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Financial Institutions

-- Banking

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Functions of

Financial Institutions 1. Aids the flow of capital

2. Credit allocation

3. Provides economies of scale and scope

4. Satisfies the needs of general public

5. Provides specialization and expertise 6. Assists asset transformation

7. Offers INTERMEDIATION

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Intermediation

The process of transforming a secondary

security into a primary security by a

financial institution.

It relates to financial investments by savorscash cash

Savors Financial Borrowers

Institutions

secondary primary

securities securities

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Dis-intermediation

The process of reversing or rejecting the

transfer of funds into the financial

institutions. This refers to the low deposit interest rates

or high operating costs charge to customers.

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Illustration of Disintermediation

The removing of Middlemen

The dis- or re-channeling funds flow from

the FI

Changing Role to the Servicing of Markets

Security Investments

Mutual Funds

Insurance

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Types of Intermediation

1. Liquidity

2. Maturity

3. Denomination

4. Risk

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Types of Financial Institutions

By Banking Business Nature:

Banks

Non-Banks

Non-Finance

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By Business Operations:

Thrift type

Contractual type

Investment type

Other type

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Thrift-type Financial Institutions Banks:

Commercial Banks

Savings Banks

Investment Banks (Merchant Banks)

etc

Non-Banks:

Deposit-taking Company, Savings and Loan,

Home Loans, Building Society,

Credit Unions

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Contract-type

Financial Institutions Insurance Companies:

Life Insurance

Accident and Healthy Insurance

Pension Funds:

Mandatory Providence Funds

Retirement Funds/Pension Funds

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Investment-type

Financial Institutions Investment Companies:

Closed-end Investment Companies - Investment

BrokersOpen-end Investment Companies - Mutual

Funds/Unit Trust

Real Estate Trust Investment Companies

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Other Financial Institutions Finance Companies

Factors Companies

Lease Companies

Mortgage Companies

Credit Card Companies

Non-finance Financial Institutions:General Electric, Ford Motors, Toyota Motors

wholesalers, Manufactures, Department Stores

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Why Financial Institutions?

Fulfill economic goals

Reduce transaction and information costs

Provide liquidity

Prevent risks

As transmission of monetary policy Provide payment mechanism

Supply credit allocation

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Analysis of Financial Institutions

1. Transaction Costs

2. Information Asymmetry -- Moral Hazard

3. Financial Risks

4. Financial Innovation

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High Transaction Costs:

Solutions Economy of Scale--to reduce the average

unit costs of production as output

increase (%Output , AC) Economy of Scope --to generate cost

synergies by producing multiple services

( C{x1, x2} < C{x1} +C{x2} ) Specialization: market niche

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Solution

Information Asymmetry--Moral Hazard:

Information Symmetry and Full Disclosure

Regulation Reform

Financial Intermediation

Financial Risks: Risk Management and Control

Burden Administration

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Solutions

Financial Innovations:

Enhance Internal Control--

Planning, Control, and Administration

Tighten Asset Management and Quality

Modernized Operation System Strengthen Regulation and Monitoring

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Duties of the Management of

Financial Institutions 1. Determining the optimal capital structure

Assets, Liabilities, and Capital

2. Managing interest rate/currency/credit risks

3. electing/Pricing investments and liabilities

Maturity Matching, Profit Making

4. Operating effectively

Information Processing

Communication Technology

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Basic Concept -- Banking

What is a Bank?

A bank is a financial intermediarywhich provides special types

services relating to finance.

A bank is a company which carrieson banking business with a valid

banking license. (Banking Ordinance)

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Banking Business

Banking Ordinance - section 2 A. Receiving from the general public

money on current deposit, savings

deposit or other similar accountrepayable on demand or within less than

three months or at call or notice of less

than three months; B Paying or collecting cheques drawn by or

paid in by customers.

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Universal Definition of A Bank

A Bank is a licensed organization that

1. Accepts Deposits from the general

public

2. Grants Loans

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Special Features of a Bank

1. It is a regulated organization.

2. It offers checking accounts (Demand

Deposit Accounts, or Current Accounts)

3. It acts as payment mechanism.

4. It can create money

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Money Creation Feature

1. Assumptions:

No cash outflow (Depositors will not make

any drawing) Comply with the Reserves Requirement on

Deposits

No Excess Reserves set by the Bank Excess Balance on the Deposits will be loaned

out

All Loans will be re-deposited back to the Bank

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Process of Money Creation: (Minimum Deposit Reserves equal to 20%)

1. Deposits $1,000 into the Banking System

bank will maintain deposit reserves $200

At the same time, $800 will be lent out

Borrower will immediately deposit the $800

back to the bankThe Bank will then have $1,800 in its Deposit

account

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B. The additional $800 deposited into theBank.

