Money and Banking Final

How to make a profit when a bank experiences a change in its deposits:

#1. Hold reserves, Invest in securities. #2 Hold reserves, Make loans. #3. Hold no reserves, Make loans: holding short-term liabilities, such as checkable deposits, and uses the proceeds to fund longer-term assets, such as loans. #4 Excess reserves are insurance against the costs associated with deposit outflows. The higher cost associated with deposits

X-Bank reported an ROE of 15% and an ROA of 1%. How well capitalized is this bank?

ROE = ROA × EM 0.15 = 0.01 ×EM EM = 15 = assets/equity So equity/assets = 6.66%. This is a well-capitalized bank, at least under the old rules. Under Dodd-Frank, all banks are required to have bank capital of 7% held as common equity. And, new rules are being developed that will require larger banks to hold an extra capital cushion of 1 to 2.5%

Reserves (A)

All banks hold some of the funds they acquire as deposits in an account at the FED. Reserves are these deposits plus currency that is physically held by banks. Although reserves earn low interest rates, banks hold them for two reasons: required reserves are held to satisfy reserve requirements, the regulation that for every dollar of checkable deposits at a bank, a certain fraction must be kept as reserves.

Duration Analysis

An alternate method for measuring interest-rate risk examines the sensitivity of the market value of the bank's total assets and liabilities to changes in interest-rates. Duration analysis is based on what is known as Macaulay's concept of duration, which measures the average lifetime of a security's stream of paynebts. Durarion is a useful concept because it provides a good approximation of the sensitivity of a security's market value to a change in its interest rate: Percent change in market value of security ~ (-)Percentage-point change in interest rate x duration in years. Duration analysis involved using the average (weighted) duration of financial institutions assets and liabilities to see how its net worth responds to a change in interest rates.

Gap Analysis: Standardized Gap Analysis

Another refinement of basic gap analysis accounts for the differing degrees of rate sensitivity for different rate-sensitive assets and liabilities.

Why has the development of overnight loan markets made it more likely that banks will hold fewer excess reserves?

Because when a deposit outflow occurs, a bank is able to borrow reserves in these overnight loan markets quickly; thus, it does not need to acquire reserves at a high cost by calling in or selling off loans. The presence of overnight loan markets thus reduces the costs associated with deposit outflows, so banks will hold fewer excess reserves.

Checkable Deposits (L)

Checkable deposits are bank accounts that allow the owner of the account to write checks to third parties. Includes: non-interest-bearing checking accounts, interest-bearing NOW (negotiable order of withdrawal) accounts, and money market deposit accounts (MMDAs). With the appearance of new financial instruments, the share of checkable deposits in bank liabilities has shrunk over time. Checkable deposits and money market deposit accounts are payable on demand; that is, if the depositor shows up at the bank and requests payment by making a withdrawal, the bank must pay the depositor immediately.

Collateral

Collateral requirements for loans are important credit risk management tools. Collateral, which is property promised to the lenders as compensation if the borrower defaults, which lessens the consequences of adverse selection because it reduces the lender's losses in the case of a loan default. It also reduces moral hazard because the borrower has more to lose from a default.

"Bank managers should always seek the highest return possible on their assets." Is this statement true, false, or uncertain? Explain.

False. If an asset has a lot of risk, a bank manager might not want to hold it even if it has a higher return than other assets. Thus a bank manager has to consider risk as well as the expected return when deciding to hold an asset.

Financial Consolidation and the Government Safety Net

Financial consolidation has been proceeding at a rapid pace, leading to both larger and more complex financial organizations. Financial consolidation poses two challenges to financial regulation because of the existence of government safety nets: 1. Increased moral hazard incentives. The increased size of financial institutions as a result of financial consolidation increases the too-big-to-fail problem, because there will be more large institutions whose failure would expose the financial system to systemic (system-wide) risk. 2. Financial Consolidation of banks with other financial services firms means that the government safety net may be extended to new activities, such as securities underwriting, insurance, or real estate activities. Increased risk taking in these activities can weaken the fabric of the financial system.

Why is being nose a desirable trait for a banker?

In order for a banker to reduce adverse selection she must screen out good from bad credit risks by learning all she can about potential borrowers. Similarly in order to minimize moral hazard, she must continually monitor borrowers to ensure that they are complying with restrictive loan covenants. Hence it pays for the banker to be nosy.

Long-Term Customer Relationships

Long-term relationships with customers through checking accounts or savings accounts or other loans reduce the cost of information collection and make it easier to screen out bad credit. Long-term relationships benefit the customer as well as the bank. A firm with good credit that has a previous relationship will find it easier to obtain a loan with a low interest rate. Borrowers with a long-term relationship also gives the borrowers the incentive to avoid risky activities in the loan contract. Long-term relationships therefore enable banks to deal with even unanticipated moral hazard contingencies.

