Transcript Assets
Chapter 9
Commercial Banking
©Thomson/South-Western 2006
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Road Map
CH 9
Commercial Bank
Balance Sheet
Commercial Bank
Management
Liquidity
Management
Assets
What are they?
Trade-Off
Liabilities Management
Technique
Liabilities
What are they?
Capital
Management
Changing Trends
Capital Accounts
What are they?
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The Commercial Bank Balance
Sheet
Banks earn a profit on the “spread”
Bank fees also played an increasingly important role
in bank profits.
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.
Liabilities are what it owes.
Net worth (capital accounts, capital) is the difference
between its assets and liabilities.
Assets - Liabilities = Net Worth
Assets = Liabilities + Net Worth
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Figure 9-1
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Table 9-1
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Table 9-1 (TH)
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Commercial Bank Assets
Cash Assets: legal reserves as dictated by reserve
requirements or required reserve ratios
Loans
Real Estate Loans: collateralized by property, securitized or packaged
collections of loans
Business Loans: regular installment loans, lines of credit
Consumer Loans: auto loans, credit cards
Other Loans: federal funds sold
Securities
About 25% in US but only about 16% in TH (% of total assets)
Building, Land, and Equipment
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Commercial Bank Liabilities (1)
Transactions Deposits (checkable deposits)
Any accounts for transaction purpose, either
saving or checking
Lowest-cost source of fund
Non-Transactions Deposits
Any accounts for saving purposes ie. Fixed saving,
CDs
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Commercial Bank Liabilities (2)
Non-deposit Borrowing or Borrowing
Borrowing from the Fed at the discount rate
Borrowing from other banks at the federal funds
rate
Borrowing through repurchase agreements
Other Liabilities
Account payables, accrued wages, and other
regular liabilities as regular businesses.
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Figure 9-2
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Thailand’s Figure 9-2
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Commercial Bank Capital
Accounts
Bank capital derives from the issue of bank
stock shares and from retained earnings.
In 2004, aggregate capital accounts of all U.S.
commercial banks were 8.2 % of total bank
assets.
Bank capital provides a cushion that protects
a bank's owners from potential bank
insolvency.
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Writing Off Bad Loans
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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 while abiding by
existing reserve requirements) by managing
liquidity and capital.
Bank use liquidity management and capital
management to maintain financial viability
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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, Wyoming.
ie. Clearing a check for $12,000 written by a bank customer
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Reserves
Withdrawal of currency and/or clearing of checks
written on a bank
Reduce the bank’s reserves by the amount of the
transaction
Deposit of currency into a bank account and/or
clearing of deposited into a customer’s account
Increase the bank’s reserves dollar for dollar
Due to fluctuation in reserves, banks try to prevent
large loss of reserves which force banks to make a
choice between bank liquidity and bank risk.
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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.
Banks that exhibit higher risk need larger
capital accounts.
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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.
If depositors withdraw $20 million, then the balance sheet changes and the
bank must come up with $18 million, of which only $10 million is liquid.
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The Liquidity-Profitability Trade-off
The bank has $10 million excess reserves.
Its assets are split between high return loans and low return securities.
If depositors withdraw $20 million, then the balance sheet changes and
the bank must come up with $8 million, but its assets are so liquid that
this is no problem.
It is less profitable because it has fewer high-risk, high-return loans on
equity for bank owners.
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Summary of LQ vs. Profit
Not enough LQ (Aggressive)
Pros: higher short-run profit
Cons: may experience LQ problem that may lead
to bank’s insolvency and eventually closed down
Maximize profit by penalizing liquidity
Too much LQ (Conservative)
Pros: less likely to experience LQ that lead to
bank’s insolvency
Cons: lower short-run profit
Minimize risk by penalizing profit
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Indicators of Bank Liquidity
The ratio of bank loans to total assets
35% in 1950s vs 60% in 2004
Low ratio means relatively more liquid
The ratio of securities to total assets
40% in 1950s vs 15% today
Low ratio means relatively less liquid
The ratio of demand deposit to total bank deposits
60% in 1960 vs 10% today
Lower ratio indicate lower liquidity need
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Liability Management 1
Yesteryears
Low competition on seeking deposits
Banks practiced asset management
– allocate funds among cash assets,
loans, and securities
Now
High competition on seeking deposits
Banks practiced liability management
– look for good lending opportunities
and then search for the funds to
finance these loans.
it can seek money by:
“buy” federal funds;
issue negotiable CDs at whatever
interest rate is required to attract
funds;
issue repurchase agreements or
borrow Eurodollars,
obtain funds through the commercial
paper market.
Asset management limited banks
ability to profit from good lending
opportunity because bank’s fund was
limited
Aggressive liability management
allows banks to make profitable loans
that they would otherwise have to
turn down.
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Liability Management 2
The Dark side of Liability Management
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.
Weaken the central bank’s ability to control aggregate
expenditure because the bank can issue more liabilities (by
borrowings) to fund surging load demand in periods when the
economy is growing too fast
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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
interest-rate risk (bank assets have longer maturity than liabilities)
liquidity risk (risk that people will withdraw funds)
political or country risk
management risk.
Predominant cause of bank insolvency is from bad loans
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Capital Management 2
A higher bank capital ratio (capital/assets)
implies a lower risk of insolvency, but also a
lower rate of return
Because higher capitals means more people
taking claims of the same piece of pie
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The Capital Management
Tradeoff
Earnings/Capital = Earnings/Total assets x
assets/Capital
Total
The left-hand side of the expression is the rate of return on
equity, or rate of return on capital
The first expression on the right-hand side is the rate of
return on total assets.
The final expression is the equity multiplier: the amount of
leverage that is applied to the rate of return on total assets. A
high capital/assets ratio represents a low equity multiplier; a
low capital/assets ratio implies a high equity multiplier.
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Increase Capital Ratio
A trade-off arises between short-run profitability and
the risk of insolvency
Indicating there must be an optimal ratio of capital to total
assets
In some cases, banks may need to increase capital ratio by
Increase retained earnings by reducing dividend payments
Issue new stocks
Shrink the bank – lower its total assets by selling securities
and reducing loan, using the proceeds to reduce bank
borrowings or other liabilities
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