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Chapter 12


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Chapter 12

  1. 1. Chapter 12 Depository Institutions: Banks and Bank Management
  2. 2. Facts of Financial Structure <ul><li>Stocks are not the most important source of external financing for businesses. </li></ul><ul><li>Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. </li></ul><ul><li>The financial system is among the most heavily regulated sectors of economy. </li></ul>
  3. 3. Facts of Financial Structure <ul><li>Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. </li></ul><ul><li>Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. </li></ul><ul><li>Only large, well-established corporations have easy access to securities markets to finance their activities. </li></ul>
  4. 4. Facts of Financial Structure <ul><li>Collateral is a prevalent feature of debt contracts for both households and businesses. </li></ul><ul><li>Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers. </li></ul><ul><ul><ul><li>To minimize the moral hazard problem </li></ul></ul></ul>
  5. 5. Transactions Costs <ul><li>Financial intermediaries make profits by reducing transactions costs </li></ul><ul><ul><li>Take advantage of economies of scale (example: mutual funds) </li></ul></ul><ul><ul><li>Develop expertise to lower transactions costs </li></ul></ul><ul><ul><ul><li>Also provides investors with liquidity </li></ul></ul></ul>
  6. 6. Tools to Help Solve Adverse Selection (Lemons) Problems <ul><li>Private Production and Sale of Information </li></ul><ul><ul><li>Companies collect and sell information about firms in order to minimize asym. Info </li></ul></ul><ul><ul><li>Free-rider problem interferes with this solution </li></ul></ul><ul><ul><ul><li>People take advantage on information that they did not pay for </li></ul></ul></ul><ul><ul><li>Example: </li></ul></ul><ul><ul><ul><li>I pay for information that allows me to distinguish good firms from bad ones </li></ul></ul></ul><ul><ul><ul><li>However, other investors can see my behavior and follow suit </li></ul></ul></ul><ul><li>Government Regulation to Increase Information </li></ul><ul><ul><li>For example, annual audits of public corporations </li></ul></ul><ul><ul><li>Minimizes but does not eliminate the problem </li></ul></ul>
  7. 7. Tools to Help Solve Adverse Selection (Lemons) Problems <ul><li>Financial Intermediation </li></ul><ul><ul><li>Avoid free-rider problem by making private loans </li></ul></ul><ul><ul><li>Example: </li></ul></ul><ul><ul><ul><li>Used car dealers act as intermediaries between people who want to buy/sell used cars </li></ul></ul></ul><ul><ul><ul><li>The dealers examine the cars (info) and then sell the cars at a higher price </li></ul></ul></ul><ul><ul><ul><ul><li>NO free rider problem because the dealer produces the information and is the only one to benefit from it (charging higher price) </li></ul></ul></ul></ul><ul><li>What happens to the dealer if it sells lemons at the higher price? </li></ul><ul><li>LOSSES REPUTATIONAL CAPITAL </li></ul>
  8. 8. <ul><ul><li>Total Bank Assets = Total Bank Liabilities + Bank Capital </li></ul></ul>
  9. 9. The Bank Balance Sheet <ul><li>The Balance Sheet is a list of a bank’s assets and liabilities </li></ul><ul><ul><li>Total assets = total liabilities + capital </li></ul></ul><ul><li>A bank’s balance sheet lists </li></ul><ul><ul><li>Sources of bank funds (liabilities, deposits) </li></ul></ul><ul><ul><li>Uses to which they are put (assets, loans) </li></ul></ul><ul><li>Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers </li></ul>
  10. 10. The Bank Balance Sheet: Liabilities (a) <ul><li>Checkable Deposits </li></ul><ul><ul><li>Includes all accounts that allow the owner (depositor) to write checks to third parties </li></ul></ul><ul><ul><ul><li>Non-interest earning checking accounts (known as DDAs) </li></ul></ul></ul><ul><ul><ul><li>Interest earning negotiable orders of withdrawal (NOW) accounts </li></ul></ul></ul><ul><ul><ul><li>Money-market deposit accounts (MMDAs) </li></ul></ul></ul><ul><ul><ul><ul><li>Typically pays the most interest among checkable deposit accounts </li></ul></ul></ul></ul><ul><li>Checkable deposits are a bank’s lowest cost funds </li></ul><ul><ul><li>Depositors want safety and liquidity and will accept a lesser interest return from the bank in order to achieve such attributes </li></ul></ul>
