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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

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..



Basic banking cash deposit
Basic Banking: Cash Deposit percentage of the total, June 2011

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 percentage of the total, June 2011

  • 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 percentage of the total, June 2011

  • 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 percentage of the total, June 2011

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 percentage of the total, June 2011

Liquidity Management

Asset Management


Chapter 10

General Principles of Bank Management percentage of the total, June 2011

  • Liability Management

  • Capital Adequacy Management


Chapter 10

General Principles of Bank Management percentage of the total, June 2011

  • Credit Risk

  • Interest-rate Risk


Liquidity management ample excess reserves
Liquidity Management: Ample Excess Reserves percentage of the total, June 2011

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 percentage of the total, June 2011

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 percentage of the total, June 2011

Cost incurred is the interest rate paid on the borrowed funds


Liquidity management securities sale
Liquidity Management: Securities Sale percentage of the total, June 2011

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


Liquidity management federal reserve
Liquidity Management: Federal Reserve percentage of the total, June 2011

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


Liquidity management reduce loans
Liquidity Management: Reduce Loans percentage of the total, June 2011

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 percentage of the total, June 2011

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 percentage of the total, June 2011

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 percentage of the total, June 2011

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 percentage of the total, June 2011

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 percentage of the total, June 2011


Capital adequacy management returns to equity holders
Capital Adequacy Management: percentage of the total, June 2011Returns to Equity Holders


Capital adequacy management safety
Capital Adequacy Management: Safety percentage of the total, June 2011

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 percentage of the total, June 2011

Screening and Monitoring

Screening.

Specialization in lending.

Monitoring and enforcement of restrictive covenants


Managing credit risk cont d
Managing Credit Risk (cont’d) percentage of the total, June 2011

Long-term customer relationships.

Loan commitments.

Collateral and compensating balances.

Credit rationing


Managing interest rate risk
Managing Interest-Rate Risk percentage of the total, June 2011

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 percentage of the total, June 2011

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) percentage of the total, June 2011

% 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 percentage of the total, June 2011

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) percentage of the total, June 2011

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) percentage of the total, June 2011

Internal controls to reduce the principal-agent problem

Separation of trading activities and bookkeeping

Limits on exposure

Value-at-risk

Stress testing