Download Money, Banking, and the Financial System

© 2014 Pearson Education, Inc.
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
10.1
Understand bank balance sheets.
10.2
Describe the basic operations of a commercial bank.
10.3
Explain how banks manage risk.
10.4
Explain the trends in the U.S. commercial banking industry.
© 2014 Pearson Education, Inc.
To Buy a House, You Need a Loan
• In 2012, despite record low mortgage interest rates, people had difficulty
in obtaining mortgage loans or refinancing old loans.
• Banks granted mortgages only to applicants with nearly perfect histories
and the willingness to make large down payments.
• Problems in the mortgage market reduced the effectiveness of the Fed’s
monetary policy, which aimed at increasing spending on goods and
services through lowering interesting rates.
© 2014 Pearson Education, Inc.
Key Issue and Question
Issue: During and immediately following the 2007–2009 financial crisis,
there was a sharp increase in the number of bank failures.
Question: Is banking a particularly risky business? If so, what types of risks
do banks face?
© 2014 Pearson Education, Inc.
4 of 55
10.1 Learning Objective
Understand bank balance sheets.
© 2014 Pearson Education, Inc.
5 of 55
The Basics of Commercial Banking: The Bank
Balance Sheet
• The key commercial banking activities are taking in deposits from savers
and making loans to households and firms.
• A bank’s primary sources of funds are deposits, and primary uses of funds
are loans, which are summarized in the bank’s balance sheet.
A balance sheet is a statement that shows an individual’s or a firm’s financial
position on a particular day.
• The typical layout of a balance sheet is based on the following accounting
equation:
Assets = Liabilities + Shareholders’ equity.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
6 of 55
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
7 of 55
Asset is something of value that an individual or a firm owns; in particular, a
financial claim.
Liability is something that an individual or a firm owes, particularly a financial
claim on an individual or a firm.
Bank capital is the difference between the value of a bank’s assets and the
value of its liabilities; also called shareholders’ equity.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
8 of 55
Bank Liabilities
Checkable Deposits
Checkable deposits (or transaction deposits) are accounts against which
depositors can write checks.
• Demand deposits are checkable deposits on which banks do not pay
interest.
• NOW (negotiable order of withdrawal) accounts are checking accounts that
pay interest.
• Checkable deposits are liabilities to banks and assets to households and
firms.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
9 of 55
Nontransaction Deposits
• The most important types of nontransaction deposits are savings accounts,
money market deposit accounts (MMDAs), and time deposits, or certificates
of deposit (CDs).
• Checkable deposits and small-denomination time deposits are covered by
federal deposit insurance.
• CDs of less than $100,000 are called small-denomination time deposits.
CDs of $100,000 or more are called large-denomination time deposits.
CDs worth $100,000 or more are negotiable, which means that investors can
buy and sell them in secondary markets prior to maturity.
Federal deposit insurance is a government guarantee of deposit account
balances up to $250,000.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
10 of 55
Borrowings
• Banks often make more loans than they can finance with funds they attract
from depositors.
• Bank borrowings include short-term loans in the federal funds market, loans
from a bank’s foreign branches or other subsidiaries or affiliates, repurchase
agreements, and discount loans from the Federal Reserve System.
• The federal funds market involves interbank loans borrowed at the federal
funds rate.
• With repurchase agreements (“repos”), banks sell securities, such as
Treasury bills, and agree to repurchase them, typically the next day.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
11 of 55
Making the Connection
The Rise and Fall and (Partial) Rise of the Checking Account
Households hold less in
checking accounts relative
to other financial assets
than they once did, partly
due to the wealth effect.
As wealth increased over
time, households were
better able to afford to hold
assets, such as CDs,
where their money was tied
up for a while but on which
they earned a higher rate
of interest.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
12 of 55
Bank Assets
Bank assets are acquired by banks with the funds they:
• receive from depositors
• borrow from other institutions
• acquire initially from shareholders
• retain as profits from operations
Reserves and Other Cash Assets
Reserves are bank assets consisting of vault cash plus bank deposits with the
Federal Reserve.
