CHAPTER 09 (Part B) Banking and Bank Management
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1 CHAPTER 09 (Part B) Banking and Bank Management Financial Environment: A Policy Perspective S.C. Savvides
2 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 ECO355-Money & Banking 1
3 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.). S.C. Savvides ECO355-Money & Banking 2
4 Changes in Financial/Banking Markets 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 Uncovered weaknesses / gaps in bank supervision and risk management practices of banks S.C. Savvides ECO355-Money & Banking 3
5 Financial Institutions 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) S.C. Savvides ECO355-Money & Banking 4
6 Other 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. S.C. Savvides ECO355-Money & Banking 5
7 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 transformation Bank liabilities: mostly short term Bank loans: mostly long term banks create liquidity S.C. Savvides ECO355-Money & Banking 6
8 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 mechanism The check-clearing system The electronic payment system S.C. Savvides ECO355-Money & Banking 7
9 Assets and Liabilities of Banks Fundamental accounting identity Assets = Liabilities + Equity (or net worth) assets must equal liabilities (the debts of the firm) plus the equity (i.e., the owner's interest). Balance Sheet The 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 S.C. Savvides ECO355-Money & Banking 8
10 Indicative Bank Balance Sheet S.C. Savvides ECO355-Money & Banking 9
11 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) S.C. Savvides ECO355-Money & Banking 10
12 Liabilities of Banks S.C. Savvides ECO355-Money & Banking 11
13 Reserves 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. S.C. Savvides ECO355-Money & Banking 12
14 Reserves Assets (Uses of Funds) 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 ECO355-Money & Banking 13
15 Assets of Banks S.C. Savvides ECO355-Money & Banking 14
16 Principles of Bank Management Liquidity Management Asset Management Managing Credit Risk Managing Interest-rate Risk Liability Management Capital Adequacy Management S.C. Savvides ECO355-Money & Banking 15
17 Initial Bank Balance Sheet S.C. Savvides ECO355-Money & Banking 16
18 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: Liquidity Management Excess reserves are an insurance against deposits outflows. S.C. Savvides ECO355-Money & Banking 17
19 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 S.C. Savvides ECO355-Money & Banking 18
20 Asset and Liability Management 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. S.C. Savvides ECO355-Money & Banking 19
21 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). S.C. Savvides ECO355-Money & Banking 20
22 Capital Adequacy 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 S.C. Savvides ECO355-Money & Banking 21
23 Capital Adequacy Management 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! S.C. Savvides ECO355-Money & Banking 22
24 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 Other assets 5 100% 5 Total assets S.C. Savvides ECO355-Money & Banking 23
25 Asymmetric Information 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 transaction In 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 S.C. Savvides ECO355-Money & Banking 24
26 Credit Risk Management 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 S.C. Savvides ECO355-Money & Banking 25
27 Credit Analysis 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 Analysis Capacity 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) S.C. Savvides ECO355-Money & Banking 26
28 Types of Risks 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). S.C. Savvides ECO355-Money & Banking 27
29 Financial 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 S.C. Savvides ECO355-Money & Banking 28
30 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 S.C. Savvides ECO355-Money & Banking 29
31 Risk Management by Banks 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. S.C. Savvides ECO355-Money & Banking 30
32 Rating Banks by Risk Category CAMEL(S): system of rating banks by risk category C: 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. S.C. Savvides ECO355-Money & Banking 31
33 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 S.C. Savvides ECO355-Money & Banking 32
34 Benefits of DIS s: Pros and Cons of DIS 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 ECO355-Money & Banking 33
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