Final Exam: Chapter 10, 11, 13

what are the two types of deposits?

- Checkable (aka "demand deposits") always available for withdrawal by savers. - Nontransaction savings and time deposits (e.g., CDs).

how do letters of credit work? (off balance sheet activity)

- Firms request that the bank send a commercial letter of credit to an exporter in another country that guarantees payment for the firm's order upon receipt. - In return for taking this risk, the bank collects a fee.

why should you not buy payday loans?

- In the past these loans were very expensive and appealed only to those who could not get credit elsewhere. - Laws are changing to rein in payday lending practices. Wal-Mart now offers safe and secure payday loans without usury interest rates.

what are a banks three lines of business in which it makes a profit?

- Interest earned on loans issued - Investment gains from securities held - Fees collected for services provided

what are the three kinds of off-balance sheet activities?

- Lines of Credit - Letters of Credit - Standby Letters of Credit

asset-side risk

- Lines of credit and other off-balance sheet arrangements (e.g, letters of credit and standby letters of credit) represent asset-side risk. - That is, they relate to loans the bank has made to others who may default

what are four basic measures of bank profitability?

- Return on Assets (ROA) - Return on Equity (ROE) - Net Interest Income - Net Interest Margin

how do lines of credit work? (off balance sheet activity)

- The fee is collected when the agreement is signed; the firm then receives a loan commitment. - Personal lines of credit are most often secured, i.e. an asset is put up as collateral. -In exchange for the loan commitment the bank collects a fee.

liability-side risk

- The sudden withdrawal of bank deposits ("run on the bank") is a liability-side risk. - That is, it relates to funds owned by others for which the bank has temporary—but uncertain-- custody.

Net Interest Margin

- a bank's net interest income divided by total assets - it signals future profitability. - a measure of bank profitability

Return on Equity (ROE)

- a bank's net profit after taxes divided by bank capital - it measures the bank's return to its owners. - a measure of bank profitability

Return on Assets (ROA)

- a bank's net profit after taxes divided by its total assets - it measures how efficiently a banks uses its assets. - a measure of bank profitability

what are three ways in which banks can prevent sovereign risk?

Banks have three options to prevent sovereign risk: - Diversification across markets - Refuse loans to certain countries - Use derivatives to hedge the risk

Where to banks lend money to?

Banks loan money to individuals via car loans, home loans, etc. . . . i.e. financial instruments -Lenders-Savers (primarily households) Banks also lend money to governments and businesses, in part with the purchase of bonds . ie funds -Borrowers-Spenders (mostly governments and firms)

what are the two ways in which banks manage foreign exchange risk?

Banks manage foreign exchange risk in two ways: 1. They seek to attract deposits that are denominated in the same currency as their loans, matching assets to liabilities. 2. They use foreign exchange futures to hedge the risk.

what are two ways banks in which can prevent operational risk?

Banks must make sure their systems and buildings are secure and sufficiently robust. This means anticipating various types of disaster and testing to ensure a system's readiness.

Where do banks obtains funds from?

Banks obtain funds from individual depositors via savings and money market accounts, CDs, and more. i.e. funds -Lenders-Savers (primarily households) Banks also obtain funds from same via interbank CDs, Federal Reserve deposits and the sale of bank bonds. i.e. financial instruments - Borrowers-Spenders (mostly governments and firms)

what is net interest income?

- the difference between interest the bank pays out on deposits and the interest it takes in on loans, mortgages and securities - it measures loan effectiveness. - a measure of bank profitability

what are two main ways commercial banks make money?

-Commercial banks make money by using customer deposits for loans with interest rates above the rates they pay to depositors. -They also make money collecting fees for various services provided.

what are three services that both depository (banks) and nondepository (non-bank) financial institutions can provide?

-Create and sell securities -Offer loans, insurance and pensions -Provide checking accounts, credit cards, debit cards, more

what do the two main kinds of securities included on a bank balance sheet? asset - use of funds

-U.S. Treasury securities -state and local gov't bonds

what are two recommended responses of interest-rate risk?

1. Closely match the maturity of both sides of the balance sheet. 2. Use derivatives such as interest-rate swaps

what are three recommended responses of credit risk?

