978-1259285295 Chapter 12 Lecture Note

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Chapter 12 – Depository Institutions: Banks and Bank Management

Chapter 12

Depository Institutions: Banks and Bank Management

Chapter Overview

This chapter examines the business of banking, looking at where depository institutions

get their funds and what they do with them. It also examines the sources of banks’

liabilities and the ways that they manage their assets. The sources of risk that banks face

are also considered, as well as how that risk can be managed.

Learning Objectives: Establish an understanding of:

1. Bank assets and liabilities

2. Bank capital and profitability

3. Bank risk and risk management.

Important Points of the Chapter

Banks are the most visible financial intermediaries in the economy. These depository

institutions accept deposits from savers and make loans to borrowers. They include

commercial banks, savings and loans, and credit unions. Banks seek to profit from their

various lines of business; they provide accounting and record keeping services, provide

access to the payments system, pool the savings of small depositors and use the funds to

make loans to borrowers, and they offer customers risk-sharing services. Banks are

important, and when they are poorly managed the entire economy suffers.

Application of Core Principles

Principle #1: Time. Banks hold only 3% of their assets as cash because holding cash is

expensive; it earns no interest.

Principle #3: Information. Among a bank’s off-balance sheet activities is the provision

of a line of credit to a trusted customer. Since the bank usually knows the customer to

whom it grants the line of credit, the cost of establishing creditworthiness (an information

cost) is negligible.

Principle #2: Risk. Banks are exposed to a host of risks, including liquidity risk, credit

risk, interest-rate risk, trading risk, and operational risk.

Principle #1: Time. Holding excess reserves is expensive, since it means forgoing the

interest that could be earned on loans or securities.

Principle #3: Information. Since banks specialize in information gathering, they attempt

to gain a competitive advantage in a narrow line of business. The problem is that doing

so exposes the bank to added risks.

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Chapter 12 – Depository Institutions: Banks and Bank Management

Teaching Tips/Student Stumbling Blocks

Here’s a great introduction to the topic of this chapter. Start with the section Your

Financial World: Choosing the Right Bank for You and follow up with this very

short (maybe 5 questions) quiz (by Holden Lewis) on the website of

Bankrate.com. Designed to help people decide if a virtual bank is right for them,

respondents click on the answers to the questions, and then submit the responses

and see the feedback. The site can be found at:

http://www.bankrate.com/brm/news/emoney/equiz1.asp

Chapter 12 builds on students’ understanding of Core Principles 1, 2 and 3, as

well as the material in Chapter 5 (on how to compute expected returns on assets

and how to measure the risk on those assets), as well as the coverage of

information problems from Chapter 11.

A number of your students may not have bank accounts of their own; a good

exercise might be to have students’ comparison shop in the area for the best deal

they could get on a checking account.

Some students, particularly if they have no background in accounting, may have

difficulty with the terms “equity” and “assets,” the calculations of the ROA and

ROE, and the development of the balance sheet. You may wish to spend extra

time on this material and reinforce with end-of-chapter problems as assignments.

Features in this Chapter

Your Financial World: Choosing the Right Bank for You

Choosing the right bank takes some work; you need to decide why you need a bank and

which one will serve your needs conveniently and cheaply. The Internet has resulted in a

number of bank services being provided over the web. However, if you choose an

Internet bank you should find out if the FDIC insures it.

Tools of the Trade: A Catalog of Depository Institutions

There are three basic types of depository institutions: commercial banks, savings

institutions and credit unions. Commercial banks are further divided into community

banks (small banks with assets of less than $1 billion), regional and super-regional banks,

and money center banks (which do not rely on deposit financing). Savings institutions

include savings and loans and savings banks (the difference being that their depositors

own the savings banks). Credit unions are nonprofit and are owned by people with a

common bond, like a place of employment.

Applying the Concept: Growth and Banking in China and India

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China and India are experiencing phenomenal economic growth rates of 8 to 10 percent

per year. Some people think they would grow even faster if their banks worked properly.

In China, banks account for too large a proportion of the country’s financial system and

are directing resources inefficiently. Indian banks attract too few deposits because people

mistrust banks.

Your Financial World: The Cost of Payday Loans

Check-cashing establishments provide loans to people who cannot borrow from

mainstream financial institutions like banks. They also offer small loans, usually called

payday loans, in which the store will lend up to $500 for a week or two. The problem

with these loans is that there is a fee, and it’s huge: as much as 15 percent of the

principal amount. And if the borrower renews the loan instead of repaying it, the fees can

amount to much more than the original loan amount.

