Salaar - Finance Capital Markets Spring Semester 2011 Lahore School of Economics Salaar farooq – Assistant Professor

Salaar - Finance Lecture Depository Institutions

Salaar - Finance Depository Institutions Learning Objectives What is a depository institution? How a DI generates income? What is the Asset/Liability problem for DI’s? What is Funding Risk? What are DI’s funding sources? What are Reserve Requirements?

Salaar - Finance Depository Institutions? Include:

Salaar - Finance Depository Institutions? Include: Institutions which take deposits Deposits represent Liabilities (debt) for DI’s Include: Banks Savings & Loan institutions Savings Banks Credit Unions

Salaar - Finance How do DI’s make money? 3 ways:

Salaar - Finance How do DI’s make money? 3 ways: Loans Make direct loans to entities Securities investments Investing in securities & holding portfolios Fees Charged to their customers

Salaar - Finance Importance of DI’s? Heavily regulated because:

Salaar - Finance Importance of DI’s? Heavily regulated because: Their role in financial system a) Creating the financial playing field Principal means of making payments a) Individuals & Businesses use for payments Vehicle for Govt monetary policy a) MP implemented through banking system

Salaar - Finance Because of their importance, Given special privileges Access to Federal Deposit Insurance Provision of liquidity in emergencies Govt has interest in DI’s stability & survival…

Salaar - Finance Asset-Liability Problem of DI’s? 2 Main problems: Funding Risk Liquidity Risk

Salaar - Finance Asset-Liability Problem of DI’s? Funding Risk: Illustrate using 100MM, 7% 1 & 10 yrs Use of Spreads (DI’s make money) Difference between bid/ask or charging premiums Gaps (Mismatches) Open positions created due to duration differences Interest rate exposure Funding/Gapping activity resulting in interest rate risk

Salaar - Finance Asset-Liability Problem of DI’s? Opportunities:

Salaar - Finance Asset-Liability Problem of DI’s? Opportunities: Interest Rate view Mgrs who have expectations of interest rate changes will seek to profit from funding/gapping If Interest rates rise What position should you have? If interest rates fall What position should you have?

Salaar - Finance Asset-Liability Problem of DI’s? Threats of positioning:

Salaar - Finance Asset-Liability Problem of DI’s? Threats of positioning: Adverse financial consequences If expectations are not realized, Huge losses can occur No one can predict interest rates consistently Highly risky? Becomes same as gambling Long run losses highly likely?

Salaar - Finance Main goal of Mgmt: Asset-Liability Problem of DI’s?

Salaar - Finance Main goal of Mgmt: Locking in the spread Minimize interest rate exposure Various financial instruments used to manage risk Asset-Liability Problem of DI’s?

Salaar - Finance Liquidity Concerns of DI’s? Balancing two activities?

Salaar - Finance Liquidity Concerns of DI’s? Balancing two activities: Satisfy Withdrawals of customers Liquidity required Provide Loans to customers Liquidity required

Salaar - Finance Liquidity Concerns of DI’s? 4 ways to solve liquidity issues?

Salaar - Finance Liquidity Concerns of DI’s? 4 ways to solve liquidity issues: Attract deposits Increase borrowing (using security collateral) Sell Securities on hand Raise Funds in Money Markets

Salaar - Finance Liquidity Concerns of DI’s? Increase Borrowing using securities: Discount window borrowing at Fed (last resort!)

Salaar - Finance Liquidity Concerns of DI’s? Sell securities it owns: DI must invest in ST, liquid securities with low price risk and keep these in its inventory E.g stocks?... No, Bonds? …. No Solution: ?

Salaar - Finance Liquidity Concerns of DI’s? Sell securities it owns: DI must invest in ST, liquid securities with little price risk and keep these in its inventory E.g stocks?... No, Bonds? …. No Solution: ST, MM or debt obligations (fed funds)

Salaar - Finance Liquidity Concerns of DI’s? SECONDARY RESERVES? Securities held by a DI for the purpose of satisfying withdrawals or loans. Disadvantage? Lower yield % of assets as secondary reserves depends on DI’s risk/return appetite

Salaar - Finance Liquidity Concerns of DI’s? One more reason for holding liquid assets?

Salaar - Finance Liquidity Concerns of DI’s? One more reason for holding liquid assets? To fulfill Govt regulation! In form of Reserve Requirements (discussed later)

Salaar - Finance Commercial Banks? 3 Main Types:

Salaar - Finance Commercial Banks? 3 Main Types: Individual Banking Institutional Banking Global Banking

Salaar - Finance Commercial Banks? Individual Banking: Consumer Lending Residential Mortgage Installment Loans Credit Card financing Car & Boat Financing Brokerage services Student Loans S10

Salaar - Finance Commercial Banks? Institutional Banking: Loans to Corporations Loans to Insurance companies Loans to Govts Commercial Financing & Leasing

Salaar - Finance Commercial Banks? Global Banking: Investment Banking business Foreign Exchange products Capital Markets products Corporate financing products (underwriting securities etc)

Salaar - Finance Commercial Banks? Banks as Dealers: Investment Banking business Foreign Exchange products Capital Markets products Corporate financing products (underwriting securities etc)

Salaar - Finance Commercial Banks? How do Banks raise Funds?

Salaar - Finance Commercial Banks? How do Banks raise Funds? 3 Main Sources of Funds Deposits Non-Deposit Borrowing (M.MKts) - Debt Common Stock & Retained Earnings

Salaar - Finance Commercial Banks? Reserve Requirement & Borrowing at the Fed Funds Mkt? Banks must maintain a %age of deposits with Fed %age is called Reserve Ratio (depends on deposit type) The cash kept with Fed is called Required Reserve

Salaar - Finance Reserve Requirements? Basic Computation: Deposit Computation Period 2 Week period where the average of the daily is taken to get RR (THR-WED) Actual Reserves RR must be met by Actual Reserves at the Fed Excess Reserves If bank reserves exceed the RR at the Fed Fed Funds Market & Fed Funds Banks short of RR borrow from Excess Reserves of other Banks Called the Fed Funds rate

Salaar - Finance Reserve Requirements? Fed Discount Window: Fed is the Banker’s Bank – last resort Charges DISCOUNT RATE (usually 50bp lower) Collateral Treasury securities, Govt securities etc. Heavily Discourages its use Will investigate if use becomes frequent

Salaar - Finance Depository Institutions Summary What is a depository institution? How a DI generates income? What is the Asset/Liability problem for DI’s? What is Funding Risk? What are DI’s funding sources? What are Reserve Requirements?

Salaar - Finance END DI’s Next Structure of Markets : Primary