Organization of Banking - 2. The Banking Environment
Balance Sheet
Assets
Assets: legal obligation by another party to replay principal plus any contracted interest to the bank within a specified period.
Loans: lending is the bread and butter business of commercial banks.
Commercial and Industrial Loans: loans that banks extend to business enterprises to meet day-to-day cash needs or to finance purchases of plants and equipment.
It accounts for more than 12% of total bank assets.
Consumer loans: so consumers can finance automobiles, mobile homes or household appliances.
Typically issued through instalment credit agreements.
9% of total bank assets.
Real Estate Loans: to finance purchases of real property, buildings, and fixtures.
Interbank loans: banks lend funds to each other directly.
Securities: treasury bills, notes, and bonds.
Cash assets: the most liquid bank asset that functions as media of exchange.
Vault cash: currency that commercial banks hold at their offices.
Reserves held within the central bank.
Correspondent balances: funds that banks hold on deposit with other private banking institutions.
Cash items in process of collection: listed as deposited for immediate credit, but may have to cancel if payment on the items is not received.
Liabilities and equity
Liability: the value of a legal claim on a bank’s asset.
Transaction deposit accounts: accounts for which owners may draw funds via checks or debit cards.
Large-denomination time deposits: denominations exceeding 100,000
Most are certificates of deposit (CDs) that fund a significant portion of banks’ short-term lending operations.
Savings deposits and small-denomination time deposits
Purchased funds: interbank borrowings, central bank borrowings and repurchase agreements.
Subordinated notes and debentures: bank debt instruments with maturities in excess of one year.
Bank capital: its net worth, or the amount by which it’s assets exceed its liabilities.
Income statement
Interest income accounts for 2/3 of revenue.
Derived from loan interest income.
Non-interest income: obtained from sources other than interest income, such as trading profits and customer service charges.
Selling of loans to other financial institutions.
Interest expenses: to attract funds, banks must pay interest on liabilities.
Accounts for just over 40% of total costs.
Expenses for loan loss provisions: banks earmark part of their cash assets as loan loss reserves.
Real resource expenses: bank must pay wages and salaries to its employees, purchase or lease other capital goods such as buildings and computer equipment.
Bank profitability measures: a bank’s net income is the dollar amount by which its combined interest and non interest income exceeds its total cost.
Return on assets and equity.
Asymmetric information
Adverse selection: the potential that those who desire funds for undeserving projects are the most likely to seek credit.
Borrowers gamble with funds that are not their own, so they are more likely to pursue projects with higher risks.
Moral hazard: borrowers may diverge from previously intended uses of funds.
Risk
Risks on Balance Sheets
Credit risk: the probability that a portion of the institution's assets will decrease in value.
Market risks: exposure to price and interest rate risk.
Liquidity risk: the probability of having insufficient cash and borrowing capability to satisfy desired depositor withdrawals.
Systemic risk: risks confronted by individual institutions have the potential to spill over onto others.
Risks not on balance sheets
Loan commitments: a promise by a bank to extend credit up to some pre-specified limit under a contracted interest rate and within a given interval.
Fixed-rate loan commitment: the interest rate on any credit drawn down by the borrower is set at a predetermined level
Floating-rate loan commitment: ties the loan rate to another market interest rate, such as the prime loan rate
Obligates a bank to bring a loan onto its balance sheet upon a customer's request.
Securitization: pooling loans with similar risk characteristics and selling this loan pool in the form of a negotiable financial instrument.
Addresses a portion of a bank’s credit and market risks by moving part of its loan portfolio off its balance sheet.
Pass-through security: passes interest and principal payments that a bank receives from borrowers through to investors on a proportionate basis
Pay-through security: a bank initially holds the interest and principal payments for an underlying pool of loans and then reallocates them into two or more separate sets of securities.
Trends
Changes in banking structures have enabled researchers to explore these effects in considerable detail.
Mergers and acquisitions.
Summary
Bank assets include loans, securities, and cash assets.
In the United States, recent years have witnessed a general increase in loan assets in proportion to total assets and a significant rise in real estate lending as a share of total lending.
Bank liabilities include transaction, savings, and time deposits and borrowings in the form of purchased funds and subordinated notes, with shares of the latter rising over time in proportion to total U.S. bank liabilities and equity capital at the expense of deposits’ shares.
During past decades, bank equity capital initially declined steadily relative to total assets until a recent upturn took place in response to capital-focused regulation.
Interest income accounts for about half of the revenues of U.S. banks, although non-interest income’s share of revenues has trended upward in recent years.
Interest expense and loan loss reserve accruals account for about half of U.S. banks’ costs.
Labor expenses contribute to nearly one-fourth of U.S. banks’ costs.
Two key measures of bank profitability, return on assets and return on equity, were very stable at U.S. banks until the late 2000s, when both measures turned negative even as another profitability indicator, net interest margin, remained stable.
Bank balance sheets are exposed to credit, market, liquidity, and systemic risks that are influenced by asymmetric information problems arising from adverse selection and moral-hazard sources.
Banks also experience off-balance-sheet sources of risk arising from commitment lending, securitization, and derivatives trading.
Since the 1990s, scores of banks and hundreds of billions of dollars of assets have been involved in mergers and acquisitions.
As a result, during the past 25 years the number of U.S. banks has dropped and the concentration of deposits among larger banks has risen even as the number of bank branches has steadily increased.