Chapter Fifteen

The Banking Firm and Bank Management

Slide 15–3

The Bank Balance Sheet

Flow of funds (tab down to commercial banks)http://www.federalreserve.gov/releases/z1/current/z1r-4.pdf

Slide 15–4

Bank Operation

• T-account Analysis: – Deposit of $100 cash into First National Bank

First National BankAssets Liabilities

Vault cash +$100 Checkabledeposits

+$100

Slide 15–5

First National BankAssets Liabilities

Cash items inprocess ofcollection

+$100 Checkabledeposits

+$100

Bank Operation

• Deposit of $100 check

• Conclusion: When bank receives deposits, reserves by equal amount; when bank loses deposits, reserves by equal amount

First National BankAssets Liabilities

Reserves +$100 Deposits +$100

Second National BankAssets Liabilities

Reserves -$100 Deposits -$100

Slide 15–6

Principles of Bank Management

1. Liquidity management

2. Asset management– Managing credit risk

– Managing interest-rate risk

3. Liability management

4. Managing capital adequacy

Slide 15–7

Principles of Bank Management

Liquidity ManagementReserves requirement = 10%, Excess reserves = $10 million

Assets Liabilities

Reserves $20 million Deposits $100 million

Loans $80 million Bank Capital $10 million

Securities $10 million

Slide 15–8

Principles of Bank Management

• With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet

Deposit outflow of $10 millionAssets Liabilities

Reserves $10 million Deposits $90 million

Loans $80 million Bank Capital $10 million

Securities $10 million

Slide 15–9

Liquidity Management

• With 10% reserve requirement, bank has $9 million reserve shortfall

No excess reservesAssets Liabilities

Reserves $10 million Deposits $100 million

Loans $90 million Bank Capital $10 million

Securities $10 million

Deposit outflow of $10 millionAssets Liabilities

Reserves $0 million Deposits $90 million

Loans $80 million Bank Capital $10 million

Securities $10 million

Slide 15–10

Liquidity Management

1. Borrow from other banks or corporationsAssets Liabilities

Reserves $9 million Deposits $100 million

Loans $90 million Borrowings $9 million

Securities $10 million Bank Capital $10 million

2. Sell securitiesAssets Liabilities

Reserves $9 million Deposits $90 million

Loans $90 million Bank Capital $10 million

Securities $1 million

Slide 15–11

Liquidity Management

• Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows

3. Borrow from FedAssets Liabilities

Reserves $10 million Deposits $90 million

Loans $90 million Discount Loans $9 million

Securities $10 million Bank Capital $10 million

4. Call in or sell off loansAssets Liabilities

Reserves $9 million Deposits $90 million

Loans $81 million Bank Capital $10 million

Securities $10 million

Slide 15–12

Asset and Liability Management

• Asset Management1. Get borrowers with low default risk, paying high interest rates

2. Buy securities with high return, low risk

3. Diversify

4. Manage liquidity

• Liability Management1. Important since 1960s

2. No longer primarily depend on deposits

3. When see loan opportunities, borrow or issue CDs to acquire funds

Slide 15–13

Capital Adequacy Management

1. Bank capital is a cushion that prevents bank failure

2. Higher is bank capital, lower is return on equity

– ROA = Net Profits/Assets

– ROE = Net Profits/Equity Capital

– EM = Assets/Equity Capital

– ROE = ROA EM

– Capital , EM , ROE

Slide 15–14

Capital Adequacy Management (cont.)

3. Tradeoff between safety (high capital) and ROE

4. Banks also hold capital to meet capital requirements

5. Strategies for Managing Capital– Sell or retire stock

– Change dividends to change retained earnings

– Change asset growth

Slide 15–15

Off-Balance-Sheet Activities

1. Fee income from– Foreign exchange trades for customers

– Servicing mortgage-backed securities

– Guarantees of debt

– Backup lines of credit

2. Financial futures and options

3. Foreign exchange trading

4. Interest rate swaps

5. Loan sales• All these activities involve risk

Banks' Income Statement

Slide 15–17

Measures of Bank Performance

• ROA = Net Profits/ Assets

• ROE = Net Profits/ Equity Capital

• NIM = [Interest Income - Interest Expenses]/ Assets

Slide 15–18

Financial Innovation

• Innovation is result of search for profits

• Response to Changes in Demand– Major change is huge increase in interest-rate risk starting in 1960s– Example: Adjustable-Rate Mortgages

• Response to Changes in Supply– Major change is improvement in computer technology

1. Increases ability to collect information

2. Lowers transactions costs

– Examples1. Bank Credit Cards

2. Electronic Banking Facilities

Slide 15–19

Avoidance of Existing Regulations

• Regulations Behind Financial Innovation

1. Reserve requirements • Tax on deposits = I rD

2. Deposit-rate ceilings (Reg Q)• As i , loophole mine to escape reserve requirement tax

and deposit-rate ceilings

Slide 15–20

Avoidance of Existing Regulations

• Examples

1. Eurodollars

2. Bank Commercial Paper

3. NOW Accounts

4. ATS Accounts

5. Sweep Accounts and Overnight RPs

6. Money Market Mutual Funds

Slide 15–21

Profiting from Treasury Strips