Banking and Management of Financial Institutions Notes

The Bank Balance Sheet

• Total assets = Total liabilities + Bank capital (banks’ net worth)

• Banks acquire funds by issuing (selling) liabilities, referred to as sources of funds.

Liabilities

• Checkable Deposits

  • Bank accounts allowing the owner to write checks to third parties.

  • Include all accounts on which checks can be drawn.

  • An asset for the depositor (part of their wealth).

  • A liability for the bank (depositor can withdraw funds).

• Nontransaction Deposits

  • Owners cannot write checks.

  • Interest rates are usually higher than on checkable deposits.

  • Fixed/Time deposits have fixed maturity lengths (several months to over five years).

  • Substantial penalties for early withdrawal.

• Borrowings

  • Banks borrow from the Central Bank, other banks, and corporations.

  • Borrowings from the Central Bank are called discount loans (advances).

  • Banks borrow reserves from other banks and financial institutions in the Federal (fed) funds market in the U.S.

• Bank Capital

  • The bank’s net worth.

  • Equals the difference between total assets and liabilities.

  • A cushion against a drop in asset value, preventing insolvency.

Assets

• Reserves

• Cash items in process of collection

• Deposits at other banks

• Securities

• Loans

• Other assets

Assets - Details

• Reserves

  • Banks hold funds as deposits in an account at the Central bank.

  • Held due to reserve requirements: a fraction of checkable deposits must be kept as reserves.

  • Required reserve ratio: $10\%$, for example.

  • Excess reserves: Additional reserves held because they are liquid and can be used to meet obligations when funds are withdrawn.

• Cash Items in Process of Collection

  • A check written on another bank's account is deposited in your bank, but funds haven't been received yet.

  • It is an asset because it is a claim on another bank for funds.

• Deposits at Other Banks

  • Small banks hold deposits in larger banks for services like check collection, foreign exchange transactions, and securities purchases.

  • Correspondent banking system.

• Securities

  • Important income-earning asset.

  • Made up entirely of debt instruments for commercial banks (banks are not allowed to hold stock).

  • According to Section 19(2) of the Banking Regulation Act, 1949, shares held by a banking company in any other company should not exceed $30\%$ of the paid-up share capital of that company or $30\%$ of its own paid-up share capital and reserves, whichever is less. Investments by a bank in a subsidiary company, financial services company, financial institution, stock, and other exchanges should not exceed $10\%$ of the bank’s paid-up share capital and reserves, and the investments in all such companies should not exceed $20\%$. See https://www.rbi.org.in/commonman/english/Scripts/Notification.aspx?Id=905

• Loans

  • Banks make profits primarily by issuing loans.

  • A loan is a liability for the recipient but an asset for the bank.

  • Loans have a higher probability of default than other assets.

  • Banks earn the highest return on loans due to lack of liquidity and higher default risk.

• Other Assets

  • Physical capital (bank buildings, computers, and other equipment).

Basic Banking

• Cash Deposit: Opens a checking account with a $100$ bill.

  • She now has $100$ checkable deposit at the bank, which shows up as a $100$ liability on the bank’s balance sheet.

  • The bank now puts her $100$ bill into its vault so that the bank’s assets rise by the $100$ increase in vault cash.

  • Vault cash increases by $+100$, checkable deposits increases by $+100$. Reserves increases by $+100$, checkable deposit increases by $+100$.

• Check Deposit

  • If Jane opened her account with a $100$ check written on an account at another bank, say, the Second National Bank, we would get the same result.

  • The First National Bank is owed $100$ by the Second National Bank. This asset for the First National Bank is entered in the T-account as $100$ of cash items in process of collection.

  • Cash items in process of collection increases by $+100$, checkable deposits increases by $+100$.

Basic Banking - Deposits and Reserves

• When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves.

  • Reserves increases by $+100$, checkable deposits increases by $+100$.

  • Reserves decreases by $-100$, checkable deposits decreases by $-100$.

• If the required reserve ratio is $10\%$, the First National Bank's required reserves have increased by $10$.

  • Required reserves increases by $+10$, Checkable deposits increases by $+100$, excess reserves increases by $+90$.

• The bank must put to productive use all or part of the $90$ of excess reserves it has available.

• Let us assume that the bank chooses not to hold any excess reserves but to make loans instead.

• The bank is now making a profit because it holds short-term liabilities such as checkable deposits and uses the proceeds to buy longer-term assets such as loans with higher interest rates.

