Financial Institutions

-- Banking

Functions of Financial Institutions

• 1. Aids the flow of capital

• 2. Credit allocation

• 3. Provides economies of scale and scope

• 4. Satisfies the needs of general public

• 5. Provides specialization and expertise

• 6. Assists asset transformation

• 7. Offers INTERMEDIATION

Intermediation

• The process of transforming a secondary security into a primary security by a financial institution.

• It relates to financial investments by savors cash cash

Savors Financial Borrowers

Institutions

secondary primary

securities securities

Dis-intermediation

• The process of reversing or rejecting the transfer of funds into the financial institutions.

• This refers to the low deposit interest rates or high operating costs charge to customers.

Illustration of Disintermediation

• The removing of Middlemen

• The dis- or re-channeling funds flow from the FI

• Changing Role to the Servicing of Markets– Security Investments– Mutual Funds– Insurance

Types of Intermediation

• 1. Liquidity

• 2. Maturity

• 3. Denomination

• 4. Risk

Types of Financial Institutions

• By Banking Business Nature:– Banks– Non-Banks– Non-Finance

• By Business Operations:

– Thrift type

– Contractual type

– Investment type

– Other type

Thrift-type Financial Institutions• Banks:

– Commercial Banks– Savings Banks– Investment Banks (Merchant Banks)– etc

• Non-Banks:– Deposit-taking Company, Savings and Loan,

Home Loans, Building Society, – Credit Unions

Contract-type Financial Institutions

• Insurance Companies:– Life Insurance– Accident and Healthy Insurance

• Pension Funds:– Mandatory Providence Funds– Retirement Funds/Pension Funds

Investment-type Financial Institutions

• Investment Companies:– Closed-end Investment Companies -

Investment Brokers– Open-end Investment Companies - Mutual

Funds/Unit Trust– Real Estate Trust Investment Companies

Other Financial Institutions• Finance Companies

• Factors Companies

• Lease Companies

• Mortgage Companies

• Credit Card Companies

• Non-finance Financial Institutions:– General Electric, Ford Motors, Toyota Motors– wholesalers, Manufactures, Department Stores

Why Financial Institutions?

• Fulfill economic goals

• Reduce transaction and information costs

• Provide liquidity

• Prevent risks

• As transmission of monetary policy

• Provide payment mechanism

• Supply credit allocation

Analysis of Financial Institutions

• 1. Transaction Costs

• 2. Information Asymmetry -- Moral Hazard

• 3. Financial Risks

• 4. Financial Innovation

High Transaction Costs: Solutions

• Economy of Scale--to reduce the average unit costs of production as output

increase (%Output , AC)• Economy of Scope --to generate cost

synergies by producing multiple services ( C{x1, x2} < C{x1} +C{x2} )

• Specialization: market niche

Solution

• Information Asymmetry--Moral Hazard:

• Information Symmetry and Full Disclosure

• Regulation Reform

• Financial Intermediation

• Financial Risks:

• Risk Management and Control

• Burden Administration

Solutions

• Financial Innovations:

• Enhance Internal Control--

• Planning, Control, and Administration

• Tighten Asset Management and Quality

• Modernized Operation System

• Strengthen Regulation and Monitoring

Duties of the Management of Financial Institutions

• 1. Determining the optimal capital structure

• Assets, Liabilities, and Capital

• 2. Managing interest rate/currency/credit risks

• 3. electing/Pricing investments and liabilities

• Maturity Matching, Profit Making

• 4. Operating effectively

• Information Processing

• Communication Technology

Basic Concept -- Banking

• What is a Bank?– A bank is a financial intermediary

which provides special types services relating to finance.

– A bank is a company which carries on “banking business” with a valid banking license. (Banking Ordinance)

Banking BusinessBanking Ordinance - section 2

• A. Receiving from the general public money on current deposit, savings

deposit or other similar account repayable on demand or

within less than three months or at call or notice of less than three months;

• B Paying or collecting cheques drawn by or paid in by customers.

Universal Definition of A Bank

• A Bank is a licensed organization that

• 1. Accepts Deposits from the generalpublic

• 2. Grants Loans

Special Features of a Bank

• 1. It is a regulated organization.

• 2. It offers checking accounts (DemandDeposit Accounts, or Current Ac

counts)

• 3. It acts as payment mechanism.

