Transcript Chapter 13

Chapter 13
The Business of Banking
Objectives
1. Analyze the strengths and weaknesses in bank
balance sheets and income statements.
2. Use T-accounts to document marginal effect of
transactions on bank balance sheets.
3. Categorize Bank Risk and Analyze Strategies
for managing risk.
4. Measure interest rate exposure with Gap
Analysis.
Bank
Balance
Sheets
Basic Operation of a Bank
General Principles of Bank Management
Liquidity
Management
Asset
Management
Managing
Credit Risk
Liability
Management
Managing
Market Risk
Capital
Adequacy
Management
Gap
Analysis
Role of Financial Intermediaries
1. Pooling Savings
•Take advantages of
economies of scale
•Diversify Risks
• Safekeeping of Assets
2. Providing Liquidity
Reduce transactions costs
by allowing depositors to
convert assets into cash.
3. Reduce Information
Costs
•Ameliorate asymmetric
information
Profits of Banking
• Banks collect retail deposits from savers
and make loans from depositors.
• Profits are earned by banks when they are
able to make loans at higher interest rates
than they pay depositors.
• Net Interest Margin is the average interest
rate earned on assets (mainly loans)
minus the average interest paid on
liabilities (mainly assets).
Net Interest Margin
HK: Net Interest Margin: Local & Foreign Retail Bank
%
2.4
2.3
2.2
2.1
2.0
1.9
1.8
1.7
1.6
1.5
Jun-1997
Jun-1998
Jun-1999
Jun-2000
Jun-2001
Jun-2002
Jun-2003
Jun-2004
Jun-2005
Sources of Bank Profits
• Net interest income
Bank of East Asia
Net Interest Income
Operating Income
• US Commercial
Banking System.
2003 (in millions)
HK$3,596.00
HK$5,496.00
65.43%
Net Interest Income
Operating Income
2001 (in millions)
$210,809
$364,543
57.83%
Bank Balance Sheets
• All balance sheets
have three categories.
Assets
$198,476,118 Liablities
Net Worth
$198,476,118
$174,089,449
$24,386,669
$198,476,118
Bank Liabilities
1. Checkable Deposits – Demand Deposits
2. Non-transactions Deposits –
•
•
•
Savings Accounts,
Money Market Deposit Accounts,
Time Deposits, Certificate Deposits.
3. Borrowings – Short-term loans from
central bank or other banks.
Liabilities of Bank of East Asia
• As an international financial center, HK
Banking system has large borrowings from
foreign banks. This may occur internally
on the books of multinational banks.
• The more domestically oriented Bank of
East Asia in 2001 gets 4.32% of liabilities
from borrowings
Deposits and Balances of Banks
Liabilities
Ratio
$7,516,565
$174,089,449
4.32%
Liabilities of the HK Banking
System: 2001
Liabilities & Net Worth
Million HK$
%
Checkable Deposits
Non-Transactions Deposits
--NCD's
--Time and Savings Deposits
Borrowings
--Domestic Banks and Institutions
--Foreign Banks
--Other Debt Instruments
138348
3423510
Liabilities
5531007
90.19%
601817
9.81%
Capital
Total
2.26%
55.82%
174082
3249428
1969149
2.84%
52.98%
32.11%
388818
1532731
47600
6132824
6.34%
24.99%
0.78%
Comparison of HK Banking w/ US
Banking
• US Banks get higher percentage of funds from
transactions deposits.
• Banks in HK have somewhat better
capitalization than US banks.
US Banking 12-2002
Transaction Deposits
Non Transaction Deposits
Borrowings
Other Liabilities
Total Liabilities
Capital
Total Assets
Billion US$
634.1
3467.7
1119.6
557.2
5778.6
498.4
6277
10.97%
60.01%
19.37%
9.64%
92.06%
7.94%
Bank Capitalization
• Compared to non-financials, banks have low capitalization.
• In 1999, ratio of assets to liabilities among top 100 HK nonfinancial corporations was 3-to-1.
• Among banks, closer to 1-to-1
HK Balance Sheets
3.5
3
2.5
2
1.5
1
0.5
0
Nonfinancial
Banks
Assets to Liabilities
Bank Capital: Funds put at risk by
the owners of the bank.
• Tier One (Shareholders Funds)
– Share Capital: Money raised by
selling equity shares in Primary
Markets.
– Reserves: Money raised through
Retained Earnings.
• Tier Two (Loan Capital)
– Subordinated Debt: Uncollateralized
junior debt.
Bank Assets
1. Cash Items
•
Primary Reserves: Vault cash + Balances at