• Asset transformation: selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics.

• The bank borrows short and lends long

  • Required reserves increases by $+10$, checkable deposits increases by $+100$, loans increases by $+90$.

General Principles of Bank Management

• The bank must have enough ready cash to pay its depositors when there are deposit outflows.

• Liquidity management: Acquisition of sufficiently liquid assets to meet the bank’s obligations to depositors.

• Asset management: Pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings.

• Liability management: Acquire funds at low cost.

• Capital adequacy management: Decide the amount of capital the bank should maintain and then acquire the needed capital.

• Credit risk: Managing the risk arising because borrowers may default.

• Interest-rate risk: Managing the riskiness of earnings and returns on bank assets that result from interest-rate changes.

Liquidity Management and the Role of Reserves

• Excess reserves:

  • The bank’s required reserves are $10\%$ of $100$ million, or $10$ million.

  • Since it holds $20$ million of reserves, the First National Bank has excess reserves of $10$ million.

  • Assets: Reserves $20M$, Loans $80M$, Securities $10M$. Liabilities: Deposits $100M$, Bank Capital $10M$.

• If a deposit outflow of $10$ million occurs, the bank’s balance sheet.

  • The bank loses $10$ million of deposits and $10$ million of reserves, but since its required reserves are now $10\%$ of only $90$ million ($9$ million), its reserves still exceed this amount by $1$ million.

  • Assets: Reserves $10M$, Loans $80M$, Securities $10M$. Liabilities: Deposits $90M$, Bank Capital $10M$.

• In short, if a bank has ample reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet.

• Shortfall

  • Let’s assume that instead of initially holding $10$ million in excess reserves, the First National Bank makes loans of $10$ million, so that it holds no excess reserves.

    • Assets: Reserves $10M$, Loans $90M$, Securities $10M$. Liabilities: Deposits $100M$, Bank Capital $10M$.

  • When it suffers the $10$ million deposit outflow, its balance sheet becomes:

    • Assets: Reserves $0M$, Loans $90M$, Securities $10M$. Liabilities: Deposits $90M$, Bank Capital $10M$.

  • After $10$ million has been withdrawn from deposits and hence reserves, the bank has a problem: It has a reserve requirement of $10\%$ of $90$ million, or $9$ million, but it has no reserves!

  • To eliminate this shortfall, the bank has four basic options. One is to acquire reserves to meet a deposit outflow by borrowing them from other banks in the federal funds market or by borrowing from corporations.

    • If the First National Bank acquires the $9$ million shortfall in reserves by borrowing it from other banks or corporations, its balance sheet becomes:

      • Assets: Reserves $9M$, Loans $90M$, Securities $10M$. Liabilities: Deposits $90M$, Borrowing $9M$, Bank Capital $10M$.

    • The cost of this activity is the interest rate on these borrowings

  • Securities Sale

    • A second alternative is for the bank to sell some of its securities to help cover the deposit outflow.

    • Assets: Reserves $9M$, Loans $90M$. Securities $1M$. Liabilities: Deposits $90M$, Bank Capital $10M$.

    • The bank incurs some brokerage and other transaction costs when it sells these securities.

  • Federal Reserve

    • A third way that the bank can meet a deposit outflow is to acquire reserves by borrowing from the Fed.

    • Assets: Reserves $9M$, Loans $90M$. Securities $10M$. Liabilities: Deposits $90M$, Borrow from Fed $9M$, Bank capital $10M$.

    • Borrowing from the Fed also incurs interest payments based on the discount rate.

  • Reduce loans

    • Finally, a bank can acquire the $9$ million of reserves to meet the deposit outflow by reducing its loans by this amount and depositing the $9$ million it then receives with the Fed, thereby increasing its reserves by $9$ million.

    • Assets: Reserves $9M$, Loans $81M$. Securities $10M$. Liabilities: Deposits $90M$, Bank Capital $10M$.

    • Reduction of loans is the most costly way of acquiring reserves.

    • Calling in loans antagonizes customers.

    • Other banks may only agree to purchase loans at a substantial discount.

  • Excess reserves are insurance against the costs associated with deposit outflows.

  • The higher the costs associated with deposit outflows, the more excess reserves a bank will want to hold.

