Chapter 12

bank's off balance sheet activities include

1. commitments (lines of credit firms & households can use whenever necessary) 2. letters of credit (guarantees that a customer will make a promised payment)

how to manage sovereign risk

1. diversification loans and securities throughout the world 2. refusing to do business with a particular country 3. can use derivatives to spread risk

loan loss reserves

An amount the bank sets aside to cover potential losses from defaulted loans

Return on Assets (ROA)

Net Income/Total Assets is an important measure of how efficiently a particular bank uses its assets

Return on Equity (ROE)

Net Income/Total Equity measures the bank's return to its owners

Basic measures of bank's profitability include?

Return on Assets (ROA) Net interest income net interest margin Return on Equity (ROE)

Certificates of Deposit (CDs)

Savings accounts that guarantee a depositor a set interest rate over a specified interval as long as the funds are not withdrawn before the end of the period

Diversification

Spreading out investments to reduce risk

Operational Risk

The risk of loss of operations due to inadequate or failed internal processes, people or systems, or as a result of external events.

Liquidity Risk

The risk that an asset cannot be sold on short notice without incurring a loss

total bank assets =

Total Bank Liabilities + Bank Capital

Interest Rate Swap

When floating rate interest payments are exchanged for fixed rate payments. this allows for the transfer of rising interest rates to another party

savings banks

accept the savings of individuals and lend pooled savings to individuals primarily in the form of mortgage loans specialize in residential mortgages that are funded by deposits

off-balance-sheet activities

activities that do not affect a bank's balance sheet because they do not increase either the bank's assets or its liabilities

demand deposits

allow a customer to withdraw funds without notice on a first come, first served basis

what happens when a loan is written off?

at some point the bank gives up hope that a loan will be repaid and the loan is erased from the bank's balance sheet and at that point, the loan loss reserve is reduced by the amount of the loan that has defaulted.

why is holding excess reserves expensive?

because it means forgoing the higher rate of interest that typically can be earned on loans or securities.

why have large certificates of deposits (CD's) become an important source of bank financing?

because large CD's can be bought and sold in the financial markets, just like bonds and commercial paper

Why do banks hold reserves?

because regulations require it and because prudent business practice dictates it

why are securities sometimes referred to as secondary reserves?

because these are very liquid and can be sold quickly if the bank needs cash, which makes them a good backup for the bank's cash balances

Why have off-balance sheet activities come under increasing scrutiny in recent years?

because they create risk for financial institutions

what is the reason for the decline of checkable deposits?

because they pay little to no interest. they are low cost source of funds for banks but a low return investment for depositors

Why do banks try to minimize their cash holdings?

because they typically earn less interest than loans or securities

How are bank's bond holdings split?

between U.S. government and agency securities and other securities that include state and local gov bonds

what is the second most important source of bank funds?

borrowing

what does leverage increase?

both risk and expected return

5 broad categories of loans

business (commercial and industrial), real estate(mortgages, home equity loans), consumer (auto loan or credit card loan), interbank, and other type of loans.

Commercial banks make loans primarily to who?

businesses

The bank holds this to meet customer's withdrawal requests and it is the most liquid of the bank's assets

cash

4 broad categories of assets?

cash, securities, loans and all other assets

Time deposits are also known as

certificates of deposits (CD's)

Foreign exchange risk

comes from holding assets mostly in one currency and liabilities denominated in another currency

credit unions specialize in what type of loans?

consumer

net interest margin can tell us ?

current and future profitability. it is a forward looking measure

what makes up the largest component of checkable deposits?

demand deposits

Banks profit from the difference between the interest rate they pay to ____________________and the interest rate they receive from ________________________.

depositors borrowers

bank liabilities are composed primarily of what? along with some _________ and ____________.

deposits borrowing and capital

How do banks manage credit risk?

diversification

An economy needs financial institutions to

effectively channel resources from savers to investors

commercial banks

established to provide banking services to businesses, allowing them to deposit funds safely and borrow them when necessary. now many offer loans and accounts to individuals as well.

Savings Institutions

financial institutions that accept deposits and provide mortgage and personal loans to individuals.

Depository Institutions

financial institutions that accept deposits from savers and make loans to borrowers Commercial banks, savings and loans, and credit unions

Ways that banks can borrow?

from the federal reserve, from other banks, and sometimes commercial banks borrow from foreign banks

Well run banks have a high or low net interest income and net interest margin?

high

If a bank's net interest margin is currently improving, its profitability is likely to do what in the future?

improve as well

reserves

include the cash in the bank's vault and bank's deposits at the Federal Reserve System

Banks obtain their funds from?

individual depositors and businesses, and from borrowing from other financial institutions and through financial markets

banks obtain funds from

individual depositors and businesses, as well as by borrowing from other financial institutions in financial markets

Capital provides some insurance against what?

insolvency (the inability to repay debts when a firm's liabilities exceed its assets)

What are the primary asset of modern commercial banks, accounting for well over 1/2 of assets?

