Part 3: Financial Institutions

Question 1

What are banks and what do they do?

Answer 1

Banks are financial institutions that take deposits and make loans.
They also play a crucial role in the channelling of funds and in reducing asymmetric information.

Question 2

What is the total size of commercial banks in the US?

Answer 2

Around $18 trillion

Question 3

What are the 3 items typically seen on the Liabilities side of the balance sheet of commercial banks?

Answer 3

1- Checkable Deposits
2- Nontransaction Deposits
3- Borrowings

Question 4

Explain what Checkable Deposits (liability) are, and their advantages and disadvantages for banks:

Answer 4

Typical deposits at banks, as seen in checking accounts.
Advantage: lowest cost source of funds for banks
Disadvantage: require a cost of servicing for clients

Question 5

Explain what Nonstransaction Deposits (liability) are:

Answer 5

Savings accounts and timed deposits. Timed deposits can be small denominations (

Question 6

Explain what Borrowings (liability) are:

Answer 6

The interbank market (Fed fund, Libor market), the Bond market, as well as discount loans obtained from the central bank.

Question 7

How important are certificates of deposits to money markets?

Answer 7

Certificates of deposit are the second most traded security in money markets, right behind Treasury Bills

Question 8

What are the 4 items typically seen on the Asset side of the balance sheet of commercial banks?

Answer 8

1- Reserves and Cash Items
2- Securities
3- Loans
4- Other assets

Question 9

What is the most important type of Asset for commercial banks, typically? Describe the asset.

Answer 9

Loans are the most important asset for banks: they are how they make most of their money. Loans include business, mortgage, and consumer loans. They are somewhat risky and not very liquid, usually.

Question 10

Describe what Reserves and Cash Items (asset) includes…

Answer 10

Reserves held at the central bank, currencies, checks (cash in the process of collection)

Question 11

Describe what the commercial bank asset “Securities” refers to:

Answer 11

Mostly fixed-rate assets (debt): short- and long-term US government securities, as well as state and local government securities

Question 12

Describe what “Other Assets” refers to on the balance sheet of commercial banks and comment on their liquidity:

Answer 12

“Other Assets” refers to a bank’s physical capital (buildings, computers, etc.). They are not very liquid.

Question 13

What are the two big differences to remember on the balance sheet of most American banks compared to the balance sheet of the typical American corporation?

Answer 13

1- The high level of leverage (small level of capital): around 90% of assets are financed by debt…

2- Sharp differences between the characteristics of assets and liabilities (assets are mostly long-term and risky, liabilities are mostly short-term and risk-free)

Question 14

How much reserves should banks own compared to checkable deposits in the US, according to regulations?

Answer 14

Reserves and cash items should represent at least 10% of all Checkable deposits. Banks typically more than comply.

Question 15

Why are there significantly more reserves held by banks now compared to pre-2007?

Answer 15

Because of quantitative easing: the Fed now pays interest on reserves. The Fed’s balance sheet increased significantly since 2008, and this is reflected on the balance sheet of commercial banks as well.

Question 16

Why are there such strong differences between the characteristics of assets and liabilities on the balance sheet of commercial banks?

Answer 16

Banks perform financial intermediation, selling liabilities with one type of characteristics and buying assets with different characteristics.

Assets are illiquid, risky, and long-term while liabilities are liquid, risk-free, and short-term.

Question 17

How does the balance sheet of commercial banks help explain the importance of securitization?

Answer 17

Securitization helps make the balance sheet’s assets more liquid. Loans are typically illiquid, risky, and long-term.

Question 18

Why is risk management so important to banks?

Answer 18

Banks need to mitigate 3 types of risk:
1- Default risk
2- Liquidity risk
3- Interest rate risk

Question 19

Why do commercial banks have Off-Balance Sheet items?

Answer 19

Because these items have unpredictable cash flows, are difficult to price, and possess complex features

Question 20

Give two examples of Off-Balance Sheet items for commercial banks

Answer 20

1- Loan Commitments: banks agreeing to lend money in the future, like credit lines
2- Derivatives: features, forwards, swap contracts, trading activities, hedging etc.

Question 21

What are the two defining characteristics of the balance sheet of commercial banks?

Answer 21

1- Very high level of leverage (or low level of capital);
2- Imbalance between the characteristics of the assets and the characteristics of liabilities;

As a result of these imbalances (2) banks need to manage risks.

Question 22

Name and describe the two items on the Operating Income section of the commercial bank’s income statement:

Answer 22

1- Interest income: interest from loan securities

2- Non-interest income: mostly due to OBS

Question 23

Name and describe the three items on the Operating Expense section of the commercial bank’s income statement:

Answer 23

1- Interest expense: interest payments made on deposits
2- Non-interest expenses: wages, servicing costs
3- Provisions: used to account for expected defaults

Question 24

What are the main characteristics of operating income statements for commercial banks prior to 2008?

Answer 24

1- Operating income shows a 2/3 - 1/3 split between interest and non-interest income, with non-interest income growing over time
2- Roughly 50-50 split between interest and non-interest expense, with provisions being relatively small (showing a good year for banks)

Question 25

What are the main characteristics of operating income statements for commercial banks in the aftermath of 2008?

