CHAPTER 09 (Part B) - WordPress.com · CHAPTER 09 (Part B) Banking and Bank Management. Learning...

Financial Environment: A Policy Perspective

© S.C. Savvides

CHAPTER 09 (Part B)Banking and Bank

Management

Learning Outcomes

Upon completion of this chapter, you will be able to:

Discuss the developments in the modern banking system.

Distinguish between the various financial intermediaries.

Understand why financial intermediaries (such as banks) exist and what are their roles and functions

© S.C. Savvides 1ECO355-Money & Banking

Changes in Financial/Banking Markets

Business Change Drivers

deregulation, globalization and ICT revolution

Traditional industry boundaries are increasingly getting blurry

No significant distinctions between banking, insurance, investments, brokerage, etc.

Development of financial supermarkets

Offer full spectrum of activities (retail, wholesale and investment banking, insurance, brokerage, fund/asset management, etc.).


Computerised trading systems

Direct trading across the globe 24 hours a day

Financial engineering

new, sophisticated products and new markets developed (derivative products)

• Collateralised debt obligations (CDOs) and asset backed securities (ABS)

• Credit default swaps(CDS)

The financial crisis of 2007-2009

Uncovered weaknesses / gaps in bank supervision and risk management practices of banks


Changes in Financial/Banking Markets

© S.C. Savvides ECO355-Money & Banking 4

Banks (or Deposit Money Banks or Depository Institutions)

banks, co-ops, savings & loan associations, credit unions.

Banks operate in two broad areas:

Accept deposits

• Demand deposits: liquid form of money to make payments. Serve the medium of exchange function of money

• Time deposits: serve to accumulate wealth.

Make loans

• Banks provide financing loans to businesses and households

• They charge a higher interest on loans than what they give on deposits (the interest rate spread)

Financial Institutions


Insurance companies.

Pension funds

Securities firms (provide access to financial markets):

Investment Banks: sell new securities for companies. Brokers: buy/sell old securities.

Mutual Fund Companies: pool the money of individuals and invest in stocks, bonds, and/or other assets.

Finance companies.

Other Financial Institutions

Functions of Modern Banking

Increase of efficiency (reduction of costs)

Banks solve the problem of “double coincidence of wants” of barter

� by capitalizing on their expertise and by achieving

economies of scale, they lower costs overall.

Maturity transformationBank liabilities: mostly short term

Bank loans: mostly long term

� banks create liquidity


Functions of Modern Banking

Risk transformation (or risk pooling)Banks know from experience that a % of loans will end as non-performing (not be repaid)

Risk is spread to the thousand (or millions) of individuals and businesses

Of course, riskier loans carry a higher interest

Facilitating the payments mechanismThe check-clearing system

The electronic payment system


Assets and Liabilities of Banks

Fundamental accounting identityAssets = Liabilities + Equity (or net worth)

assets must equal liabilities (the debts of the firm) plus the equity (i.e., the owner's interest).

Balance SheetThe balance sheet presents the above relationship

Basic form: a T-account (2 columns)

Usually, assets are on the left, and liabilities on the right

They sum up to the same amount


Indicative Bank Balance Sheet


Liabilities (Sources of Funds)

Deposits

Demand deposits

Savings accounts

Time deposits

Short-term financing

Borrowing from other banks

Borrowing from central bank

Capital (long term financing)

Share capital

Loan capital (bonds, debentures)


Liabilities of Banks



Reserve requirements are the money that a bank has to maintain (at all times!) in liquid form to meet liquidity needs of its customers.

They are made up of cash in the vault plus deposits with the Central Bank.

The reserve ratio is the minimum level of reserves that a bank has to maintain (decided by the Central Bank).

This is the ratio of reserves to deposits (or the percentage of deposits that have to be kept as reserves).

E.g., if the reserve ratio is set at 10%, then a bank has to keep €10 in required reserves for every €100 in new deposits.

Excess reserves are the reserves that exceed the required reserves.

Reserves

Assets (Uses of Funds)

Reserves

Cash in vault

Deposits with central bank

Short-term lending to other banks

Lending to customers

To individuals

To businesses

Investments

Government bonds

Property investments© S.C. Savvides 13ECO355-Money & Banking

Assets of Banks


Principles of Bank Management

Liquidity Management

Asset Management

Managing Credit Risk

Managing Interest-rate Risk

Liability Management

Capital Adequacy Management


Initial Bank Balance Sheet



Assume a bank loses 10 bil. euros from time deposits:

How can it manage its liquidity?

If it has excess reserves (ER), it may do nothing

If ER are zero or insufficient to cover deposit outflow:

• It can borrow in the interbank

• It can borrow from the central bank (discount window)

• It can sell some of its holdings in government securities

• It can call in loans

Conclusion:

Excess reserves are an insurance against deposits outflows.

Liquidity Management

Balance Sheet (after dep. outflow)


Reserves cannot be zero, so now the bank has to replenish the reserves by liquidating other asset classes:

e.g. sell investments or loan portfolios or borrow from CB


Asset Management

Find borrowing customers willing to pay higher interest rates, but who have low default risk

Buy securities with high return and low risk

Diversify the bank’s assets to minimize risk:

• holding many types of securities and

• making many types of loans

Manage liquidity

• Hold some excess reserves to protect against deposit outflows, even though the interest rate on these assets may be zero or very low.

Asset and Liability Management


Liability Management

Current a/cs are low-cost, but they constitute a small portion of deposit base

If there are good loan opportunities, banks can raise liquidity by issuing CDs or debentures to acquire funds (though at higher cost)

By borrowing from other banks (interbank funds)

By borrowing from non-bank institutions (repurchase agreements, REPOs).

