The Banking Firm

1
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

2
The Banks Balance Sheet

• Assets Liabilities Equity
• Assets -- Market value of items in your
  possession.
• Liabilities -- Amounts owed to other parties.
• Equity Assets - Liabilities

3
Working With Assets, Liabilities, and Equity

• Note Definition of equity implies
• Assets Liabilities Equity
• (Balance sheets balance!).

4
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

5
The Banks Major Liabilities and Equity

• (1) Checkable Deposits (D)
• Includes Demand Deposits, Negotiable Order of
  Withdrawal (NOW) Acounts, Automatic Transfer of
  Savings (ATS) Accounts, and MMDA
• Not a major source of funds for banks

6

• 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

7

• (3) Borrowings (BORR) -- Funds
• borrowed by banks, usually to
• meet reserve requirements
• Eurodollars
• Repurchase Agreements Issued
• Federal Funds borrowed
• Discount Window Borrowings

8

• (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 banks health

9
The Banks 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

10
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

11
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

12
Other Assets

• (2) Cash items in the Process of
• Collection -- uncleared checks
• (3) Deposits at Other Banks
• (Correspondent Banking)

13
(4) Securities Holdings (B)

• Mostly bonds, some stock
• Revenue source for banks
• Short-term bonds -- secondary reserves
• Holdings include Negotiable CDs of other banks
• Long-term bonds -- can enjoy conveniences of bonds

14
(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

15
(5) Loans, Continued

• Preferred to bonds as a revenue source for banks.
• -- Inconveniences imply higher
• interest rate
• -- Personal aspect, tradition of
• banking (US).

16
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)

17
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.

18
An Example Customer Withdrawal

• Customer withdraws 200 from their savings
  deposit (T) at Chase
• Chase
• ?R - 200 ?T - 200

19
New Customer Deposits

• Example Customer deposits 300 in their
  checkable deposit (D)
• Chase
• ?R 300 ?D 300

20
Banks as Financial
Intermediaries

• Financial Intermediary -- An institution that
  borrowers from lenders, then loans to borrowers.
• Takes advantage of institutional fact of life --
  lenders want to lend small, but borrowers want
  to borrow large.

21
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).

22
Balance Sheet Description

• Chase
• ?R 1000 ?D 50
• ?L - 200 ?T 300
• ?E 450
• Bank Profit 800 - 350 450
• (?E)

23
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.

24
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).

25
The Banks Nightmares

• Financial intermediaries have inherent
  instabilities.
• The bank can only reduce the probability of
  occurrence.
• Bank regulation and regulatory agencies -- seek
  to reduce the probability of occurrence or reduce
  the impact to the bank when they happen.

26
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.

27
The Bank Run The Most Dramatic
Case

• Consider 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!!).

28
Ways to Reduce Adverse Effects Disintermediation

• Seek sufficient liquidity in asset portfolio
• Increase excess reserves for anticipated unusual
  withdrawals
• Be competitive
• Use borrowing sources, when needed

29
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!).

30
Ways to Reduce Interest Rate Risk

• Reduce the gap in maturity between assets and
  liabilities
• -- Promote shorter term loans
• -- Promote longer-term deposits
• Seek other sources of income/profits
  (off the balance sheet banking)

31
Nightmare 3 -- Loan Default

• Loan Default -- Borrower fails to repay loan
• Declaring 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
  have significant loss in value

32
Example Loan Default

• Consider 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

33
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

34
Ways to Reduce Adverse Effects of Loan Default

• Screening/Collateral
• Knowing clientele
• Portfolio Diversification
• Seek to maintain sufficiently large equity-asset
  ratio

35
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