Central Bank.
•
•
The central bank is the bank of banks. Banks keep
deposit accounts at the central bank for the purpose of
clearing checks and electronic transactions.
Other Cash Items
•
•
Amount Due from Other Banks: Deposits at other
banks. As an international financial center, loans to and
from foreign banks are an important part of balance
sheets in HK.
Cash Items in Process of Collection
Bank Assets Pt. 2
2. Loans - Chief purpose of banks is making loans.
Loans are the least liquid of bank assets, but
typically pay the highest returns
3. Securities – Banks sometimes hold government
and other bonds as an important category of
assets. Government securities are very liquid and
are held as secondary reserves. Some securities
are less liquid and are held as an alternative to
loans.
4. Tangible Assets – Land & Buildings,
Repossessed Collateral
Assets: Hong Kong Banking
Industry
Assets
Primary Reserves
--Aggregate Balances
--Cash
Amount Due From Other Banks
--Domestic
--Foreign
Loans to Customers
NCDs
Securities
Other Assets
HK Million %
12686
0.21%
596
0.01%
12090
0.20%
2754497 44.91%
487789
7.95%
2266708 36.96%
2116848 34.52%
135716
2.21%
871853 14.22%
241224
3.93%
6132824
100%
Basic Operation of the Bank
T-Accounts
• T-Accounts are a handy tool for examining
the effects that any transaction has on
balance sheets.
• A bank transaction will change both
liabilities and assets (and possibly net
worth). The total change in liabilities plus
net worth must always equal the total
change in assets.
Ex: Check Deposit
• A Hang Seng customer sells his car for a
check drawn on BOC for $100. He deposits
the check in his Hang Seng account and
Hang Seng sends the check to HKMA for
settlement.
• Hang Seng
Assets
Reserves +
$100
Liabilities
Checkable Deposits
+$100
Ex: Bank Lends Funds to
Customer
• Hang Seng bank lends $100 to a customer
by crediting their checking account.
Assets
Loans + $100
Liabilities
Checkable Deposits
+$100
• The customer writes a check to a BOC
customer. BOC passes the check to
HKMA Assets
Liabilities
Reserves $100
Checkable Deposits -$100
• A bank writes off a
loan of $100.
• A bank sell equity
shares for more
than book value
Assets
-$100
Loans
Liabilities &
Net Worth
-$100 Net
Worth
Assets
Liabilities &
Net Worth
-$100
Shares
+$110
Cash
+$10 Net
Worth
General Principles of Bank
Management
Banks as Risk Taking Institutions
•
Banks may specialize in ameliorating effects of
asymmetric information.
• But there is still asymmetric information
between banks and depositors.
Banks info advantages are offset in at least 2
ways.
1. Bank Capital – Owners of banks put some of
their own funds into banks and these funds are
at risk.
2. Liquidity Advantage of Depositors – Depositors
can withdraw funds very quickly from banks.
Managing Banks: Balance Risks
and Returns
• Banks must take risks as part of their
business.
• Often most profitable activities of a bank
will generate most risks for the banks.
• Bank managers must manage risk return
trade-offs.
Types of Risk
•
•
•
•
•
Liquidity Risk
Credit Risk
Interest Rate Risk
Market Risk
Operational Risk
Bank Management
1. Liquidity Management: The decisions made by
a bank to maintain sufficient liquid assets to meet
the demand by depositors.
2. Asset Management: The acquisition of assets
that have a low rate of default and diversification of
asset holdings to increase profits.
3. Liability Management: The acquisition of funds
at low cost to increase profits.
4. Capital Adequacy Management: A bank’s
decision about and acquisition of the amount of
capital it should maintain.
Liquidity Management
•
Majority of Bank liabilities are very Liquid.
– Checkable deposits & Savings deposits can
be withdrawn at any time. Time Accounts &
CD’s are typically of short maturity and can be
withdrawn with some penalty to depositor.
– Most profitable bank assets, loans, are illiquid.
•
Liquidity Risk: The possibility that
depositors may collectively decide to
