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Capital Markets

Capital Markets. Spring Semester 2011 Lahore School of Economics. Salaar farooq – Assistant Professor. Depository Institutions. Lecture. Depository Institutions Learning Objectives. What is a depository institution? How a DI generates income? What is the Asset/Liability problem for DI’s?

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Capital Markets

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  1. Capital Markets Spring Semester 2011 Lahore School of Economics Salaar farooq– Assistant Professor

  2. Depository Institutions Lecture

  3. Depository InstitutionsLearning Objectives • What is a depository institution? • How a DI generates income? • What is the Asset/Liability problem for DI’s? • What is Funding Risk? • What are DI’s funding sources? • What are Reserve Requirements?

  4. Depository Institutions? Include:

  5. Depository Institutions? Include: • Institutions which take deposits • Deposits represent Liabilities (debt) for DI’s Include: • Banks • Savings & Loan institutions • Savings Banks • Credit Unions

  6. How do DI’s make money? 3 ways:

  7. How do DI’s make money? 3 ways: • Loans Make direct loans to entities • Securities investments Investing in securities & holding portfolios • Fees Charged to their customers

  8. Importance of DI’s? Heavily regulated because:

  9. Importance of DI’s? Heavily regulated because: • Their role in financial system a) Creating the financial playing field • Principal means of making payments a) Individuals & Businesses use for payments • Vehicle for Govt monetary policy a) MP implemented through banking system

  10. Because of their importance, Given special privileges • Access to Federal Deposit Insurance • Provision of liquidity in emergencies • Govt has interest in DI’s stability & survival…

  11. Asset-Liability Problem of DI’s? 2 Main problems: • Funding Risk • Liquidity Risk

  12. Asset-Liability Problem of DI’s? Funding Risk: Illustrate using 100MM, 7% 1 & 10 yrs • Use of Spreads (DI’s make money) Difference between bid/ask or charging premiums • Gaps (Mismatches) Open positions created due to duration differences • Interest rate exposure Funding/Gapping activity resulting in interest rate risk

  13. Asset-Liability Problem of DI’s? Opportunities:

  14. Asset-Liability Problem of DI’s? Opportunities: • Interest Rate view Mgrs who have expectations of interest rate changes will seek to profit from funding/gapping • If Interest rates rise What position should you have? • If interest rates fall What position should you have?

  15. Asset-Liability Problem of DI’s? Threats of positioning:

  16. Asset-Liability Problem of DI’s? Threats of positioning: • Adverse financial consequences If expectations are not realized, Huge losses can occur • No one can predict interest rates consistently Highly risky? • Becomes same as gambling Long run losses highly likely?

  17. Asset-Liability Problem of DI’s? Main goal of Mgmt:

  18. Asset-Liability Problem of DI’s? Main goal of Mgmt: • Locking in the spread • Minimize interest rate exposure • Various financial instruments used to manage risk

  19. Liquidity Concerns of DI’s? Balancing two activities?

  20. Liquidity Concerns of DI’s? Balancing two activities: • Satisfy Withdrawals of customers Liquidity required • Provide Loans to customers Liquidity required

  21. Liquidity Concerns of DI’s? 4 ways to solve liquidity issues?

  22. Liquidity Concerns of DI’s? 4 ways to solve liquidity issues: • Attract deposits • Increase borrowing (using security collateral) • Sell Securities on hand • Raise Funds in Money Markets

  23. Liquidity Concerns of DI’s? Increase Borrowing using securities: • Discount window borrowing at Fed (last resort!)

  24. Liquidity Concerns of DI’s? Sell securities it owns: • DI must invest in ST, liquid securities with low price risk and keep these in its inventory • E.g stocks?... No, Bonds? …. No • Solution: ?

  25. Liquidity Concerns of DI’s? Sell securities it owns: • DI must invest in ST, liquid securities with little price risk and keep these in its inventory • E.g stocks?... No, Bonds? …. No • Solution: ST, MM or debt obligations (fed funds)

  26. Liquidity Concerns of DI’s? SECONDARY RESERVES? • Securities held by a DI for the purpose of satisfying withdrawals or loans. • Disadvantage? Lower yield % of assets as secondary reserves depends on DI’s risk/return appetite

  27. Liquidity Concerns of DI’s? One more reason for holding liquid assets?

  28. Liquidity Concerns of DI’s? One more reason for holding liquid assets? • To fulfill Govt regulation! • In form of Reserve Requirements (discussed later)

  29. Commercial Banks? 3 Main Types:

  30. Commercial Banks? 3 Main Types: • Individual Banking • Institutional Banking • Global Banking

  31. Commercial Banks? Individual Banking: • Consumer Lending • Residential Mortgage • Installment Loans • Credit Card financing • Car & Boat Financing • Brokerage services • Student Loans S10

  32. Commercial Banks? Institutional Banking: • Loans to Corporations • Loans to Insurance companies • Loans to Govts • Commercial Financing & Leasing

  33. Commercial Banks? Global Banking: • Investment Banking business • Foreign Exchange products • Capital Markets products • Corporate financing products (underwriting securities etc)

  34. Commercial Banks? Banks as Dealers: • Investment Banking business • Foreign Exchange products • Capital Markets products • Corporate financing products (underwriting securities etc)

  35. Commercial Banks? How do Banks raise Funds?

  36. Commercial Banks? How do Banks raise Funds? 3 Main Sources of Funds • Deposits • Non-Deposit Borrowing (M.MKts) - Debt • Common Stock & Retained Earnings

  37. Commercial Banks? Reserve Requirement & Borrowing at the Fed Funds Mkt? • Banks must maintain a %age of deposits with Fed • %age is called Reserve Ratio(depends on deposit type) • The cash kept with Fed is called Required Reserve

  38. Reserve Requirements? Basic Computation: • Deposit Computation Period 2 Week period where the average of the daily is taken to get RR (THR-WED) • Actual Reserves RR must be met by Actual Reserves at the Fed • Excess Reserves If bank reserves exceed the RR at the Fed • Fed Funds Market & Fed Funds Banks short of RR borrow from Excess Reserves of other Banks Called the Fed Funds rate

  39. Reserve Requirements? Fed Discount Window: • Fed is the Banker’s Bank – last resort • Charges DISCOUNT RATE (usually 50bp lower) • Collateral Treasury securities, Govt securities etc. • Heavily Discourages its use Will investigate if use becomes frequent

  40. Depository InstitutionsSummary • What is a depository institution? • How a DI generates income? • What is the Asset/Liability problem for DI’s? • What is Funding Risk? • What are DI’s funding sources? • What are Reserve Requirements?

  41. END DI’s • Next Structure of Markets : Primary

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