Chapter 9. The Bank Firm & Bank Management Balance sheet Bank Management Credit Risk Interest Risk...
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Transcript of Chapter 9. The Bank Firm & Bank Management Balance sheet Bank Management Credit Risk Interest Risk...
Chapter 9. The Bank Firm Chapter 9. The Bank Firm & Bank Management& Bank Management
Chapter 9. The Bank Firm Chapter 9. The Bank Firm & Bank Management& Bank Management
• Balance sheet
• Bank Management
• Credit Risk
• Interest Risk
• Other activities & financial innovation
• Balance sheet
• Bank Management
• Credit Risk
• Interest Risk
• Other activities & financial innovation
I. Balance SheetI. Balance SheetI. Balance SheetI. Balance Sheet
• liabilities ($8.25 trillion) sources of bank funds
• assets ($9.1 trillion) uses of bank funds
• liabilities ($8.25 trillion) sources of bank funds
• assets ($9.1 trillion) uses of bank funds
LiabilitiesLiabilitiesLiabilitiesLiabilities
• deposits ($5.95 trillion, 72%) checkable deposits savings deposits time deposits (CDs)
• deposits ($5.95 trillion, 72%) checkable deposits savings deposits time deposits (CDs)
• borrowed funds discount loans (Federal Reserve) federal funds (other banks) repos eurodollar loans commercial paper
• borrowed funds discount loans (Federal Reserve) federal funds (other banks) repos eurodollar loans commercial paper
AssetsAssetsAssetsAssets
• cash items (< $1 trillion) reserves
-- required
-- excess deposits at other banks cash items in collection
• cash items (< $1 trillion) reserves
-- required
-- excess deposits at other banks cash items in collection
• securities ($1.77 trillion) debt securities U.S. gov’t debt municipal debt
• loans ($5.35 trillion, 59%) commercial real estate consumer interbank
• securities ($1.77 trillion) debt securities U.S. gov’t debt municipal debt
• loans ($5.35 trillion, 59%) commercial real estate consumer interbank
Bank capitalBank capitalBank capitalBank capital
• or net worth
= assets - liabilities
• banks have capital requirement cushion against bad loan losses
• or net worth
= assets - liabilities
• banks have capital requirement cushion against bad loan losses
Using T-accountsUsing T-accountsUsing T-accountsUsing T-accounts
• show changes in assets & liabilities
• show how money supply changes• show changes in assets & liabilities
• show how money supply changes
exampleexampleexampleexample
• I empty Timmy’s piggy bank
• open a savings account
• $50
• I empty Timmy’s piggy bank
• open a savings account
• $50
• $50 in cash increases assets
• $50 in savings increases liabilities• $50 in cash increases assets
• $50 in savings increases liabilities
• suppose required reserves are
10% of deposits required reserve ratio
• suppose required reserves are
10% of deposits required reserve ratio
• bank lends excess reserves,• bank lends excess reserves,
II. Bank ManagementII. Bank ManagementII. Bank ManagementII. Bank Management
• liquidity management need cash to deal with deposit
outflows but holding cash drags down
profits
• liquidity management need cash to deal with deposit
outflows but holding cash drags down
profits
• if too low on cash, borrow from banks or Fed sell securities call in or sell loans
all of which are costly
• if too low on cash, borrow from banks or Fed sell securities call in or sell loans
all of which are costly
• asset management maximize returns (profits) acceptable risk
-- diversified loan portfolio adequate liquidity regulatory compliance
• asset management maximize returns (profits) acceptable risk
-- diversified loan portfolio adequate liquidity regulatory compliance
• liability management banks increasingly compete for
funds w/ other institutions banks have more choices in raising
funds money center banks
-- large banks
-- rely on commercial paper, CDs, federal funds
• liability management banks increasingly compete for
funds w/ other institutions banks have more choices in raising
funds money center banks
-- large banks
-- rely on commercial paper, CDs, federal funds
• capital management protects from insolvency but capital drags down shareholder
return (ROE) regulations set minimum capital
requirements
-- as a % of risk-adjusted assets
-- increased in 1990
-- credit crunch in ‘90-’91 recession
• capital management protects from insolvency but capital drags down shareholder
return (ROE) regulations set minimum capital
requirements
-- as a % of risk-adjusted assets
-- increased in 1990
-- credit crunch in ‘90-’91 recession
III. Managing Credit RiskIII. Managing Credit RiskIII. Managing Credit RiskIII. Managing Credit Risk
• loans are primary asset problems of
adverse selection
-- BEFORE loan
moral hazard
-- AFTER loan
• loans are primary asset problems of
adverse selection
-- BEFORE loan
moral hazard
-- AFTER loan
Banks gather informationBanks gather informationBanks gather informationBanks gather information
• screening adverse selection credit history (FICO score) industry specialization in lending
-- become experts in screening,
-- but lack of diversification
increase risk of assets
• screening adverse selection credit history (FICO score) industry specialization in lending