Asset Management

• To maximize its profits, a bank has to:

  1. Seek the highest possible returns on loans and securities.

  2. Reduce risk.

  3. Have adequate liquidity.

• Four Tools:

  1. Find borrowers who will pay high interest rates and have a low possibility of defaulting.

  2. Purchase securities with high returns and low risk.

  3. Lower risk by diversifying.

  4. Balance need for liquidity against increased returns from less liquid assets.

Liability Management

• For the most part, banks took their liabilities as fixed and spent their time trying to achieve an optimal mix of assets.

• Expansion of overnight loan markets.

• This new flexibility in liability management meant that banks could take a different approach to bank management.

• The increased importance of liability management, most banks manage now both sides of the balance sheet together in a so-called asset–liability management (ALM) committee.

Capital Adequacy Management

• Banks have to make decisions about the amount of capital they need to hold for three reasons.

  • First, bank capital helps prevent bank failure

  • Second, the amount of capital affects returns for the owners (equity holders) of the bank.

  • And third, a minimum amount of bank capital (bank capital requirements) is required by regulatory authorities.

• Suppose that both banks get caught up in the euphoria of the telecom market, only to find that $5$ million of their telecom loans became worthless later.

• When these bad loans are written off (valued at zero), the total value of assets declines by $5$ million, and so bank capital, which equals total assets minus liabilities, also declines by $5$ million.

Capital Adequacy Management - Bank failure

• The High Capital Bank still has a positive net worth (bank capital) of $5$ million after the loss.

• The Low Capital Bank, net worth is now $-$$1$ million and hence it is insolvent.

• When a bank becomes insolvent, government regulators close the bank.

• A bank maintains bank capital to lessen the chance that it will become insolvent.

Capital Adequacy Management - Measure of bank profitability

• A basic measure of bank profitability is the return on assets (ROA), the net profit after taxes per dollar of assets.

• The return on assets provides information on how efficiently a bank is being run, because it indicates how much profits are generated on average by each dollar of assets.

• However, what the bank’s owners (equity holders) care about most is how much the bank is earning on their equity investment.

• This information is provided by the return on equity (ROE), the net profit after taxes per dollar of equity (bank) capital.

• Return on Assets: net profit after taxes per dollar of assets

  • $ROA = \frac{\text{net profit after taxes}}{\text{assets}}$

• Return on Equity: net profit after taxes per dollar of equity capital

  • $ROE = \frac{\text{net profit after taxes}}{\text{equity capital}}$

• Relationship between ROA and ROE is expressed by the Equity Multiplier: the amount of assets per dollar of equity capital

  • $EM = \frac{\text{Assets}}{\text{Equity Capital}}$

  • $ROE = \frac{\text{net profit after taxes}}{\text{equity capital}} = \frac{\text{net profit after taxes}}{\text{assets}} \times \frac{\text{assets}}{\text{equity capital}} = ROA \times EM$

Capital Adequacy Management - relationship ROA and ROE

• There is a direct relationship between the return on assets (which measures how efficiently the bank is run) and the return on equity (which measures how well the owners are doing on their investment).

• This relationship is determined by the so-called equity multiplier (EM), which is the amount of assets per dollar of equity capital.

• The High Capital Bank initially has $100$ million of assets and $10$ million of equity, which gives it an equity multiplier of $10$ ($=$$100$ million/$10$ million).

• The Low Capital Bank, by contrast, has only $4$ million of equity, so its equity multiplier is higher, equalling $25$ ($=$ $100$ million/$4$ million).

• Suppose that these banks have been equally well run so that they both have the same return on assets, $1\%$.

• The return on equity for the High Capital Bank equals $1\%$ X $10 =10\%$,

• The return on equity for the Low Capital Bank equals $1\%$ X $25 = 25\%$.

• The equity holders in the Low Capital Bank are clearly a lot happier than the equity holders in the High Capital Bank because they are earning more than twice as high a return.

• We now see why owners of a bank may not want it to hold too much capital.

• Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

Capital Adequacy Management - Benefits and costs

• Bank capital has benefits and costs.

• Bank capital benefits the owners of a bank in that it makes their investment safer by reducing the likelihood of bankruptcy.

• But bank capital is costly because the higher it is, the lower will be the return on equity for a given return on assets.

• In determining the amount of bank capital, managers must decide how much of the increased safety that comes with higher capital (the benefit) they are willing to trade off against the lower return on equity that comes with higher capital (the cost).

Managing Credit Risk

• Adverse selection and moral hazard in loan markets.

• To be profitable, financial institutions must overcome the adverse selection and moral hazard problems that make loan defaults more likely.

