Banking and the Bank Balance Sheet Flashcards
Principal banking actives and what makes them special
- borrow money from customers
- lend money to customers
they facilitate flow of funds through the economy but aren’t just intermediaries, they are agents providing a venue for borrowers and lenders
- Act as principal for their own account
Have promoted economic mobility and pushed the global economy to greater heights
Meltdown in banking sector has catastrophic effects
Bank balance sheet and the golden rule
the statement of what a financial institution of company owes at a given point in time
Golden rule: total assets = total liabilities
assets are the uses of funds and interest payments on them
liabilities are the sources of funds that the bank uses
difference between bank and company balance sheets
a bank balance sheet is applicable only on the banks which are prepared to reflect the tradeoff between the profit of the bank and its risk
a company balance sheet is applicable on all types of companies which are prepared to reflect the financial status of the business
Assets and components
- Financial assets
- Liquidity assets
- Reserves (includes vault cash): required reserves and excess reserves
- Deposits at other banks
- securities
- customer assets (loans)
- Real estate and other commercial assets
- Mortgages and other retail assets - Physical assets
- Branches, call centres, buildings, technology etc
- Banks own few physical assets in relation to their total assets
Liabilities and components
- Wholesale funding
- Customer deposits
- commercial deposits - including non-transaction deposits
- Retails deposits - including non-transaction
- customer deposits to calculate a banks loan to deposit ratio base
- Bank capital
- Equity = assets - liabilities
sits on the liability side as it is owed to shareholders
- cushion against a drop in the value of assets which could force the bank into insolvency
loan to deposit ratio base
if LDR>100%, bank has loan book greater than deposit base
Banks with high LDR are more reliant on wholesale borrowing
Wholesale funding refers to the use of deposits and other liabilities from institutions such as banks, pension funds, money market mutual funds and other financial intermediaries. When a bank relies on short-term wholesale funds to support long-term illiquid assets, it becomes vulnerable to runs by wholesale creditors.
Bank equity and Net Interest Margin
NIM is the difference between the interest rate a bank pays on its liabilities and the interest rate it generates from its financial assets
- is why shareholders put themselves in a position where they are first in line to absorb the losses of a banks bad debt
If bank charges 5% on customer assets and pays 3% on customer deposits - NIM is 2%
Value of this NIM on 500bn balance sheet would therefore by 10 billion
if running this bank has costs of 5bn, shareholders would then get dividends of 5bn
Basic banking
basic operation of a bank is asset transformation
a T-account is a simplified balance sheet with lines in the form of a T
it lists only the changes that occur in balance sheet items starting from initial balance sheet position
Opening a current account and using cash deposit
increases on asset (cash) side and on liability side (checkable deposits interest)
leads to an increase in banks reserves equal to the increase in checkable deposits
when a bank loses a deposit, it loses an equal amount of reserves and vice versa
Asset transformation
selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics
The bank borrows short and lends long: fundamental activities
Primary concerns of a bank manager
- Liquidity management
- asset management
- liability management
- capital adequacy management
Liquidity management and the role of reserves
bank has required reserves of 10% and suffers deposit outflow of 10m
- If a bank has ample reserves, a deposit outflow does not require changes in other parts of balance sheet
Shortfall
reserves are a legal requirement and the shortfall must be eliminated
excess reserves are insurance against the costs associated with deposit outflows
A shortfall is an amount by which a financial obligation or liability exceeds the required amount of cash that is available.
A funding shortfall is a lack of money to meet projected needs. Such shortages are a particular concerns for governments and non-governmental organizations that provide services to members of the public.
Ways of eliminating shortfall
1.Borrowing
- cost incurred is the interest rate paid on borrowed funds
- Security sale
- the costs of selling securities is the brokerage and transaction costs
- Central bank
- Borrowing from the CB also incurs interest payments
This interest rate in the US is called the discount rate
- reduce loans
- reducing loans is the most costly way of acquiring reserves
- calling in loans antagonises customers
- other banks may only agree to purchase loans at a substantial discount
Asset management goals
- seek the highest possible returns on loans and securities
- reduce risk
- have adequate liquidity
Asset management tools
- Find borrowers who will pay high interest rates and have low possibility of defaulting
- purchase securities with high returns and low risk
- lower risk by diversifying
- balance need for liquidity against increased returns from less liquid assets
Liability management
the decision made by a bank in order to maintain liquid assets to meet the banks obligations to depositors
phenomenon due to rise of money centre banks in 1960s
checkable deposits have decreased in importance as source of bank funds
Capital Adequacy management
Banks hold capital for 3 reasons
- Helps prevent bank failure
- Amount of capital affects return for the owners (equity holders) of the banks
- Regulatory requirement
How does bank capital help prevent failure or insolvency?
