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Chapter 9. The Banking Firm and the Management of Financial Institutions. Commercial banks are the most important financial intermediaries in the economy, so it is important to understand how they operate, and understand bank management. THE BANK BALANCE SHEET

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Chapter 9

The Banking Firm and the Management of Financial Institutions

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Commercial banks are the most important financial intermediaries in the economy, so it is important to understand how they operate, and understand bank management.

THE BANK BALANCE SHEET

  • To understand how a bank operates, we first examine a commercial bank's balance sheet, where:
  •  Total Assets = Total Liabilities + Capital  
bank liabilities sources of funds
BANK LIABILITIES (Sources of Funds)

1. Checkable Deposits

Are bank accounts that allow owner of the account to write checks to third parties. They include:

a. Demand deposits (non-interest-bearing checking)

b. Negotiable Order of Withdrawal (NOW) accounts (interest-bearing checking)

c. Money market deposit accounts (MMDAs) - money market mutual funds.

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Checkable deposits are payable on demand, you can write a check for any amount, including your entire balance.
  • Checkable deposits are lowest cost source of funds for a bank, sometimes zero (demand deposits).
  • Because people like the liquidity of checking accounts, they are willing to give up interest for convenience of checks.
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2. Nontransaction Deposits

Account owner is not allowed to write checks, but

receives interest rates higher than checkable deposits.

a. Savings accounts: funds can be added or withdrawn from the account.

b. Time Deposit Accounts:

  • Fixed maturity from several months to 10 years.
  • Higher interest rates than saving accounts.
  • Has penalties for early withdrawal.
  • Less liquid.
  • More costly source of funds for the bank.
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3. Borrowings

a. from other banks (interbank Market)

b. from the central bank (discount Window)

c. from parent companies (bank holding companies)

d. from corporations (repurchase agreements)

e. from foreign banks (Eurodollar deposits)

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4. Bank capital (Net Worth)
  • Net worth is the difference between total assets and liabilities.
  • Consists of stocks and retained earnings.
  • Bank capital is a cushion against a drop in the value of assets, to protect against bankruptcy (insolvency).
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BANK ASSETS (Uses of Funds):

Banks use their deposits to acquire income-earning

assets, to make profits, by earning more interest on

assets than they pay out on liabilities.

1. Reserves :

  • Consists of deposits kept on account at the central bank  plus cash held at the bank.
  • Some reserves are required by the central bank and others ( called excess reserves) are voluntary.
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Required Reserves: banks are required to hold a percentage of certain deposits in an account at the central bank.
  • Excess reserves: in addition to required reserves, banks hold extra reserves for increased liquidity (to meet demand for cash withdrawals and check clearing).
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2. Cash Items in Process of Collection

Funds from checks written on other banks but are not

yet collected (received) from the other bank.

3. Deposits at Other Banks

Many (small) banks hold deposits at other (larger)

banks to use them in getting a number of services such

as: check collection, foreign exchange transactions, and

buying securities.

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4. Securities :
  • An important source of income to banks.
  • Made up entirely of government debt instruments because commercial banks are not allowed to own stocks.
  • Short term securities are highly liquid (go to the market and sell it), thus are called secondary reserves.
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5. Loans :

Most bank profits come from Loans. 

A loan is a liability for the borrower but an asset for the

bank because it generates income.

Loan Types:

a. Commercial loans to businesses

b. Real estate loans (mortgages, home improvement loans)

c. Consumer loans (Cars, furniture)

d. Interbank loans (overnight loans to other banks through the interbank market)

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Loans are less liquid than other assets because they are tied up for the length of the loan.
  • Loans are also more risky, have higher default risk than securities.
  • Because loans are more risky and less liquid, they earn more interest for banks.

6. Other Assets :

  • Property, plant and equipment.  Buildings, office equipment, computer systems, etc.
basic operation of a bank
BASIC OPERATION OF A BANK
  • Banks make profits by selling liabilities with one set

of characteristics (liquidity, risk, and return) and buying assts with different set of characteristics.

