fin2700 ch09

							Chapter 9




      Commercial Banks
             Contents

Commercial Bank Balance Sheet
  Commercial Bank Liabilities

  Commercial Bank Assets

  Commercial Bank Capital Accounts

Commercial Bank Management
  Liquidity Management

  Liability Management

  Capital Management
                   The Importance of
                   Commercial Banks
                   Primary claims


                      Funds




Savers                                       Borrower



         Funds                       Funds
                       Financial
                    Intermediaries
Secondary claims                     Primary claims
               The Importance of
               Commercial Banks
• Depository institutions play a key role in
  channeling funds from savers (surplus unit)
  to borrowers (deficit units)

• Commercial banks dominate among
  depository institutions.

• Banks take in funds by accepting _____
                                   deposit
• Banks use the funds mainly to ______
                                grant loans
             The Importance of
             Commercial Banks
• Commercial banks are the oldest
  and most diversified of all financial
  intermediaries.
• Banks are important in the money
  supply process.
• Banks create money by lending or
  buying the securities
                 The Commercial Bank
                 Balance Sheet




• Banks earn a profit on the “spread” (3%-4%)
  by obtaining funds at relatively low interest
  rates and lending at higher interest rates.
• In recent years, fees have played an
  increasingly important role in bank profits.
                 The Commercial Bank
                 Balance Sheet

• A bank balance sheet is a statement of its
  assets, liabilities, and net worth at a given point
  in time.
     • Assets are what it owns.
     Loan, securities (Investment)  earning
       assets
     • Liabilities are what it owes.
     Demand deposit, saving deposit, time deposit
                The Commercial Bank
                Balance Sheet

– Net worth (capital accounts, capital)
 is the difference between its assets and
 liabilities.
Common stocks, retained earning


  • Assets = Liabilities + Net Worth


  • Assets - Liabilities = Net Worth
Figure 9-1
Table 9-1
          Commercial Bank
          Liabilities

Transactions Deposits
 (checkable deposits)
Non-transaction Deposits
Non-deposit borrowing
Other liabilities
               Commercial Bank
               Liabilities
Transactions Deposits (checkable deposits)
     Demand Deposits: non-interest bearing
     checking accounts
     Negotiable Order Of Withdrawal (NOW)
     Accounts: interest-bearing checking
     accounts
     Automatic Transfer Service (ATS)
     Accounts:Paired accounts with checks on
     non-interest baring accounts & automatic
     transfers to it from interest-bearing
     accounts
               Commercial Bank
               Liabilities
Non-Transactions Deposits
     Passbook Savings Accounts
     Any amount of funds can be added or
     withdrawn at any time
     Small Certificates of Deposit (CDs up to
     $100,000)
     There are penalties if withdrawing before
     maturity (3 months to 5 years)  similar
     to time deposit in Thailand
     Money Market Deposit Accounts (MMDAs)
     Special type of saving account with limited
     check writing feature (no more than 6
               Commercial Bank
               Liabilities
Non-deposit Borrowing
    Borrowing from the Fed
     discount loans, discount window
     pay interest at the discount rate
    Borrowing from other banks’ excess reserve
     overnights loans between bank
     federal funds
     pay interest at federal fund rate
           Commercial Bank
           Assets

 Cash Assets
 Loans
 Securities
 Other Assets
               Commercial Bank
               Assets
Most of banks’ assets are in form of income-
earning assets or earning assets (85%)
 Loan
 Securities
 However, banks are subjected to maintains
portion of their source of funds (liabilities) in
form of non-interest-earning legal reserves
 Coin and currency in banks
 Bank’s deposit balance at the central bank
                     Commercial Bank
                     Assets
Cash Assets
  Vault cash -        Currency and coins at bank
   o to meet public’s demand
   o to meet reserve required
  Deposits with Federal Reserve Bank (central bank)
   o to meet reserve required
   o to facilitate check clearing process

