Money, Banking, and Financial Markets about commercial bank

1. Contents
Chapter 9
Commercial Bank Balance Sheet
Commercial Bank Liabilities
Commercial Bank Assets
Commercial Bank Capital Accounts
Commercial Bank Management
Liquidity Management
Commercial Banks Liability Management
Capital Management
The Importance of The Importance of
Commercial Banks Commercial Banks
Primary claims
• Depository institutions play a key role in
Funds channeling funds from savers (surplus unit)
to borrowers (deficit units)
Savers
• Commercial banks dominate among
Borrower
depository institutions.
Funds • Banks take in funds by accepting _____
deposit
Funds
Financial grant loans
• Banks use the funds mainly to ______
Intermediaries
Secondary claims Primary claims
The Importance of The Commercial Bank
Commercial Banks Balance Sheet
• Commercial banks are the oldest
and most diversified of all financial
intermediaries.
• Banks are important in the money
• Banks earn a profit on the “spread” (3%-4%)
supply process.
by obtaining funds at relatively low interest
• Banks create money by lending or rates and lending at higher interest rates.
buying the securities • In recent years, fees have played an
increasingly important role in bank profits.
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2. The Commercial Bank The Commercial Bank
Balance Sheet Balance Sheet
• A bank balance sheet is a statement of its – Net worth (capital accounts, capital)
assets, liabilities, and net worth at a given point is the difference between its assets and
in time.
liabilities.
• Assets are what it owns.
Common stocks, retained earning
Loan, securities (Investment) earning
assets
• Liabilities are what it owes. • Assets = Liabilities + Net Worth
Demand deposit, saving deposit, time deposit
• Assets - Liabilities = Net Worth
Figure 9-1 Table 9-1
Commercial Bank Commercial Bank
Liabilities Liabilities
Transactions Deposits (checkable deposits)
Transactions Deposits Demand Deposits: non-interest bearing
checking accounts
(checkable deposits)
Negotiable Order Of Withdrawal (NOW)
Non-transaction Deposits Accounts: interest-bearing checking
Non-deposit borrowing accounts
Automatic Transfer Service (ATS)
Other liabilities Accounts:Paired accounts with checks on
non-interest baring accounts & automatic
transfers to it from interest-bearing
accounts
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3. Commercial Bank Commercial Bank
Liabilities Liabilities
Non-Transactions Deposits Non-deposit Borrowing
Passbook Savings Accounts
Borrowing from the Fed
Any amount of funds can be added or
withdrawn at any time discount loans, discount window
Small Certificates of Deposit (CDs up to pay interest at the discount rate
$100,000) Borrowing from other banks’ excess reserve
There are penalties if withdrawing before overnights loans between bank
maturity (3 months to 5 years) similar
federal funds
to time deposit in Thailand
Money Market Deposit Accounts (MMDAs) pay interest at federal fund rate
Special type of saving account with limited
check writing feature (no more than 6
times per month)
Commercial Bank Commercial Bank
Assets Assets
Most of banks’ assets are in form of income-
Cash Assets earning assets or earning assets (85%)
Loans Loan
Securities
Securities However, banks are subjected to maintains
portion of their source of funds (liabilities) in
Other Assets
form of non-interest-earning legal reserves
Coin and currency in banks
Bank’s deposit balance at the central bank
Commercial Bank Commercial Bank
Assets Assets
Cash Assets Loans
Vault cash - Currency and coins at bank Real Estate Loans: collateralized by property (real estate),
o to meet public’s demand Ex. Mortgage
o to meet reserve required
Securitization – banks bundle many real estate
Deposits with Federal Reserve Bank (central bank) loans into the package and issue the
o to meet reserve required
securities based on this package to investors
o to facilitate check clearing process
Business Loans:
Deposits with other banks Regular installment loans
o Correspondent banking – smaller banks maintain deposits in Lines of credit (subject to compensating balance)
larger banks in return of services e.g. check collection,
investment counsel, and transaction in securities and foreign
currency
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4. Commercial Bank Commercial Bank Capital
Assets Accounts
Consumer Loans: • Bank capital derives from the issue of bank stock
Auto loans
shares and from retained earnings
Credit cards banks get the fee from business accepting
the card and also get the interest rate if the cardholders • Bank capital provides a cushion that protects a bank's
design to pay the minimum balance.
owners from potential bank insolvency
Overdraft arrangement
Other Loans: – Total assets are less than total liabilities
Federal funds sold – Negative net worth
Securities
Other assets Building, Land, Equipment
Writing Off Bad Loans Writing Off Bad Loans
Bank needs to write off $600,000 for bad loans
• Immediate write off bad loans can make the bank to
face the situation of insolvency.
– Close the banks
– Find new owners to take over the bank
(through Merger & Acquisition)
• Bank usually (also subject to the regulation) sets aside
contingent funds against loan loss in advance
loan loss reserve (Allowance for bad debts)
Commercial Bank
Management
T-Accounts
• Commercial banks strive to: • T-accounts are statements of the change in
the balance sheet resulting from a given
– earn solid profits;
event.
– maintain extremely low exposure to the – ie. if a customer withdraws $200 in cash from a
possibility of becoming insolvent, and savings account at the Bank of Medicine Bow.