Lessons from the Crisis: Insufficient Bank Capital

The financial crisis of 2007-2009 and the recession it triggered led to projected losses on

U.S. bank assets of nearly $1 trillion. A bank’s capital is its net worth—the difference

between the value of its assets and its liabilities. The larger this difference the less likely

the bank will be made insolvent by an adverse unexpected event. During the crisis, the

difference was insufficient to cushion against the market risks that surfaced. Many bank

assets were negatively affected by the decline in the market prices of housing, which

lowered the value of MBSs. But holding capital to reduce this risk is costly, so banks did

not. Further, banks increased leverage to boost profits. Highly leveraged firms are

vulnerable even to modes declines in market prices, as the financial crisis proved.

In the News: Lessons from the London Whale

A report detailing losses incurred by JPMorgan Chase for the trading of credit default

swaps. While JPMorgan Chase did not require a government bailout, losses were

significant. These losses took the bank and regulators by surprise, mainly because they

were not paying attention to a small group of traders working for the bank’s chief

investment unit, which was supposed to be hedging against future losses. This group

amassed a large, complex financial portfolio largely ignored by managers and

supervisors.

Lessons of the Article: Whatever their purpose, trading operations are notoriously

difficult to monitor, and they can go dramatically wrong. Traders gamble with someone

else’s money and are prone to taking too much risk. In big, cross‐border intermediaries,

where the firm’s top leaders have no direct control over traders who transact in

complex instruments, oversight is particularly challenging. If management systems

don’t keep up with risk taking, or a trader’s superiors lack proper training and

incentives, trading failures can bring down the entire financial institution.

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Applying the Concept: The Tri-Party Repo Market

Repurchase agreements (repos) are a key form of short-term finance for many

intermediaries. For lenders, repo is a close substitute for cash. For borrowers, the repo

market often funds inventories of stocks and bonds. In 2008, repo lenders sought to avoid

receiving illiquid or questionable collateral, so repo lenders stopped lending and the repo

market shriveled. Policymakers concerned about systemic fragilities have promoted

reforms in the repo market.

Additional Teaching Tools

In the Wall Street Journal article “Sweeter Deals for Brokers,” Brett Philbin and Annie

Gasparro investigate newly developing pay packages for brokers at Morgan Stanley,

Bank of America’s Merill Lynch Wealth Management, and Smith Barney, signalling a

heating up of the labor market for brokers.

Virtual Tools

Visit the web site of the FDIC to learn more about this insurer of bank deposits:

http://www.fdic.gov/

Here’s another bank that only exists in cyberspace: visit Virtual Bank at:

http://www.virtualbank.com/default.asp

For More Discussion

Banks in Japan are allowed to own stock while U.S. banks are not. Is this a good idea?

This is a good lead in to the coverage of regulation.

Chapter Outline

I. The Balance Sheet of Commercial Banks

A. Assets: Uses of Funds

1. The asset side of a bank’s balance sheet includes cash, securities, loans, and

all other assets (which includes mostly buildings and equipment).

2. Cash Items: The three types of cash assets are reserves (which includes cash

in the bank’s vault as well as its deposits at the Federal Reserve); cash items in

the process of collections (uncollected funds the bank expects to receive); and

the balances of accounts that banks hold at other banks (correspondent

banking).

3. Securities: The second largest component of bank assets; includes U.S.

Treasury securities and state and local government bonds. Securities are

sometimes called secondary reserves because they are highly liquid and can

be sold quickly if the bank needs cash.

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4. Loans: The primary asset of modern commercial banks; includes business

loans (commercial and industrial loans), real estate loans, consumer loans,

interbank loans, and loans for the purchase of other securities. The primary

difference among the various types of depository institutions is in the

composition of their loan portfolios.

B. Liabilities: Sources of Funds

1. Banks need funds to finance their operations; they get them from savers and

from borrowing in the financial markets.

2. There are two types of deposit accounts, transactions (checkable deposits) and

nontransactions.

3. Checkable deposits: A typical bank will offer 6 or more types of checking

accounts. In recent decades these deposits have declined because the accounts

pay low interest rates.

4. Nontransactions Deposits: These include savings and time deposits and

account for nearly two-thirds of all commercial bank liabilities. Certificates

of deposit can be small ($100,000 or less) or large (more than $100,000), and

the large ones can be bought and sold in financial markets.

