FMI Lec13 Commercial Banking

largest class of financial intermediaries

commercial banks

Are deposits assets or liabilities

liabilities

Are loans assets or liabilities

assets

investment banks are not ______

depository

mutual funds

“pool” deposits and issue shares, ppl invest, and buy securities

• not depository

• issue shares

• collect proceeds

• invest in other securities

Commercial banking assets

• reserves and cash

• securities (gov debt)

  • loans

Commercial banking liabilities

• deposits

• s-t borrowing

  • capital:difference between Assets and Liabilities

OBS: Off-balance sheet items

1. securitization — sell loans to free up balance sheet

2. loan commitments — promises to lend to x in the future

   1. trading/hedging— options, futures, interest rate swaps

When are OBS items considered?

When evaluating equity because they can be risky. Can be used to conceal liabilities and bolster assets

Asset transformation

eg turning a deposit (liability) into a mortgage (asset)

profitable but risky

Maturity transformation

borrow short (deposits) lend long (loans)T

The mismatch of timelines in maturity transformation increases _____

interest rate risk

4 concerns of commercial banks

1. liquidity management

2. asset management

3. Liability management: how to fund banking

4. capital adequacy= enough equity to absorb losses

maturity of _____ > maturity of _____

maturity of assets > maturity of liabilities

need liquidity, as creditors may need to be paid before assets mature

Liquidity management

need enough reserves to pay debt

1. borrow from other bank (fed funds)

2. sell securities (transaction costs)

3. borrow from fed (discount window)

4. call in or sell off loans (loss of rep+low liquidity)

bank run

mismatch of maturities leads to inability to handle panicked withdrawals

asset management

try to earn highest ROA while minimizing risk

1. screening borrowers

2. buy good securities

3. diversify

4. manage liquidity

How to choose between funding with additional deposits or issuing commercial paper

If you take deposits, you must keep eg 10% reserves. Compare the ratio of interest paid / money available to lend

Commercial banks increasingly use ___ based funding

market

Larger banks rely less on ____ than smaller banks

deposits

deposits have lower ____ but are more expensive because of _____

deposits have lower interest rate costs but are more expensive because of reserve requirements

____ is an easy buffer for absorbing loan losses

capital

How does capital affect bank profitability

higher capital lowers bank profitability — ROC (ROE) falls if equity rises

Is bank capital an asset or liability on BS

liability

Insolvency

sale of all banks assets would not raise enough to reimburse creditors

forced into bankruptcy, ownership change, or stockholders provide new funds

Banks prefer ___ equity, while government enforces ____

low

high

Options to raise capital/equity

1. issue stock

2. reduce divs to grow retained earnings

3. slow asset growth— reduce loans, sell assets

Credit Crunch 2007

housing boom and bust = bank losses

losses reflected on balance sheet → bank capital reduced

banks could either raise new capital or reduce lending.

raising capital unappealing due to low stock prices.

Became hard to get credit

ROA

net income (excl taxes, loan loss provisions)/Assets

Equity multiplier

Equity multiplier * Equity = Assets

EM * ROA =

ROE

Net Interest Margin

how well bank generates income from its core function