Banks and Bank Mgmt. Balance sheet Bank Risks

Bank Balance Sheet Assets: Uses of funds Liabilities: Sources of funds

Assets cash items reserves -- required -- excess deposits at other banks cash items in collection

securities debt securities U.S. gov’t debt public debt loans commercial real estate consumer interbank

Liabilities deposits transaction deposits Non-transaction deposits Savings CDs (large CDs, >$100,000 can be resold)

borrowed funds discount loans (Federal Reserve) federal funds (other banks) commercial paper

Bank capital or net worth = assets – liabilities 10 to 1 leverage! banks have capital requirement cushion against bad loan losses

Bank capital and profits ROE = net after tax profit bank capital Higher bank capital lowers ROE

Bank risks Liquidity risk Credit risk Interest-rate risk Other Trading Foreign currency sovereignty operational

Liquidity Risks Risk of running short of cash need cash to deal with deposit outflows but holding cash drags down profits Holding too little cash, bank incurs costs of raising additional funds

Credit risk Risk of unpaid loans How to minimize? Credit risk analysis Credit history, scores Monitoring, collateral Diversification Tradeoff with the gains of loan specialization

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

liabilities cost of funds goes up with interest rates -- rates on CDs, money market accounts, savings, checking

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 Floating rate loans, swaps

Other Risks Trading risk Securities fluctuate in values Traders do not personally corver losses Solution: monitoring, limits

Foreign exchange risk Currency fluctuations affect value of foreign assets Use derivatives to manage Sovereign risk Governments interfere with currency transfers

Operational risk Damage to physical/computer infrastructure Backup systems, geographically dispersed