Transcript Document

Money and Banking
Chapter 9
Lecture 12
Selcuk Caner
Bilkent University
7/21/2015
1
Financial Economics

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Mishkin, Chapter 9
2
The Business of Banking

How and why make loans

How they acquire funds

How they manage their assets and
liabilities

How
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they earn income
3
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Basic Banking—Cash Deposit
First National Bank
Assets
Vault
Cash

+$100
First National Bank
Liabilities
Checkable
deposits
+$100
Assets
Reserve
s
Liabilities
+$100 Checkable
deposits
+$100
Opening of a checking account leads to an
increase in the bank’s reserves equal to the
increase in checkable deposits
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Basic Banking—Check
Deposit
When a bank receives
First National Bank
Assets
Cash items
in process
of
collection
+$100
Checkable
deposits
+$100
Reserve
s
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gains an equal amount of reserves;
when it loses deposits,
it loses an equal amount of reserves
First National Bank
Assets
additional deposits, it
Liabilities
Second National Bank
Liabilities
+$100 Checkable
deposits
+$100
Assets
Reserves
-$100
Liabilities
Checkable
deposits
-$100
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Basic Banking—Making a
Profit
First National Bank
Assets
Liabilities
Required +$100 Checkable
reserves
deposits
Excess
reserves


Second National Bank
+$90
+$100
Assets
Required
reserves
Loans
Liabilities
+$100 Checkable
deposits
+$100
+$90
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
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Bank Management
Liquidity Management
 Asset Management
 Liability Management
 Capital Adequacy Management
 Credit Risk
 Interest-rate Risk

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Liquidity Management:
Ample Excess Reserves
Assets
Liabilities
Reserves
$20M Deposits
Loans
$80M Bank
Capital
$10M
Securitie
s

$100M
$10M
Assets
Liabilities
Reserves
$10M Deposits
$90M
Loans
$80M Bank
Capital
$10M
$10M
Securitie
s
If a bank has ample excess reserves, a
deposit outflow does not necessitate
changes in other parts of its balance sheet
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Liquidity Management:
Shortfall in Reserves
Assets
Liabilities
Reserves
$10M Deposits
Loans
$90M Bank
Capital
$10M
Securitie
s
$100M
$10M
Assets
Reserves
Loans
Securitie
s
Liabilities
$0 Deposits
$90M Bank
Capital
$10M
$90M
$10M

Reserves are a legal requirement and the
shortfall must be eliminated
 Excess reserves are insurance against the
costs associated with deposit outflows
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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
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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
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Liquidity Management:
Central Bank
Assets
Reserves
Liabilities
$9M Deposits
Loans
$90M Borrow from Fed
Securities
$10M Bank Capital

$90M
$9M
$10M
Borrowing from the Central Bank also
incurs interest payments based on the
discount rate
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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
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Asset Management: Three
Goals

Seek the highest possible returns on
loans and securities

Reduce risk

Have adequate liquidity
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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
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
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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
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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
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Capital Adequacy Management:
Preventing Bank Failure When
Assets Decline
High Bank Capital
Assets
Liabilities
Low Bank Capital
Assets
Liabilities
Reserve
s
$10M Deposits
$90M Reserve
s
$10M Deposits
Loans
$90M Bank
Capital
$10M Loans
$90M Bank
Capital
High Bank Capital
Assets
Liabilities
Reserve
s
$10M Deposits
Loans
$85M Bank
Capital
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$96M
$4M
Low Bank Capital
Assets
$90M Reserve
s
$5M Loans
Liabilities
$10M Deposits
$96M
$85M Bank
Capital
-$1M
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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
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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

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Credit Risk: Overcoming Adverse
Selection and Moral Hazard

Screening and information collection

Specialization in lending

Monitoring and enforcement of
restrictive covenants

Long-term customer relationships

Loan commitments

Collateral and compensating balances

Credit rationing
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Interest-Rate Risk
First National Bank
Assets
Rate-sensitive assets
Liabilities
$20M Rate-sensitive liabilities
Variable-rate and short-term loans
Variable-rate CDs
Short-term securities
Money market deposit
accounts
Fixed-rate assets
$80M Fixed-rate liabilities
Reserves
Checkable deposits
Long-term loans
Savings deposits
Long-term securities
Long-term CDs
$50M
$50M
Equity capital

If a bank has more rate-sensitive liabilities than assets, a rise
in interest rates will reduce bank profits and a decline in
interest rates will raise bank profits
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Interest Rate Risk: Gap
Analysis
Basic Gap Analysis:
(rate-sensitive assets  rate sensitive liabilities)
  interest rates =  in bank profits
Maturity Bucket Approach
measures the gap for several maturity subintervals
Standardized Gap Analysis
accounts for differing degrees of rate sensitivity
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Interest Rate Risk: Duration
Analysis
Duration Analysis:
% market value of security 
percentage point  interest rate  duration in years
Uses the weighted average duration of
a financial institution's assets and of its liabilities
to see how net worth responds to a change in
interest rates
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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
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Off-Balance-Sheet Activities
(cont’d)

Trading activities and risk
management techniques (cont’d)
– Principal-agent problem
– Internal Controls
• Separation of trading activities and
bookkeeping
• Limits on exposure
• Value-at-risk
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• Stress testing
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Bank Balance Sheet

Liabilities: sources of bank funds
– Checkable Deposits – 9%
• Lowest cost source of bank funds
– Nontransaction Deposits – 63%
• Small vs. Large
– Borrowing – 21%
• Discount loans/advances vs. other loans
– Bank Capital – 7%
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Bank Balance Sheet

Assets: use of funds
– Reserves
• Required vs. excess
– Cash Items in Process of Collection
– Deposits at other banks
– Securities (Bonds) – 25%
– Loans – 63%
– Other assets – 8%
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T-account

Operations like deposit taking, private
lending, reserve management, loss
provisioning, always affects two items of
the balance sheet

Example: moving to NL
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How to make profits?

Asset transformation
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Balance Sheet Management

Liquidity Management

Asset Management

Liability Management

Capital Adequacy Management
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•Have enough currency for deposit
outflows
•RESERVES
•Not enough?
–Borrow from other banks or corporations
(federal funds rate/interest rate)
–Sell securities (brokerage and/or
transaction costs)
–Borrow from the Fed (discount rate)
–Reduce loans (loss of business; finding
someone to take the loans)
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Asset Management

Seek high interest-rate, low-default rate
loans

Purchase securities with high returns,
low-risk

Lower risk through diversification
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
Keep liquidity in mind
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Liability Management

When see a profitable investment
opportunity
– Borrow from banks
– Negociable CD trading

No longer as dependent on
checkable deposits
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Total Assets – Total Liabilities = Bank
Capital/Equity
1. Prevent bank failure
2. Returns to equity holders
•
ROA = Net profit after taxes/ assets
•
ROE = net profits after taxes/ equity
capital
•
EM = assets / equity capital
•
ROE = ROA x EM
3. Regulation
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How to Change Bank Equity?
1.
2.
3.
Buy back/issue new bank stock
Pay higher/lower dividends to
stockholders
Increase/decrease bank’s assets
a. Loans
b. securities
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Credit Risk Management

Risk of defaults and payment problems
among borrowers
1.
Screening, Monitoring & Enforcing
Specializing
Long-term relationships
Collateral
Credit Rationing
2.
3.
4.
5.
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The 5C-model
Five indicators for banks when assessing
a loan application
 Character: behavior of management
 Capacity
: ability to repay
 Capital: net worth
 Collateral: assets to be seized
 Conditions: environment
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