Chapter 9: Banking and the Management of Financial Institutions Flashcards
Checkable deposits :
bank account that allows the owner to write checks to
third parties
Non-transaction deposits:
primary source of bank funds: owners cannot
write checks on it, but interest rates are higher.
Bank capital :
bank’s net worth: total assets – liabilities
- Raised by selling new equity or from retaining earnings
- Cushion against a drop in the value of the bank’s assets
Liabilities: sources of funds for banks
- Checkable deposits
- Non-transaction deposits
- Borrowings from other banks on the interbank market
- Bank capital
Assets: uses of fund from bank
- Reserves
- Cash items in process of collection
- Deposits at other banks (small banks holding deposits at larger banks in exchange for a variety of services: forex transactions, help with securities purchases)
- Securities (Federal government, local government and other)
- Loans (profits come from issuing loans)
- Other assets: physical assets (buildings, computers, other equipment)
Reserves (meaning and kinds?)
deposits plus currency physically held by the bank
- Required reserves: regulation that for every dollar in deposits, a certain fraction must be kept in reserves: 10% (required reserve ratio).
- Excess reserves: additional reserves a bank holds to meet its obligations when funds are withdrawn.
Asset transformation
profit comes from selling liabilities and using the proceeds to buy assets with
different set of characteristics
Basic Banking, variables:
- Asset transformation
- Cash Deposit
- Check Deposit
- Making a profit
- Evaluation of potential borrowers
- Asset transformation
- The bank borrows short and lends long
Check Deposit
When a bank receives additional deposits, it gains an equal amount of reserves; when it loses
deposits, it loses an equal amount of reserves.
• Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits.
Asset transformation:
selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics
the 5 C’s
Evaluation of potential borrowers: character, capacity, collateral, conditions, capital
4 primary concerns when managing bank
- Holding enough cash to meet the deposit outflows
-> Liquidity Management - Have an acceptable low level of risk
-> Asset Management - Acquiring funds at low costs
-> Liability Management - Decide the amount of capital the bank should maintain and acquiring the
needed capital
-> Capital Adequacy Management
Liquidity Management :
acquisition of assets that are liquid enough to meet the bank’s obligations to depositors
Asset Management :
acquiring assets that have a low rate of default by
diversifying asset holdings
Credit Risk:
the risk arising because borrowers may default
Interest-rate Risk:
the riskiness of earnings and returns on bank assets
caused by interest-rate changes.
(Liquidity Management and the Role of) Reserves, kinds:
- Excess reserves
* Shortfall: A bank holds insufficient reserves
Shortfall: A bank holds insufficient reserves
• Reserves are a legal requirement and the shortfall must be eliminated.
• Excess reserves are insurance against the costs associated with deposit
outflows.
Shortfall, The bank has 4 basic options:
- Borrowing on the interbank market
- Reducing loans
- Securities sales
- Borrowing from the Fed (ECB)
Shortfall Option 1: Borrowing
• Cost incurred is the interest rate paid on the borrowed funds (federal funds rate, interbank rate)
Shortfall Option 2: Securities sale
The cost of selling securities is the brokerage and other transaction costs.
Shortfall Option 3: Federal Reserve
• Borrowing from the Fed also incurs interest payments based on the
discount rate.
Shortfall Option 4: Reduce loans (what + how?)
• Reduction of loans is the most costly way of acquiring reserves.
How?
• Calling in loans (not renewing loans when the come due. This antagonizes
customers.
• Other banks may only agree to purchase loans at a substantial discount.
Why do banks hold excess reserves although loans earn higher returns?
Excess reserves enable banks to escape the costs of: • Borrowing from other banks • Selling securities • Borrowing from the central bank • Calling in or selling off loans
Excess reserves are insurance against the costs associated with deposit
outflows. The higher the costs associated with deposit outflows, the
more excess reserves a bank will want to hold.
Asset Management has Three goals:
- Seek the highest possible returns on loans and securities.
- Reduce risk.
- Have adequate liquidity.