Vault cash is cash on hand in a bank (including currency in ATMs and deposits
with other banks).
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
13 of 55
Required reserves are reserves the Fed requires banks to hold against
demand deposit and NOW account balances.
Excess reserves are reserves banks hold above those necessary to meet
reserve requirements.
• Excess reserves can provide an important source of liquidity to banks, and
during the financial crisis, bank holdings of excess reserves soared.
• Another important cash asset is cash items in the process of collection—
claims banks have on other banks for uncollected funds.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
14 of 55
Securities
• Marketable securities are liquid assets that banks trade in financial markets.
• Banks are allowed to hold securities issued by the U.S. Treasury and other
government agencies and corporate bonds.
• Bank holdings of U.S. Treasury securities are also called secondary
reserves due to their liquidity,
• In the United States, commercial banks cannot invest checkable deposits in
corporate bonds or common stock.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
15 of 55
Loans
• The largest category of bank assets.
• Loans are illiquid relative to marketable securities and have greater default
risk and higher information costs.
• There are three categories of loans:
(1) loans to businesses: commercial and industrial loans
(2) consumer loans: made to households primarily to buy automobiles and
other goods
(3) real estate loans: residential and commercial mortgages
• The commercial paper market in the 1980s caused banks to lose many of
the businesses that had been using short-term commercial and industrial
loans.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
16 of 55
Loans
Figure 10.1
The Changing Mix of
Bank Loans, 1973–2012
The types of loans granted by
banks have changed
significantly since the early
1970s.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
17 of 55
Other Assets
This category includes:
•banks’ physical assets (e.g., computer equipment and buildings).
•collateral received from borrowers who have defaulted on loans.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
18 of 55
Bank Capital
• Also called shareholders’ equity, or bank net worth.
• Bank capital is the difference between the value of a bank’s assets and the
value of its liabilities.
• A bank’s capital represents the funds contributed by the bank’s shareholders
through their purchases of stock the bank has issued plus accumulated
retained profits.
• In 2012, bank capital was about 13% of bank assets for the U.S. banking
system as a whole.
• As the value of a bank’s assets or liabilities changes, so does the value of
the bank’s capital.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
19 of 55
Solved Problem 10.1
Constructing a Bank Balance Sheet
a. Use the entries to construct a balance sheet similar to the one in Table 10.1,
with assets on the left side of the balance sheet and liabilities and bank
capital on the right side.
b. The bank’s capital is what percentage of its assets?
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
20 of 55
Solved Problem 10.1
10.1
Constructing a Bank Balance Sheet
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by using the entries to construct the bank’s balance
sheet.
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
21 of 55
Solved Problem 10.1
Constructing a Bank Balance Sheet
Step 3 Answer part (b) by calculating the bank’s capital as a percentage of
its assets.
Total assets = $2,223 billion
Bank capital = $231 billion
Bank capital as a percentage of assets
The Basics of Commercial Banking: The Bank Balance Sheet
© 2014 Pearson Education, Inc.
22 of 55
10.2 Learning Objective
Describe the basic operations of a commercial bank.
© 2014 Pearson Education, Inc.
23 of 55
The Basic Operations of a Commercial Bank
T-account is an accounting tool used to show changes in balance sheet items.
Example: You open a checking account with $100 at Wells Fargo.
Wells Fargo uses its excess reserves to buy Treasury bills worth $30 and make
a loan worth $60.
The Basic Operations of a Commercial Bank
© 2014 Pearson Education, Inc.
24 of 55
Making the Connection
In Your Interest
Your Bank’s Message to You: “Please Go Away!”
• Your bank may well lose money on your checking account, which typically
costs about $300 a year to maintain.
• In addition to loaning out depositors’ money, banks traditionally earn income
from depositors by: (1) collecting fees from stores when debit cards are used,
(2) charging overdraft fees, and (3) collecting fees when depositors
purchase financial products.
• Dodd-Frank Act of 2012 placed limits on fees for debit cards and overdrafts.
• Banks have responded to the new regulations by closing branches in lowerincome neighborhoods, increasing their marketing of financial services to
higher-income customers, and raising minimum balance requirements.
