Chapter 10 Banking and the Management of Financial Institutions PART I BANK BALANCE SHEET 1 Liabilities sources of funds 1 Checkable Deposit Transactions Deposits Non interest bearing checking accounts demand deposits Interest bearing NOW Negotiable order of withdrawal accounts Money Market Deposit Accounts MMDAs not subject to reserve requirements not included in M1 2 Non transaction Deposit Primary source of funds Saving Accounts Time Deposits Certificate of deposit or CDs o Small denomination time deposit o Large denomination time deposit Negotiable CDs bought by corporations or other banks MMMF as alternative assets to T bills can be resold in second market 3 Borrowings From Federal Reserve System Discount rate advances From other banks borrow reserves overnight in the Federal Funds Market From corporations loan arrangements with corporations repurchase agreements commercial paper 4 Capital Net worth of the bank Can be raised by selling new equity stocks or from retained earnings 2 Assets uses of funds 1 Reserves and Cash Items Required Reserves Required Reserve ratio Checkable Deposit Excess Reserves to meet obligations when funds are withdrawn Cash Items Reserves cash items in process of collection deposits at other banks reserves 2 Securities all debt instruments banks are not allowed to hold stock US government and agency securities most liquid so called secondary State and local government securities less liquid default risk Other securities less liquid default risk 3 Loans Primary income earning asset Less liquid high default risk highest return on loans Make loans to commercial real estate consumer other banks fed funds market overnight 4 Other assets PART II BASIC BANKING 1 Cash Deposit of 100 in First National Bank Opening of a checking account increase in reserves by same amount 2 Check Deposit of 100 in First National Bank When a bank receives additional deposits it gains an equal amount of reserves when it loses deposits it loses an equal amount of reserves 3 Making Profits Borrow short and lend long PART III GENERAL PRINCIPLES OF BANK MANAGEMENT 1 Liquidity Management With ample excess reserve What if reserve requirement is not met Borrow from Fed Reserve Discount Rate Borrow from other banks In Fed Funds Market Borrow from Corporations Repo Market Sell Securities with transaction costs and possible capital loss Calling in or selling off Loans most costly way 2 Asset Management acquire assets with low default risk and diversify assets Find borrowers who will pay high interest rates and lower default risk Diversity their assets Balance liquidity requirement and high return less liquidity assets Invest in securities with high returns and low risks Credit Risk o Screening and information collection o Specialization on lending o Monitoring and enforcement of restrictive covenants o Long term customer relationships o Loan commitments o Collateral and compensating balances o Credit rationing Interest Rate Risk o GAP rate sensitive assets rate sensitive liabilities o Change in Bank Profit GAP change in interest rate o If a bank has more rate sensitive liabilities than assets a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits 3 Liability Management acquire funds at lower cost Checkable deposit decreases higher portion of assets held as loan Overnight loan markets and new financial instruments negotiable CDs Growth in borrowing 4 Capital Adequacy Management Bank Capital helps prevent bank failure Minimum Capital Requirement How to increase Bank Capital o Sell stocks increase equity o Reduce dividends and increase retained earnings o Slow asset growth and reduce debt contraction in lending High capital lower ROE o ROA Net profit after tax Assets o ROE Net profit after tax Equity o Equity Multiplier Assets Equity Capital Measure of Leverage o ROE ROA EM
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