Fin. Markets-ch.4

loans

-LARGEST category of bank assets -illiquid compared to marketable securities, higher default risk, and higher info cost (this is why interest rates are HIGHER on loans) -3 categories: A. loans to businesses (commercial and industrial loans-for equipment or inventories) B. consumer loans (made to households to buy cars, furniture, other goods) C. real estate loans (includes mortgage loans and any other loans backed with real estate as collateral)

interest risk

-LARGEST risk -effect in the change of market interest rates on a banks profit or capital -RISE in market interest rate will LOWER present value of banks assets and liabilities (INVERSELY related) -effect of change in interest rates depends partly on whether they are VARIABLE RATE (interest rate changes at least once per year) or FIXED RATE (interest rate changes less often than once per year) -FALLING int rates= good-INCREASE profit/capital -RISING int rates= bad- DECREASE profit/capital

reserves

-a bank asset consisting of vault cash (cash on hand in a bank- includes currency in ATMs and deposits with other banks) plus bank deposits with the Fed -Fed mandates that a bank holds a certain percentage of demands deposits and NOW accounts (but not MMDAs)= REQUIRED RESERVES -any reserves a bank holds above those necessary to meet reserve requirements= EXCESS RESERVES- important source of liquidity

Troubled Asset Relief Program (TARP)

-a gov't program under which the US treasury purchased stock in hundreds of banks to increase the banks capital. -provided the Treasury and the Fed with $700 billion in funding to help restore the market for mortgage backed securities and toxic assets

federal deposit insurance

-a government guarantee of deposit accounts up to $250,000 -households with limited funds will hold funds in checkable deposits and SMALL denomination time deposits because they are covered by this. -this gives banks an edge over other fin. intermediaries with small savers because others, such as mutual funds, lack this guarantee

standby letters of credit

-a promise by a bank to lend funds, if necessary, to a seller of commercial paper at the time that the commercial paper matures. -needed to sell commercial paper

checkable deposits

-accounts against which depositors can write checks -also called "transaction deposits" -MOST IMP types= demand deposits (banks do not pay interest) and NOW accounts (negotiable order of withdrawal- accounts that pay interest-not allowed by US banking regulations) -hold large balances in demand deposits because they are a LIQUID asset that can be accessed with low transaction costs. -must pay all on demand- liabilities to banks because they must pay them on demand. -assets to households and firms because even though bank has them in possession, you still own them.

loan agreement

-agreement by a bank to provide a borrower with a stated amount of funds during some specified period of time -borrower then decides if they want to take the loan -banks commitment to lend ceases if borrower's financial condition deteriorates below a specified level.

bank capital

-also called "shareholders equity" -also reffered to as the firms NET WORTH -difference between the value of the firms assets and the value of their liabilities -BC=A-L -represents what owners would be left with if the firm closed, sold its assets and paid off liabilities -includes $ made from shareholders purchases of stock + accumulated retained earnings. -2010: US banking system as a whole, capital was 12% of assets -as value of assets/liabilities change, so does capital

Gap analysis

-analysis of the difference or GAP between the dollar value of a banks variable-rate assets and the dollar value of its variable-rate liabilities -measures vulnerability of a bank to interest-rate risk -often have NEGATIVE gaps because liabilities are more likely to have variable rates than their assets.

Duration analysis

-another way to measure a bank's vulnerability to interest-rate risk -analysis of how sensitive a bank's capital is to changes in market interest rates -difference between the average duration of the bank's assets and the average duration of the bank's liabilities -typically have POSITIVE duration gap= duration of assets is greater than duration liabilities -the longer the duration of an asset or liability , the more the value will change as a result of a change in market interest rates -so an inc in market interest rates will cause a larger decrease in assets than liabilities, causing a DECREASE in capital

Borrowings

-banks have more opportunities to make loans than they can finance through deposits, so they raise funds by borrowing -can earn a profit from borrowing if the interest rate they pay to borrow funds is less than the interest rate it earns by lending the funds. -includes short-term loans in the federal funds market (banks make over night loans to other banks-int rate= federal funds rate), loans from a banks foreign branches or other subsidiaries or affiliates, repurchase agreements(repos= banks sell securities and agree to repurchase the next day-usually to firms or other banks; collateral=security), and discount loans from the Fed

non transaction deposits

-banks offer this to savers who are willing to sacrifice immediate access to their funds in exchange for higher interest payments -MOST IMP= savings accounts(must give 30 day notice to access funds- banks usually let you have immediate access), money market deposit accounts (MMDAs- pay interest, but you can only write 3 checks per month against them), and "time deposits" or certificates of deposit (CDs- have specified maturities that typically range from months to years-banks penalize you if you withdrawal prior to maturity- forfeit part of interest; less liquid, but pay higher int. rates) -MORE RISKY

other assets

-banks physical assets: computer equipment/building -collateral received from borrowers who have defaulted on loans -following financial crisis, bank owned a significant number of houses and residential lots as borrowers defaulted

virtual banks

-carry out all banking activities online -can open accounts, pay bills, have paychecks directly deposited (all without paper) -electronic clearing of checks

cash items in the process of collection

-cash asset- claim banks have on other banks for uncollected funds -ex: your aunt writes you a check from a bank in a different state and you deposit it at your bank, eventually your bank will collect the funds from her bank and they are converted to reserves on your banks BS

