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as CDs or certificates of deposit) ◦ Savings accounts: In these accounts funds can be added or from which funds can be withdrawn at any time.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. 17-32 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