e.g during GFC if 5m of housing loans are written off
bank capital allows the reduction of the possibility of becoming insolvent
Insolvency could lead to a bank run
Return on assets (ROA)
net profit after taxes per pound of assets
= net profit after taxes/assets
Return on Equity (ROE)
net profit after taxes per pound of equity (bank) capital
= net profit after taxes/equity capital
Equity Multiplier (EM)
the amount of assets per pound of equity capital
= assets/equity capital
ROE = ROA x EM
Trade-off between safety and returns to equity holders
- benefits the owner of a bank by making their investment safe
- costly to owners of a bank because the higher the bank capital, the lower the return on equity
- choice depends on the state of the economy and levels of confidence
Regulatory requirements
- Banks hold capital as a requirement
- Due to the costs of holding bank capital, banks prefer to hold less capital relative to assets that is required by authorities
- The setting of capital adequacy standards are coordinated at a global level by an organisation called the Basel Committee on Banking Supervision
Managing credit risk
Credit risk is the risk that a contracted payment will not be made.
Markets put a price on this risk which is included in the market’s purchase price for the contracted payment.
» The part of the price that is due to credit risk is the credit spread.
What a typical credit risk model includes
» the conditions of the general economy and those of the specific firm in question as inputs.
» generate credit spread as the output.
To estimate the amount of economic capital needed to support their credit risk activities, banks can employ an analytical framework
» that relates the required economic capital for credit risk to their portfolio’s probability density function (PDF) of credit losses.
Problems to overcome with credit risk
» adverse selection – those most likely to default on their loans are also the most likely to be selected
» moral hazard – lender subject to hazard of default when borrower engages in high risk activities and is less likely to pay back loan
Principles for managing credit risk
- Screening and monitoring
- Specialisation in Lending
- Long-term customer relationships
- Loan commitments
- Collateral and compensating balances
- Credit rationing
Screening and monitoring
» Screening – collecting reliable information on potential borrowers (outstanding loans, cars, salary, marital status etc)
- Can use this to calculate your credit score to evaluate such credit risk
Monitoring and enforcement of restrictive covenants.
- Writing provisions/restrictive covenants into loan contracts can restrict borrowers from engaging in risky activity
- Leads to banks spending a lot of money on auditing and collecting information
Specialisation in Lending
when banks tend to specialise in lending to local firms or those in certain industries – doesn’t diversify its loan portfolio so is exposing itself to more risk
- Can help however when becoming more knowledgeable about certain industries and the risks they bare
Long-term customer relationships
» Reduce costs of information collection.
- Reduces costs of monitoring as bank knows how to deal with customer
» Easier to screen bad credit risks.
- Can lead to firms getting lower interest rates on loans as bank spends less money on screening and monitoring
- Shows an incentive to avoid risky activities in order to get future loans
Loan commitments
- A banks commitment for certain amount of time to provide a firm up to a given amount at an interest rate tied to some market rate
» Promotes long-term relationships.
» Good for information gathering.
Collateral and compensating balances
Property promised in compensation if borrower defaults so reduces the consequences of adverse selection
Also reduces moral hazard as borrower has more to lose at default
» Compensating balances often required – a firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank in case of default
Helps the bank monitor the borrower and reduces moral hazard – bank can monitor firms check payment practices
Any change in the borrower’s payment schedule is a signal to the bank to make inquiries
Credit rationing
2 forms
» Lender refuses loan for any amount no matter what interest rate. – firms willing to pay higher rates are usually those up to more risky activities
»Lender willing to loan less than borrower would like. – the larger the loan, the less likely one is to engage in activities that lead to not paying it back
Gap analysis
a method of measuring the sensitivity of a bank’s profit to changes in interest rates (interest-rate risk).
Basic gap analysis
Amount of rate sensitive liabilities is subtracted from amount of rate sensitive assets - the ‘gap’.
(Rate sensitive assets − rate sensitive liabilities) × ∆ interest rates = ∆ in bank profit
Change in value of assets = - (rate change) x average duration x asset value
Change in value of liabilities = - (rate change) x average duration x liability value
Change in net worth = change in assets – change in liabilities
- Can either lengthen liability duration or shorten asset duration
- Can use inter-banking system to move debt from one bank to another
Other gap analyses
Maturity bucket approach:
» Addresses the weakness the basic gap analysis.
» Measures the gap for several maturity subintervals, called maturity buckets.
Standardised gap analysis:
» Also improves on the basic gap analysis.
» Accounts for different degrees of rate sensitivity among rate sensitive assets and liabilities.
Duration analysis
measures the sensitivity of the market value (MV) of the bank’s total assets and liabilities to changes in interest rates.
