1. Chapter 4 Commercial Bank’s Sources and Uses of Funds
Lecture Objectives
1.   To describe the Profit and Loss Account and Balance Sheet of a commercial bank
2.   To identify the sources and uses of funds of commercial banks
3.   To explain the goals and management strategies of commercial banks
4.   To define funds management
5.   To review the latest performance of Hong Kong banking sector

2. Commercial Bank’s Profit and Loss Account
Interest Income
– Interest Expenses
= Net Interest
Income (Spread)

3. Commercial Bank’s Profit and Loss Account
Net Interest Income
– Provision for loan
losses
+ Non-interest Income
(Fees)
– Non-interest Expenses
(Overheads)
= Income before taxes and
investment gain / (loss)

4. Commercial Bank’s Balance Sheet
Assets :
Cash
Amounts due from financial institutions
Trade bills
Advances and loans to customers
Investment
Fixed Assets

5. Commercial Bank’s Balance Sheet
Liabilities :
Amounts due to financial institutions
Deposits from customers
Certificates of deposits
Provisions for loan loss

6. Commercial Bank’s Balance Sheet
Shareholders’ Funds :
Share capital
Reserves

7. Commercial Bank’s Sources and Uses of Funds
A commercial bank’s main sources of funds come from the customers’ deposits, the issue of certificates of deposit, the share capital contributed by the bank’s shareholders and the reserves from the retained profits.

8. Commercial Bank’s Sources and Uses of Funds
A commercial bank’s main uses of funds are for lending to customers and investments. But a commercial bank has to keep substantial funds in the form of cash and short-term investments as liquid assets.

9. Commercial Bank’s Sources and Uses of Funds
The profitability of a commercial bank depends on the composition of its balance sheet and the efficiency of its operation. Nowadays there is a trend to increase the non-interest income because keen competition among commercial banks has decreased the Spread.

10. Commercial Bank’s Sources and Uses of Funds
It is vital for banks to maintain sufficient cash and near-liquid funds to repay depositors. However, the problem of maintaining assets in the form of cash or near-liquid fund is that the more liquid it is, the lower rate of interest it earns. The highest rates of interest are charged for the most illiquid assets, i.e. advances and loans to business and personal customers.

11. Liquidity (L) versus Profitability (P)
Assets
Period
Borrowers
Yield
Cash -
Nil
Money at call
1-14 days
Money market
1%-2%
Bills discounted
1-6 months
Business customers
3%-4%
Investment
6 months – 5 years
Capital market
5%-6%
Advances and Loans
1 day – 30 years
Business and Personal Customers
7%-10% P

12. Goals of a Commercial Bank
Increased shareholders’ wealth
Maximum net earnings
Increased rate of growth
Improved services to the public

13. Commercial Bank’s Financial Management
Management of Assets :
Maximize yields available
Satisfy the liquidity needs and regulations
Management of Liabilities :
Minimize costs of funds raised
Promote the growth in total funds available

14. Commercial Bank’s Financial Management
Management of Capital :
Minimize the owners’ total investment in the firm
Minimize risk exposure
Satisfy the government’s regulations
Marketing Policies :
Identify consumers’ needs
Develop new products, pricing and promotion campaigns
Expense Control :
Increase efficiency in the use of resources
New money-saving methods

15. Commercial Bank’s Risk Management
The focus of the assets and liabilities management of commercial banks is always in the reduction of interest-rate risk, liquidity risk, credit risk and foreign exchange risk.

16. Commercial Bank’s Risk Management
Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. A sound basis for evaluating funds management requires understanding the bank, its customer mix, the nature of its assets and liabilities, as well as the economic environment.

17. Liquidity
A bank has adequate liquidity when it can obtain sufficient funds, either by increasing liabilities or by converting assets into cash, promptly and at a reasonable cost. Liquidity is met through holding high quality short-term assets (like treasury bills). The price of liquidity is the income not earned from not holding lower quality longer-term assets (like some long-term commercial loans).

18. Interest Rate Risk Management
The interest rate risk management is achieved through the asset-liability management of a commercial bank. Management must consider the cost of maintaining liquidity. Changes in money market conditions may cause a deterioration in a bank’s capacity to borrow at a favourable interest rate. Therefore, seasonal and cyclical factors may also cause an increase in loan demand and a decrease in deposits or an increase in deposits and a decrease in loan demand. As a result, the interest rate margins and income may fluctuate.

19. Performance of the Hong Kong banking sector in 2003
The Hong Kong economy was marked by continuing deflation, declining property prices, and historically high unemployment and personal bankruptcies in The economic conditions were aggravated by the SARS outbreak.

20. Performance of the Hong Kong banking sector in 2003
The declining loan demand resulted in a highly liquid banking sector, with the Hong Kong dollar interest rates dropped to a new low. The one-month HIBOR fell to an annual average of 0.92% and the one-month time deposit rate fell to an annual average of 0.07%. But the best lending rate remained unchanged at 5.00%, resulting in a widening interest rate spreads. The spread between the average best lending rate and the average one-month HIBOR widened to 408 basis points.

21. Performance of the Hong Kong banking sector in 2003
However, the pre-tax operating profits of retail banks increased by 5.3% due to gains in treasury operations (foreign exchange trading), increased income from fees and commissions, and reduced bad debt provisions and operating expenses.

