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					UALR, College of Business MONEY AND BANKING, COURSE 3310 The Banking Firm and the Management of Financial Institutions
Chapter Nine (Updated)
I. What Does the Bank Balance Sheet look like? A. B. Total Assets = Total Liabilities + ____ _______/________. Assets include 1. Cash on hand (reserves/vault cash, about 5% of assets). The amount of cash that banks keep on hand and in reserves is dictated by Federal Law. a. b. c. d. 2. Required reserve ratio (percentage required for checking/demand deposits, which is currently 10%.) Excess reserves (reserves held above the minimum level) Cash on hand also includes cash items (checks) in the process of collection and Deposits at other banks

Securities (investments/interest earning assets) a. b. Account for approximately 25% of assets Considered to be secondary reserves

3.

Loans (about 56% of assets). The types of loans are: a. Commercial b. Consumer, such as auto, credit cards c. Real Estate d. Interbank e. Other Physical Assets (bank buildings, etc, 6% of assets) Deposits at Other Banks Cash Items (checks) in Process of Being Collected.

4. 5. 6.

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C.

Liabilities include: 1. _________ (checking accounts) deposits (can write checks to third parties) (9% of funds) a. b. c. 2. Non-interest earning checking accounts (require reserves) NOW accounts (require reserves) Money market deposit account

Nontransaction Deposits (account for half of funds) (56%) a. b. c. Small _______ accounts (passbook accounts) Small denomination time-deposits (less than $100k) Large denomination time-deposits ($100k and more)

3.

Borrowings from other financial institutions, including the Federal Reserve. Net Worth/equity (7%) a. b. Book value of stock Retained _________

4.

II.

How do Banks Operate? A. B. C. D. E. Begin by obtaining liabilities/deposits, followed by Obtaining assets or the making of loans and/or buying of securities. This process is called _______ Transformation. A deposit increases reserves by the ______ amount, dollar for dollar. A withdrawal decreases reserves by the _____ amount, dollar for dollar.

F.

If $2,000 is deposited into a checking account and there are no excess reserves at the bank, the bank is required that $200 be placed into reserves, which allows the bank to loan out $1,800.

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G.

If the bank has excess reserves of $200 or more, the full $2,000 can be loaned out.

III.

What are the General Principles of Good Bank Management? A. To ensure the bank has enough ready cash to pay it depositors __________ management. Acquiring assets with low levels of risk - _____ management. Acquiring funds at a low cost - ________ management. Maintaining the appropriate level of capital/net worth/equity compared to total assets - ________ management.

B. C. D.

IV.

Liquidity Management involves: A. Example: pages 220 & 221 1. A withdrawal is made, but the bank still has sufficient reserves

2.

A withdrawal is made and the bank lacks sufficient reserves. a. There is now a need for additional funds to meet the banks legal reserve requirement. Funds can be either borrowed in the Fed Funds market, which is from other banks, or from the ________ _________. Borrowing from the Federal Reserve has multiple costs. The interest expense associated with the loan and making the Federal Reserve unhappy with your bank's poor liquidity management. Or the Bank can sell of its securities for cash, if it owns any. Or, by reducing its loan portfolio by calling in loans - the cost is very bad _________ _________.
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b.

c.

d. e.

B.

Excess reserves are a good insurance policy against the costs associated with deposits outflows. The higher the costs associated with deposit outflows, the more excess reserves the bank will want to hold.

V.

Asset Management or How to Maximize the Bank's Profits involves: A. Seek the highest possible ________ on loans and securities while limiting ______ and making adequate provisions for _________ needs. To obtain the highest returns: 1. 2. 3. C. Advertise and solicit for loans with good customers Default rate should be 1% or lower. Purchase securities with high returns and low risk

B.

To manage/avoid Credit Risk or avoiding/limiting the Adverse Selection and Moral Hazard Risks the bank should: 1. Screen is loan applicants - ____________ bad credit risks from good credit risks. This process is facilitated through extensive interviews, which include reviewing the applicants: a. b. _____ and ________ history. Current level of assets less liabilities, or determining the applicant’s net worth Credit _______, and Personal history - bankruptcy, criminal record, etc

c. d. 2.

If it is a business then the company should provide a complete and accurate business plans with projected __________ ______ and income statements.

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B.

By Specialization in Lending to certain Markets or Industries, Banks can: 1. 2. Be more efficient at __________ their applicants. However, this does _______ loan portfolio diversification.

C. D.

By monitoring and enforcing ___________ loan covenants. By encouraging long-term relationships 1. Marketing to existing customers with ______ business relationships with the bank.

