Presentation on theme: "Chapter 11 Banking and the Management of financial institutions."— Presentation transcript:
Chapter 11 Banking and the Management of financial institutions
Functions of the commercial Banks The Bank Balance Sheet Basic Banking General Principles of Bank Management Managing Credit Risk
Definition Bank: is an institution which collects money from those who saving it out of their incomes, and it lends this money out to those who require it. Among depositary institutions, commercial banks are the dominant players. They are also the oldest& most diversified of all financial intermediaries.
Functions of Commercial Banks 1.Accepting deposits 2.Lending loans 3.Providing special services to customers
1- Accepting deposits from the public Deposits may be of different types a)Current accounts: these enable customers (depositors) any time to order the bank to make payments from their accounts up to the sum deposited. No interest b)Deposit accounts: these earn an interest, since the customers are not expected to make frequent withdrawals, and should give notice in advance
C) Credit transfers: any person whether a customer or not and provided that he makes the money available, request the bank to transfer a sum of money to another’s account
2- lending loans Commercial banks lend the money deposited with them to other customers, with the exception of a safe percentage of actual cash. Before granting a loan to customers, commercial banks consider two points: 1.The nature of the guarantee which the customer can offer. 2.The length of time for which the loan is required
Types of loans: a)Loans to individuals b)Loans to government A)Loans to individuals & Businessmen: Loans may be provided to traders. Commercial banks provide long term loans on fixed assets. Commercial banks make a loan to private individuals.
b) Loans to the government: These may be short term or long term loans Short term loans : they are highly liquid Long term loans: they are not liquid, they are marketable (can be sold in the market) include government bonds
3- providing special services to customers These services include: 1- exchanging the local currency for foreign currencies 2- advising customers on investment 3- collecting checks on behalf their clients 4- transferring money from one client or person to another.
The commercial Bank Balance sheet The balance sheet is a statement of its assets, liabilities, and net worth at a given point in time. A Bank’s assets are indications of what the bank owns (uses of funds) A Bank’s liabilities are indications of the claims on the bank that are held by external entities (sources of funds). Net worth is a residual term that is calculated by subtracting total liabilities from total Assets. Capital accounts (capital)
Assets _ Liabilities = Net worth Assets = Liabilities +Net worth (capital) The bank’s liabilities: are its sources of funds which include: a) Checkable Deposits : are bank accounts that allow the owner of the account to write checks to third parties A checkable deposit is an asset, for the depositor, because it part of his wealth. A checkable deposits are a liability, for the bank, because the depositor can withdraw funds from his account
b) Non transaction deposits : owners cannot write checks on non transaction deposits, but the interest rates are usually high. c) Borrowings: banks obtain funds by borrowing from the central bank, other banks & corporations. Borrowing from the central bank are called discount loans
Bank Equity Capital This is the bank’s net worth, which equals the difference between total Assets and Liabilities The funds are raised by selling new equities ( stocks) of from retained earnings. The bank’s Assets: are its uses of funds Include: a)Reserves Are either bank deposits held at the central bank, or currency that is physically held by banks (called vault cash) Required reserves : a certain fraction of deposits must be held as reserves by law Excess reserves:are the reserve held above &beyond the amount needed for required reserves
b) Cash items in process of collection Suppose that 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. The check is classified as a cash item in process of collection It is an assets because it is a claim on another bank for funds that will be paid within a few days
c) Deposits at other Banks: Many small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions and help with securities purchases d) Securities: A bank’s holdings of securities are an important income earning asset. Called secondary reserve because that the most liquid that can be easily traded and converted into cash with low transaction costs.
e) Loans: A loan is a liability for the individual or corporation receiving it, but an asset for A bank Loans are typically less liquid than other assets because they cannot be turned into cash until the loan matures Loans also have a higher probability of default than other assets. So, because of the lack of liquidity and higher default risk, the bank earns its highest return on loans
f) Other Assets: The physical capital (bank buildings, computers and other equipment) owned by the banks
Basic Banking (basic operation) Banks make profits by selling liabilities with one set of characteristics( a particular combination of liquidity, risk, size and return) and using the proceeds to buy assets with a different set of characteristics. This process is often referred to as asset transformation. For example, a saving deposit held by one person can provide the funds that enable the bank to make a loan to another person We use T account. A T account is a simplified balance sheet, that list only the changes that occur in balance sheet items starting from initial balance sheet position.
