Chapter 12 Depository Institutions: Banks and Bank Management

Depository Institutions: The Big Questions Where do commercial banks get their funds and what do they do with them? How do commercial banks manage their balance sheets? What risks do banks face?

Balance Sheet of Commercial Banks: Assets, Liabilities, and Capital The balance sheet identity: Bank Assets = [Bank Liabilities + Bank Capital] When one side changes, the other side must change as well. A bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets)

Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2014)

Liabilities are Sources of Funds Checkable Deposits: Called transactions deposits, includes all accounts that allow the owner (depositor) to write checks to third parties: non-interest earning checking accounts (known as - demand deposit accounts because you can demand cash), Interest earning negotiable orders of withdrawal (NOW) accounts, and Money-market deposit accounts (MMDAs), which typically pay the most interest among checkable deposit accounts About 11% of bank source of funds

Liabilities – Sources of Funds Non-transaction Deposits: generally a bank’s highest cost funds. Banks want deposits which are more stable and predictable and will pay more to attract such funds. The largest source of funds ~ 58%

Liabilities – Sources of Funds Borrowings: Banks borrow from: the Federal Reserve System: discount loans other banks: Fed funds and repos corporations: Repos and commercial paper About 20% of bank source of funds

Bank Capital – Source of Funds Bank Capital: the source of funds supplied by the bank owners, either through purchase of ownership shares or retained earnings Bank capital provides a cushion, thus capital levels are important. About 11% of bank source of funds A very important topic in bank regulation.

Assets are Uses of Funds Reserves: funds held in accounts with the Fed (vault cash and cash in the ATM machine is included). Required reserves represent what is required by law - reserve requirement or required reserve ratios. Any reserves beyond this are called excess reserves. About 19% of bank assets.

Assets – Uses of Funds Securities: includes U.S. government debt, agency debt, municipal debt, and other (non-equity) securities. About 19% of assets. Short-term US Treasury debt (Treasury Bills) is often referred to as secondary reserves because of its high liquidity. Commercial banks can not hold stock.

Assets – Uses of Funds Loans: business loans, auto loans, and mortgages. Generally not very liquid. About 53% of bank assets. Most banks tend to specialize in either consumer loans or business loans, and even take that as far as loans to specific groups (such as a particular industry).

Assets – Uses of Funds Other Assets: bank buildings, computer systems, and other equipment.

Commercial Bank Liability Trend Checkable Deposits (11%, up from 6% in Dec 2008) Have declined substantially in importance Transactions deposits were 61% of bank funds in 1960. Transactions deposit available on demand

Commercial Bank Liability Trend Nontransaction Deposits (55%) Borrowing (20%, around 31% in 2008) Discount loans for the Fed Reserves from other banks in the Federal Funds Market (unsecured) Repurchase agreements Bank Capital (11%)

Balance Sheet of Commercial Banks: Changes in Liabilities over time Transactions deposits were 61% of bank funds in 1960, 6.0% in 2008. Borrowings provided only 2% of bank funds in 1960, up to 31% in 2008.

Balance Sheet of Commercial Banks: Change in Assets over time Security holdings down from 70% in 1947 to 20% now. Loans( C&I, real estate, and consumer loans) ~ 50%.

Bank Capital and Profitability Remember that net worth equals assets minus liabilities. Net worth is referred to as bank capital, or equity capital. Capital represents the owners’ stake in the bank. Capital is the cushion banks have against a sudden drop in the value of their assets or an unexpected withdrawal of liabilities. It provides some insurance against insolvency.

Bank Capital and Profitability An important component of bank capital is loan loss reserves: an amount the bank sets aside to cover potential losses from defaulted loans. At some point the bank gives up hope and the loan will be written off - or erased from the balance sheet. At this point, the loan loss reserve is reduced by the amount of the loan that has defaulted.

Bank Capital and Profitability Data in Table 12.1 shows in Dec. 2015, bank capital was $1.7 trillion. This was combined with $13.8 trillion of liabilities to purchase $15.5 trillion of assets. Couple of ways to look at this: ratio of debt to equity is 8.1 to 1 ratio of equity to assets is about 11% ratio of assets to equity is 9.11 every $100 is assets was financed with $11 of equity and $89 of debt This is a substantial amount of leverage.

Bank Capital and Profitability Although that is a substantial amount of leverage, it is nearly 25% below the average commercial bank leverage ratio that prevailed prior to the financial crisis of 2007-2009. Debt-to-equity ratio for nonfinancial business in the U.S. is less than 1 to 1. Household leverage is roughly 1/3 to 1.

Bank Capital and Profitability Recall from Chapter 5, leverage increases expected return and risk. Expected return and risk doubles if leverage ratio (ratio of assets-to-equity)increases from 1-to-1 to 2-to-1. For banks the ratio is 9-to-1. Risk and return increase by a factor of 9! Banking is a risky business.

