Transcript Document
Money and Banking
Chapter 9
Lecture 12
Selcuk Caner
Bilkent University
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Financial Economics
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Mishkin, Chapter 9
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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
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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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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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