Lecture 8 - Banking and the management of financial institutions

Question 1

What is a bank balance sheet?

Answer 1

A list of a bank’s assets (uses to which funds are put) and liabilities (sources of funds).

Question 2

Total assets equals…

Answer 2

Total liabilities plus capital.

Question 3

How do banks obtain funds?

Answer 3

They do this by borrowing from savers and by issuing other liabilities such as deposits. They then use these funds to acquire assets such as securities and loans lent to businesses or individuals that need to finance consumption or investments in physical/human capital.

Question 4

How do banks make profits?

Answer 4

They charge interest rates on their asset holdings of securities and loans higher than the interest rate they themselves pay when raising funds.

Question 5

What are sight deposits?

Answer 5

Bank accounts that allow the owner of the account to write cheques to third parties or to draw cash out of ATMs without loss of interest. They are payable on demand; that is, if a depositor shows up at a bank and requests payment by making a withdrawal, the bank must pay the depositor immediately. Similarly, if a person who receives a cheque written on an account from a bank presents that cheque at the bank, it must pay the funds out immediately.

Question 6

What do sight deposits include?

Answer 6

All accounts on which cheques can be drawn: non bearing accounts (demand deposits) and interest bearing cheque accounts.

Question 7

A sight deposit is an asset for…

Answer 7

The depositor because it is part of their wealth. As the depositor can withdraw funds and the bank is obliged to pay, sight deposits are a liability for the bank. They are usually the lowest cost source of bank funds because banks pay no interest or a very small amount of interest on these deposits and depositors are willing to forgo some interest to have access to a liquid asset that they can use to make purchases.

Question 8

What do a bank’s costs of maintaining cheque deposits include?

Answer 8

Interest payments and the costs incurred in servicing these accounts - processing and preparing monthly statements, advertising and marketing to entice customers, conveniently locating branches and maintaining impressive offices.

Question 9

What are time deposits?

Answer 9

These cannot be withdrawn on demand like sight deposits. They have a fixed term to maturity which means that the funds have to be kept in the account for a minimum period to earn interest. Maturity ranges from several months to over five years. Depositors cannot write cheques on time deposits, but the interest rates paid on these deposits are usually higher than those on sight deposits. Time deposits also include savings accounts.

Question 10

What are banks’ deposits?

Answer 10

Banks borrow and lend through the interbank market. These interbank deposits can be the same as demand deposits or they can have fixed maturities of one or three months or even several years.

Question 11

What is the function of the interbank market?

Answer 11

To distribute funds between banks that have surplus funds and banks that have shortages of funds. Banks deposit funds (lend) in the interbank market and other banks bid (borrow) funds. The process of bid and offer produces a market rate of interest at which banks are willing to lend to each other or borrow from each other. A bank can also borrow from the central bank at times.

Question 12

How do banks obtain funds from the financial market?

Answer 12

By issuing bonds and certificates of deposits. CDs are negotiable; like bonds, they can be resold in a secondary market before they mature. For this reason, negotiable CDs are held by corporations, money market mutual funds and other financial institutions as alternative assets to Treasury bills and other short term bonds.

Question 13

What are foreign currency deposits?

Answer 13

Certain foreign currency deposits like US dollars can be held by domestic residents and foreigners can also deposit funds in their own currency. Holding foreign currency exposes the banks to foreign currency risk. The most common way is to maturity match by holding an equivalent amount of that currency assets. So if the exchange rate were to change the banks’ net foreign currency exposure (foreign currency assets less foreign currency liabilities) is small.

Question 14

What is bank capital?

Answer 14

This is the bank’s net worth, which equals the difference between total assets and liabilities.

Question 15

How is bank capital raised?

Answer 15

By selling new equity or from retained earnings. Bank capital is a cushion against a drop in the value of its assets, which could force the bank to into insolvency (having liabilities in excess of assets, meaning that the bank can be forced into liquidation).

Question 16

What are reserves?

Answer 16

Deposits plus currency that is physically held by banks (called vault cash because it is stored in bank vaults overnight).

Question 17

Despite earning low interest rates, why do banks hold reserves?

