Banking and the Management of Financial InstitutionsThe Bank Balance SheetTotal assets = total liabilities + capitalBank sources of funds (liabilities)Checkable deposits (payable on demand)Nontransaction depositsSavings deposits – funds can be added or withdrawn any time.Small-denomination time deposits – less than $100,000 for a fixed time period.Large-denomination time deposits (negotiable CDs) – $100,000 or more purchased by corporations and financial institutions. BorrowingsDiscount loans – loans from the Federal Reserve to a bankFederal funds loans – loans from one bank to another bankLoans from parent companies (bank holding companies)Repurchase agreementsEurodollarsBank uses of funds (Assets)Reserves -- deposits held in an account at the Fed. Res. plus vault cash (currency held by banks)Required reserves -- fraction of checkable deposits that must be kept as reservesExcess reserves -- additional reserves that banks hold meet check-clearing obligationsReserves = Required reserves + Excess reservesCash Items in Process of Collection -- accounting transaction until anticipated funds are physically received from another bankDeposits at other banks -- used by smaller banks to provide a broader array of services for the smaller banks' customersSecurities -- bank holdings of U.S. government and agency securities, municipal securities, and investment-grade corporate securities. Banks cannot hold stock.Loans -- primary source of income for banks. Wide variety of loans.Other assets -- physical assets such as buildings, equipment, artwork.Bank Capital = Total assets - Total liabilitiesBasic BankingWork through T-accounts here.Remember: whenever a bank receives deposits, it receives an equal amount of reserves. Whenever a bank loses deposits, it loses an equal amount of reserves. All check-clearing occurs in the bank's reserve account.Bank ManagementLiquidity Management -- acquisition of sufficiently liquid assets to meet the bank'sobligations to depositors.Liquidity Management -- ample excess reservesIf a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet.Work through T-accounts here.Liquidity Management -- Shortfall in reservesIf a deposit outflow results in reserves falling below the required amount, banks must quickly eliminate the shortfall.Liquidity Management -- BorrowingBanks may choose to borrow from another bank in the federal funds marketor borrow from corporations by selling negotiable CDs. Cost of this option is the interest rate on the borrowings.Work through T-account here.Liquidity Management -- Securities SaleBanks may choose to sell some of the securities it owns. Cost of this optionare the brokerage and other transactions costs.Work through T-account here.Liquidity Management -- Borrow from the Federal ReserveU.S. banks may choose to borrow funds from the Federal Reserve (the U.S. central bank). A loan from the Federal Reserve to a bank is called a discount loan. Costs of borrowing from the Federal Reserve is the interest paid (discount rate). The discount rate is usually higher than the federal funds rate.Work through T-account here.Liquidity Management -- reduce loansBanks may choose to sell loans to other banks or call-in loans. If a bank sells loans to another institution they will have to sell them at a lower price because the other banks' are concerned about adverse selection. A call-in loan happens when a short-term loan is not renewed. Likely to antagonize and lose customers.Work through T-account here.Asset Management1. Seek the highest possible returns on loans and securities2. Reduce risk3. Have adequate liquidityLiability ManagementAcquire funds quickly in the least-costly methodCapital Adequacy ManagementBanks make decisions about the capital it holds for three reasons:- Capital helps to prevent bank failure- The amount of capital held impacts the returns for the owners- Regulators require a minimum amount of capitalHow Bank Capital Helps Prevent Bank FailureWork through T-account hereHow the Amount of Bank Capital Impacts Returns to Equity HoldersReturn on Assets (ROA) = the net profit after taxes per dollar of assetsReturn on Equity (ROE) = the net profit after taxes per dollar of equity (bank) capitalEquity Multiplier (EM) = the amount of assets per dollar of equity capitalROE = ROA x EMGiven the return on assets, the lower the bank capital, the higher is the return for the owners of the bank.Trade-off between safety and returns to owners – higher capital means a safer bank, but lowers the returns to the owners.Managing Credit Risk(ways in which a bank can reduce the adverse selection and moral hazard problems inherent in making loans and still make a profit)- Screening – gather information to reduce adverse selection problem- Specialize in lending – specialized information helps to reduce the adverse selection problem- Monitoring and Enforcement of Restrictive Covenants – reduce the moral hazard problem by making sure the borrower is following the requirements of the loan contract- Long-Term Customer Relationships – reduce the cost of collecting information- Loan commitments – reduce the cost of collecting information- Collateral and compensating balances – reduces lenders loss in the case of adefault- Credit rationing – two types. Reduce adverse selection and moral hazard problemsManaging Interest-rate RiskResponse of a bank’s profits to changes in the interest rate.Work through T-account here.Off-Balance-Sheet ActivitiesActivities that impact a bank’s profits but that do not appear on bank balance sheets such as trading financial instruments and generating income from fees and loan sales.Loan Sales (Secondary Loan participation)Generation of Fee IncomeForeign exchange trades for customersServicing mortgage-backed securitiesProviding backup lines of creditTrading