Answer 25

1- Operating income shows a 2/3 - 1/3 split between interest and non-interest income, with non-interest income growing over time
2- Provisions for loan losses increased a LOT
3- Banks still show a profit, because the Fed kept interest rates low and interest rates on liabilities reset faster than interest rates on assets

Question 26

What are the operating income statements of commercial banks like now?

Answer 26

1- Operating income shows a 2/3 - 1/3 split between interest and non-interest income, with non-interest income growing over time
2- Interest expense is still low (low interest rates by Fed)
3- Provisions for loan losses are still high

Question 27

What are the 3 key metrics in performance analysis for commercial banks?

Answer 27

1- Return on Asset (ROA)
2- Return on Equity (ROE)
3- Net Interest Margin (NIM)

Question 28

Describe the performance metric ROA

Answer 28

ROA = Net Income / Assets

ROA measures how efficiently a business uses its assets to produce a profit

Question 29

Describe what the performance metric ROE analyses and its relation to ROA

Answer 29

ROE = Net Income / Capital, or Equity

ROE essentially represents a leveraged version of ROA

Question 30

Describe the performance metric NIM

Answer 30

NIM = (Interest Income - Interest Expense) / Assets

Net Interest Margin only focuses on the core activities of commercial banks: taking deposits and making loans. It examines the core profitability of commercial banks.

Question 31

Why is it more useful to look at ROA than ROE when looking at banking trends over the years?

Answer 31

Because ROE is essentially just a more volatile version of ROA.

Question 32

Why is ROA increasing over time even though NIM remains stable?

Answer 32

Because NIM is stable, this means this augment in profitability cannot be due to the core activities (interest expense and interest income). It is, in fact, due to an increase in activities (and income) of Off-Balance Sheet items, as well as a reduction in servicing costs due to advances in technology.

Question 33

What is Universal Banking?

Answer 33

Universal Banks are banks that participate in many different activities including Securities, Asset Management, Commercial Banking, and Insurance.

Question 34

Why is there a trend in banks becoming universal banks?

Answer 34

Because while financial institutions are still more important than capital markets in the channelling of funds today, capital markets are gaining ground reducing the influence of the bank. Banks transition into universal banks to offset the revenue drop in commercial banking by increasing revenue in investment banking, asset management etc.

Question 35

What are the three reasons why the importance of capital markets is increasing over time

Answer 35

1- Improvement in technology
2- Avoidance of regulation on financial institutions
3- Better education amongst investors

Question 36

What is the Glass-Seagall Act and why is it important?

Answer 36

The Glass-Seagall Act imposed a strict separation between commercial banking and investment banking making it harder for U.S. commercial banks to diversify their activities

Question 37

What happened to the Glass-Seagall Act?

Answer 37

Banks tried to push the boundaries of the act by managing mutual funds, performing brokerage, and underwriting (without taking risk in it).
In 1997, authorities allowed banks to acquire securities firms
In 1999, the Glass Seagall Act was repealed

Question 38

What are the possible advantages of Universal Banking?

Answer 38

1- Cross-selling: clients can have all their needs met at the same institution
2- Diversification benefits: earnings volatility is reduced (if a division performs poorly, another may have done better, offsetting this)
3- Cost reduction: banks grow larger, reaching economies of scale

Question 39

What are the possible drawbacks of universal banking?

Answer 39

1- Banks can develop monopolistic behaviours
2- Conflict of interest: banks can stuff unwanted securities in funds sold to clients to dispose of them
3- Banks can engage in excessively dangerous behaviour because they’re guaranteed to be bailed out
4- Regulatory oversight: who should monitor these huge institutions?

Question 40

What is the Volcker Rule and what does it mean for banks?

Answer 40

The Volcker rule bans proprietary trading for banks asking banks to make a clear case that they are buying securities for hedging purposes, not speculation

Question 41

What is Shadow Banking?

Answer 41

Shadow Banks are non-banks (not subject to regulatory oversight) that are very important to the channelling of funds.

Essentially, if you take away the shadow bank from a financial market, the market disappears. This is a Shadow Bank.

Question 42

What 4 institutions do we classify as shadow banks?

Answer 42

1- Money Market Funds
2- Hedge Funds
3- Pools of securitized assets
4- Investment Firms

Question 43

Are shadow banks bigger than commercial banks?

Answer 43

Yes

Question 44

What are the two types of assets of Shadow Banks

Answer 44

1- Mortgage products (for investment banks and conduits)

2- Risky debt (for money market funds)

Question 45

What are the three types of liabilities of shadow banks

Answer 45

Short-term Liquid Investments
1- Client’s Money (for conduits and money market funds)
2- Repos (for investment banks, hedge funds)

Capital

Question 46

Define the imbalance between assets and liabilities of shadow banks

Answer 46

1- Assets: illiquid, risky, and long-term

2- Liabilities: liquid, not risky, short-term

Question 47

Do shadow banks use a substantial amount of leverage?

Answer 47

Yes.