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Chapter 9 Banking and the Management of Financial Institutions 9.1 © 2008 Pearson Education Canada The Bank Balance Sheet 9.2 © 2008 Pearson Education Canada Liabilities • • • • Demand and Notice Deposits Fixed – Term Deposits Borrowings Bank capital 9.3 © 2008 Pearson Education Canada Assets • • • • • • Cash reserves Deposits at Other Banks Cash Items in Process of Collection Securities Loans Fixed and Other Assets 9.4 © 2008 Pearson Education Canada Basic Banking—Cash Deposit First Bank Assets Vault Cash +$100 First Bank Liabilities Chequable deposits +$100 Assets Reserves Liabilities +$100 Chequable deposits +$100 • Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in chequable deposits 9.5 © 2008 Pearson Education Canada Basic Banking—Cheque Deposit When a bank receives First Bank Assets Liabilities Cash items +$100 in process of collection Chequable deposits +$100 additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves First Bank Assets Reserves 9.6 +$100 Second Bank Liabilities Chequable deposits +$100 Assets Reserves Liabilities -$100 Chequable deposits -$100 © 2008 Pearson Education Canada Basic Banking—Making a Profit First Bank Assets Desired reserves Excess reserves First Bank Liabilities +$100 Chequable deposits +$90 +$100 Assets Liabilities Desired reserves +$10 Chequable deposits Loans +$90 +$100 • Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics • The bank borrows short and lends long 9.7 © 2008 Pearson Education Canada Bank Management • • • • • • Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk 9.8 © 2008 Pearson Education Canada Liquidity Management: Ample Excess Reserves Assets Liabilities Reserves $20M Deposits Loans $80M Bank Capital $10M Securities Assets $100M $10M Liabilities Reserves $10M Deposits $90M Loans $80M Bank Capital $10M $10M Securities • If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet 9.9 © 2008 Pearson Education Canada Liquidity Management: Shortfall in Reserves Assets Liabilities Reserves $10M Deposits Loans $90M Bank Capital $10M Securities Assets $100M $10M Reserves Loans Securities Liabilities $0 Deposits $90M Bank Capital $10M $90M $10M • Reserves are now short of the desired amount and the shortfall must be eliminated • Excess reserves are insurance against the costs associated with deposit outflows 9.10 © 2008 Pearson Education Canada Liquidity Management: Borrowing Assets Reserves Liabilities $9M Deposits $90M Loans $90M Borrowing $9M Securities $10M Bank Capital $10M • Cost incurred is the interest rate paid on the borrowed funds 9.11 © 2008 Pearson Education Canada Liquidity Management: Securities Sale Assets Reserves Loans Securities Liabilities $9M Deposits $90M Bank Capital $90M $10M $1M • The cost of selling securities is the brokerage and other transaction costs 9.12 © 2008 Pearson Education Canada Liquidity Management: Bank of Canada Advances Assets Reserves Liabilities $9M Deposits $90M Loans $90M Advance Bank of Canada Securities $10M Bank Capital $9M $10M • Borrowing from the Bank of Canada also incurs interest payments based on the discount rate 9.13 © 2008 Pearson Education Canada Liquidity Management: Reduce Loans Assets Reserves Liabilities $9M Deposits Loans $81M Bank Capital Securities $10M $90M $10M • Reduction of loans is the most costly way of acquiring reserves • Calling in loans antagonizes customers • Other banks may only agree to purchase loans at a substantial discount 9.14 © 2008 Pearson Education Canada Asset Management: Three Goals • Seek the highest possible returns on loans and securities • Reduce risk • Have adequate liquidity 9.15 © 2008 Pearson Education Canada Asset Management: Four Tools • Find borrowers who will pay high interest rates and have low possibility of defaulting • Purchase securities with high returns and low risk • Lower risk by diversifying • Balance need for liquidity against increased returns from less liquid assets 9.16 © 2008 Pearson Education Canada Liability Management • Recent phenomenon due to rise of money center banks • Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) • Checkable deposits have decreased in importance as source of bank funds 9.17 © 2008 Pearson Education Canada Capital Adequacy Management • Bank capital helps prevent bank failure • The amount of capital affects return for the owners (equity holders) of the bank • Regulatory requirement 9.18 © 2008 Pearson Education Canada Capital Adequacy Management: Preventing Bank Failure High Bank Capital Assets Liabilities Low Bank Capital Assets Liabilities Reserves $10M Deposits $90M Reserves $10M Deposits Loans $90M Bank Capital $10M Loans $90M Bank Capital High Bank Capital Assets Liabilities Reserves $10M Deposits Loans $85M Bank Capital 9.19 $96M $4M Low Bank Capital Assets $90M Reserves $5M Loans Liabilities $10M Deposits $96M $85M Bank Capital -$1M © 2008 Pearson Education Canada Capital Adequacy Management: Returns to Equity Holders Return on Assets: net profit after taxes per dollar of assets net profit after taxes assets Return on Equity: net profit after taxes per dollar of equity capital ROA = ROE = net profit after taxes equity capital Relationship between ROA and ROE is expressed by the Equity Multiplier: the amount of assets per dollar of equity capital EM = Assets Equity Capital net profit after taxes net profit after taxes assets equity capital assets equity capital ROE = ROA EM 9.20 © 2008 Pearson Education Canada Capital Adequacy Management: Safety • Benefits the owners of a bank by making their investment safe • Costly to owners of a bank because the higher the bank capital, the lower the return on equity • Choice depends on the state of the economy and levels of confidence • Bank capital requirement 9.21 © 2008 Pearson Education Canada Strategies for Lowering Bank Capital 1. Buying back some of Bank’s stock 2. Pay out higher dividend to shareholders 3. Acquire new funds and increase assets 9.22 © 2008 Pearson Education Canada Strategies for Raising Bank Capital 1. Issue more common stock 2. Reducing dividend to shareholders 3. Issue fewer loans or sell securities and use proceeds to reduce liabilities 9.23 © 2008 Pearson Education Canada Off-Balance-Sheet Activities • Loan sales (secondary loan participation) • Generation of fee income • Trading activities and risk management techniques – Futures, options, interest-rate swaps, foreign exchange – Speculation 9.24 © 2008 Pearson Education Canada Off-Balance-Sheet Activities (Cont’d) • Trading activities and risk management techniques (continued) – Principal-agent problem – Internal Controls • Separation of trading activities and bookkeeping • Limits on exposure • Value-at-risk • Stress testing 9.25 © 2008 Pearson Education Canada Measuring Bank Performance 9.26 © 2008 Pearson Education Canada Measuring Bank Performance (Cont’d) • Operating Income • Operating Expenses • Net Operating Income • Net Income 9.27 © 2008 Pearson Education Canada Measuring Bank Performance (Cont’d) ROA = net income/assets ROE = net income/equity capital NIM = (interest income-interest expenses)/assets 9.28 © 2008 Pearson Education Canada