Chapter 17

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					Banking and the Management
of Financial Institutions

          Chapter 17
          Sajad Ahmad
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   In this chapter, we examine how banking is
    conducted to earn the highest profits possible. In
    the commercial banking setting, we look at loans,
    balance sheet management, and income

    Topics include:
    ◦ The Bank Balance Sheet
    ◦ Basics of Banking
    ◦ General Principles of Bank Management
    ◦ Off-Balance Sheet Activities
    ◦ Measuring Bank Performance
The Bank Balance Sheet
   The Balance Sheet is a list of a bank’s assets and liabilities
    ◦ Total assets = total liabilities + capital (total equity)
   A bank’s balance sheet lists sources of bank funds (liabilities)
    and uses to which they are put (assets)
   Banks obtain funds by borrowing and by issuing other
    liabilities such as deposits
   They use these funds to acquire assets such as securities
    and loans
   Banks invest these liabilities (sources) into assets (uses) in
    order to create value for their capital providers.

The Bank Balance Sheet

The Bank Balance Sheet:
   Checkable Deposits: includes all accounts
    that allow the owner (depositor) to write
    checks to third parties; examples include non-
    interest earning checking accounts (known as
    DDAs—demand deposit accounts), interest
    earning negotiable orders of withdrawal
    (NOW) accounts, and money-market deposit
    accounts (MMDAs), which typically pay the
    most interest among checkable deposit

    The Bank Balance Sheet:
 Checkable deposits are payable on demand
 Checkable deposits are a bank’s lowest cost funds
  because depositors want safety and liquidity and
  will accept a lesser interest return from the bank
  in order to achieve such attributes.
 The bank’s cost of maintaining checkable deposits
  include interest payments and the costs incurred
  in servicing these accounts.
    ◦ Such as processing, preparing, and sending out
      monthly statements, providing tellers...

The Bank Balance Sheet:
   Nontransaction Deposits: are the overall primary
    source of bank liabilities and are accounts from which the
    depositor cannot write checks; examples include savings
    accounts and time deposits (also known as CDs or
    certificates of deposit)
    ◦ Savings accounts: In these accounts funds can be added
      or from which funds can be withdrawn at any time.
       Transactions and interest payments are recorded in a
        monthly statement
    ◦ Time deposits have a fixed maturity length, ranging from
      several months to over five years, and assess penalties for
      early withdrawal.

The Bank Balance Sheet:
   Nontransaction deposits are generally a bank’s
    highest cost funds because banks want deposits
    which are more stable and predictable and will
    pay more to the depositors (funds suppliers) in
    order to achieve such attributes.

    The Bank Balance Sheet:
   Borrowings: banks obtain funds by borrowing from
    the Federal Reserve System, other banks, and
    corporations; these borrowings are called: discount
    loans/advances (from the Fed), fed funds (from other
    banks), interbank offshore dollar deposits (from other
    banks), repurchase agreements ( ―repos‖ from other
    banks and companies), commercial paper and notes
    (from companies and institutional investors)

The Bank Balance Sheet:
 Bank Capital: is the source of funds supplied by
  the bank owners, either directly through purchase
  of ownership shares or indirectly through
  retention of earnings.
 Since assets minus liabilities equals capital, capital is
  seen as protecting the liability suppliers from asset
  devaluations or write-offs (capital is also called the
  balance sheet’s ―shock absorber,‖ thus capital levels
  are important).

The Bank Balance Sheet:
   Reserves: funds held in account with the Fed and
    the currency that is physically held by banks (called
    vault cash as well).
   Reserves do not pay any interest. Still banks hold them
    for two reasons:
    ◦ Required reserves are held because of reserve
      requirements, is required by law under current
      required reserve ratios.
    ◦ Any reserves beyond this area called excess
      reserves.They are the most liquid assets and used
      to meet its obligations.

    The Bank Balance Sheet:
 Cash items in Process of Collection: checks
  deposited at a bank, but where the funds have not yet
  been transferred from the other bank.
  ◦ It is an assets for your bank because it is a claim on
    another bank for funds that will be paid within a few
 Deposits at Other Banks: usually deposits from
  small banks at larger banks
 Reserves, Cash items in Process of Collection, and
  Deposits at Other Banks are collectively referred to
  as Cash Items generally in the balance sheet.

