The Banking Firm and the

Management of Financial Institutions

Chapter 9

1. The Bank Balance Sheet



1. Liabilities



1. Checkable deposits - allow the owner of the deposit (the bank customer) to write checks to third parties. - payable on demand.



1. may be interest - leaving or not



2. most checkable deposits require the banks to hold reserves of some payment.



3. money market deposits accounts do not require reserves.



4. accounted for 11% of liabilities in 1999



5. they are usually the lowest cost source of funds to the bank.



2. Nontransactions deposits - large and small - denominations time deposits and savings accounts.



1. account for 52% of bank's liabilities in 1999.



2. owners cannot write checks but interest is generally higher.



3. cd's make up most of the category



4. cd's over $100,000. (Large denomination) are negotiable and are sold on the secondary market. They accounted for 12% of banks liabilities in 1999.



3. Borrowing from the Federal Reserve, other banks and corporations.



1. borrowing from the Fed are discount loans.



2. Overnight borrowing from other banks and financial institutions is Fed funds.



3. Loans made by banks to their parent companies (bank holding companies) are in this category.



4. Borrowing is much more important now (25% of liabilities) compared to the 60's (2% of liabilities)
4. Bank Capital is the bank's net worth and come from stock sales and retained earnings.



1. This provides the security cushion against in the event that the value of the bank's assets fall.



2. A major part of bank capital is its loan loss reserve.



2. Assets



1. include deposits int eh Fed plus cash and are held for two reasons:



1. they are required to keep a fraction of their deposits as .



2. excess reserves are kept to pay obligations when funds are withdrawn.



2. Cash items in of collections occur when a customer deposits a check drawn another bank.



1. the bank incurs a liability in the account but has not yet collected the cash.



2. this is a "temporary" asset.



3. Deposits in other banks



1. Generally smaller banks hold deposits ion banks in order to receive services they cannot provide such as check collection, foreign exchange etc.



2. This is called a correspondent bank relationship



4. Securities



1. They are required by law to be debt instruments (no stocks)



2. They are an important income-earning asset



3. They were 22 percent of assets in 1999 and provided 15 percent of earnings



4. The three categories are U.S. government, state and local government , and others.



5. Because U.S. government securities are so liquid they are called secondary



5. Loans



1. Account for 66 percent of the banks assets and are the primary source of income



2. Loans are typically not very liquid



3. Communal and Industrial as well as real estate make up the bulk of loans



4. If the bank is a net lender of Fed funds, it up us interbank loans



6. Other assets which is primarily physical assets.
2. Basic Operations of a Bank



1. Asset transformation -how banks make a profit.



1. Banks sell liabilities with one set of characteristics (liquidity and return) and buy assets with another set of characteristics.





2. T account analysis of bank operations



1. Assume a customer opens a checking account by depositing cash











2. Vault cash is part of reserves.











3. If the deposit had been a check















4. We can add the bank from which the check was drawn













5. If we assume that the bank is required to help 10 percent of checkable accounts as









6. They are now available to be loaned.











3. General Problems of Bank Management



1. Four concerns:



1. Making sure the bank has enough ready cash to pay their customers when a deposit outflow occurs (liquidity management).



2. Make sure the bank maintains an acceptably low level of risk (asset management).



3. Acquire funds at low cost (liabilities management).



4. Determine the amount of capital the bank needs and then acquire the capital (capital adequacy management).



2. Liquidity Management -- four scenarios in response to deposit outflow



1. Borrow from other banks



2. Sell securities



3. Borrow from the Fed



4. Call in or sell off loans
3. Asset management



1. Banks face conflicting goals



1. Obtain high returns on loans and securities



2. Reduce risk



3. Maintain liquidity



2. Four ways the bank achieves their objectives



1. Try to lend money at high interest rates to borrowers who are not likely to default.



1. Banks are usually conservative, but if they are too conservative, they miss out on opportunities for profit.



2. Try to buy securities with high returns and low risk.



3. Diversify their loan and securities portfolio



1. Different terms



2. Different industries



4. Manage the liquidity of assets so they can easily meet reserve requirements.



1. They hold very liquid assets as secondary reserves.



2. these generally have low earnings but are better than holding too much excess reserves.



4. Liabilities Management



1. This has become an issue since the 1960's.



1. Prior to that, banks could not compete for checkable accounts since interest could not be paid on checkable accounts.



2. Checkable accounts made up over 60 percent of bank sources of funds.





2. Two developments since the 60's.



1. The Fed funds market developed.



2. Negotiable CD's came into existence.



3. Consequences



1. Large banks can now aggressively pursue loan customers without depending on deposits as a source of funds.



2. The composition of bank balance sheets has changed dramatically.



1. Loans have increased from 2 percent in 1960 to 44 percent in 1999.



2. Checkable accounts have decreased from 61 percent in 1960 to 11 percent on 1999.



5. Capital adequacy management.



1. Three reasons to be concerned about the amount of capital a bank has.



1. Banks are required to maintain a certain level of capital.



2. Bank capital helps prevent bank failure, which favors a high equity capital to assets ratio.



3. The amount of capital impacts the earnings on equity, which favors a low equity to capital to assets ratio.



4. Managing Credit Risk



1. Banks (and other lenders) must overcome the adverse selection problem, i.e., they must choose to lend to borrowers who will repay.