  Deposits with other banks
   o Correspondent banking – smaller banks maintain deposits in
     larger banks in return of services e.g. check collection,
     investment counsel, and transaction in securities and foreign
     currency
                  Commercial Bank
                  Assets
Loans
  Real Estate Loans: collateralized by property (real estate),
   Ex. Mortgage

   Securitization – banks bundle many real estate
    loans into the package and issue the
    securities based on this package to investors
  Business Loans:
    Regular installment loans
    Lines of credit (subject to compensating balance)
                  Commercial Bank
                  Assets
  Consumer Loans:
    Auto loans
    Credit cards  banks get the fee from business accepting
    the card and also get the interest rate if the cardholders
    design to pay the minimum balance.
    Overdraft arrangement
  Other Loans:
    Federal funds sold

Securities
Other assets  Building, Land, Equipment
                     Commercial Bank Capital
                     Accounts

• Bank capital derives from the issue of bank stock
  shares and from retained earnings

• Bank capital provides a cushion that protects a bank's
  owners from potential bank insolvency
   – Total assets are less than total liabilities

   – Negative net worth
             Writing Off Bad Loans
Bank needs to write off $600,000 for bad loans
                   Writing Off Bad Loans

• Immediate write off bad loans can make the bank to
  face the situation of insolvency.
   – Close the banks

   – Find new owners to take over the bank

     (through Merger & Acquisition)

• Bank usually (also subject to the regulation) sets aside
  contingent funds against loan loss in advance

   loan loss reserve (Allowance for bad debts)
               Commercial Bank
               Management

• Commercial banks strive to:
  – earn solid profits;
  – maintain extremely low exposure to the
    possibility of becoming insolvent, and
  – maintain high liquidity (the ability to
    immediately meet currency withdrawals)
    by managing liquidity and capital.
                    T-Accounts

• T-accounts are statements of the change in
  the balance sheet resulting from a given
  event.
  – ie. if a customer withdraws $200 in cash from a
    savings account at the Bank of Medicine Bow.



   ie. Clearing a check for $12,000 written by a
  bank customer
                The Importance of
                Liquidity
• Banks must have emergency plans to meet
  large reserve withdrawals, so banks need to
  hold liquid assets like Treasury bills.

• If a bank is exposed to large deposit outflows
  and can obtain reserves only at substantial
  cost, it could find itself in serious trouble,
  even if it has a relatively large capital
  account.
               The Liquidity-Risk
               Trade-off
• If bank decides to maintains high
  liquidity,
  bank will face less risk

• If bank decides to maintains low liquidity,
  bank will face higher risk
                       The Liquidity-Risk
                       Trade-off




 With a reserve requirement of 10%, the bank has no excess
  reserves.
 Its assets are 90% in high return loans and 10% in low return
  securities.
 What if depositors withdraw $20 million?
                        The Liquidity-Risk
                        Trade-off




 If depositors withdraw $20 million,
     Deposit decreases to $380 million
     Reserves also decreases to $20 million
 However, required reserve ratio is 10%, bank need to maintain
  reserves at $38 million  bank need to find more reserve for $18
  million
 Bank has marketable securities (liquid assets) only $10 million that
  is not enough  bank need to find other funds
                    The Liquidity-Profitability
                    Trade-off

• If bank decides to maintains low liquidity,
  bank will have a change to get higher
  return

• If bank decides to maintains high liquidity,
  bank will get lower return

• Higher liquidity means bank will hold more excess reserve
  (no return) and more marketable securities (low return)
  rather than lending the loan (higher return)
               The Liquidity-Profitability
               Trade-off




• The bank has $10 million excess reserves.
• Its assets are split between high return
  loans & low return securities.
                       The Liquidity-Profitability
                       Trade-off




• If depositors withdraw $20 m, then the balance sheet changes
   – Deposit decrease to $380 million
   – Reserves decrease to $30 million
• With 10% required reserve ratio, bank has to maintain $38
  million reserve  bank need more $8 million
• Bank have lots of marketable securities to be liquidated and
  change to reserve  no problem
• However, it is less profitable because it has fewer high-return
  loans.
              The Liquidity-Profitability
              Trade-off