Answer 17

• For every pound of sight deposits at a bank, a certain fraction must be kept as reserves. Required reserves are held because of reserve requirements, a regulation set by the bank. This fraction is called required reserve ratio. Additional reserves are called excess reserves. These are held because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly when a cheque is written on an account .

Question 18

A bank’s holding of securities are an important…

Answer 18

Income earning asset.

Question 19

What are the most liquid securities?

Answer 19

Treasury bills and other short term government debt are the most liquid because they can be easily traded and converted into cash with low transaction costs. As they have high liquidity, short term government securities are called secondary reserves.

Question 20

Why do banks hold commercial paper and other short term securities of the non financial company sector?

Answer 20

• Companies are more likely to do business with banks that hold their securities.
• Short term company securities are liquid, but less liquid and riskier than equivalent maturity government securities, primarily because of default risk: there is some possibility that the issuer of the securities may not be able to make its interest payments or pay back the face value of the securities when they mature. Therefore, the interest rate on commercial paper is normally higher than that on Treasury bills.

Question 21

What is a loan?

Answer 21

A liability for the individual or corporation receiving it, but an asset for a bank, because it provides income to the bank.

Question 22

Why are loans typically less liquid than other assets?

Answer 22

They cannot be turned into cash until the loan matures. Loans also have a higher probability of default than other assets. Due to the lack of liquidity and higher default risk, the bank earns its highest return on loans.

Question 23

What is the major difference in the balance sheets of the various depository institutions?

Answer 23

Primarily the types of loans they specialise in. Savings banks, for example, specialise in mortgages, wile credit banks tend to make consumer loans.

Question 24

What are trading assets?

Answer 24

Government securities, asset backed securities or commercial securities such as derivatives that the bank holds for the purpose of selling them for a profit. They are valued at the existing market price and are bought at a low price and sold at a high price. These assets are held for a short period so as to gain from a profit in trade. The bank also holds trading liabilities where they might guarantee or sell asset backed securities and derivatives. The subtraction of these from its assets gives its net trading assets.

Question 25

What are other assets?

Answer 25

The physical capital (bank buildings, computers etc).

Question 26

In general terms, how do banks make profits?

Answer 26

They sell liabilities with one set of characteristics (a particular combination of risk, liquidity, size and return) and use these proceeds to buy assets with a different set of characteristics. This process is often referred to as asset transformation.

Question 27

Example of asset transformation.

Answer 27

A savings deposit held by one person can provide the funds that enable the bank to make a mortgage loan to another person. The bank has, in effect, transformed the savings deposit (an asset held by the depositor) into a mortgage loan (an asset held by the bank). It can be said that the bank ‘borrows short and lends long’ because it makes long term loans and funds them by issuing short dated deposits. Depositors do not withdraw their funds at the same time as other customers. This means that banks only need to hold a certain amount of reserves to meet day to day withdrawals and lend the rest in long term loans.

Question 28

What is maturity transformation?

Answer 28

The process by which banks accept short maturity deposits and convert them into long maturity loans. If the bank produces desirable services at low cost and earns substantial income on its assets, it earns profits; if not the bank suffers losses.

Question 29

Interest income comes from…

Answer 29

Interest received on loans to households and firms, interest from fixed income securities such as government bills and commercial paper, and receivables from equity related securities and variable income securities.

Question 30

Interest expenses are…

Answer 30

Interest paid to depositors and to loans taken from other banks through the interbank market.

Question 31

What is commission income?

Answer 31

The fees the bank charges for its various financial services and investment activities and net commission is the net income after subtracting the costs associated with these services.

Question 32

What is other operating income derived from?

Answer 32

Leasing activity or the sale of assets that are not on the trading account and net trading income is the net revenue obtained from the buying and selling of financial securities.

Question 33

Administrative costs include what?

Answer 33

Costs of labour and other variable costs such as running the premises and security etc.

Question 34

What are loan loss provisions?

Answer 34

Special reserves held on anticipation of defaults of loans and write downs are loans that have gone bad and are unrecoverable.

Question 35

What is a T account?

Answer 35

A simplified balance sheet, with lines in the form of a T, that lists only the changes that occur in balance sheet items starting from some initial balance sheet positions.

