Chapter 17: Banking and the financial management of institutions FIN3244

Starting in the 1960s, however, large banks (called money center banks) in key financial centers, such as New York, Chicago, and San Francisco, began to

explore ways in which the liabilities on their balance sheets could provide them with reserves and liquidity. This move led to an expansion of overnight loan markets, such as the federal funds market, and the development of new financial instruments such as negotiable CDs (first developed in 1961), which enabled money center banks to acquire funds quickly

Net operating income

is closely watched by bank managers, bank shareholders, and bank regulators because it indicates how well the bank is doing on an ongoing basis.

Types of Assets: Cash Items in Process of Collection

Suppose that a check written on an account at another bank is deposited in your bank and the funds for this check have not yet been received (collected) from the other bank

Excess reserves are insurance against the costs associated with deposit outflows.

The higher the costs associated with deposit outflows, the more excess reserves banks will want to hold

Types of Assets: other assets

The physical capital (bank buildings, computers, and other equipment) owned by the banks is included in this category

. To maximize its profits, a bank must simultaneously seek the highest returns possible on loans and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets. Banks try to accomplish these three goals in four basic ways. First,

banks try to find borrowers who will pay high interest rates and are unlikely to default on their loans.

Second

banks try to purchase securities with high returns and low risk

Banks hold additional reserves, called excess reserves

because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account

the fourth option is

by reducing its loans by the needed amount and depositing the the amount it then receives with the Fed. This is the costliest way of acquiring reserves

A bank reduces its loans by

calling them in (not renewing some loans when they come due) or sell them off to other banks

Collectively, reserves, cash items in process of collection, and deposits at other banks are referred to as

cash items

Bank loan officers evaluate potential borrowers using what are called the "five Cs":

character, capacity (ability to repay), collateral, conditions (in the local and national economies), and capital (net worth) before they agree to lend.

the largest categories of loans for commercial banks are

commercial and industrial loans made to businesses and real estate loans.

Borrowings from the Fed are called

discount loans

net income

ells us most directly how well the bank is doing because it is the amount that the bank has available to keep as retained earnings or to pay out to stockholders as dividends

operating income

is the income that comes from a bank's ongoing operations. Most of a bank's operating income is generated by interest on its assets, particularly loans.

the third option is

is to acquire reserves by borrowing from the Fed

To eliminate a shortfall in reserves, the bank has four basic options. One being

is to acquire reserves to meet a deposit outflow by borrowing them from other banks in the federal funds market or by borrowing from corporations

a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits,

it loses an equal amount of reserves

Large-denomination CDs are negotiable

like bonds, they can be resold in a secondary market before they mature

Other sources of borrowed funds are

loans made to banks by their parent companies (bank holding companies), loan arrangements with corporations (such as repurchase agreements), and borrowings of Eurodollars (deposits denominated in U.S. dollars residing in foreign banks or foreign branches of U.S. banks).

Banks borrow funds overnight to have enough deposits at the Federal Reserve to

meet the amount required by the Fed. (The federal funds designation is somewhat confusing because these loans are not made by the federal government or by the Federal Reserve, but rather by banks to other banks.)

Banks hold state and local government securities because state and local governments are

more likely to do business with banks that hold their securities

Types of assets: loans

primary source of assets for banks. A loan is a liability for the individual or corporation receiving it, but an asset for a bank, because it provides income to the bank. Loans are typically less liquid than other assets because they cannot be turned into cash until the loan matures

net income

profits after taxes

Net income before taxes is more commonly referred to as

profits before taxes

The final item listed under operating expenses is

provisions for loan losses. When a bank has a bad debt or anticipates that a loan might become a bad debt, it can write up the loss as a current expense in its income statement under the "provision for loan losses" heading.

There are two basic types of nontransaction deposits:

savings accounts and time deposits (also called certificates of deposit, or CDs).

