econ 2035 chapter 10

involves interbank loans borrowed at the federal funds rate

The federal funds market

duration analysis

an analysis of how sensitive a bank's capital is to changes in market interest rates

gap analysis

an analysis of the gap between the dollar value of a bank's variable-rate assets and the dollar value of its variable-rate liabilities

explicit provisions in the loan agreement that prohibit the borrower from engaging in certain activities

restrictive covenants

roe=

roa x (bank assets/ bank capital)

non-transaction deposits

savings accounts money market deposit accounts certificates of deposit

Types of Nontransaction Deposits

savings accounts money market deposit accounts time deposits or cds

Bank holdings of U.S. Treasury securities are also called

secondary securities

cant own stocks only bonds

securities

the high-quality borrowers paid

the prime rate

three categories of loans

(1) loans to businesses: commercial and industrial loans (2) consumer loans: made to households primarily to buy automobiles and other goods (3) real estate loans: residential and commercial mortgages

liability management

-Borrowing funds in the federal funds market •Engaging in repurchase agreements •Obtaining discount loans from the Fed

bank borrowings include

-Short-term loans in the federal funds market • Loans from a bank's foreign branches or other subsidiaries or affiliates • Repurchase agreements • Discount loans from the Federal Reserve System

managing bank risk

1) liquidity risk 2) credit risk 3) interest- rate risk

the ratio of the value of a bank's after tax profit to the value of its capital

ROE

banks may reduce liquidity risk through

Asset management liability management

the effect of a change in market interest rates on a bank's profit or capital

Interest-rate risk

A high ratio of assets to capital (high leverage) is a two-edged sword:

Leverage can magnify relatively small ROAs into large ROEs, but it can do the same for losses

The ability of banks to assess credit risks on the basis of private information on borrowers

Long-Term Business Relationships

checking accounts that pay interest

NOW negotiable order of withdrawal

the ratio of the value of a bank's after-tax profit to the value of its assets

ROA

roa formula

after tax profit/ bank assets

ROE formula

after tax profit/ bank capital

something of value that an individual or a firm owns

asset

Duration gap =

average duration of assets − average duration of liabilities

a statement that shows and individual's or a firm's assets and liabilities to indicate its financial position on a particular day

balance sheet

the difference between the value of a bank's assets and the value of its liabilities

bank capital also called shareholders' equity

The ratio of assets to capital is one measure of

bank leverage

the ratio of the value of a bank's assets to the value of its capital

bank leverage

placed limits on the value of the assets commercial banks can acquire relative to their capital.

capital requirements

reserves

cash items vault cash and deposits with the fed

accounts against which depositors can write checks

checkable deposits

deposits

checkable deposits now

In the United States, commercial banks cannot invest

checkable deposits in corporate bonds or common stock

cash items in the process of collection

claims banks have on other banks for uncollected funds

a required minimum amount that the business taking out the loan must maintain in a checking account with the lending bank

compensating balance

largest category of bank assets

loans

the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate.

credit rationing

risk that borrowers might default on their loans

credit risk

the process that bank loan officers use to screen loan applicants

credit risk analysis

predict whether a borrower is likely to default

credit scoring system

checkable deposits on which banks do not pay interest

demand deposits

a bank's primary sources of funds are

deposits

liabilities and bank capital

deposits borrowings capital

borrowings

discount loans short term loans in the federal funds market repurchase agreements (repos)

reserves banks hold above those necessary to meet reserve requirements

excess reserves

government guarantee of deposit account balances up to 250,000

federal deposit insurance

used to calculate the vulnerability of a bank's profits to changes in market interest rates

gap analysis

Moral hazard can contribute to

high bank leverage

Loan and credit limits reduce moral hazard by

increasing the chance a borrower will repay

loans

loans to businesses; consumer loans; and real estate loans

agree to exchange the payments from a fixed-rate loan for the payments on an adjustable-rate loan

interest rate swaps

a measure of how much debt an investor assumes in making an investment

leverage

The inverse of bank leverage is the

leverage ratio.

something that an individual or a firm owes

liability

possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost.

liquidity risk

_____ are illiquid relative to marketable securities and have greater default risk and higher information costs

loans

a banks primary uses of funds

loans

A rise in the market interest rate will

lower the present value of a bank's assets and liabilities

Banks with negative gaps can

make more adjustable-rate or floating rate loans.

liquid assets that banks trade in financial markets

marketable securities

Most banks have ______ gaps because their ____ are more likely to have variable rates than are their assets (loans and securities).

negative, liabilities (deposits)

the difference between the interest a bank receives on its securities and loans and the interest it pays on deposits and debt, divided by the total value of its earning assets.

net interest margin

A bank's profits are commonly expressed in terms

of its return on assets

other assets

physical capital and collateral

most banks charge rates that reflect changing market interest rates instead of the

prime rate

was formerly the interest rate banks charged on six-month loans to high-quality borrowers (now an interest rate banks charge primarily to smaller borrowers).

prime rate

By diversifying, banks can

reduce the credit risk associated with lending too much to a single borrower

Federal deposit insurance has increased moral hazard by

reducing the incentive depositors have to monitor the behavior of bank managers

banks sell securities, such as Treasury bills, and agree to repurchase them, typically the next day

repos

Reserves formula

required + excess

reserves the Fed requires banks to hold against demand deposit and NOW account balances.

required reserves

bank assets consisting of vault cash plus bank deposits with the Federal Reserve

reserves

bank assets list

reserves securities loans other assets

As the value of a bank's assets or liabilities changes,

so does the value of the bank's capital

accounting tool used to show changes in balance sheet items

t account

the key banking activities are

taking in deposits from savers and making loans to households and firms

Banks are allowed to hold securities issued by

the U.S. Treasury and other government agencies and corporate bonds

If a bank has a positive duration gap, then

the duration of the bank's assets is greater than the duration of the bank's liabilities.

A bank's capital represents

the funds contributed by the bank's shareholders through their purchases of stock the bank has issued plus accumulated retained profits.

If a bank cannot distinguish low- from high-risk borrowers,

then it will run the risk of losing the low-risk borrowers when it raises the interest rate, leaving only the high-risk borrowers—a case of adverse selection.

If managers are compensated for a high ROE,

they may take on more risk than shareholders would prefer.

is cash on hand in a bank

vault cash (including currency in ATMs or deposits with other banks)

Banks can reduce credit risk by different methods (6)

§ Diversification § Credit-risk analysis § Collateral and compensating balance § Credit rationing § Monitoring and restrictive covenants § Long-term business relationships

asset management

§ Lending funds in the federal funds market § Engaging in reverse repurchase agreements

Bank assets are acquired by banks with the funds they:

• receive from depositors • borrow from other institutions • acquire initially from shareholders • retain as profits from operations