Example Suppose that John Brown has heard that the first National Bank provides excellent service, so he opens a checking account with 100 $ He now has a 100$ checkable deposit at the bank, which shows up as a 100$ liability on the bank’s balance sheet The bank now puts his 100$ into its vault so that the bank’s assets rise by the 100$ increase in vault cash
Assets liabilities Vault cash 100$ checkable deposits 100$ Because vault cash is part of the bank’s reserves, we can rewrite the T account as follows:
Assets liabilities Reserves 100$ checkable deposits 100$ If john had opened his account with a 100$ check written on an account at another bank, say the second National Bank, we would get the same result. The initial effect on the T-account of the first National Bank as follows
Assets Liabilities cash item in 100$ checkable deposits 100$ process of collection
The final balance sheet positions of two banks are as follows: First National Bank Assets Liabilities Reserves 100$ checkable deposits 100$
second National Bank Assets liabilities Reserves - 100$ checkable deposits -100
The process can be summarized as follows: 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.
General principles of Bank Management The bank manager has four primary concern: First: is to make sure that the bank has enough ready cash to pay its depositors when there are deposit outflows.(Liquidity management) Second: the bank manager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default & by diversifying asset holdings (Asset Management)
Third: concern is to acquire funds at low cost ( liability Management) Finally: the manager must decide the amount of capital the bank should maintain, and then acquire the needed capital (capital Adequacy management)
A) Liquidity Management & the Role of Reserves Required Reserves: are equal to the amount of demand deposits multiplied by the required reserve ratio. Excess Reserves: are the reserve held above &beyond the amount needed for required reserves Total (Actual ) reserves: Required Reserves+ Excess Reserves
Example Suppose that the first National bank has the following balance sheet position, and the required reserve ratio on deposits is 20% Assets Liabilities Reserves 25 m Deposits 100 m Loans 75 Bank capital 10 Securities 10
1)If the bank suffers a deposit outflow of 6 million, what will its balance sheet now look like?. Must the bank make any adjustment in its balance sheet? Why? 2)Suppose the bank now is hit by another 4 million deposits outflow. What will its balance sheet position look like now? Must the bank make any adjustment in its balance sheet? Why? 3)If the bank satisfies its reserve requirements by selling of securities, how much will it have to sell? Why?
4) After selling off the securities to meet its reserve requirement, what will its balance sheet look like? 5) If after selling off the securities the bank is now hit by another 10 million withdrawals of deposits, and it sells off all its securities to obtain reserves, what will its balance sheet look like? 6) If the bank is now unable to call in or sell any of its loans and no one is willing to lend funds to this bank, then what will happen to the bank and why?
Answer 1)If the bank suffers a deposit outflow of 6 million, what will its balance sheet now look like?. Must the bank make any adjustment in its balance sheet? Why? Assets Liabilities Reserves 19 m deposits 94 m loans 75 Bank capital 10 securities 10 Reserves 25-6= 19, Deposits 100-6= 94 No, because the bank doesn’t need to make any adjustments in its balance sheet. The answer is no because the bank still satisfy its reserve requirement (94 * 20%)== 18.8 million
2) Suppose the bank now is hit by another 4 million deposits outflow. What will its balance sheet position look like now? Must the bank make any adjustment in its balance sheet? Why? Assets Liabilities Reserves 15 m deposits 90 m loans 75 Bank capital 10 securities 10 Reserves = 15 m, Deposits 94 – 4 = 90 m Required reserve : 90 * 20 % =18 m but the reserves are only 15 m, defficiency 3 m The answer is yes because the bank must make an adjustment to its balance sheet, because its required reserve are 18 million. It has a reserve deficiency of 3 million
3) If the bank satisfies its reserve requirements by selling of securities, how much will it have to sell? Why? That bank will have to sell 3 million. As the bank has a reserve shortfall of 3 million, which it can acquire by selling the 3 million of securities. Securities=10-3= 7
4) After selling off the securities to meet its reserve requirement, what will its balance sheet look like? Assets Liabilities Reserves 18m deposits 90 m loans 75 Bank capital 10 securities 7 Reserves 15 m + 3 = 18 m, deposits 90 ( the same ), securities will be 10-3 = 7
5) If after selling off the securities the bank is now hit by another 10 million withdrawals of deposits, and it sells off all its securities to obtain reserves, what will its balance sheet look like? Assets Liabilities Reserves 15m deposits 80m loans 75 Bank capital 10 securities 0 With drawal of deposits = 10m, sells off all its securities: Deposits 90 – 10 = 80 m, all 7 securities will be sold, remaining 3, will be withdrawal from the reserves 18 – 3 = 15 m
6) If the bank is now unable to call in or sell any of its loans and no one is willing to lend funds to this bank, then what will happen to the bank and why? The bank could fail. The required reserves for the bank are 16 million (20% of 80 million), but it has 15 million of reserve. Deposits 80 m * 20% = 16 m but it has 15 m, the proceeds from the distress sale of loans could result in loss that exceeds bank capital causung the bank to become insolvent.