1. Diversify to spread risk 2. Use statistical models to screen for creditworthy borrowers 3. Monitor to reduct moral hazard

what are three recommended responses of liquidity risk?

1. Hold sufficient cash reserves to meet customer demand. 2. Manage assets by selling securities or loans (contracts the size of the balance sheet) 3. Manage liabilities by attracting more deposits (maintains the size of the balance sheet)

provide an example of interest rate risk.

Consider a bank with a two-year horizon that has issued a one-year CD for $50 million at an interest rate of 2 percent. It now has $50 million on which it must pay 2% interest for one year. With the proceeds, the bank buys a two-year Treasury note that pays 4 percent interest. Year 1: $50M CD, 2% i = bank pays $1.0M $50M Treasury, 4% i = bank receives $2.0M Profit = $1.0M Now say interest rates rise 1% in Year 2. . . . A rise in interest rates would increase the amount of interest the bank has to pay on the CD the second year...but the interest income on the two-year Treasury note would not change, so net interest income declines.... Year 1: $50M CD, 2% i = bank pays $1.0M $50M Treasury, 4% i = bank receives $2.0M Profit = $1.0M Year 2: $50M CD, 3% i = bank pays $1.5M $50M Treasury, 4% i = bank receives $2.0M Profit = $0.5M

how does credit risk analysis work? (managing credit risk)

Credit risk analysis produces information that is very similar to the way investors rate companies issuing bonds. Banks do this for small firms wishing to borrow, and credit rating agencies do this for consumers. The result is an assessment of the likelihood that a particular borrower will default.

Credit risk

Credit risk is the risk that a bank's loans will not be repaid.

What are the banks PRIMARY liability?

Deposits are the bank's primary liability.

what are two kinds of deposits bank balance sheets include? liabilities - sources of funds

Deposits are the bank's primary liability. Deposits include: - money lent to the bank by savers - money borrowed by the bank in the financial markets.

what are two primary tools banks use to manage credit risk?

Diversification Credit Risk Analysis

how can diversification be difficult for banks? (managing credit risk)

Diversification can be difficult for banks, especially if they focus on certain types of lending. If a bank lends in only one geographic area or only in one industry, it is exposed to economic downturns that are local or industry-specific. Sometimes small business loan requests are denied simply because that bank doesn't know that industry very well—not because the business idea is not sound.

Reserves (cash item) asset - use of funds

Reserves - (vault cash plus Fed Reserve deposits)

what are 3 cash items? (under assets)

Reserves - vault cash plus Fed Reserve deposits Uncollected funds - the bank expects to receive Account balances - held at other banks (correspondent banking)

what is the bank's goal?

The bank's goal is to make a profit in each of its three lines of business. - Interest earned on loans issued - Investment gains from securities held - Fees collected for services provided

what is current trend in the banking industry among non depository institutions?

There is a currently a tendency with non depository institutions toward consolidation.

what the kinds of loans are included on a bank balance sheet?

These loans include: -business loans (commercial and industrial) C & I loans -real estate loans -consumer loans - interbank loans -loans for the purchase of other securities

how do stand by letters of credits work?

These open-ended extensions of credit act as a form of insurance for those receiving the letters; recipients know the firm or government can access cash if needed. Note: the bank's risk is not apparent on its balance sheet and the credit may or may not be used. The bank collects the fee regardless.

why is a strong credit score so important?

This is another reason why a strong credit score is important to YOU—low credit scores mean a higher interest rate on home mortgages and car loans.

what is the most common type of loan?

a pay day loan

repurchase agreement

a short-term collateralized loan exchanging a security for cash. a way banks can borrow liabilities - sources of funds

Commercials banks

are privately-owned, profit-making businesses that provide various services to individuals and businesses, allowing both to deposit funds safely and to borrow funds when necessary.

what is the equation used to determine net worth?

assets - liabilities

To start a bank, one needs permission in the form of a ______________.

bank charter To start a bank, one needs permission in the form of a bank charter. Prior to 1863, all bank charters were issued by state banking authorities.

provide a recent example of trading risk.

