Money and Banking

1
Money and Banking

• Spring 2007
• Martin Andreas Wurm
• University of Wisconsin - Milwaukee

2
Commercial Banking

• Required Reading Mishkin, Chapter 9, 11
• Recommended Reading Mishkin, Chapter 10

3
Commercial Banking

• 1. Overview
• We briefly introduced banks as financial
  intermediaries at the beginning of the semester
• The banking sector plays a predominant role in
  financial markets, with roughly 6 Trillion
  US-Dollars of credit provided annually in the
  U.S.
• Its primary function is the provision of loans to
  businesses and households as well as the
  provision of other services such as checking/
  saving accounts. Further banks are involved in
  the money creation process.

4
Commercial Banking

• 1. Overview
• We will start the discussion of commercial
  banking by an overview of how banks operate, how
  they provide loans, acquire funds and what
  generates their income.
• Then we will briefly discuss the banking
  structure in the U.S. and analyze why and how the
  banking sector is regulated.
• The natural starting point for this discussion is
  a typical banks balance sheet.

5
Commercial Banking

• 2.1. A typical banks balance sheet
• Composition of the balance sheet of all
  commercial banks

Assets
Liabilities

• Reserves/ Cash items in process of transition
  4
• Securities U.S. Govt
  15 State/ Local Govt
  Others
  10
• Loans Commercial/Industrial
  12 Real Estate
  32 Consumer
  9 Interbank
  4 Other
  6
• Other Assets 8
• Total
  100

• Checkable Deposits
  9
• Non-Transaction Deposits Small
  Denomination Time
  Deposits
  Savings Deposits
  47
• Large Denomination Time
  Deposits
  16
• Borrowings
  21
• Banks Capital
  7
• Total
  100

6
Commercial Banking

• 2.2. A Typical Banks Balance sheet
• Liabilities are the sources of funds for a bank,
  assets indicate the uses of these funds.
• The value of a banks assets must always equal
  the value of its liabilities its (equity)
  capital by the principle of double-entry
  bookkeeping
• Each transaction always addresses two items on
  the balance sheet, such that it balances again
  after the transaction is recorded. (see example
  below)
• Technically each transaction addresses two out
  of a large number of T-accounts, which then are
  transferred into the balance sheet once or more
  often per year

7
Commercial Banking

• 2.2. Liabilities
• The right hand side of the banks balance sheet
  lists the source of funds for a banks
  operations
• Checkable deposits are deposits which sometimes
  bear a (small) interest rate.
• Payable on demand
• Can be used directly as means of payment through
  checks
• Provide the lowest-cost for banks, since lenders
  are willing to forgo some interest in exchange
  for the high liquidity
• In comparison Interest payments on deposits
  (checkable and time) make up for about 25 of
  banks operating cost, service costs make about
  50 (!).

8
Commercial Banking

• 2.2. Liabilities
• 2. Non-transaction deposits
• Checks cannot be written on non-transaction
  deposits (hence, the name) and these deposits are
  the primary source of funding for banks.
• The two types of non-transaction deposits are
  savings deposits and time deposits (certificates
  of deposit)
• Since these types of deposits are generally less
  liquid than checkable deposits, banks pay a
  higher interest rate on them.

9
Commercial Banking

• 2.2. Liabilities
• 3. Borrowing
• In principle banks can borrow from the Federal
  Reserve System, Federal home loan banks, other
  banks or the corporate sector
• The Fed provides so called discount loans (also
  advances), however, discourages their use. The
  interest rate paid on these funds is the discount
  rate, which is set directly by the Fed.

10
Commercial Banking

• 2.2. Liabilities
• 3. Borrowing
• An increasingly common channel of borrowing are
  inter-bank loans, which are settled in the
  Federal Funds Market
• In this market Banks borrow funds overnight to
  have enough deposits at the Federal reserve to
  meet their reserve requirements. The interest
  rate at which these loans are traded is known as
  the Federal Funds Rate, which is the rate
  commonly referred to as the interest rate by
  the media.

11
Commercial Banking

• 2.2. Liabilities
• 4. Capital
• Finally capital/equity sources are the sources of
  funds the owners of the bank provide themselves,
  such as share capital, retained earnings, etc.
• There are strict requirements on how much capital
  owners have to keep within a bank (see banking
  regulation). The Basel Accord of 1988 is a
  frequently mentioned international agreement
  aimed at standardization of international bank
  capital requirements.

