Commercial Banking

Credit risk of loan portfolios

Banks increasingly rely on internal credit risk ratings to measure the risk of loan portfolios for: Diversifying across geographic regions, loan type and borrower type Using credit derivatives to minimise credit risk exposure

Loans

Banks make profits primarily by issuing loans Loans are less liquid than other assets Other assets Tangible assets e.g. bank buildings, computers

Managing interest rate risk

Banks manage interest rate risk to ensure they profit from the spread between borrowing rates and rates of return on loans and investments

Trading activities - derivative securities

Banks participate in markets for interest rate and currency forwards, futures, options and swaps.

Income for commercial bank

Commercial banks are profit-maximising business firms who primary source of income is interest earned on loans and investment securities.

Reserves

Deposits in an account at the central bank and vault cash Don't pay interest, held for two reasons: regulation requirement and liquidity management Required reserves (fraction of transaction deposit) & excess reserve

Profitability

ROAA - Rate of return on average average assets ROAE - Rate of return on average equity NIM - Net interest margin

Off-balance-sheet banking

There has been a large increase in off-balance-sheet banking over the last 20 years Trading financial instruments Generating income from fees and loan sales (loans brokerage) Activities that affect bank profits but do not appear on bank balance

Basic banking - deposits

When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits; it loses an equal amount of reserves

Primary reserves

Immediately available to accommodate liquidity demands Vault cash, deposits at correspondent banks and deposits held at the RBA

Profitability vs Safety

Increase profit by taking more risk Bank must balance demands of shareholders, depositors and regulators Balance the trade-off between: Profitability - Liquidity - Solvency

Asset management - excess reserves

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.

Sources of income

Interest income - major source Non-interest income Atm surcharges Credit card fees Fees from the sale of managed funds Trust operations Investment services, insurance and financial products

Expenses for banks

Interest paid on deposits and borrowed funds along with salaries and employees benefits

Operation expense

Interest rate payments Non-interest expenses Provision for loan loss

Deposits

Interest rates paid on deposits has accounted much less than the cost involved in servicing accounts (employee salaries, building rent, and so on)

Basic banking - Transforming assets

Issuing liabilities and buying assets Borrows short and lends long

Liability Management

Liability management involves attracting additional funds by increasing the interest rate on interest sensitive securities Negotiable CDs, repos, and Eurodollar borrowings

Loan commitments

Line of credit - agreement under which a customer can borrow up to a predetermined limit on a short-term basis Term loans - agreement under which a bank will lend a customer a certain dollar amount for a period exceeding a year Revolving credit facilities - customer has ability to borrow, repay and re-borrow during loan period.

Deposits outflows - Asset Management

Maintaining sufficient cash and non-cash assets that can be quickly converted to cash

Measuring interest rate risk

Maturity gap analysis, used to ensure bank's assets have maturities similar to the liabilities Duration gap analysis, more precise and used by large instiutions Value of Risk (VaR)

Managing interest rate risk

Micro hedging - hedging a specific transaction or - matched funding (fixed rate loans are funded with deposits or borrowed funds of the same maturity) Macro hedging - through the use of financial futures, options on futures and interest rate swaps

Capital accounts

Bank capital is the ownership funds of the bank Loan and security losses are charged against this account

Credit risk of individual loans

Once a loan is made, banks must monitor its performance Indicators of problem loans: Failure to make loan payments Adverse changes in a customer's credit rating Adverse changes in deposit balances, sales and earnings Delays in supplying financial statements or other documents

Bank capital management

Performs several important roles Provides a financial cushion Helps maintain public confidence Provides some protection to depositors Serve as a source of funds for expansion A minimum amount of bank capital is required by regulatory authority Maintains bank capital to lessen the chance that it will become insolvent

Asset management classifications

Primary reserves Secondary reserves Bank loans Investments

Source of bank funds

Principal source Demand, savings and terms deposits Increase demand for loans has outpaced the growth on deposits and banks rely on borrowed funds to finance their operations.

Secondary reserves

Provide banks with additional liquidity while earning some interest income T-bills and short-term government agency securities

Deposits outflows - Liability Management

Acquiring liquidity from the liability side of the balance sheet

Securities

An important income-earning assets Debt instruments Treasury securities are called secondary reserves

Borrowed funds

Borrowed funds are short-term borrowings by commercial banks from the wholesale money markets From central bank From other banks From corporations/parent companies/eurocurrency

CAMELS

Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk Rated on scale from 1 (Best) to 5 (Worst) Composite rating based on all six components

Off-balance-sheet banking Fee income

Fees that banks receive for providing specialized services to customers e.g. making foreign exchange trades on customer's behalf providing backup lines of credit (loan commitment), which increases the default and liquidity risks a bank faces

Asset management

Find borrowers paying high rates and unlikely to default Purchase securities with high returns and low risk Diversifying (purchasing many different types of assets) Liquidity management (reserves)

Bank use of funds

Funds used for issuing loans or purchasing investments

Purpose of derivative securities

Hedging risk Speculation - on changes in interest rates or currency exchange rates Serving as a counterparty for a customer

Deposit accounts - nontransaction deposits

Savings Accounts - interest bearing accounts of individuals and partnerships Time (Term) Deposits - are legally due on a maturity date and the funds cannot be transferred to others

Bank Capital

Share capital - common or preferred stock Retained earnings Cushion against drop in assets value

Basic banking - Providing a set of services (cheque clearing, record keeping, credit analysis etc.)

To make profit, produces desirable services at low cost and earns substantial income on assets

Deposit accounts

Transaction Accounts (demand deposits) In which the owner is entitled to receive their funds on demand, which transfers ownership of the funds to others by cheque or EFTPOS Lowest-cost source of bank funds

Open-market investments

Undertaken once loan demand has been satisfied Long-term treasury securities, state, local government and corporate bonds.

Bank loans

Undertaken once the bank has satisfied its liquidity needs Loans to business firms and individuals