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Banking in the US. All Banks in the US are Chartered National Banks: Comptroller of the Currency National Banks: Comptroller of the Currency State Banks:

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  • Banking in the US

  • All Banks in the US are CharteredNational Banks: Comptroller of the CurrencyState Banks: State AuthoritiesSavings & Loans: Office of Thrift SupervisionCredit Union: National Credit Union Administration

  • Federal Reserve MembershipNational Banks are Required to be members of the Federal Reserve System (Membership is optional for state banks)Federal Reserve members are required to purchase stock in the federal reserve system.Federal Reserve members provide input to the election of Federal Reserve Board MembersThe Federal Reserve provides emergency loans (discount window) to all banks.The Federal Reserve provides check clearing services

  • Federal Deposit InsuranceFDIC insured banks are charged 0-27 cents per $100 of eligible deposits. All deposits up to $100,000 are insured by the FDIC. Federal reserve members are required to purchase deposit insurance.

  • Bank Supervision/RegulationNational Banks State Banks (Fed Members) Federal ReserveFederal Reserve OCCState AuthorityFDICFDIC

    State Banks (FDIC) State Banks(Non-FDIC)FDICState AuthorityState Authority

  • Banks, like any other business, exist to earn profitsBanks accept deposits and then use those funds to create loansProfit = Loans(rl)-Deposits(rs)

  • An ExampleSuppose that you raise $10 in initial equity to start a bank. You use this initial equity to by T-Bills.

  • An ExampleAssetsReserves: Securities: $10MLoans Consumer:Commercial/Industrial:Real Estate:Other:

    LiabilitiesTransaction DepositsChecking:Savings: Non-Transaction Deposits: Loans:Equity: $10M

  • An ExampleSuppose that you raise $10 in initial equity to start a bank. You collect $10M in checking accounts and $20M in savings accounts. Checking accounts earn no interest, savings accounts pay 2% annually.

  • An ExampleAssetsReserves: $30MSecurities: $10MLoans Consumer:Commercial:Real Estate:Other:

    LiabilitiesTransaction DepositsChecking (0%): $10MSavings (2%): $20MNon-Transaction Deposits: Loans:Equity: $10M

  • An ExampleSuppose that you raise $10 in initial equity to start a bank. You collect $10M in checking accounts and $20M in savings accounts. Checking accounts earn no interest, savings accounts pay 2% annually. The Federal Reserve requires you keep at least 5% in your vault ($1.5M)The remainder you loan out and buy T-Bills

  • An ExampleAssetsReserves: $2MSecurities (3%): $15MLoans Consumer:Commercial (7%): $20MReal Estate (8%): $3MOther:

    LiabilitiesTransaction DepositsChecking (0%): $10MSavings (2%): $20MNon-Transaction Deposits: Loans:Equity: $10M

  • An ExampleYour Profit after the first year will be:

    (.03)$15M + (.07)$20M + (.08)$3M (Interest Income)(.02) $20M (Interest Cost)$1,690,000

  • An ExampleSuppose that $1M was withdrawn from checking accounts

  • An ExampleAssetsCash Reserves: $1MSecurities (3%): $15MLoans Consumer:Commercial (7%): $20MReal Estate (8%): $3MOther:

    LiabilitiesTransaction DepositsChecking (0%): $9MSavings (2%): $20MNon-Transaction Deposits: Loans:Equity: $10M

  • An ExampleSuppose that $1M was withdrawn from checking accountsYour cash balances are now below the required 5% of deposits ($1.450,000). What do you do?

  • An ExampleSuppose that $1M was withdrawn from checking accountsYour cash balances are now below the required 5% of deposits ($1,450,000). What do you do?Recall a loanBorrow from another bank (federal funds market)Borrow from the federal reserve (discount window)Sell some securities

  • An ExampleAssetsCash Reserves: $6MSecurities (3%): $15MLoans Consumer:Commercial (7%): $20MReal Estate (8%): $3MOther:

    LiabilitiesTransaction DepositsChecking (0%): $9MSavings (2%): $20MNon-Transaction Deposits: Loans: $5M Equity: $10M

  • Equity CapitalNet Worth (Equity Capital) is the difference between a banks assets and liabilities Banks are required to maintain a minimum capital adequacy (equity capital >4% of risk weighted assets)

  • Risk weighted assets

  • Risk weighted assets4% of $24M ($960,000) is your required equity

  • An ExampleSuppose a $10M commercial loan defaults

  • An ExampleAssetsCash Reserves: $6MSecurities (3%): $15MLoans Consumer:Commercial (7%): $10MReal Estate (8%): $3MOther:

    LiabilitiesTransaction DepositsChecking (0%): $9MSavings (2%): $20MNon-Transaction Deposits: Loans: $5M Equity: $0M

  • An ExampleSuppose a $10M commercial loan defaultsWhat do you do now?

  • An ExampleSuppose a $10M commercial loan defaultsWhat do you do now?You need to raise equity or shut down!