Question 36

When a cheque written on an account at one bank is deposited in another, the bank receiving the deposit gains reserves equal to the amount of the cheque, while the bank on which the the cheque is written sees its reserves fall by the same amount. When a bank receives additional deposits, it gains…

Answer 36

An equal amount of reserves; when it loses deposits, it loses an equal amount of reserves.

Question 37

What is a clearing house?

Answer 37

A process by which cheques are netted out between banks and only the net amount is debited or credited from a bank’s balance sheet. This process is most commonly done electronically through the use of debit or credit cards and the process of ‘pinning’.

Question 38

Asset transformation allows banks to make profit if…

Answer 38

The interest rate on long term assets (such as loans) is greater than the interest rate on short term liabilities (such as sight deposits).

Question 39

What are the main areas of bank management?

Answer 39

• Liquidity management is the acquisition of sufficiently liquid assets to meet the bank’s obligations to depositors and to keep enough cash on hand.
• Asset management is when the bank manager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings.
• Liability management means to acquire funds at low cost.
• Capital adequacy management is when the bank manager must decide the amount of capital the bank should maintain and then acquire the needed capital.

Question 40

What are deposit outflows?

Answer 40

Banks want to make sure they have enough ready cash to meet their obligations when depositors make withdrawals and demand payments.

Question 41

If a bank has ample excess reserves, a deposit outflow…

Answer 41

Does not necessitate changes in other parts of its balance sheet. Reserves work as a cushion against unexpected outflows.

Question 42

If a bank has a liquidity problem, what options does it have to eliminate this shortfall of reserves?

Answer 42

• It can acquire reserves to meet a deposit outflow by borrowing them from other banks in the central bank funds market or by borrowing from corporations. The cost of this activity is the interest rate on these borrowings, such as the central bank’s funds rate.
• The bank can sell some of its securities to help cover the deposit outflow. The bank incurs some brokerage and other transaction costs when it sells these securities. The government securities that are classified as secondary reserves are very liquid, so the transaction costs of selling them are quite modest. However, the other securities the bank holds are less liquid, and the transaction cost can be appreciably higher.
• A bank can also meet a deposit outflow by acquiring reserves by borrowing from the central bank. The cost associated with (CB borrowing) discount loans is the interest rate that must be paid to the central bank.
• A bank can reduce its loans by the amount of reserves required and deposit this amount it receives with the central bank, thereby increasing its reserves by that amount. This process of reducing its loans is the bank’s costliest way of acquiring reserves when there is a deposit outflow.

Question 43

How can a bank reduce its loans?

Answer 43

• Calling in loans; that is by not renewing some loans when they come due. These customers are likely to take their business elsewhere in the future.
• The bank could sell its loans to other banks. Other banks do not personally know the customers who have taken out the loans and so may not be willing to buy the loans at their full value (adverse selection problem).

Question 44

When a deposit outflow occurs, holding excess reserves allows the bank to escape…

Answer 44

• The costs of borrowing from other banks or corporations.
• Selling securities.
• Borrowing from the central bank.
• Calling in or selling off loans.

Question 45

Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows…

Answer 45

The more excess reserves banks will want to hold.

Question 46

To maximises its profits…

Answer 46

A bank must simultaneously seek the highest returns possible on loans and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets.

Question 47

How do banks try to achieve these goals?

Answer 47

• They try to find borrowers who will pay high interest rates and are unlikely to default on their loans. They seek out loan business by advertising their borrowing rates and by approaching corporations directly to solicit loans. It is up to the bank’s loan officer to decide if potential borrowers are good credit risks who will make interest and principal payments on time. Typically, banks are conservative in their loan policies; the default rate is usually less than 1%. t is important, however, that banks not be so conservative that they miss out on attractive lending opportunities that earn high interest rates.
• Banks try to purchase securities with high returns and low risk.
• In managing their assets, banks must attempt to lower risk by diversifying. They accomplish this by purchasing many different types of assets (short and long term, government and commercial bonds).
• The bank must manage the liquidity of its assets so that it can satisfy its reserve requirements without bearing huge costs. This means that it will hold liquid securities even if they earn a somewhat lower return than other assets. The bank must decide, for example, how much in excess reserves must be held to avoid costs from a deposit outflow. In addition, it will want to hold Treasury bills or other government securities as secondary reserves so that even if a deposit outflow forces some costs on the bank, these will not be terribly high. Again, it is not wise for a bank to be too conservative. If it avoids all costs associated with deposit outflows by holding only excess reserves, the bank suffers losses because reserves earn low interest, while the bank’s liabilities are costly to maintain. The bank must balance its desire for liquidity against the increased earnings that can be obtained from less liquid assets such as loans.