22. Performance of the Hong Kong banking sector in 2003
Retail banks’ total lending fell modestly by 0.6% and property lending decreased by 2% in The holding of negotiable debt instruments excluding negotiable certificate of deposits, by retail banks grew by 13.3% in The increase was largely in corporate debt instruments and floating rate notes denominated in foreign currencies.

23. Performance of the Hong Kong banking sector in 2003
The liquidity of retail banks remained high and the loan-to-deposit ratio dipped to 49.6%. But the asset quality of banks improved in 2003 as the classified and non-performing loan ratios dropped to 3.91% and 3.16% respectively.

24. Tutorial
Study the Balance Sheet: All Authorized Institutions.
1.What are the largest items in the Liabilities and Assets ?
2. Discuss the characteristics of the sources and uses of funds of the authorized institutions in Hong Kong.

25. Tutorial
Study the Profit and Loss Accounts and Balance Sheets of the Hongkong and Shanghai Banking Corporation Ltd., Standard Chartered Bank Ltd. and Bank of China Hong Kong Ltd. for the year 2003, compare their strengths and weaknesses.

26. Performance of the Hong Kong Banking Sector in 2003
Performance Indicator
2002
2003
Return on Assets (Before Tax)
0.91%
0.93%
Net Interest Margin
1.52%
1.41%
Bad debt charge to average Total Assets
0.24%
Loan to Deposit Ratio (Hong Kong dollar)
88.5%
81.5%

27. The largest items of liabilities and assets
Deposits from customers
Capital, Reserves and other liabilities
Amount due to Authorized Institutions in Hong Kong
Assets
Loans and advances to customers
Government bills, notes and bonds
Amount due from Authorized Institutions in Hong Kong

28. Sources and Uses of Funds of Authorized Institutions in Hong Kong
The financial intermediation functions prevail. The main source of fund is customers’ deposits and the main use of fund is loans and advances to customers.
The HKD deposits are concentrated in a few big banks like HSBC, Hang Seng Bank, Bank of China, Standard Chartered Bank, etc. Other banks have to borrow HKD funds from the big banks through the interbank market. Therefore, Amount due to AIs and and Amount due from AIs are also important source and use of funds.

29. Sources and Uses of Funds of Authorized Institutions in Hong Kong
Capital and reserves are important sources of fund. The traditional practice is for banks in Hong Kong to reserve a larger portion of the profits as reserves for future business expansion.
Government bills, notes and bonds are high quality short-term assets which the banks hold to earn interest while at the same time to maintain liquidity, because the investment can be converted into cash quickly.

30. Compare the Profit and Loss Accounts of HSBC, SC and BOC for the Year 2003 (HKD’million)
Items
HSBC SC
BOC
Interest Income
55,770
4,790
17,759
Interest Expense
17,032
1,822
4,888
Net Interest Income
38,738
2,968
12,871
Non-interest Income
22,627
1,156
4,385
Operating Expenses
24,024
2,664
5,660
Operating Profit Before Provisions
37,341
2,089
11,596
Provision for Bad and Doubtful Debts
3,386
536
1,671

31. Compare the Profit and Loss Accounts of HSBC, SC and BOC for the Year 2003 (% of Total Income)
Items
HSBC SC
BOC
Interest Income
71%
81%
80%
Non-interest Income
29%
19%
20%
Interest Expense
22%
31%
Operating Expenses
45%
26%
Provisions for Bad and Doubtful Debts 4% 9% 8%

32. Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (HKD’million)
Items
HSBC SC
BOC
Total Assets
2,148,741
120,282
762,586
Advances to customers
815,004
59,744
300,094
Cash and short-term funds
359,137
7,524
134,106
Long-term Investment
399,642
23,500
172,518
Fixed Assets
34,875
884
17,582
Lending to banks
113,322
13,354
78,240

33. Compare the Balance Sheets of HSBC, SC and BEA for the Year 2003 (HKD’million)
Items
HSBC SC
BOC
Total Liabilities
2,009,883
112,567
705,228
Current, Savings and Other Deposits
1,669,704
73,767
600,826
Borrowing from banks
68,111
10,924
41,347
Debt Securities -
6,062
2,432
Shareholders’ Funds
138,858
7,715
57,358

34. Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (HKD’million)
Special Items
HSBC SC
BOC
Assets
HKSAR Government Certificates of Indebtedness
85,294 ?
31,460
Liabilities
HKSAR currency notes in circulation

35. Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (%)
Items
HSBC SC
BOC
Advances to Customers / Total Assets
38%
50%
39%
Long-term Investment (Approximately) / Total Assets
19%
20%
23%
Cash and Short-term Funds / Total Assets
17% 6%
18%
Fixed Assets / Total Assets 2% 1%
Lending to Banks / Total Assets 5%
11%
10%

36. Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (%)
Items
HSBC SC
BOC
Customers’ Deposits and Debt Securities / Total Liabilities
83%
71%
86%
Shareholders’ Funds / Total Liabilities 7% 8%
Borrowing from Banks / Total Liabilities 3%
10% 6%
Loans to Deposits
49%
81%
50%
Cash and Short-term Funds / Customers’ Deposits
22%