Deposits at Other Banks (A)

Many small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions, and help with securities purchases. This is an aspect of a system called correspondent banking.

Return on assets (ROA)

Measures how efficient a bank is being run. The net profit after taxed per dollar of assets: 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 average, by each dollar of assets.

Return on equity (ROE)

Measures how well the owners are doing on their investments. The net profit after taxes per dollar of equity (bank) capital. Tells how much the bank is earning on their equity investments. ROE = (net profit after taxes) / (equity capital).

Moral hazard

Moral hazard exists in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lender's point of view. Once borrowers have obtained a loan, they are more likely to invest in high risk investment projects.

Adverse Selection

Adverse selection and loan markets occurs because bad credit risks are the ones who usually lined up for loans; In other words, those who are most likely to produce an adverse outcome are the most likely to be selected. Borrowers with very risky investment projects have much to gain if their projects are successful, So they are the most eager to obtain loans. Clearly, However, they are the least desirable borrowers because of the greater possibility that they will be unable to pay back their loans.

Credit Rationing

Refusing to make loans even though borrowers are willing to pay the stated interest rate or even a higher rate. Credit rationing takes two forms. The first occurs 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. The second occurs when a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like.

If a bank is falling short of meeting its capital requirements by $1 million, what three things can it do to rectify the situation?

#1. Issue equity (common stock) #2. Reduce bank dividends to shareholders, thereby increasing retained earnings. #3. Keep capital at the same level but reduce the bank's assets by making fewer loans or by selling off securities and then using the proceeds to reduce its liabilities. You might choose the third alternative and decide to shrink size of the bank if capital markets are tight or shareholders protest to their dividends being cut. A shortfall of bank capital is likely to lead to a bank reducing its assets and therefore a contraction on lending.

Strategies for Managing Bank Capital: Raise the Amount of Capital Relative to Assets

#1. Issue equity (common stock) #2. Reduce bank dividends to shareholders, thereby increasing retained earnings. #3. Keep capital at the same level but reduce the bank's assets by making fewer loans or by selling off securities and then using the proceeds to reduce its liabilities. You might choose the third alternative and decide to shrink size of the bank if capital markets are tight or shareholders protest to their dividends being cut. A shortfall of bank capital is likely to lead to a bank reducing its assets and therefore a contraction on lending. .

The bank has the following balance sheet, Assets Liabilities Reserves $75 million Deposits $500 million Loans $525 million Bank Capital $100 million If the bank suffers a deposit outflow of $50 million with a required reserve ration on deposits of 10%, what actions should you take?

1 To acquire reserves to meet a deposit outflow by borrowing from other banks in the federal funds market or by borrowing from corporations. Bank acquires $20 million by borrowing from bank or corporation: Assets Reserves $45 million Loans $525 million Liabilities Deposits $450 million Bank Borrowings $20 million Bank Capital $100 million 2 Reducing its loans by this amount and depositing $20 million it then receives with the Fed, thereby increasing its reserved by $20 million. . Assets Reserves $45 million Loans $505 million Liabilities Deposits $450 million Bank Capital $100 million 3 Acquire reserves by borrowing from the Fed. Assets Reserves $45 million Loans $525 million Liabilities Deposits $500 million Fed Borrowings $20 million Bank Capital $100 million 4 Sell securities to help cover the deposit outflow. 5 Choices #1 and #3 raise the expenses of a bank and #2 and #4 reduce the bank's revenues.

Strategies for Managing Interest-Rate Risk: Gap Analysis

1. If you firmly believe interest rates will fall in the future, you may be willing to take no actin because you know that the bank has more rate-sensitive liabilities than rate-sensitive assets and so will benefit from the expected interest-rate decline. 2. To eliminate interest-rate risk given the possibility that interest rates will rise, shorten the duration of the bank's assets to increase their rate sensitivity. 3. Alternatively, you could lengthen the duration of the liabilities. By this adjustment of the bank's assets and liabilities, the bank's income will be less affected by the interest-rate swings.

Problems With Too-Big-To-Fail Policy...

1. It increases the moral hazard incentives for big banks. Once large depositors know that a bank is too big to fail, they have no incentive to monitor the bank and pull out their deposits when it takes on too much risk: No matter what the bank does, large depositors will not suffer any losses. The result of the too-big-to-fail policy is that big banks might take on even greater risks, thereby making bank failures more likely. 2. Increases moral hazard incentives for non-bank financial institutions that are extended a government safety net. As a result of little incentive to monitor the institution, large or interconnected financial institutions will be more likely to engage in highly risky activities, making it more likely that a financial crisis will occur.