The U.S. government and agency securities are the most liquid because they can be easily traded and converted into cash with low transaction costs. Because of their high liquidity, short-term U.S. government securities are called

secondary reserves

Other lines of credit for which banks get fees include

standby letters of credit to back up issues of commercial paper and other securities and credit lines (called note issuance facilities, NIFs, and revolving underwriting facilities, RUFs) for underwriting Euronotes, which are medium-term Eurobonds.

To keep enough cash on hand, the bank must engage in liquidity management,

the acquisition of sufficiently liquid assets to meet the bank's obligations to depositors

second,

the amount of capital affects returns for the owners (equity holders) of the bank.

Because of the lack of liquidity and higher default risk

the bank earns its highest return on loans

The second concern of the bank manager is

the bank manager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings (asset management)

Fourth

the bank must manage the liquidity of its assets so that it can satisfy its reserve requirements without bearing huge costs. This means that it will hold liquid securities even if they earn a somewhat lower return than other assets

When a check written on an account at one bank is deposited in another

the bank receiving the deposit gains reserves equal to the amount of the check, while the bank on which the check is written sees its reserves fall by the same amount

Types of Liabilities: Bank capital

the bank's net worth, which equals the difference between total assets and liabilities (

The cost associated with discount loans is the interest rate that must be paid to the Fed is called

the discount rate

Fourth,

the manager must decide the amount of capital the bank should maintain and then acquire the needed capital (capital adequacy management)

This fraction is called

the required reserve ratio

A basic measure of bank profitability that corrects for the size of the bank is

the return on assets (ROA), mentioned ear-lier, which divides the net income of the bank by the amount of its assets.

How well a bank manages its assets and liabilities is affected by

the spread between the interest earned on the bank's assets and the interest costs on its liabilities. This spread is exactly what the net interest margin measures.

The third concern is

to acquire funds at low cost (liability management)

The bank manager has four primary concerns. The first is

to make sure that the bank has enough ready cash to pay its depositors when there are deposit outflows—that is, when deposits are lost because depositors make withdrawals and demand payment

A bank maintains bank capital to lessen the chance that it will become insolvent

true

A bank's capital is raised by selling new equity (stock) or from retained earnings. Bank capital is a cushion against a drop in the value of its assets, which could force the bank into insolvency (having liabilities in excess of assets, meaning that the bank can be forced into liquidation).

true

Banks earn profits by selling loans for an amount slightly greater than that of the original loan. Because the high interest rate on these loans makes them attractive, institu-tions are willing to buy them, even though the higher price means that they earn a slightly lower interest rate than the original interest rate on the loan, usually on the order of 0.15 percentage point.

true

Checkable deposits and money market deposit accounts are payable on demand; that is, if a depositor shows up at the bank and requests payment by making a withdrawal, the bank must pay the depositor immediately

true

Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

true

If the issuer of the security defaults, the bank is left holding the bag and must pay off the security's owner. Backup credit lines also expose the bank to risk because the bank may be forced to provide loans when it does not have sufficient liquidity or when the borrower is a very poor credit risk.

true

Off-balance-sheet activities involving guarantees of securities and backup credit lines increase the risk a bank faces.

true

ROE = ROA * EM

true

The cost of this activity is the interest rate on these borrowings, such as the federal funds rate

true

There are several types of backup lines of credit. The most important is the loan commitment

under which for a fee the bank agrees to provide a loan at the customer's request, up to a given dollar amount, over a specified period of time.

checkable deposits are

usually the lowest-cost source of bank funds because depositors are willing to forgo some interest to have access to a liquid asset that can be used to make purchases

Types of Assets: Reserves

All banks hold some of the funds they acquire as deposits in an account at the Fed. Reserves are these deposits plus currency that is physically held by banks (called vault cash because it is stored in bank vaults)

Types of Liabilities: Borrowings

Banks also obtain funds by borrowing from the Federal Reserve System, the Federal Home Loan banks, other banks, and corporations

Types of Liabilities: Checkable deposits

Checkable deposits are bank accounts that allow the owner of the account to write checks to third parties. Checkable deposits include all accounts on which checks can be drawn: non-interest-bearing checking accounts (demand deposits), interest-bearing NOW (negotiable order of withdrawal) accounts, and money market deposit accounts (MMDAs)

There is a direct relationship between the return on assets (which measures how efficiently the bank is run) and the return on equity (which measures how well the owners are doing on their investment). This relationship is determined by the equity multiplier (EM), the amount of assets per dollar of equity capital

EM = assets / equity capital

Although reserves earn a low interest rate, banks hold them for two reasons

First, some reserves, called required reserves, are held because of reserve requirements, the regulation that for every dollar of checkable deposits at a bank, a certain fraction (10 cents, for example) must be kept as reserves.