Question 48

Explain the trade off between degree of liquidity and expected return in asset management.

Answer 48

• The higher the degree of liquidity of an asset, the lower the expected
  rate of return on that asset.
• If bank invests mainly in long-term, illiquid assets  high expected
  return, but high chance bank will face high costs when experiencing
  deposit outflows
  – If a bank invests mainly in short-term, liquid assets there are no costs caused by
  deposit outflows, but a low expected return.
• Typically banks try to find a compromise by holding some excess
  reserves and some highly liquid assets (T-bills) to minimise the costs associated with deposit outflows while maximising expected returns.

Question 49

Flexibility in liability management means that…

Answer 49

Banks no longer need to depend on sight deposits as the primary source of bank funds. Instead, they aggressively set target goals for their asset growth and try to acquire funds by issuing liabilities as they are needed. The importance of sight deposits as a source of funds have decreased. Before the 1960s, sight deposits were the main source of bank funds and by law, banks were not allowed to pay interest on them so there was no competition among banks to attract customers and funds. Nowadays, banks compete to attract customers’ funds and actively participate in the interbank market.

Question 50

Why is capital adequacy management important?

Answer 50

• Bank capital helps prevent bank failure, a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors and so goes out of business.
• The amount of capital affects returns for the owners (equity holders) of the bank.
• A minimum amount of bank capital is required by regulatory authorities.

Question 51

A bank maintains bank capital to…

Answer 51

Lessen the chance that it will become insolvent. This means that it has insufficient assets to pay off all holders of its liabilities. When a bank has negative net worth, it becomes insolvent.

Question 52

What information does return on assets provide?

Answer 52

How efficiently a bank is being run, because it indicates how much profits are generated on average by each pound of assets.

Question 53

What information does return on equity provide?

Answer 53

How much a bank is earning on their equity investment.

Question 54

Given the return on assets, the lower the bank capital…

Answer 54

The higher the return for the owners of the bank. An increase in equity capital decreases the return on equity. A decrease in equity capital increases the return on equity.

Question 55

Benefits and costs of bank capital.

Answer 55

Bank capital benefits the owners of a bank in that it makes their investment safer by reducing the likelihood of bankruptcy. However, bank capital is costly because the higher it is, the lower will be the return on equity for a given return on assets. In determining the amount of bank capital, managers must decide how much of the increased safety that comes with higher capital (the benefit) they are willing to trade off against the lower return on equity that comes with higher capital (the cost). In more uncertain times, when the possibility of large losses on loans increases, bank managers might want to hold more capital to protect the equity holders. Conversely, if they have confidence that loan losses will not occur, they might want to reduce the amount of bank capital, have a high equity multiplier, and thereby increase the return on equity.

Question 56

How can you lower the amount of capital relative to assets and raise the equity multiplier?

Answer 56

• Reduce the amount of bank capital by buying back some of the bank’s stock.
• Reduce the bank’s capital by paying out higher dividends to its stock holders, thereby reducing the bank’s retained earnings.
• Keep bank capital constant but increase the bank’s assets by acquiring new funds, for example by issuing CDs, and then seeking out loan business or purchasing more securities with these new funds.

Question 57

How can you raise the amount of capital relative to assets?

Answer 57

• Raise capital for the bank by having it issue equity (common stock).
• Raise capital by reducing the bank’s dividends to shareholders, thereby increasing retained earnings that it can put into its capital account.
• Keep capital at the same level but reduce the bank’s assets by making fewer loans or by selling off securities and then using the proceeds to reduce its liabilities.

Question 58

Why does adverse selection in the loan market occur?

Answer 58

Bad credit risks (those most likely to default on their loans) are the ones who usually line up for loans; those who are most likely to produce an adverse outcome are the most likely to be selected. Borrowers with very risky investment projects have much to gain if their projects are successful, so they are the most eager to obtain loans. Clearly, however, they are the least desirable borrowers because of the greater possibility that they will be unable to pay back their loans.