  • Bank ProfitabilityReturn on Assets = After Tax Profits/Total AssetsReturn to Equity = After Tax Profits/Equity CapitalROE = ROA*(Assets/Equity Capital)

  • ROE vs. ROACompany AAssets = 100Profits = 10Debt = 20Equity = 80_________ROA = 10%ROE = 12.5%

    Company BAssets = 100Profits = 10Debt = 80Equity = 20_________ROA = 10%ROE = 50%

  • Equity Capital to Assets

  • Return on Assets

  • Return on Equity

  • Key issues in BankingManaging informational problems (moral hazard, adverse selection)Managing LiquidityManaging interest rate risk

  • Asymmetric Information Between Banks & BorrowersDiversificationCredit ScoringCollateralRationing (Credit Limits)Restrictive Covenants & MonitoringPersonal Relationships

  • Asymmetric Information Between Banks & SaversFDIC and Government RegulationCheckable Deposits as a commitment deviceCapital Adequacy Management

  • Managing LiquidityBanks dont like holding cash because it pays no interest, however a bank must always be able to meet the cash requirements of its demand depositsThis can be handled through excess reserves, active participation in the federal funds market or through asset & liability management

  • Interest Rate RiskA banks assets and liabilities are comprised of payments made or received over time. Therefore, their value depends on the interest rate.

  • Present ValueGiven some interest rate, the present value of $X to be paid in N years is:

    PV = $X/(1+i)^N

  • An ExampleSuppose you have a $10,000 loan with an annual interest rate equal to 5%. You agree to pay off the loan in three annual payments.

  • An ExampleSuppose you have a $10,000 loan with an annual interest rate equal to 5%. You agree to pay off the loan in three annual payments.

    P/(1.05) + P/(1.05)^2 + P/(1.05)^3 = ?

  • An ExampleSuppose you have a $10,000 loan with an annual interest rate equal to 5%. You agree to pay off the loan in three annual payments.

    P/(1.05) + P/(1.05)^2 + P/(1.05)^3 = $10,000

    P = $3,671

  • An ExampleSuppose you have a $10,000 loan with an annual interest rate equal to 5%. You agree to pay off the loan in three annual payments of $3,671. If the current rate of interest is 7%, what is the present value of this payment stream?

    PV = $3,671/(1.07) + $3,671/(1.07)^2 + $3,671/(1.07)^3 = $3,430 + $3,206 + $2,996 = $9,632

  • An ExampleThe loan originally had a value of $10,000 (when the market interest rate was 5%).A 2% rise in the interest rate caused the value of the loan to drop to $9,632 (a 4% decrease)

  • Duration & Interest Rate RiskThe duration of an asset or liability is the average payment date.The duration of an asset or liability represents an elasticity with respect to interest rate changesThe duration gap is the difference between the duration of assets and liabilitiesA bank with a positive (negative) duration gap is hurt by interest rate increases (decreases)

  • ExampleIn the previous example, our loan made three payments of $3,671. $3,671/(1.05) = $3,497$3,671/(1.05)^2 = $3,332$3,671/(1.05)^3 = $3,171 $10,000

  • ExampleIn the previous example, our loan made three payments of $3,671. $3,497/10,000 = .36 * 1 = .36$3,332/10,000 = .34 * 2 = .68$3,171/10,000 = .32 * 3 = .96 2.00

    %Change in value = (Duration)*(%Change in Interest Rate)

  • Back to our previous exampleAssetsCash Reserves: $6M (0)Securities (3%): $15M (5)Loans Consumer:Commercial (7%): $20M (10)Real Estate (8%): $3M (15)Other:

    LiabilitiesTransaction DepositsChecking (0%): $9M (0)Savings (2%): $20M (0)Non-Transaction Deposits: Loans: $5M (0)Equity: $10M

  • Duration GapTotal Assets = $44M

    (6/44)* 0 = 0(15/44)* 5 = 1.70(20/44)* 10 = 4.55( 3/44)* 15 = 1.02 7.27

    Total Liabilities = $34M

    (9/34)* 0 = 0(20/34)* 0 = 1.70( 5/34)* 0 = 2.04 0

  • Duration GapTotal Assets = $44M

    (6/44)* 0 = 0(15/44)* 5 = 1.70(20/44)* 10 = 4.55( 3/44)* 15 = 1.02 7.27

    Total Liabilities = $34M

    (9/34)* 0 = 0(20/34)* 0 = 1.70( 5/34)* 0 = 2.04 0

    Duration Gap = 7.27 0(34/44) = 7.27

  • Duration Gap %Change in Equity/Assets = - (dg)(%change in interest rate)dg > 0: Your equity capital falls when interest rates risedg < 0: Your equity capital rises when interest rates rise

  • Duration Gap In our example, we had equity equal to (10/44) = 22% of assets and a duration gap of 7.27.

  • Duration Gap In our example, we had equity equal to (10/44) = 22% of assets and a duration gap of 7.27.If interest rates rise by 1%, our equity capital falls by 7% to 15% of assets.

  • Duration Gap In our example, we had equity equal to (10/44) = 22% of assets and a duration gap of 7.27.If interest rates rise by 1%, our equity capital falls by 7% to 15% of assets.Recall, we are required to hold equity equal to at least 4% of assets. Therefore, if interest rates rise by more than (22-4)/7 = 2.5%, well be shut down! What should we do?

  • Dealing With Interest Rate RiskDuration Gap ManagementFloating Rate LoansSwapsFutures & Options

  • The Money MultiplierWhile the Fed controls M0 (Cash + Reserves), Banks largely control M1 (Cash + Demand Deposits)The money multiplier relates change in M1 to changes in the monetary baseChange in M1 = mm* Change in M0For example, if the multiplier was equal to 5, every $1 increase in M0 will increase M1 by $5.

  • Money Multiplier

  • Money MultiplierM0 = Cash (C) + Reserves (R)M1 = Cash (C) + Demand Deposits (D)

    mm = M1/M0 = (C + D)/(C + R)

    = (C/D + 1) (C/D + R/D)

  • Money Multiplier

    mm = (C/D + 1) (C/D + R/D)

    D = $650BC = $720BR = $45B

    mm = 1.81