T-account

A T-account is a simplified balance sheet, with lines in the form of a T, that lists only the changes that occur in the balance sheet items starting from some initial balance sheet position. #1. An increase in the bank's reserves equal to the increase in checkable deposits. #2. When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves. #3. If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet.

Liabilities

A bank acquires funds by issuing (selling) liabilities which are the sources of funds the bank uses. The funds from issuing liabilities are used to purchase income-earning assets.

How Bank Capital Helps Prevent Bank Failure

A bank maintains bank capital to lessen the chance that it will become insolvent. When a bank becomes insolvent, government regulators close the bank, its assets are sold off, and its managers are fired. The larger the cushion of bank capital to absorb the losses, the more positive the net worth (bank capital).

Assets

A bank uses funds that is has acquired by issuing liabilities to purchase income-earning assets. Bank assets are thus naturally referred to as uses of funds, and the interest payments earned on them are what enables banks to make profits.

Securities (A)

A bank's holding of securities are an important income-bearing asset: Securities, made up entirely of debt instruments for commercial banks, because banks are not allowed to hold stock). Securities can be classified into three categories: The U.S. government and agency securities, state and local government securities, and other securities. The U.S government and agency securities are the most liquid because they can be easily traded and converted into cash with low transaction costs. Because of their high liquidity, short-term U.S. government and agency securities are called secondary reserves.

Equity multiplier (EM)

A direct relationship between the ROA and the ROE. EM is the amount of assets per dollar of equity capital. EM = (assets) / (equity capital). To see this relationship, ROE = ROA x EM; (net profit after taxes)/ (equity capital) = (net profit after taxes) / (assets) x (assets) / (equity capital). This formula tells us what happens to the return on equity when a bank hold a smaller amount of capital (equity) for a given amount of assets. Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

Deposit Insurance

A guarantee such as that provided by the Federal Deposit Insurance Corporation (FDIC) in the United States, in which currently depositors are paid in full on the first $250,000 they have deposited in a bank if the bank fails

Loan Commitments

A loan commitment is a bank's commitment (for a specified future period of time) to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate. The majority of commercial and industrial loans are made under the loan commitment arrangement. The advantage for the firm is that it has a source of credit when it needs it. The advantage for the bank is that the loan commitment promotes a long-term relationship, which in turn facilitates information collection. In addition, provisions in thje loan commitment agreement require that the firm continually supply the bank with information about the firm's income., asset and liability position, business activities, and so on. Loan commitment agreement is a powerful method for reducing the bank's cost for screening and information collecting.

Loan Sales

A loan sale, also called a secondary loan participation, involves a contract that sells a;; or part of the cash stream from a specific loan and thereby removes the loan so that it no longer is an asset on the bank's balance sheet. Banks earn profits by selling loans for an amount slightly greater than that of the original loan. Because the high interest rates on these loans make them attractive, institutions are willing to buy them, even though the higher price means that they earn a slightly lower interest rate than the original interest rate on the loan, usually on the order of 0.15 percentage point.

Screening and Monitoring

Asymmetric information is present and loan markets because lenders have less information about the investment opportunities and activities of borrowers then borrowers do. The business of thinking is the production of information. For effective screening, lenders must collect reliable information from prospective borrowers to manage credit risk. Whether for personal or business loans, bankers and other financial institutions need to be nosy.

Asymmetric Information and Financial Regulation

Asymmetric information-the fact that different parties in a financial contract do not have the same information-leads to adverse selection and moral hazard problems that have an important impact on our financial system. These concepts are especially useful in understanding why government has chosen the form of financial regulation we see in the United States and in other countries. There are ten basic categories of financial regulation: the government safety net, restrictions on asset holdings, capital requirements, disclosure requirements, consumer protection, restrictions on competition, and macro-prudential supervision.

Trade-off Between Safety and Returns to Equity Holders

Bank capital has benefits and costs. Bank capital benefits the owners of a bank in that it makes their investment safer by reducing the likelihood of bankruptcy. However, bank capital is costly because the higher it is, the lower will be the return on equity for a given return on assets.

Restrictions on Asset Holdings

Bank regulations that restrict asset holdings are directed at minimizing the moral hazard associated with a government safety net, which can also cost taxpayers dearly. Risky assets may provide the financial institution with higher earnings when they pay off; but if they do not pay off and the institutions fails, depositors and creditors are left holding the bag. Unfortunately, acquiring information on an institution's activities to learn how much risk it is taking can be a difficult task.Because banks are prone to panics, they are subjected to strict regulations to restrict their holdings of risky assets, such as common stocks,. Bank regulations also promote diversification, which reduces risk by reducing the dollar amount of loans in particular categories or to individual borrowers.