withdraw more funds than the bank has on
hand.
Liquidity Measures
• Loan to Deposit Ratio – Ratio of illiquid
loans to liquid deposits. High measure of
loan-to-deposit ratio indicates high liquidity
risk.
Loans
Deposits
Ratio
$108,379,794
$163,737,665
0.662
• Banking system as a whole had ratio of
2255196
 .597
3423510
Liquidity and Reserves
• If banks face an unexpected withdrawal of
funds and they have no liquid assets they
will face the cost of liquidating some
assets to meet depositor demand.
• Banks hold reserves of liquid assets to
meet depositor withdrawals.
• Primary
Vault Cash
Reserves =
+
Balances at Central Bank
Required Reserves & Excess
Reserves
•
In many countries, banks are required to
keep some percentage of their deposit
liabilities as reserves at the central bank
1. Required Reserves: The minimum amount that
depositary institutions are required to hold as
deposits at the central bank.
2. Excess Reserves: Reserves held beyond the
minimum amount.
Reserves in Hong Kong
• In Hong Kong, banks reserves at the central bank (the
HKMA) are called Clearing Balances.
• These are held for the sole purpose of clearing interbank
transactions.
– For example, if a depositor at Hang Seng bank writes a $100
check to a depositor at Bank of China, the transaction will be
cleared when the HKMA deducts $100 from Hang Seng’s
Clearing Balance account and credits the BOC’s Clearing
Balance account.
• Banks in Hong Kong are only required to have enough
on hand in their clearing balances to meet their payment
obligations. Beyond that there are no required reserves.
Secondary Reserves
• Having primary reserves directly reduces
the liqudity risk. But banks cannot
eliminate liquidity risk entirely, since
primary reserves pay 0 interest.
• Secondary reserves are interest paying
government securities held by banks to
meet short-term liquidity needs.
– In Hong Kong, Hong Kong dollar secondary
reserves are Exchange Fund Bills.
– U.S. Treasury Securities are US dollar
secondary reserves.
Managing Liquidity Risk
• A bank faces withdrawals of $5 million.
Assets
Cash - $5
Liabilities
Checkable Deposits -$5
• This reduces liquidity. The bank can
restore liquidity by managing assets or
liabilities.
• Liquidity can be
restored by converting
secondary reserves
(market securities) into
primary reserves (cash)
Assets
Liabilities
Cash +$5
Securities
-$5
Assets
Liabilities
• The bank can also
engage more short-term Cash +$5 Borrowings+$5
liabilities by increasing
borrowings from other
banks or central bank.
Banks manage their interest
rate/liquidity tradeoff by keeping
more primary reserves.
Reserves to Deposit Ratios
7.00%
6.00%
5.00%
4.00%
%
Primary
Secondary
3.00%
2.00%
1.00%
Mar-05
Sep-04
Mar-04
Sep-03
Mar-03
Sep-02
Mar-02
Sep-01
Mar-01
Sep-00
Mar-00
Sep-99
Mar-99
Sep-98
0.00%
Asset Management
•
•
•
•
Banks must maximize the returns earned by
their assets while minimizing risk of default.
Credit Risk: The risk arising from the possibility
that the borrower will default.
Financial Intermediaries in general and banks in
particular exist because of their efficiency in
dealing with credit risk.
Much of credit risk in financial markets occurs
due to asymmetric information and its
associated phenomena, adverse selection and
moral hazard.
Principles for Maximizing Returns
while dealing with credit risk
Diamonds in the rough
– Banks try to find borrowers who will pay high
interest rates but who are unlikely to default.
– Borrowers who are well known to be good
credit risks will have many sources of funds.
– Banks need to find information about certain
borrowers not publicly available.
Strategies
for Managing Credit Risk
1. Credit-Risk Analysis – A loan officer
manages banks relationship with
borrowers and evaluate potential
borrowers.
•
•
Loan officers may have some specialization
with certain industries or businesses.
Loan officers also use credit scoring
systems which use statistical data to
