Money and Banking Chapter 10

Bank Capital

Raised by selling equity or from retained earnings Bank capital is a cushion against a drop in value of assets.

Off-Balance-Sheet Activities

Involve trading financial instruments and generating income from fees and loan sales. Loan Sale: Involves 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 of the bank's.

Managing Credit Risk

Screening: Prevents asymmetric information by having the lender collect information about the prospective borrower. Specialization in Lending: Certain banks will specialize in certain kinds of loans, which although it doesn't lead to a diverse lending portfolio, it makes the risks they take to be sure things. Enforcement of Restrictive Covenants: Writing provisions to prevent the borrower from taking larger risks and lead to the loan not being aid off. Monitoring their activities helps to prevent these issues before they arise. Long Term Customer Relationships: A customer that has had a savings account with the bank for extended periods of time can be screened easier and may have an easier time taking out a loan. Customers benefit by getting better rates, and banks benefit by getting sure bets. Loan Commitments: 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. This creates a long term relationship for the firm and bank Collateral and Compensating Balances: Collateral is property promised by the borrower to the lender as compensation if the borrower defaults. One form of this is compensating balances, a firm receiving the loan must keep a minimum amount of funds in its checking account. This allows the bank to monitor the firm because they will have a checking account with the bank. Credit Rationing: Refusing to make loans even though borrowers are willing to pay the stated interest rate or higher. The bank either prevents all loans or only doles out specific sizes of loans. This is adverse selection, sure the bank could make more on a higher interest rate, but that increases the risk of the borrower defaulting which mean the bank gets nothing.

Basic Banking

Banks make profits by selling liabilities with one set of characteristics and using the proceeds to buy asets with a different set of characteristics (Liquidity, size, risk and return).

Loans

Banks make their profits and assets mostly from issuing loans. Some 56% of bank assets are in the form of loans. A loan is a liability for the individual or corporation receiving it, but an asset for the bank. Loans are less liquid because they cannot be turned into cash until the loan matures.

Capital Adequacy Management

Banks must decide how much capital to hold for three reasons; 1. To prevent bank failure -A bank maintains bank capital to lessen the chance that it will become insolvent 2.The amount of capital affects returns for the equity holder of the banks -Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank 3. A minimum amount of bank capital is required by regulatory authorities

Return on Assets and Equity

ROA is equal to the net profit after taxes per dollar of assets. NPaT/Assets = ROA ROE is equal to the net profit of after taxes dollars per dollar of equity. NPaT/Equity = ROE Equity Multiplier is equal to the amount of assets per dollar of equity capital. EM = Assets/Equity Capital ROE=ROA x EM

Asset Managment

1. Banks 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 risks 3. A 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.

Bank Balance Sheet

A list of the banks assets and liabilities Total Assets=Total Liabilities + capital Also list sources of bank funds (Liabilities) and uses to which the funds (Assets) are put. They use these funds to acquire securities.

General Principles of Bank Management

Bank Manager has four primary concerns; Asset Management: Manager must pursue low level of risk by acquiring low risk assets and diversifying assets. Liability Management: Manager must acquire funds at a low cost Capital Adequacy Management: Manager must decide the amount of capital the bank must maintain and then acquire the needed capital. Liquidity Management: When deposits are lost because depositors make withdrawals and demand payments. To keep enough cash on hand, the acquisition of sufficiently liquid assets to meet the banks obligations to depositors Managers must also consider risk of assets; Credit Risk: Risk arising if borrower defaults Interest-Rate Risk: The riskiness of earnings and returns on banks assets that results from interest-rate changes

Checkable Deposits

Bank accounts that allow the owner of the account to write checks to third parties, payable on demand Non Interest Bearing Accounts, Interest Bearing Negotiable Order of Withdrawal Accounts, and Money Market Deposit Accounts. Money Market Deposit Accounts: Not subject to reserve requirements and not included in M1. Payable on demand.

Borrowings

Banks also obtain funds from borrowing from the federal reserve or other banks and organizations. Borrowing from feds is called a discount loan, which happens over night. Other sources include borrowing from Eurodollar funds, Bank Holding Companies, repurchase agreemants with corporations.

Deposit Outflow Mitigation

Banks can mitigate deposit outflow hurt by; 1. Borrowing from other banks 2. Selling securities 3. Borrowing from the Fed 4. Calling in or selling off loans Excess reserves are insurance against the costs associated with outflows. The higher the costs associated with deposit outflows, the more excess reserves banks will want you to hold

Reserves

Deposits plus currency that is physically held by banks (Vault Cash held in bank vaults overnight). Although they have low interest rates, banks carry them for two reasons; Reserve Requirements: The regulation for what the bank has to hold in reserve, usually 10% of checkable deposits, this ratio is called the required reserve ratio Excess Reserves: Reserves used to service cash withdrawals at the bank.

Gap and Duration Analysis

Gap analysis is the amount of rate sensitive liabilities subtracted from the amount of rate sensitive assets. - RSL-RSA=Gap Analysis Duration analysis examines the sensitivity of the market value of the bank's total assets and liabilities to changes in interest rates - % change in Security value= % change in interest rate/Duration in years

Liquidity Management and the Role of Reserves

If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of the balance sheet. They can recover funds by borrowing rom the federal reserve at the discount rate, however this is the costliest way to acquire reserves.

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.

Securities

Important income earning asset. Securities account for 19% of bank assets. Usually hold US government and agency securities, state and local government securities, and other securities. US Gov and Agency securities are so liquid that they are considered secondary reserves for bank.

Nontransaction Deposits

Primary source of banks funds. Owners cannot write checks on nontransaction deposits, but the interest rates paid on these deposits are usually higher than those on checkable deposits. Two types; Savings Accounts: Transactions and interest payments are recorded in a monthly statement or in a passbook held by the owner Time Deposits: Fixed maturity length, ranging from several months to over five years, an assess substantial penalties for early withdrawal. Less liquid, earn high interest rates, and are a more costly source of funds for banks. Large Denomination Time Deposits (CDs): Denominations more than $100,000 are typically bought by corporations or other banks. Negotiable CDs are held by financial institutions as alternative assets to treasury bills and other short term bonds.

T-Account

Simplified balance sheet with lines in the form of a T that lists only the changes that occur in balance sheet items starting from some initial balance sheet position. Note that an increase in the banks reserves equal to the increase in checkable deposits 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. Therefore, when a bank receives additional deposits, it gains an equal amount of reserves. When it loses deposits it loses an equal amount of reserves

Strategies for Managing Bank Capital

To lower the amount of capital relative to assets and raise the equity multiplier you can; 1.Reduce the amount of bank capital by buying back some of the banks stocks 2. You can reduce the bank's retained earnings by paying out higher dividends to the banks stockholders 3. You can keep bank capital constant but increase the bank's assets by acquiring new funds and then seeking out loan business or purchasing more securities with these new funds. To increase the amount of capital relative to assets you can; 1. Raise capital for the bank by having it issue equity 2. Raise capital by reducing the banks dividends to shareholders. 3. Keep capital at the same level but reduce the bank's assets by making fewer loans or selling securities. Shrink bank size A shortfall of bank capital is likely to lead to a bank reducing its assets and therefore a contraction in lending.