• 4. It can create money

Money Creation Feature

• 1. Assumptions:– No cash outflow (Depositors will not make

any drawing)– Comply with the Reserves Requirement on

Deposits– No Excess Reserves set by the Bank– Excess Balance on the Deposits will be loaned

out– All Loans will be re-deposited back to the Bank

• Process of Money Creation:

• (Minimum Deposit Reserves equal to 20%)

• 1. Deposits $1,000 into the Banking System– bank will maintain deposit reserves $200– At the same time, $800 will be lent out– Borrower will immediately deposit the $800

back to the bank– The Bank will then have $1,800 in its Deposit

account

• B. The additional $800 deposited into the Bank.– 20% of $800 ($160) will be taken out as

reserves.– The remaining balance of $640 will be lent out.– Borrower(s) will not withdraw cash and deposit

the $640 into the Bank– The Bank will have a total of 2,440 in Deposits.

($1,000+$800+$640)

• C. The process repeats again until the reserves requirement equal to the original deposits amount. The “Multiple Effect” appears.

• D = deposits; r= reserves requirement

• MC=Money Creation

• MC = D/r)$1,000 x (1/0.2) = $5,000 ….. (M1)

• Minimum Reserves is $5,000 x 0.2 =$1,000

• The “multiplier” is 5

• Money creation equals $4,000

• r = 0.2; Multiplier = 5

• r = 0.1; Multiplier = 10

• r = 0.25; Multiplier = 4

• r = 0.08; Multiplier = 12.5

• In Reality, the “Multiplier” may not be exactly the same (as 5 on the reserves requirement is 20%).

• M1 is always larger than original deposits.

• Monetary Policy can increase or decrease the reserves requirement to control the money supply.

Bank Organization Structure

• Unit Banking

• Branch Banking

• Dual Banking

• Bank Holding Company

• Multinational Banking

• Retail Banking

• Wholesale Banking

HK Banking System

• 3 tier Banking System: (Structure):

• 1981: Licensed Banks

• Licensed Deposit-taking Companies

• Registered DTC

• 1989: Licensed Banks

• Registered Licensed Banks

• Deposit-taking Companies

Banks in Hong KongSource: HKMA Monthly Statistical bulletin, January 2002

Restricted licence banks Deposit-taking companiesIncor- Incor- Incor- Incor- Incor- Incor- All

porated porated porated porated porated porated authorisedAs at end of in HK outside HK in HK outside HK in HK outside HK institutions

Licensed banks

1995 31 154 37 26 129 3 3801996 31 151 38 24 121 3 3681997 31 149 39 27 113 2 3611998 31 141 35 25 99 2 3331999 31 125 33 25 71 0 2852000 31 123 28 20 61 0 2632001 29 118 29 20 54 0 250

Balance Sheet of HK Banks Source:HKMA Monthly Statistical Bulletin, January 2002

Balance Sheet of HK Licensed Banks (Dec.31, 2001) in 000,000 Mill $HK$ F.C. Total

Assets Notes and Coins 12 2 14 Due From AIs 276 166 442 Due from Banks Abroad 110 2,023 2,134 Loans and Advances to Customers 1,508 521 2,029 Negotiable CDs 84 38 122 Negotiable Debt other than CDs 339 516 855 Acceptance and Bills of Exchange 2 32 34 FRNs and CP 44 200 244 Government Bills Bonds and Notes 201 76 277 Other Debt Instruments 92 207 299 Investments in Shareholdings 42 3 45 Land and Buildings 63 1 64 Other Assets 107 67 174 Total Assets 2,880 3,852 6,733

Liabilities - Due to AIs 175 168 343 Due to Banks Abroad 163 1,254 1,417 Deposits from Customers 1,832 1,486 3,318 Negotiable CDs outstanding 132 35 167 Other Debt Instruments 1 42 43 Capital Reserves and other Liabilities 437 156 593

2,740 3,141 5,881

Funds Flow of a Bank

• Funds Flow-in:– Deposits– Borrowing / NCD– Contributed Capital

• Funds Flow-out:– Loans and Advances– Investments– Capital Expenditures

Balance Sheet Presentation

• Assets Side:

• - Cash and Balance due from Depository Institutions

• - Investments (Short- and Long-term)

• - Loans and Advances

• - Plant and Equipment

• - Investments in Subsidiaries

• Liabilities:

• - Core Deposits

• - Certificate Deposits

• - Borrowings (Short- and Long-term)

• Equity Capital

• - Paid-in Capital

• - Retained Earnings (Reserves)

Bank Assets and Liabilities Structure

• Rate Sensitive Assets Rate Sensitive Liab.

