Chapter 10 Banking and Bank Management Chapter 9 ALTERNATE 8TH EDITION

Depository Institutions: The Big Questions Where do 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)

Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2011

Balance Sheet of All Commercial Banks (items as a percentage of the total, December 2008) 4

Liabilities – Sources of Funds Checkable Deposits: Referred to as transactions deposits, includes all accounts that allow the owner (depositor) to write checks to third parties; Include non-interest earning checking accounts (known as - demand deposit accounts), Interest earning negotiable orders of withdrawal (NOW) accounts, and Money-market deposit accounts (MMDAs), which typically pay the most interest among checkable deposit accounts

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. Also the largest source of funds.

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

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.

Assets – Uses of Funds Reserves: funds held in account with the Fed (vault cash and cash in the ATM machine is included). Required reserves represent what is required by law under required reserve ratios. Any reserves beyond this are called excess reserves.

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 Treasury debt is often referred to as secondary reserves because of its high liquidity.

Assets – Uses of Funds Loans: business loans, auto loans, and mortgages. Generally not very liquid. 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 (10%, up from 6% in Dec 2008) Transactions deposit available on demand Have declined substantially in importance Transactions deposits were 61% of bank funds in 1960.

Commercial Bank Liability Trend Nontransaction Deposits (55%) Borrowing (23%, around 31% in 2008) Discount loans for the Fed Reserves from other banks in the Federal Funds Market (unsecured) Repurchase agreements Bank Capital (12%, up from 10% in 2008)

Secondary Markets, Increased Liquidity Balance Sheet of Commercial Banks: Changes in Assets (use of funds)over time 1947-2006 Securities Down Secondary Markets, Increased Liquidity Security holdings down from 70% in 1947 to less than 20% in 2011. Loans( C&I, mortgage, and consumer loans) over 50%.

The Balance Sheet of Commercial Banks – Sources of Funds 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.

Basic Banking Transaction Cash Deposit of $100 in First National Bank Assets Liabilities Vault Cash +$100 Checkable deposits Reserves The above example presents 2 ways to record the same transaction. Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits(NOTE: vault cash counts as reserves)

Check Deposit of $100 into FNB written on SNB First National Bank Second National Bank 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 Banks use excess reserves to make loans or invest in bonds. The bank makes a profit because it borrows short and lends long

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

General Principles of Bank Management How does a bank manage its assets and liabilities. Four primary concerns: Liquidity management Asset management Managing credit risk Managing interest-rate risk Liability management Managing capital adequacy

Principles of Bank Management Liquidity Management Reserves requirement = 10%, Excess reserves = $10 million Deposit outflow = $10 million With 10% reserve requirement, bank has excess reserves of $1 million: no changes needed in balance sheet

Liquidity Management No excess reserves - Deposit outflow of $10 million With 10% reserve requirement, bank has $9 million reserve shortfall

Other banks - Federal Funds Market Corporations - CP or Repo 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 - CP or Repo There’s a cost - interest rate paid on the borrowed funds

Liquidity Management: Borrow from the Fed Assets Liabilities Reserves $9M Deposits $90M Loans Borrow from Fed Securities $10M Bank Capital Incur interest 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 (not renewing short-term loans) antagonizes customers Not a liquid asset, other banks may only agree to purchase loans at a substantial discount

Asset Management Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk. Get borrowers with low default risk, paying high interest rates Buy securities with high return, low risk Diversified portfolio Manage liquidity

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 source of funds: from deposits, to CDs, to other debt. Important since 1960s No longer primarily depend on 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 Jan 2007, commercial bank capital was $860 million, 8.8% of assets ($9.77 Billion) June 2011 bank capital at 12% of assets

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

Capital Adequacy Management High Capital bank has a 10% capital ratio. Low Capital bank has a 4% capital ratio.