12
Commercial Banking

• 2.3. Assets
• Banks in their essence are enterprises like
  many others. Since their owners are primarily
  interested in creating profit, funds dont just
  rest within the bank, but find a variety of uses,
  which serve this purpose.
• The assets in a banks balance sheet list the
  uses a banks resources are directed to. As we
  will see later, the activities a bank can get
  engaged in are strongly regulated (e.g. banks
  cannot hold common stock).

13
Commercial Banking

• 2.3. Assets
• 1. Reserves
• There are two types of reserves a bank holds
• 1. Required reserves For each Dollar deposited
  in a checking account, banks must hold a certain
  percentage (normally around 10, i.e. 10 cents)
  in an account at the Federal Reserve. This ratio
  is known as the required reserve ratio, the
  remaining funds banks achieve through checking
  deposits are free to their disposal.

14
Commercial Banking

• 2.3. Assets
• 1. Reserves
• There are two types of reserves a bank holds
• 2. Excess/Free Reserves In addition to required
  reserves, banks also can hold free reserves, in
  form of deposits at the Fed or simply physical
  currency (known as vault cash).
• Why are reserves required/ of interest to a bank?

15
Commercial Banking

• 2.3. Assets
• 1. Reserves
• Remember that checkable deposits and saving
  deposits can be withdrawn from a bank on demand.
• While generally not all of these deposits are
  withdrawn at the same time, a bank must make sure
  that it can pay off those that are. In order to
  be able do so, a bank must hold reserves.
  Reserves on the other hand do not produce any
  rent for a bank and banks have an incentive to
  keep their reserve holdings low.
• In response to this banks are required by law to
  hold a certain amount of reserves with the Fed.
  However, banks also keep excess reserves in order
  to be able to meet these requirements.

16
Commercial Banking

• 2.3. Assets
• 1. Reserves
• Reserves consist of
• Deposits with the Fed/ Vault money
• Cash items in process of transactions Checks
  written on accounts in other banks, which are
  already deposited with a bank, while the
  corresponding funds have not yet been transferred
  
• Deposits with other banks (common among smaller
  banks)

17
Commercial Banking

• 2.3. Assets
• 2. Securities
• Securities are an important source of revenue for
  banks and consist of three types
• US. Government / agency securities
• State local government securities
• Other securities
• Because of their high liquidity U.S. governments/
  agency securities are also called second reserves.

18
Commercial Banking

• 2.3. Assets
• 3. Loans
• Loans are the primary source of income for banks
  and different specializations in the type of
  loans banks focus on are the primary differences
  between them (e.g. savings loans banks focus on
  mortgages).
• Loans are not very liquid (to varying extents),
  have a positive and sometimes significant default
  risk and usually pay a return for the bank only
  at the maturity date

19
Commercial Banking

• 2.3. Assets
• 4. Other Assets
• Banks further keep a variety of physical assets
  in their portfolio which are often of significant
  value.
• Part of these assets are buildings, real estate,
  but also items such as art collections.

20
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• There are four broad categories of banking
  management
• 1. Liquidity Management Assures a banks ability
  to service deposit withdrawal request.
• 2. Asset Management Intends to balance the
  tradeoff between the profitability of assets and
  their default risk
• 3. Liability Management Aims at finding cheap
  and steady sources of funding for a bank
• 4. Capital Management Deals with the acquisition
  and maintenance of an appropriate amount of
  capital

21
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• In order to see what banks primarily do and why
  there are certain problems connected to it,
  consider the following transaction
• Assume someone deposits a 100 banknote with a
  bank.
• This transaction addresses (at least) two items
  on the balance sheet such, that the values of
  total assets and total liabilities remain equal
  to each other.

22
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• Assume further, that the total value of
  assets/liabilities is initially equal to 1000.
  The 100 bill raises checkable deposits on the
  one hand (1), and required and excess reserves
  correspondingly(2). Further it increases the
  values of total assets/ liabilities each by
  100(3)

Assets
Liabilities

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Required Reserves (Assuming a required
  reserve ratio of 10)
  10
• Excess Reserves 90
• Total 1,000100
  

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Checkable Deposits
  100
• Total 1,000100

1.
2.
3.
3.
23
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• More complicated transactions are handled in the
  same fashion. Assume for example, that somebody
  deposits a check worth a 100 dollars written on
  an account with another bank into his checking
  account with the UW credit union.
• Two transactions take place 1. The check is
  deposited. 2. The UW credit union settles this
  check with the other bank and retrieves the
  corresponding funds.

24
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• 1. When the cash is checked, the checkable
  deposits of the UW Credit Union increase by 100.
  Simultaneously, cash items in the process of
  transaction increase by a 100.

