease)

  42. Duration & Interest Rate Risk • The duration of an asset or liability is the “average” payment date. • The duration of an asset or liability represents an elasticity with respect to interest rate changes • The duration gap is the difference between the duration of assets and liabilities • A bank with a positive (negative) duration gap is hurt by interest rate increases (decreases)

  43. Example • In the previous example, our loan made three payments of $3,671. $3,671/(1.05) = $3,497 $3,671/(1.05)^2 = $3,332 $3,671/(1.05)^3 = $3,171 $10,000

  44. Example • In the previous example, our loan made three payments of $3,671. $3,497/10,000 = .36 * 1 = .36 $3,332/10,000 = .34 * 2 = .68 $3,171/10,000 = .32 * 3 = .96 2.00 %Change in value = (Duration)*(%Change in Interest Rate)

  45. Assets Cash Reserves: $6M (0) Securities (3%): $15M (5) Loans Consumer: Commercial (7%): $20M (10) Real Estate (8%): $3M (15) Other: Liabilities Transaction Deposits Checking (0%): $9M (0) Savings (2%): $20M (0) Non-Transaction Deposits: Loans: $5M(0) Equity: $10M Back to our previous example

  46. Total Assets = $44M (6/44)* 0 = 0 (15/44)* 5 = 1.70 (20/44)* 10 = 4.55 ( 3/44)* 15 = 1.02 7.27 Total Liabilities = $34M (9/34)* 0 = 0 (20/34)* 0 = 1.70 ( 5/34)* 0 = 2.04 0 Duration Gap

  47. Total Assets = $44M (6/44)* 0 = 0 (15/44)* 5 = 1.70 (20/44)* 10 = 4.55 ( 3/44)* 15 = 1.02 7.27 Total Liabilities = $34M (9/34)* 0 = 0 (20/34)* 0 = 1.70 ( 5/34)* 0 = 2.04 0 Duration Gap = 7.27 – 0(34/44) = 7.27 Duration Gap

  48. Duration Gap • %Change in Equity/Assets = - (dg)(%change in interest rate) • dg > 0: Your equity capital falls when interest rates rise • dg < 0: Your equity capital rises when interest rates rise

  49. Duration Gap • In our example, we had equity equal to (10/44) = 22% of assets and a duration gap of 7.27.

  50. Duration Gap • In our example, we had equity equal to (10/44) = 22% of assets and a duration gap of 7.27. • If interest rates rise by 1%, our equity capital falls by 7% to 15% of assets.

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