• Fixed Rate Assets Fixed Rate Liab.

• Non-Rate Assets Equity

Bank Balance Sheet Characteristics

• 1. Few Fixed Assets -- Low Degree of Operating Leverage

• 2. Substantial Amount Short-termLiabilities (Deposits) -- Requires

High Liquidity

• 3. Substantial Amount of Assets Relative toEquity Capital -- High Degree of

Financial Leverage

Services Provided by Banks

• General Areas:

• - Intermediation: Liquidity, Maturity

• Risk, Denomination

• - Cost Reduction

• - Price Reduction

• - Information

Special Services Provided by Banks

• 1. Money Supply Transmissions

• 2. Credit Allocation

Development Factors in Financial Institutions

• 1. Crossing Traditional Boundaries

• 2. Global Competition

• 3. New Opportunities

• 4. Deregulation/Re-regulation

• 5. Corporate Restructuring

The Development in Banking Industry

• 1. Institutionalization

• 2. Globalization

• 3. Securitization

Structural Change in Banking

• 1. Technological Change

• 2. Regulation Change

• 3. Economical Change - Interest Rate Fluctuation

• 4. Competition Induced Change

• 5. Bank International Settlement Requirement --Capital (Kapital) Change

• **TRICK**

Financial Innovation in Banking

• TRICK + Rational Self-Interest =

• Financial Innovation

• New financial products and processes that improve the economic efficiency with which financial transactions are conducted, either by serving customers’ needs in new unregulated ways or by lowering costs.

• Examples of Financial Innovations:

• Negotiable Certificate Deposits

• ZERO-Coupon Securities

• Financial Futures

• Negotiable Order of Withdrawal (NOW a/c)

• Money Market Deposit Account (MMDA)

• Euro-Dollar Deposits

• Securitization

Banking Regulations

Reasons for Banking Regulations

• 1. Protect Customers• 2. Improve Implementation of Monetary Policy• 3. Ensure Competitive Markets• 4. Prevent from Bank Run • 5. Eliminate Prejudice in Supply• 6. Pursue Desirable Credit Allocation• 7. Protect Taxpayers from Bailouts• 8. Reduce Information Asymmetries

What IF There is NO Regulations

• Money will be destroyed

• Payment Mechanism will be Disrupted

• Credit will be Shrink

• Risk will be increased

• Information Flow will be retarded

Objectives of Bank Regulations

• 1. Safety

• 2. Stability

• 3. Structure

Forms of Bank Regulations

• Entry Control - Licensed

• Safety and Soundness Control:– Liquidity – Capital Adequacy– Concentration Limits

• Credit Allocation Control

• Geographical Expansion Control

Cost/Banefit Analysis of Regulation

• Cost – Filing Cost– restricted Activities– Taxes

• Benefits:– Restricted Competition– Government Support

Banking Operating Structure

• Industry Organization Model:

• Structure

• Conducts

• Performance

Bank Organization Structure

• Merge and Acquisition -- Super Size Banks– Efficiency– Effectiveness

• Multinational Foreign Banks

• Multinational Bank Holding Companies– Double Leverage

Double Leverage for MBHC

• Bank Parent Company: raise funds $10 Billion by issuing bonds or borrowing

• This amount is then transferred/invested into the subsidiary Bank

• The funds are used to expand the subsidiary bank’s capital size.

• If the subsidiary bank maintain an 20% required ratio of Equity to Asset

• The subsidiary bank’s assets will be increase by $50 billion while meeting the regulatory capital requirement of 20%.

• Increase Injected Bank Equity Funds

• in =

• Assets Required Reserves Ratio

• Increase in Assets = $10b / 0.20 = $50b

Bank Performance

Risks Faced by Bank Operations

• Liquidity Risk

• Credit (Default) Risk

• Interest Rate Risk

• Technology/Operational Risk

• Regulatory Risk

• Country/Sovereign Risk

• Currency (Foreign Exchange) Risk

• Political Risk

• Off-Balance Sheet Risk

Objectives of Bank Performance

• To Reduce Risks

• To Maximize Net Worth

• To Maximize Profit

• To Comply with Regulations

• To Fulfill Bank Policies

Features of Bank Performance

• Accepts general public’s savings as deposits and grant loans to those who need them.

