Chapter banking firm and bank management

Chapter The banking firm and Bank management Chapter The banking firm and Bank management In this chapter we examine how banks operate to earn the highest profits possible how and why they make loans,.

Chapter: The banking firm and Bank management In this chapter we examine how banks operate to earn the highest profits possible: how and why they make loans, how they acquire funds and manage their assets and liabilities and how they earn income The bank balance sheet   Bank balance sheet is a list of the bank’ assets and liabilities Characteristics : Total assets = total liabilities + capital Liabilities     Checkable deposits: are bank accounts that allow the owner of the account to write checks to third parties Checkable deposits include all accounts on which check can be drawn: Checkable deposits and money market deposit accounts are payable on demand A checkable deposit is an asset for the depositor and a liability for the bank Non transaction deposits: Types: - saving accounts - Time deposit Borrowings: Banks obtain funds by borrowing from the Fed, other banks and corporations Borrowings from the Fed are called discount loans Bank capital : Bank capital is the bank’s net worth, which equals the difference between total assets and liabilities Assets       Reserves: are deposits in an account at the Fed plus currency that is physically held by banks (vault cash) Bank hold reserves for two reasons: - By law: - Protect them from large depositors' withdrawal Cash items in process of collection Deposits at other banks Securities: -> US government and agency securities -> State and local government securities ->Other securities Loans : Other assets : General principle of bank management  The bank manager has four primary concerns - Liquidity management; - Asset management ; - Liability management ; - Capital adequacy management Liquidity management and the role of reserves  If a bank has ample reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet Conclusion: Excess reserves are insurance against the costs associated with deposit outflows The higher the costs associated with deposit outflows, the more excess reserves bank will want to hold Asset management   Three goals of bank: -> seek the highest returns possible on loans and securities -> reduce risk -> make adequate provision for liquidity by holding liquid assets Four basic ways to accomplish bank’s goals (1) Try to find borrowers who will pay high interest rate and are unlikely to default on their loans (2) Try to purchase securities with high return and low risk (3) Attempt to lower risk by diversifying (4) Manage the liquidity of its assets so that it can satisfy its reserve requirements without bearing huge costs Liabilities management Capital adequacy management   Banks have to make decisions about the amount of capital they need to hold for three reasons : (1) Prevent bank failure (2) Amount of capital effects returns for the owners of the bank (3) A minimum amount of bank capital is required by regulatory authorities How bank capital helps prevent bank failure Conclusion : A bank maintains bank capital to lessen the chance that it will become insolvent How the amount of bank capital affects returns to equity holders    ROA : Return on assets net profit after taxes ROA = assets Assets EM = Equity capital Net profit after taxes Net profit after taxes Assets = x -Equity Capital Assets Equity capital or ROE = ROA x EM => Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank Trade - off between safety and returns to equity holders Bank capital requirements Insurance Management  Screening  Risk-Based Premium  Restrictive Provisions  Prevention of Fraud  Cancellation of Insurance  Deductibles  Coinsurance  Limits on the Amount of Insurance Finance Companies History of finance companies  Purpose of finance companies  Risk in finance companies Finance companies face several types of risk: + Default risk: the chance that customers will fail to repay their loans + Liquidity risk: refers to problem that arises when a firm runs short of cash  Types of finance companies Business ( commercial ) finance companies  Factoring  Leasing  Floor plan loans  Consumer finance companies  Sales finance companies  Finance Companies Different Types of Business Loans Finance Company Balance Sheet            Assets Billions of dollars Consumer loans 112.6 Business loans 287.8 Real estate loans 67.2 Less reserve for loan losses 59.0 Other assets 169.7 Total Assets 578.3 100% Liabilities Bank loans 25.8 Commercial paper 149.9 Owed to parent 47.9 Debt not elsewhere 198.1 Other liabilities 87.6 Equity 68.9 Total Liabilities and Equity 578.3 Percent of Total 19% 50% 12% –10% 29% 5% 26% 8% 34% 15% 12% 100% Growth in Finance Companies 1979–1996 Securities Firms  Investment Banks  Underwriting stocks and bonds + Giving advice + Filing documents + Underwriting + Best efforts Private placements  Mergers and acquisitions Underwriting Stocks and Bonds  Giving Advice When to offer? At what Price?  Filing Documents SEC Registration statement Prospectus  Underwriting Syndicate  Tombstones Fully Subscribed Undersubscribed Oversubscribed  Best Efforts Ten Largest Underwriters in the U.S  Securities brokers and dealers  Brokerage services Securities orders +Market order +Limit order +Short sell  Other services Full- service versus discount brokers Full- service brokers Discount brokers  Securities Dealers Risk management in financial institutions In this chapter we examine how managers of financial institutions cope with credit risk, the risk arising because borrowers may default on their obligations, and with interest – rate risk, the risk arising from fluctuations in interest rate We will look at the tools that these managers use to measure risk and the strategies that they employ reduce it Managing Credit Risk Screening and monitoring  Establishment of long term customer relationship  Loan commitment  Collateral  Compensating balance requirements and credit rationing   Screening and monitoring Managing Interest Rate Risk First National Bank Assets Liabilities Reserves and cash items $ 5m Securities less than year $ 5m to year $ 5m greater than year $10 m $15 m Residential mortgages Variable rate $10 m Fixed rate (30 year) $10 m $15 m to year Commercial Loans less than year $15 m to year $10 m greater than year $25 m Physical capital $ 5m Checkable deposits Money market deposit accounts $15 m $ 5m Savings deposits CDs Variable-rate $10 m less than year $ 5m greater than year $ m Fed funds Borrowings to year $ m greater than year $ m Bank capital less than year $ 5m $ 5m $10 m Income Gap Analysis Rate-Sensitive Assets = $5m + $ 10m + $15m + 20% $20m RSA = $32 m Rate-Sensitive Liabs = $10m + $25m + $5m + $10m + 10% $15m + 20% $15m RSL = $54.5 m i  5%  Asset income = + 5% $32.0m Liability Costs = + 5% $54.5m Income = $ 1.6m – $ 2.7m If RSL > RSA, i  NIM  , Income  = + $ 1.6m = + $ 2.7m = – $1.1 m GAP = RSA – RSL = $32.0m – $54.5m = – $2.5m Income = GAP  i = –$22.5m 5% = $ – 1.1m ... primary concerns - Liquidity management; - Asset management ; - Liability management ; - Capital adequacy management Liquidity management and the role of reserves  If a bank has ample reserves,... Fed, other banks and corporations Borrowings from the Fed are called discount loans Bank capital : Bank capital is the bank? ??s net worth, which equals the difference between total assets and liabilities... the owners of the bank (3) A minimum amount of bank capital is required by regulatory authorities How bank capital helps prevent bank failure Conclusion : A bank maintains bank capital to lessen