Generation of Fee Income

Banks also generate income from fees from providing specialized services to their customers, such as making foreign exchange trades on a customer's behalf, servicing a mortgage-backed security by collecting interest and principal payments and then paying them out, guaranteeing debt securities such as banker's acceptances (by which a bank promises to make interests and principal payments if the party issuing the security cannot), and providing backup lines of credit. Off-balance-sheet activities involving guarantees of securities and backup lines increase the default risk a bank faces.

Bank Capital Requirements

Banks also hold capital because they are required to do so by regulatory authorities. Because of the high costs of holding capital, bank managers often want to hold less bank capital relative to assets than is required by the regulatory authorities. In more uncertain times, when the possibility of large losses on loans increases, bank managers might want to hold more capital to protect the equity holders. Conversely, if they have confidence that loan losses won't occur, they might want to reduce the amount of bank capital, have a high equity multiplier, and thereby increase the return on equity.

Borrowings

Banks also obtain funds by borrowing from the Federal Reserve System, the Federal Home Loan banks, and other banks, and corporations. Banks also borrow reserves over night in the fed funds market from other U.S. banks and financial institutions. Banks borrow overnight to have enough deposits at the Federal Reserve to meet the amount required by the fed.

Managing Credit Risk

Banks and other financial institutions must make successful loans that are paid back in full if they are to earn high profits. The economic concepts of adverse selection and moral hazard provide a framework for understanding the principles that financial institutions have to follow to reduce credit risk and make successful loans.

Why has non-interest income been growing as a source of bank operating income?

Banks can increase profits by engaging in noninterest income, or off-balance-sheet activities

Excess Reserves

Banks hold additional reserves, excess reserves, because they are the most liquid of all bank assets and a bank can use them to meets its obligations when funds are withdrawn. Excess reserves are 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.

Loans (A)

Banks make their profits primarily by issuing loans. A loan is a liability for the individual or corporation receiving it, but an asset for the bank, because it provides income to the bank . Loans are typically less liquid than other assets, because they cannot be turned into cash until the loan matures. Loans have a higher probability of default than other assets. Because of the lack of liquidity and higher default risk, the bank earns its highest returns on loans.

Why might a bank be willing to borrow funds from other banks at a higher rate than it can borrow from the Fed?

Banks may be willing to borrow funds from other banks at a higher rate than they can borrow from the Fed for two reasons: First, the borrowing bank may find it easier with less requirements to borrow from another bank, as long as they can make a profit via their lending. For instance, when a bank borrows from the FED it often has to put forward collateral. Borrowing in an inter-bank market may be accomplished on an unsecured basis thereby requiring a higher interest rate but without a need for a pledge of collateral. Secondly, overnight lending between banks is faster, and less expensive than overnight lending from the Fed.

"too many eggs in one basket"

Banks that had overspecialized in making loans to energy componies, real estate developers, or farmers suffered huge losses in the 1980s, with the slump in energy, property, and farm prices. Many of these banks went broke because they had "put too many eggs in one basket."

"Too Big to Fail"

Because the failure of a very large financial institution makes it more likely that a major financial disruption will occur, financial regulators are naturally reluctant to allow a big institution to fail and cause losses to its depositors and creditors. The term "Too big to fail" is now applied to a policy in which government provides guarantees of repayment of large uninsured creditors of the largest banks, so that no depositor or creditor suffers a loss, even when they are not automatically entitled to this guarantee. The FDIC would do this by using the purchase and assumption method.

Government Safety Net: Bank Failures and the Need for Deposit Insurance

Being unable to learn if bank managers were taking on too much risk or were outright crooks and the depositors' lack of information about the quality of bank assets can lead to depositors being reluctant to put money in banks, thus leading to bank panics, which can have serious harmful effects on the economy. A government safety net for depositors can short-circuit runs on banks and bank panics, and by providing protection for the depositor, it can overcome reluctance to put funds in the banking system. One form of the safety net is deposit insurance. In recent years, government deposit insurance has been growing in popularity and has spread to many countries throughout the world.

Discount Loans

Borrowings from the Fed (also known as advances)

A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why?

Compensating balances can act as collateral. They also help establish long-term customer relationships, which make it easier for the bank to collect information about prospective borrowers, thus reducing the adverse selection problem. Compensating balances help the bank monitor the activities of a borrowing firm so that it can prevent the firm from taking on too much risk, thereby not acting in the interest of the bank.

"Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans." Is this statement true, false, or uncertain? Explain your answer.

False. Although diversification is a desirable strategy for a bank, it may still make sense for a bank to specialize in certain types of lending. For example, a bank may have developed expertise in screening and monitoring borrowers for a particular kind of loan, thus improving its ability to handle problems of adverse selection and moral hazard.

