BUSFIN 4211: 5.4 Capital Structure of Banks

5.4 PP

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Banks’ Balance Sheet Includes

• Loans and securities

• Reserves

• Deposits (money added to a bank account)

• Equity

Stats: Average deposits-to-assets ratio is

90% — much higher that non-

financial firms (Ex. Retailers, Manufacturers, like Apple and Nike AI)

Stats: Banks are required to maintain at least

8% of equity by Basel II

Banks’ deposit rates are

much lower than market rates

• Ex. 1 p.p. increase in FFR => 40 b.p. increase in deposit rates

• Banks do not raise deposit rates enough

Bank Deposits:Checking accounts:

regular spending accounts, usually do not pay any

interest

Bank Deposits:Saving accounts:

money-market accounts that pay low interest rates

Bank Deposits:Time deposits:

certificates of deposits that pay higher rates but

require locking money in the bank account

Bank Deposits:Wholesale deposits:

large deposit accounts, usually corporate

Insurance and Risks

• FDIC insures any type of deposits up to $250,000

• No limit on a number of accounts

• Wholesale deposits end up uninsured

Large banks in the US have more than

60% of their deposits insured

Why do customers value deposits?

• Deposits are safe and give access to banks’ services

• Credit cards often require having deposit accounts

• Payment services require deposit accounts

• Customers are ready to forgo higher interest rates to keep their services

What happens when interest rates rise?

• Deposits flow out.

• Banks keep their rates low

• Some depositors decide to invest elsewhere

• Banks make this decision rationally and their profits go up

• Hence, deposits are a very cheap and safe source of financing for banks!

• This only works if deposits are insured

Deposit Franchise Value/Interest Rates

• So when interest rates are high, banks gain something very special

from having leverage (deposit franchise value)

• Because banks’ deposits are valuable, banks make profits from them

when interest rates are high

• Non-financial firms with high leverage suffer from interest rate hikes

Why do banks hold equity?

• Safety measure in case of crisis

• Raising equity is much more

expensive than raising deposits

• Without capital requirements,

banks would probably hold more

deposits

• Some politicians argue for more capital requirement

• Most of the assets are in

loans and securities

• The rest is in reserves at the Fed

More About Reserves

• There are currently no reserve requirements in the US

• Reserves are safe, loans are risky

Loans: Personal loans (credit cards, auto loans) –

usually short-term

Loans: Commercial and Industrial (C&I) loans – Loans designed to provide businesses with funds needed for expenditures.

usually medium-term and syndicated

Loans: Mortgages – Loan used to purchase or maintain a home, land, or other types of real estate.

usually long-term

Banks’ loans are not just risky, they also

pay in long-term

Banks have to

pay for deposits very frequently

Interest Rates and Bank

• Banks only get their loan payments in medium or long term

• This raises interest rate risk

• When interest rates are high, banks’ assets shrink (because more defaults,

lower demand) AI: Think of buying houses and making payments

How do banks hedge against interest risk?

• Direct way.

• Deposit franchise.

• Large banks made trillion dollars after recent policy rate hikes

Direct Way

sell some assets (mortgages become mortgage-backed securities)

• This reduces maturity of assets

SVB: deposits were

uninsured, no franchise value

Silicon Valley Bank SVB: Their assets were also

not marked to market: (AI: Think honesty)

• If assets are classified to be held-to-maturity, they do not need to be marked

to market (AI: Keep the same value)

• Banks cheat and hide their losses doing this

SVB’s asset losses came as a

surprise when they sold their

held-to-maturity MBS

Are banks at risk? Large banks are

fine, some smaller banks with uninsured deposits

might be at risk

Reserves

• On balance sheet, reserves seem tiny

• They pay interest to banks – called Interest on Reserve Balances (IORB)

• Most activities happen off balance sheet

Treasury Settlement

• US Treasury sells $80 billion worth of Treasuries to banks

• Banks sell them to hedge funds

• To settle, hedge funds borrow from the banks using overnight repo

Bank Constraints

• Leverage Ratio

• Leverage Cover Ratio

Leverage Ratio

banks cannot hold too much leverage relative to assets

• Treasuries are low-yield (AI: Low risk, low return)

Leverage Coverage Ratio

banks have to have enough reserves to cope with stress

Why do banks want reserves?

• Combination of LCR and leverage ratio imply that banks cannot lend

to hedge funds too much but they want to sell Treasuries

• Treasury settlements are posted on Fedwire Securities and amount to

more than $2 trillion a day! Interbank transfers are posted on Fedwire and amount to $4 trillion a

day

• This is all off balance sheet, i.e., invisible on balance sheets

Monetary Policy

• Banks need reserves to support the payment system and avoid

shortages such as in September 2019 or March 2020

• Borrowing from the Fed is stigmatized since 2008

• Hence, the Fed is forced to maintain abundant balance sheets

• When banks feel reserve shortage, they cut lending