5 - Ec R of Banks Flashcards
What is the primarily role of a bank?
Take in funds (called deposits), pool them and lend them to those who need funds
What will you not find under a banks balance sheet?
Inventory
Accounts Receivable
Accounts Payable
How is a banks balance sheet different to a typical company?
You won’t find:
Inventory
Accounts Receivable
Accounts Payable
You will mostly see:
Assets:
• Loans: Banks provide loans to customers
• Investments: Banks invests in various financial instruments, such as government bonds, corporate bonds and securities
Liabilities:
• Deposits: Customers deposit money into their accounts at a bank which is recorded as a liability
• Borrowing: Banks may borrow money from other financial institutions or issue bonds
Why does banks have cash and cash equivalent in the balance sheet?
Generally, for liquidity reasons
Loans in the balance sheet represent
Represents majority of banks assets.
Bank: Loan versus securities
Can typically earn a higher interest rate on loans than on securites
What is PP&E in the balance sheet, and how big will it be?
Property, Plant and Equipment.
Usually only a small fraction of the assets
What is goodwill in the balance sheet?
Typically reflects the value of intangible assets, like:
a) Strong brand name
b) good customer relations
c) good employee relations
What is Off-Balance Sheet (OBS)?
Assets or liabilities that do not appear on a company’s balance sheet, but that are nonetheless effectively assets or liabilities in the company.
Example of typical Off-Balance Sheet (OBS)
Some loans are securitized and sold off as investments. The securitized debt will be kept off the banks books (operating lease is one of the most common off-balance items)
How does a bank typically categorize their revenue
1) Interest Income
2) Non-Interest Income
What is the “spread” for a bank
The difference in interest that a bank earn on loans and paid to their depositors
How does banks earn a non-interest income?
Provide a variety of value-added serviced like
a) Trading of securities
b) commissions on securities
c) assisting companies to issue new equity financing
d) Wealth management
What are reserve requirements?
A regulation from the central bank.
A commercial bank must hold a minimu amount of liquid cash (normally in a bank vault)
Why are banks required to hold reserves?
If many depositors withdraw their money before the loan due date, it might be difficult for the bank to fill the withdrawal.
What is capital requirement?
The amount of capital a bank or other financial institutions has to hold as required by its financial regulator.
How are capital requirements usually expressed?
As a capital adequacy ratio of equity tht must be held asa percentage of risk-weighted assets
Four brackets of typical bank services
Individual banking
Business banking
Digital Banking
Loans
What is individual banking
Services to assist individuals in managing their finances
What is individual banking
Services to assist individuals in managing their finances
examples of individual banking
Checking accounts
Savings account
Debit credit cards
Insurance
Wealth management
What is business banking
Offer financial services for business owners who need to differentiate professional and personal finance
Example of business banking
Checking accounts
Savings account
Debit and credit cards
Merchant services
Cash management
What is digital banking?
The ability to manage your finances from your computer, tablet, or smartphone. The use of technology
Some different types of loans?
1) Personal loans
2) Home equity loans
3) Home equity lines of credit
4) Home loans
5) Business loans
What are the two major types of financial markets where firms can borrow money in form of debt?
1) Bank loan markets
2) Capital markets
What are capital markets?
Markets for buying and selling equity and debt instruments
How do we split up the capital market?
a) Primarily markets: Where stock and bond issues are sold to investors
b) Secondary markets: Trading of existing securities
What are the main differences between bank lending and capital markets?
1) A regular bank is not securitized
2) Lending from banks and similar institutions is more heavily regulated than capital market lending
3) Bank depositors tend to be more risk averse than capital market investors
What is the predominat source of external funding in all countries? What is the role of capital markets in this?
Bank loans. Capital markets have never been a significant source of financing and equity markets are insignificant
What is a bond?
Instrument of debt of the bond to the holders. A debt security, under which the ssuer holds a debt and, depending on the terms of the bond, is obliged to pay them interest (coupon) and/or to repay the principal at a later date
Major difference between stocks and bonds?
Both are securities
Main difference: (Capital) stockholders have an equity stake in a company (investors) whereas bondholders have a creditor stake in the company (lenders)
Who has priority of bondholders and stockholders?
Bondholders are creditors, and have a priority over stockholders. They will get repaid in advance.
Fixed Rate Bond
Coupon that remains throughout the life of the bond
Floating Rate Notes (FRNs, Floaters)
Variable coupon linked to a reference of interest, such as LIBOR or Euribor
ZCBs
No regular interest. Issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity
High-yield bonds (junk bonds)
Bonds that are rated below investment grade by the credit rating agencies. As these bonds are riskier, investors expect a higher return
Convertible bonds
- Lets a bondholder exchange a bond to a number of shares of the issuers common stock.