Question 59

Why does moral hazard exist in the loan markets?

Answer 59

Borrowers may have incentives to engage in activities that are undesirable from the lender’s point of view. In such situations, it is more likely that the lender will be subjected to the hazard of default. Once borrowers have obtained a loan, they are more likely to invest in high risk investment projects - projects that pay high returns to the borrowers if successful. The high risk, however, makes it less likely that they will be able to pay the loan back.

Question 60

What is screening?

Answer 60

Lenders screen out the bad credit risks from the good ones so that loans are profitable to them. To accomplish effective screening, lenders must collect reliable information from prospective borrowers. The lender uses this information to evaluate how good a credit risk you are by calculating your credit score, a statistical measure derived from your answers that predicts whether you are likely to have trouble making your loan payment. For consumer loans, questions may be asked about salaries, bank accounts, assets, number of years worked etc. For business loans, questions may be asked about future investment plans, competition in the industry, company’s profits, balance sheets etc.

Question 61

Is specialisation in lending good or bad?

Answer 61

In one sense, it can be bad because the bank is not diversifying its portfolio of loans and thus is exposing itself to risk. The default rate will rise substantially if a negative shock hits a specific industry. On the other hand, this allows banks to become more knowledgeable about specific industries and are therefore better able to predict which firms will be able to make timely payments on their debt.

Question 62

What is monitoring?

Answer 62

Lenders should write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities. By monitoring borrowers’ activities to see whether they are complying with the restrictive covenants and by enforcing the covenants if they are not, lenders can make sure that borrowers are not taking on risks at their expense.

Question 63

How are long term customer relationships beneficial?

Answer 63

Long term customer relationships reduce the costs of information collections and make it easier to screen out bad credit risks. If the borrower has borrowed from the bank before, the bank has already established procedures for monitoring that customer. Therefore, the costs of monitoring long term customers are lower than those for new customers. Additionally, they benefit the customer as well as the bank. A firm with a previous relationship will find it easier to obtain a loan at a low interest rate because the bank has an easier time determining if the prospective borrower is a good credit risk and incurs fewer costs in monitoring the borrower.

Question 64

What is a loan commitment?

Answer 64

A bank’s commitment (for a specified future period of time) to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate. The advantage for the firm is that it has a source of credit when it needs it. The advantage for the bank is that the loan commitment promotes a long term relationship, which in turn facilitates information collection. Provisions in the loan commitment agreement require that the firm continually supply the bank with information about the firm’s income, asset and liability position, business activities etc. A loan commitment arrangement is a powerful method for reducing the bank’s costs for screening and information collections.

Question 65

How does collateral help manage credit risk?

Answer 65

Collateral, which is property promised to the lender as compensation if the borrower defaults, lessens the consequences of adverse selection because it reduces the lender’s losses in the case of a loan default. It also reduces moral hazard because the borrower has more to lose from a default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for its losses on the loan.

Question 66

What is compensating balances?

Answer 66

A firm receiving a loan must keep a required minimum amount of funds in a cheque account in a bank.

Question 67

How do compensating balances help increase the likelihood that a loan will be paid off?

Answer 67

They help the bank monitor the borrower and consequently reduce moral hazard. Specifically, by requiring the borrower to use a cheque account at the bank, the bank can observe the firm’s cheque payment practices, which may yield a great deal of information about the borrower’s financial condition. They make it easier for banks to monitor borrowers more effectively.

Question 68

What is credit rationing?

Answer 68

Refusing to make loans even though borrowers are willing to pay the stated interest rate or even higher. The first form is when a lender refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a higher interest rate. Charging a higher interest rate makes adverse selection worse for the lender; that is, it increases the likelihood that the lender is lending to a bad credit risk. The lender would therefore rather not make any loans at a higher interest rate, instead it would turn down loans. The second occurs when a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like. This guards against moral hazard. The larger the loan, the greater the benefit from moral hazard. The larger your loan, the greater your incentives to engage in activities that make it less likely that you will repay the loan. More borrowers repay their loans if the loan amounts are small and hence why financial institutions ration credit by providing borrowers with smaller loans than they seek.