measure default probabilities and charge
interest rate commensurate with risk.
Strategies
for Managing Credit Risk (cont.)
2. Monitoring – Loan agreements may
contain restrictions on borrower behavior
or value of assets. Loan officers monitor
behavior and may recall loans if
covenants are violated.
Strategies for Managing Credit Risk
(cont.)
3. Collateral – Loans identify physical assets
which may be taken by the bank in case of
default.
4. Long-term Relationships – Banks often have
relationships with certain businesses which
reduces information problems.
Relationships have value to businesses
which they are loathe to jeopardize by
engaging in moral hazard behavior.
Strategies for Managing Credit Risk
(cont.)
5. Diversification – Banks can limit the likelihood of
default by reducing exposure to a particular
borrower or class of borrower.
•
Sometimes there is a trade-off between
diversification needs and strategies for finding
diamonds in the rough, such as specialization
or long-term relationships which may tend to
reduce
Liability Management
• Before 1960’s, banks relied on retail
deposits (checking and savings accounts)
for liabilities. Liabilities management was
easy.
• Since then, banks have increasingly
looked for flexible, low cost liabilities to
fund asset positions.
Bank Liabilities
1. Checkable Deposits – Demand Deposits
2. Non-transactions Deposits –
1. Savings Accounts,
2. Money Market Deposit Accounts,
3. Time Deposits, Certificate Deposits.
3. Borrowings – Short-term loans from central
bank or other banks.
As an international financial center, HK has large
borrowings from foreign banks.
Core Deposits vs. Managed
Liabilities
• Bank Liabilities can be divided into two parts.
1. Core Deposits – Demand Deposits, Savings
Accounts, Small Time Deposits (Retail Funds)
2. Managed Liabilities – Borrowings from Other
Banks, Securities, Large CD’s and Time
Deposits (Wholesale Funds)
• Retail funds have lower interest costs and are
thought to be more stable.
Capital Adequacy
Management
•
•
Bank capital is the funds invested by the
owners of banks in the bank.
Three factors affect the decisions of bank
owners to invest capital:
1. Bank capital prevents bank failure.
2. Bank capitalization affects returns to
shareholders
3. Government regulations affect capitalization
(next chapter)
Bank Failure
• Bank failure occurs when a bank cannot
pay its depositors in full.
• Riskier and less liquid assets make bank
failure more likely.
• Banks with high levels of capital can have
some negative profits and still avoid failure.
• Bank owners need to invest their own
funds to offset its own moral hazard
issues.,
How Bank Capital Prevents Bank
Failure
• Consider two banks with identical balance
sheets except that Bank A is well capitalized
while bank B is poorly capitalized.
Assets
Liabilities
Assets
Liabilities
Reserves $10
Deposits $90
Reserves $10
Deposits $96
Loan $90
Capital $10
Loan $90
Capital $4
How Bank Capital Prevents Bank
Failure
• Bad economic times cause borrowers to default
on $5 million in loans. This wipes out the capital
of the weakly capitalize bank but leave the highly
capitalized bank in business.
Assets
Liabilities
Assets
Liabilities
Reserves $10 Deposits $90
Reserves $10
Deposits $96
Loan $85
Loan $85
Capital -$1
Capital $5
Capitalization
• The owners of banks will protect against
bank failure if they invest a high level of
capital.
• The owners of banks will earn high returns
if they invest relatively little compared to the
size of assets.
• We can compare capital as a share of assets for
Bank of East Asia with banking system as a
whole.
2003
Authorized Institutions
Bank of East Asia
Net Worth
717149.3
26164
Total Assets
6490721
198476
Capitalization
11.05%
13.18%
Equity Multiplier
• Another measure of
leverage is the equity
multiplier.
• This is assets relative
to shareholders equity
(i.e. net worth less
loan capital)
EM 
ASSETS
EQUITY
Total Assets
$198,476,118