• If bank decides to maintains low
 liquidity,
 bank will face higher risk but have more
 opportunity to get higher return


• If bank decides to maintains high
 liquidity,
 bank will face lower risk and get lower
                    Indicators of Bank
                    Liquidity

• The ratio of bank loans to total assets
   – Higher ratio  lower liquidity

• The ratio of securities to total assets
   – Higher ratio  higher liquidity

• The ratio of demand deposit to total bank deposits
   – Higher ratio  Bank need to maintain
     more liquidity
                    Liability Management

• Banks look for good lending opportunities and then search
  for the funds to finance these loans.
• When a large bank finds a profitable lending opportunity, it
  can:
   – “buy” federal funds;
   – issue negotiable CDs at whatever interest rate is required
     to attract funds;
   – issue repurchase agreements or borrow Eurodollars, or
   – obtain funds through the commercial paper market.
                     Liability Management

• Aggressive liability management allows banks to
  make profitable loans that they would otherwise
  have to turn down.

• Aggressive liability management can be dangerous,
  because a bank’s assets typically have longer
  maturities than its liabilities.
• If interest rates rise sharply, banks can suffer
  severe losses.
                 Liability Management

                   Loans




5%     5%            5%


Now   2nd year     3rd year       10th year



                     7%
       4%
1%

                  Deposit
                       Capital Management

• Bank capital provides a financial cushion so that transitory
  adverse developments will not cause insolvency.

• Bank capital also protects bank managers and owners from
  their own mistakes and from various risks:
   – default risk  borrowers do not pay back their loans
   – interest-rate risk  when interest rate changes
   – liquidity risk  depositors will withdraw the fund
   – Foreign exchange rate risk  when exchange rate change
   – political or country risk  risk that fund or assets in other
     countries cannot be mobilized to home country
   – management risk  employees will engage in activities
     involving enormous risk (Barings Bank – Nicholas Leeson)
              Capital Management

                            Capital
• Bank capital ratio =
                             Asset




• higher bank capital ratio
  – implies a lower risk of insolvency,
  – but also a lower rate of return.
                      The Capital Management
                      Tradeoff

  Earning                Earning            Total Assets
                =                       x
  Capital             Total Assets              Capital

Return on Equity =       ROA       *     Equity Multiplier


Note: A high capital ratio represents a low equity multiplier;
      A low capital ratio represents a high equity multiplier

  A trade-off arises between short-run profitability &
                  the risk of insolvency
              Capital Management

Earning/Capital = Earning/TA x TA/Capital

  Suppose a bank has net income (earnings)
 1m, TA 100m
Case 1: a bank has capital = 5m
Earning / Capital = ???
Case 2 : a bank has capital = 10m
Earning / Capital = ???
                   Summary

Commercial bank raise the funds from accepting deposit and
use the funds in granting the loan
Bank earn interest rate spread between deposit rate and
loan rate and also earn the service fees
If bank faces daily shortage in reserve, bank can borrow
from Fed at discount rate or borrow from other banks at fed
fund rate
Loans are most-income-earning assets of the banks
Banks are subjected to maintains portion of their source of
funds in form of non-interest-earning legal reserves
(currency and deposit at Fed)
                  Summary

Smaller banks maintain deposits in larger banks in
return of services e.g. check collection, investment
counsel, and transaction in securities and foreign
currency  Correspondent banking system
Bank may bundle many real estate loans into the
package and issue the securities based on this package
to investors  securitization
Bank becomes insolvency if total asset is less than
total liability or negative net worth (equity)
                   Summary

If bank decides to maintains low liquidity, bank will face
higher risk but have more opportunity to get higher return
Aggressive liability management can be dangerous, because
a bank’s assets typically have longer maturities than its
liabilities. If interest rates rise sharply, banks can suffer
severe losses.
Bank capital provides a cushion that protects a bank's
owners from potential bank insolvency
higher bank capital ratio, implies a lower risk of insolvency,
but also a lower rate of return.