Money and Banking: Chapter 9 (Banking and the Management of Financial Institutions)

If reserves have a low interest rate, then why do banks hang on to them?

1. Required Reserves (A fraction of checkable deposits must be kept as reserves) 2. Excess Reserves (most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn) Excess reserves = The amount that's left over from required reserves

Review All types of Assets for a bank

1. Reserves 2. Cash Items in Process of Collection 3. Deposits at Other Banks 4. Securities 5. Loans 6. Other Assets

Two basic types of nontransaction deposits

1. Savings Accounts 2. Time deposits (certificates of deposit, or CD's)

Because banking plays such a major role in channeling funds to borrowers with productive investment opportunities, financial activity is important in ensuring that the financial system and the economy run ____ and _____

1. Smoothly 2. Efficiently Banks supply $10 trillion in credit annually (Provide loans to businesses, finance college and purchases of cars/homes, and provides us with service such as a savings account, debit cards, and ATM)

Explain the concept of "borrow short lend long" for a bank with asset transformation

A bank makes long-term loans by funding them through short-term deposits. (make money)

Loan Commitment

A bank's commitment to provide a firm with loans up to a given amount at an interest rate that's tied to some market interest rate

Securities

A bank's holding of securities are an important income-earning asset (made up entirely of debt instruments for commercial banks)

Liabilities

A banks acquires funds by issuing liabilities, the sources of funds the bank uses. These funds are used to purchase income earning assets

Balance Sheet

A list of the bank's assets and liabilities

Example of asset transformation

A savings deposit held by one person can provide the funds that enable the bank to make a mortgage loan to another person. The bank has transformed the savings deposit (an asset held by the depositor) into a mortgage loan (an asset held by the bank).

T-account

A simplified balance sheet that lists only the changes that occur in balance sheet items.

Asset Management

Acquiring assets that have a low rate of default and by diversifying asset holdings Bank Managers must pursue low level of risk

Liability management

Acquiring funds at a low cost

Cash Items in Process of Collection

Another asset A claim on another bank for funds (A check written on an account at another bank is deposited in your bank, and the funds for this check have not yet been received from the other bank) This check would be "cash item in process of collection"

Deposits at other banks

Asset Many small banks hold deposits in larger banks in exchange for a variety of services (check collecting, foreign exchange, help with security purchases, etc.) Cash items - cash items in process of collection and deposits at other banks

How do banks make profits?

Asset Transformation They sell liabilities and use the proceeds from the liabilities to buy assets

Borrowings

Bank Capital (Bank's net worth) Raised by selling equity (stock) or from retained earnings A bank's capital is its cushion against a drop in the value of its assets

Checkable Deposits

Bank accounts that allow the owner of the account to write checks to third parties. (all accounts on which checks are drawn) Were once the most important source of bank funds, but it has shrunk overtime due to more popular measures of acquiring funds.

Assets

Bank assets = uses of funds, and the interest payments earned on them (allows banks to make profits) Anything that's used to earn income

Loans

Banks make their profits primarily by issuing loans A liability for the individual or corporation receiving it, but an asset for a bank (provides income for the bank) Less liquid than other assets (cannot turn into account until the loan matures) - higher probability of default

Discount Loans

Borrowings from the Fed (known as "advances")

Small denomination time deposits

Deposits less than $100,000 1. less liquid for the depositor, 2. earn higher interest rates 3. more costly source of funds for the bank

If the bank is taking a loss (keep records, pay tellers, pay for check clearing, etc.), what might the bank do with it's required reserves?

Invest in securities or loans.

Review Reserves earn ____

Little Interest (less money for a bank)

Why are banks important?

Major financial intermediary, involved in money supply process, important lender to smaller businesses They channel funds to borrowers with productive investment opportunities They help to ensure that the financial system and the economy run smoothly

Can banks hold stocks?

No

Can owners write checks on nontransaction deposits?