1. Adverse selection occurs because those who are the worst risk are the most aggressive in seeking loans.



1. If the venture pays off, they have much to gain-but it may not pay off.



2. The moral hazard problem occurs because, once the money is obtained, the borrower may be inclined to invest in more high-risk projects.



2. Overcoming the adverse selection and moral hazard problems-how it is done.



1. Screening and monitoring-two information gathering activities.



1. In personal or consumer loans, the bank may ask for financial information like your monthly debt payments, income, job stability and past credit experience.



2. Similar information is obtained from businesses seeking a loan.



3. Much of this information is collected by specialized services like credit bureaus or standard and Poors.





4. Banks often "specialize" in lending, e.g. to local firms or firms in particular industries.



1. this may cause problems with portfolio diversification.



2. The advantage is they can better avoid adverse selection because they have better information and may be better able to evaluate the information.



5. Banks monitor the activities of borrowers once the loan is made.



1. Often the loan has "restrictive covenants" that prohibit certain activities of the borrower.



2. Examples include limiting further borrowing, maintaining a certain liquidity ratio, etc.



2. Maintaining long-term customer relationships



1. This is partly an information gathering activity.



2. The bank has ready access to information on liquidity, seasonality of their business, etc.



3. It is more cost efficient to lend to a previous borrower because they already have much or the information needed.



4. The relationship is also beneficial to the borrower because it makes borrowing easier.



3. Banks may require collateral, i.e., property promised to the lender as compensation if the borrower defaults.



1. These are real estate or chattel mortgages.



4. Compensating balances are a requirement that the borrower maintain a certain proportion of the loan in a checking account in the bank.



1. This serves as a type of collateral.



2. It increases the cost of the loan to the borrower.



3. It allows the bank to monitor the balances of the borrower.



4. The bank could even monitor such things as the recipient of checks drawn on the account.



5. Credit rationing occurs when the lender restricts the amount of credit granted.



1. They may turn down a loan completely-even if the borrower was willing to pay a high interest rate.



2. They may be willing to lend less than the borrower wants because the larger the loan, the greater the chance of moral hazzard.



5. Managing interest rate risk, i.e., the volatility of earnings as a result of interest rate changes.



1. Short term assets and liabilities are sensitive to changes in interest rates, i.e., rate sensitive.



1. Since the amount of short term liabilities is generally higher than the amount of short term assets, an increase in interest rates can have a negative impact on profits.



2. See the example in the text.









2. Gap analysis is used to determine the impact of changes in interest rates. (See next page)





6. Financial innovation



1. Three types



1. Response to changes in demand conditions.



2. Response to changes in supply conditions.



3. Avoidance of regulation.



2. Response to changes in demand conditions.



1. The primary change in demand conditions is the increased volatility of interest rates.(see next page)



2. In response, banks developed instruments that lowered interest rate risk.



1. The adjustable rate mortgage was introduced in 1975.



1. interest if tied to some benchmark security like a treasury bill.



2. If interest rate changes on the benchmark, the rate on the mortgage changes (generally every six months or once per year).



3. Either the term of the mortgage is changed or the monthly payment is adjusted.



3. Responses to changes in supply conditions.



1. The primary cause in changes in products and instruments offered by banks is the improvement in electronic data processing.



2. Bank credit and debit cards.



1. Credit cards have been around a long time but bank credit cards came about in the 1960's.



2. Debit cards were initiated much more recently.



3. The difference between credit cards and debit cards is that the debit card purchase is deducted from your checking account immediately.





3. Electronic banking facilities.



1. Automated teller machines (ATM).



2. Home banking



3. Virtual banks-banks that have no physical location and are only available on the internet.
4. Avoidance of existing regulations



1. Two types of regulations have been important in stimulating "loophole mining."



1. Reserve requirements



2. Restrictions on interest rates banks can pay on deposits.



2. Banks found sources of funds that were not subject of reserve requirements.



1. Eurodollars, i.e., dollars denominated in dollars that were borrowed from banks outside the United States;



2. Bank commercial paper, i.e., funds borrowed by bank holding companies issuing bonds.



3. Banks found ways to pay interest on checkable accounts.



1. NOW accounts were originated in Massachusetts in 1970 by a savings and loan company



1. in was not really a checking account but a negotiable order of withdrawal.



2. In the 1980 congress passed legislation permitting interest on checking accounts but also allowed nonbank financial institutions to have checkable accounts.



3. Sweep accounts were introduced for commercial accounts



1. they allowed banks ot take money out os commercial accounts at the end of the day and invest them in interest bearing instruments.