20% of $800 ($160) will be taken out as

reserves.

The remaining balance of $640 will be lent out.

Borrower(s) will not withdraw cash and deposit

the $640 into the Bank

The Bank will have a total of 2,440 in Deposits.($1,000+$800+$640)

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C. The process repeats again until the

reserves requirement equal to the originaldeposits amount. The Multiple Effect

appears.

D = deposits; r= reserves requirement MC=Money Creation

MC = D/r)$1,000 x (1/0.2) = $5,000 ..

(M1) Minimum Reserves is $5,000 x 0.2 =$1,000

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The multiplier is 5

Money creation equals $4,000

r = 0.2; Multiplier = 5



r = 0.08; Multiplier = 12.5

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In Reality, the Multiplier may not be

exactly the same (as 5 on the reserves

requirement is 20%).

M1 is always larger than original deposits.

Monetary Policy can increase or decrease

the reserves requirement to control the

money supply.

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Bank Organization Structure

Unit Banking

Branch Banking

Dual Banking

Bank Holding Company

Multinational Banking

Retail Banking

Wholesale Banking

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HK Banking System

3 tier Banking System: (Structure):

1981: Licensed Banks

Licensed Deposit-taking Companies

Registered DTC

1989: Licensed Banks

Registered Licensed Banks

Deposit-taking Companies

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Banks in Hong KongSource: HKMA Monthly Statistical bulletin, January 2002

Restricted licence banks Deposit-taking companies

Incor- Incor- Incor- Incor- Incor- Incor- All

porated porated porated porated porated porated authorised

As at end of in HK outside HK in HK outside HK in HK outside HK institutions

Licensed banks

1995 31 154 37 26 129 3 380

1996 31 151 38 24 121 3 368

1997 31 149 39 27 113 2 361

1998 31 141 35 25 99 2 333

1999 31 125 33 25 71 0 285

2000 31 123 28 20 61 0 263

2001 29 118 29 20 54 0 250

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Balance Sheet of HK BanksSource:HKMA Monthly Statistical Bulletin, January 2002

Balance Sheet of HK Licensed Banks (Dec.31, 2001) in 000,000 Mill $HK$ F.C. Total

Assets

Notes and Coins 12 2 14

Due From AIs 276 166 442

Due from Banks Abroad 110 2,023 2,134

Loans and Advances to Customers 1,508 521 2,029

Negotiable CDs 84 38 122

Negotiable Debt other than CDs 339 516 855

Acceptance and Bills of Exchange 2 32 34

FRNs and CP 44 200 244

Government Bil ls Bonds and Notes 201 76 277

Other Debt Instruments 92 207 299

Investments in Shareholdings 42 3 45

Land and Buildings 63 1 64

Other Assets 107 67 174

Total Assets 2,880 3,852 6,733

Liabilities -

Due to AIs 175 168 343

Due to Banks Abroad 163 1,254 1,417

Deposits from Customers 1,832 1,486 3,318

Negotiable CDs outstanding 132 35 167

Other Debt Instruments 1 42 43

Capital Reserves and other Liabil it ies 437 156 593

2,740 3,141 5,881

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Funds Flow of a Bank

Funds Flow-in:

Deposits

Borrowing / NCD

Contributed Capital

Funds Flow-out:

Loans and Advances

Investments

Capital Expenditures

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Balance Sheet Presentation

Assets Side:

- Cash and Balance due from Depository

Institutions

- Investments (Short- and Long-term)

- Loans and Advances

- Plant and Equipment

- Investments in Subsidiaries

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Liabilities:

- Core Deposits

- Certificate Deposits

- Borrowings (Short- and Long-term)

Equity Capital

- Paid-in Capital

- Retained Earnings (Reserves)

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Bank Assets and

Liabilities Structure

Rate Sensitive Assets Rate Sensitive Liab.