The Basic Operations of a Commercial Bank
© 2014 Pearson Education, Inc.
25 of 55
Bank Capital and Bank Profits
Net interest margin is the difference between the interest a bank receives on
its securities and loans and the interest it pays on deposits and debt, divided by
the total value of its earning assets.
• A bank’s profits are commonly expressed in terms of its return on
assets.
Return on assets (ROA) is the ratio of the value of a bank’s after-tax profit
to the value of its assets.
The Basic Operations of a Commercial Bank
© 2014 Pearson Education, Inc.
26 of 55
• To judge how much a bank’s managers are able to earn on the
shareholder’s investment, we use the return on equity.
Return on equity (ROE) is the ratio of the value of a bank’s after-tax profit to
the value of its capital.
• ROA and ROE are related by the ratio of a bank’s assets to its capital:
The Basic Operations of a Commercial Bank
© 2014 Pearson Education, Inc.
27 of 55
• Managers of banks and other financial firms may have an incentive to hold a
high ratio of assets to capital.
• The ratio of assets to capital is one measure of bank leverage, the inverse of
which (capital to assets) is called a bank’s leverage ratio.
Leverage is a measure of how much debt an investor assumes in making
an investment.
Bank leverage is the ratio of the value of a bank’s assets to the value of its
capital.
• The inverse of bank leverage is the leverage ratio.
• A high ratio of assets to capital (high leverage) is a two-edged sword:
Leverage can magnify relatively small ROAs into large ROEs, but it can
do the same for losses.
The Basic Operations of a Commercial Bank
© 2014 Pearson Education, Inc.
28 of 55
• Moral hazard can contribute to high bank leverage.
• If managers are compensated for a high ROE, they may take on more
risk than shareholders would prefer.
• Federal deposit insurance has increased moral hazard by reducing the
incentive depositors have to monitor the behavior of bank managers.
• To deal with this risk, government regulations called capital
requirements have placed limits on the value of the assets commercial
banks can acquire relative to their capital.
The Basic Operations of a Commercial Bank
© 2014 Pearson Education, Inc.
29 of 55
10.3 Learning Objective
Explain how banks manage risk.
© 2014 Pearson Education, Inc.
30 of 55
Managing Bank Risk
Managing Liquidity Risk
Liquidity risk is the possibility that a bank may not be able to meet its cash
needs by selling assets or raising funds at a reasonable cost.
• Banks reduce liquidity risk through strategies of asset management and
liquidity management.
• Asset management involves lending funds in the federal funds market,
usually for one day at a time.
• Bank can also use reverse repurchase agreements: buying Treasury
securities while at the same time agreeing to sell the securities back at a
later date, often the next morning.
• Liability management involves determining the best mix of borrowings using
repurchase agreements or discount loans.
Managing Bank Risk
© 2014 Pearson Education, Inc.
31 of 55
Managing Credit Risk
Credit risk is the risk that borrowers might default on their loans.
Diversification
• By diversifying, banks can reduce the credit risk associated with lending too
much to a single borrower.
Managing Bank Risk
© 2014 Pearson Education, Inc.
32 of 55
Credit-Risk Analysis
Credit-risk analysis is the process that bank loan officers use to screen loan
applicants.
• Banks often use credit-scoring systems to predict whether a borrower is
likely to default.
• Historically, the high-quality borrowers paid the prime rate.
• Today, most banks charge rates that reflect changing market interest rates
instead of the prime rate.
Prime rate was formerly the interest rate banks charged on six-month loans to
high-quality borrowers (now an interest rate banks charge primarily to smaller
borrowers).
Managing Bank Risk
© 2014 Pearson Education, Inc.
33 of 55
Collateral
• Collateral is assets pledged to the bank in the event that the borrower
defaults.
• Used to reduce adverse selection.
• A compensating balance is a required minimum amount that the business
taking out the loan must maintain in a checking account with the lending
bank.
Credit Rationing
Credit rationing is the restriction of credit by lenders such that borrowers
cannot obtain the funds they desire at the given interest rate.
