Chapter 9. The Bank Firm Chapter 9. The Bank Firm & Bank Management& Bank Management

Chapter 9. The Bank Firm Chapter 9. The Bank Firm & Bank Management& Bank Management

• Balance sheet

• Bank Management

• Credit Risk

• Interest Risk

• Other activities & financial innovation

• Balance sheet

• Bank Management

• Credit Risk

• Interest Risk

• Other activities & financial innovation

I. Balance SheetI. Balance SheetI. Balance SheetI. Balance Sheet

• liabilities ($8.25 trillion) sources of bank funds

• assets ($9.1 trillion) uses of bank funds

• liabilities ($8.25 trillion) sources of bank funds

• assets ($9.1 trillion) uses of bank funds

LiabilitiesLiabilitiesLiabilitiesLiabilities

• deposits ($5.95 trillion, 72%) checkable deposits savings deposits time deposits (CDs)

• deposits ($5.95 trillion, 72%) checkable deposits savings deposits time deposits (CDs)

• borrowed funds discount loans (Federal Reserve) federal funds (other banks) repos eurodollar loans commercial paper

• borrowed funds discount loans (Federal Reserve) federal funds (other banks) repos eurodollar loans commercial paper

AssetsAssetsAssetsAssets

• cash items (< $1 trillion) reserves

-- required

-- excess deposits at other banks cash items in collection

• cash items (< $1 trillion) reserves

-- required

-- excess deposits at other banks cash items in collection

• securities ($1.77 trillion) debt securities U.S. gov’t debt municipal debt

• loans ($5.35 trillion, 59%) commercial real estate consumer interbank

• securities ($1.77 trillion) debt securities U.S. gov’t debt municipal debt

• loans ($5.35 trillion, 59%) commercial real estate consumer interbank

Bank capitalBank capitalBank capitalBank capital

• or net worth

= assets - liabilities

• banks have capital requirement cushion against bad loan losses

• or net worth

= assets - liabilities

• banks have capital requirement cushion against bad loan losses

Using T-accountsUsing T-accountsUsing T-accountsUsing T-accounts

• show changes in assets & liabilities

• show how money supply changes• show changes in assets & liabilities

• show how money supply changes

exampleexampleexampleexample

• I empty Timmy’s piggy bank

• open a savings account

• $50

• I empty Timmy’s piggy bank

• open a savings account

• $50

• $50 in cash increases assets

• $50 in savings increases liabilities• $50 in cash increases assets

• $50 in savings increases liabilities

• suppose required reserves are

10% of deposits required reserve ratio

• suppose required reserves are

10% of deposits required reserve ratio

• bank lends excess reserves,• bank lends excess reserves,

II. Bank ManagementII. Bank ManagementII. Bank ManagementII. Bank Management

• liquidity management need cash to deal with deposit

outflows but holding cash drags down

profits

• liquidity management need cash to deal with deposit

outflows but holding cash drags down

profits

• if too low on cash, borrow from banks or Fed sell securities call in or sell loans

all of which are costly

• if too low on cash, borrow from banks or Fed sell securities call in or sell loans

all of which are costly

• asset management maximize returns (profits) acceptable risk

-- diversified loan portfolio adequate liquidity regulatory compliance

• asset management maximize returns (profits) acceptable risk

-- diversified loan portfolio adequate liquidity regulatory compliance

• liability management banks increasingly compete for

funds w/ other institutions banks have more choices in raising

funds money center banks

-- large banks

-- rely on commercial paper, CDs, federal funds

• liability management banks increasingly compete for

funds w/ other institutions banks have more choices in raising

funds money center banks

-- large banks

-- rely on commercial paper, CDs, federal funds

• capital management protects from insolvency but capital drags down shareholder

return (ROE) regulations set minimum capital

requirements

-- as a % of risk-adjusted assets

-- increased in 1990

-- credit crunch in ‘90-’91 recession

• capital management protects from insolvency but capital drags down shareholder

return (ROE) regulations set minimum capital

requirements

-- as a % of risk-adjusted assets

-- increased in 1990

-- credit crunch in ‘90-’91 recession

III. Managing Credit RiskIII. Managing Credit RiskIII. Managing Credit RiskIII. Managing Credit Risk

• loans are primary asset problems of

adverse selection

-- BEFORE loan

moral hazard

-- AFTER loan

• loans are primary asset problems of

adverse selection

-- BEFORE loan

moral hazard

-- AFTER loan

Banks gather informationBanks gather informationBanks gather informationBanks gather information

• screening adverse selection credit history (FICO score) industry specialization in lending