Although net income gives us an idea of how well a bank is doing, it suffers from one major drawback:

It does not adjust for the bank's size, thus making it hard to compare how well one bank is doing relative to another

Provisions for loan losses are directly related to loan loss reserves. When a bank wants to increase its loan loss reserves account by, say, $1 million, it does this by adding $1 million to its provisions for loan losses

Loan loss reserves rise when this is done because by increasing expenses when losses have not yet occurred, earnings are being set aside to deal with the losses in the future.

Types of Assets: Deposits at other banks

Many small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions, and help with securities purchases. This is an aspect of a system called correspondent banking

Another commonly watched measure of bank performance is called the net interest margin (NIM), the difference between interest income and interest expenses as a percentage of total assets:

NIM = (interest income - interest expenses) / assets

Types of liabilities: Nontransaction Deposits

Owners cannot write checks on nontransaction deposits, but the interest rates paid on these deposits are usually higher than those on checkable deposits.

. A basic measure of bank profitability is the return on assets (ROA), the net profit after taxes per dollar of assets:

ROA = net profit after taxes/assets

what the bank's owners (equity holders) care about most is how much the bank is earning on their equity investment. This information is provided by the other basic measure of bank profitability, the return on equity (ROE), the net profit after taxes per dollar of equity (bank) capital:

ROE = net profit after taxes / equity capital

The major difference in the balance sheets of the various depository institutions is primarily in the type of loan in which they specialize

Savings and loans and mutual savings banks, for example, specialize in residential mortgages, while credit unions tend to make consumer loans

Types of Assets: securities

Securities (made up entirely of debt instruments for commercial banks, because banks are not allowed to hold stock)

These securities can be classified into three categories:

U.S. government and agency securities, state and local government securities, and other securities.

if a bank has ample excess reserves

a deposit outflow does not necessitate changes in other parts of its balance sheet

A bank's balance sheet is also

a list of its sources of bank funds (liabilities) and uses to which the funds are put (assets).

third,

a minimum amount of bank capital (bank capital requirements) is required by regulatory authorities

Two items, gains (or losses) on securities sold by banks and net extraordinary items, which are events or transactions that are both unusual and infrequent

are added to the net operating income figure to get the figure for net income before taxes.

State and local government and other securities, although tax deductible

are both less marketable (less liquid) and riskier than U.S. government securities, primarily because of default risk: There is some possibility that the issuer of the securities may not be able to make its interest payments or pay back the face value of the securities when they mature

operating expenses

are the expenses incurred in conducting the bank's ongoing operations. An important component of a bank's operating expenses is the interest payments that it must make on its liabilities, particularly on its deposits

Because of the increased importance of liability management, most banks now man-age both sides of the balance sheet together in an

asset-liability management (ALM) committee

Banks have to make decisions about the amount of capital they need to hold for three reasons. First

bank capital helps prevent bank failure, a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors and so goes out of business.

Third

banks must attempt to lower risk by diversifying. They accomplish this by purchasing many different types of assets (short-and long-term, U.S. Treasury, and municipal bonds) and approving many types of loans to a number of customers

the second option to eliminate a shortfall in reserves is

for the bank to sell some of its securities to help cover the deposit outflow

Off-balance-sheet activities

involve trading financial instruments and generating income from fees and loan sales, activities that affect bank profits but do not appear on bank balance sheets

A loan sale, also called a secondary loan participation

involves a contract that sells all or part of the cash stream from a specific loan and thereby removes the loan from the bank's balance sheet