Capital Requirements

Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions. When a financial institution is forced to hold a large amount of equity capita, the institution has more to lose if it fails and thus is more likely to pursue less risky activities. In additions, capital cushions make it less likely that the financial institutions will fail when bad shocks occur, thereby directly adding to the safety and soundness of financial institutions. Capital requirements for banks take two forms: leverage ratio and off-balance-sheet activities.

If a bank doubles the amount of its capital and ROA stays constant, what will happen to ROE?

If the bank doubles it's capital with a constant ROA than the ROE will become half of what it was before because the return on the assets stays constant; however, the actual amount of assets is doubled therefore leaving ROE to be cut in half.

Basic Banking

In general terms, banks make profits by selling liabilities with one set of characteristics (a particular combination of liquidity, risk, size, and return) ad using the proceeds to buy assets with a different set of characteristics. This process is referred to as asset transformation. For example, a savings deposit held by one person can provide the bank with the funds that enable the bank to make a mortgage loan to another person. The bank "borrows short and lends long."

If the president of a bank told you that the bank was so well run that it never had to call in loans, sell securities, or borrow as a result of a deposit outflow, would you be willing to buy stock in that bank? Why?

No, because the bank president is not managing the bank well. The fact that the bank has never incurred costs as a result of a deposit outflow means that the bank is holding a lot of reserves that do not earn any interest. Thus the bank's profits are low, and stock in the bank is not a good investment.

If a bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explaining that you don't have any excess reserves to lend out? Why or why not? What options are available for you to provide the funds your customer needs?

No. When you turn a customer down, you may lose that customer's business forever, which is extremely costly. Instead, you might go out and borrow from other banks, corporations, or the Bank of Canada to obtain funds so that you can make the customer loans. Alternatively, you might sell negotiable CDs or some of your securities to acquire the necessary funds.

Off-Balance-Sheet Activities

Off-Balance-Sheet activities involve trading financial instruments and generating income from fees and loan sales, activities that affect bank profits do not appear on bank balance sheets.

Payoff Method

One of two primary methods the FDIC uses to handle a failed bank. With the payoff method, the FDIC allows the bank to fail and payoff deposits up to the $250,000 insurance limit (with funds acquired from the insurance premiums paid by the banks who have bought FDIC insurance). After the bank has been liquidated, the FDIC lines up with other creditors of the bank and is paid its share of the proceeds from the liquidated assets.

Compensating Balances

One particular form of collateral required when a bank makes commercial loans is called compensating balances: a firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank. Besides serving as collateral, compensating balances help increase the likelihood that a loan will be paid off by helping the bank monitor and reduce moral hazard.

Specialization in Lending

One puzzling feature of bank lending is that a bank often specializes in lending to local firms or to firms in particular industries, such as energy. In one sense, this behavior seems surprising, because it means that the bank is not diversifying its portfolio of loans thus exposing itself to more risk. From another perspective, such specialization makes perfect sense. It is easier for the firms to collect information about local firms creditworthiness and the more they specialize, the more knowledge gained regarding the industry and are thus better able to predict which firms will be able to make timely payments on their debt.

Gap Analysis: Maturity Bucket Approach

One refinement of the basic gap analysis is to measure the gap for several, maturity subintervals, called maturity buckets, so that effects of interest-rate changes over a multiyear period can be calculated.

"Lender of Last Resort"

One way governments provide support is through lending from the central bank to troubled institutions, as the Federal Reserve did during the global financial crisis.

Regulatory Arbitrage

Over time, limitations of the Basel Accord have become apparent, because the regulatory measure of a bank risk, as stipulated by the risk weights, can differ substantially from the actual risk the bank faces. This has resulted in regulatory arbitrage, a practice in which banks keep on their books assets that have the same risk-based capital requirement but are relatively risky, such as a loan to a company with a very low credit rating while taking off their books low-risk assets, such as a loan to a company with a very high credit rating.

Adverse Selection and Government Safety Net

People who are most likely to produce the adverse outcome insured against (bank failure) are those who want to take advantage of the insurance. - risk loving entrepreneurs might find the financial industry a particular attractive one to enter-they know that they will be able to engage in highly risky activity.

Vault Cash

Physical currency that is held in bank vaults overnight.

Nontransaction Deposits (L)

Primary source of bank funds. Owners cannot write checks on non-transaction deposits, but the inters paid on these deposits are usually higher than those on checkable deposits. There are two basic types of nontransaction deposits: savings accounts, and time deposits (CDs). Time deposits have a fixed maturity length , ranging from several months to over five years, and assess substantial penalties for early withdrawal (the forfeiture of several months' interest.) Small denomination time deposits (deposits less than $100,000) are less liquid for the depositor , earn higher interest rates, and are a more costly source of funds for banks. Large denomination time deposits (CDs) are available in denominations of $100,000 or more are typically bought by corporations or other banks. CDs are negotiable; like bonds, they can be resold in secondary market before they mature. Important source of bank funds.