Fixed Rate Assets Fixed Rate Liab.

Non-Rate Assets Equity

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Bank Balance Sheet

Characteristics 1. Few Fixed Assets -- Low Degree of

Operating Leverage

2. Substantial Amount Short-termLiabilities (Deposits) -- Requires High

Liquidity

3. Substantial Amount of Assets Relative toEquity Capital -- High Degree of

Financial Leverage

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Services Provided by Banks

General Areas:

- Intermediation: Liquidity, Maturity

Risk, Denomination

- Cost Reduction

- Price Reduction

- Information

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Special Services Provided by

Banks

1. Money Supply Transmissions

2. Credit Allocation

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Development Factors

in Financial Institutions 1. Crossing Traditional Boundaries

2. Global Competition

3. New Opportunities

4. Deregulation/Re-regulation

5. Corporate Restructuring

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The Development in

Banking Industry 1. Institutionalization

2. Globalization

3. Securitization

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Structural Change in Banking

1. Technological Change

2. Regulation Change

3. Economical Change - Interest Rate

Fluctuation

4. Competition Induced Change

5. Bank International Settlement

Requirement --Capital (Kapital) Change

**TRICK**

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Financial Innovation in Banking

TRICK + Rational Self-Interest =

Financial Innovation

New financial products and processes that

improve the economic efficiency with

which financial transactions are conducted,either by serving customers needs in new

unregulated ways or by lowering costs.

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Examples of Financial Innovations:

Negotiable Certificate Deposits

ZERO-Coupon Securities

Financial Futures Negotiable Order of Withdrawal (NOW a/c)

Money Market Deposit Account (MMDA)

Euro-Dollar Deposits Securitization

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Banking Regulations

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Reasons for Banking Regulations

1. Protect Customers

2. Improve Implementation of Monetary Policy

3. Ensure Competitive Markets 4. Prevent from Bank Run

5. Eliminate Prejudice in Supply

6. Pursue Desirable Credit Allocation 7. Protect Taxpayers from Bailouts

8. Reduce Information Asymmetries

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What IF There is NO Regulations

Money will be destroyed

Payment Mechanism will be Disrupted

Credit will be Shrink

Risk will be increased

Information Flow will be retarded

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Objectives of Bank Regulations

1. Safety

2. Stability

3. Structure

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Forms of Bank Regulations

Entry Control - Licensed

Safety and Soundness Control:

Liquidity

Capital Adequacy

Concentration Limits

Credit Allocation Control

Geographical Expansion Control

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Cost/Banefit Analysis of

Regulation Cost

Filing Cost

restricted ActivitiesTaxes

Benefits:

Restricted CompetitionGovernment Support

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Banking Operating Structure

Industry Organization Model:

Structure

Conducts

Performance

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Bank Organization Structure

Merge and Acquisition -- Super Size Banks

Efficiency

Effectiveness

Multinational Foreign Banks

Multinational Bank Holding Companies

Double Leverage

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Double Leverage for MBHC

Bank Parent Company: raise funds $10

Billion by issuing bonds or borrowing

This amount is then transferred/investedinto the subsidiary Bank

The funds are used to expand the subsidiary

banks capital size. If the subsidiary bank maintain an 20%

required ratio of Equity to Asset

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The subsidiary banks assets will be

increase by $50 billion while meeting the

regulatory capital requirement of 20%.

Increase Injected Bank Equity Funds

in =

Assets Required Reserves Ratio

Increase in Assets = $10b / 0.20 = $50b

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Bank Performance

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Risks Faced by Bank Operations

Liquidity Risk

Credit (Default) Risk

Interest Rate Risk

Technology/Operational Risk

Regulatory Risk

Country/Sovereign Risk

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Currency (Foreign Exchange) Risk

Political Risk

Off-Balance Sheet Risk

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Objectives of Bank Performance

To Reduce Risks

To Maximize Net Worth

To Maximize Profit

To Comply with Regulations

To Fulfill Bank Policies

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Features of Bank Performance

Accepts general publics savings as deposits

and grant loans to those who need them.