In the Spring of 2012, JPMorgan's London investment office experienced large trading losses. The bank's main trader their, nicknamed the London Whale, accumulated very large positions in complex financial instruments known as Credit Default Swaps. The strategy failed and the bank's related losses totaled $6.2 billion US. (The bank still earned a record profit overall of $21.3 billion that year.)

why is it so difficult for banks to monitor traders? (trading risk)

Large banks find it difficult to monitor traders, whose activities are very complex. Banks also have difficulty monitoring the managers who are supposed to be monitoring the traders.

Large time deposits

Large time deposits are Jumbo CDs (+$100K) liabilities - sources of funds

Liabilities

Liabilities - sources of funds; something owed

Lines of credit (off balance sheet activity)

Lines of credit - similar to limits on credit cards, a firm pays the bank a fee in return for the ability to borrow when necessary.

Liquidity risk (kind of bank risk)

Liquidity risk is the risk of a sudden demand for bank funds. Banks face liquidity risk on both sides of their balance sheets.

what are a bank's PRIMARY asset? asset - use of funds

Loans are the bank's primary asset

interest-rate risk

A bank's liabilities (deposits) tend to be short-term, while its assets (loans) tend to be long term. This mismatch between the two sides of the balance sheet creates interest-rate risk.

what is the equation for net interest income?

Net Interest Income = Interest earned on loans - Interest paid on deposits Revenue generated from bank assets less expense associated with bank liabilities.

What is the cushion that banks have against a sudden drop in asset value or an unexpected withdrawal of liabilities?

Bank Capital

what is a key use of bank capital?

Bank capital is also key for loan loss reserves -the amount set aside to cover loan defaults.

what are five kinds of bank risks?

Bank risks include: - Liquidity risk - Credit risk - Interest-rate risk - Trading risk - Other risk

what is the equation for net interest margin?

Net Interest Margin = Net Interest Income x 100 / Total Assets - The bank's ability to earn interest income relative to the debt (assets) it holds. - A negative value suggests interest expenses were greater than the amount of returns generated by bank investments.

Net Worth

Net Worth - the difference between the two assets - liabilities (aka Bank Capital or Shareholder Equity)

Nontransaction deposits liabilities - sources of funds

Nontransaction deposits savings and time deposits (e.g., CDs).

Operational risk

Operational risk is when computer systems fail, security is breached or buildings burn down.

Other Assets (on a bank balance sheet)

Other Assets include mostly: building and equipment collateral repossessed from borrowers who defaulted on bank loans

what is a recommended response of trading (market) risk?

closely monitor traders using management tools, including value at risk.

what is the source of credit risk?

default by borrowers on their loans

why are deposits listed as liabilities?

deposits are listed as liabilities because they are owned by others who have a financial claim on those funds.

how do banks earn a profit?

fees the bank collects for services it provides + the return the bank receives on its assets (i.e. interest it receives on the loans it makes) - what the bank pays for its liabilities (i.e. interest it pays on deposits it holds) = Bank Profit

why are loans the bank makes considered assets?

loans the bank makes are listed as assets because they represent a financial claim on funds the bank owns and has lent to others.

what is the source of interest-rate risk?

mismatch in maturity of assets and liabilities coupled with a change in interest rates

what is the source of liquidity risk?

sudden withdrawals by depositors or takedowns of credit lines

loan loss reserves

the amount set aside to cover loan defaults.

what is a recent example of operational risk?

Physical damage to buildings and networks was an issue for some banks when the World Trade Center was destroyed. Data security is now an ever-present risk that is difficult to quantify.

net worth

the value of the bank to its owners

what are letters of credit? (off balance sheet activity) what are they used for?

these guarantee that a customer of the bank will be able to make a promised payment. - used to initiate international transactions.

what is the source of trading (market) risk?

trading losses in the bank's own account

diversification (tool used to manage credit risk)

where banks make a variety of different loans to spread the risk.

credit risk analysis (tool used to manage credit risk)

where the bank examines the borrower's credit history to determine the appropriate interest rate to change.

Checkable deposits (aka demand deposits) liabilities - sources of funds

Checkable (aka demand deposits) always available for withdrawal by savers.