• Bank products are mainly services

• The income and expenses are divided into – Interest Portion– Non-interest Portion

Profitability Analysis

Measurement of Profitability

• Net Interest Income (NII) =

• Interest Income – Interest Expenses

• Net Interest Margin (NIM) =

• Interest Income – Interest Expenses

• Total Earning Assets

• Spread = (Average Interest Income Rate –

• Average Interest Expense Rate)

Factors Affecting NIM/NII• Credit Risk - Higher Risk; Higher Yields

• Interest Rate Fluctuation

• Funding Mix: S/T vs L/T– Sources:wholesale vs retail; savings vs time– Uses: commercial vs mortgage vs consumers

• Pricing Mix: Fixed Rate vs Floating Rate

• Non-performance Assets

• Tax Exempted Investments

Impact of Interest Rate Fluctuation on NIM

• Monitoring Rate Sensitive Assets and Liabilities -- Gap ManagementRSA > RSL ..…….. Positive GapRSA < RSL ……… Negative GapRSA = RSL ……… Zero GapWhen Interest Rate increases, + Gap: IR > IE … + NII ; + NIM– Gap: IR < IE … – NII ; – NIM

Measurement Return on Net Worth

• Return on New Worth (RONW) =

• (Total Net Income / Total Equity on MV)

• Return on Assets (ROA) =

• (Total Net Income / Total Assets)

• Return on Equity (ROE) =

• (Total Net Income / Total Equity on BV)

Asset/Liability Management• Monitoring Assets and Liabilities Mix:

Actively Management the Which Assets are funded by What LiabilitiesThe GAP (RSA = RSL)RSA financed by FRLFRA financed by FRL

NRA financed by FRL

• Determine the Amount, Rate Differential and the Expected Earnings of all the items.

Illustration of Active Mgt• Example:

• RSA 8% $ 170 RSL 6% $ 150

• FRA11% 155 FRL 8.5% 185

• NRA 30 Equity 20

• Total $ 355 Total $ 355

• Rate Differentials (Annual)

• On RSA and RSL (8% - 6%) 2%

• On FRA and FRL (11% - 8.5%) 1.5%

• On GAP and FRL (8,5% - 8%) 0.5%

• On NRA and FRL (8.5% - 0%) ( 8.5%)

• Profitability Analysis• RSA financed by RSL ($150 @ 2%) $3• FRA financed by FRL ($155 @ 1.5%) 2.325• GAP financed by FRL ($20 @ 0.5%) 0.1• NRA financed by FRL ($10 @ 8.5%) (0.85)• NRA financed by Equity ($20 @ --) 0

Total Pre-tax Profits $4.575

• RONW (ROE) = $4.575 20 = 0.22875 ~ 22.875%

Liquidity Analysis

Nature of Liquidity

• 1. The ability to maintain sufficient fundsto fulfill the regulatory

requirement

• 2. The ease with which a bank to convertthe assets into cash to meet the

claims of withdrawals and /or to repay the debts and expenses.

Concepts of Liquidity• Narrow Concept: the ability to maintain

sufficient funds or to raise a certain amount of deposits at a certain cost within a certain amount of time to meet the needs by the bank

• -- Store Liquidity

• Broad Concept: the ability to include the ease with which the bank can obtain cash by borrowing from external sources -- Purchasing Liquidity

Liquidity Requirement byHong Kong Banking Ordinanace• Any Licensed Bank should maintain the Liq

uidity Ratio of not less than 25% of Liquefiable Assets to its Qualifying Liabilities for each calendar month, based on the sum of net weighted amount of the liquefiable assets and the sum of the qualifying liabilities for each working day of the month.

Causes of Liquidity

• 1. Liability-side Causes: • Depositors withdraw cash from their

accounts or additional deposits do notcome as expected

• 2. Asset-side Causes:• Lending commitments or Matured Loans

do not pay on time.•

Indicators of Liquidity Risk

• 1. Mis-Matching of maturities of Qualifying Assets to Liquefiable

Liabilities

• 2. Inadequate Liquidity Ratio onQualifying Assets to Liquefiable

Liabilities

Measurement of Liquidity Risk

• 1. Static Measurement:

• a. Liquidity Ratio:

• Qualifying Assets

• Liquefiable Liabilities

• b. Net Cash Flows Analysis:

• Cash In-flows — Cash Out-flows

• 2. Dynamic Measurement:• a. Liquidity Planning: to analyze the

deposits withdrawals and additional deposits, and the loans commitments and loans repayments. To determine the net effect on the Liquidity Position.