Bank products are mainly services The income and expenses are divided into

Interest Portion

Non-interest Portion

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Profitability Analysis

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Measurement of Profitability

Net Interest Income (NII) =

Interest Income Interest Expenses

Net Interest Margin (NIM) =

Interest Income Interest Expenses

Total Earning Assets

Spread = (Average Interest Income Rate

Average Interest Expense Rate)

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Factors Affecting NIM/NII

Credit Risk - Higher Risk; Higher Yields

Interest Rate Fluctuation

Funding Mix: S/T vs L/TSources:wholesale vs retail; savings vs time

Uses: commercial vs mortgage vs consumers

Pricing Mix: Fixed Rate vs Floating Rate Non-performance Assets

Tax Exempted Investments

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Impact of Interest Rate

Fluctuation on NIM Monitoring Rate Sensitive Assets

and Liabilities -- Gap Management

RSA > RSL .... Positive GapRSA < RSL Negative Gap

RSA = RSL Zero Gap

When Interest Rate increases,+ Gap: IR > IE + NII ; + NIM

Gap: IR < IE NII ; NIM

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Measurement

Return on Net Worth Return on New Worth (RONW) =

(Total Net Income / Total Equity on MV)

Return on Assets (ROA) =

(Total Net Income / Total Assets)

Return on Equity (ROE) =

(Total Net Income / Total Equity on BV)

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Asset/Liability Management Monitoring Assets and Liabilities Mix:

Actively Management the Which Assets are

funded by What Liabilities

The GAP (RSA = RSL)RSA financed by FRL

FRA financed by FRL

NRA financed by FRL Determine the Amount, Rate Differential

and the Expected Earnings of all the items.

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Illustration of Active Mgt Example:

RSA 8% $ 170 RSL 6% $ 150

FRA11% 155 FRL 8.5% 185

NRA 30 Equity 20

Total $ 355 Total $ 355

Rate Differentials (Annual)

On RSA and RSL (8% - 6%) 2% On FRA and FRL (11% - 8.5%) 1.5%

On GAP and FRL (8,5% - 8%) 0.5%

On NRA and FRL (8.5% - 0%) ( 8.5%)

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Profitability Analysis

RSA financed by RSL ($150 @ 2%) $3 FRA financed by FRL ($155 @ 1.5%) 2.325

GAP financed by FRL ($20 @ 0.5%) 0.1

NRA financed by FRL ($10 @ 8.5%) (0.85) NRA financed by Equity ($20 @ --) 0

Total Pre-tax Profits $4.575

RONW (ROE) = $4.575 20 = 0.22875

~ 22.875%

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Liquidity Analysis

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Nature of Liquidity

1. The ability to maintain sufficient funds

to fulfill the regulatory requirement

2. The ease with which a bank to convertthe assets into cash to meet the claims of

withdrawals and /or to repay the debts

and expenses.

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Concepts of Liquidity

Narrow Concept: the ability to maintain

sufficient funds or to raise a certain amount of

deposits at a certain cost within a certain

amount of time to meet the needs by the bank -- Store Liquidity

Broad Concept: the ability to include the

ease with which the bank can obtain cash byborrowing from external sources --

Purchasing Liquidity

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Liquidity Requirement by

Hong Kong Banking Ordinanace Any Licensed Bank should maintain the

Liquidity Ratio of not less than 25% of

Liquefiable Assets to its QualifyingLiabilities for each calendar month, based

on the sum of net weighted amount of the

liquefiable assets and the sum of the

qualifying liabilities for each working day

of the month.

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Causes of Liquidity

1. Liability-side Causes:

Depositors withdraw cash from their

accounts or additional deposits do notcome as expected

2. Asset-side Causes:

Lending commitments or Matured Loansdo not pay on time.

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Indicators of Liquidity Risk

1. Mis-Matching of maturities of

Qualifying Assets to Liquefiable

Liabilities 2. Inadequate Liquidity Ratio on

Qualifying Assets to Liquefiable

Liabilities

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Measurement of Liquidity Risk

1. Static Measurement:

a. Liquidity Ratio:

Qualifying Assets

Liquefiable Liabilities

b. Net Cash Flows Analysis:

Cash In-flowsCash Out-flows

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2. Dynamic Measurement:

a. Liquidity Planning: to analyze thedeposits withdrawals and additional

deposits, and the loans commitments

and loans repayments. To determine

the net effect on the Liquidity

Position.

Liq.Bal Deposits Loans Net Change

+ + $140 $50 $75 $100 $80 $???