Example Suppose you are the manager of a bank with the following balance sheet, with a required reserve ratio of 10% Assets liabilities Reserve 20 m Deposits 100 Loans 80 Bank capital 10 Securities 10
1)If the bank suffers a deposit outflow of 10 million, what will its balance sheet? 2)Let’s assume that instead of initially holding 10 million in excess reserves, the bank makes loans of 10 million so that it holds no excess reserves. What will its balance sheet position look like now 3)Suppose the bank now is hit by 10 million deposit outflow. What will its balance sheet position look like now? Must the bank make any adjustment in its balance sheet ? Why?
Answer: a) If the bank suffers a deposit outflow of 10 million, what will its balance sheet? Assets liabilities Reserves 10 deposits 90 Loans 80 Bank capital 10 Securities 10 Require reserve ratio= 100 *10%=10 m 90 m *10% =9m
Answer: b) Let’s assume that instead of initially holding 10 million in excess reserves, the bank makes loans of 10 million so that it holds no excess reserves. What will its balance sheet position look like now Assets liabilities Reserves 10 deposits 100 Loans 90 Bank capital 10 Securities 10
Answer: c) Suppose the bank now is hit by 10 million deposit outflow. What will its balance sheet position look like now? Must the bank make any adjustment in its balance sheet ? Why? Assets liabilities Reserves 0 deposits 90 Loans 90 Bank capital 10 Securities 10
Answer: 4 options 1 )sell some of its securities Assets liabilities Reserves 9 deposits 90 Loans 90 Bank capital 10 Securities 1
Answer: 4 options 2 )borrowing from central bank Assets liabilities Reserves 9 deposits 90 Loans 90 Discount loans 9 Bank capital 10 Securities 10
Answer: 4 options 3 )borrowing from other banks Assets liabilities Reserves 9 deposits 90 Loans 90 Borrowing from other banks 9 Bank capital 10 Securities 10
Answer: 4 options 4 )Reducing its loans Assets liabilities Reserves 9 deposits 90 Loans 81 Bank capital 10 Securities 10
B) Assets Management To maximize its profits, a bank must simultaneously seek: a)The highest returns possible on loans & securities b)Reduce Risk c)Make adequate provisions for liquidity by holding liquid assets
Banks try to accomplish these three goals in four basic ways: First: banks try to find borrowers who will pay high interest rates, and are unlikely to default on their loans. Second: banks try to purchase securities with high returns and low risk
Third: banks in managing their assets must attempt to lower risk by diversifying. They accomplish this by purchasing many different types of assets and approving many types of loans to a number of customers Fourth: the bank must manage the liquidity of its assets so that it can satisfy its reserve requirements without bearing huge costs. This means hold liquid securities even if they earn lower return than other assets.
It is not wise for a bank to be too conservative. If it avoids all costs associated with deposit outflow by holding only excess reserves, losses are suffered because reserves earn no interest, while the bank’s liabilities are costly to maintain. The bank must balance its desire for liquidity against the increased earnings that can be obtained from less liquid assets
c) Liability Management Starting in the 1960s large banks began to explore ways in which liabilities on their balance sheet could provide them with reserves and liquidity This led to an expansion of overnight loan markets and the development of new Financial instruments such as: negotiable certificate of deposit.
D) Capital Adequacy Management banks have to make decisions about the amount of capital they need to hold for 3 reasons: First: bank capital helps prevents bank failure Second: the amount of capital affects returns for the owners of the bank Third: a minimum amount of bank capital is required by regulatory authorities
1- how bank capital helps prevent bank failure Banks are exposed to several types of risk First: default Risk: the risk that a loan will not be repaid Second: interest rate risk: or the risk that interest rates may rise after securities have been purchased, depressing the prices of the securities Third: liquidity risk: the risk that depositors may pull their funds out
Fourth: foreign exchange rate risk: the risk that exchange rates may move in a way that causes losses to banks. Fifth: political or country risk: which involves the possibility that a bank’s funds or assets outside the country may be confiscated or otherwise prevented from being returned to the same country
2- how the amount of bank capital affects returns to equity holders Because owners of a bank must know whether their bank is being managed well, they need good measures of bank profitability A basic measure of bank profitability is the return on assets(ROA) net profit after taxes ROA = Assets It indicates how much profits are generated on average by each dollar or assets
Indeed, what the bank’s owners care about most is how much the bank is earning on their equity investment. This information is provided by the other basic measure of bank profitability, the return on equity (ROE) net profit after taxes ROE = Equity Capital
There is a direct relationship between the return on assets, and the return on Equity. this relationship is determined by Equity Multiplier (EM) which is the amount of assets per dollar of equity capital Assets EM = Equity capital
ROE = ROA * EM This equation tells us what happens to the return on equity when a bank holds a smaller amount of equity for a given amount of assets. A high capital to total assets ratio represents a low Equity Multiplier & a low ROE
Example Let ‘s consider two banks with identical balance sheets, except that the High Capital Bank has a ratio of capital to assets of 10%, while the Low Capital Bank has a ratio of 4%
High capital Bank Assets Liabilities Reserves 10m deposits 90 m loans 90 Bank capital 10
Low capital Bank Assets Liabilities Reserves 10m deposits 96m loans 90 Bank capital 4
The high capital bank has 100 million of assets, and 10 million of capital, which gives it an equity multiplier of 10 (100/10) The low capital bank has only 4 million of capital, so its equity multiplier is higher, equaling 25 (100/4) Suppose that these banks have been equally well run so that they both have the same return on assets 1% The return on equity for the high capital bank equals 1% * 10= 10% while
The return on equity for the low capital bank equals 1%*25= 25% We now see why owners of a bank may not want it to hold too much capital.
