1. Bank Business Models and the Financial System: An Overview
B BUS 558, Spring 2014
Bank Business Models and the Financial System: An Overview

2. Introduction to Bank Business Models
What is a bank?
What are principal ways in which banks make money?
To whom are they answerable? For what aspect of their performance?
What are the key risks?
What are the implications for financial reporting?

3. The Economics What is a bank?
Financial institution that arbitrages across horizon mismatches in the economy:
Depositors want liquidity and safety … short term
Borrowers want long term capital … longer term
What are principal ways in which banks make money?
Interest received – interest paid: “wedge”
Fees
Returns on investments

4. Accountability
To whom are they answerable? For what aspect of their performance?
Depositors
Equity providers
Loan capital providers
Regulators
Borrowers

5. Risks & Financial Reporting
What are the key risks?
LOB 1: Lending
Interest rate risk
Prepayment risk … fee implications
Default risk
LOB 2: Borrowing (depositors)
Interest rate risk … fee implications, “float”
Early withdrawal risk
LOB 3: Investment
Market risk
Systemic/regulatory risk
Crisis … respond to increased capital requirements
What are the implications for financial reporting?

6. Consider an island economy with one bank.
The bank takes deposits and makes loans. Depositors are (a) net suppliers of assets and (b) can withdraw their funds on demand. Depositors therefore are the bank’s creditors while borrowers are its debtors.
Tension: Depositors want no losses. (They want all their money back).
Solution: Obtain risk (equity) capital.
Price: Cost of risk must be covered.
What are the implications of these arrangements for the bank’s business model?
Let the total deposits be $1 and the rate of interest paid on deposits be r.
Suppose the bank lends $α, [0<α<1], at an interest rate i.
Sample Bank F/S
Interest Income iα
Interest Expense r
Profit (to equity) p
Bank 1 $
Retail
Depositors
Borrowers
What are the banker’s key challenges?
Default risk: borrowers may fail to repay.

7. But higher i reduces demand for money. Friction!
Note that α must be > 0 for the bank to profitable and, in this basic economy, it must also be < 1 since the bank cannot lend more than its deposits.
Sample Bank F/S
Interest Income iα
Interest Expense r
Profit (to equity) p
In efficient markets, i, r and p all will depend on α, i.e., on bank riskiness .
As α → 1, the wedge changes because
the first term ↓, but,
risk ↑ as well and the 2nd term, p(α)↓.
The “right” α* “balances” these two forces.
“wedge”
Introducing equity raises the cost of lending. Even when α=1, the risk premium p(α) must still be recovered so that i>r!
But higher i reduces demand for money. Friction!

8. Innovation: Moral(s) of the story of our island economy thus far:
Balancing liquidity (to serve depositors) and risk (of borrower default) are the twin challenges of a banker. Increasing liquidity by reducing α increases the wedge because the bank must cover (1) the cost of undeployed funds, r(α)*α, and (2) the insurance premium or cost of risk-bearing p(α).
Innovation:
If, somehow, α could be increased to above 1, i.e., the bank could lend more than it takes in by way of deposits, then the wedge could be reduced because
If the bank can borrow at a rate lower than i, it can use leverage to increase profits. If bank issues $δ of debt at a rate rδ (<i), the cost of the debt is rδδ. The bank can now lend up to αd=$1+δ-c, where c is a liquidity cushion. The bank’s earnings now are:
Sample Bank I/S
Interest income iαd
Interest expense r+ (1-τ)rδδ
Profit iαd - [r+rδδ] = (iα-r) + [i(αd -α) - rδδ]
= p + [i(αd -α) - rδδ]
Incremental
amount lent
borrowing cost
Profit at “old” lending levels
Incremental profit from using leverage

9. 1st generation banking system Bank 1 Interconnections …
Conduit
(SPE?)
Loans
ABS
ABS Markets
Long-term
Investors $
Arbitrageurs
“Shadow banks”
Other asset markets
Defaults
1st generation banking system
Bank 1 $
Retail
Depositors
Borrowers
Interconnections …
GSEs
Inter-bank
loan market
Fed
Saturation
Bank 2 $
Retail
Depositors
Borrowers
2nd generation banking system
Markets collapse, the banking system does not!

10. More interconnections
Bank 1 $
Retail
Depositors
Borrowers
Bank 2
Fed
Inter-bank
loan market
GSEs
Conduit
(SPE?)
Loans
ABS
ABS Markets
Long-term
Investors
Arbitrageurs
“Shadow banks”
Other asset markets
Defaults
More interconnections
3rd generation banking system
Innovation: allow arbitrage between asset and inter-bank markets (allow shadow banks access to inter-bank markets, allow banks to own arbitrage units).
Inter-bank market (cheaper capital) becomes net lender to asset markets (higher returns)
As asset markets collapse, owners of those assets have to take write-downs, impairing their balance sheets (and creditworthiness). They cannot repay the amounts borrowed from the inter-bank market and default. These defaults trigger losses for banks, causing a potential run on the bank by panicked depositors unless a tall bearded uncle wearing a top hat and red white and blue cummerbund shows up with bags of $$$ in hand …

11. Bank Project Pick a large money center bank (why?)
Identify its systemic interconnections
Bank F/S
Research: analysts commentary, press reports …
Reference: Harris, Hertz and Nissim (2012)
Pick a disclosure related to securitization risks or some other complex financial exposure
Examine & grade the reporting