  11. 11. The Bank Balance Sheet: Liabilities (b) <ul><li>Nontransaction Deposits : </li></ul><ul><ul><li>The overall primary source of bank liabilities (61%) </li></ul></ul><ul><ul><li>Accounts from which the depositor cannot write checks; </li></ul></ul><ul><ul><ul><li>Savings accounts </li></ul></ul></ul><ul><ul><ul><li>Time deposits (also known as CDs) </li></ul></ul></ul><ul><ul><li>Generally a bank’s highest cost funds </li></ul></ul><ul><ul><ul><li>Banks want deposits which are more stable and predictable </li></ul></ul></ul><ul><ul><ul><ul><li>Achieve this by paying more to the depositors in order to achieve such attributes </li></ul></ul></ul></ul>
  12. 12. The Bank Balance Sheet: Liabilities (c) <ul><li>Borrowings </li></ul><ul><ul><li>Banks obtain funds by borrowing from the Federal Reserve System, other banks, and corporations </li></ul></ul><ul><ul><ul><li>these borrowings are called: discount loans/advances (from the Fed), </li></ul></ul></ul><ul><ul><ul><li>fed funds (from other banks) </li></ul></ul></ul><ul><ul><ul><li>Repurchase agreements </li></ul></ul></ul><ul><ul><ul><ul><li>“ Repos” from other banks and companies </li></ul></ul></ul></ul><ul><ul><ul><li>Commercial paper and notes </li></ul></ul></ul><ul><ul><ul><ul><li>From other companies and institutional investors </li></ul></ul></ul></ul>
  13. 13. The Bank Balance Sheet: <ul><li>Bank Capital </li></ul><ul><ul><li>The source of funds supplied by the bank owners </li></ul></ul><ul><ul><ul><li>Directly through purchase of ownership shares </li></ul></ul></ul><ul><ul><ul><li>Indirectly through retention of earnings </li></ul></ul></ul><ul><ul><ul><ul><li>The portion of funds which are earned as profits but not paid out to owners as dividends </li></ul></ul></ul></ul><ul><li>Since assets minus liabilities equals capital, capital is seen as protecting the liability suppliers from asset devaluations or write-offs </li></ul><ul><ul><li>Capital is also called the balance sheet’s “shock absorber,” thus capital levels are important </li></ul></ul>
  14. 14. Bank Risk <ul><li>Liquidity Risk </li></ul><ul><ul><li>the risk of a sudden demand for liquid funds </li></ul></ul><ul><li>Credit Risk </li></ul><ul><ul><li>a bank’s loans will not be repaid </li></ul></ul><ul><li>Interest-Rate Risk </li></ul><ul><ul><li>bank's liabilities tend to be short-term, while its assets tend to be long-term. </li></ul></ul><ul><ul><li>This mismatch between the maturities of the two sides of the balance sheet creates interest-rate risk. </li></ul></ul>
  15. 15. Bank Risk <ul><li>Trading Risk </li></ul><ul><ul><li>If the price at which an instrument is purchased differs from the price at which it is sold, the risk is that the instrument may go down in value rather than up. </li></ul></ul><ul><li>Foreign exchange risk </li></ul><ul><ul><li>holding assets denominated in one currency and liabilities denominated in another </li></ul></ul>
  16. 17. Bank Risk
  17. 18. Bank Risk
  18. 19. Bank Risk
  19. 20. Bank Risk
  20. 21. Basics of Banking <ul><li>T-account Analysis: </li></ul><ul><ul><li>Deposit of $100 cash into First National Bank </li></ul></ul>
  21. 22. Basics of Banking <ul><li>Deposit of $100 check </li></ul>Conclusion: When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount
  22. 23. Basics of Banking <ul><li>This simple analysis gets more complicated when we add bank regulations to the picture. </li></ul><ul><li>Example </li></ul><ul><ul><li>If we return to the $100 deposit, recall that banks must maintain reserves, or vault cash. </li></ul></ul><ul><ul><li>This changes how the $100 deposit is recorded. </li></ul></ul>
  23. 24. Basics of Banking <ul><li>T-account Analysis: </li></ul><ul><ul><li>Deposit of $100 cash into First National Bank </li></ul></ul>
