Chapter 9 Banks and Bank Management Depository Institutions: The Big Questions Where do commercial banks get their funds and what do they do with them? How do commercial banks manage their balance sheets? What risks do banks face? Balance Sheet of Commercial Banks:,, and Capital The balance sheet identity: Bank = [Bank + Bank Capital] Uses of bank funds Sources of bank funds When one side changes, the other side must change as well. A bank s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets) 1
Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2014) are Sources of Funds Checkable Deposits: Called transactions deposits - all accounts that allow the owner (depositor) to write checks to third parties: non-interest earning checking accounts (known as - demand deposit accounts because funds are due on demand, Interest earning negotiable orders of withdrawal (NOW) accounts (interest earning checking account), and Money-market deposit accounts (MMDAs), which typically pay the most interest among checkable deposit accounts About 11% of bank source of funds Sources of Funds Non-transaction Deposits: savings type account - generally a bank s highest cost funds. Banks want deposits which are more stable and predictable and will pay more to attract such funds. The largest source of funds ~ 58% 2
Sources of Funds Borrowings: Banks borrow from: the Federal Reserve System: discount loans other banks: Fed funds and repos corporations: Repos and commercial paper About 20% of bank source of funds Repurchase Agreement - Repo Bank Capital Source of Funds Bank Capital: funds supplied by the bank owners either through purchase of ownership shares or retained earnings Bank capital provides a cushion capital levels are important. About 11% of bank source of funds A very important topic in bank regulation. 3
are Uses of Funds Reserves: funds held in accounts with the Fed (vault cash and cash in the ATM machine is included). Required reserves represent what is required by law - reserve requirement or required reserve ratios. Any reserves beyond this are called excess reserves. About 19% of bank assets. Uses of Funds Securities: includes U.S. government debt, agency debt, municipal debt, and other (nonequity) securities. About 19% of assets. Short-term US Treasury debt (Treasury Bills) is often referred to as secondary reserves because of its high liquidity. Commercial banks in the US may not hold stock. Uses of Funds Loans: business loans, auto loans, and mortgages, loans to other banks. Generally not very liquid. About 53% of bank assets. Many banks tend to specialize in either consumer loans or business loans. 4
Uses of Funds Other : bank buildings, computer systems, and other equipment. Commercial Bank Liability Trend Checkable Deposits have declined substantially in importance were 61% of bank funds in 1960, down to about 11%. Transactions deposit available on demand Balance Sheet of Commercial Banks: Changes in over time Transactions deposits were 61% of bank funds in 1960, 6.0% in 2008. Borrowings provided only 2% of bank funds in 1960, up to 31% in 2008. 5
Changes in Bank Over Time Security holdings down from 70% in 1947 to 20% now. Loans( C&I, real estate, and consumer loans) ~ 50%. Bank Capital and Profitability Net worth equals assets minus liabilities - referred to as bank capital, or equity capital. Capital represents the owners stake in the bank. Bank capital acts as a cushion against a sudden drop in the value of their assets or an unexpected withdrawal of liabilities. It provides some insurance against insolvency. ratio of equity to assets is 11%(equity ratio) ratio of assets to equity is 9.11 (leverage ratio) every $100 is assets was financed with $11 of equity and $89 of debt 6
Bank Capital and Profitability Leverage increases expected return and risk. Expected return and risk double if leverage ratio (ratio of assets-to-equity) increases from 1-to-1 to 2-to-1. For banks the ratio is 9-to-1. Risk and return increase by a factor of 9! Banking is a risky business. Why So Much Leverage One explanation - the existence of government guarantees like FDIC deposit insurance. Too big to fail. Government guarantees allow banks to capture the benefits of risk taking without subjecting depositors to potential losses. Basic Banking Transactions Cash Deposit of $100 in First National Bank First National Bank First National Bank Vault Cash +$100 Checkable deposits +$100 Reserves +$100 Checkable deposits +$100 The above example presents two ways to record the same transaction. Opening of a checking account leads to an equal increase in the bank s reserves. NOTE: vault cash counts as reserves 7