Assets
Liabilities

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Cash items in the process of transaction
  100
• Total 1,000100
  

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Checkable Deposits
  100
• Total 1,000100

25
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• 2. Once the funds are transferred from the other
  bank to the UW Credit Union at the Federal
  Reserve, both cash items in the process of
  transaction as well as required/excess reserves
  can be addressed. Note, that this does not change
  the total value of assets.

Assets
Liabilities

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Cash items in the process of transaction
  - 100
• Required reserves 10
• Excess reserves 90
• Total 1,100
  

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Checkable Deposits
  100
• Total 1,100

26
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• We already figured that a bank runs for profit,
  that means that the funds it receives from its
  depositors are not just going to sit around in
  form of cash, which produces no return for the
  bank.
• Instead a bank shifts its reserves into other
  assets such as loans or securities for which the
  bank earns a return.
• Lets assume for example, that the UW credit
  union in our example shifts 80 dollars of its
  excess reserves into loans and 10 dollars in
  securities

27
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• While excess reserves decline, securities and
  loans are increased correspondingly. The value of
  all assets remains unchanged.

Assets
Liabilities

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Required reserves 10
• Excess reserves - 90
• Securities 10
• Loans
  80
• Total 1,100
  

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Checkable Deposits
  100
• Total 1,100

28
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• However, there is an inherent problem to this
  procedure Since checkable deposits can be
  liquidated any time, while loans are less liquid,
  sudden, large scale withdrawals from a banks
  deposits can lead to liquidity problems and in
  the extreme to the insolvency of the bank.

29
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• Assume that 15 are withdrawn from the banks
  checkable deposits. This reduces the amount of
  checkable deposits to 85. At the same time it
  reduces the banks cash reserves. Since there are
  only required reserves left, the bank cannot use
  them to satisfy this withdrawal entirely.

Assets
Liabilities

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Required reserves 10
• 
  -10
• Securities 10
• Loans
  80
• Total 1,090
  

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Checkable Deposits
  100
• 
  - 15
• Total 1,085

30
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• In a situation like this, the bank is left with a
  number of options
• 1. Borrow from other banks or the Fed
• 2. Sell other assets
• 3. Fail (usually not the preferred option)

31
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• Borrowing
• Banks can either borrow from other banks in the
  Federal Funds Market at the Federal Funds Rate or
  by using the discount window of the Federal
  Reserve at the discount rate (which, however, is
  only an emergency channel).

32
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• In our example, the bank would have to borrow at
  least 5 Dollars not to run into insolvency. In
  reality, however, the bank would also have to
  meet its reserve requirements of 10, and hence,
  borrow 15

Assets
Liabilities

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Required reserves 10
• 
  -10
• Securities 10
• Loans
  80
• Total 1,090
  

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Checkable Deposits
  100
• 
  - 15
• Borrowings 5
• Total 1,090

33
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• Sale of assets
• Otherwise the bank can try to liquidate some of
  its assets. This is easy in the case of
  government securities, but can be more difficult
  for other types of securities. For loans it can
  become virtually impossible in the very short
  run.
• Lets assume, the banks sells 5 worth of its
  securities instead of borrowing and the situation
  is resolved as follows

34
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 1. Liquidity Management and Asset Transformation
• In our example, the banks securities decrease by
  5, its required reserves decrease by 10 and its
  checkable deposits decrease by 15.

Assets
Liabilities

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Required reserves 10
• 
  -10
• Securities 10
• 
  - 5
• Loans
  80
• Total 1,085
  

• ltOther Items in the balance sheet (for
  example) gt 1,000
• Checkable Deposits
  100
• 
  - 15
• Total 1,085

35
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 2. Asset Management
• The discussion of a banks asset management could
  fill an entire lecture, but it basically follows
  the same principles as other forms of investment
  management.
• The basic idea is to maximize the return on a
  banks assets while at the same time keeping the
  risk of assets going bad at reasonable levels.
  Classical tools are portfolio selection, risk and
  loan management, etc.

36
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 3. Liabilities Management
• Up until the 1960s banks at large took the stream
  of funds flowing in through various types of
  deposits as given.
• Only since then the location of other, more
  flexible forms of funding such as borrowing
  through the Federal Funds Market- has become part
  of commercial banks agenda

37
Commercial Banking

• 2.4. Some General Principles of Banking
  Management
• 4. Bank capital management
• Bank capital management finally deals with
  questions of how to manage a banks equity.
• There are strong regulations for the precise
  capital coverage a bank has to exhibit (see the
  discussion of the Basel and Basel II accords).
• Further, decisions on retained earnings,
  dividends, etc. are important in the context of
  capital management.