Econ330 Money and Banking 01 29 2013 Exam 2 Tuesday Chapter 10 11 12 16 17 Chapter 10 Bank and Bank Management The Balance Sheet of Commercial Banks Assets uses of Funds o Reserves and cash items Reserve deposits at Fed Vault Cash o Securities o Loans Secondary reserves especially T Bills Liabilities Sources of Funds o Checkable deposits o Non transactions deposits CD s Savings accounts o Borrowings From the Fed discount loans From other banks federal funds market Bank and non bank repurchase agreements repo Commercial paper Commercial Bank Liabilities Sources of Funds Checkable Deposits 10 up from 6 in Dec 2008 o Available on demand o Also known as transactions deposits o Have declined substantially in importance Transactions deposits were 61 of bank funds in 1960 Non transactions deposits 55 Borrowing 23 around 31 in 2008 o Discount loans for the Fed o Reserves from other banks in the Federal Funds Market o Repurchase agreements Bank Capital 12 up from 10 in 2008 Basic Banking Making a Profit 10 reserve requirement banks use excess reserves to make loans or invest in bonds the bank makes a profit because it borrows short and lends long General Principles of Bank Management What is the basic operation of a bank Banks make profits by o Selling liabilities with one set of characteristics liquidity risk o Buying assets with a different set of characteristics liquidity size return risk size return o Process known as asset transformation also referred to as maturity transformation How banks manage their balance sheet Liquidity management use of funds Asset management use of funds o Credit risk o Interest rate risk Liability management Capital adequacy management o Is there sufficient capital Asset Management Four Tools Find borrowers who will pay high interest rates and have low possibility of defaulting Purchase securities with high returns and low risk Lower risk by diversifying Balance need for liquidity against increased returns from less liquid assets hazard Asset Management Credit Risk Overcoming adverse selection and moral Screening and information collection Specialization in lending Diversification by industry and geography Monitoring and enforcement of restrictive covenants Long term customer relationships Collateral and compensating balances Liability management Important since 1960s banks no longer depend on checking deposits o Fell from 61 in 1960 to a low of 6 in 2008 Resulted in higher proportion of assets held as loans o Expansion of overnight loan markets and new financial instruments Growth in borrowing from 2 in 1960 to 31 in 2008 Bank Capital equity Assets liabilities net worth Called bank capital o The value of the bank to its owners Capital adequacy management Bank capital is a cushion that helps prevent bank failure o As banks write down assets bank capital takes a hit Regulatory requirement regulators set minimum capital requirements Capital Adequacy management strategies for increasing capital Sell stock increase equity Reduce dividend and increase retained earnings Slow asset growth and reduce debt o Commercial banks have done all of the above over the past few years Capital Adequacy Management There s a tradeoff Benefit to owners of a bank by making their investment in the bank Costly to owners of a bank because the higher the bank capital the safe lower return on equity Capital Adequacy Management Return to Equity holders Return on assets net profit after taxes per dollar of assets ROA net profit after taxes assets Return on equity net profit after taxes per dollar of equity capital ROE net profit after taxes equity capital o Relationship between ROA and ROE is expressed by the equity multiplier The amount of assets per dollar of equity capital EM Assets Equity Capital ROE ROA EM Equity Multiplier and Equity Ratio Total assets equity capital This is actually a measure of leverage EM 10 means 1 of equity supports 10 in assets The bank borrows 9 Bank Profitability ROA is typically 1 2 to 1 3 ROE is 10 to 12 times ROA Bank Capital Currently U S Commercial banks combine about 1 5 trillion in bank capital with 11 Trillion of borrowed funds to purchase 12 5 Trillion Ratio of debt equity 10 to 1 historically Highly leveraged Now in assets about 8 to 1 o Non financial corporation about 1 to 1 Ratio of assets equity 12 5 1 5 8 33 down from over 11 o Government guarantees contributes to banks ability to hold so much debt How a capital crunch caused a credit crunch in 2008 The slowdown in growth of credit triggered a crunch in 2007 credit was hard to get What caused the credit crunch Housing boom and bust led to large bank losses The losses reduced bank capital o Banks were forced to either 1 raise new capital or 2 reduce lending o Guess which route they chose Managing Interest Rate Risk Bank assets don t match liabilities Borrow short and lend long Creates maturity mismatch Also assets and liabilities classified into interest rate sensitive and non interest rate sensitive o Deposits tied to market rates o Long term fixed rate loan What happens if interest rates rise o Deposit costs based on flexible short term interest rates rise o Loan revenues based on fixed interest rate remain fixed o Profit reduction Chapter 11 Economic Analysis of Banking Regulation Bank Failure Any indication of insolvency can cause a run on banks which can push a healthy bank into insolvency o Creating losses for its owners and depositors Depositors cannot tell the good from the bad o Problem of asymmetric information contagion effect An example of a Bank Run Assume depositors lose confidence in an otherwise healthy bank causing a run of the bank The bank first uses liquid reserves and sells securities to meet depositor demands to withdraw funds The bank is next forced to sell loans at the fire sale of 50 per 1 the bank pays off half of remaining deposits The bank cannot pay off the remaining deposits and has negative net worth so the remaining depositors and bank owners both lose o The example shows how a bank run can make a healthy bank insolvent Run on a Bank Example reserves 10 is liquidated at 100 loans 80 is liquidate at 50 Cyclical downturns are associated with bank panics bank runs The period prior to the Federal Reserve from 1871 1913 o Eleven recessions o Bank panics during 7 recessions o No panics without recessions The Government Safety net Lender of last resort Federal Reserve 1913 Deposit insurance FDIC 1934 Federal Reserve Lender of Last Resort Safety Net Intent lend to