3- Bank capital Requirements Banks hold capital because they are required to do so by regulatory authorities.
To lower the amount of capital relative to assets, and raise the Equity Multiplier Reduce the amount of bank capital by buying back some of the bank’s stock Reduce the bank’s capital by paying out higher dividends to its stockholders, there by reducing the bank’s retained earnings Keep bank capital constant, but increase the bank’s assets by acquiring new funds
To raise the amount of capital relative to assets Raise capital for the bank by having it issue equity Raise capital by reducing the bank’s dividends to shareholders, there by increasing retained earnings that it can put into its capital account You can keep capital at the same level, but reduce the bank’s assets by making fewer loans
Managing Credit Risk This is the risk arising because borrowers may default The concepts of Adverse selection & Moral Hazard explain or provide a framework for understanding the principles that financial institutions have to follow to reduce credit risk& make successful loans. Adverse selection occurs when the potential borrowers who are the most likely to produce an undesirable outcome are the ones who most actively seek out a loan & are those most likely to be selected
Moral Hazard is the risk that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view, because they make it less likely that the loan will be paid back. The attempts of financial institutions to solve these problems help explain a number of principles for managing credit risk:
1- Screening& monitoring 2- Specialization in lending 3- Enforcement of restrictive covenants 4- fostering Establish long term customers relationships 5- Requiring collateral & compensating balances 6- credit Rationing 7- loan commitment Arrangements
1- Screening Good from bad credit risks Adverse selection in loan markets requires that banks screen out the bad credit risks from the good ones, so that loans are profitable to the bank To accomplish effective screening banks must collect reliable information from prospective borrowers. Effective screening & information collection together from an important principle of credit risk management
2- specializing in lending to particular firms Bank specializes in lending to local firms or to firms in particular industries Opinion 1: it means that the bank is not diversifying its portfolio of loans and thus exposing to more risk Opinion2 : such specialization makes perfect sense 3- Monitoring and Enforcement of Restrictive covenants Once a loan has been made, the borrower has an incentive to engage in risky activities that make it less likely that the loan will be paid off. To reduce this moral hazard, banks should write provisions into loan contracts that restrict borrowers from engaging in risky activities
4- Fostering long term relationships with loan customers An additional way for banks to obtain information about their borrowers is through long term customer relationships The balances in the checking and savings accounts tell the banker how liquid the potential borrower is, and at what time of year the borrower has a strong need for cash Long term relationships benefit the customers as well as the bank A firm with a previous relationship will find it easier to obtain a loan at a low interest rate, because the bank has an easier time determining if the prospective borrower is a good credit risk
5- Requiring collateral & compensating Balances Collateral, which is property promise to the lender as compensation if the borrower defaults, lessens the consequences of adverse selection. If the borrower defaults on a loan, the bank (lender) can sell the collateral & use the precedes to make up for its losses on the loan One particular form of collateral required when a bank makes commercial loans is called compensating balances: a firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank.
6- Rationing Credit (credit Rationing) Credit rationing is a way in which successful banks deal with adverse selection & moral hazard; so that lenders refuse to make loans even though borrowers are willing to pay the stated interest rate or even a higher rate. Credit Rationing takes two forms: First: occur when a bank refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a higher interest rate Second: occurs when a bank is willing to make a loan, but restricts the size of the loan less than the borrower would like
7- loan commitment Arrangements Banks also create long term relationships& gather information by issuing loan commitments to commercial customers. A loan commitment is a bank’s commitment (for a specified future period of time) to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate The advantage for the firm is that it has a source of credit when it needs it. The advantage for the bank is that the loan commitment promotes a long term relationship, which is turn facilitates information collection