- Typically known as hybrid securities, because they combine equity and debt features
inflation-indexed bonds
Principal amount and interest payment are indexed to inflation.
Interest rate is normally lower than for fixed rate bonds with comparable maturity. However, as the principal grows, the payments increase with inflation
Subordinated bonds
Bodns that have a lower priority than other bonds of the issuer in case of liquidation. Lower ranked in the hierarchy on who gets paid first. Yields higher risk, and will usually have a lower credit rating
In case of bankruptcy, when does the subordinated bondholders get paid? Explain the hierarchy
1) First the liquidation is paid
2) then the holders of senior bonds get paid
then the subordinated bondholders get paid
Government bonds
Also called Treasury bonds. Issued by a national government and is not exposed to default risk. Is characterized as the safest bond - with the lower interest rate
What is lines of credit?
A borrowing limit is extended to a customer, and funds can be borrowed again later after the money is repaid
What is revolving credit?
Type of credit that basically is an arrangement allowing for the loan amount to be withdrawn, repaid, and withdrawn again in the manner and any number of times, until the arrangement expires
Examples of revolving loans?
Credit card loans
Overdrafts
Difference between Bank Loans and Bonds: Revolving Concentrated vs. dispersed lenders
A bond typically has thousands of holders while a bank loan only have one or a few (syndicate) as lenders
What are the two types of covenants?
Financial covenants
Negative covenants
What are financial covenants?
Require the borrower to maintain certain financial ratios or performance measures.
Often:
Leverage
Debt-to-EBITDA ratio.
What are negative covenants?
Restrict borrower from certain actions such as
* excessive investments,
* distribution of dividends,
* asset sales,
* change in company control,
* misuse of cash flows etc.
What is the simplest way to justify the existence of banks?
Reduce transaction costs
Transaction costs include two different types of costs:
Observable costs (e.g., travelling, time and effort)
Unobservable costs (e.g., agency costs)
What do we mean by economies of scale?
The reduction in the average costs (cost per unit) associated with increasing the scale of production for a single product type.
What do we mean by economies of scope?
Lowering the average cost for a firm in producing two or more products (Example, Mcdonalds; fries & burger)
How can banks reduce transaction costs?
a) Economies of scale
b) Economies of scope
c) Digitalization
d) Regulation and supervision of banks by the authorities
Compared to small lenders/borrowers, banks will save money from economies of scale by having less costs of:
Searching or matching,
screening,
contracting,
negotiation,
diversification,
monitoring
How will banks save money due to economies of scope?
INFORMATION.
Enjoy access to privileged information, and can evaluate borrowers creditworthiness
Banks advantage in relationship lending?
Economies of scope:
1) Lend to same firm over time, sthrengtens relationship and customer loyalty.
2) Custommer has specialized financial products designed from demographics, such as students, seniors or the wealthy.
Customers advantage when it comes to commercial banks
The authorities look over the behavior of the banks. So the customers dont have to spend resources on it
How does a bank reduce transaction costs when it comes to searching and matching?
Hire professionals
Employs advanced equipmend
Repeatedly conducting the searching or matching process
Why do banks exist?
Diversification
Explain diversification
A risk management technique that mixes a wide variety of investments within a portfolio
What are the two general techniques for reducing risk?
Diversification
Hedging
What are the four main functions of a bank
1) Offer liquidity and payment services
2) Transforming assets
3) Managing risks
4) Processing information and monitoring borrowers
What is commodity money, or fiat money?
Money without an intrinsic value. Not backed by gold etc.
How does a bank transform assets?
a) Banks choose the unit size (denomination) of its products (deposits and loans)
b) Risk transformation
c) Maturity transformation
Explain Transforming assets: convenience of denomination
Match small deposits with large loans and large deposits with small loans.
Without a bank, lenders and borrowers have to match by themselves. Banks are more professional to do the job due to economies of scale & scope
Explain Transforming assets: Risk transformation
Banks deposits better risk-return characteristics than direct investments because of:
a) Risk management: small investors cannot diversify their portfolios
b) asymmetric information: banks have better information or expertise than depositors
Explain Transforming assets: Maturity transformation
Transformi ng short-term liabilities into long-term assets. This is the source of interest rate risk and liquidity risk
What are the traditional sources of risk affecting banks
1) Credit Risk
2) Interest rate risk and liquidity risk
3) Off-balance-sheet operations
Explain a banks Credit Risk
Risk that aa borrower is not able to repay its debt
How will a bank try to limit the Credit Risk?
Collateral
Diversification
Explain the banks interest rate risk and liquidity riskn
Cost of funds may rise above the interest rates that are granted by the bank
Unexpected withdrawals of deposits may force banks to seek more expensive sources of funds
What are the banks risks when it comes to Off-Balance-Sheet Operations
This usually means an asset or debt or financing activity that are not in the company’s balance sheet