loans

Banks transform deposit liabilities into assets as _____________________ and in the process, they pool savings, provide liquidity services, allow for diversification of risk and capitalize on the advantages they have in producing information.

loans and securities

interbank loans

loans made from one bank to another

a bank's assets tend to be short or long term?

long term

For a bank to make a profit, the interest rate on its liabilities must be lower or higher than the interest rate on its assets?

lower

the higher the risk inherent in the bank's portfolio, the more capital the bank will need in order to?

make sure the institution remains solvent

gap analysis

managers compute an estimate of the change in the bank's profit for each one-percentage point change in the interest rate this highlights the gap or difference between the yield on interest rate sensitive assets and yield on interest rate sensitive liabilities

the second largest component of bank assets

marketable securities

Another term for a bank's capital is?

net worth

credit unions

nonprofit depository institutions that serve members who have a common affiliation. they specialize in making small consumer loans

To generate fees, what do banks engage in?

numerous off-balance sheet activities

leverage

portion of an asset that is purchased using borrowed funds

Banks borrow using an instrument called?

repurchase agreement or repo

three types of cash assets

reserves cash items in process of collection balances of the accounts that banks hold at other banks

required reserves

reserves that a bank is legally required to hold, based on its checking account deposits

Sovereign Risk

risk associated with a foreign government defaulting on its debt obligations

Where do the bank's profits come from?

services fees and the difference between what the bank pays for its liabilities and the return it receives on its assets.

a bank's liabilities tend to be short or long term?

short term

Two varieties of certificates of deposits (CDs)

small ($100,000 or less) large (>$100,000)

Community banks

small banks with assets less than $1 billion that concentrate on serving consumers and small businesses

How do banks borrow from other banks?

that is, banks with excess reserves will lend their surplus funds to banks that need them through an interbank market called federal funds market

Net Interest Income

the difference between interest earned and interest paid

The U.S. banking system has a large amount of leverage, one of the possible reason is ?

the existence of government guarantees like deposit insurance, which allows banks to capture the benefits of risk taking without subjecting depositors to potential losses

Banks make profits by turning liabilities into assets, so when their balance sheets are smaller, that means?

the lower their profits

Credit Risk

the probability that the borrower will fail to pay some of the interest or principal

interest rate risk

the risk of capital losses to which investors are exposed because of changing interest rates

when interest rates rise, what risk do banks face?

the risk that the value of their assets will fall more than the value of their liabilities

trading risk

the risk that traders who work for a bank will create losses on the bank's own account

What is the primary difference among various kinds of depository institutions?

their composition of their loan portfolios

How to manage interest rate risk?

Can do so by determining how sensitive the bank's balance sheet is to a change in interest rates. The simplest way is to match the interest rate sensitivity of assets with the interest rate sensitivity of liabilities can also make long-term loans at a floating interest rate as in ARMs instead of at the fixed interest rate (this approach increase credit risk though) The use of derivatives (interest rate swaps) to transfer risk of rising interest rates to another party

excess reserves

a bank's reserves over and above its required reserves

net interest income can also be expressed as?

a percentage of total assets to yield a quantity called net interest margin

Repurchase Agreements

a short-term collateralized loan in which a security is exchanged for cash, with the agreement that the parties will reverse the transaction on a specific future date, as soon as the next day

About how much of all securities are mortgage backed?

about half

balance sheet

list of firm's assets and liabilities

other ways to respond the shortfall created by a customer's large withdrawal of money, say $5 million, other than holding excess reserves?

it can either adjust its assets or its liabilities. on the asset side, bank could sell a portion of its securities portfolio because some are U.S. Treasuries so they can be sold quickly and low cost or the bank can sell some of its loans to another bank. The bank could also refuse to renew a customer loan that has come due but this is less appealing because they may lose a customer

A bank's net interest margin is closely related to?

its return on assets

transaction accounts

known as checkable deposits

The sources of funds are called ? while the uses to which those funds are put are called?

liabilities vs assets

Capital appears on what side of the balance sheet?

liability

because banks want bigger balance sheets for more profits, they prefer to use what kind of management to address liquidity risk?

liability management, that is, instead of selling assets in response to a deposit withdrawal, they find other sources of funds.

Risks that banks face

liquidity credit interest-rate trading

Two ways that banks can obtain funds, instead of selling assets?

they can borrow to meet the shortfall, from the Federal Reserve or from another bank. Or they can attract additional deposits, most commonly by issuing large certificates of deposits (CD's)

Large certificates of Deposits (greater than $100,000) offer the banks an opportunity to manage what risk and how?

they can manage liquidity risk, without changing the asset side of their balance sheets

what is the solution for the moral hazard problem in trading?

to compute the risk the portfolios traders generate using measures like standard deviation and value at risk. the bank manager can then limit the amount of risk any individual trader is allowed to assume and monitors each trader's holdings closely

2 types of deposit accounts

transaction and non-transaction

Loans made in the federal funds market are secured or unsecured?

unsecured --they lack collateral

net worth

value of the bank to its owners

interest rate spread

weighted average difference between the interest rate received on assets and the interest rate paid for liabilities