2.

Encourage customers to borrow over and over by offering good service and incentives For the bank to hold an ______ stake in the companies they loan funds to and share officers on boards of directors

3.

E.

By establishing a loan commitment where the bank commits to provide up to a certain amount of funds at a specified interest rate By requiring collateral and/or compensating balances 1. 2. Collateral - the pledging of an _______. Compensating ___________ – requires the borrower to keep a specified sum of money in a checking account at the bank the company borrowed from.

F.

G.

By Credit Rationing - ________ the amount the borrow can have or just saying no.

VI.

Liability Management includes these instruments: A. B. Checking/Demand deposits - becoming less and less important Negotiable certificates of deposits (CDs)

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C.

Borrowing from other institutions

VII.

Capital Adequacy Management includes: A. Ensuring that there is enough ________ to weather bad times so as to avoid insolvency, the old run on the bank play. By maintaining the right balance between ________ while not depressing earnings on net worth. 1. The calculations for measuring the appropriateness of net worth balances are: a. Return on assets (ROA) = net profit after taxes divided by total assets. Return on equity/net worth (ROE) = net profit after taxes divided by total equity/net worth..

B.

b.

c.

The Equity Multiplier (EM) the amount of assets per dollar or equity EM = assets/equity ROE = ROA * EM

3.

Comparing returns versus the percentage of equity or the EM a. The higher the EM factor, all else being equal, the _______ the ROE.

b.

The lower the EM factor, all else being equal, the ________ the
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ROE.

C.

What should typically be the appropriate equity level for a bank is often influenced by the condition of the economy, such as when there is a: 1. Strong economy – a _______ than average equity level may be appropriate. Weak economy – a ________ than average equity level may be appropriate.

2.

VIII.

What are Some Strategies for Managing Bank Capital A. Increase the bank's EM ratio or reduce its capital surplus for higher ROEs and a lower degree of safety, being more aggressive, by: 1. 2. 3. Buying ______ some of the bank's stock. Pay out _______ dividend payments. Keeping the bank’s equity constant and grow through additional deposits.

B.

Decrease the bank's EM ratio or increase its equity capital for lower ROEs and a higher degree of safety, or being more conservative, by: 1. 2. 3. Issuing _________ common stock. Paying out _______ dividend payments Make fewer loans or ________ off securities

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IX.

The Art of Matching Assets and Liabilities or How to Manage Interest-Rate Risk Entails: A. It is difficult to often do since usually banks borrow for the ______-term and lend money out for the _____ - term (mortgages). Then if interest rates move up, bank's profits will be _______. Interest rates decline, bank's profits will ___________. Example of interest rate changes and the bank's profitability

B. C. D.

X.

What is the Gap Analysis? A. The difference in the term (time to maturity) of the liabilities versus the assets and the amount of assets and liabilities that are rate sensitive Using the concept of duration, the banks asset/liability gap can be measured. 1. 2. Compare average duration of assets to average duration of liabilities. Calculating the effect of the difference in duration and its effect on equity when interest rates change Examples

B.

3.

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XI.

Banks and Off-Balance Sheet Activities - are they more or less important? A. Off balance sheet activities have grown substantially over the last twenty years Include loan sales by which the bank collects fees. Fee income from special services and not so special services such as overdraft charges. While income returns for banks have remained relatively constant the portion provided by off-balance activities has increased many fold.

B. C.

D.

XII.

Financial Innovation and the Banking System Dealing with Difficult Times A. Innovation was stimulated by high inflation rates and _______ interest rates experienced during the mid to late 70's. Innovation was also stimulated by competition from _________ banks and other types of financial institutions, such as insurance companies. Subsequently, consumers demanded new and different services and products

B.

C.

D.

New products results such as: 1. 2. 3. 4. 5. Adjustable-rate mortgages Credit and debit cards ATM's Virtual Banks NOW accounts and overnight repos

E.

The Federal Government responded with changes in regulations, which allowed Banks and Savings and Loans to be more competitive.
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1.

Removal of interest rate regulations originally established by Regulation Q so as to correct for disintermediation (the loss of deposits) by the end of the 1980's. The increased use of Eurodollars and commercial paper for raising funds a. Eurodollars - deposits in banks located in other nations denominated in dollars i. ii. Do not require reserve requirements Not subject to Regulation Q

2.

3. 4.

Banks are able to act more like brokerages. Also, there are now virtually no laws prohibiting expansion beyond state borders.

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