econ 2035 chapter 10
involves interbank loans borrowed at the federal funds rate
The federal funds market
duration analysis
an analysis of how sensitive a bank's capital is to changes in market interest rates
gap analysis
an analysis of the gap between the dollar value of a bank's variable-rate assets and the dollar value of its variable-rate liabilities
explicit provisions in the loan agreement that prohibit the borrower from engaging in certain activities
restrictive covenants
roe=
roa x (bank assets/ bank capital)
non-transaction deposits
savings accounts money market deposit accounts certificates of deposit
Types of Nontransaction Deposits
savings accounts money market deposit accounts time deposits or cds
Bank holdings of U.S. Treasury securities are also called
secondary securities
cant own stocks only bonds
securities
the high-quality borrowers paid
the prime rate
three categories of loans
(1) loans to businesses: commercial and industrial loans (2) consumer loans: made to households primarily to buy automobiles and other goods (3) real estate loans: residential and commercial mortgages
liability management
-Borrowing funds in the federal funds market •Engaging in repurchase agreements •Obtaining discount loans from the Fed
bank borrowings include
-Short-term loans in the federal funds market • Loans from a bank's foreign branches or other subsidiaries or affiliates • Repurchase agreements • Discount loans from the Federal Reserve System
managing bank risk
1) liquidity risk 2) credit risk 3) interest- rate risk
the ratio of the value of a bank's after tax profit to the value of its capital
ROE
banks may reduce liquidity risk through
Asset management liability management
the effect of a change in market interest rates on a bank's profit or capital
Interest-rate risk
A high ratio of assets to capital (high leverage) is a two-edged sword:
Leverage can magnify relatively small ROAs into large ROEs, but it can do the same for losses
The ability of banks to assess credit risks on the basis of private information on borrowers
Long-Term Business Relationships
checking accounts that pay interest
NOW negotiable order of withdrawal
the ratio of the value of a bank's after-tax profit to the value of its assets
ROA
roa formula
after tax profit/ bank assets
ROE formula
after tax profit/ bank capital
something of value that an individual or a firm owns
asset
Duration gap =
average duration of assets − average duration of liabilities
a statement that shows and individual's or a firm's assets and liabilities to indicate its financial position on a particular day
balance sheet
the difference between the value of a bank's assets and the value of its liabilities
bank capital also called shareholders' equity
The ratio of assets to capital is one measure of
bank leverage
the ratio of the value of a bank's assets to the value of its capital
bank leverage
placed limits on the value of the assets commercial banks can acquire relative to their capital.
capital requirements
reserves
cash items vault cash and deposits with the fed
accounts against which depositors can write checks
checkable deposits
deposits
checkable deposits now
In the United States, commercial banks cannot invest
checkable deposits in corporate bonds or common stock
cash items in the process of collection
claims banks have on other banks for uncollected funds
a required minimum amount that the business taking out the loan must maintain in a checking account with the lending bank
compensating balance
largest category of bank assets
loans
the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate.
credit rationing
risk that borrowers might default on their loans
credit risk
the process that bank loan officers use to screen loan applicants
credit risk analysis
predict whether a borrower is likely to default
credit scoring system
checkable deposits on which banks do not pay interest
demand deposits
a bank's primary sources of funds are
deposits
liabilities and bank capital
deposits borrowings capital
borrowings
discount loans short term loans in the federal funds market repurchase agreements (repos)
reserves banks hold above those necessary to meet reserve requirements
excess reserves
government guarantee of deposit account balances up to 250,000
federal deposit insurance
used to calculate the vulnerability of a bank's profits to changes in market interest rates
gap analysis
Moral hazard can contribute to
high bank leverage
Loan and credit limits reduce moral hazard by
increasing the chance a borrower will repay
loans
loans to businesses; consumer loans; and real estate loans
agree to exchange the payments from a fixed-rate loan for the payments on an adjustable-rate loan
interest rate swaps
a measure of how much debt an investor assumes in making an investment
leverage
The inverse of bank leverage is the
leverage ratio.
something that an individual or a firm owes
liability
possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost.
liquidity risk
_____ are illiquid relative to marketable securities and have greater default risk and higher information costs
loans
a banks primary uses of funds
loans
A rise in the market interest rate will
lower the present value of a bank's assets and liabilities
Banks with negative gaps can
make more adjustable-rate or floating rate loans.
liquid assets that banks trade in financial markets
marketable securities
Most banks have ______ gaps because their ____ are more likely to have variable rates than are their assets (loans and securities).
negative, liabilities (deposits)
the difference between the interest a bank receives on its securities and loans and the interest it pays on deposits and debt, divided by the total value of its earning assets.
net interest margin
A bank's profits are commonly expressed in terms
of its return on assets
other assets
physical capital and collateral
most banks charge rates that reflect changing market interest rates instead of the
prime rate
was formerly the interest rate banks charged on six-month loans to high-quality borrowers (now an interest rate banks charge primarily to smaller borrowers).
prime rate
By diversifying, banks can
reduce the credit risk associated with lending too much to a single borrower
Federal deposit insurance has increased moral hazard by
reducing the incentive depositors have to monitor the behavior of bank managers
banks sell securities, such as Treasury bills, and agree to repurchase them, typically the next day
repos
Reserves formula
required + excess
reserves the Fed requires banks to hold against demand deposit and NOW account balances.
required reserves
bank assets consisting of vault cash plus bank deposits with the Federal Reserve
reserves
bank assets list
reserves securities loans other assets
As the value of a bank's assets or liabilities changes,
so does the value of the bank's capital
accounting tool used to show changes in balance sheet items
t account
the key banking activities are
taking in deposits from savers and making loans to households and firms
Banks are allowed to hold securities issued by
the U.S. Treasury and other government agencies and corporate bonds
If a bank has a positive duration gap, then
the duration of the bank's assets is greater than the duration of the bank's liabilities.
A bank's capital represents
the funds contributed by the bank's shareholders through their purchases of stock the bank has issued plus accumulated retained profits.
If a bank cannot distinguish low- from high-risk borrowers,
then it will run the risk of losing the low-risk borrowers when it raises the interest rate, leaving only the high-risk borrowers—a case of adverse selection.
If managers are compensated for a high ROE,
they may take on more risk than shareholders would prefer.
is cash on hand in a bank
vault cash (including currency in ATMs or deposits with other banks)
Banks can reduce credit risk by different methods (6)
§ Diversification § Credit-risk analysis § Collateral and compensating balance § Credit rationing § Monitoring and restrictive covenants § Long-term business relationships
asset management
§ Lending funds in the federal funds market § Engaging in reverse repurchase agreements
Bank assets are acquired by banks with the funds they:
• receive from depositors • borrow from other institutions • acquire initially from shareholders • retain as profits from operations