 9.874
Shareholders Funds $20,101,500
CAPITAL
ROA/ROE
• A measure of the returns
PROFITS DUE TO SHAREHOLDERS
ROA 
earned on assets is
TOTAL ASSETS
Return on Assets
PROFITS DUE TO SHAREHOLDERS
• Owners of banks are
ROE 
concerned with the payEQUITY CAPITAL
off they earn per each
dollar originally invested
ROE  ROA EM
in the bank. They care
about the Return on
Equity
• Its easy to see that equity
returns are a positive
function of ROA and
leverage
Profits
Assets
Shareholder's Funds
B of EA
2003
1921714
198476118
20101500
ROA
ROE
0.009682344 0.095600527
Performance of US Banks
COMMERCIAL BANK CONCENTRATION, NUMBERS AND ASSETS, 2000 AND 2004
($ billions, end of year)
By asset size
Less than
$100
$1 billion
$100
Percent of million to Percent of to $10 Percent of Greater than Percent of
million
total
$1 billion
total
billion
total
$10 billion
total
2000
Number of
banks
4,842
Total
assets
$231.20
Total
deposits
194.9
Return on
assets
1.01
Return on
equity
9.09
2004
Number of
banks
3,655
Total
assets
$189.00
Total
deposits
158.2
Return on
assets
0.99
Return on
equity
8.46
NA=Not applicable.
Total banks
58.20%
3,078
37.00%
313
3.80%
82
1.00%
8,315
3.7
$773.00
12.4
$884.10
14.2
$4,350.40
69.7
$6,238.70
4.7
632.5
15.1
621.6
14.9
2,727.60
65.3
4,176.60
NA
1.28
NA
1.29
NA
1.16
NA
1.19
NA
13.56
NA
14.57
NA
14.42
NA
14.07
47.90%
3,530
46.30%
360
4.70%
85
1.10%
7,630
2.2
$953.40
11.3
$973.00
11.6
$6,297.30
74.9
$8,412.80
2.8
770.9
13.8
666.5
11.9
3,997.20
71.5
5,592.80
NA
1.28
NA
1.46
NA
1.3
NA
1.31
NA
12.88
NA
13.48
NA
14.24
NA
13.82
Source: Federal Deposit Insurance Corporation.
Market Risk
•
•
•
Interest Risk – The risk to an institution's
financial condition resulting from adverse
movements in interest rates.
An asset (or a liability) represents a set of
payments that must be made at times in
the future.
Define PVT as the present value of a future
payments made to an asset or a set of
assets in T periods.
Duration Measure of Interest Rate Risk
• Define market value, MV, of an
T
asset or a set of assets as the
MV

