Transcript Chapter 17

Banking and the Management
of Financial Institutions
Chapter 17
By;
Sajad Ahmad
Chapter Preview

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
determinants.
Topics include:
◦ The Bank Balance Sheet
◦ Basics of Banking
◦ General Principles of Bank Management
◦ Off-Balance Sheet Activities
◦ Measuring Bank Performance
17-2
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.
17-3
The Bank Balance Sheet
17-4
The Bank Balance Sheet:
Liabilities

Checkable Deposits: includes all accounts
that allow the owner (depositor) to write
checks to third parties; examples include noninterest 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
accounts
17-5
The Bank Balance Sheet:
Liabilities
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...
17-6
The Bank Balance Sheet:
Liabilities

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or from which funds can be withdrawn at any time.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.
17-7
The Bank Balance Sheet:
Liabilities

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.
17-8
The Bank Balance Sheet:
Liabilities

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)
17-9
The Bank Balance Sheet:
Liabilities
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).

17-10
The Bank Balance Sheet:
Assets


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.
17-11
The Bank Balance Sheet:
Assets



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
days.
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.
17-12
The Bank Balance Sheet:
Assets


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.
17-13
The Bank Balance Sheet:
Assets


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
industry).
Other Assets: the physical capital such as bank
buildings, computer systems, and other equipment
owned by the banks is included in this category.
17-14
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.
17-15
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
maturity).
17-16
Basics of Banking

T-account Analysis:
◦ Deposit of $100 cash into First National Bank
First National Bank
Assets
Vault cash
+$100
Liabili ties
Checkable
deposits
17-17
+$100
Basics of Banking

Deposit of $100 check
First National Bank
Assets
Cash items in
process of
collection
Liabili ties
+$100
First National Bank
Assets
Reserves
+$100
Liabilities
Deposits
+$100
Checkable
deposits
+$100
Second National Bank
Assets
Reserves
-$100
Liabili ties
Deposits
-$100
Conclusion: When bank receives deposits, reserves  by equal
amount; when bank loses deposits, reserves  by equal amount
17-18
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.
17-19
Basics of Banking

T-account Analysis:
◦ Deposit of $100 cash into First National Bank
First National Bank
Assets
Required reserves +$10
Excess reserves
+$90
Liabilities
Checkable
deposits
17-20
+$100
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.
17-21
Basics of Banking

T-account Analysis:
◦ Deposit of $100 cash into First National Bank
First National Bank
Assets
Required reserves +$10
Loans
+$90
Liabilities
Checkable
deposits
17-22
+$100
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

17-23
General Principles of Bank Management
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.
3.
17-24
Liquidity Management and the Role of
Reserves
Liquidity Ma nagement
Reserves requirement = 10%, Excess reserves = $10 million
Assets
Liabili ties
Reserves
$20 million
Deposits
Loans
$80 million
Bank Capit al
Securiti es
$10 million
$100 million
$10 million
17-25
Liquidity Management and the Role of
Reserves
Deposit outflow of $10 million
Assets
Liabili ties
Reserves
$10 million
Deposits
$90 million
Loans
$80 million
Bank Capit al
$10 million
Securiti es
$10 million

With 10% reserve requirement, bank still has excess
reserves of $1 million: no changes needed in balance
sheet
17-26
Liquidity Management and the Role of
Reserves
No excess reserves
Assets
Liabili ties
Reserves
$10 million
Deposits
$100 million
Loans
$90 million
Bank Capit al
Securiti es
$10 million
$10 million
Deposit outflow of $10 million
Assets
Reserves

Liabili ties
$0 million
Loans
$80 million
Securiti es
$10 million
Deposits
$90 million
Bank Capit al
$10 million
With 10% reserve requirement, bank has $9 million reserve
shortfall
17-27
Liquidity Management and the Role of
Reserves
1. Borrow from other banks o r corporations
Assets
Liabili ties
Reserves
Loans
$9 million
$90 million
Deposits
Borrowings
Securiti es
$10 million
Bank Capit al
$100 million
$9 million
$10 million
2. Sell securities
Assets
Liabili ties
Reserves
Loans
$9 million
$90 million
Securiti es
$1 million
Deposits
Bank Capit al
$90 million
$10 million
17-28
Liquidity Management and the Role of
Reserves
3. Borrow from Fed
Assets
Liabilities
Reserves
Loans
$9 million Deposits
$90 million Discount Loans
$90 million
$9 million
Securities
$10 million Bank Capital
$10 million
4. Call in or sell off loans
Assets
Liabili ties
Reserves
Loans
$9 million
$81 million
Securiti es
$10 million
Deposits
Bank Capit al
$90 million
$10 million
17-29
Liquidity Management and the Role of
Reserves



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.
17-30
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
way:
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.
17-31
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.
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Capital Adequacy Management
Banks have to control their capital for three
reasons:

◦
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
17-33
Capital Adequacy Management
1.
Bank capital is a cushion that prevents bank failure.
For example, consider these two banks:
High Capital Bank
Assets
Reserves
Loans
Liabilities
$10 million Deposits
$90 million Bank Capital
$90 million
$10 million
Low Capital Bank
Assets
Reserves
Loans
Liabilities
$10 million Deposits
$90 million Bank Capital
$96 million
$4 million
17-34
Capital Adequacy Management
Impact of $5 million loan loss
High Capital Bank
Assets
Reserves
Loans
Liabilities
$10 million Deposits
$85 million Bank Capital
$90 million
$5 million
Low Capital Bank
Assets
Reserves
Loans
Liabilities
$10 million Deposits
$85 million Bank Capital
$96 million
-$1 million
Conclusion: A bank maintains reserves to lessen the
chance that it will become insolvent.
17-35
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
17-36
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.
17-37
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.
17-38
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)
17-39
The Practicing Manager:
Reversing these strategies will help a manager
if she feels the bank is holding too little
capital?
•
Issue stock
•
Decrease dividends to increase retained
earnings
•
Slow asset growth (retire debt)
17-40
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.
17-41
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
chose?
17-42
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.

17-43
Off-Balance-Sheet Activities
◦
2.
The high interest rate on these loans makes them
attractive so institutions are willing to buy them
even though they pay high price.
Generation of Fee income
◦ Foreign exchange trades for customers
◦ Servicing mortgage-backed securities
◦ Guarantees of debt (banker’s acceptances)
◦ Backup lines of credit
17-44
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
operations.
 It is composed of interest income and non-interest
income
17-45
Measuring Bank Performance
◦ Operating Expenses
 Are the expenses incurred in conducting the
bank’s ongoing operations.
 Again composed of interest and non-interest
expenses
◦ Net Operating Income
 Difference between income and expenses
 Indicates how well the bank is doing on an
ongoing basis.
17-46
Banks' Income
Statement
1747
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
liabilities.
17-48