Cash Items in Process of Collection (A)

Suppose that a check was written on an account at another bank is deposited in your bank and the funds for this check have not yet been received (collected) from the other bank. The check is an asset for your bank because it is a claim on another bank for funds that will be paid within a few days.

Basel Accord

The Basel Committee on Banking Supervision implemented the Basel Accord, which deals with a second type of capital requirement, risk-based capital requirements. The Basel Accord, which required the banks hold as capital at least 8% of their risk-weighted assets, has been adopted by more than 100 countries, including the United States. Assets and off-balance-sheet activities were allocated into four categories, each with a different weight to reflect the degree of credit risk. The first category holds zero weight and includes items that have little default risk, such as reserves and government securities in OECD countries (Organization for Economic Cooperation and Development). The second category has 20% weight and includes claims on banks in OECD countries. The third category has a weight of 50% and includes municipal bonds and residential mortgages. The fourth category has the maximum weight of 100% and includes loans to consumers and corporations. Off-balance-sheet activities are treated in a similar manner by assigning a credit-equivalent percentage that converts them to on-balance-sheet items to which the appropriate risk weight applies, and there are minimum capital requirements for risks in banks' trading accounts. Because of Regulatory arbitrage, the Basel Accord could lead to an increase in risk taking, the opposite of its intent. To address these limitations, the Basel Committee on Bank Supervision came up with a new capital accord, often referred to as Basel 2, but in the aftermath of the global financial crisis, it developed a new accord dubbed "Basel 3"

Leverage Ratio

The amount of capital divided by the bank's total assets. To be classified as well capitalized, a bank's leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers an increase in regulatory restrictions on the bank.

Capital Adequacy Management

The amount of capital the bank decides to maintain and then acquire the needed capital. Banks have to make decisions about the amount of capital they hold for three reasons: #1. Bank capital has to help prevent bank failure. #2. The amount of capital affects returns for the owners (equity holders) of the bank. #3. A minimum amount of bank capital (bank capital requirements) is required by regulatory authorities.

Suppose that you are the manager of a bank whose $100 billion of assets have an average duration of four years and whose $90 billion of liabilities have an average duration of 2.5 years. Conduct a duration analysis for the bank and show what will happen to the net worth of the bank if interest rates rise by 2 percentage points. What actions could you take to reduce the bank's interest rate risk?

The assets fall by $8 billion ($100 × .02 × 4) and the value of the liabilities rise by $4.5 billion ($90 × .02 × 2.5) so the bank's net worth (capital) is expected to decrease by $3.5 billion. The interest rate risk can be reduced by shortening the maturity of the assets or by lengthening the maturity of the liabilities. Alternatively, you could engage in an interest-rate swap, in which you swap the interest earned on your assets with the interest on another bank's assets that have a duration of 2.5 years.

Asset Management

The bank manager must pursue an acceptably low level of risk by acquiring assets that have low rate of default and by diversifying asset holdings. To maximize its profits, a bank must simultaneously seek the highest returns possible on loans and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets. Banks try to accomplish these three goals in four different ways: #1. Banks try to find borrowers who will pay high interest rates and are unlikely to default on their loans. Loan officers engage in screening to reduce the adverse selection problem. #2. Banks try to purchase securities with high returns and low risk. #3. Banks must attempt to lower their risk by diversifying when managing their assets. They accomplish this by purchasing many different types of assets (Short- and long-term, U.S. Treasury, and municipal bonds) and approving many types of loans to a number 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 that it will hold liquid securities even if they earn somewhat lower return than other assets. In addition, it will want to hold U.S. government securities as secondary reserves so that even if a deposit outflow forces some costs on the bank, these will not be terribly high. If it avoids all costs associated with deposit outflows by holding only excess reserves, the bank suffers losses because reserves earn low interest, while the banks liabilities are costly to maintain. The bank must balance its desire for liquidity against the increased earnings that can be obtained from less liquid assets, such as loans.

Bank Capital (L)

The bank's net worth, which equals the difference between total assets and liabilities.Bank capital is raised by selling equity (stock) or from retaining earnings. A bank's capital is a cushion against a drop in the value of its assets, which could force the bank into insolvency (having liabilities in excess of assets, meaning the bank can be forced into liquidation).

Why do equity holder care more about ROE than about ROA?

The bank's owners (equity holders) care about most is how much the bank is earning on their equity investment. This information is provided by ROE, the net profit after taxes per dollar of equity capital. This formula lets us know, given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

What are the benefits and costs for a bank when it decides to increase the amount of its bank capital?

The benefit is that the bank now has a larger cushion of bank capital and so is less likely to go broke if there are losses on its loans or other assets. The cost is that for the same ROA, it will have a lower ROE, return on equity.