Bank Capital and Profitability One explanation for the relatively high degree of leverage in banking is the existence of government guarantees like deposit insurance. These government guarantees allow banks to capture the benefits of risk taking without subjecting depositors to potential losses.

Basic Banking Transactions Cash Deposit of $100 in First National Bank Assets Liabilities Vault Cash +$100 Checkable deposits Reserves The above example presents two ways to record the same transaction. Opening of a checking account leads to an equal increase in the bank’s reserves. NOTE: vault cash counts as reserves

First National Bank (FNB) Second National Bank (SNB) Basic Banking Transaction Check Deposit of $100 into First National Bank that is written on Second National Bank First National Bank (FNB) Second National Bank (SNB) Assets Liabilities Reserves +$100 Checkable deposits -$100 FNB gains reserves and SNB loses reserves

Basic Banking - Making a Profit First National Bank Assets Liabilities Required reserves +$10 Checkable deposits +$100 Excess reserves +$90 Loans 10% Reserve Requirement Bank use excess reserves to make loans or invest in bonds. Bank makes a profit because it borrows short (at a relatively low interest rate) and lends long (at a relatively high interest rate)

General Principles of Bank Management The basic operation of a bank - Make profits by: Selling liabilities with one set of characteristics (high liquidity, low risk , small size, low return). [Source of Funds] Buying assets with a different set of characteristics (low liquidity, high risk ,large size, hugh return). [Use of Funds] Process known as “asset transformation” also referred to as “maturity transformation.”

General Principles of Bank Management Managing Risk. Four primary concerns: Liquidity Risk Credit Risk Interest Rate Risk Capital adequacy I do not cover trading risk.

Managing Liquidity Risk Reserves requirement = 10%, Excess reserves = $10 million Deposit outflow = $10 million After the deposit outflow, the bank has excess reserves of $__million. Is there a need to change the balance sheet?

Managing Liquidity Risk Reserves requirement = 10%, Excess reserves = $10 million Bank with no excess reserves - Deposit outflow of $10 million With 10% reserve requirement, bank has $9 million reserve shortfall

Other banks - Federal Funds Market Liquidity Management - Shortfall in Reserves: Borrow from other banks or corporations. Assets Liabilities Reserves $9M Deposits $90M Loans Borrowing Securities $10M Bank Capital Other banks - Federal Funds Market Corporations – Issue CP or engage in Repo There’s a cost - interest rate paid on the borrowed funds

Liquidity Management - Shortfall in Reserves: Borrow from the Fed Assets Liabilities Reserves $9M Deposits $90M Loans Borrow from Fed Securities $10M Bank Capital There’s a cost - payments to Fed based on the discount rate

Liquidity Management: Sell Securities Assets Liabilities Reserves $9M Deposits $90M Loans Bank Capital $10M Securities $1M There are costs: transaction costs and possible capital loss.

Liquidity Management: Reduce Loans Assets Liabilities Reserves $9M Deposits $90M Loans $81M Bank Capital $10M Securities Reduction of loans is the most costly way of acquiring reserves Calling in loans (basically not renewing short-term loans) antagonizes customers Loans are not a liquid asset. Other banks may only agree to purchase loans at a substantial discount

Asset Management - Credit Risk: Overcoming Adverse Selection and Moral Hazard Screening and information collection Specialization in lending (e.g. energy sector) Diversification - by industry and geography Monitoring and enforcement of restrictive covenants Long-term customer relationships Collateral and compensating balances

Liability Management Managing the sources of funds: from deposits, to CDs, to other debt. Important since 1960s Banks no longer primarily depend on transactions deposits More dependent on non-transactions deposits and borrowing. Growth in borrowing from 2% in 1960 to 31% in 2008. Negotiable CDs at 19%

Bank Capital (Equity) Assets – Liabilities = Net Worth Called Bank Capital. The value of the bank to its owners. In Dec 2006, commercial bank capital was $0.86 trillion equal to 8.8% of total assets of $9.77 Trillion In Dec 2015, commercial bank capital was $1.7 trillion equal to 11% of total assets of $15.5 Trillion

Capital Adequacy Management Bank capital is a cushion that helps prevent bank failure. As banks write down assets, bank capital takes a hit. Regulators set minimum capital requirements.

