1. BuffDaniel Presents
Money and Banking
Chapter 7
Bank Management

2. Balance Sheet: A balance sheet lists the uses of acquired funds, assets; the source of acquired funds, liabilities; and the difference between the two, net worth.
Assets = Liabilities + Capital

3. Assets – use of funds: Bank assets include cash items and funds used in securities investments, loans, and other asset holdings.
The most liquid asset held by banks is reserves, which consist of vault cash—cash on hand in the bank or in deposits at other banks—and deposits with the Federal Reserve System
Required
Excess
The Fed requires banks to hold some of their deposits as required reserves in the form of vault cash or in reserve accounts at a Federal Reserve bank.
Marketable securities are liquid assets that banks trade in securities markets.
U.S. Govt
State and Local
Two-thirds of bank assets are loans
Business
Consumer
Mortgages
Other bank assets include the equipment and buildings the bank owns and collateral received from borrowers in default.
Cash items in processing
Deposits in other banks

4. Liabilities – Sources of funds: Bank liabilities are the funds the bank acquires from savers.
Demand deposits: Banks offer savers checkable deposits, accounts that grant a depositor the right to write checks.
Savings Deposits: To attract funds from depositors who want to earn interest on their funds, banks offer nontransactions deposits, such as savings accounts, money market deposit accounts, and certificates of deposit.
In the United States federal deposit insurance provides government guarantees for account balances up to $100,000.
Borrowings, or nondeposit liabilities, include short-term loans in the federal funds market, loans from a bank’s foreign branches or other subsidiaries or affiliates, repurchase agreements, and loans from the Federal Reserve System (known as discount loans).

5. Bank net worth, or equity capital, is the difference between the value of assets and the value of liabilities.
A bank failure occurs when a bank cannot repay its depositors with enough reserves left to meet its reserve requirements.
To analyze movements in bank profits, use is made of an accounting tool called a T-account, which lists change in balance sheet items from an initial position as they occur.

6. Starting a Bank Why start a bank? Obtain a charter Raise Funds (200)
To make profits for the owners
Make profits by loaning
Obtain a charter
Raise Funds (200)
Building = 100
Cash = 100
Reserve Requirement of 10%
Percentage of Deposits that must be held in the FED
Accept Deposits
Make Loans

7. Revenues Costs Profits Basic Operation Interest income
Noninterest income
Trading income – derivates (options and futures)
Customer fees
Costs
Interest Expense
Loan Losses
Resource Expense
Profits
Revenues - Costs
Basic Operation
T – accounts
Someone opens a checking account
Bank makes a loan
Bank borrows from the FED
What if reserves fall below required amount

8. Services Traditional Modern Checking Savings Loans Bill paying
Retirement accounts
Money market accounts
Investments
Credit and Debit Cards
Insurance
Tax help
Online banking

9. Types of Bank Management
Asset management – maximize profits by loaning, maintaining liquidity, and meeting reserve requirements
Liability management – borrowing from other banks, the FED and corporations and issuing CD’s
Capital Management – prevent bank failure, meet requirements, maintain returns to owners

10. Types of Bank Risk
Leverage Risk – Extent to which a bank’s assets are purchased with debt
Credit Risk – Extent to which a bank’s borrowers will default
Credit or default risk—the risk that the borrower is unwilling or unable to live up to the terms of the liability it has sold
Interest Rate Risk – Extent to which assets and liabilities are subject to interest rate changes
Interest Rate Risk—the risk that the interest rate will unexpectedly change so that the costs of an FI’s liabilities exceed the earnings on its assets or that the value of long-term fixed rate assets has fallen as interest rates rise.
Trading Risk – Extent to which a banks financial instruments are subject to losses caused by the market
Liquidity Risk – Extent to which banks are subject to unexpected withdrawals or unexpected loan demand
Liquidity Risk—the risk that the FI will be required to make a payment when the intermediary has only long-term assets that cannot be converted to liquid funds quickly without a capital loss.
Exchange Rate Risk—the risk that changes in the exchange rate can adversely affect the value of foreign exchange or foreign financial assets.