– maintain high liquidity (the ability to
immediately meet currency withdrawals)
ie. Clearing a check for $12,000 written by a
by managing liquidity and capital.
bank customer
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5. The Importance of The Liquidity-Risk
Liquidity Trade-off
• Banks must have emergency plans to meet
• If bank decides to maintains high
large reserve withdrawals, so banks need to
hold liquid assets like Treasury bills. liquidity,
bank will face less risk
• If a bank is exposed to large deposit outflows
and can obtain reserves only at substantial • If bank decides to maintains low liquidity,
cost, it could find itself in serious trouble, bank will face higher risk
even if it has a relatively large capital
account.
The Liquidity-Risk The Liquidity-Risk
Trade-off Trade-off
If depositors withdraw $20 million,
With a reserve requirement of 10%, the bank has no excess
Deposit decreases to $380 million
reserves.
Reserves also decreases to $20 million
Its assets are 90% in high return loans and 10% in low return
securities. However, required reserve ratio is 10%, bank need to maintain
reserves at $38 million bank need to find more reserve for $18
What if depositors withdraw $20 million?
million
Bank has marketable securities (liquid assets) only $10 million that
is not enough bank need to find other funds
The Liquidity-Profitability The Liquidity-Profitability
Trade-off Trade-off
• If bank decides to maintains low liquidity,
bank will have a change to get higher
return
• If bank decides to maintains high liquidity, • The bank has $10 million excess reserves.
bank will get lower return • Its assets are split between high return
loans & low return securities.
• Higher liquidity means bank will hold more excess reserve
(no return) and more marketable securities (low return)
rather than lending the loan (higher return)
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6. The Liquidity-Profitability The Liquidity-Profitability
Trade-off Trade-off
• If bank decides to maintains low
liquidity,
• If depositors withdraw $20 m, then the balance sheet changes bank will face higher risk but have more
– Deposit decrease to $380 million
– Reserves decrease to $30 million
opportunity to get higher return
• With 10% required reserve ratio, bank has to maintain $38
million reserve bank need more $8 million
• Bank have lots of marketable securities to be liquidated and • If bank decides to maintains high
change to reserve no problem
liquidity,
• However, it is less profitable because it has fewer high-return
loans. bank will face lower risk and get lower
Indicators of Bank
Liquidity
Liability Management
• Banks look for good lending opportunities and then search
• The ratio of bank loans to total assets
for the funds to finance these loans.
– Higher ratio lower liquidity
• When a large bank finds a profitable lending opportunity, it
can:
• The ratio of securities to total assets
– “buy” federal funds;
– Higher ratio higher liquidity
– issue negotiable CDs at whatever interest rate is required
• The ratio of demand deposit to total bank deposits to attract funds;
– Higher ratio Bank need to maintain – issue repurchase agreements or borrow Eurodollars, or
more liquidity – obtain funds through the commercial paper market.
Liability Management Liability Management
Loans
• Aggressive liability management allows banks to
make profitable loans that they would otherwise
have to turn down.
5% 5% 5%
• Aggressive liability management can be dangerous,
because a bank’s assets typically have longer Now 2nd year 3rd year 10th year
maturities than its liabilities.
7%
• If interest rates rise sharply, banks can suffer 4%
severe losses. 1%
Deposit
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7. Capital Management Capital Management
• Bank capital provides a financial cushion so that transitory
adverse developments will not cause insolvency. Capital
• Bank capital ratio =
• Bank capital also protects bank managers and owners from Asset
their own mistakes and from various risks:
– default risk borrowers do not pay back their loans
– interest-rate risk when interest rate changes
– liquidity risk depositors will withdraw the fund
– Foreign exchange rate risk when exchange rate change • higher bank capital ratio
– political or country risk risk that fund or assets in other
countries cannot be mobilized to home country – implies a lower risk of insolvency,
– management risk employees will engage in activities – but also a lower rate of return.
involving enormous risk (Barings Bank – Nicholas Leeson)
The Capital Management
Tradeoff
Capital Management
Earning Earning Total Assets
Earning/Capital = Earning/TA x TA/Capital
= x
Capital Total Assets Capital
Suppose a bank has net income (earnings)
Return on Equity = ROA * Equity Multiplier
1m, TA 100m
Case 1: a bank has capital = 5m
Note: A high capital ratio represents a low equity multiplier;
Earning / Capital = ???
A low capital ratio represents a high equity multiplier
Case 2 : a bank has capital = 10m
A trade-off arises between short-run profitability &
the risk of insolvency
Earning / Capital = ???
Summary Summary
Commercial bank raise the funds from accepting deposit and Smaller banks maintain deposits in larger banks in
use the funds in granting the loan return of services e.g. check collection, investment
Bank earn interest rate spread between deposit rate and counsel, and transaction in securities and foreign
loan rate and also earn the service fees currency Correspondent banking system
If bank faces daily shortage in reserve, bank can borrow Bank may bundle many real estate loans into the
from Fed at discount rate or borrow from other banks at fed package and issue the securities based on this package
fund rate to investors securitization
Loans are most-income-earning assets of the banks Bank becomes insolvency if total asset is less than
Banks are subjected to maintains portion of their source of total liability or negative net worth (equity)
funds in form of non-interest-earning legal reserves
(currency and deposit at Fed)
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8. Summary
If bank decides to maintains low liquidity, bank will face
higher risk but have more opportunity to get higher return
Aggressive liability management can be dangerous, because
a bank’s assets typically have longer maturities than its
liabilities. If interest rates rise sharply, banks can suffer
severe losses.
Bank capital provides a cushion that protects a bank's
owners from potential bank insolvency
higher bank capital ratio, implies a lower risk of insolvency,
but also a lower rate of return.
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