Week 6
Chapter 9
The Banking Firm and the Management of Financial Institutions
The Bank Balance Sheet
Balance Sheet of all Commercial Banks (percent of total 1999)Assets / Liabilities + capital
Reserves (1%)
Cash items in the process (4%)
of collection + deposits at
other banks
Securities
U.S. government (14%)
State and Local (8%)
Loans
Commercial and Industrial (18%)
Real Estate (26%)
Consumer (9%)
Interbank (4%)
Other (9%)
Other assets (bulldings, (7%)
Computers, etc( / Checkable deposits (11%)
Nontransaction deposits (37%)
§ Small denomination time deposits (<100,000) + savings deposits
§ Large denomination time deposits (15%)
Borrowings (29%)
Bank Capital (8%)
Liabilities -- what the bank owes other people
Checkable deposits
§ Non interest bearing checking accounts (demand deposits), NOW accounts, money market deposits accounts
§ Essentially M1
Nontransaction deposits
§ Deposits that don’t allow check writing privileges (usually have higher interest rates).
§ Savings accounts (no maturity date). Can usually withdraw when you present yourself to bank. Could require that you wait for a period of time before withdrawal.
§ Time deposits < 100,000 (CD’s) have a maturity date and penalty for early withdrawal. Less liquid than savings accounts but pay higher interest. (components of M2)
§ Time deposits >=100,000 (CD’s) are negotiable – sold in secondary market. (Components of M3)
Borrowings
§ From FED (called discount loans)
§ From other banks (overnight borrowing of other banks reserves. This is called the federal funds market. It has nothing to do with the government. The purpose is to ensure that a bank has adequate reserves to meet FED requirements)
§ From parent company (called a holding company).
§ Loans from companies (repos –repurchase agreements)
§ Borrowings of Eurodollars (deposits denominated in U.S. dollars residing in foreign banks or foreign branches of U.S. banks).
Bank Capital
§ This is owed to the banks owners (stockholders). This is what they stand to lose if the bank fails. The hope is they will hire good managers so they will not lose this money.
ASSETS -- this is what the banks use to earn revenue.
Reserves – a bank must hold reserves to be able to pay depositors. Reserves consist of currency that the bank holds (vault cash) plus deposits that the bank has with the FED. Banks earn nothing on reserves.
§ Required reserves – this is the amount that the FED forces the banks to have as reserves. This will be some percentage of deposits. Used by the FED to prevent bank panics and control the money supply.
§ Excess reserves = amount of reserves a banks has in addition to required reserves.
o total Reserves = required reserves + excess reserves
The existence of excess reserves permits the expansion of the money supply
§ Cash items in the process of collection
§ Deposits at other banks
o Correspondent banking – small banks have deposits at large banks as a means of paying for certain services such as check collection, foreign exchange transactions and the purchase of securities.
§ Securities – Treasury bonds, treasury bills, U.S. government agency securities, State and Local government securities. These area very liquid assets and can be bought or sold in s secondary market. Often called secondary reserves because they are so liquid. These are also important in the control of the money supply.
§ Loans -- chief source of bank earnings. Not as liquid as securities but more profitable (as long as they are good loans).
o Commercial and industrial – to companies
o Consumer loans – for cars, home improvement
o Real Estate loans -- mortgages
o Loans to other banks via federal funds/
§ Other assets – the bank buildings, computers and other physical capital. Note that banks are not allowed to own other companies or farms or real estate.
Bank Operations
Create the bank – some close friends scrape together $1000 to create a bank. The $1000 is bank capital is a liability but the bank can use it as an asset to make money. Initially it will be a part of bank reserves until they buy a security or make a loan.
Assets / Liabilites + capitalReserves $1000 / Capital $1000
Bank gets depositors – they deposit $10000 in a checking accoung
Assets / Liabilites + capitalReserves $11000
Total $11000 / DdDemand deposits $10,000
Capital $1000
Total $11000
The bank is still not making money. To do so it makes some loans and buys some government securities. Let us suppose that the FED requires the bank to keep 10% of demand deposits in the form of reserves (Reserve Ratio = 0.1).
