Chapter 9

Balance Sheet

- A list of the banks assets and liabilities - total assets = liabilities + capital - A list of its sources of bank funds (liabilities and capital) and uses to which the funds are put (assets)

Banks have 4 options to eliminate shortfall in reserves (option 1)

1) It can acquire the reserves needed to meet a deposit outflow by borrowing them from other banks in the federal funds market, or by borrowing from corporations - this increases liabilities by the amount borrowed under a new category called borrowings form other banks/corps - cost of this activity is the interest rate on the borrowings (such as federal funds rate)

To raise the amount of capital relative to assets:

1) You can raise capital by having it issue equity (common stock) 2) you can raise capital by reducing the banks dividends to shareholders, thereby increasing retained earnings that it can put into its capital account 3) you can keep capital at the same level but reduce the banks assets by making fewer loans or by selling off securities and then using the proceeds to reduce the banks liabilities

When deposit outflow occurs, excess reserves enable the bank to escape the costs of:

1) borrowing from other banks or corporations 2) selling securities 3) borrowing from the Fed 4) calling in or selling off loans

How banks reduce loans:

1) the bank can reduce its total amount of loans by "calling in loans" which is by not renewing some loans when they come due - this is costly because it annoys customers because they do not deserve this and they would bring their business somewhere else then 2) They can sell their loans off to other banks - it is costly because banks do not know how risky these loans may be and so may not be willing to buy the loans at their full value

Loan Commitment

is a banks commitment to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate - it is a powerful method for reducing the banks costs of screening and information collection

How financial institutions overcome adverse selection and moral hazard:

Specialization in Lending - Banks often only give loans to local firms because it is easier for a bank to collect info about these firms and determine their creditworthiness compared to firms further away - they also specialize in specific industries because they learn more about a particular industry and can better predict which firms will not default on them

Liquidity Management

The acquisition of assets that are liquid enough to meet the banks obligations to depositors - bank managers engage in this to keep enough cash on hand

When a checking account is opened:

The banks liabilities will increase by 100. Then the bank puts the money into vault cash which also increases by 100 on the asset side. - Note: An increase in the banks reserves is equal to the increase in checkable deposits

Asset Transformation

The process of selling liabilities with one set of characteristics (combination of liquidity, risk, size, and return) and using the proceeds to buy assets with a different set of characteristics

Credit Risk

The risk arising because borrowers may default

Banks obtain funds by:

borrowing and by issuing other liabilities, such as deposits

Banks make profits by:

earning interest on their asset holdings of securities and loans that is higher than an interest and other expenses on their own liabilities

Collateral

is property promised to the lender as compensation if the borrower defaults, lessens the consequence of adverse selection because it reduces the lenders losses in the case of a loan default - it also reduces moral hazard because the borrower has more to lose from defaulting

A shortfall of bank capital is likely to lead a bank to:

reduce its assets and therefore is likely to cause a contraction in lending

Credit rationing

refusing to make loans even though borrowers are willing to pay the stated interest rate, or higher two forms: 1) when a lender refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a higher interest rate 2) Occurs when a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like

Asset Management -- Highest possible profit on loans and securities for banks occurs when

seek the highest possible return, reduce the risk, and make adequate provisions for liquidity by holding liquid assets

Other assets

the physical capital owned by banks included in the other assets category - include bank buildings, computers, and other equipment

Interest rate risk

the riskiness of earnings and returns on bank assets caused by interest rate changes

Interest Rate risk

the riskiness of earnings and returns that is associated with changes in interest rate

Banks use funds:

to acquire assets such as securities and loans

Borrowings (liability)

- Banks also obtain funds by borrowing from the federal reserve system, the federal home loan banks, other banks, and corporations - They also borrow reserves overnight in the Fed funds market from other US banks and financial institutions in order to have enough deposits at the Federal Reserve to meet the amount required by the Fed - Other sources of borrowed funds are loans made to banks by their parent companies, loan arrangements with corporations, and borrowings of Eurodollars

How the amount of Bank Capital Affects Returns to Equity Holders

- Owners of a bank must know whether their bank is being managed well so they need to measure their bank profitability - Banks care more about how much the bank is earning on their equity investment

Reserves (asset)

- Reserves are held at the fed - they consist of these deposits plus currency that is physically held b banks - Earn a low interest rate - Hold them for 2 reasons: 1) Required reserves - are held because of reserve requirements which is a regulation that for every dollar of checkable deposits at a bank, a fraction must be kept as reserves (called the required reserves ratio) 2) Excess reserves - hold these because they are the most liquid of all assets and a bank can use them to meet obligations when funds are withdrawn

Measure of Bank Profitability:

- Return on Equity (ROE) which is defined a the net profit of taxes per dollar of equity (bank) capital - ROE = net profit after taxes / equity capital - 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), or the amount of assets per dollar of equity capital - EM = assets / equity capital - ROE = ROA * EM - Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank

Bank Capital (liability)

- The banks net worth which equals the difference b/w total assets and liabilities - It is raised by selling new equity or from retained earnings - It is the banks cushion against a drop in the value of its assets, which could force the bank into insolvency (bank has liabilities in excess of assets)

Managing Credit Risk

- The economic concepts of adverse selection and moral hazard provide a framework for understanding the principles that financial institutions must follow if they are to reduce credit risk and make successful loans - to be profitable financial institutions need to overcome the adverse selection and moral hazard problems that make loan defaults more likely

4 primary concern of a bank manager

- To make sure the bank has enough ready cash to pay its depositors when there are deposit outflows - 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 - 3rd concern is acquiring funds at a low cost - Manager must decide the amount of capital the bank should maintain and then acquire the needed capital

Discount Loans (liability)

- When a bank borrows from the Fed

Assets

- a bank uses the funds it has acquired by issuing liabilities to purchase income earning assets - Bank assets are referred to as uses of funds and the interest payments earned on them are what enable banks to make profits

Sensitivity of bank profits to changes in interest rates:

- is measured by Gap analysis which is the amount of rate-sensitive liabilities is subtracted from the amount of rate-sensitive assets - by multiplying the gap time the change in the interest rate, we can obtain the effect on bank profits

Loans (asset)

- make their profits primarily on these - produce more than half of their profits - 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 - less liquid than other assets because they cannot be turned into cash until the loan matures - have a higher probability of default

Liabilities

-Sources of funds that bank uses - These funds are used to purchase income earning assets

Deposits at other banks (asset)

...

Capital Adequacy Management -- Banks have to make a decision about the amount of capital they need to hold for three reasons:

1) 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 2) The amount of capital held affects returns for the owners (equity holders) of the bank 3) A minimum amount of capital is required by regulatory authorities

Measuring interest rate risk

1) Gap analysis 2) Duration Analysis

Asset Management -- Goals for highest possible return are accomplished by:

1) they try to find borrowers who will pay high interest rates and are unlikely to default on their loans 2) Banks try to purchase securities with high returns and low risk 3) In managing their risks, banks must attempt to lower risk by diversifying - this is accomplished by by purchasing many different types of assets and approving many types of loans to a variety of customers 4) The bank must manage the liquidity of its assets so that it can meet deposit outflows and still satisfy its reserve requirements without bearing huge costs - this means it will hold liquid securities even if they earn a somewhat lower return than other assets - for example the bank must decide how much it should hold in excess reserves to avoid the costs associated with a deposit outflow. In addition it will hold US govt securities as secondary reserves so that even if a deposit outflow forces some costs on the bank, they won't be that high

How to lower capital relative to assets and raise the EM:

1) you can reduce the amount of bank capital by buying back some of the banks stock 2) you can reduce the amount of back capital by paying out higher dividends to its stockholders, thereby reducing the banks retained earnings 3) you can keep bank capital constant but increase the banks assets by acquiring new funds, say by issuing CDs and then seeking out loan business or purchasing more securities with these funds

Gap Analysis refined (accounts for diff. maturities of assets and liabilities)

1)Maturity bucket approach: - Measures the gap for several maturity sub intervals so that effects of interest rate changed over a multi year period can be calculated 2) Standardized gap analysis: - accounts for the differing degrees of rate sensitivity among rate-sensitive assets and liabilities

How financial institutions overcome adverse selection and moral hazard:

1)Screening and monitoring: - asymmetric information is present in loan markets because lenders have less info about the investment opportunities and activities of borrowers than borrowers do so banks engage in screening and monitoring to find more info

Banks have 4 options to eliminate shortfall in reserves (option 2)

2) The bank can sell some of its securities to help cover the deposit outflow - for example it might sell $9 million of its securities and deposit the proceeds with the Fed which will decrease securities by the amount sold on the asset side - bank incurs brokerage cost and other transaction costs

Banks have 4 options to eliminate shortfall in reserves (option 3)

3) It can acquire reserves by borrowing from the Fed - Would leave security and loan holdings the same, but would borrow $9million in discount loans from the Fed - cost associated with discount loans is the interest rate they must pay to the Fed known as discount rate

Loan Sales

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 so that it is no longer an asset on the balance sheet - banks earn profits by selling loans for amounts higher than the amounts of original loans -have high interest rates

T-Account

A simplified balance sheet that lists only the changes that occur in balance sheet items starting from initial balance sheet positio

Adverse Selection

Adverse selection in loan markets occurs because bad credit risks are the ones who usually line up for loans - in other words those who are most likely to produce an adverse outcome are also the most likely to be selected - Borrowers with very risky investment projects have much to agin if their projects are successful, so they are most eager to obtain loans - However, these are the least desirable borrowers becaue of the great possibility that they will be unable to pay back their loans