Duration analysis is based on Macaulay’s concept of duration:
%∆(in market value of security) ≈ − %age point ∆ in interest rate x duration in years
Uses the weighted average duration of a financial institution’s assets and of its liabilities to see how net worth responds to a change in interest rates.
Gap and duration analysis conclusions
In summary, both gap and duration analysis suggest that banks
» will suffer if interest rates rise, but gain if interest rates fall.
Both analyses are important tools for a bank manager to know the bank’s degree of exposure to interest rate risk.
If a bank is subject to substantial interest rate risk e.g a future rate rise:
» it can eliminate the interest rate risk by adjusting its balance sheets. shorten the duration of the assets or lengthen the duration of its liabilities.
Can also engage in an interest rate swap in which it swaps the interest earned on its assets with the interest earned on another banks assets that have a longer duration
Off-Balance sheet activities
Loan sales
Generation of fee income
Trading activities and risk management techniques
Loan sales
secondary loan participation). – a contract that sells all or part of the cash stream from a specific loan and removes the loan so it’s no longer an asset on the banks balance sheet
Banks earn profits from this as selling at a higher rate than they were issued – the high interest rates on some loans make them attractive so some firms pay a premium, even though the higher price means they earn a slightly lower interest rate than on the original loan
Generation of fee income
fees from providing specialised services for customers such as forex trades, collecting interest on mortgage-backed securities, providing back up lines of credit (such as overdraft privileges)
Trading activities and risk management techniques
Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market, and speculation. Principal-agent problem arises.
Off-balance sheet activities increase a banks risk as exposes them to more default risk
Internal problems to reduce the principal-agent problem
» Separation of trading activities and bookkeeping.
» Limits on exposure.
» Value-at-risk.
» Stress testing.
The principal-agent problem is a conflict in priorities between the owner of an asset and the person to whom control of the asset has been delegated. The problem can occur in many situations, from the relationship between a client and a lawyer to the relationship between stockholders and a CEO.
Impacts of climate risk drivers to banks
Climate risk classified into:
1. Physical risks - landslides, floods, wildfires, storms etc.
2. Transition risks - related to the process of adjustment towards a low-carbon economy.
Climate risk drivers:
1. Physical risks.
2. Transition risks.
The effects of climate risk drivers on banks’ financial risks are complex.
Liquidity risk summary
- danger from sudden withdrawal of funds by depositors
can respond by holding cash reserves, managing assets (sell loans and securities) and managing liabilities (borrow)
Credit risk summary
- danger from borrowers defaulting
respond by:
- holding sufficient capital
- diversifying to spread risk
- screening for credit worthy borrowers
- monitor to reduce moral hazard
- other measures
Interest rate risk summary
- danger from mismatching of assets and liabilities with a change in interest rates
can respond by closely matching the maturity on both sides of the balance sheet
Trading risk summary
- danger from trading losses within the banks own account
respond by closely monitoring traders with risk management tools
Why would equity holders care more about the ROE than the ROA
ROE tells equity holders how much they are earning on their equity investment, while ROA only provides an indication of how well a banks assets are being managed
Benefits and costs of increasing bank capital the bank holds
The benefit is that the bank will have a larger cushion of bank capital and so is less likely to go broke if there are losses on its loans or other assets
The cost is that for the same ROA, the bank will have a lower ROE
What can be done to raise the ROE
To lower capital and raise ROE, holding assets constant, the bank can pay out more dividends or buy back some of its shares
Alternatively, keeping the bank capital constant, can increase the amount of assets by acquiring new funds and then seeking out new loan business or purchasing new securities with these new funds
3 things a bank can do to increase its capital
issue new stock
reduce dividends
decrease amount of banks assets so bank capital relative to assets increases
Assessing financial risks from climate exposure
- Credit risk - affects asset side of the bank
Effect on loans
- increased default risk
- increased default on mortgages from households and businesses
- this is due to damages on properties
- collateral taken damaged (physical assets reduced)
MV of assets thereby appear to be less than that of liabilities
- Liquidity risk - liability side
- There will be an increased demand for liquidity by depositors
- This is because they may want to rebuild, move or take out insurance
- There’s a refinancing risk due to the effects on creditor side
- Market risk
- Have to reprice equities
- Fixed income effected
- Banks commodities effected
What can the bank do to improve this liquidity, credit and market risk
Screening
- Change lending behaviour
Don’t use loans from areas prone to floods/fires
- Diversify
Start lending to areas not affected - Take insurance against climate risks or damage to collateral
- Securitisation
If mortgages given in a prone area, sell them off to a different bank willing to take on the risk - Hedging with weather derivatives