Application: How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis

The dramatic slowdown in the growth of credit in the wake of the financial crisis starting in 2007 triggered a "credit crunch" in which credit was hard to get. As a result, the performance of the economy in 2008 and 2009 was very poor. Shortfalls of bank capital lead to slower credit growth. A major boom and bust in the housing market lead to losses for banks from their holdings of securities backed by residential mortgages. In addition, banks had to take back onto their balance sheets many of the structured investment vehicles (SIVs) they had sponsored. The losses that reduced bank capital, along with the need for more capital to support the assets coming back onto their balance sheets, lead to capital shortfalls: Banks had to either raise new capital or restrict asset growth by cutting back on lending. Raising new capital was extremely difficult so banks also chose to tighten their lending standards and reduce lending.

Contagion Effect

The failure of one bank can hasten the failure of others.

Required reserve ratio

The fraction of every dollar that must be kept as reserves.

Purchase and Assumption Method

The other primary method the FDIC uses to reorganize the bank, typically by finding a willing merger partner who assumes (takes over) all of the failed bank's liabilities so that no depositor or other creditor loses a penny. The FDIC often sweetens the pot for the merger partner by providing it with subsidized loans or buying some of the failed bank's weaker loans. The FDIC guarantees ALL liabilities and deposits with this method, not just deposits under $250,000. This method is more costly for the FDIC than the payoff method.

Other Assets (A)

The physical capital (bank buildings, computers, and other equipment) owned by banks is included in this category.

Credit Risk

The risk arising because borrowers may default

Gap Analysis

The sensitivity of bank profits to changes in interest rates can be measured more directly using gap analysis, in which the amount of rate-sensitive liabilities is subtracted from the amount of rate-sensitive assets. By multiplying the gap times the change in interest rate, we can immediately obtain the effect on bank profits.

If a deposit outflow of $50 million occurs, which balance sheet would a bank rather have initially, the balance sheet in the previous question or the following balance sheet? Why? Assets Liabilities Reserves $100 million Deposits $500 million Loans $500 million Bank Capital $100 million

This bank still holds enough reserves to meet the required reserve level and therefore need not adjust its balance sheet any more. While this may appear to be good that it does not have to incur the additional expenses or loss of revenues that the bank in problem #3 did, it must be remembered that this bank also gave up earning interest on its assets prior to this withdrawal (notice, in order to hold a higher amount of reserves the bank in problem #4 held fewer interest bearing loans). Thus, while the surprise withdrawal outflow is painful for the bank of problem #3, it may have earned enough revenue from its increased prior lending that it ends up in a better position than that of bank #4

Suppose you are the manager of a bank that has $15 million of fixed rate assets, $30 million of rate sensitive assets, $25 million of fixed rate liabilities and $20 million of rate sensitive liabilities. Conduct a gap analysis for the bank and show what will happen to bank profits if interest rates rise by 5 percentage points. What action could you take to reduce the bank's interest rate risk?

This bank's gap is $10 million ($30 rate sensitive assets - $20 rate sensitive liabilities). An increase in interest rates by 5% will raise profits by $500,000 (5% of the gap). While banks enjoy the higher profits, a decrease in interest rates would have reversed the profits into losses of equal amounts. To avoid this profit variability, this bank could have tried to increase the amount of interest rate sensitive liabilities it holds, decrease the rate sensitive assets it holds, or engage in an interest rate swap with another company.

Liability Management

To acquire funds at a low cost. Before the 1960s, banks took their liabilities as fixed and spent their time trying to achieve an optimal mix of assets for two reasons: #1. more than 60% of bank funds were obtained through checkable (demand) deposits that by law could not pay any interest. Thus banks could not compete with one another for these deposits by paying interest on them. #2. The markets for making overnight loans between banks were not well developed, banks rarely borrowed from each other to meet reserve needs. Starting in the 1960s, money center banks (large banks in key financial centers) caused an expansion of overnight loan markets, such as the federal funds market, and the development of new financial instruments, such as negotiable CDs (1961), which enabled money center banks to acquire funds quickly. Banks no longer needed to depend on checkable deposits as the primary source of bank funds and no longer treated their liabilities as given. Instead, they aggressively set target goals for their asset growth and tried to acquire funds by issuing liabilities as needed. Ex: When a money center bank finds an attractive loan opportunity, it can acquire funds by selling a negotiable CD. Or, if it has a reserve shortfall, it can borrow funds from another bank in the federal funds market without incurring high transaction costs. Newfound flexibility in liability management and the search for higher profits have also stimulated banks to increase the proportion of their assets held in loans, which earn a higher income.

When a bank holds insufficient excess reserves and suffers a deposit outflow...