Federal Reserve Act of 1913

-congress finally decided we needed a central bank and the Fed began operating in 1914 -later the federal deposit insurance was brought about as well to prevent bank runs/panics during the Great Depression (depositors now have little incentive to withdrawal money)

off-balance sheet activities

-do not affect a banks BS, do not increase assets or liabilities -ex: selling foreign exchange for customers- charge a fee for service, but the foreign exchange doesn't appear on the BS There are 4 of them: -standby letters of credit -loan commitment -loan sale -trading activities

trading activities

-earn fees from trading in multi-billion dollar markets for futures, options, and interest rate swaps -primarily related to hedging the banks loan and securities portfolios or to hedging services provided to customers.

national bank

-federally chartered bank

loan sale

-financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party -also called secondary loan participation -sold WITHOUT RECOURSE- bank provides no guarantee of the value of the sold loan and no insurance

prime rate

-formerly, the interest rate banks charged on six month loans to high-quality borrowers (lowest expected default risk) -currently, the interest rate banks charge primarily to smaller borrowers, now they charge more to large and medium sized businesses, reflecting changing market interest rates

bank runs

-large numbers of depositors would decide that a bank may be in danger of failure and would demand their deposits back. -if only a few banks were hit, they would likely be able to satisfy the demand by borrowing from other banks, but if many banks experienced runs at once it would result in a BANK PANIC- banks unable to return depositors money- these typically resulted in recessions

marketable securities

-liquid assets banks trade in fin. markets. -can hold securities issued by US Treasury/gov't agencies, corporate bonds that received investment-grade ratings when first issued, and limited amounts of municipal bonds (issued by state and local governments). -US treasury securities are very liquid- holdings are sometimes called SECONDARY RESERVES -US: commercial banks CANNOT invest checkable deposits in corporate bonds or common stock. -banks have increased holdings of mortgage backed securities- this is why in the financial crisis of 2007-2009 many banks suffered and some failed.

bank deposits

-offer certain advantages over other ways of holding funds -ex: rather than holding cash, they offer more safety against theft and may also pay interest. -more liquid than treasury bills -convenient way to make payments- writing checks -two main types= checkable and non transaction deposits

liquidity risk

-possibility that a bank many not be able to meet its cash needs by selling assets or raising funds at a reasonable cost -ex: large deposit withdrawals might force a bank to sell relatively liquid loans, possibly suffering losses on the sale -can minimize liquidity risk by holding fewer loans and securities and more reserves (reduces profitability-earn no interest on vault cash- so instead they use asset and liquidity management to reduce risk)

credit risk analysis

-process than bank loan officers use to screen loan applicants -must give info about employment, income, and net worth -use credit scoring systems to predict risk -also monitor a person during the term of the loan

unit banking states

-prohibited banks from having more than one branch -other countries have had relatively few banks with many branches -we wanted to keep bank power limited so we limited them geographically and kept them small (1 branch) -this failed to take advantage of economies of scale -credit risk- keeping banks in one geographical area -1994: congress removed restrictions on interstate banking

national banking acts of 1863/1864

-prohibited banks from using deposits to buy ownership of non financial firms. -does not exist in some other countries (Germany and Japan)

credit risk

-risk that borrowers may default on their loan -can arise from asymmetric info. -DIVERSIFICATION= banks spreading out loans to multiple borrowers and in multiple regions to reduce credit risk. -ex: if a bank granted most of their loans in New Orleans, they would have suffered serious losses after Hurricane Katrina

small vs. large denomination time deposits

-small= CDs of less than $100,000 -large= CDs of more than $100,000 (these are more negotiable, meaning investors can buy and sell them in secondary markets prior to maturity)

assets

-something of value an individual or firm owns (claim) -MOST LIQUID= reserves (includes vault cash, required and excess reserves) -on BS includes: reserves, securities, loans, trading assets

liabilities

-something owed -most important= funds bank acquires from savers- use them to make investments/loans to borrowers -on balance sheet include: DEPOSITS (checkable and non transaction) and BORROWINGS ($ banks borrow from others)

dual banking system

-system in the US in which banks are chartered by either a state or federal government.

credit rationing

-the restriction of credit by lenders such that borrowers cannot obtain funds they desire at the given interest rate. -bank may either grant loan application, but limit the loan size, or decline to lend ANY money to them at the given interest rate- reducing loan size reduced moral hazard and inc. chance the borrower will repay the loan. -Ex: credit cards putting a limit on spending- if you have a limit you are more likely to pay it off than if you had no limit and were tempted to spend more money than you could repay

Capital Purchase Program (CPP)

-treasury purchased stock in hundreds of banks, increasing their capital -participating banks had to pay the treasury a yearly dividend of 5% of the value of the stock and allow them to purchase additional shares equal to 15% of their original investment -partial gov't ownership of banks, but they did not get involved in management decisions

mortgage loan types

1. residential mortgages= loans made to purchase homes 2. commercial mortgages= loans made to purchase stores, offices, factories, and other commercial buildings

balance sheet

a statement that shows an individual or firms financial position on a particular day. -bank's sources and uses of funds -Assets=Liabilities+Shareholders Equity