Chapter 10 - The Business of Banking

Bank Liabilities

- checkable deposits - non-transactions deposits - loans

what happens to a bank's balance sheet when you open a checking account with $500 in cash

- checkable deposits increase by $500 - vault cash (or cash in the process of collection if you used a check from another bank) increases by $500

reducing credit risk

- diversified portfolio of loans - credit-risk analysis (credit score) - collateral and compensating balance - credit rationing - monitoring borrowers and placing restrictive covenants or explicit provisions - maintaining long-term relations with custormers

time deposits

- have fixed maturities, with a penalty in the form of interest foregone for withdrawal of funds before maturity - resulting lack of liquidity --> higher interest rate than savings deposits - small-denomination and large-denomination time deposits

revenue sources for a bank

- interest earned - fees on credit cards - service fees

cost sources for a bank

- interest paid on deposits - interest paid on loans & debt - cost of providing services

liability management

- involves use of borrowing in the federal funds market or from Fed and repurchase agreements on government securities

asset management

- lending to other banks in a federal funds market one day at a time - engaging in reserve repurchase agreements

T-account

- lists changes in balance sheet items from an initial position - to analyze movements in bank profits

how to reduce interest rate risk

- making floating/adjustable rate loans -->benchmark rate + some rate to reflect credit risk - using interest rate swaps --> banks agree to exchange/swap payments from a fixed rate loan for the repayments on an adjustable rate loan owned by a corporation or another financial firm - using futures and options contracts

net worth is a buffer against risk

- managers have incentive to reduce equity and earn a higher rate of return - while depositors/savers prefer comfortable equity cushion - savers prefer higher net worth and lower leverage risk - equity holders prefer higher ROE (prefer manager hold stock)

reserves

- most liquid asset held by banks - consists of vault cash and deposits with the Fed - required reserves + excess reserves

Bank Borrowings

- non-deposit liabilities - short-term loans in the federal funds market - repurchase agreements - discount loans

Bank Assets

- reserves - cash items in the process of collection - marketable securities - loans - equipment - building - collateral received from borrowers in default

balance sheet

- statement that shows an individual's or firm's financial position on a particular day - lists assets, liabilities, and net worth/bank capital

how can moral hazard contribute to high bank leverage? 1st way

1 - bank managers' compensation is positively related to their ability to provide a high ROE to shareholders = incentive to increase bank asset/capital ratio = increase in riskiness (savers don't like this) = if managers are compensated for a high ROE, may take on too much risk

how can moral hazard contribute to high bank leverage? 2nd way

2 - FDIC has increased moral hazard by reducing incentive depositors have to monitor behavior of bank managers = they're shielded from losses due to deposit insurance

relationship between ROE and ROA

ROE = ROA * (Bank Assets / Bank Capital)

net worth

Equity Capital Contributed By Shareholders + Accumulated and Retained Profits

duration analysis

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

excess reserves

any reserves banks hold above those necessary to meet reserve requirements - can provide an important source of liquidity to banks - during financial crisis, bank holdings of excess reserves soared - can be invested into loans or securities or other assets

how do banks earn profit?

by acquiring funds at a cost and lending them at a rate higher than that cost

vault cash

cash on hand in the bank or in deposits at other banks (Fed)

cash items in the process of collection

claims banks have on other banks for uncollected funds

C&I loans

commercial and industrial loans - loans to businesses

real estate laons

commercial and residential mortgages

net interest margin

difference between the interest it receives on its securities and loans and the interest it pays on deposits, dividing by the total value of its interest earning assets (not vault cash)

positive duration gap (duration of assets - duration of liabilities > 0)

duration of assets > duration of liabilities i will increase, reduce PV of bank's assets more than PV of bank's liabilities, which will decrease PV of bank's capital

interest rate risk

effect of a change in market interest rates on a bank's profit or capital; bank experiences this risk if changes in market interest rates cause bank profits to fluctuate

non-transactions deposits

for depositors who want to earn an interest on funds that they are not likely to use for day-to-day transactions - savings accounts - money market deposit accounts - time deposits/certificates of deposits

money market account

funds are used to buy commercial paper and Treasury securities - savers earn an interest rate that varies with the short-term yield in such markets and also have some check writing priviledges

checkable deposits

grants the depositor the right to write checks - demand deposits - NOW accounts - very liquid

why the increased uncertainty in high leverage?

higher amounts loans, higher interest earnings, higher current profits, and lower net worth - this strategy increases default risk and interest rate risk

interest on required reserves

if interest rate on reserves increases, no bank will lend at a lower rate - Federal Funds Rate will increase without the need for an Open Market Sale - interest rate for reserves sets a FLOOR for Federal Funds Rate

federal funds rate

interest rate on inter-bank loan in the federal funds market

capital requirements

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

marketable securities

liquid assets that banks trade in securities markets (T-bonds and municipal bonds) - Treasury securities are very liquid and serve as secondary reserves

discount loans

loans from the Federal Reserve System

consumer loans

loans to households to buy cars, furniture, etc.

federal funds market

market for unsecured loans overnight between banks

leverage

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

demand deposits

non-interest bearing accounts

NOW (negotiable order of withdrawal) accounts

pay a small interest while allowing the saver to write checks (not businesses)

liquidity risk

possibility that bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost; possibility that depositors may withdraw more funds than the banks has immediately on hand - can be reduced by increasing reserves held - but reduces profits (no interest earned on excess reserves held as vault cash) - asset management - liability management

Federal Deposit Insurance Corporation (FDIC)

provides government guarantees for bank account balances up to $250,000, giving banks an edge over other intermediaries in acquiring funds

bank leverage

ratio of the value of a bank's assets to the value of its capital - high leverage = swings in profit - can magnify small ROAs into large ROEs (same for losses) - increased uncertainty

credit risk

risk that borrowers might default on their loans

repurchase agreements (repos)

securities sold and purchased the next day - banks sell securities like T-bills and agree to repurchase them, typically the next day - typically between large banks or corporations, so counterparty risk is small

liabilities

sources of acquired funds (what is owes)

gap analysis

used to calculate vulnerability of bank's profits to changes in market interest rates - most banks have negative gaps because their liabilities (deposits) are more likely to have variable rates than their assets (loans/securities) - reducing the size of the gap reduces interest rate risk

assets

uses of acquired funds (what it owns)

bank failure

when a bank cannot repay its depositors with enough reserves left to meet its reserve requirements (or very low net worth)

Return on Assets (ROA)

(After-Tax Profit) / (Bank Assets)

Return on Equity (ROE)

(After-Tax Profits) / (Bank Capital) - shareholders own equity capital, so they are interested in this

Loans (to borrowers)

- 2/3 of bank assets (a bank is not allowed to loan more than 15% of its capital to any single borrower) - loans are very illiquid, entail a default risk and information cost - interest rate is higher on loans than other assets - C&I loans - consumer loans - real estate loans

net worth/bank capital/shareholder equity

Assets - Liabilities

small-denomination time deposits

CDs less than $100,000

large-denomination time deposits

CDs of $100,000 or more - negotiable - can be traded in secondary markets before maturity date - generally held by financial institutions and non-financial corporations

required reserves

Fed made it compulsory for these banks to hold some of their deposits in the form of vault cash or in reserve accounts at a Federal Reserve Bank - a % of checkable deposits that the bank is barred from lending - some interest paid on required reserves