The Bank Balance Sheet:
   Securities: these are either U.S. government/agency
    debt, municipal debt, and other (non-equity) securities.
    ◦ Short-term Treasury debt is often referred to as
      secondary reserves because of its high liquidity.
   Loans: are a bank’s income-earning assets, such as
    business loans, auto loans, and mortgages.
    ◦ These are generally not very liquid.
    ◦ Loans also have a higher probability of default than
      other assets.
       Banks earns its highest return on loans.

The Bank Balance Sheet:
   Most banks tend to specialize in either consumer
    loans or business loans, and even take that as far as
    loans to specific groups (such as a particular
   Other Assets: the physical capital such as bank
    buildings, computer systems, and other equipment
    owned by the banks is included in this category.

Basics of Banking

  Before we explore the main role of banks—that
  is, asset transformation—it is helpful to
  understand some of the simple accounting
  associated with the process of banking. But
  think beyond the debits/credit – and try to see
  that banks engage in asset transformation.

Basics of Banking

  Asset transformation is, for example, when a
  bank takes your savings deposits and uses the
  funds to make, say, a mortgage loan. Banks tend
  to ―borrow short and lend long‖ (in terms of

Basics of Banking

   T-account Analysis:
    ◦ Deposit of $100 cash into First National Bank

       Basics of Banking

          Deposit of $100 check

Conclusion: When bank receives deposits, reserves  by equal
amount; when bank loses deposits, reserves  by equal amount

Basics of Banking

  This simple analysis gets more complicated
  when we add bank regulations to the picture.
  For example, if we return to the $100 deposit,
  recall that banks must maintain reserves, or
  vault cash. This changes how the $100 deposit
  is recorded.

Basics of Banking

   T-account Analysis:
    ◦ Deposit of $100 cash into First National Bank

Basics of Banking

  As we can see, $10 of the deposit must remain
  with the bank to meeting federal regulations.
  Now, the bank is free to work with the $90 in
  its asset transformation functions. In this case,
  the bank loans the $90 to its customers.

Basics of Banking

   T-account Analysis:
    ◦ Deposit of $100 cash into First National Bank

General Principles of Bank Management
  The bank has four primary concerns:
1. Liquidity management
  ◦ The acquisition of sufficiently liquid assets to meet
     the bank’s obligation to depositors.
2. Asset management
  ◦ The bank manager must try to keep level of risk low
     by acquiring assets that have a low rate of default
     and diversifying asset holdings-managing credit risk
  ◦ Also try to match the maturity of assets and
     liabilities-managing interest-rate risk

General Principles of Bank Management
 3. Liability management
   ◦ The bank manager must try to acquire funds at
      low cost.
 4. Managing capital adequacy
   ◦ The bank manager must decide the amount of
      capital the bank should maintain and then
      acquire the needed capital.

Liquidity Management and the Role of

      Liquidity Management and the Role of

   With 10% reserve requirement, bank still has excess
    reserves of $1 million: no changes needed in balance

     Liquidity Management and the Role of

   With 10% reserve requirement, bank has $9 million reserve
Liquidity Management and the Role of

Liquidity Management and the Role of

Liquidity Management and the Role of
 Thus bank hold excess reserves instead of investing
  the funds into securities or extending loans with
  higher returns in order to escape the costs of
  ◦ Borrowing from other banks or corporations
  ◦ Selling securities
  ◦ Borrowing from the Fed
  ◦ Calling in or selling off loans
 Excess reserves are insurance against the costs
  associated with deposit outflows.
 The higher the costs associated with deposit outflows,
  the more excess reserves banks will want to hold.
Asset Management
   Asset Management: the attempt to earn the
    highest possible return on assets while minimizing
    the risk.
   Banks try to manage their assets by four basic
    1. Try to find borrowers who will pay high interest
       rates and unlikely to default on their loans.
    2. Try to buy securities with high return, low risk.
    3. Try to lower risk by diversifying.
    4. Try to manage liquidity to satisfy its reserve
       requirements without bearing huge costs.
Liability Management
   Liability Management: managing the source of funds,
    from deposits, to CDs, to other debt.
    1. Important since 1960s
    2. No longer primarily depend on deposits
    3. When see loan opportunities, borrow or issue
       CDs to acquire funds
   It’s important to understand that banks now manage
    both sides of the balance sheet together, whereas it
    was more separate in the past. Indeed, most banks
    now manage this via the asset-liability management
    (ALM) committee.