To eliminate this shortfall, the bank has four options: #1. Acquire reserves to meet a deposit outflow by borrowing them from other banks in the federal funds market or by borrowing from corporations. The cost of this activity is the interest rate on these borrowings. #2. Sell some of its securities to help cover the deposit outflow. The bank incurs some brokerage and other transaction costs when it sells these securities. U.S. government securities are considered secondary reserves and are very liquid, so the transaction costs of selling them are quite modest. However, other securities are less liquid and the transaction costs can be appreciably higher. #3. Acquire reserves by borrowing from the Fed. The cost associated with discount loans is the interest rate that must be paid to the Fed (discount rate). #4. Calling in or selling off loans. Reducing its loans by this amount and depositing the money it receives with the Fed, thereby increasing its reserves. Calling in loans is the costliest way of acquiring reserves when a deposit outflow exists. Calling in loans is likely to antagonize the customers whose loans are not being renewed because they have not done anything to deserve such treatment. Selling off loans is very costly because other bankss do not personally know the customers who have taken out the loans so they might not be willing to buy the loans at their full value.

Liquidity Management

To keep enough cash on hand, the bank must engage in liquidity management, the acquisition of sufficiently liquid assets to meet the bank's obligation to depositors.

If a bank finds that its ROE is too low because it has too much bank capital, what can you do to raise its ROE?

To lower capital and raise ROE holding its assets constant, it can pay out more dividends or buy back some of its shares. Alternatively, it can keep its capital constant, but increase the amount of its assets by acquiring new funds and then seeking out new loan business or purchasing more securities with these new funds.

Strategies for Managing Bank Capital: Have Capital Surplus and Should Increase the Equity Multiplier to Raise Return on Equity

To lower the amount of capital relative to assets and raise the equity multiplier, you can do any of three things: #1. Reduce the amount of bank capital by buying back some of the bank's stock. #2. Reduce the bank's capital by paying out higher dividend to its stockholders. #3. Keep bank capital constant but increase the bank's assets by acquiring new funds-say, by issuing CDs-and then seeking out loan business or purchasing more securities with these new funds. Because you think that it would enhance your position with the stockholders, you decide to pursue the second option.

Monitoring and Enforcement of Restrictive Covenants

To reduce moral hazard, financial institutions must adhere to the principle for managing credit risk that a lender should write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities. By monitoring borrowers' activities to see whether they are complying with the restrictive covenants and by enforcing the covenants if they are not, lenders can make sure that borrowers are not taking on risks at their expense. This need for screening and monitoring explains why banks spend so much money on auditing and information -collecting activities.

Deposit outflows

When deposits are lost because depositors make withdrawals and demand payment.

Moral Hazard and the Government Safety Net

With a safety net, depositors know they will not suffer losses if a financial institution fails, so they do not impose the discipline of the marketplace on these institutions by withdrawing funds when they suspect that the financial institution is taking on too much risk. Consequently, financial institutions with a government safety net have an incentive to take on greater risks than they otherwise would, with taxpayers paying the bill if the bank subsequently goes belly up. Financial institutions have been given the following bet: "Heads I win, tails the taxpayer loses."

Managing Interest-Rate Risk

With the increased volatility of interest raters that occurred in the 1980s, banks and other financial institutions became more concerned about their exposure to interest rate risk, the riskiness of earnings and returns that is associated with changes in the interest rates. 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.

If you are a banker and expect interest rates to rise in the future, would you want to make short-term or long-term loans?

You should want to make short-term loans. Then, when these loans mature, you will be able to make loans at higher interest rates, which will generate more income for the bank.

Rank the following bank assets from most to least liquid: a. Commercial loans b. Securities c. Reserves d. Physical capital

a. Commercial Loans (3): a loan is a liability for the individual or corporation receiving it, but an asset for the bank, because it provides income to the bank. Loans are typically less liquid than other assets, because they cannot be turned into cash until the loan matures. b. Securities (2): The U.S. Government and agency securities are the most liquid because they can be easily traded and converted into cash with low transaction costs. Because of their high liquidity, short term U.S. government securities are called secondary reserves. c. Reserves (1): Reserves are these deposits plus currency that is physically held by banks (called vault cash because its stored in bank vaults overnight). d. Physical Capital (4):

Balance Sheet

total assets = total liabilities + capital A bank's balance sheet is a list of its sources of bank funds (liabilities) and uses to which the funds are put (assets). Banks obtain funds by borrowing and by issuing other liabilities, such as deposits. Then they use these funds to acquire assets such as securities and loans. Banks make profits by earning interest on their asset holdings of securities and loans that is higher than the interest and other expenses on their liabilities.

Interest-rate risk

the riskiness of earnings and returns on bank assets that results from interest-rate changes.