Assets / Liabilites + capitalReserves $2000
Required $1000
Excess $1000
Loans $4000
Bonds $5000
Total $11000 / DdDemand deposits $10,000
Capital $1000
Total $11000
Because assets = liabilities + capital this bank must have $11000 in assets. If the bank has purchased $5000 in bonds and make loans totaling $4000 then that accounts for $9000 of the assets. The remainder, $2000, is in the form of reserves. The FED requires the bank to have 0.1*10000 in the form of required reserves. The amount in excess of requires reserves is excess reserve = $1000.
Someone writes a check for $1000 on their deposit
Assets / Liabilites + capitalReserves $1000
Required $900
Excess $100
Loans $4000
Bonds $5000
Total $10000 / DdDemand deposits $9,000
Capital $1000
Total $10000
Why Have Excess Reserves
Banks earn no direct profits by holding excess reserves, so why do it? Consider a bank with zero excess reserves.
Assets / Liabilites + capitalReserves $1000
Required $1000
Excess $ 0
Loans $5000
Bonds $5000
Total $11000 / DdDemand deposits $10,000
Capital $1000
Total $110000
Now suppose someone cashes a check
Assets / Liabilites + capitalReserves $ 0
Required $900
Excess -$900
Loans $5000
Bonds $5000
Total $10000 / DdDemand deposits $9,000
Capital $1000
Total $10000
However banks must have at least the required amount of reserves on hand. So if a bank has zero excess reserves it cannot meet the reserve requirement of the FED if anyone cashes a check on the bank or withdraws a deposit.
What might the bank do to get adequate required reserves in this case?
1. Borrow from other banks in the federal funds market (must pay interest)
2. Sell some securities (may take a capital loss).
3. Call in loans (not renewing short term loans – makes customers mad.)
o Can also sell loans to other banks likely at a loss.
4. Borrowing from the FED
o Pay interest to FED
o FED discourages regular borrowing. This should only be used for extraordinary circumstances.
All four of these options are costly. For that reason banks find it useful to maintain a level of excess reserves greater than zero. The trade off is that the bank earns no profits on excess reserves.
Asset Management
How do banks allocate assets between securities, reserves, and loans? Loans tend to be the most profitable on average. The also tend to be riskier than securities. Reserves are risk free but earn nothing. Banks must balance risk and return.
1. Try to find borrowers who will pay high interest rates and are unlikely to default. Banks are very conservative and the default rate is only about 1%. Banks often specialize in making loans to specific borrowers such as farmers, energy companies and real estate developers. This can be risky if the industry slumps.
2. Find government securities that pay high returns and have little risk. There is very little default risk with government securities. There is still interest rate risk with holding long term bonds.
3. Must manage assets to meet reserve requirements.
Liability Management
Not a problem before the 60’s. Banks had few different types of liabilities. Sixty percent of the liabilities were checkable deposits that didn’t pay interest. So there was little competition for depositors (well they did give away toaster ovens). Also there was little bank borrowing from one another to meet reserve needs.
Banks began to seek depositors by creating new kinds of liabilities (NOW accounts, negotiable CD’s, federal funds market). If banks have more liabilities they also have more assets.
Bank Capital
Bank capital is what the bank owes to the stockholders. Stockholders would like to be owed nothing they would prefer to have the money now. Consider the following situation.
Assets / Liabilites + capitalReserves $2000
Required $1000
Excess $1000
Loans $4000
Bonds $5000
Total $11000 / DdDemand deposits $10,000
Capital $1000
Total $11000
Now the banks sells a bond it has on the books for $1000 and receives $2000 for it.
Assets / Liabilites + capitalReserves $4000
Required $1000
Excess $3000
Loans $4000
Bonds $4000
Total $12000 / DdDemand deposits $10,000
Capital $2000
Total $12000
Assets increase by $1000 which goes into reserves and liabilities also increase by $1000 which goes into bank capital. The bank could give the $1000 to the stockholders in the form of dividends. In fact they could give the stockholders $2000 in dividends. Capital belongs to the stockholders. Why not give them what they own?
