Depository Institutions

Depository InstitutionsInclude:

Institutions which take deposits Deposits represent Liabilities (debt) for DI’s

Include: Banks Savings & Loan institutions Savings Banks Credit Unions

Asset/liability problem of Depository institutions

A depository institution seeks to earn a positive spread between the assets it in invests in (loans and securities) and the costs of funds(deposits and other sources)

How do DI’s make money?

3 ways:

LoansMake direct loans to entities

Securities investmentsInvesting in securities & holding portfolios

FeesCharged to their customers

Asset/liability problem of Depository institutionsRisks faced by the depository

institutions

Credit risk-default risk that the borrower will default on his loan obligation or that the issuer of the security that the depository institution holds defaults on its obligation.

Regulatory risk-regulators will change the rules so as to impact the earnings of the institution unfavorably

Asset/liability problem of Depository institutionsFunding riskIllustrationSuppose that the depository institution

raises $100 million by issuing a deposit account that has a maturity of one year and by agreeing to pay 7% interest

Suppose that $100 million is invested in a government security that matures in 15 years , paying an interest rate of 9%

Asset/liability problem of Depository institutionsIf interest rates declines, the spread will

increase

If Interest rates riseWhat position should you have?

If interest rates fallWhat position should you have?

Asset/liability problem of Depository institutionsWhen interest rates are expected

to decline, depository institutions borrow short and lent long

When interest rates are expected to rise, depository institutions borrow long and lent short

Asset-Liability Problem of DI’s?

Threats of positioning:

Adverse financial consequences If expectations are not realized, Huge losses can occur

No one can predict interest rates consistentlyHighly risky?

Becomes same as gamblingLong run losses highly likely?

Liquidity concernsA depository institution must be prepared to

satisfy withdrawals of funds by depositors and to provide loans to customers

4 ways to solve liquidity issues?Attract additional depositsBorrowing from the federal agency or other

financial institutionsSell securities that it ownsRaise short term funds in the money market

Commercial Banks5 largest banks of Pakistan

Commercial BanksBank services:Individual bankingInstitutional bankingGlobal banking-Corporate financingCapital market productsForeign exchange products and services

Bank FundingThree sources of funds for banks:

DepositsNon deposit borrowingCommon stocks and retained

earnings

Bank FundingDeposits

Demand depositsSavings depositsTime deposits

Bank FundingReserve requirements and

borrowing in the federal funds market

All banks must maintain a specified percentage of their deposits in a non- interest bearing account at the State bank.

Reserve ratioRequired reserve

Bank FundingExcess reserves- when actual reserves

exceed required reserves. Banks temporarily short of funds can

borrow reserves from banks that have excess reserves.

The market where banks can borrow or lend reserves is called the federal funds market.

The interest rate that is charged to borrow funds in this market is called the federal funds rate.

Bank FundingBorrowing at the Fed discount window:Banks temporarily short of funds can

borrow from the Fed at its discount window

Collateral is necessary to borrowDiscount rate- the interest rate that

the Fed charges to borrow funds at the discount window

Borrowing from the Fed is done basically to meet short term liquidity needs

Bank FundingOther non deposit borrowingIssuing obligations in the money

market, or intermediate to long term in the form of issuing securities in the bond market.

Regulation Ceilings imposed on the interest rates that

can be paid on deposit accounts

Geographical restrictions on branch banking

Permissible activities for commercial banks

Capital requirements for commercial banks

Savings and loan AssociationsProvision of funds for financing of

a home.

The collateral for the loans would be the home being financed

Mutually owned or corporate stock ownership

Savings and loan AssociationsAssets:Traditionally, the only assets in which

S&L’s were allowed to invest have been mortgages, and government securities.

Problem:Maturity matching problem

Savings and loan AssociationsOther investments:Consumer loans( loans for home

improvement , automobiles, education , business or credit cards)

Non consumer loans ( commercial , corporate , business or agriculture loans)

Junk bondsInvestment in short term assets for

operational or regulatory purposes.

Savings and loan AssociationsFunding:Savings and time depositsNegotiable order of withdrawal

(NOW) accountsMoney market deposit accounts

(MMDA)

The S&L Crisis

Credit unions“Common bond” requirement for

credit union membership No corporate ownershipPurpose:Serve member’s saving and

borrowing needsCredit unions are owned by their

members, member deposits are called shares.