5. Borrowings: The second most important source of bank funds; banks borrow

from the Federal Reserve or from other banks in the federal funds market.

Banks can also borrow by using a repurchase agreement or repo, which is a

short-term collateralized loan in which a security is exchanged for cash, with

the agreement that the parties will reverse the transaction on a specific future

date (might be as soon as the next day).

C. Bank Capital and Profitability

1. The net worth of banks is called bank capital; it is the owners’ stake in the

bank.

2. Capital is the cushion that banks have against a sudden drop in the value of

their assets or an unexpected withdrawal of liabilities.

3. An important component of bank capital is loan loss reserves, an amount the

bank sets aside to cover potential losses from defaulted loans.

4. There are several basic measures of bank profitability: return on assets (a

bank’s net profit after taxes divided by its total assets) and return on equity (a

bank’s net profit after taxes divided by its capital).

5. Net interest income is another measure of profitability; it is the difference

between the interest the bank pays and what it receives.

6. Net interest income can also be expressed as a percentage of total assets; that

is called net interest margin, or the bank’s interest rate spread.

7. Net interest margin is an indicator of future profitability as well as current

profitability.

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D. Off-Balance-Sheet Activities

1. Banks engage in these activities in order to generate fee income; these

activities include providing trusted customers with lines of credit.

2. Letters of credit are another important off-balance-sheet activity; they

guarantee that a customer will be able to make a promised payment. In so

doing, the bank, in exchange for a fee, substitutes its own guarantee for that of

the customer and enables a transaction to go forward.

3. A standby letter of credit is a form of insurance; the bank promises that it will

repay the lender should the borrower default.

4. Off-balance-sheet activities create risk for financial institutions and so have

come under increasing scrutiny in recent years.

II. Bank Risk: Where It Comes from and What to Do About It

A. Liquidity Risk

1. Liquidity risk is the risk of a sudden demand for funds and it can come from

both sides of a bank’s balance sheet (deposit withdrawal on one side and the

funds needed for its off-balance sheet activities on the liabilities side).

2. If a bank cannot meet customers’ requests for immediate funds it runs the risk

of failure; even with a positive net worth, illiquidity can drive it out of

business.

3. One way to manage liquidity risk is to hold sufficient excess reserves (beyond

the required reserves mandated by the Federal Reserve) to accommodate

customers’ withdrawals. However, this is expensive (interest is foregone).

4. Two other ways to manage liquidity risk are adjusting assets or adjusting

liabilities.

5. A bank can adjust its assets by selling a portion of its securities portfolio, or

by selling some of its loans, or by refusing to renew a customer loan that has

come due.

6. Banks do not like to meet their deposit outflows by contracting the asset side

of the balance sheet because doing so shrinks the size of the bank.

7. Banks can use liability management to obtain additional funds by borrowing

(from the Federal Reserve or from another bank) or by attracting additional

deposits (by issuing large CDs).

B. Credit Risk

1. This is the risk that loans will not be repaid and it can be managed through

diversification and credit-risk analysis.

2. Diversification can be difficult for banks, especially those that focus on

certain kinds of lending.

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3. Credit-risk analysis produces information that is very similar to the

bond-rating systems and is done using a combination of statistical models and

information specific to the loan applicant.

4. Lending is plagued by adverse selection and moral hazard, and financial

institutions use a variety of methods to mitigate these problems.

C. Interest-Rate Risk

1. The two sides of a bank’s balance sheet often do not match up because

liabilities tend to be short-term while assets tend to be long-term; this creates

interest-rate risk.

2. In order to manage interest-rate risk, the bank must determine how sensitive

its balance sheet is to a change in interest rates; gap analysis highlights the gap

or difference between the yield on interest sensitive assets and the yield on

interest-sensitive liabilities.

3. Multiplying the gap by the projected change in the interest rate yields the

change in the bank’s profit.

4. Gap analysis can be further refined to take account of differences in the

maturity of assets and liabilities.

5. Banks can manage interest-rate risk by matching the interest-rate sensitivity of

assets with the interest-rate sensitivity of liabilities, but this approach

increases credit risk.

6. Bankers can use derivatives, like interest-rate swaps, to manage interest-rate

risk.

D. Trading Risk

1. Banks today hire traders to actively buy and sell securities, loans, and

derivatives using a portion of the bank’s capital in the hope of making

additional profits.