– Liq.Bal Deposits Loans Net Change + – + – $140 $50 $75 $100 $80 $??? +Liq – Liq –Liq +Liq

• B. Trends Analysis on Loans and Deposits: • $ • Deposits• Liquidity• Gap• Loans

• t

Management of Liquidity Risks

• 1. Store Liquidity

• a. Maintain sufficient CASH and Near Cash

• b. Maintain Good Quality Loans

• c. Retain Deposits in the Bank

• 2. Purchase Liquidity:

• a. Maintain Diversified Borrowing Sources:

• (I) Inter-bank Loans

• (ii) Other Borrowings

• (iii) Discount Windows (LAF)

• (iv) REPO

• (v) NCD

• b. Increase Deposits

• c. Seek Deposit Sources (Euro$ Deposit)

Lending Analysis

Nature of Lending

• Lending is the single and largest categories for banking

• Lending provides the primary source of revenue for banking

• Banking business is to grant loans to allocate capital

• Lending classes: Commercial and Industry, Real Estate (Mortgage). Consumer, and others (leasing, agriculture, gov’t, etc)

Concepts of Bank Lending• 1. The possibility of total loss become less

as the number of loans increases

• 2. The possibility of no losses also becomeless as number of loans increase

• 3. As loan portfolio getting larger, numberof loans that will go bad can be predicted

• 4. The Larger the loan portfolio, thepossibilities of total loss are very remote

• 5. In large loan portfolio, some losses are certain

Elements for Lending Policy

• Size

• Maturity

• Composition

• Interest Rate: Loan Pricing

• Fixed Rate or Floating Rate

• Analyze Loan Loss

Strategies for Lending Policy

• Loan Analysis– No Analysis– Subjective Analysis

• 5 Cs’

• Ratio Analysis and Cash Flow Analysis

– Objective Analysis• Credit Score

• Z Score

•Credit Score – Altman’s Z Score

• Z = 1.2X1 +1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

• X1 = Working Capital / Total Assets

• X2 =Retained Earnings / Total Assets]

• X3 = EBIT / Total Assets

• X4 = M. Value of Equity / B. Value of Total Debts

• X5 = Sales / Total Assets

• Z Score Probability of Failure

• 1.8 or less Very High

• 1.81 – 2.99 Not Sure

• 3.0 or Above Unlikely

• Loan Administration– Centralized Approval– Decentralized Approval

• Loan Authorization– Personnel– Authorized Line of Credit

• Loan Monitoring

• Loan Delinquency• a. Workout Agreement

• b. Collateral Liquidation• c. Reducing Debt to Collecting Judgment• d. Charge off • e. Bankruptcy

Capital Analysis

Role of Capital

• To Support Operating Asset Commitments

• To Promote Depositors’ Confidence

• To Improve Growth - Loans and Deposits

• - Earnings

• To Prevent Morale Hazard

Composition of Capital• Traditional Concept: (GAAP Concept)

• 1. Contributed Capital:

• -- Core and Supplementary Capital

• 2. Book Value

• Regulatory Concept: (Regulatory Accounting Principles)

• 1. Contributed Capital plus Debt Capital

• 2. Market Value

Debt as Source of Capital

•Attribute of Debt: (Regulatory point of view) 1. It is legally subordinate to deposits. 2. It does not require immediate

repayment.3. It offers some protection to

depositors.4. It is a sources of funds

Conditions for Debt as Capital

• Original maturity of 5 year or more

• When Issue must Identify as Subordinate to deposits

• Must be Uninsured

Capital Adequacy

• Regulatory Requirement: (Bank ofInternational Settlement Requirement)Capital / Risk Adjusted Assets > 8% Core Capital / Risk Adjusted Assets > 4%

• Internal Requirement: -Add a Premium onto the BIS requirement -Currently Average Ratio is 20%

Quantitative Analysis of Capital Adequacy

• 1. Leverage Analysis:NW/ Total AssetsNW / Risk Adjusted AssetsNW / Average LoansNW / Average Deposits

• 2. Net Capital Ratio:Capital + R.E. – Problem Assets

Risk Adjusted AssetsNCR < 2.74 ---- Inadequate

Qualitative Analysis of Capital Adequacy

• Regulatory Analysis:CAMEL --- Capital size

Asset Quality Management

Earning History Liquidity Position

Continued

• For Bank Holding Company InstitutesCAMEL + BOPEC

Bank SubsidiaryOther Subsidiaries

Parent Company Earnings (Consolidated) Capital (Consolidated)