  • This process is called “Asset Transformation.”

Example:

A savings deposit (liability) can be used by the bank to make a loan (asset).

  • The bank borrows short-term and lends long-term.
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The process of asset transformation and providing services is similar to the production process by firms.
  • If the bank produces at low cost and earns higher return on its assets, then it makes profit, vice versa.
  • A tool used in analyzing bank operation is the

T-account: a simplified balance sheet that lists only changes occurring in balance sheet items from a transaction.

example
Example
  • 1. A person opens a checking account at “First National Bank (FNB)” with $100 in cash. This shows up as a liability on the bank balance sheet.
  • If the bank keeps the $100 as cash, this raises the bank assets (excess reserves).

First National Bank

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Since the cash (excess reserves) is part of the bank’s reserves, we can rewrite the T-account as follows:

First National Bank

Result: opening a checking account with cash increases the bank’s reserves equal to the increase in checkable deposits.

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2. If a person opens a checking account with a $100 check written on her account at another bank “Second National Bank (SNB).”
  • FNB is owed $100 by SNB. This asset for FNB appears in its T-account as cash items in process of collection.
  • FNB deposits the check in its account at the central bank who transfers $100 of reserves from SNB to FNB.
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First National Bank

The final balance sheet positions of the two banks are as follows:

First National Bank

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Second National Bank

Result: when opening a checking account with a check, the bank receiving the deposit (FNB) gains reserves equal to the amount of the check, while the bank on which the check is written (SNB) loses reserves by the same amount.

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How the bank is making profit?
  • If FNB receives a $100 checkable deposit.
  • If the required reserve ratio is 10%.
  • The required reserves are $_____, and the excess reserves

are $_____. The T-account becomes:

First National Bank

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If the FNB decides not to hold excess reserves, it makes a loan of $____ (Why not $100?), the T-account becomes:

FNB

If the bank charges 10% on loans, managing each account costs $3 (pay tellers, pay for check clearing), paying 5% interest on each account (with NOW account). What is the bank's profit from these two transactions?

Profit =

general principles of bank management
GENERAL PRINCIPLES OF BANK MANAGEMENT

1. Liquidity Management:

Maintaining enough liquid assets to meet obligations to

depositors (deposit outflows) and to the central bank.

2. Asset Management:

Managing assets with low rate of default, and diversification assets holdings.

3. Liability Management:

Acquiring funds at the lowest possible cost.

4. Capital Adequacy Management:

Maintaining the appropriate capital (or raising capital) to meet central bank regulations and prevent bank failure (if capital drops).

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FIRST: LIQUIDITY MANAGEMENT

Management of bank reserves. Two concerns:

1) excess reserves and 2) insufficient reserves.

Example (1): Bank holds excess reserves

 Assume the bank's initial balance sheet is as follows:

                             First National Bank

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If required reserve ratio is 10%, the required reserves are: _________. But since the bank's total reserves are ________, the excess reserves are ______.
  • If depositors withdraw $10 million, the bank's balance sheet becomes:

First National Bank

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The bank lost $_____of deposits and

$______ of reserves. The required reserves

declined from $______ to $______ (Why?).

  • Excess reserved declined from $______ to $______ (why?)
  • Result:

If bank has excess reserves, a decline in deposits does not necessitate (leads to) changes in other parts of its balance sheet.

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Example (2): Bank holds no excess reserves

 Assume the bank's initial balance sheet is as follows:

 First National Bank

If depositors withdraw $10 million, the bank's balance sheet becomes:

 First National Bank

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The bank lost $_____of deposits and $_____of reserves.

Total reserves declined from $______ to $_______.

Required reserves should be $______, but the bank has $_____ reserves (is there a problem?)

To get funds to meet reserve requirements, the bank has four options:

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1. Borrow from other banks

from the( -------)market charged by (------)rate

In this case the balance sheet becomes:

                            First National Bank

The cost of this activity is the interest paid on loans.