-- become experts in screening,

-- but lack of diversification

increase risk of assets

• screening adverse selection credit history (FICO score) industry specialization in lending

-- become experts in screening,

-- but lack of diversification

increase risk of assets

• monitoring moral hazard monitor borrow after loan

-- restrictive covenants

-- enforce agreements

• monitoring moral hazard monitor borrow after loan

-- restrictive covenants

-- enforce agreements

• example of monitoring mortgage escrow account

-- banks collects monthly

insurance, tax payments

from homeowner

-- ensures that owner pays

taxes, insurance

• example of monitoring mortgage escrow account

-- banks collects monthly

insurance, tax payments

from homeowner

-- ensures that owner pays

taxes, insurance

• long-term customers less screening & monitoring encouraged with better terms

• long-term customers less screening & monitoring encouraged with better terms

• collateral protects bank from loss adverse selection

-- discourages certain borrowers moral hazard

-- discourages borrower risk-taking,

since borrower is risking property

• collateral protects bank from loss adverse selection

-- discourages certain borrowers moral hazard

-- discourages borrower risk-taking,

since borrower is risking property

• credit rationing riskier borrowers would be willing

to pay high rates good borrowers won’t so banks will not lend to certain

borrowers at ANY rate

or only small amounts

• credit rationing riskier borrowers would be willing

to pay high rates good borrowers won’t so banks will not lend to certain

borrowers at ANY rate

or only small amounts

IV. Managing Interest Rate RiskIV. Managing Interest Rate RiskIV. Managing Interest Rate RiskIV. Managing Interest Rate Risk

• changes in interest rates affect BOTH assets and liabilities

• assets changes VALUE changes the amount of interest

income depends on whether LT or ST

• changes in interest rates affect BOTH assets and liabilities

• assets changes VALUE changes the amount of interest

income depends on whether LT or ST

• liabilities cost of funds goes up with interest

rates

-- rates on CDs, money market accounts very sensitive

-- rates on savings, checking not

as sensitive

• liabilities cost of funds goes up with interest

rates

-- rates on CDs, money market accounts very sensitive

-- rates on savings, checking not

as sensitive

overall impactoverall impactoverall impactoverall impact

• rising interest rates asset income will go up cost of funds will go up

• total impact depends on amount of rate-sensitive assets vs.

rate-sensitive liabilities

• rising interest rates asset income will go up cost of funds will go up

• total impact depends on amount of rate-sensitive assets vs.

rate-sensitive liabilities

• banks typically borrow short-term

and lend long-term

• so rate sensitive liabilities >

rate sensitive assets

• so as interest rates rise costs increase faster than income bank profits fall banks must manage interest rate

risk

• banks typically borrow short-term

and lend long-term

• so rate sensitive liabilities >

rate sensitive assets

• so as interest rates rise costs increase faster than income bank profits fall banks must manage interest rate

risk

V. Other Bank ActivitiesV. Other Bank ActivitiesV. Other Bank ActivitiesV. Other Bank Activities

• Off-balance sheet

• loan sales secondary market frees up capital to make more

loans

• Off-balance sheet

• loan sales secondary market frees up capital to make more

loans

• fee income growing portion of bank profits ATM, service fees guarantee fees makes banks less dependent on

spread between deposit & lending rates

• fee income growing portion of bank profits ATM, service fees guarantee fees makes banks less dependent on

spread between deposit & lending rates

• risk management trading derivative securities introduces new risks

-- possible to lose LOTS of money

in a short period of time

-- traders make unauthorized trades

• risk management trading derivative securities introduces new risks

-- possible to lose LOTS of money

in a short period of time

-- traders make unauthorized trades

VI. Financial InnovationVI. Financial InnovationVI. Financial InnovationVI. Financial Innovation

• new types of assets, new activities

• why? changing demand conditions changing supply conditions regulatory avoidance

• new types of assets, new activities

• why? changing demand conditions changing supply conditions regulatory avoidance

demanddemanddemanddemand

• interest rate volatility (and risk)

increase in 1970s banks demand new products

to manage the risk ARM reduces bank interest rate

risk

• interest rate volatility (and risk)

increase in 1970s banks demand new products

to manage the risk ARM reduces bank interest rate

risk

supplysupplysupplysupply

• banks supplying new services

• cost of financial transactions have fallen with new technologies ATMs credit/debit cards internet banking

• banks supplying new services

• cost of financial transactions have fallen with new technologies ATMs credit/debit cards internet banking

regulationregulationregulationregulation

• avoiding reserve requirements minimize liabilities subject to

requirement eurodollars commercial paper

• avoiding reserve requirements minimize liabilities subject to

requirement eurodollars commercial paper