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Depository Institutions Include: n Institutions which take deposits n Deposits represent Liabilities (debt) for DI’s Include: n Banks n Savings & Loan institutions n Savings Banks n Credit Unions
Asset/liability problem of Depository institutions �A depository institution seeks to earn a positive spread between the assets it in invests in (loans and securities) and the costs of funds(deposits and other sources)
How do DI’s make money? 3 ways: n Loans Make direct loans to entities n Securities investments Investing in securities & holding portfolios n Fees Charged to their customers
Asset/liability problem of Depository institutions �Risks faced by the depository institutions �Credit risk-default risk that the borrower will default on his loan obligation or that the issuer of the security that the depository institution holds defaults on its obligation. �Regulatory risk-regulators will change the rules so as to impact the earnings of the institution unfavorably
Asset/liability problem of Depository institutions �Funding risk �Illustration � Suppose that the depository institution raises $100 million by issuing a deposit account that has a maturity of one year and by agreeing to pay 7% interest � Suppose that $100 million is invested in a government security that matures in 15 years , paying an interest rate of 9%
Asset/liability problem of Depository institutions �If interest rates declines, the spread will increase n. If Interest rates rise What position should you have? n. If interest rates fall What position should you have?
Asset/liability problem of Depository institutions �When interest rates are expected to decline, depository institutions borrow short and lent long �When interest rates are expected to rise, depository institutions borrow long and lent short
Asset-Liability Problem of DI’s? Threats of positioning: n Adverse financial consequences If expectations are not realized, Huge losses can occur n No one can predict interest rates consistently Highly risky? n Becomes same as gambling Long run losses highly likely?
Liquidity concerns �A depository institution must be prepared to satisfy withdrawals of funds by depositors and to provide loans to customers � 4 ways to solve liquidity issues? �Attract additional deposits �Borrowing from the federal agency or other financial institutions �Sell securities that it owns �Raise short term funds in the money market
Commercial Banks � 5 largest banks of Pakistan
Commercial Banks �Bank services: �Individual banking �Institutional banking �Global banking� Corporate financing � Capital market products � Foreign exchange products and services
Bank Funding �Three sources of funds for banks: �Deposits �Non deposit borrowing �Common stocks and retained earnings
Bank Funding �Deposits �Demand deposits �Savings deposits �Time deposits
Bank Funding �Reserve requirements and borrowing in the federal funds market �All banks must maintain a specified percentage of their deposits in a noninterest bearing account at the State bank. �Reserve ratio �Required reserve
Bank Funding �Excess reserves- when actual reserves exceed required reserves. �Banks temporarily short of funds can borrow reserves from banks that have excess reserves. �The market where banks can borrow or lend reserves is called the federal funds market. �The interest rate that is charged to borrow funds in this market is called the federal funds rate.
Bank Funding �Borrowing at the Fed discount window: �Banks temporarily short of funds can borrow from the Fed at its discount window �Collateral is necessary to borrow �Discount rate- the interest rate that the Fed charges to borrow funds at the discount window �Borrowing from the Fed is done basically to meet short term liquidity needs
Bank Funding �Other non deposit borrowing �Issuing obligations in the money market, or intermediate to long term in the form of issuing securities in the bond market.
Regulation �Ceilings imposed on the interest rates that can be paid on deposit accounts �Geographical �Permissible �Capital restrictions on branch banking activities for commercial banks requirements for commercial banks
Savings and loan Associations �Provision of funds for financing of a home. �The collateral for the loans would be the home being financed �Mutually owned or corporate stock ownership
Savings and loan Associations �Assets: �Traditionally, the only assets in which S&L’s were allowed to invest have been mortgages, and government securities. �Problem: �Maturity matching problem
Savings and loan Associations �Other investments: �Consumer loans( loans for home improvement , automobiles, education , business or credit cards) �Non consumer loans ( commercial , corporate , business or agriculture loans) �Junk bonds �Investment in short term assets for operational or regulatory purposes.
Savings and loan Associations �Funding: �Savings and time deposits �Negotiable order of withdrawal (NOW) accounts �Money market deposit accounts (MMDA)
The S&L Crisis
Credit unions �“Common bond” requirement for credit union membership �No corporate ownership �Purpose: �Serve member’s saving and borrowing needs �Credit unions are owned by their members, member deposits are called shares.