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2. Sell securities

  Sell securities and deposit the revenues with the central bank, the balance sheet becomes:

First National Bank

Selling securities has brokerage costs, they are low for

government securities because they are very liquid, but

may be high for other securities.

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3. Borrow from the central bank

 Borrow from the C.B., the balance sheet is:

                            First National Bank

Two costs associated with borrowing from CB:

A.Direct Cost: The amount of interest paid on the loan (Discount Rate).

B.Indirect Costs: 1) The CB discourages too much

borrowing, 2) the CB carefully examines the bank, and 3) the CB may close the discount window.

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4. Reducing Loans

 The bank can reduce loans in two ways:

  • Not renewing short term loans ,and
  • Selling loans to other banks and deposit the revenues with the CB.

The balance sheet become:

First National Bank

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This is the most costy way because:

1) Not renewing loans discourages future business with borrowers.

2) Selling loans may require banks to sell them at lower value to encourage other banks to buy them (why?).

3) The bank will give up potential interest on loans.

Result:

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

2) The higher the costs to provide required reserves, the more excess reserves banks will want to hold.

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SECOND: ASSET MANAGEMENT

Banks manage their assets to maximize profits by:

1. Assess creditworthiness of potential borrowers to avoid costly defaults.

(Banks usually conservative, default rate less than 1%).

 2. Buying securities with high returns and low risks.

 3. Diversify assets.

  • Securities: Short (T-bill) and long term (Gov’t bond)
  • Loan portfolio (commercial, Consumer, mortgage).
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4. Manage assets to ensure liquidity by holding sufficient liquid assets in case of large deposit outflows.
  • For example, T-Bills are so safe and liquid that they are considered "secondary reserves." 
  • The bank has to balance liquidity against increased earnings from less liquid assets (like loans).
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Third: Capital Adequacy Management

Banks choose the amount of capital they hold for three

reasons:

1. It Helps Prevent Bank Failure:

Bank failure occurs when a bank cannot satisfy its

obligations to pay its depositors and creditors and so

goes out of business.

Example

Consider two banks, one with low capital to assets ratio

and the other high ratio.

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High Capital Bank

Low Capital Bank

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If the two banks lose $ 5 million of their loans, their assets and capital will decline too by the same amount.

The new balance sheets become as follows:

High Capital Bank

Low Capital Bank

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RESULT:
  • The high capital bank is in a good situation because its net worth (capital) is positive ($5 m.).
  • The low capital bank is in a bad situation because its net worth is negative (-$1 m.).
  • The value of assets for low capital bank is less thanits liabilities, therefore it is insolvent(bankrupt):

Insolvent: It does not have enough assets to pay off holders of its liabilities (depositors, creditors).

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2. It Affects Returns to Equity Holders

Bank owners need measures indicating if the bank is

being managed well or not.

Return on Assets (ROA):

ROA = net profit after taxes / assets

The ROA shows how efficiently a bank is being run by

indicating how much profits are generated on average

by each dollar of assets.

Return on Equity (ROE):

ROE = net profit after taxes / equity capital

The ROE shows how much the bank earnson equity

investment.

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Equity Multiplier (EM):

 EM = assets / equity capital

It is the amount of assets per dollar of equity capital.

It shows the direct relationship between ROA and ROE:

 ROE = ROA . EM

The formula shows what happens to the return on

equity when a bank holds a smaller amount of equity

capital for a given amount of assets.

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Example

The high capital bank: EM = $____ m. / $____ m.=

The low capital bank: EM = $____ m. / $____ m.=

If ROA is 1%, then:

ROE for the high capital bank = ____% X ___ = ____%

ROE for the low capital bank = ____% X ___ = ____%

Equity holders of the low capital bank are happier

because they have a return twice higher.

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Thus, bank owners don't like holding a lot of capital

( because it reduces ROE).

Result:

Given the ROA, the lower the bank capital, the higher

the ROE. This shows that there is a trade-off between safety (the case of insolvency ) and returns (high ROE).