+Liq Liq Liq +Liq

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B. Trends Analysis on Loans and Deposits:

$ Deposits

Liquidity

Gap Loans

t

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Management of Liquidity Risks

1. Store Liquidity

a. Maintain sufficient CASH and Near

Cash b. Maintain Good Quality Loans

c. Retain Deposits in the Bank

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2. Purchase Liquidity:

a. Maintain Diversified Borrowing

Sources:

(I) Inter-bank Loans

(ii) Other Borrowings (iii) Discount Windows (LAF)

(iv) REPO

(v) NCD b. Increase Deposits

c. Seek Deposit Sources (Euro$ Deposit)

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Lending Analysis

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Nature of Lending

Lending is the single and largest categoriesfor banking

Lending provides the primary source of

revenue for banking

Banking business is to grant loans to

allocate capital

Lending classes: Commercial and Industry,

Real Estate (Mortgage). Consumer, and

others (leasing, agriculture, govt, etc)

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Concepts of Bank Lending

1. The possibility of total loss become less

as the number of loans increases

2. The possibility of no losses also become

less as number of loans increase

3. As loan portfolio getting larger, number

of loans that will go bad can be predicted

4. The Larger the loan portfolio, thepossibilities of total loss are very remote

5. In large loan portfolio, some losses are

certain

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Elements for Lending Policy

Size

Maturity

Composition

Interest Rate: Loan Pricing

Fixed Rate or Floating Rate

Analyze Loan Loss

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Strategies for Lending Policy

Loan Analysis

No Analysis

Subjective Analysis 5 Cs

Ratio Analysis and Cash Flow Analysis

Objective Analysis

Credit Score

Z Score

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Credit ScoreAltmans Z Score

Z = 1.2X1 +1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

X1 = Working Capital / Total Assets

X2 =Retained Earnings / Total Assets]

X3 = EBIT / Total Assets

X4

= M. Value of Equity / B. Value of Total Debts

X5 = Sales / Total Assets

Z Score Probability of Failure

1.8 or less Very High

1.812.99 Not Sure 3.0 or Above Unlikely

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Loan Administration

Centralized Approval

Decentralized Approval Loan Authorization

Personnel

Authorized Line of Credit Loan Monitoring

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Loan Delinquency

a. Workout Agreement b. Collateral Liquidation

c. Reducing Debt to Collecting Judgment

d. Charge off

e. Bankruptcy

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Capital Analysis

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Role of Capital

To Support Operating Asset Commitments

To Promote Depositors Confidence

To Improve Growth - Loans and Deposits

- Earnings

To Prevent Morale Hazard

C i i f C i l

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Composition of Capital

Traditional Concept: (GAAP Concept) 1. Contributed Capital:

-- Core and Supplementary Capital

2. Book Value

Regulatory Concept: (Regulatory

Accounting Principles)

1. Contributed Capital plus Debt Capital

2. Market Value

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Debt as Source of Capital

Attribute of Debt: (Regulatory point of view)

1. It is legally subordinate to deposits.

2. It does not require immediaterepayment.

3. It offers some protection to

depositors.

4. It is a sources of funds

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Conditions for Debt as Capital

Original maturity of 5 year or more

When Issue must Identify as

Subordinate to deposits

Must be Uninsured

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Capital Adequacy

Regulatory Requirement: (Bank of

International Settlement Requirement)

Capital / Risk Adjusted Assets > 8%Core Capital / Risk Adjusted Assets > 4%

Internal Requirement:

-Add a Premium onto the BIS requirement-Currently Average Ratio is 20%

Quantitative Analysis

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Quantitative Analysis

of Capital Adequacy 1. Leverage Analysis:

NW/ Total Assets

NW / Risk Adjusted Assets

NW / Average LoansNW / Average Deposits

2. Net Capital Ratio:

Capital + R.E.Problem AssetsRisk Adjusted Assets

NCR < 2.74 ---- Inadequate

Q alitati e Anal sis

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Qualitative Analysis

of Capital Adequacy Regulatory Analysis:

CAMEL --- Capital size

Asset QualityManagement

Earning History

Liquidity Position

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Continued

For Bank Holding Company Institutes

CAMEL + BOPEC

Bank SubsidiaryOther Subsidiaries

Parent Company

Earnings (Consolidated)

Capital (Consolidated)

Documents

4 Banking