Basic Banking Transactions Check Deposit of $100 into First National Bank that is written on Second National Bank First National Bank (FNB) Second National Bank (SNB) Reserves +$100 Checkable deposits +$100 Reserves -$100 Checkable deposits -$100 FNB gains reserves and SNB loses reserves Basic Banking - Making a Profit First National Bank First National Bank Required reserves +$10 Checkable deposits +$100 Required reserves +$10 Checkable deposits +$100 Excess reserves +$90 Loans +$90 10% Reserve Requirement Bank use excess reserves to make loans or invest in bonds. Makes a profit because it borrows short (at a relatively low interest rate) and lends long (at a relatively high interest rate) General Principles of Bank Management Make profits by: Selling liabilities with one set of characteristics (high liquidity, low risk, small size, low return). [Source of Funds] Buying assets with a different set of characteristics (low liquidity, high risk,large size, high return). [Use of Funds] Process known as asset transformation also referred to as maturity transformation. 8
General Principles of Bank Management Managing Risk. Four primary concerns: 1. Liquidity Risk 2. Credit Risk 3. Interest Rate Risk 4. Capital adequacy I do not cover trading risk. Managing Liquidity Risk Reserves requirement = 10%, Excess reserves = $10 million Deposit outflow = $10 million After the deposit outflow, the bank has excess reserves of $ million. Is there a need to change the balance sheet? Managing Liquidity Risk Reserves requirement = 10%, Excess reserves = $0 Bank with no excess reserves Deposit outflow of $10 million With 10% reserve requirement, bank has reserve shortfall of $9 million. 9
Options to Correct the Shortfall in Reserves: Borrow from other banks or corporations. Reserves $9M Deposits $90M Loans $90M Borrowing $9M Securities $10M Bank Capital $10M Other banks - Federal Funds Market Corporations Issue CP or engage in Repo There s a cost - interest rate paid on the borrowed funds Liquidity Management - Shortfall in Reserves: Borrow from the Fed Reserves $9M Deposits $90M Loans $90M Borrow from Fed $9M Securities $10M Bank Capital $10M There s a cost - payments to Fed based on the discount rate Liquidity Management Shortfall in Reserves: Sell Securities Reserves $9M Deposits $90M Loans $90M Bank Capital $10M Securities $1M There are costs: transaction costs and possible capital loss. 10
Liquidity Management: Reduce Loans Reduction of loans is the most costly way of acquiring reserves Reserves $9M Deposits $90M Loans $81M Bank Capital $10M Securities $10M Calling in loans (basically not renewing short-term loans) antagonizes customers Loans are not a liquid asset. Other banks may only agree to purchase loans at a substantial discount Asset Management - Credit Risk: Overcoming Adverse Selection and Moral Hazard Screening and information collection Specialization in lending (e.g. energy sector) Diversification - by industry and geography Monitoring and enforcement of restrictive covenants Long-term customer relationships Collateral and compensating balances Liability Management Managing the sources of funds: from deposits, to CDs, to other debt. 1. Important since 1960s 2. Banks no longer primarily depend on transactions deposits 3. More dependent on non-transactions deposits and borrowing. Growth in borrowing from 2% in 1960 to 31% in 2008. Negotiable CDs at 19% 11
Bank Capital Management In Dec 2006, commercial bank capital was $0.86 trillion equal to 8.8% of total assets of $9.77 Trillion Leverage = 9.77/0.86 = 11.4 In Dec 2015, commercial bank capital was $1.7 trillion equal to 11% of total assets of $15.5 Trillion Leverage = 15.5/1.7= 9.1 Capital Adequacy Management Bank capital is a cushion that helps prevent bank failure. As banks write down assets, bank capital takes a hit. Regulators set minimum capital requirements. Capital Adequacy Management Case Study: Borrower defaults on $5 million loan High Bank Capital Low Bank Capital Reserves $10M Deposits $90M Reserves $10M Deposits $96M Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M High Bank Capital Low Bank Capital Reserves $10M Deposits $90M Reserves $10M Deposits $96M Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M 12
Basic Strategies for Managing Capital What can a bank do if bank is holding too little capital (i.e., the capital ratio is too low)? Issue stock to attract new equity capital. Decrease dividends to increase retained earnings which adds to equity capital. Reduce assets or slow asset growth (retire debt) Bank Capital and Profitability There are several measures of bank profitability. 1. Return on assets (ROA) ROA is the bank s net profit left after taxes divided by the bank s total assets. Net profit after taxes ROA = Total Bank It is a measure of how efficiently a banks uses its assets. However, it is less important to bank owners than the return on their own investment. Bank Capital and Profitability 2. The bank s return to its owners is measured by the return on equity (ROE). This is the bank s net profit after taxes divided by the bank s capital. Net profit after taxes ROE = Bank Capital ROA and ROE are related to leverage. Multiplying ROA by this ratio yields ROE. 13