No However, the interest rates paid on these deposits are usually higher than those on checkable deposits

____ deposits are the primary source of bank funds (58% of bank liabilities)

Nontransaction deposits these are accounts where the legal arrangement is that you do not formally have a claim to get your money back immediately, or accounts where people customarily leave

A shortfall of bank capital is likely to lead a bank to __ its assets

Reduce Therefore is likely to cause a contraction in lending

Credit Rationing

Refusing to make loans even though borrowers are willing to pay the stated interest rate, or even a higher rate

Now let's assume that First National Bank received the extra $100 of checkable deposits (from Second National Bank) Assuming that the bank is obliged to keep a reserve ratio of 10%, draw the T-account for First National Bank

Required reserves increase by $10 ($100 * 10%) and the excess reserves are (100-10)

ROE

Return on Equity Net profit after taxes / equity capital ROE = ROA * EM

How is bank capital raised

Selling new equity (stock) or from retained earnings

Liquidity Mangement

Use the book, too complex

Duration Analysis

Used to measure interest-rate risk Examines the sensitivity of the market value of the bank's total assets and liabilities to change in interest rates

General rule for the situation in which a check is written on an account at one bank, and then deposited in another.

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

Balance sheet equation

total assets = total liabilities + capital

Large denomination time deposits

1. Also known as Certificate of deposits (CD's) 2. available in denominations of more than $100,000 3. bought by corporations or other banks 4. negotiable like bonds (resold in the secondary market before they mature)

How do banks obtain funds?

1. Borrowing 2. Issuing other liabilities, such as deposits

Review 4 types of liabilities for banks in this chapter

1. Checkable Deposits 2. Nontransaction Deposits 3. Borrowings 4. Bank Capital

The largest category of loans to banks

1. Commercial and industrial loans made to businesses 2. Real Estate loans

Banks also obtain funds by borrowing from the _____ (4 sources to borrow from)

1. FED (Federal Reserve System) 2. Federal Home Loan banks 3. other banks 4. corporations

The bank's costs of maintaining checkable deposits

1. Interest payments 2. the costs incurred in servicing these accounts (processing, preparing, sending out statements) 3. maintaining an impressive building 4. advertising/marketing customers to deposit their funds in the bank

"Borrow Short, Lend Long" example If the loans have an interest rate of 10% per year, the bank earns ___ in income from its loans over the year. If the $100 of checkable deposits is in a NOW account with a 5% interest rate and costs another $3 per year to service the account, the cost per year of these deposits is __. The bank's profit on the new deposits is then __ per year. Loans = $90

1. Loans = $90, Interest = 10% per year, $9 in income 2. 100 * 0.05 = 5 + 3 (service the account) = $8 in costs 3. Profit = 9-8 = $1 You can also factor in any interest that's earned on required reserves

Four primary concerns of the bank manager (for maximizing bank profits)

1. Make sure that the bank has enough ready cash to pay its depositors when there are deposit outflows when deposits are lost due to withdrawals and demand payment (the bank must make sure they have enough money stored for withdraws. 2. Asset Management 3. Liability Management 4. Capital Adequacy Management

Other Assets

1. Physical capital (bank buildings, computers, and other equipment) owned by other banks

3 categories of Bank Securities

1. U.S. government and agency securities - most liquid (easily traded and converted into cash with low transaction costs) Short-term U.S. gov and agency securities = secondary reserves 2. State and local government securities (state and local governments are more likely to do business with banks that hold their securities) - Local governments are more likely to do business with banks that hold their securities less liquid and riskier than U.S. gov (does have default risk: issuer might not be able to make interest payments) 3. other securities All debt security, no equity

Problem Let's say that Jane Brown has heard that First National Bank provides excellent service, so she opens a checking account with a $100 bill. What's the assets and/or liabilities that are associated with this transaction (for First National Bank)

1. When Jane opened her checking account with $100, she now has a $100 checkable deposit at the bank (the bank must pay her back $100 if she decides to withdraw it). Therefore, liabilities go up by $100. With Vault Cash, the bank puts her $100 bill into its vault so that the bank's assets rise by the $100 increase in vault cash (the bank hold physical possession [physical capital] of the $100 bill). 2. With the second T-table, vault cash is part of the bank's reserves. Thus, their reserves will increase by $100 (asset) Liabilities, when Jane wants her checkable deposit back (withdraw), the bank must pay her back (checkable deposits +100)

Who holds CDs (Large denomination time deposits)

1. corporations, money market mutual funds, and other financial institutions

Excess reserves are _ against the cost associated with deposit outflows. The higher the costs associated with deposit outflows, the more __ reserves a bank will want to hold