PV

t
sum of present values derived
t 1
from payments made in each
future period.
• Define the duration of an asset as
d
d
• The % change of the market
value of an asset to a change in
the interest rate is approximately
proportional to the duration of an
asset.
T
PVt
t

MV
t 1
MV
i
 d 
MV
1 i
Example
• Two period coupon
bond with face value
of 100, coupon of 10
and yield to maturity
of 10%.
• Yield Rises to 11%
MV 
10 110

 100
2
1.1 (1.1)
10
110 21
d  1
2

110
121 11
10
110
MV


98.2875

 .017125
2
1.11 (1.11)
MV
i
21 .01
d 
 
 .01736
1 i
11 1.1
MV 
Example
• 5 period fixed payment loan of 100. Yield to
maturity of 10%
100 100 100 100 100
2 2 3 3 4 4 5 5
1.1
1.1
1.1
1.1  2.8101
d  1.1
379.1
MV
.01
 2.8101 
 .0255
MV
1.10
1 

1

100 100 100 100 100  1.15 
MV 
 2 3 4 5
100  379.1
1.1 1.1 1.1 1.1 1.1
.1
Measuring Interest
Exposure
• Calculate the duration of A  d  i
A
A
1 i
a banks assets, dA.
Calculate the duration of
L
i


d

L
a banks liabilities, dL.
L
1 i
• An increase in the
interest rate will have the
following effect on assets
and liabilities.
• Calculate the GAP as a
L

function of duration of
GAP   d A  d L 
A

assets and liabilities.
An increase in interest rates
changes the value of a banks
assets and liabilities.
NW A L A L L




