Chapter 7 Bank Management Balance Sheet A balance

Chapter 7 Bank Management

Balance Sheet: A balance sheet lists the uses of acquired funds, assets; the source of acquired funds, liabilities; and the difference between the two, net worth. n n Assets = Liabilities + Capital

Assets – use of funds: Bank assets include cash items and funds used in securities investments, loans, and other asset holdings. n n The most liquid asset held by banks is reserves, which consist of vault cash —cash on hand in the bank or in deposits at other banks—and deposits with the Federal Reserve System n n The Fed requires banks to hold some of their deposits as required reserves in the form of vault cash or in reserve accounts at a Federal Reserve bank. Marketable securities are liquid assets that banks trade in securities markets. n n n n U. S. Govt State and Local Two-thirds of bank assets are loans n n Required Excess Business Consumer Mortgages Other bank assets include the equipment and buildings the bank owns and collateral received from borrowers in default. Cash items in processing Deposits in other banks

Liabilities – Sources of funds: Bank liabilities are the funds the bank acquires from savers. n n n Demand deposits: Banks offer savers checkable deposits, accounts that grant a depositor the right to write checks. Savings Deposits: To attract funds from depositors who want to earn interest on their funds, banks offer nontransactions deposits, such as savings accounts, money market deposit accounts, and certificates of deposit. In the United States federal deposit insurance provides government guarantees for account balances up to $100, 000. Borrowings, or nondeposit liabilities, include short-term loans in the federal funds market, loans from a bank’s foreign branches or other subsidiaries or affiliates, repurchase agreements, and loans from the Federal Reserve System (known as discount loans).

n n n Bank net worth, or equity capital, is the difference between the value of assets and the value of liabilities. A bank failure occurs when a bank cannot repay its depositors with enough reserves left to meet its reserve requirements. To analyze movements in bank profits, use is made of an accounting tool called a T-account, which lists change in balance sheet items from an initial position as they occur.

Starting a Bank n Why start a bank? n To make profits for the owners n n Obtain a charter Raise Funds (200) n n Building = 100 Cash = 100 Reserve Requirement of 10% n n n Make profits by loaning Percentage of Deposits that must be held in the FED Accept Deposits Make Loans

Revenues n n n Interest income Noninterest income n Trading income – derivates (options and futures) n Customer fees Costs n n Interest Expense Loan Losses Resource Expense Profits n n Revenues - Costs Basic Operation n n T – accounts n Someone opens a checking account n Bank makes a loan n Bank borrows from the FED n What if reserves fall below required amount

Services n Traditional n n Checking Savings Loans Modern n n n n Bill paying Retirement accounts Money market accounts Investments Credit and Debit Cards Insurance Tax help Online banking

Types of Bank Management n n Asset management – maximize profits by loaning, maintaining liquidity, and meeting reserve requirements Liability management – borrowing from other banks, the FED and corporations and issuing CD’s Capital Management – prevent bank failure, meet requirements, maintain returns to owners

Types of Bank Risk n Leverage Risk – Extent to which a bank’s assets are purchased with debt Credit Risk – Extent to which a bank’s borrowers will default n n n Interest Rate Risk – Extent to which assets and liabilities are subject to interest rate changes n n Interest Rate Risk—the risk that the interest rate will unexpectedly change so that the costs of an FI’s liabilities exceed the earnings on its assets or that the value of long-term fixed rate assets has fallen as interest rates rise. Trading Risk – Extent to which a banks financial instruments are subject to losses caused by the market Liquidity Risk – Extent to which banks are subject to unexpected withdrawals or unexpected loan demand n n Credit or default risk—the risk that the borrower is unwilling or unable to live up to the terms of the liability it has sold Liquidity Risk—the risk that the FI will be required to make a payment when the intermediary has only long-term assets that cannot be converted to liquid funds quickly without a capital loss. Exchange Rate Risk—the risk that changes in the exchange rate can adversely affect the value of foreign exchange or foreign financial assets.