1. insurance 2. excess

Other sources of borrowed funds

1. loans made to the banks by their parent companies (bank holding companies) 2. loan arrangements with corporations 3. borrowings of Eurodollars (deposits denominated in U.S. dollars in foreign banks) Borrowed funds make up 20% of the bank's liabilities

If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will ____ bank profits, and a decline in interest rates will ___ bank profits

1. reduce 2. raise

Interest paid on deposits has accounted for around __ of total bank operating expenses Costs involved in servicing accounts (employee salaries, rent) have been approximately __% of operating expenses

10% 85%

EM

Equity Multiplier Assets / equity capital

True or False? A checkable deposit is a liability for the depositor

False A checkable deposit is an asset for the depositor because it is part of his or her wealth (because the depositor can withdraw funds and the bank is obligated to pay, checkable deposits are a liability for the bank)

True or False? Checkable deposits are payable on supply

False They are payable on demand

What if Jane opened her account with a $100 check written on an account at another bank, Second National Bank. Draw the T-table for this

First National Bank is owed $100 by the Second National Bank.

Savings account

Funds can be added to or withdrawn from savings accounts at any time Transactions and interest payments are recorded in a monthly statement or in a passbook held by the owner of the account.

Time deposits

Have a fixed maturity length (several months to 5 years) and has penalties for early withdrawal of funds.

Given the return on assets, the lower the bank capital, the ____ the return for the owners of the bank

Higher

What if both of these banks are in separate states (time consuming and costly to directly lend funds). Explain the T-table if SNB and FNB transferred with the Fed. (check)

If First National Bank deposits the check into its account at the Fed, and the Fed collects the funds from Second National Bank, then the Fed transfers $100 of reserves from the Second National Bank to the First National Bank. When a check written on an account at one bank is deposited in another, the bank receiving the deposit gains reserves equal to the amount of the check, while the bank on which the check is written sees its reserves fall by the same amount.

What does payable on demand mean?

If a depositor shows up at the bank and requests a withdrawal, then the bank is obligated to pay (liability, since the bank has to give the depositor their money back) This also applies to a check. If a person who receives a check presents the check at a bank, the bank must pay the funds out immediately (credit to that person's account).

Liquidity Management

The acquisition of assets that are liquid enough to meet the bank's obligations to depositors

Capital Adequacy management

The amount of capital the bank should maintain and then acquire the needed capital

Gap Analysis

The amount of rate-sensitive liabilities is subtracted from the amount of rate-sensitive assets 50mil - 20mil = 30mil

Let's assume that First National Bank chooses not to hold any excess reserves but to make loans instead. $100 checkable deposits 10% required reserve ratio Draw the t-table

The bank is now making a profit because it holds short-term liabilities, such as checkable deposits, and uses the proceeds to fund longer-term assets (loans with higher interest rates)

Bank Capital

The bank's net worth The difference between total assets and liabilities (assets - liabilities = bank capital)

Required reserve ratio

The fraction of reserve requirements

What do banks do when they obtain funds?

They use these funds to acquire assets (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.

What's the primary purpose of bank capital?

To cushion the bank against a drop in the value of the bank's assets (forcing a bank into having a greater amount of liabilities than assets)

Why would Banks do this (borrow reserves overnight)?

To meet Federal Reserve requirements (authorized by the Fed)

True or False A bank's balance sheet is also a list of its sources of bank funds (liabilities and capital) and uses to which funds are put (assets)

True

True or False? Banks also borrow reserves overnight in the federal (fed) funds market from other U.S. banks and financial institutions.

True

True or False A checkable deposit is the lowest-cost source of bank funds

True, because depositors are willing to forgo some interest in exchange for access to a liquid asset that they can make purchases with immediately.

Reserves

Type of asset Funds that are acquired as deposits plus the currency that is physically held by banks vault cash = currency that's physically held by the banks Has a low interest rate

Which security is the most liquid for banks?

U.S. government and agency securities (easily traded and converted into cash with low transaction costs) Because they're the most liquid, U.S. government and agency securities are also known as Secondary Reserves

Secondary Reserves

U.S. government and agency securities (that are short-term)

ROA

return on asset Net profit after taxes/ assets