• Loan and credit limits reduce moral hazard by increasing the chance a
borrower will repay.
• If a bank cannot distinguish low- from high-risk borrowers, then it will run the
risk of losing the low-risk borrowers when it raises the interest rate, leaving
only the high-risk borrowers—a case of adverse selection.
Managing Bank Risk
© 2014 Pearson Education, Inc.
34 of 55
Monitoring and Restrictive Covenants
• Banks keep track of whether borrowers are obeying restrictive
covenants—explicit provisions in the loan agreement that prohibit the
borrower from engaging in certain activities.
Long-Term Business Relationships
• The ability of banks to assess credit risks on the basis of private
information on borrowers.
• By observing the borrower, the bank can reduce problems of
asymmetric information.
• Good borrowers can obtain credit at a lower interest rate or with fewer
restrictions.
Managing Bank Risk
© 2014 Pearson Education, Inc.
35 of 55
Managing Interest-Rate Risk
Interest-rate risk is the effect of a change in market interest rates on a bank’s
profit or capital.
A rise (fall) in the market interest rate will lower (increase) the present value
of a bank’s assets and liabilities.
Managing Bank Risk
© 2014 Pearson Education, Inc.
36 of 55
Measuring Interest-Rate Risk: Gap Analysis and Duration Analysis
Gap analysis is an analysis of the gap between the dollar value of a bank’s
variable-rate assets and the dollar value of its variable-rate liabilities.
• Gap analysis is used to calculate the vulnerability of a bank’s profits to
changes in market interest rates.
• Most banks have negative gaps because their liabilities (deposits) are more
likely to have variable rates than are their assets (loans and securities).
Managing Bank Risk
© 2014 Pearson Education, Inc.
37 of 55
Duration analysis is an analysis of how sensitive a bank’s capital is to
changes in market interest rates.
If a bank has a positive duration gap, then:
• the duration of the bank’s assets is greater than the duration of the bank’s
liabilities.
• an increase in market interest rates will reduce the value of the bank’s assets
more than the value of the bank’s liabilities, which will decrease the bank’s
capital.
Managing Bank Risk
© 2014 Pearson Education, Inc.
38 of 55
Reducing Interest-Rate Risk
• Banks with negative gaps can make more adjustable-rate or floating-rate
loans. So, if market interest rates rise, banks pay higher interest rates on
deposits and also receive higher interest rates on their loans.
• Banks can use interest-rate swaps—agree to exchange the payments from a
fixed-rate loan for the payments on an adjustable-rate loan.
• Banks can use futures contracts and options contracts that can help hedge
interest-rate risk.
Managing Bank Risk
© 2014 Pearson Education, Inc.
39 of 55
10.4 Learning Objective
Explain the trends in the U.S. commercial banking industry.
© 2014 Pearson Education, Inc.
40 of 55
Trends in the U.S. Commercial Banking Industry
The Early History of U.S. Banking
The National Banking Act of 1863 made it possible for a bank to obtain a
federal charter.
National bank is a federally chartered bank.
Dual banking system is the system in the United States in which banks are
chartered by either a state government or the federal government.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
41 of 55
Bank Panics, the Federal Reserve,
and the Federal Deposit Insurance Corporation
• The Federal Reserve plays the role of a lender of last resort by making
discount loans to banks.
• Before the Fed existed, banks were subject to bank runs.
• If many banks simultaneously experienced runs, a bank panic often resulted
in banks being unable to return depositors’ money.
• After the severe bank panic of 1907, Congress passed the Federal Reserve
Act in 1913.
• The Great Depression led to bank panics, and Congress responded with the
creation of the Federal Deposit Insurance Corporation (FDIC) in 1934.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
42 of 55
Figure 10.2
Commercial Bank Failures in the United States, 1980–2012
Bank failures in the United States were at low levels from 1960 until the savings and loan
crisis of the mid-1980s.
By the mid-1990s, bank failures had returned to low levels through the beginning of the
financial crisis in 2007.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
43 of 55
The Rise of Nationwide Banking
• In the early 1900s, banks were prohibited from crossing state lines.