2. However, trading such instruments is risky (the price may go down instead of

up); this is called trading risk or market risk.

3. Managing trading risk is a major concern for today’s banks, and bank risk

managers place limits on the amount of risk any individual trader is allowed to

assume.

4. Banks also need to hold more capital if there is more risk in their portfolio.

E. Other Risks

1. Banks that operate internationally will face foreign exchange risk (the risk

from unfavorable moves in the exchange rate) and sovereign risk (the risk

from a government prohibiting the repayment of loans).

2. Banks manage their foreign exchange risk by attracting deposits denominated

in the same currency as the loans and by using foreign exchange futures and

swaps to hedge the risk.

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3. Banks manage sovereign risk by diversification, by refusing to do business in

a particular country or set of countries, and by using derivatives to hedge the

risk.

4. Banks also face operational risk, the risk that their computer system may fail

or that their buildings may burn down.

5. To manage operational risk the bank must make sure that its computer systems

and buildings are sufficiently robust to withstand potential disasters.

Terms Introduced in Chapter 12

bank capital

credit risk

depository institution

discount loans

excess reserves

federal funds market

interest-rate risk

interest rate spread

liquidity risk

loan loss reserves

net interest margin

nondepository institution

off-balance-sheet activities

operational risk

repurchase agreement (repo)

required reserves

reserves

return on assets (ROA)

return on equity (ROE)

trading risk

vault cash

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Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

Commercial banks USNUM

Bank failures BKFTTLA641N

Net interest margin USNIM

Return on equity USROE

Net loan losses/Average total loans USLSTL

Loan loss reserve/Total loans USLLRTL

Commercial bank assets TLAACBM027SBOG

Cash assets CASACBM027SBOG

Securities INVEST

Loans LOANS

Commercial bank liabilities TLBACBM027SBOG

Deposits DPSACBM027SBOG

Borrowings BOWACBM027SBOG

Bank capital/Net worth (assets less liabilities) RALACBM027SBOG

Lessons of Chapter 12

1. Bank assets equal bank liabilities plus bank capital.

a. Bank assets are the uses for bank funds.

i. They include reserves, securities, and loans.

ii. Over the years, securities have become less important and

mortgages more important as a use for bank funds.

b. Banks liabilities are the sources of bank funds.

i. They include transactions and nontransactions deposits, as well as

borrowings.

ii. Over the years, transaction deposits have become less important as

a source of bank funds.

c. Bank capital is the contribution of the bank’s owners; it acts as a cushion

against a fall in the value of the bank’s assets or a withdrawal of its

liabilities.

d. Banks make a profit for their owners. Measures of a bank’s profitability

include return on assets (ROA), return on equity (ROE), net interest

income, and net interest margin.

e. Banks’ off-balance-sheet activities have become increasingly important in

recent years. They include

i. Loan commitments, which are lines of credit that firms can use

whenever necessary.

ii. Letters of credit, which are guarantees that a customer will make a

promised payment.

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2. Banks face several types of risk in day-to-day business. They include

a. Liquidity risk – the risk that customers will demand cash immediately

i. Liability-side liquidity risk arises from deposit withdrawals.

ii. Asset-side liquidity risk arises from the use of loan commitments

to borrow.

iii. Banks can manage liquidity risk by adjusting either their assets or

their liabilities.

b. Credit risk – the risk that customers will not repay their loans. Banks can

manage credit risk by:

i. Diversifying their loan portfolios.

ii. Using statistical models to analyze borrowers’ creditworthiness.

iii. Monitoring borrowers to ensure that they use borrowed funds

properly.

iv. Purchase credit default swaps (CDS) to insure against borrower

default.

c. Interest-rate risk – the risk that a movement in interest rates will change

the value of the bank’s assets more than the value of its liabilities.

i. When a bank lends long and borrows short, increases in interest

rates will drive down the bank’s profits.

ii. Banks use a variety of tools, such as gap analysis, to assess the

sensitivity of their balance sheets to a change in interest rates.

iii. Banks manage interest-rate risk by matching the maturity of their

assets and liabilities and using derivatives like interest-rate swaps.

d. Trading risk – the risk that traders who work for the bank will create

losses on the bank’s own account. Banks can manage this risk using

complex statistical models and closely monitoring traders

e. Other risks banks face include foreign exchange risk, sovereign risk, and

operational risk.

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