Capital Adequacy Management: Preventing Bank Failure When Assets Decline Scenario: Borrower defaults on $5 million loan and minimum capital requirement is 5%. High Bank Capital Low Bank Capital Assets Liabilities Reserves $10M Deposits $90M $96M Loans Bank Capital $4M $85M $5M -$1M

Capital Adequacy Management: Return to Equity Holders

Capital Adequacy Management Tradeoff between safety (high capital) and ROE Banks also hold capital to meet capital requirements If Equity Capital ↑ => EM ↓ => ROE ↓

Strategies for Managing Capital What should a bank manager do if she feels the bank is holding too much capital? Buy or retire stock Increase dividends to reduce retained earnings Increase asset growth via debt (like CDs)

Strategies for Managing Capital Reverse these strategies if bank is holding too little capital? Issue stock Decrease dividends to increase retained earnings Slow asset growth (retire debt)

Equity Multiplier and Capital Ratio This 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: http://www2.fdic.gov/qbp/2013dec/cb1.html

Bank Capital U.S. commercial banks combine about $1.5 trillion in bank capital (equity) with $11.0 trillion of borrowed funds to purchase $12.5 trillion in assets. Ratio of debt/equity = 10 to 1 historically. Highly leveraged. Now about 8 to 1. Non-financial corporation about 1 to 1. Ratio of Assets/Equity = 12.5/1.5 = 8.33 (down from over 11) Note: Government guarantees contributes to banks ability to hold so much debt.

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 Savings Inst. 1.91 1.68 .23 8.4 Credit Unions 0.75 .66 .09 Investment Banks 5.4 5.23 .17 31.7 (1/31.7) = .0315 GSEs 1.63 1.56 .067 24.7 Overall 20.5 18.8 1.7 12.2

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 – Sheet 1 Assets Liabilities Cash $10 Debt $90 Loans/Securities $90 Equity Capital $10 Total $100 Total $100 National Capital Bank – Sheet 2 Assets Liabilities Cash $10 Debt $90 Loans/Securities $91 Equity Capital $11 Total $101 capital ratio is 10.89% > 10% National Capital Bank – Sheet 3 Assets Liabilities Cash $10 Debt $99 Loans $100 Equity Capital $11 Total $110 Total $110

Loans/Securities $90 Capital $10 The mechanism works in reverse when times are not so good. Loan portfolio decreases by $1. De-leveraging the balance sheet National Capital Bank - Sheet 1 Assets Liabilities Cash $10 Debt $90 Loans/Securities $90 Capital $10 National Capital Bank – Sheet 2 Assets Liabilities Cash $10 Debt $90 Loans/Securities $89 Capital $9 capital ratio is 9.09% < 10% National Capital Bank – Sheet 3 Assets Liabilities Cash $10 Debt $81 Loans/Securities $80 Capital $9 Total $90 Total $90

How a Capital Crunch Caused a Credit Crunch in 2008 Housing boom and bust led to large bank losses (including losses on SIVs which had to be recognized on the balance sheet). The losses reduced bank capital.

How a Capital Crunch Caused a Credit Crunch in 2008 Banks were forced to either (1) raise new capital or (2) reduce lending. Guess which route they chose? Why would banks be hesitant to raise new capital (equity) during an economic downturn and a financial crisis?

Banks Must Manage Interest-Rate Risk: WHY? Bank assets don’t match liabilities Banks “borrow short” and “lend long” Creates a maturity mismatch

Managing Interest Rate Risk Also, banks have 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) What happens if interest rate rise? Deposit costs based on flexible short-term interest rates rise. Loan revenues based on fixed interest rate remain fixed. Profit reduction

Interest-Rate Risk – Simple Gap Analysis First National Bank Assets Liabilities Rate-sensitive assets $20M Rate-sensitive liabilities $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 [Rate sensitive assets – rate sensitive liabilities] 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

Special Purpose Vehicle Bank Assets Liab. Converting on-balance sheet assets to a securitized asset: SPV is set up solely for this purpose. It acts as a conduit passing cash flows to investors for a fee. It has no rights to the cash flows and it ceases to exist when the Asset Backed Security (ABS) matures. Deposits All Other Assets Other Liabilities Capital Loans Loans Cash SPV Assets Liab. ABS Loans Investors ABS Cash

Structured Investment Vehicle Bank Converting on-balance sheet assets to a securitized asset: SIV is a structured operating company set up to earn higher returns then its cost of funds. Borrows very short-term and invest long-term. How does this differ from a bank? Huge liquidity risk! Assets Liab. Deposits All Other Assets Other Liabilities Capital Loans Cash Loans SIV Assets Liab. ABCP and Repo Loans Commercial Paper Investors Cash