The Banking Firm

Purpose of Chapter -- Introduction to basic operations of the individual bank.

Four types of Banks Commercial Banks Savings and Loans Savings Banks Credit Unions

The Bank’s Balance Sheet

Assets Liabilities + Equity

Assets -- Market value of items in your possession.

Liabilities -- Amounts owed to other parties.

Equity = Assets - Liabilities

Working With Assets, Liabilities, and Equity

Note: Definition of equity implies:

Assets = Liabilities + Equity

(Balance sheets balance!).

A Balance Sheet Example

Consider a house that you buy worth $120,000. You take out a mortgage of $100,000.

Assets Liabilities + Equity House $120,000 Mortgage $100,000 Equity $20,000

The Bank’s Major Liabilities and Equity

(1) Checkable Deposits (D) Includes Demand Deposits,

Negotiable Order of Withdrawal (NOW) Acounts, Automatic Transfer of Savings (ATS) Accounts.

Not a major source of funds for banks

(2) Nontransactions Deposits (T) Includes Savings Deposits, and

Small and Large Time Deposits (Negotiable CDs)

Major source of funds for banks -- higher interest rate (cost), but less frequency/more predictability of withdrawal

(3) Borrowings (BORR) -- Funds borrowed by banks, usually to meet reserve requirements

Eurodollars Repurchase Agreements Issued Federal Funds borrowed Discount Window Borrowings

(4) Equity (or Equity Capital) (E) E = Total Assets - Total Liabilities Increases with bank profits,

decreases with bank losses Equity-Asset Ratio =

(Equity/Total Assets) -- measure of bank’s health

The Bank’s Major Assets

(1) Reserves (R) -- vault cash of banks plus deposits at the Federal Reserve

Interest earning, but interest rate less than loan rates

Purpose: to back up withdrawals from customer deposits

How much reserves to hold? Profit versus safety

Reserve Requirements: The “Minimum Safety Level”

Federal Reserve: issues reserve ratios on checkable deposits (rD) and savings and time deposits (rT) with the provision that, at any time

R > rDD + rTT

Decomposition of Reserves

Required Reserves (RR), RR = rDD + rTT

Excess Reserves (ER), ER = R - RR

Equivalent Ways to Express Reserve Requirement R RR, or ER 0

Other Assets

(2) Cash items in the Process of

Collection -- uncleared checks

(3) Deposits at Other Banks

(Correspondent Banking)

(4) Securities Holdings (B)

Holdings of Bonds, holding stock is not allowed

Revenue source for banks Short-term bonds -- “secondary

reserves” Holdings include Negotiable CDs of

other banks Long-term bonds -- can enjoy

conveniences of bonds

(5) Loans

Other major revenue source Less liquid than bonds. For the

most part, the bank must hold them until maturity

Higher default risk than bonds

(5) Loans, Continued

Preferred to bonds as a revenue source for banks.

-- Inconveniences imply higher

interest rate

-- Personal aspect, tradition of

banking (US).

Distinction Between Types of Banks (Loans)

Commercial Banks -- “Full Service Banks”, any type of loan

Savings and Loans -- primarily consumer mortgages

Savings Banks -- primarily consumer mortgages and consumer loans

Credit Unions -- primarily consumer loans (different tax treatment as well)

Fundamental Balance Sheet Rule

Any customer withdrawal from any of their deposits (checkable deposits or savings and time deposits) must be met with an equal decrease in reserves.

An Example: Customer Withdrawal

Customer withdraws $200 from their savings deposit (T) at Chase

Chase

R - $200 T - $200

New Customer Deposits

Example: Customer deposits $300 in their checkable deposit (D)

Chase

R + $300 D + $300

Banks as Financial Intermediaries

Financial Intermediary -- An institution that borrows from lenders, then loans to borrowers.

Takes advantage of institutional fact of life -- lenders want to “lend small”, but borrowers want to “borrow large”.

An Example -- The Bank Increasing Its Profits

You make a $1000 mortgage payment to Chase, $800 is interest and $200 is payment to principal. Interest paid on deposits: $300 to holders of savings and time deposits (T) and $50 to holders of checkable deposits (D).

Balance Sheet Description

Chase

R + $1000 D + $50

L - $200 T + $300

E + $450

Bank Profit (E) = $800 - $350 = $450

A Banking Philosophy: Liability Management

Liability Management -- Seek loan demand, then finance it by issuing CDs, or borrowing if under reserve requirements.

Aggressive, profit-oriented policy, followed mainly by large banks.

Liability Management: Evidence

Negotiable CDs have become the primary source of bank funds.

More bank borrowing (more outlets to borrow as well).

Aggregate excess reserves are generally close to zero.

Greater percentage of loans in asset portfolio (less liquid, more default risk than bonds).

The Bank’s Nightmares

Financial intermediaries have inherent fundamental instabilities.

The bank can only reduce their probability of occurrence and the impact if they do occur.

Bank regulation and regulatory agencies seek as well to reduce the probability of occurrence or reduce the impact to the bank when they happen (next chapter).

Nightmare # 1 -- Disintermediation

Disintermediation -- The systematic withdrawal of customer funds, which can create a minor or major liquidity crisis.

Adverse effect of minor case: bank slips below reserve requirement.

The Bank Run: The Most Dramatic CaseConsider the following balance sheet

situation (rD = 0.10, rT = 0.05). Chase R $500 D $2000 L $6500 T $6000 Bonds $2000 E $1000

Customers want 50% of D and 50% of T (HELP!!).

Ways to Reduce Adverse Effects: Disintermediation

Seek sufficient liquidity in asset portfolio

Increase excess reserves for anticipated unusual withdrawals

Be competitiveUse borrowing sources, when

needed

Nightmare #2 -- Interest Rate Risk

Interest Rate Risk -- Increases in interest rates (cost of funds) that the bank cannot pass on to its existing loans.

Creates reduced profits or even losses on existing loans

Most risky -- fixed rate mortgages (Savings and Loans!).

Ways to Reduce Interest Rate Risk

Reduce the gap in maturity between assets and liabilities

-- Promote shorter term loans

-- Promote longer-term depositsSeek other sources of

income/profits (“off the balance sheet” banking)

Nightmare #3 -- Loan Default

Loan Default -- Borrower fails to repay loanDeclaring bankruptcy -- chapter 7

(consumers sell assets for discharge of debts), as opposed to chapter 13 (debtor arranges plan to repay debt).

Most frequent for consumers – credit card balances (unsecured)

Default on mortgages – secured loans, but could be a problem for banks if housing prices have fallen significantly.

Example: Loan DefaultConsider the following balance sheet

situation (rD = 0.10, rT = 0.05).

Chase

R $500 D $2000

L $6500 T $6000

Bonds $2000 E $1000

Equity-Asset Ratio

= (1000/9000) = 11.1%

The Balance Sheet After a Loan Default$500 loan default. Chase R $500 D $2000 L $6000 T $6000 Bonds $2000 E $500

Equity-Asset Ratio = (500/8500) = 5.6%

Ways to Reduce Adverse Effects of Loan Default

Screening/Collateral Knowing clientelePortfolio DiversificationSeek to maintain sufficiently large

equity-asset ratio

A Preview of the Next Chapter

Bank regulation – how regulatory agencies regulate the banking system.

Wins and losses – US banking in the postwar period, with recent developments and current issues