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Chapter 12 Depository Institutions: Banks and Bank Management McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008 Depository Institutions: The Big Questions • What is a bank? • Where do banks get their funds and what do they do with them? • What are the risks banks face? 12-2 Depository Institutions: Roadmap • Commercial Bank Balance Sheets • Bank Risk 12-3 Preliminaries: Financial Institutions Financial institutions are firms whose assets and liabilities are primarily financial instruments. 12-4 Preliminary: Financial Institutions • Depository Institutions: Financial institutions that accept deposits. Includes banks, savings and loans, savings banks, and credit unions. We’ll call all of these Banks • Nondepository institutions: Financial institutions – insurance companies, pension funds, mutual funds and the like – do not accept deposits. 12-5 Balance Sheet of Commercial Banks: Assets, Liabilities, and Capital • The balance sheet identity: Bank Assets = Bank Liabilities + Bank Capital When one side changes, the other side must change as well. 12-6 Balance Sheet of Commercial Banks: U.S. Banks 12-7 Commercial Bank Assets: Uses of Funds • Cash (3.1%) – Reserves = vault cash + deposits at the Fed – Cash Items in process of collection – Balances held at other banks 12-8 Commercial Bank Assets: Uses of Funds • Cash (3.1%) • Securities (22.7%) – U.S. Treasury = 12.3% of assets – State and Local Government = 10.4% of assets – These are very liquid. They are secondary reserves. – U.S. Commercial banks are not allowed to purchase stocks. 12-9 Commercial Bank Assets: Uses of Funds • Cash (3.1%) • Securities (22.7%) • Loans (65.6%) – – – – – Commercial and Industrial (C&I) Real Estate Consumer Interbank Primary differences among various depository institutions is in the composition of their loan portfolio. 12-10 Balance Sheet of Commercial Banks: Changes in Assets over time 12-11 Commercial Bank Liabilities: Sources of Funds • Checkable Deposits (7.3%) – Available on Demand – Include Now accounts, Super-Now, Insured Market Rate accounts – Also known as transactions deposits – Have declined substantially in importance 12-12 Commercial Bank Liabilities: Sources of Funds • Checkable Deposits (7.3%) • Nontransaction Deposits (64.1%) – Certificates of Deposit – Large (> $100,000) are negotiable 12-13 Commercial Bank Liabilities: Sources of Funds • Checkable Deposits (7.3%) • Nontransaction Deposits (64.1%) • Borrowing (22.0%) – Discount loans for the Fed – Reserves from other banks in the Federal Funds Market (unsecured) – Repurchase agreements 12-14 12-15 Balance Sheet of Commercial Banks: Changes in Liabilities over time 12-16 • Finding the right bank takes some work • Decide what services you need • Shop around looking for a bank that provides them cheaply • Be sure that your bank is insured 12-17 • China & India a growing at 8 to 10% per yr • It could be even faster. Here’s why: • China: – 75% of investment goes through banks – State-owned enterprises (48% of GDP) receive 73% of credit – Need to use banks less. • India: – 40% of investment goes through banks – People mistrust banks – Need to use banks more. 12-18 Bank Capital • • • • • • Assets – Liabilities = Net Worth This is bank capital. It is the value of the bank to its owners. Bank capital is roughly 9% of assets Ratio of Debt to Equity is about 10 to 1 That’s substantial leverage! 12-19 Bank Profitability • Return on Assets (ROA) Net profit after taxes ROA = Total Bank Assets • Return on Equity (ROE) Net profit after taxes ROE = Bank Capital 12-20 Bank Profitability • ROE = ROA x (Assets/Capital) • U.S. bank ROA is typically 1.2 to 1.3% • ROE is 10 to 12 times that! • Note trend in profits: Fees are an increasing % of profit. 12-21 Off-Balance-Sheet Activities • Don’t show up as assets or liabilities • Generate income through fees and compensation for risk bearing • Examples: – Loan Commitments – Letters of Credit 12-22 • It is easy to get a payday loan • You need a ID, a phone or utility bill, and a pay stub. • The problem is that they are very expensive. • Payday loans are really a last resort 12-23 Sources of Bank Risk • • • • • Liquidity Risk Credit Risk Interest-Rate Risk Trading Risk Foreign Exchange, Sovereign & Operational Risk 12-24 Liquidity Risk • Source: – Withdrawal from Transaction deposit – “Take down” of loan commitment • Management – Asset Adjustment Not very appealing: it shrinks the size of the bank – Liquidity Adjustment Issue large denomination CDs 12-25 12-26 12-27 Credit Risk • Source: Borrower default • Management: – Diversification – Credit-risk analysis (also addresses information asymmetry) – Collateral – Long-term relationship 12-28 • For years banks accepted deposits in lowincome neighborhoods and made loans to high-income borrowers. • This could have been either – good business, controlling risk – discrimination • Believing that discrimination explained at least part of this, the law now requires bankers to make loans in neighborhoods where they take deposits 12-29 Interest-Rate Risk: Source • • • • Banks assets don’t match liabilities They “borrow short” and “lend long” Creates a maturity mismatch When interest rates move, it affects Revenue from the assets Costs of the liabilities differently 12-30 Interest-Rate Risk: Source • Classify assets and liabilities into – Interest-rate sensitive – deposits – Not interest-rate sensitive – long-term loans • What happens if interest rate rise? – Deposit costs based on flexible short-term interest rates rise – Loan revenues based on past (fixed) long-term interest rates don’t 12-31 Interest-Rate Risk: Management • Change maturity structure of assets to better match liabilities using instruments like Adjustable Rate Loans • Use derivatives, like swaps Remember an interest-rate swap turns fixed-rate into flexible-rate bonds 12-32 12-33 Trading Risk • Source: – Banks employ traders who use bank capital to try and make profits. – Trading creates risk of losses. • Management: Statistical models to calculate value-at-risk 12-34 Other Risks • Foreign-Exchange Risk – Make loans in foreign currency – Exposure to exchange rate fluctuations • Sovereign Risk – What if a foreign government stands in the way of repayment? • Operational Risk – Computers might go down – Buildings may become inaccessible. 12-35 Summary of Sources and Management of Bank Risk 12-36 12-37 Chapter 12 Depository Institutions: Banks and Bank Management McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008