Asset and Liability Management


Recall the accounting identity

Assets = Liabilities + Capital (equity or net worth)

Capital = Assets – Liabilities

Example

High-capital bank (H-bank)

• Assets (€1000): reserves=€100, loans=€900

• Liabilities (€1000): deposits=€900; capital=€100

Low-capital bank (L-bank)

• Assets (€1000): reserves=€100, loans=€900

• Liabilities (€1000): deposits=€950; capital=€50



Assume that both banks write off €60 in bad loans (loans to companies that go bankrupt)

The value of loans at both banks falls by €60

Also, the capital base of both banks is reduced by €60.

High-capital bank (H-bank)Assets (€940): Reserves=€100, loans=€840

Liabilities (€940): Deposits=€900; capital=€40

Low-capital bank (L-bank)Assets (€940): Reserves=€100, loans=€840

Liabilities (€940): Deposits=€950; capital=-€10

Conclusion: capital is a cushion against loan losses!



Capital Adequacy Ratio (CAR)

Example of Calculating Risk-weighted Assets

Value of assets (€bil.) Risk factor Risk-weighted assets (€bil.)

Cash 20 0% 0

Gov’t bonds 5 0% 0

Housing loans 30 50% 15

Other loans 40 100% 40

Other assets 5 100% 5

Total assets 100 60


Adverse selection: behaviour before the transaction

Problems with pricing a good induces low quality of sellers in the market, where asymmetric information prevents buyers from distinguishing quality.

Example: high-risk customers dominate the market

Moral hazard: behaviour after transactionIn banking, the incentive of a borrower to change his/her behaviour after the contract has been signed, at the expense of the bank.

Example: using the loan for a different reason than

specified in the contract

Asymmetric Information


Banks have to find ways to solve the problems of Asymmetric Information (adverse selection and moral hazard)

Screening and monitoring

Credit ratings

Include restrictive covenants in loan agreements

Specialize in lending in certain sectors: know the market

Know-your-customer: Establish long-term customer relationships

Credit Risk Management


Credit analysis assesses the ability and willingness of borrowers to repay the loan

Screening: analysis before the lending

Monitoring: periodic analysis during the life of the loan

Factors in Credit AnalysisCapacity for the borrower to obtain the loan

Character (borrowers’ reputation / credit history)

Own contribution or Capital (e.g. down payment on a house)—signifies commitment of borrower

Collateral (reduces risk of repayment of loan)

Economic/market conditions (e.g., changes in interest rates may affect the individuals’ ability to repay the loan)

Credit Analysis


Risk

the chance that the actual outcome of a decision (e.g., repayment of a loan or the return of an investment) is different from the expected.

Types of risks

Non-financial: not directly related to assets or liabilities (e.g., business & strategy risks)

Financial: they are a direct influence on the loss of value of monetary assets and liabilities (e.g., market risk, credit risk, liquidity risk and operational and legal risks).

Types of Risks


Market risk

“the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices”

It comprises the following:

Exchange risk: resulting from variations in exchange rates

Interest risk: resulting from variations in the interest rates

Risk of price variations in financial assets other than fixed income assets

• Price variations is the largest category of market risk

Financial Risks


Credit risk

the possibility that over time a decrease in the real value of a bank’s client portfolio may occur as a result of credit quality deterioration suffered by those making up the loan portfolio

Liquidity risk

the possibility for potential losses due to a lack of sufficient reserves to meet assumed short-term liabilities (deposit withdrawals)

Operational and Legal risks

those deriving from say errors or failings in established procedures

Financial Risks


Risk management

actively managing all uncertainty and taking cost-effective action to increase the likelihood of better results and decrease the likelihood of worse results.

Risk management is concerned with the:

identification and assessment of key risks, and

design and implementation of processes intended to manage these risks and maintain them at acceptable levels.

Risk Management by Banks


Rating Banks by Risk Category

CAMEL(S): system of rating banks by risk categoryC: Capital Adequacy

A: Asset Quality - How "overdue" must a loan be to be removed from the balance sheet?

open ended loans: 180 days past due

closed-ended loans: 120 days past due

M: Management (including board of directors)

E: Earnings: Profitability of the bank, taking risk into account

L: Liquidity

S: Sensitivity to market risk.

Deposit Insurance Scheme

Since 2000, a deposit insurance scheme operates in Cyprus

It is managed by the Central Bank of Cyprus

Purpose: the protection of depositors in the case of inability of a member bank to repay the depositors.

It removes the chance of a “run on banks”

Main provisions of the scheme are:

Insures deposits up to 100,000 Euros per customer per bank

deposits in all currencies are covered

the payout is 100 percent of the guaranteed deposits

the payout time is lower than three months


Pros and Cons of DIS

Benefits of DIS’s:

Deposit insurance schemes (DIS) contribute to the orderly functioning of banking system.

DIS’s protect small depositors, and

smaller banks compete with larger ones for deposits.

although some bank failures are good for market discipline, systemic failures may fuel banking crises.

It removes the chance of a “run on banks”

Criticisms of DIS’s:DIS’s introduce a costly side effect – moral hazard.

• Bankers take on increased risks, thus leading to failures as a result of riskier banking practices.

Not all deposits are covered.

Red tape delays in getting money back© S.C. Savvides 33ECO355-Money & Banking

CHAPTER 09 (Part B) - WordPress.com · CHAPTER 09 (Part B) Banking and Bank Management. Learning...

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