Asset Management has
Four 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.
Why do banks have to make decisions about the amount of capital they need
to hold?
- Bank capital helps prevent bank failure.
- The amount of capital affects return for the owners (equity holders) of the bank.
- Regulatory requirement
Bank Capital has both benefits and costs:
- Benefits to the owners 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
Managing Credit Risk is …
Making successful loans that are paid back in full if banks want to earn high
profits.
what are the Principles that financial institutions must follow to reduce credit risk (to overcome Adverse Selection and Moral Hazard)
- Screening and Monitoring
- Long-Term Customer Relationships
- Loan Commitments
- Collateral and Compensating Balances
- Credit Rationing
Screening:
screen out the bad credit risk from the good so lenders have to collect reliable information from prospective borrowers.
Borrowers have to fill out forms, information about your personal finances to
calculate your credit score – based on data and judgment
Specialization in lending:
Lending to local firms or to firms in particular industries (easier to collect information, can better predict credit worthiness)
Monitoring and enforcement of restrictive covenants:
Writing provisions into loan contracts to restrict borrowers from taking risky
activities.
Long-term customer relationships:
Obtain information about their borrowers: through long-term customer
relationships
– reduced costs of information collection and easier to screen out bad credit risks
Loan commitments
A bank’s commitment for a specified future period of time to provide a firm
with loans up to a given amount at an interest that is tied to some market
interest rate.
Compensating balances:
a firm receiving a loan must keep a required minimum amount of funds in an
account at the bank
Refining the basic gap analysis by:
Maturity bucked approach:
• Measures the gap for several maturity subintervals (buckets) to calculate the effects of interest-rate changes can be calculated over a multiyear period
Standardized gap analysis:
• Accounts for different degrees of rate sensitivity among rate-sensitive assets and liabilities.
Duration analysis:
examines the sensitivity of the market value of the bank’s total assets and
liabilities to changes in the interest rates
Gap and Duration Analysis: (use)
Both duration analysis and gap analysis are useful tools for a manager of a financial institution who is concerned about the degree of exposure to interest-rate risk
kinds of Off-Balance-Sheet Activities
- Loan sales (secondary loan participation)
- 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 so removes the loan so that it is no
longer an asset on the bank’s balance sheet.
Trading activities and risk management techniques:
• Financial futures, options for debt instruments, interest rate swaps,
transactions in the foreign exchange market and speculation to reduce
risk or facilitating other bank business
• Principal-agent problem arises
• Importance of internal controls to prevent debacles
Money center banks:
large banks in key financial centers began to explore ways to get reserves and liabilities
How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis
Shortfalls of bank capital led to slower credit growth:
- Huge losses for banks from their holdings of securities backed by residential mortgages.
- Losses reduced bank capital
Banks could not raise much capital on a weak economy and had to tighten their lending standards and reduce lending.
Collateral:
property promised to the lender as compensation if the borrower defaults to reduce the risk of adverse selection and moral hazard.
eg., you can give your portfolio as your colladeral, so if your house is burned down and you need a loan to buy a new one but you didn’t get the money of the insurance yet then your can give the claim on that insurance as colladeral
Credit rationing
Refusing to make loans even though borrowers are willing to pay the stated interest rate, or even a higher rate
Generation of fee income. Examples:
- Specialized services to customers: making forex trades on a customer’s behalf, servicing mortgage-backed securities by collecting interest and principal payments and paying them out, …
- Creating SIVs (structured investment vehicles) which can potentially expose banks to risk, as it happened in the global financial crisis
Importance of internal controls to prevent debacles:
- Separation of people in charge of trading activities from those in charge of the bookkeeping for trades
- Limits on the amount of traders’ transactions
- Limits on the institution’s risk exposure
- Scrutinize risk assessment procedures (e.g. VaR –Value at Risk and stress testing)
restrictive covenants
covenant acknowledged in a deed or lease that restricts the free use or occupancy of property (as by forbidding commercial use or types of structures) one who purchases for value and without notice takes the land free from the restrictive covenant