Checkable deposits (liability)

Are bank accounts that allow the owner of the account to write checks to 3rd parties - Include all accounts on which checks can be drawn - Are payable on demand (if a depositor shows up at the bank and requests payment by making a withdrawal, the bank must pay them immediately) - It is an asset for the depositor because it is part of his wealth - Is a liability for the bank - Usually the lowest cost source of bank funds because depositors are willing to forgo some interest in exchange for access to a liquid asset - The cost of maintaining checkable deposits include interest payments and the costs incurred in servicing these accounts (processing, preparing, and sending out monthly statements, etc) - Interest paid on deposits has accounted for around 10% of total ban operating expenses while the costs involved in servicing accounts have been approximately 85% of operating expenses

Excess reserves

Are insurance against the cost associated with deposited outflows. The higher the costs associated with deposit outflows, the more excess reserves a bank will want to hold

Securities (asset)

Classified into 3 categories: 1) US gov't and agency securities - the most liquid because they can be easily traded and converted into cash with low transaction costs 2) State and local govt securities - they hold these because state and local gov'ts are more likely to do business with banks that hold their securities. - these are less marketable and riskier because of default risk 3) Other securities

Duration Analysis

Examines the sensitivity of the market value of banks total assets and liabilities to changes in interest rates - duration measures the average lifetime of a security stream of payments and it is useful because it provides a good approx. of the sensitivity of a security market value to a change in interest rate - % change in mkt value of security = %-point change in interest rate * duration in years uses average

How Bank Capital Helps Prevent Bank Failure:

Example: 2 banks (1 with capital to assets ratio of 10% and the other with 4%) - If $5 million of their housing loans have become worthless because of the housing bubble, these loans will be written off and have a value of 0 - This causes total value of assets to decline by 5 million which also causes bank capital to decrease by that amount because bank capital = assets - liabilities - since the capital of the bank with less bank capital will fall below 0, the bank becomes insolvent and the govt will close the bank, its assets are sold off, and its managers are fired.

Managing interest rate risk

If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits, and a decline in interest rates will raise bank profits

Trade off between safety and returns to equity holders

In more uncertain times, when the possibility of large losses on loans increases, bank managers might want to hold more capital in order to protect the equity holders

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 the bank balance sheets

Liability Manament:

It allowed for banks no longer depend on checkable deposits as the primary source of bank funds and as a result no longer treated their sources of funds (liabilities) as given. Instead they set target goals for their asset growth and tried to acquire funds as they were needed - example) when a money center bank finds an attractive loan opportunity it can acquire funds by selling a negotiable CD - Example) If it has a reserve shortfall, it can borrow funds from another bank in federal funds market without incurring high transaction costs

Banks have 4 options to eliminate shortfall in reserves (option 4)

It can acquire the the $9 million of reserves to meet the deposit outflow by reducing its loans by this amount and depositing the $9 million it then receives with the fed, thereby increasing its reserved by $9million - the banks costliest way of acquiring reserves when a deposit outflow exists

Cash items in process collection (asset)

It is a claim on another bank for funds that will paid within a few days

Liability Management Development

Money Center Banks (large banks) began to explore new ways in which the liabilities on their balance sheets could provide them with reserves and liquidity. This led to an expansion of loan markets, such as the federal funds market, and the development of new financial instruments such as negotiable CDs, which enabled banks to acquire funds quickly

How financial institutions overcome adverse selection and moral hazard:

Monitoring and Enforcement of Restrictive Covenants - Banks write provisions into a loan contract that restrict borrowers from engaging in risky activities

Moral Hazard

Moral hazard exists in loan markets because borrowers ma have incentives to engage in activities that are undesirable from the lenders point of view - It is more likely that the lender will be subjected to hazard of default - Once borrowers have obtained a loan, they are more likely to invest in high risk investments that pay high returns to the borrower if successful - There is high risk associated with these investments make it less likely that these borrowers will be able to pay back their loans

Non transaction Deposits (liability)

Primary source of banks funds (58%) - Owners cannot write checks on nontranscation deposits, but the interest rates paid on these deposits are usually higher than those on checkable deposits - Two basic types: 1) Savings accounts 2) Time Deposits (known as certificates of deposit, or CDS)

Measure of bank profitability:

Return on Assets (ROA) - ROA = net profit after taxes / assets - the return on assets provides information on how efficiently a bank is being run because it indicates how much profit is generated, on avg, by each dollar asset

Secondary reserves

Short term US government securities are called this because they are highly liquid

When a checking account is opened at another bank

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

Deposit Outflows

When deposits are lost because depositors make withdrawals and demand payment