Account balances (cash item) asset - use of funds

Account balances - held at other banks (correspondent banking)

Assets

Assets - uses of funds; something owned

what are the three things the balance sheet provides details on?

Assets - uses of funds; something owned Liabilities - sources of funds; something owed Net Worth - the difference between the two

how do banks make profit from investment gains from securities held?

Banks want to earn more on the securities they hold than they pay in interest for the deposits needed to purchase those securities.

how do banks make profit from fees collected for services provided?

Banks want to manage their transactions such that the fees they collect exceed the cost of the risks they incur.

how do banks make profit from interest earned on loans issued?

Banks want to pay less interest on deposits held than they receive on loans issued.

in what year were the commercial banks, investment banks and insurance companies were allowed to merge?

Beginning in 2000, the commercial banks, investment banks and insurance companies were allowed to merge. This created very large organizations that offer numerous financial services under one roof.

what are Borrowings? what are the two ways in which they can borrow?

Borrowings come from the Federal Reserve and from other banks (aka interbank CDs). Banks can also borrow via a repurchase agreement, a short-term collateralized loan exchanging a security for cash. liabilities - sources of funds

For decades, most U.S. banks were _______ banks, meaning banks without branches.

For decades, most U.S. banks were unit banks, meaning banks without branches.

Foreign exchange risk

Foreign exchange risk comes from holding assets denominated in one currency and liabilities denominated in another.

what is the equation for Return on Assets (ROA)?

Return on Assets (ROA) = Net Income x 100 / Total Assets e.g. Return on Assets (ROA) = 1000 x 100 / 40,000 = 2.5% Net Income is revenues minus cost of doing business, depreciation, interest, taxes and other expenses, aka the bottom line.

what is the equation for Return on Equity (ROE)?

Return on Equity (ROE) = Net Income x 100 / Bank Capital Bank Capital is to a bank what Shareholder Equity is to a stock, i.e. assets minus liabilities.

what compounds the problem of interest rate-risk?

Rising interest rates compound this problem of interest-rate risk: banks raise interest rates paid on short-term deposits immediately, but must wait to raise rates charged on long-term loans.

trading risk (or market risk)

Risk that the securities traded may go down in value is called trading risk, or market risk. All markets are complex and the moving parts interact in confusing and unpredictable ways.

what are securities also known as?

Securities are also called "secondary reserves" since they are nearly as liquid as cash.

what is a pay day loan?

Small stores act as financial intermediaries to provide loans to people who cannot borrow from mainstream financial institutions, like banks

what is sovereign risk?

Sovereign risk arises from the fact that some foreign borrowers may not repay their loans because their government prohibits them from doing so. If a foreign country is experiencing a financial crisis, the government may decide to restrict dollar-denominated payments.

Standby letter of credit (off balance sheet activity)

Standby letter of credit are issued to firms and governments that wish to borrow in the financial markets.

Balance Sheet

The Balance Sheet of a commercial bank provides a snapshot of the bank's financial resources. It indicates the value of the bank to its owners, i.e., it's net worth.

what is the net worth of the bank called? i.e. bank assets - bank liabilities

The net worth of a bank is called its Bank Capital -It is the owners' stake in the bank.

what are off-balance sheet activities used for?

To generate fees, banks engage in several off-balance-sheet activities Off balance sheet means the bank does not have a legal claim or responsibility for these activities, which vary based upon the amount of business the bank can drum up.

who do banks hire to actively buy and sell securities, loans, and derivatives using a portion of the bank's capital?

Today banks hire traders to actively buy and sell securities, loans, and derivatives using a portion of the bank's capital.

currently how many of U.S. banks are unit banks?

Today, only one-third of U.S. banks are unit banks.

True or False. Today, both depository (banks) and nondepository (non-bank) financial institutions provide a broad menu or services including: -Create and sell securities -Offer loans, insurance and pensions -Provide checking accounts, credit cards, debit cards, more

True. Today, both depository (banks) and nondepository (non-bank) financial institutions provide a broad menu or services including: -Create and sell securities -Offer loans, insurance and pensions -Provide checking accounts, credit cards, debit cards, more

Uncollected funds (cash item) asset - use of funds

Uncollected funds - the bank expects to receive