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Lecture 4.2

Banking and the Management of Financial Institutions

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Source: Mishkin ch 9

This lecture examines the business model of banks, specifically:
how they make a profit, and
how they manage their risks

Learning Objectives
Summarize the main features of a commercial bank balance sheet
Analyze changes to a bank’s assets and liabilities
Identify ways in which banks can manage their assets and liabilities to maximize profit
Examine the ways banks manage risk

Simple example of a balance sheet: Smartmoney Inc.
Business structure of Smartmoney Inc.
The business model of the company is to make a profit by borrowing and lending money
Shareholders in Smartmoney Inc. have contributed $5m of capital to start the company
The company borrows money ($95m) by issuing bonds in the market
It uses that money to lend to customers ($90m)
Some of the borrowed money is also used to pay for the office premises where the company operates ($10m)
Balance sheet of Smartmoney Inc.
Assets Liabilities
Loans to customers 90 Bonds issued 95
Business premises 10 Capital 5
Total 100 Total 100

The Bank balance sheet (1)
Central concept: Sources of funds = Uses of funds
Or equivalently, Liabilities = Assets
The core business of a commercial bank is to take deposits and make loans
Hence, deposits are the largest item on the liabilities side of the balance sheet
Loans are the largest item on the asset side
The main mechanism for making a profit is the net interest margin (that is, the difference between the average interest rates on deposits and loans)

Determination of Bank Lending Rates
A consequence of this is that bank lending rates are typically set at a margin above the cash rate.
That margin is competitively determined, and can also vary in response to other factors affecting the cost of doing business.

Major Banks Net Interest Margin

The Bank Balance Sheet (2)
Liabilities:
Current deposits
Term deposits
Non-deposit borrowings (eg, bonds issued)
Bank capital

The Bank Balance Sheet (3)
Cash and reserves held at the central bank
Deposits at other banks
Securities
Other assets (eg investments in subsidiaries)

Q: Why is capital a liability?
Capital is the notional claim that shareholders have on the net assets of the company
in other words, it’s what the company owes to the shareholders, and would have to pay if the company is wound up
This explains why a balance sheet always balances:
any change in the net value of assets is passed through into an equivalent change in capital
Example: Capital position of a company before and after a loss of asset value
Assets Liabilities
Investments 100 Bonds issued 90
Capital 10
Total 100 Total 100

Assets Liabilities
Investments 95 Bonds issued 90
Capital 5
Total 95 Total 95

After $5m loss on investments:

Table 1 Balance Sheet of All U.S. Commercial Banks (items as a percentage of the total)

Australian banks balance sheet composition
As at Jan 2022, the aggregate magnitudes for the main items were as follows:
Deposits: $2.6tr
Other borrowings $0.9tr
Assets: $5.0 tr, of which
loans $3.1 tr
cash and liquid assets $0.5 tr
Securities $0.5 tr
The net interest margin is about 2.1 per cent

Source: APRA Monthly Banking Statistics

Basic Banking: a deposit transaction
Deposit of cash (currency) with the bank:

Opening of a checking (or current) account leads to an increase in the commercial bank’s reserves equal to the increase in checkable deposits.
[Spelling note: check (US) = cheque (Aus and UK) ]
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Vault Cash +$100 Checkable (or current) deposits +$100 Reserves +$100 Checkable deposits +$100

Basic Banking: deposit transfer between banks
First National Bank Second National Bank
Assets Liabilities Assets Liabilities
Reserves +$100 Checkable deposits +$100 Reserves -$100 Checkable deposits -$100

Check/current deposit:
When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves.

When a depositor of one bank makes a payment to a depositor of another bank, the corresponding transfer of reserves takes place through the central bank

Basic Banking: making a profit by asset transformation

Asset transformation: issuing liabilities with one set of characteristics and using the funds to buy assets with a different set of characteristics
A bank typically “borrows short and lends long” (note: making a loan can be considered buying an asset).
Loans earn a higher rate of interest than is paid on deposits
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Required reserves +$10 Checkable deposits +$100 Required reserves +$10 Checkable deposits +$100
Excess reserves +$90 Loans +$90

Two key risks that banks need to manage
Liquidity risk: inability to repay deposits when called up
remedy: hold sufficient liquid assets (reserves)

Capital adequacy risk: losses exceed the value of bank capital, so the bank becomes insolvent
hold sufficient capital
manage and control default risk

Liquidity Management and the Role of Reserves
Excess reserves:

Suppose a bank’s required reserves are 10% of deposits.
If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet.

Assets Liabilities Assets Liabilities
Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank Capital $10M Loans $80M Bank Capital $10M
Securities $10M Securities $10M

Liquidity Management and the Role of Reserves
Example of a shortfall in reserves:

Required reserves are a legal requirement and the shortfall must be eliminated.
Excess reserves (the reserves in excess of required reserves) are a buffer for the possibility of deposit outflows.

Assets Liabilities Assets Liabilities
Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $10M
Securities $10M Securities $10M

Liquidity Management and the Role of Reserves
Borrowing to cover a shortfall in reserves:

Cost incurred is the interest rate paid on the borrowed funds
May be hard to borrow in a stress environment
May have to pay a high rate

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M

Liquidity Management and the Role of Reserves
Securities sale:

The cost of selling securities is the brokerage and other transaction costs, plus the opportunity cost in returns foregone.
Securities markets may become illiquid in a stress environment

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M

Liquidity Management and the Role of Reserves
Central banks generally provide a borrowing facility for authorised banks to cover liquidity shortfalls:

Borrowing from the central bank typically incurs a penalty rate of interest (designed to discourage poor liquidity management by banks).

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Emergency borrowing from CB $9M
Securities $10M Bank Capital $10M

Liquidity Management and the Role of Reserves
Reduce loans:

Reduction of loans is the most costly way of acquiring reserves.
Calling in loans (that is, requiring immediate repayment of the loan) antagonizes customers.
Loans can be sold, but possibly at “fire-sale” prices
Potentially disruptive to the wider economy, especially in a crisis.

Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M

Capital adequacy: role of credit risk management
One way to protect against solvency risk is through management of default or credit risk.
The tools available for this include:
Diversification: spread risks across a large number of different types of loans and geographical areas
Screening: check credit history, income history, financial position of borrowers
Monitoring and enforcement of restrictive covenants: loan can only be used for approved purposes
Collateral: lender has a legal claim on the borrower’s other assets (eg a secured housing loan)

An example of poor credit risk management: non-performing loans during the GFC

Capital Adequacy Management
Solvency can also be protected by ensuring a bank has sufficient capital to absorb potential losses
Capital allows losses to be absorbed without defaulting on liabilities to depositors and other non-capital liabilities
Banks chose to hold capital to support confidence in their business
It is also a regulatory requirement to ensure that banks meet minimum safety standards

How Bank Capital Helps Prevent Bank Failure:

Capital Adequacy Management

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