PA974001PA974-001Monetary Policy & Financial Regulation in a Globalized Economya Globalized EconomyLecture16Lecture 16 27 October 2010Instructor: Menzie ChinnFall 2010Fall 2010Copyright © 2007 Pearson Addison-Wesley. All rights reserved.9-2Basic Banking—Cash DepositgpFirst National Bank First National BankAssets Liabilities Assets LiabilitiesVault+$100Checkable+$100Reserves+$100Checkable+$100Oi fhki tldtVault Cash+$100Checkable deposits+$100Reserves+$100Checkable deposits+$100•Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable depositsincrease in checkable depositsCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-3Basic Banking—Check DepositgpWhenabankreceivesFirst National BankWhenabankreceivesadditional deposits, it gains an equal amount of reserves;whenitlosesdepositsFirst National BankAssets LiabilitiesCash items in process+$100 Checkabledeposits+$100 whenitlosesdeposits,it loses an equal amount of reservesFi t N ti l B kSdNtilBkin process of collectiondepositsFirst National BankSecond National BankAssets Liabilities Assets LiabilitiesReserves +$100 Checkable +$100 Reserves -$100 Checkable -$100deposits depositsCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-4Basic Banking—Making a ProfitggFirst National BankSecond National BankFirst National BankSecond National BankAssets Liabilities Assets LiabilitiesRequired reser es+$100 Checkable deposits+$100 Required reser es+$100 Checkable deposits+$100reservesdepositsreservesdepositsExcess reserves+$90 Loans +$90• Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics• The bank borrows short and lends longCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-5Bank ManagementgLi idit M t•Liquidity Management• Asset Management• Liability Management•Capital Adequacy Management•Capital Adequacy Management• Credit Risk• Interest-rate RiskCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-6Liquidity Management: Ample Excess ReservesAmple Excess ReservesAssets Liabilities Assets LiabilitiesReserves $20M Deposits $100M Reserves $10M Deposits $90MLoans $80M Bank Capital$10M Loans $80M Bank Capital$10MSecurities $10M Securities $10M• If a bank has ample excess reserves, a deposit outflow does not necessitate changes gin other parts of its balance sheetCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-7Liquidity Management: Shortfall in ReservesShortfall in ReservesAssets Liabilities Assets LiabilitiesReserves $10M Deposits $100M Reserves $0 Deposits $90MLoans $90M Bank Capital$10M Loans $90M Bank Capital$10MSecurities $10M Securities $10M• Reserves are a legal requirement and the shortfall must be eliminated• Excess reserves are insurance against the costs associated with deposit outflowsCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-8pLiquidity Management: Borrowingqy g gAssets LiabilitiesReserves $9M Deposits $90MLoans $90M Borrowing $9MSecurities $10M Bank Capital $10M• Cost incurred is the interest rate paid on the borrowed fundsCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-9Liquidity Management: Securities SaleSecurities SaleAssets LiabilitiesReserves $9M Deposits $90MLoans $90M Bank Capital $10MSecurities $1M• The cost of selling securities is the brokerage and other transaction costsCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-10Liquidity Management: Federal ReserveFederal ReserveAssets LiabilitiesReserves $9M Deposits $90MLoans $90M Borrow from Fed $9MSecurities $10M Bank Capital $10M• Borrowing from the Fed also incurs interest payments based on the discount ratepyCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-11Liquidity Management: Reduce Loansqy gAssets LiabilitiesReserves $9M Deposits $90MLoans $81M Bank Capital $10MSecurities $10M• Reduction of loans is the most costly way of acquiring reserves• Calling in loans antagonizes customers• Other banks may only agree to purchase loans at a substantial discountCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-12substantial discountAsset Management: Three GoalsgS k th hi h t ibl t•Seek the highest possible returns on loans and securities• Reduce riskH d t li idit•Have adequate liquidityCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-13Asset Management: Four ToolsgFind borrowers who will pay high•Find borrowers who will pay high interest rates and have low possibility of defaultingof defaulting• Purchase securities with high returns dl i kand low risk• Lower risk by diversifyingyyg• Balance need for liquidity against increased returns from less liquid assetsCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-14increased returns from less liquid assetsLiability ManagementygRth dtif•Recent phenomenon due to rise of money center banks• Expansion of overnight loan markets and new financial instruments (such as (negotiable CDs)Ch k bl d it h d d i•Checkable deposits have decreased in importance as source of bank fundsCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-15Capital Adequacy ManagementpqygBk itlhl tbkfil•Bank capital helps prevent bank failure• The amount of capital affects return for pthe owners (equity holders) of the bankRlt i t•Regulatory requirementCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-16Capital Adequacy Management: Preventing Bank Failure WhenPreventing Bank Failure When Assets DeclineHigh Bank Capital Low Bank CapitalAssets Liabilities Assets LiabilitiesReserves $10M Deposits $90M Reserves $10M Deposits $96MLoans $90M Bank Capital $10M Loans $90M Bank Capital $4MHigh Bank Capital Low Bank CapitalAssets Liabilities Assets LiabilitiesReserves$10MDeposits$90MReserves$10MDeposits$96MReserves$10MDeposits$90MReserves$10MDeposits$96MLoans $85M Bank Capital $5M Loans $85M Bank Capital -$1MCopyright © 2007 Pearson Addison-Wesley. All rights reserved.9-17Capital Adequacy Management: Returns to Equity HoldersReturns to Equity HoldersReturnonAssets:netprofitaftertaxesperdollarofassetsReturnonAssets:netprofitaftertaxesperdollarofassetsROA = net profit after taxesassetsReturnonEquity:netprofitaftertaxesperdollarofequitycapitalReturn onEquity:netprofitaftertaxes perdollarofequitycapitalROE = net profit after taxesequity