Managing Credit Risk: Banks are concerned about credit risk, the risk that borrowers might default on their loans, which arises because of problems of adverse selection and moral hazard. n Diversification n Banks can reduce credit risk by holding a diversified portfolio of loans. n Banks can also reduce credit risk by performing credit-risk analysis, in which the bank examines the borrower’s likelihood of repayment and general business conditions that might influence the borrower’s ability to repay the loan. Banks require collateral, or assets pledged to the bank in the event that the borrower defaults. n n Collateral requirements n n To reduce adverse selection and moral hazard problems banks sometimes practice credit rationing, in which case the size of a borrower’s loan is limited or the borrower is simply not allowed to borrow any amount at the going interest rate. n n n Compensating balances – minimum balance in an account Credit rationing – restricting who gets the loan and the amount To reduce the costs of moral hazard banks monitor borrowers and place restrictive covenants in loan agreements

One of the best ways for a bank to gather information about a borrower’s prospects or to monitor a borrower’s activities is for the bank to have a long-term relationship with the borrower. Screening applicants – applying for a loan n Beacon Scores - 400 to 850 n n n n 775+ Preferred 725 – 774 Platinum 700 – 724 Gold 680 – 699 Standard 1 640 – 679 Standard 2 620 – 639 Standard 3 0 - 619 Forget it Determinants of your credit score n n n Payment History 35% n Credit cards, retail accounts, carloans, and mortgages Amount owed 30% n Number of accounts with balances n The amount you owe vs amount of credit available Credit History 15% n The amount of time you’ve had each account n The longer the better New credit 10% n Number of accounts opened recently n Number of recent inquiries n Opening accounts in a short period is not good Types of credit used 10% n Number of credit cards, retail accounts, consumer finance accounts, and mortgages n Less credit cards is better

n 5 C’s of Credit n n n Character – financial integrity and management skills n Clean credit history and report Capacity – ability to repay a loan n Income n Profits from business n Ratio of debt to income Capital – additional funds available or resources n Assets such as Savings n Liabilities such as mortgage or credit card balance Conditions – external economic and noneconomic influences n Is your job subject to the state of the economy? Collateral – guarantee or security for a loan n Car or home

n Ratings n n n n n Pass Substandard Doubtful Loss – will not be paid back Maintaining good credit Bankruptcy Types of Loans Lines of Credit External influences n n War Elections

Specializing in the types of loans they provide Monitoring the covenants of a loan agreement n n n Enforcing those agreements Establish long term relationships with customers Loan commitments to commercial customers for a long period of time (line of credit)

Managing Bank Risk: Banks experience interest rate risk if changes in market interest rates cause bank profits to fluctuate n To evaluate their exposure to interest rate risk, banks measure the duration of their assets and liabilities, which is the responsiveness of the assets’ or liabilities’ market value to a change in the market interest rate. n n n Duration analysis – measures value of assets and liabilities to interest rates Banks can reduce the risk of interest rate fluctuations through the use of floating-rate debt, with the loan interest rate being variable. Banks can also reduce their exposure to interest rate (and exchange rate) risk by using swaps, such as an interest rate swap that exchanges the expected future return on one financial instrument for the expected future return on another. Gap analysis – measures bank profits sensitivity to interest rates

Off-Balance Sheet Activities n Letters of Credit and Loan Commitments Loan Sales – selling a debt Generation of fee income n n n ATM fees and over drafts Trading in other markets

Financial innovation: Financial innovation is the creation of new financial instruments, markets, and institutions, new ways for people to spend, save, and borrow funds, and changes in the operation and scope of activities by financial intermediaries. n Financial engineering – coming up with new products and services to meet the needs of the customers Demand condition changes n n n Supply condition changes n n n Adjustable rate mortgages in Chicago in 1975 1960’s with computers came credit cards and debit cards Electronic banking Cyber banks Electronic money Avoiding Existing Regulations by creating new types of accounts (NOW) that are specified in the requirements

Bank Supervision n Focus on safety and soundness n n Bank performance Financial condition Compliance with regulations CAMELS n n n n Capital Adequacy Asset Quality Management Earnings Liquidity Sensitivity to market risk