• Screening: To accomplish effective screening, lenders must collect reliable information from prospective borrowers.

• Effective screening and information collection together form an important principle of credit risk management.

Managing Credit Risk - Specialization in Lending

• One puzzling feature of bank lending is that a bank often specializes in lending to local firms or to firms in particular industries, such as energy.

• In one sense, this behavior seems surprising, because it means that the bank is not diversifying its portfolio of loans and thus is exposing itself to more risk.

• It is easier for the bank to collect information about local firms/ firms in specific industries and determine their creditworthiness.

Managing Credit Risk - loans

• Financial institutions must adhere to the principle for managing credit risk that a lender should write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities.

• By monitoring borrowers’ activities to see whether they are complying with the restrictive covenants and by enforcing the covenants if they are not, lenders can make sure that borrowers are not taking on risks at their expense.

• The need for banks and other financial institutions to engage in screening and monitoring explains why they spend so much money on auditing and information- collecting activities.

• Long-term customer relationships

• Loan commitments

• Collateral and compensating balances

• Credit rationing

Managing Credit Risk - long-term customer relationship

• Long-term customer relationships reduce the costs of information collection and make it easier to screen out bad credit risks.

• A firm with a previous relationship will find it easier to obtain a loan at a low interest rate because the bank has an easier time determining if the prospective borrower is a good credit risk and incurs fewer costs in monitoring the borrower.

Managing Credit Risk - Loan Commitments

• A loan commitment is a bank’s commitment (for a specified future period of time) to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate.

• The majority of commercial and industrial loans are made under the loan commitment arrangement.

• The advantage for the firm is that it has a source of credit when it needs it.

• The advantage for the bank is that the loan commitment promotes a long-term relationship, which in turn facilitates information collection.

Managing Credit Risk - collateral

• One particular form of collateral required when a bank makes commercial loans is called compensating balances.

• A firm receiving a loan must keep a required minimum amount of funds in an account at the bank.

• For example, a business getting a $10$ million loan may be required to keep compensating balances of at least $1$ million in its account at the bank.

Managing Credit Risk - Credit Rationing

• Credit rationing: refusing to make loans even though borrowers are willing to pay the stated interest rate or even a higher rate.

• Credit rationing takes two forms.

  • The first occurs when a lender refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a higher interest rate.

  • The second occurs when a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like.

Managing Interest-Rate Risk

• A total of $20$ million of its assets are rate-sensitive, with interest rates that change frequently (at least once a year), and $80$ million of its assets are fixed-rate, with interest rates that remain unchanged for a long period (over a year).

• On the liabilities side, the First National Bank has $50$ million of rate-sensitive liabilities and $50$ million of fixed-rate liabilities.

• Suppose that interest rates rise by $5$ percentage points on average, from $10\%$ to $15\%$.

• The income on the assets rises by $1$ million ($=5\%$ X $20$ million of rate-sensitive assets), while the payments on the liabilities rise by $2.5$ million ($=5\%$ X $50$ million of rate-sensitive liabilities).

• The First National Bank’s profits now decline by $1.5$ million ($=$$1$ million - $2.5$ million).

• Conversely, if interest rates fall by $5$ percentage points, similar reasoning tells us that the First National Bank’s profits rise by $1.5$ million.

• If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits.

Gap and Duration Analysis

• The sensitivity of bank profits to changes in interest rates can be measured more directly using gap analysis.

• In our example, this calculation (called the “gap”) is $-$$30$ million ($=$$20$ million - $50$ million).

• For example, when interest rates rise by $5$ percentage points, the change in profits is $5\%$X $-$$30$ million, which equals $-$$1.5$ million.

• The analysis we just conducted is known as basic gap analysis.

Gap and Duration Analysis - refinements

• The basic gap analysis can be refined in two ways.

  • Not all assets and liabilities in the fixed-rate category have the same maturity.

  • One refinement, the maturity bucket approach, is to measure the gap for several maturity subintervals, called maturity buckets, so that effects of interest-rate changes over a multiyear period can be calculated.

  • The second refinement, called standardized gap analysis, accounts for the differing degrees of rate sensitivity for different rate-sensitive assets and liabilities.

• Basic gap analysis: (rate sensitive assets – rate sensitive liabilities) $\times$ Δ interest rates = Δ in bank profit

• Maturity bucked approach: Measures the gap for several maturity subintervals

• Standardized gap analysis: Accounts for different degrees of rate sensitivity