Chapter 17 - Commercial Banking

Question 1

Commercial banks

Answer 1

institutions that accept deposits (liabilities) and make loans (assets). Traditionally larger than FI by asset size. Investment banks are not depository institutions. Mutual funds also don’t accept deposits, but issue shares and invest them in other securities.

Question 2

Why do banks go Off Balance Sheet

Answer 2

banks want more assets and less liabilities, thus wanting to go more and more OBS. OBS activities don’t show up in book equity, but are taken into consideration for market equity.

Question 3

What are off balance sheet components? (3)

Answer 3

1. securization (sell loans and repackage them into securities to free up space in balance sheet)
2. loan commitments (provide up to $X to borrower)
3. Trading/hedging (e.g. derivatives: options, futures, interest rate swaps)

Question 4

Basics of banking (2)

Answer 4

1. banks engage in asset transformation: bank uses deposits to make loans
2. banks tend to borrow short and lend long (maturity wise)

Question 5

General principles of Bank Management (4)

Answer 5

1. Liquidity Management
2. Asset management
3. Liability Management
4. Managing capital adequacy

(1&4 and 2&3 go together)

Question 6

Liquidity management

Answer 6

this is needed because the maturity of banks’ assets is generally longer than the maturity of liabilities, so a bank might have to pay before it receives proceeds from assets. this ensures that there is enough cash to pay depositors if they wish to withdraw their money.

Question 7

How to solve no excess reserves? (4)

Answer 7

1. borrow from other banks - cost: FedFund rate
2. sell securities - cost: transaction costs
3. Borrow from Fed - cost: discount rate (higher than FedFund rate)
4. call in or sell off loans - cost: low liquidity in secondary market for loans.

Question 8

what is the problem of large reserves?

Answer 8

large reserves reduce profitability, less loans.

Question 9

Asset management

Answer 9

the attempt to earn the highest possible return on assets while minimizing the risk (and holding liquidity)

Question 10

liability management

Answer 10

managing the source of funds, from deposits, to CDs, to other debt.

Question 11

Capital adequacy management

Answer 11

funds are supplied by bank owners directly via purchases of shares, or through retention of retained earnings. when losses occur, they first get subtracted from the bank’s net worth, before other creditors get affected. If assets drop below the value of liabilities if becomes negative, meaning the bank is insolvent

Question 12

what does insolvency mean

Answer 12

even if the bank sells all its assets it will not be enough to pay all its creditors

Question 13

banks need to manage the amount of capital held because: (2)

Answer 13

1. a strong capital stock protects from banks failure

2. the capital stock affects the bank’s profitability (negatively)

Question 14

retained earnings

Answer 14

portion of profits that are not distributed through dividends

Question 15

insolvent banks go bankrupt unless: (3)

Answer 15

1. the owners (stockholders) provide new funds
2. new owner steps in
3. sometimes buying an insolvent bank is cheap

Question 16

Return of Assets (ROA)

Answer 16

broad idea of how well the bank is using its assets to generate income

Question 17

Return on Equity (ROE)

Answer 17

what owners (equity holders) ultimately care about: the return they get on the capital they provided to the bank

Question 18

Equity multiplier (EM)

Answer 18

the smaller the ratio of capital to assets, the greater the ROE, for any given net income. Equity holders prefer to have less capital (more leverage)

Question 19

Net Interest Margin (NIM)

Answer 19

measures how well the bank generates income from its primary function: issuing liabilities and investing in interest-earning assets. NIM is the spread between what the bank earns in interest income and what it has to pay