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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.

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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
I. Balance Sheet
  • liabilities ($8.25 trillion)
    • sources of bank funds
  • assets ($9.1 trillion)
    • uses of bank funds
liabilities
Liabilities
  • deposits ($5.95 trillion, 72%)
    • checkable deposits
    • savings deposits
    • time deposits (CDs)
slide4
borrowed funds
    • discount loans (Federal Reserve)
    • federal funds (other banks)
    • repos
    • eurodollar loans
    • commercial paper
assets
Assets
  • cash items (< $1 trillion)
    • reserves

-- required

-- excess

    • deposits at other banks
    • cash items in collection
slide6
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
Bank capital
  • or net worth

= assets - liabilities

  • banks have capital requirement
    • cushion against bad loan losses
using t accounts
Using T-accounts
  • show changes in assets & liabilities
  • show how money supply changes
example
example
  • I empty Timmy’s piggy bank
  • open a savings account
  • $50
slide10
$50 in cash increases assets
  • $50 in savings increases liabilities
slide11
suppose required reserves are

10% of deposits

    • required reserve ratio
ii bank management
II. Bank Management
  • liquidity management
    • need cash to deal with deposit outflows
    • but holding cash drags down profits
slide14
if too low on cash,
    • borrow from banks or Fed
    • sell securities
    • call in or sell loans

all of which are costly

slide15
asset management
    • maximize returns (profits)
    • acceptable risk

-- diversified loan portfolio

    • adequate liquidity
    • regulatory compliance
slide16
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

slide17
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
III. Managing Credit Risk
  • loans are primary asset
    • problems of

adverse selection

-- BEFORE loan

moral hazard

-- AFTER loan

banks gather information
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

slide20
monitoring
    • moral hazard
    • monitor borrow after loan

-- restrictive covenants

-- enforce agreements

slide21
example of monitoring
    • mortgage escrow account

-- banks collects monthly

insurance, tax payments

from homeowner

-- ensures that owner pays

taxes, insurance

slide22
long-term customers
    • less screening & monitoring
    • encouraged with better terms
slide23
collateral
    • protects bank from loss
    • adverse selection

-- discourages certain borrowers

    • moral hazard

-- discourages borrower risk-taking,

since borrower is risking property

slide24
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
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
slide26
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
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

slide28
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
V. Other Bank Activities
  • Off-balance sheet
  • loan sales
    • secondary market
    • frees up capital to make more loans
slide30
fee income
    • growing portion of bank profits
    • ATM, service fees
    • guarantee fees
    • makes banks less dependent on

spread between deposit & lending rates

slide31
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
VI. Financial Innovation
  • new types of assets, new activities
  • why?
    • changing demand conditions
    • changing supply conditions
    • regulatory avoidance
demand
demand
  • interest rate volatility (and risk)

increase in 1970s

    • banks demand new products to manage the risk
    • ARM reduces bank interest rate risk
supply
supply
  • banks supplying new services
  • cost of financial transactions have fallen with new technologies
    • ATMs
    • credit/debit cards
    • internet banking
regulation
regulation
  • avoiding reserve requirements
    • minimize liabilities subject to requirement
    • eurodollars
    • commercial paper