-- become experts in screening,
-- but lack of diversification
increase risk of assets
• monitoring moral hazard monitor borrow after loan
-- restrictive covenants
-- enforce agreements
• monitoring moral hazard monitor borrow after loan
-- restrictive covenants
-- enforce agreements
• example of monitoring mortgage escrow account
-- banks collects monthly
insurance, tax payments
from homeowner
-- ensures that owner pays
taxes, insurance
• example of monitoring mortgage escrow account
-- banks collects monthly
insurance, tax payments
from homeowner
-- ensures that owner pays
taxes, insurance
• long-term customers less screening & monitoring encouraged with better terms
• long-term customers less screening & monitoring encouraged with better terms
• collateral protects bank from loss adverse selection
-- discourages certain borrowers moral hazard
-- discourages borrower risk-taking,
since borrower is risking property
• collateral protects bank from loss adverse selection
-- discourages certain borrowers moral hazard
-- discourages borrower risk-taking,
since borrower is risking property
• credit rationing riskier borrowers would be willing
to pay high rates good borrowers won’t so banks will not lend to certain
borrowers at ANY rate
or only small amounts
• credit rationing riskier borrowers would be willing
to pay high rates good borrowers won’t so banks will not lend to certain
borrowers at ANY rate
or only small amounts
IV. Managing Interest Rate RiskIV. Managing Interest Rate RiskIV. Managing Interest Rate RiskIV. Managing Interest Rate Risk
• changes in interest rates affect BOTH assets and liabilities
• assets changes VALUE changes the amount of interest
income depends on whether LT or ST
• changes in interest rates affect BOTH assets and liabilities
• assets changes VALUE changes the amount of interest
income depends on whether LT or ST
• liabilities cost of funds goes up with interest
rates
-- rates on CDs, money market accounts very sensitive
-- rates on savings, checking not
as sensitive
• liabilities cost of funds goes up with interest
rates
-- rates on CDs, money market accounts very sensitive
-- rates on savings, checking not
as sensitive
overall impactoverall impactoverall impactoverall impact
• rising interest rates asset income will go up cost of funds will go up
• total impact depends on amount of rate-sensitive assets vs.
rate-sensitive liabilities
• rising interest rates asset income will go up cost of funds will go up
• total impact depends on amount of rate-sensitive assets vs.
rate-sensitive liabilities
• banks typically borrow short-term
and lend long-term
• so rate sensitive liabilities >
rate sensitive assets
• so as interest rates rise costs increase faster than income bank profits fall banks must manage interest rate
risk
• banks typically borrow short-term
and lend long-term
• so rate sensitive liabilities >
rate sensitive assets
• so as interest rates rise costs increase faster than income bank profits fall banks must manage interest rate
risk
V. Other Bank ActivitiesV. Other Bank ActivitiesV. Other Bank ActivitiesV. Other Bank Activities
• Off-balance sheet
• loan sales secondary market frees up capital to make more
loans
• Off-balance sheet
• loan sales secondary market frees up capital to make more
loans
• fee income growing portion of bank profits ATM, service fees guarantee fees makes banks less dependent on
spread between deposit & lending rates
• fee income growing portion of bank profits ATM, service fees guarantee fees makes banks less dependent on
spread between deposit & lending rates
• risk management trading derivative securities introduces new risks
-- possible to lose LOTS of money
in a short period of time
-- traders make unauthorized trades
• risk management trading derivative securities introduces new risks
-- possible to lose LOTS of money
in a short period of time
-- traders make unauthorized trades
VI. Financial InnovationVI. Financial InnovationVI. Financial InnovationVI. Financial Innovation
• new types of assets, new activities
• why? changing demand conditions changing supply conditions regulatory avoidance
• new types of assets, new activities
• why? changing demand conditions changing supply conditions regulatory avoidance
demanddemanddemanddemand
• interest rate volatility (and risk)
increase in 1970s banks demand new products
to manage the risk ARM reduces bank interest rate
risk
• interest rate volatility (and risk)
increase in 1970s banks demand new products
to manage the risk ARM reduces bank interest rate
risk
supplysupplysupplysupply
• banks supplying new services
• cost of financial transactions have fallen with new technologies ATMs credit/debit cards internet banking
• banks supplying new services
• cost of financial transactions have fallen with new technologies ATMs credit/debit cards internet banking
regulationregulationregulationregulation
• avoiding reserve requirements minimize liabilities subject to
requirement eurodollars commercial paper
• avoiding reserve requirements minimize liabilities subject to
requirement eurodollars commercial paper