Capital Adequacy Management
       Banks have to control their capital for three
    ◦ Bank capital helps prevent bank failure
      Bank failure is a situation in which the bank
        cannot satisfy its obligations to pay its depositors
        and other creditors and so goes out of business.
    ◦ The amount of capital affects returns for the
      owner (equity holders) of the bank.
    ◦ A minimum amount of bank capital (bank capital
      requirement) is required by regulatory authorities

 Capital Adequacy Management
1.   Bank capital is a cushion that prevents bank failure.
     For example, consider these two banks:

Capital Adequacy Management
            Impact of $5 million loan loss

Conclusion: A bank maintains reserves to lessen the
chance that it will become insolvent.
Capital Adequacy Management
   Higher is bank capital, lower is return on equity
    ◦       ROA = Net Profits/Assets
            Provides information on how efficiently a bank is
             being run
            It indicates how much profits are generated on
             average by each dollar of assets
    ◦       ROE = Net Profits/Equity Capital
            Shows how much the bank is earning on their
             equity investment.
            Net profit after taxes per dollar of equity (bank)

Capital Adequacy Management
   ◦       EM = Assets/Equity Capital
           Amount of assets per dollar of equity capital
   ◦       ROE = ROA  EM
   ◦       Capital , EM , ROE 
   ◦       Given the return on assets, the lower the bank
           capital, the higher the return for the owners of
           the bank.

        Capital Adequacy Management
       Tradeoff between safety (high capital) and ROE
    ◦    Bank capital benefits the owners of a bank in that it
         makes their investment safer by reducing the
         likelihood of bankruptcy.
    ◦    Bank capital is also costly because the higher it is,
         the lower will be the return on equity for a given
         return on assets.

       Banks also hold capital to meet capital
        requirements asked by the regulatory authorities.

The Practicing Manager:

      Strategies for Managing Capital: what should a
      bank manager do if she feels the bank is
      holding too much capital?
  •     Sell or retire stock
  •     Increase dividends to reduce retained earnings
  •     Increase asset growth via debt (like CDs)

The Practicing Manager:

      Reversing these strategies will help a manager
      if she feels the bank is holding too little
  •     Issue stock
  •     Decrease dividends to increase retained
  •     Slow asset growth (retire debt)

The Capital Crunch and the
Credit Crunch in the early 1990s
  Did the capital crunch cause the credit crunch
  in the early 1990s?
  ◦ In 1990 and 1991 credit growth slowed to an
    extremely low pace
  ◦ Our analysis suggests that a capital crunch was a
    likely cause. Loan losses in the late 80s and an
    increase in capital requirements immediately
    preceded this period.

The Capital Crunch and the
Credit Crunch in the early 1990s
  Did the capital crunch cause the credit crunch
  in the early 1990s?
  ◦ Banks were forced to either (1) raise new capital
    or (2) reduce lending. Guess which route they

Off-Balance-Sheet Activities
 Involve trading financial instruments and generating
  income from fees and loan sales.
 Activities that affect bank profits but do not appear on
  bank balance sheets.
 The activities:
1. Loan sales (secondary loan participation): involves a
    contract that sells all or part of the cash stream from
    a specific loan and thereby removes the loan from the
    bank’s balance sheet.
  ◦ Banks earn profits by selling loans for an amount
      slightly greater than the amount of the original loan.

 Off-Balance-Sheet Activities
     ◦     The high interest rate on these loans makes them
           attractive so institutions are willing to buy them
           even though they pay high price.
2.        Generation of Fee income
         ◦ Foreign exchange trades for customers
         ◦ Servicing mortgage-backed securities
         ◦ Guarantees of debt (banker’s acceptances)
         ◦ Backup lines of credit

Measuring Bank Performance
   Much like any business, measuring bank performance
    requires a look at the income statement. For banks,
    this is separated into three parts:
    ◦ Operating Income
       Is the income that comes from a bank’s ongoing
       It is composed of interest income and non-interest

Measuring Bank Performance
  ◦ Operating Expenses
     Are the expenses incurred in conducting the
      bank’s ongoing operations.
     Again composed of interest and non-interest

  ◦ Net Operating Income
     Difference between income and expenses
     Indicates how well the bank is doing on an
      ongoing basis.

Banks' Income

Measuring Bank Performance
 As, much like any firm, ratio analysis is useful to
  measure performance and compare performance
  among banks.
 The most commonly used ratios are ROA and ROE.
 Besides NIM (net interest margin) is also looked at.
  ◦ NIM = [Interest Income - Interest Expenses]/ Assets
  ◦ It is the difference between interest income and
    interest expense as a percentage of total assets.
  ◦ It shows how well a bank manages its assets and


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