3. Bank Capital Requirements

Banks hold capital because they are required by law to do so.

fourth liability management
FOURTH: LIABILITY MANAGEMENT
  • Acquiring funds at the lowest possible cost.
  • For example: Options to obtain sources of funds from either accepting deposits ( interest rate paid), or borrowing ( interest rate charged).
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Managing Risks

1) Interest Rate Risk

High volatility in interest rates makes banks exposed to

interest- rate risk:

The riskiness of earnings and returns that is associated

with changes in interest rates.

First National Bank

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Example:

First National Bank

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Example:

If interest rate rises from 10% to 15% ( Δ = __%)

Δ Profit = Δ income – Δ cost

Δ income = Δ interest  X rate sensitive assets

                = __%   X $ ___ million  =  $ ___ million

Δ cost = Δ interest  X rate sensitive liabilities

            = __%   X $ ___ million  =  $ ___ million

Δ Profit =

For your own assignment:

What if interest rate falls by 5%?

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Gap Analysis

- Sensitivity of bank profits to changes in interest rates.

- It can be measured using the gap analysis by subtracting the amount of rate sensitive liabilities from the amount of rate sensitive assets.

- Gap = RSA – RSL = ____ – ____ = $ ____ million

Δ profit = Δ interest X Gap

Δ profit = __%  X  $___ million = $___ million

Result

If a bank has more rate-sensitive liabilities than assets, a

rise in interest rates reduces bank profits, while a

decline in interest rates raises profits.

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Duration Analysis

- Examines the sensitivity of market value of the bank's

total assets and liabilities to changes in interest rates.

- Uses the average duration of assets and liabilities to

measure the change in net worth for a given change in

the interest rate.

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Example: Assuming average duration of assets 3 years and liabilities 2. The value of assets is $100 million and value of liabilities is $90 million. If interest rate rises by 5%.

Δ Net Worth = Δ $ assets - Δ $ Liabilities

% Δ Assets = - Δ interest X Average Asset duration

= ____% X _____= ____%

Δ $ Assets = % Δ Assets X $ Assets

= _______% X $______ = $_______

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% Δ Liab’s = - Δ interest X Average Liab’s duration

= ____% X _____= ____%

Δ $ Liab’s = % Δ Liab’s X $ Liab’s

= _______% X $______ = $_______

Δ Net Worth = $ _____ - $ ______ = $ _______

For your own assignment:

What if interest rate falls by 5%?

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2)Managing Credit Risk

1. Screening and Monitoring

a- Screening (screen out bad credit risks)

Through collecting information about the borrowers for evaluations.

b- Specialization in Lending

Doing so, will ease up the process of screening out the bad borrowers , but it squeezes the ability diversifying risks.

c- Monitoring and Enforcement of Restrictive Covenants

monitoring the activities made by borrowers through enforcing the borrowers to write a provision into the loan contract.

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2. Long-Term Customer Relationships

This reduces; costs of information collection, and makes it easier to screen out bad credit risks

3. Loan Commitments

The bank makes a commitment to firms in providing a loan in the future if needed. Such method promotes long term relationship which reduces costs of information collection and costs of screening

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4. Collateral & Compensating Balances

Collateral: a property promised to lender as compensation if the borrower defaults.

Compensating Balances: the required minimum amount of funds kept (by the firm receiving the loan) in the checking Acc.

5. Credit Rationing

This is when the bank limits the supply of loans

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Off-Balance-Sheet Activities

1. Loan sales

Income generated from loan sales

2. Generation of Fee income from

A. Foreign exchange (FROX) trades for customers

fees charged when trading in FROX on the behalf of customers

B. Servicing mortgage-backed securities

issued by firms through banks, so banks take fees for such action

C. Guarantees of debt

Banks usually issue acceptances and guarantees to customers ( firms mostly) but with fees

D. Backup lines of credit

Proving a loan in the future based on the “loan commitment”, or standby letter of credit

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3. Trading Activities and Risk Management Techniques

“ income generated from trading in such activities is recorded at off-balance sheet “

A. Financial futures

B. Financial options

C. Foreign exchange or forward exchange

D. Swaps (currency or interest rate)