We want the bank owners to hire responsible managers who will not make overly risky loans or other bad investments. If the owners stand to lose nothing they may not care about what the manager does. If they stand to lose funds they are apt to be far more interested in hiring responsible managers.
For this reason banking regulators require a certain amount of the banks liabilities in the form of capital.
The 1990’s Credit Crunch
In the late 1980’s banks lost a lot of money due to failed real estate loans. The bank had to write off bad loans. This reduction in assets must be offset by a reduction on the liabilities side (a reduction in capital). At this time regulators were also raising capital requirements. Banks had to raise new capital or cut back on lending. This occurred during a recession and probably made the recession worse.
Managing Credit Risk
Adverse Selection and Moral Hazard
Adverse Selection: Bad credit risks are likely to apply to numerous banks for loans. If they get turned down at one place they will try again. There is some probability that they will slip through somewhere and get a loan.
Moral Hazard: once a borrower has got a loan they may be tempted to invest in high risk projects. This will pay them high returns but make it more likely that they will not be able to repay the loan.
Banks will be more profitable if they can reduce these problems.
Banks reduce the problems associated with adverse selection by
Banks reduce adverse selection by
§ Screening: Prospective borrowers must provide information about their credit history and current financial situation (income, debt, assets) and other personal information (age, employment history, number of children). This and other information (credit bureau reports) are used to determine if the borrower gets a loan.
§ Specializing in Lending Banks often make loans to specific borrowers (farm, energy companies, real estate developers). By specializing banks become familiar with the workings of the industry and of the individuals operating in the industry. This knowledge should be useful in determining who to lend to.
There is a problem. What happens when the industry goes sour and this is the only thing you specialize in. The bank does not diversify.
Moral Hazard Banks monitor activities of borrowers. They may require provisions in the loan contract that restrict the activities of the borrower.
Long Term Customer Relationships: Another way of gaining information about the customer. The bank has knowledge about customers that it has had a history of banking activity. This also makes it easier for customers to get loans. Banks engage in activities to establish long term relationships with customers.
§ Loan Commitments: The bank makes a commitment to make loans to commercial customers. The customer has access to funds—the bank builds a relationship.
§ Collateral and Compensating Balances: Collateral is what the borrower stands to lose if a loan is not repaid. The house is usually used a collateral for a home mortgage loan. Customers are often required to maintain deposits in the bank where a loan is made (Compensating balance). This also gives the bank a means of monitoring the behavior of the borrower (moral hazard) –the bank can track check payment practices.
Managing Interest Rate Risk
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First National BankAssets / Liabilities
Rate sensitive assets $20 mil / Rate—sensitive liabilities $50 mil
Variable rate loans
Short term securities
Federal funds / Variable rate CD’s
Money market deposit accounts
Fixed rate assets $80 mil / Fixed—rate liabilities $50 mil
Reserves
Long term loans
Long term securities / Checkable deposits
Savings deposits
Long term CD’s
Bank Capital
This bank has a mismatch between assets and liabilities. The bank may have to compete by offering higher interest rates to holders of rate sensitive deposits (50 mil). But the bank only has $20 million in rate sensitive assets. If the bank has to offer the holders of rate sensitive deposits higher interest rates to keep them as customers it will have difficulty in offsetting this using its rate sensitive assets because they only amount to $20 mil. If interest rates rise this bank will lose profits. Of course the bank will increase profits if interest rates fall.
If the bank manager believes that interest rates will fall he may decide to do nothing. If he believes that they will rise he may decide to sell some long term securities or loans. Of course if a lot of other people feel the same way the bank may take a loss on the sale.
Off Balance Sheet Activities
Loan Sales
The banks sells a loan to some other party. The loan disappears from the balance sheet. If the bank earns a profit then it may pay the bank owners a dividend. These may be particularly profitable if interest rates fall.
Generation of Fee Income
Income the bank generates by charging fees for services provided to customers.
§ Assisting customers with foreign exchange trades
§ Guaranteeing debt securities such as bankers acceptances.
§ Providing backup lines of credit