Capital Adequacy Management: Return to Equity Holders Return on : net profit after taxes per dollar of assets net profit after taxes ROA = assets Return on Equity: net profit after taxes per dollar of equity capital ROE = net profit after taxes equity capital Relationship between ROA and ROE is expressed by the Equity Multiplier: the amount of assets per dollar of equity capital net profit after taxes equity capital EM = Equity Capital net profit after taxes assets ROE = ROA EM assets equity capital Capital Adequacy Management There is a tradeoff between safety (high capital) and ROE If Equity Capital => EM => ROE Prudent to hold equity capital. Unfortunately, banks aren t very prudent. Equity Multiplier and Capital Ratio Total EM Equity Capital Equity Capital CapitalRatio EM = 10, means $1 of equity supports $10 in assets. The bank borrows $9. EM = 25, means $1 of equity supports $25 in assets. The bank borrows $24. EM is the inverse of the capital ratio 14
Bank Profitability ROA is typically 1.2 to 1.3% ROE is 10 to 12 times ROA. Let s take a look: https://www2.fdic.gov/qbp/2014dec/cb1.html Leverage of Various Financial Institutions prior to Financial Crisis Commercial Banks $Trillion $Trillion Equity $Trillion Leverage /Equity 10.8 9.7 1.1 9.8(10.2%) Savings Inst. 1.91 1.68.23 8.4(11.9%) Credit Unions 0.75.66.09 8.4(11.9%) Investment Banks 5.4 5.23.17 31.7 (1/31.7) = 3.15% GSEs 1.63 1.56.067 24.7(4.0%) Overall 20.5 18.8 1.7 12.2(8.2%) Suppose banks are required to maintain a capital ratio of 10%. Assume times are good and loan portfolio increases by $1. National Capital Bank January Cash $10 Debt $90 Loans/Securities $90 Equity Capital $10 Total $100 Total $100 National Capital Bank June Cash $10 Debt $90 Loans/Securities $91 Equity Capital $11 Total $101 capital ratio is 10.89% > 10% National Capital Bank December Cash $10 Debt $99 Loans $100 Equity Capital $11 Total $110 Total $110 15
The mechanism works in reverse when times are bad. Loan portfolio decreases by $1: De-leveraging the balance sheet National Capital Bank - January Cash $10 Debt $90 Loans/Securities $90 Capital $10 Total $100 Total $100 National Capital Bank June Cash $10 Debt $90 Loans/Securities $89 Capital $9 Total $99 Total $99 capital ratio is 9.09% < 10% National Capital Bank December Cash $10 Debt $81 Loans/Securities $80 Capital $9 Total $90 Total $90 Banks do not have to de-leverage if they can raise more equity capital and pay off some debt National Capital Bank June Cash $10 Debt $89.1 Loans/Securities $89 Capital $9.9 Total $99 Total $99.0 capital ratio is = 10% How a Capital Crunch Caused a Credit Crunch in 2008 Housing bust led to large bank losses Value of assets reduced. The losses reduced bank capital. Banks required to rebuild capital a capital crunch! Banks had two option: (1) raise new capital or (2)reduce lending Which option? 16
Managing Interest Rate Risk In addition to the borrow/short - lend/long mismatch, banks also have a mismatch between assets and liabilities that are interestrate sensitive and non-interest rate sensitive. For example, deposit rates tied to market rates (interest rate sensitive cost) long-term fixed rate loan ( Non-interest rate sensitive income) Managing Interest Rate Risk What happens if interest rate rise? Deposit rates tied to flexible short-term interest rates rise. Loan revenues based on fixed interest rate remain fixed. Profits fall. Interest-Rate Risk Simple Gap Analysis Rate-sensitive assets(rsa) Variable-rate and short-term loans Short-term securities First National Bank $20M Rate-sensitive liabilities (RSL) Variable-rate CDs Money market deposit accounts $50M Fixed-rate assets $80M Fixed-rate liabilities $50M Reserves Checkable deposits Long-term loans Long-term securities Savings deposits Long-term CDs Equity capital If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits 17
Interest Rate Risk: Gap Analysis Basic Gap Analysis Δ bank profits = (RSA RSL) x Δ interest rate We will not cover duration! Managing Interest-Rate Risk Basis Gap Analysis GAP = rate-sensitive assets rate-sensitive liabilities = $20 $50 = $30 million When i 5%: 1. Δ Income on assets =.05 $20m = +$1 million 2. Δ Costs of liabilities =.05 $50m = +$2.5 million 3. Profits = $1m $2.5m = -$1.5m Profits = i GAP =.05 (GAP) =.05 ($20 - $50) =.05 x -$30 =-$1.5 1. Loan sales Off-Balance-Sheet Activities 2. Fee income from Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit 3. Trading Activities and Risk Management Techniques Financial futures and options Foreign exchange trading Interest rate swaps All these activities involve risk and potential conflicts 18