A
A
A
A
L A
i
i L
L  i

 d A
 dL
   d A  d L 
1 i
1 i A
A  1 i

NW NW NW
i


 GAP

A
NW
A
1 i
NW
i
  EM  GAP 
NW
1 i
Managing Interest Rate Risk
• A bank which has a large stock of assets which
will pay a fixed interest rate may face losses if
market interest rates rise.
• Since deposits must be redeemed at any time,
the bank must offer market interest rates. If
market interest rates rise, loan spreads will be
cut.
• Banks may use asset and liability management
to match the sensitivity of assets and liabilities to
interest rates.
Responses to a perceived risk of a rise in
interest rates.
• If interest rates are expected to rise, banks
would like to reduce their long-term fixed
interest rate assets and lock in current low
interest rates by increasing their stock of
long-term liabilities
– Asset Management: Increase holdings of
short-term loans or securities.
– Liabilities Management: Sell long-term
certificates of deposit.
Floating Rate Loans
• Fixed payment loans have a constant payment based on a
fixed interest rate.
• Floating rate loan payments are based on an interest rate
that changes as some benchmark interest rate changes
• A HK$ floating rate loan will be quoted as a spread over
Hong Kong InterBank Offered Rate (HIBOR), the rate at
which banks lend aggregate balances to each other.
• A US$ floating rate Euroloan will be typically quoted as a
spread over London InterBank Offered Rate (LIBOR).
Interest Rate Swaps
• Problem: Hang Seng can make fixed rate loans but
does not want to bear interest rate risk.
• Hang Seng may find a firm willing to swap interest
payments for a floating interest rate payment.
• “Plain Vanilla” Interest Swap
– Two parties agree on a notional amount of principal
(which does not change hands).
– One party will pay the counterparty a fixed interest in
every period.
– The counterparty will pay the first a floating interest rate
as a markup over LIBOR.
– Only the net difference in interest is actually paid.
Loan Securitization
• Banks make loans in a certain class, bundle the
loans into a portfolio, sell securities, and dedicate
the principal and interest payments on the loans
to making coupon and face value payments on
the securities.
– Banks profits come as fee for setting up loan back
securities.
• Banks reduce the maturity mismatch between
assets and liabilities by raising funds this way
instead of deposits reducing interest rate and
liquidity risk.
– Primarily mortgage loans are securitized but also
securitization of credit card receivables, auto loans and
even leasing payments by rental companies.
Growth in Asset Backed Securities
Asset Back Securities USA
1800
1600
1400
1200
Billions US$
1000
800
600
400
200
0
Mortgages
Consumer loans
1985
1995
Business loans
2004
Trade receivables
Market Risk
•
Market Risk : Risk to banks liquidity and/or
assets from movements in asset prices
1. Exchange Rate Risk – The potential
fluctuations in the value of assets or liabilities
denominated in foreign currencies due to
fluctuations in the exchange rate.
2. Collateral Risk - The risk to the value of
assets used as collateral for loans.
Exchange Rate Risk
• International banks often issue liabilities and assets in a
variety of different currencies. If there is an imbalance, a
change in the exchange rate can affect firms balance
sheets.
• Example 1 : In Hong Kong, banks accept large foreign
currency deposits but less demand for US$ loans in
Hong Kong.
• Example 2: In Argentina, fixed exchange rate with the
US dollar (EX = 1) has led Argentine banks to engage in
large scale off-shore borrowing denominated in dollars
and on-shore borrowing in pesos. What happens to
Argentine banks if the peso is devalued?
Licensed Banks Balance Sheets in
2001: HKMA
Total Assets
HK$ Assets
-Loans to Customers
-Advances Due from Banks
-Securites and Other
Foreign Currency Assets
-Loans to Customers
-Advances Due from Banks
-Securites and Other
6241252
2662668
1502813
120477
1039378
3578585
606001
2160909
811675
Total Liabilities and Capital
HK$ Liabilities
-Deposits
-Due to Banks Abroad
-Other
Foreign Currency Liabilities
-Deposits
-Due to Banks Abroad
-Other
6241252
2849549
1830474
171007
848068
3391704
1605443
1349723
436537
• Balance Sheets Prior to Devaluation
Assets
Loans
P$125
Liabilities
Borrowings US$100 (=
P$100)
Net Worth P$25
• Balance Sheets After Devaluation (EX = .8)
Assets
Loans
P$125
Liabilities
Borrowings US$100 (=
P$125)
Net Worth P$0
Managing Exchange Rate Risk
• Asset and Liability Management: Hong
Kong Banks Borrow and Lend to Foreign
Banks to Match Currencies of Liabilities
and Assets.
• Exchange Rate Swaps
• Exchange Rates Futures and Forward
Contracts.
Plain Vanilla Exchange Rate
Swaps
•
•
One bank has two many dollar loans and
another has two many yen loans.
Two banks swap loans.
1. Principal is exchanged at the current exchange rate.
2. Interest on the loans is paid at subsequent periods.
3. At end of loans, the party’s buy back the principal at
final maturity date exchange rate.
Exchange Rate Futures
• A futures contract is an agreement that specifies
the delivery of commodity, currency at a prespecified date and price.
• A bank with a foreign currency loan may engage in
a futures transactions that will entitle them to sell
the principal for domestic currency at a prespecified price shifting exchange risk to their
counterparty.
• Participants in futures markets are hedgers if they
are getting rid of risk to speculators who will take it
at a price.
Non Interest Income is growing as
a share of operating income
Non Interest Income as % of Income
45.00%
40.00%
35.00%
30.00%
25.00%
%
20.00%
15.00%
10.00%
5.00%
0.00%
1991
1996
USA
Japan
2001
New Sources of Bank Profits
• Before 1970’s, banks had almost
complete dominance of external finance
markets. Over time, in all markets,
securities markets make up a larger share
of finance.
• Banks have innovated to find new sources
of profits taking advantage of their
competitive strength in analyzing and
monitoring borrowers.
Off-Balance Sheet Lending
• Standby Letters of Credit: Commercial paper is
short-term uncollateralized debt. An SLC is a
promise by a bank to lend money to CP issuers
when they must repay their CP. This service earns
fees even if no loans are made.
• Loan Commitments – A more general promise to
make loans in exchange for a fee.
• Loan Sales – Banks sell loans to 3rd parties willing
to bear the credit risk.
• Fees for information Services.
Credit Derivatives
• Banks can reduce their exposure to credit
risk through credit derivatives.
• Credit Swaps – Bank pays a protection
fee, counterparty pays a contingent
amount if a “credit event” occurs.
• Total Return Swap – Bank swaps total
return of a given asset for specified
floating interest payments
Notional Amounts of Credit
Derivatives
Credit Derivatives
$14,000.00
$12,000.00
$10,000.00
$8,000.00
$6,000.00
$4,000.00
$2,000.00
$0.00
1H01
2H01
1H02
2H02
1H03
2H03
Source: Goldman Sachs, In Trillions of US $
1H04
2H04
1H05
Credit Risk Models
• Banks construct statistical models of their
portfolios of assets to calculate the probability
that the value of overall portfolio will drop by a
certain amount.
• Value at Risk models.
– Input: classifications of quantities of different types of
assets in the portfolio (cash, loans to borrowers by
credit scores, securities, …)
– Output: Minimum value of portfolio at different
horizons at given probabilities (i.e. your portfolio has a
95% chance of being above $1.23769 billion next
year.