• In 1900, only 87 of the 12,427 commercial banks in the United States
had any branches—unit banking.
• The U.S. system of many small, geographically limited banks failed to
take advantage of economies of scale in banking.
• Restrictions on branching within the state loosened after the mid1970s.
• In 1994, the Riegle-Neal Interstate Banking and Branching Efficiency
Act allowed for the phased removal of restrictions on interstate
banking, further raising consolidation of banks.
• In 2010, concerns about bank size and banks “too big to fail” were
discussed in Congress, but no limits on size were finally enacted.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
44 of 55
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
45 of 55
Expanding the Boundaries of Banking
• Between 1960 and 2010, banks:
1. increased their funds and borrowings
2. relied less on C&I and consumer loans and more on real estate loans
3. expanded into nontraditional lending activities and activities generating
revenue from fees
Off-Balance-Sheet Activities
Off-balance-sheet activities are activities that do not affect a bank’s balance
sheet because they do not increase either the bank’s assets or its liabilities.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
46 of 55
Off-Balance-Sheet Activities
Four important off-balance-sheet activities that banks have come to rely on
to earn fee income:
1. Standby letters of credit.
Standby letter of credit is a promise by a bank to lend funds, if necessary,
to a seller of commercial paper at the time that the commercial paper
matures.
2. Loan commitments.
Loan commitment is an agreement by a bank to provide a borrower with a
stated amount of funds during some specified period of time.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
47 of 55
Off-Balance-Sheet Activities
Four important off-balance-sheet activities that banks have come to rely on
to earn fee income:
3. Loan sales.
Loan sale is a financial contract in which a bank agrees to sell the expected
future returns from an underlying bank loan to a third party.
4. Trading activities.
• Banks earn fees from trading in the multibillion-dollar markets for futures,
options, and interest-rate swaps.
• Bank losses from trading in securities became a concern during the
financial crisis of 2007-2009.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
48 of 55
Electronic Banking
• The first important development in electronic banking was the spread of
automatic teller machines (ATMs).
• By the mid-1990s, virtual banks (banks that carry out all their banking
activities online) began to appear.
• By the mid-2000s, most traditional banks had also begun providing online
services.
• Check clearing is now done electronically.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
49 of 55
In Your Interest
Is Your Neighborhood ATM About to Disappear?
Making the Connection
• ATMs are considered the first major product of modern information
technology.
• In response to recent regulations on charging certain fees, banks have
closed some branches and charged customers fees for using a bank
teller—leading to increased use of ATMs
• Increased use of debit cards and smart phones to pay for goods have
led to a reduction in the use of currency and ATMs.
• In the face of the conflicting influences, the future of the ATM remains
to be seen.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
50 of 55
The Financial Crisis, TARP, and Partial Government
Ownership of Banks
• As the financial crisis unfolded, residential real estate mortgages began to
decline in value.
• The market for mortgage-backed securities froze, making it very difficult to
determine their market prices. These securities became “toxic assets.”
• Evaluating balance sheets and determining the true value of bank capital
were difficult.
• Banks responded to their worsening balance sheets by tightening credit
standards for consumer and commercial loans.
• The resulting credit crunch helped cause the recession of 2007-2009, as
households and firms had trouble funding their spending.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
51 of 55
Troubled Asset Relief Program (TARP) is a government program under
which the U.S. Treasury purchased stock in hundreds of banks to increase the
banks’ capital.
Capital Purchase Program (CPP) is another initiative to inject capital into banks
by purchasing stock in hundreds of troubled banks.
Trends in the U.S. Commercial Banking Industry
© 2014 Pearson Education, Inc.
52 of 55
Answering the Key Question
At the beginning of this chapter, we asked the question:
“Is banking a particularly risky business? If so, what types of risks do
banks face?”
In a market system, businesses of all types face risks.
Of particular concern is the risk and potential for failure that banks face
because they play a vital role in the financial system.
The basic business of commercial banking entails several types of risks:
liquidity risk, credit risk, and interest-rate risk.
© 2014 Pearson Education, Inc.
53 of 55