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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%)
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–
–
–
–
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
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•
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•
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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
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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
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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