Chapter 9. The Bank Firm & Bank Management

Chapter 9. The Bank Firm & Bank Management • Balance sheet • Bank Management • Credit Risk • Interest Risk • Other activities & financial innovation

I. Balance Sheet • liabilities ($8.25 trillion) • sources of bank funds • assets ($9.1 trillion) • uses of bank funds

Liabilities • deposits ($5.95 trillion, 72%) • checkable deposits • savings deposits • time deposits (CDs)

borrowed funds • discount loans (Federal Reserve) • federal funds (other banks) • repos • eurodollar loans • commercial paper

Assets • cash items (< $1 trillion) • reserves -- required -- excess • deposits at other banks • cash items in collection

securities ($1.77 trillion) • debt securities • U.S. gov’t debt • municipal debt • loans ($5.35 trillion, 59%) • commercial • real estate • consumer • interbank

Bank capital • or net worth = assets - liabilities • banks have capital requirement • cushion against bad loan losses

Using T-accounts • show changes in assets & liabilities • show how money supply changes

example • I empty Timmy’s piggy bank • open a savings account • $50

$50 in cash increases assets • $50 in savings increases liabilities

suppose required reserves are 10% of deposits • required reserve ratio

bank lends excess reserves,

II. Bank Management • liquidity management • need cash to deal with deposit outflows • but holding cash drags down profits

if too low on cash, • borrow from banks or Fed • sell securities • call in or sell loans all of which are costly

asset management • maximize returns (profits) • acceptable risk -- diversified loan portfolio • adequate liquidity • regulatory compliance

liability management • banks increasingly compete for funds w/ other institutions • banks have more choices in raising funds • money center banks -- large banks -- rely on commercial paper, CDs, federal funds

capital management • protects from insolvency • but capital drags down shareholder return (ROE) • regulations set minimum capital requirements -- as a % of risk-adjusted assets -- increased in 1990 -- credit crunch in ‘90-’91 recession

III. Managing Credit Risk • loans are primary asset • problems of adverse selection -- BEFORE loan moral hazard -- AFTER loan

Banks gather information • screening • adverse selection • credit history (FICO score) • industry specialization in lending -- become experts in screening, -- but lack of diversification increase risk of assets

monitoring • moral hazard • monitor borrow after loan -- restrictive covenants -- enforce agreements

example of monitoring • mortgage escrow account -- banks collects monthly insurance, tax payments from homeowner -- ensures that owner pays taxes, insurance

long-term customers • less screening & monitoring • encouraged with better terms

collateral • protects bank from loss • adverse selection -- discourages certain borrowers • moral hazard -- discourages borrower risk-taking, since borrower is risking property

credit rationing • riskier borrowers would be willing to pay high rates • good borrowers won’t • so banks will not lend to certain borrowers at ANY rate or only small amounts

IV. Managing Interest Rate Risk • changes in interest rates affect BOTH assets and liabilities • assets • changes VALUE • changes the amount of interest income • depends on whether LT or ST

liabilities • cost of funds goes up with interest rates -- rates on CDs, money market accounts very sensitive -- rates on savings, checking not as sensitive

overall impact • rising interest rates • asset income will go up • cost of funds will go up • total impact depends on • amount of rate-sensitive assets vs. rate-sensitive liabilities

banks typically borrow short-term and lend long-term • so rate sensitive liabilities > rate sensitive assets • so as interest rates rise • costs increase faster than income • bank profits fall • banks must manage interest rate risk

V. Other Bank Activities • Off-balance sheet • loan sales • secondary market • frees up capital to make more loans

fee income • growing portion of bank profits • ATM, service fees • guarantee fees • makes banks less dependent on spread between deposit & lending rates

risk management • trading derivative securities • introduces new risks -- possible to lose LOTS of money in a short period of time -- traders make unauthorized trades

VI. Financial Innovation • new types of assets, new activities • why? • changing demand conditions • changing supply conditions • regulatory avoidance

demand • interest rate volatility (and risk) increase in 1970s • banks demand new products to manage the risk • ARM reduces bank interest rate risk

supply • banks supplying new services • cost of financial transactions have fallen with new technologies • ATMs • credit/debit cards • internet banking

regulation • avoiding reserve requirements • minimize liabilities subject to requirement • eurodollars • commercial paper

Chapter 9. The Bank Firm & Bank Management