11. Managing Credit Risk: Banks are concerned about credit risk, the risk that borrowers might default on their loans, which arises because of problems of adverse selection and moral hazard.
Diversification
Banks can reduce credit risk by holding a diversified portfolio of loans.
Banks can also reduce credit risk by performing credit-risk analysis, in which the bank examines the borrower’s likelihood of repayment and general business conditions that might influence the borrower’s ability to repay the loan.
Banks require collateral, or assets pledged to the bank in the event that the borrower defaults.
Collateral requirements
Compensating balances – minimum balance in an account
To reduce adverse selection and moral hazard problems banks sometimes practice credit rationing, in which case the size of a borrower’s loan is limited or the borrower is simply not allowed to borrow any amount at the going interest rate.
Credit rationing – restricting who gets the loan and the amount
To reduce the costs of moral hazard banks monitor borrowers and place restrictive covenants in loan agreements

12. Screening applicants – applying for a loan
One of the best ways for a bank to gather information about a borrower’s prospects or to monitor a borrower’s activities is for the bank to have a long-term relationship with the borrower.
Screening applicants – applying for a loan
Beacon Scores to 850
775+ Preferred
725 – 774 Platinum
700 – 724 Gold
680 – 699 Standard 1
640 – 679 Standard 2
620 – 639 Standard 3
Forget it
Determinants of your credit score
Payment History 35%
Credit cards, retail accounts, carloans, and mortgages
Amount owed 30%
Number of accounts with balances
The amount you owe vs amount of credit available
Credit History 15%
The amount of time you’ve had each account
The longer the better
New credit 10%
Number of accounts opened recently
Number of recent inquiries
Opening accounts in a short period is not good
Types of credit used 10%
Number of credit cards, retail accounts, consumer finance accounts, and mortgages
Less credit cards is better

13. 5 C’s of Credit Character – financial integrity and management skills
Clean credit history and report
Capacity – ability to repay a loan
Income
Profits from business
Ratio of debt to income
Capital – additional funds available or resources
Assets such as Savings
Liabilities such as mortgage or credit card balance
Conditions – external economic and noneconomic influences
Is your job subject to the state of the economy?
Collateral – guarantee or security for a loan
Car or home

14. Maintaining good credit Bankruptcy Types of Loans Lines of Credit
Ratings
Pass
Substandard
Doubtful
Loss – will not be paid back
Maintaining good credit
Bankruptcy
Types of Loans
Lines of Credit
External influences
War
Elections

15. Specializing in the types of loans they provide
Monitoring the covenants of a loan agreement
Enforcing those agreements
Establish long term relationships with customers
Loan commitments to commercial customers for a long period of time (line of credit)

16. Managing Bank Risk: Banks experience interest rate risk if changes in market interest rates cause bank profits to fluctuate
To evaluate their exposure to interest rate risk, banks measure the duration of their assets and liabilities, which is the responsiveness of the assets’ or liabilities’ market value to a change in the market interest rate.
Duration analysis – measures value of assets and liabilities to interest rates
Banks can reduce the risk of interest rate fluctuations through the use of floating-rate debt, with the loan interest rate being variable.
Banks can also reduce their exposure to interest rate (and exchange rate) risk by using swaps, such as an interest rate swap that exchanges the expected future return on one financial instrument for the expected future return on another.
Gap analysis – measures bank profits sensitivity to interest rates

17. Off-Balance Sheet Activities
Letters of Credit and Loan Commitments
Loan Sales – selling a debt
Generation of fee income
ATM fees and over drafts
Trading in other markets

18. Financial innovation: Financial innovation is the creation of new financial instruments, markets, and institutions, new ways for people to spend, save, and borrow funds, and changes in the operation and scope of activities by financial intermediaries.
Financial engineering – coming up with new products and services to meet the needs of the customers
Demand condition changes
Adjustable rate mortgages in Chicago in 1975
Supply condition changes
1960’s with computers came credit cards and debit cards
Electronic banking
Cyber banks
Electronic money
Avoiding Existing Regulations by creating new types of accounts (NOW) that are specified in the requirements

19. Bank Supervision Focus on safety and soundness CAMELS Bank performance
Financial condition
Compliance with regulations
CAMELS
Capital Adequacy
Asset Quality
Management
Earnings
Liquidity
Sensitivity to market risk