Commercial Banking
Credit risk of loan portfolios
Banks increasingly rely on internal credit risk ratings to measure the risk of loan portfolios for: Diversifying across geographic regions, loan type and borrower type Using credit derivatives to minimise credit risk exposure
Loans
Banks make profits primarily by issuing loans Loans are less liquid than other assets Other assets Tangible assets e.g. bank buildings, computers
Managing interest rate risk
Banks manage interest rate risk to ensure they profit from the spread between borrowing rates and rates of return on loans and investments
Trading activities - derivative securities
Banks participate in markets for interest rate and currency forwards, futures, options and swaps.
Income for commercial bank
Commercial banks are profit-maximising business firms who primary source of income is interest earned on loans and investment securities.
Reserves
Deposits in an account at the central bank and vault cash Don't pay interest, held for two reasons: regulation requirement and liquidity management Required reserves (fraction of transaction deposit) & excess reserve
Profitability
ROAA - Rate of return on average average assets ROAE - Rate of return on average equity NIM - Net interest margin
Off-balance-sheet banking
There has been a large increase in off-balance-sheet banking over the last 20 years Trading financial instruments Generating income from fees and loan sales (loans brokerage) Activities that affect bank profits but do not appear on bank balance
Basic banking - deposits
When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits; it loses an equal amount of reserves
Primary reserves
Immediately available to accommodate liquidity demands Vault cash, deposits at correspondent banks and deposits held at the RBA
Profitability vs Safety
Increase profit by taking more risk Bank must balance demands of shareholders, depositors and regulators Balance the trade-off between: Profitability - Liquidity - Solvency
Asset management - excess reserves
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.
Sources of income
Interest income - major source Non-interest income Atm surcharges Credit card fees Fees from the sale of managed funds Trust operations Investment services, insurance and financial products
Expenses for banks
Interest paid on deposits and borrowed funds along with salaries and employees benefits
Operation expense
Interest rate payments Non-interest expenses Provision for loan loss
Deposits
Interest rates paid on deposits has accounted much less than the cost involved in servicing accounts (employee salaries, building rent, and so on)
Basic banking - Transforming assets
Issuing liabilities and buying assets Borrows short and lends long
Liability Management
Liability management involves attracting additional funds by increasing the interest rate on interest sensitive securities Negotiable CDs, repos, and Eurodollar borrowings
Loan commitments
Line of credit - agreement under which a customer can borrow up to a predetermined limit on a short-term basis Term loans - agreement under which a bank will lend a customer a certain dollar amount for a period exceeding a year Revolving credit facilities - customer has ability to borrow, repay and re-borrow during loan period.
Deposits outflows - Asset Management
Maintaining sufficient cash and non-cash assets that can be quickly converted to cash
Measuring interest rate risk
Maturity gap analysis, used to ensure bank's assets have maturities similar to the liabilities Duration gap analysis, more precise and used by large instiutions Value of Risk (VaR)
Managing interest rate risk
Micro hedging - hedging a specific transaction or - matched funding (fixed rate loans are funded with deposits or borrowed funds of the same maturity) Macro hedging - through the use of financial futures, options on futures and interest rate swaps
Capital accounts
Bank capital is the ownership funds of the bank Loan and security losses are charged against this account
Credit risk of individual loans
Once a loan is made, banks must monitor its performance Indicators of problem loans: Failure to make loan payments Adverse changes in a customer's credit rating Adverse changes in deposit balances, sales and earnings Delays in supplying financial statements or other documents
Bank capital management
Performs several important roles Provides a financial cushion Helps maintain public confidence Provides some protection to depositors Serve as a source of funds for expansion A minimum amount of bank capital is required by regulatory authority Maintains bank capital to lessen the chance that it will become insolvent
Asset management classifications
Primary reserves Secondary reserves Bank loans Investments
Source of bank funds
Principal source Demand, savings and terms deposits Increase demand for loans has outpaced the growth on deposits and banks rely on borrowed funds to finance their operations.
Secondary reserves
Provide banks with additional liquidity while earning some interest income T-bills and short-term government agency securities
Deposits outflows - Liability Management
Acquiring liquidity from the liability side of the balance sheet
Securities
An important income-earning assets Debt instruments Treasury securities are called secondary reserves
Borrowed funds
Borrowed funds are short-term borrowings by commercial banks from the wholesale money markets From central bank From other banks From corporations/parent companies/eurocurrency
CAMELS
Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk Rated on scale from 1 (Best) to 5 (Worst) Composite rating based on all six components
Off-balance-sheet banking Fee income
Fees that banks receive for providing specialized services to customers e.g. making foreign exchange trades on customer's behalf providing backup lines of credit (loan commitment), which increases the default and liquidity risks a bank faces
Asset management
Find borrowers paying high rates and unlikely to default Purchase securities with high returns and low risk Diversifying (purchasing many different types of assets) Liquidity management (reserves)
Bank use of funds
Funds used for issuing loans or purchasing investments
Purpose of derivative securities
Hedging risk Speculation - on changes in interest rates or currency exchange rates Serving as a counterparty for a customer
Deposit accounts - nontransaction deposits
Savings Accounts - interest bearing accounts of individuals and partnerships Time (Term) Deposits - are legally due on a maturity date and the funds cannot be transferred to others
Bank Capital
Share capital - common or preferred stock Retained earnings Cushion against drop in assets value
Basic banking - Providing a set of services (cheque clearing, record keeping, credit analysis etc.)
To make profit, produces desirable services at low cost and earns substantial income on assets
Deposit accounts
Transaction Accounts (demand deposits) In which the owner is entitled to receive their funds on demand, which transfers ownership of the funds to others by cheque or EFTPOS Lowest-cost source of bank funds
Open-market investments
Undertaken once loan demand has been satisfied Long-term treasury securities, state, local government and corporate bonds.
Bank loans
Undertaken once the bank has satisfied its liquidity needs Loans to business firms and individuals