Capital Adequacy Management Scenario: Borrower defaults on $5 million loan High Bank Capital Low Bank Capital Assets Liabilities Reserves $10M Deposits $90M $96M Loans Bank Capital $4M $85M $5M -$1M

Basic Strategies for Managing Capital What should a bank manager do if she feels the bank is holding too little capital (i.e., the capital ratio is too low)? Issue stock to attract new capital Decrease dividends to increase retained earnings which adds to equity Slow asset growth (retire debt)

Capital Adequacy Management: Return to Equity Holders

Capital Adequacy Management Tradeoff between safety (high capital) and ROE Prudent to hold equity capital. Unfortunately, banks aren’t very prudent. If Equity Capital ↑ => EM ↓ => ROE ↓

Equity Multiplier and Capital Ratio EM is actually a measure of leverage EM = 10, means $1 of equity supports $10 in assets. The bank borrows $9. EM = 25, means $1 of equity supports $25 in assets. The bank borrows $24. EM is the inverse of the capital ratio

Bank Profitability ROA is typically 1.2 to 1.3% ROE is 10 to 12 times ROA. Let’s take a look: https://www2.fdic.gov/qbp/2014dec/cb1.html

Leverage of Various Financial Institutions prior to Financial Crisis Assets $Trillion Liabilities Equity Leverage Assets/Equity Commercial Banks 10.8 9.7 1.1 9.8(10.2%) Savings Inst. 1.91 1.68 .23 8.4(11.9%) Credit Unions 0.75 .66 .09 Investment Banks 5.4 5.23 .17 31.7 (1/31.7) = 3.15% GSEs 1.63 1.56 .067 24.7(4.0%) Overall 20.5 18.8 1.7 12.2(8.2%)

Loans/Securities $90 Equity Capital $10 Total $100 Total $100 Suppose banks are required to maintain a capital ratio of 10%. Assume times are good and loan portfolio increases by $1. National Capital Bank – January Assets Liabilities Cash $10 Debt $90 Loans/Securities $90 Equity Capital $10 Total $100 Total $100 National Capital Bank – June Assets Liabilities Cash $10 Debt $90 Loans/Securities $91 Equity Capital $11 Total $101 capital ratio is 10.89% > 10% National Capital Bank – December Assets Liabilities Cash $10 Debt $99 Loans $100 Equity Capital $11 Total $110 Total $110

Loans/Securities $80 Capital $9 Total $90 Total $90 The mechanism works in reverse when times are bad. Loan portfolio decreases by $1. De-leveraging the balance sheet National Capital Bank - January Assets Liabilities Cash $10 Debt $90 Loans/Securities $90 Capital $10 Total $100 Total $100 National Capital Bank – June Assets Liabilities Cash $10 Debt $90 Loans/Securities $89 Capital $9 Total $99 Total $99 capital ratio is 9.09% < 10% National Capital Bank – December Assets Liabilities Cash $10 Debt $81 Loans/Securities $80 Capital $9 Total $90 Total $90

National Capital Bank – June Banks do not have to de-leverage if they can raise more equity capital and pay off some debt National Capital Bank – June Assets Liabilities Cash $10 Debt $89.1 Loans/Securities $89 Capital $9.9 Total $99 Total $99 capital ratio is = 10%

How a Capital Crunch Caused a Credit Crunch in 2008 Housing bust led to large bank losses Value of assets reduced. The losses reduced bank capital. Banks required to rebuild capital – a capital crunch! Banks had two option: (1) raise new capital, or (2) reduce lending. Which option?

Managing Interest Rate Risk In addition to the borrow/short - lend/long mismatch, banks also have a mismatch between assets and liabilities that are interest-rate sensitive and non-interest rate sensitive. For example, deposit rates tied to market rates (interest rate sensitive cost) long-term fixed rate loan ( Non-interest rate sensitive income)

Managing Interest Rate Risk What happens if interest rate rise? Deposit rates tied to flexible short-term interest rates rise. Loan revenues based on fixed interest rate remain fixed. Profits fall.

Interest-Rate Risk – Simple Gap Analysis First National Bank Assets Liabilities Rate-sensitive assets(RSA) $20M Rate-sensitive liabilities (RSL) $50M Variable-rate and short-term loans Variable-rate CDs Short-term securities Money market deposit accounts Fixed-rate assets $80M Fixed-rate liabilities Reserves Checkable deposits Long-term loans Savings deposits Long-term securities Long-term CDs Equity capital If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits

Interest Rate Risk: Gap Analysis Basic Gap Analysis (RSA – RSL) x Δ interest rate = Δ bank profits

Managing Interest-Rate Risk Basis Gap Analysis GAP = rate-sensitive assets – rate-sensitive liabilities = $20 – $50 = –$30 million When i  5%: 1. Income on assets = + $1 million (= 5%  $20m) 2. Costs of liabilities = +$2.5 million (= 5%  $50m) 3. Profits = $1m – $2.5m = –$1.5m = 5%  (GAP) = 5%  ($20 - $50) = .05x -$30 =-$1.5 4. Profits = i  GAP

Off-Balance-Sheet Activities Loan sales Fee income from Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit Trading Activities and Risk Management Techniques Financial futures and options Foreign exchange trading Interest rate swaps All these activities involve risk and potential conflicts