  24. 25. Basics of Banking <ul><li>As we can see, $10 of the deposit must remain with the bank to meeting federal regulations. </li></ul><ul><ul><li>Reserve requirements </li></ul></ul><ul><li>Now, the bank is free to work with the $90 in its asset transformation functions. </li></ul><ul><ul><li>The bank loans the $90 to its customers. </li></ul></ul>
  25. 26. General Principles of Bank Management <ul><li>Liquidity management </li></ul><ul><li>Asset management </li></ul><ul><ul><li>Managing credit risk </li></ul></ul><ul><ul><li>Managing interest-rate risk </li></ul></ul><ul><li>Liability management </li></ul><ul><li>Managing capital adequacy </li></ul>
  26. 27. Principles of Bank Management
  27. 28. Principles of Bank Management <ul><li>With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet </li></ul>
  28. 29. Liquidity Management <ul><li>With 10% reserve requirement, bank has $9 million reserve shortfall </li></ul>
  29. 30. Liquidity Management
  30. 31. Liquidity Management <ul><li>Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows </li></ul>
  31. 32. Asset Management <ul><li>Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk. </li></ul><ul><ul><li>Get borrowers with low default risk, paying high interest rates </li></ul></ul><ul><ul><li>Buy securities with high return, low risk </li></ul></ul><ul><ul><li>Diversify </li></ul></ul><ul><ul><li>Manage liquidity </li></ul></ul>
  32. 33. Capital Adequacy Management <ul><li>Bank capital is a cushion that prevents bank failure </li></ul><ul><li>The higher the bank capital, the lower the return on equity </li></ul><ul><ul><li>ROA = Net Profits/Assets </li></ul></ul><ul><ul><li>ROE = Net Profits/Equity Capital </li></ul></ul><ul><ul><li>EM = Assets/Equity Capital </li></ul></ul><ul><ul><li>ROE = ROA  EM </li></ul></ul><ul><ul><li>Capital  , EM  , ROE  </li></ul></ul>
  33. 34. Capital Adequacy Management <ul><li>Tradeoff between safety (high capital) and ROE </li></ul><ul><li>Banks also hold capital to meet capital requirements </li></ul><ul><li>Strategies for Managing Capital </li></ul><ul><ul><li>Sell or retire stock </li></ul></ul><ul><ul><li>Change dividends to change retained earnings </li></ul></ul><ul><ul><li>Change asset growth </li></ul></ul>
  34. 35. Banks' Income Statement
  35. 36. Financial Development and Economic Growth <ul><li>Financial repression leads to low growth </li></ul><ul><li>Poorly developed economic systems are more susceptible to financial crises </li></ul><ul><ul><li>Free market economies are better than government run enterprises </li></ul></ul><ul><li>Why? </li></ul><ul><ul><li>Poor legal system </li></ul></ul><ul><ul><li>Weak accounting standards </li></ul></ul><ul><ul><li>Government directs credit </li></ul></ul><ul><ul><li>Financial institutions nationalized </li></ul></ul><ul><ul><li>Inadequate government regulation </li></ul></ul><ul><li>Result of most financial crises is the inability of markets to channel funds from savers to productive investment opportunities (borrowers). </li></ul>
  36. 37. Financial Crises and Aggregate Economic Activity <ul><li>Factors Causing Financial Crises </li></ul><ul><ul><li>Increases in Interest Rates </li></ul></ul><ul><ul><li>Increases in Uncertainty </li></ul></ul><ul><ul><li>Asset Market Effects on Balance Sheets </li></ul></ul><ul><ul><ul><li>Stock market effects on net worth </li></ul></ul></ul><ul><ul><ul><li>Unanticipated deflation </li></ul></ul></ul><ul><ul><ul><li>Cash flow effects </li></ul></ul></ul><ul><ul><li>Bank Panics </li></ul></ul><ul><ul><li>Government Fiscal Imbalances </li></ul></ul>
  37. 38. Chapter 11 The Economics of Financial Intermediation
  38. 39. Roles of Financial Intermediaries <ul><li>Pooling Savings : </li></ul><ul><ul><li>Accepting resources from a large number of small savers/lenders in order to provide large loans to borrowers. </li></ul></ul><ul><li>Safekeeping and Accounting : </li></ul><ul><ul><li>Keeping depositors’ savings safe, giving them access to the payments system, and providing them with accounting statements that help them to track their income and expenditures. </li></ul></ul><ul><li>Providing Liquidity : </li></ul><ul><ul><li>Allowing depositors to transform their financial assets into money quickly, easily, and at low cost. </li></ul></ul><ul><li>Risk sharing : </li></ul><ul><ul><li>Providing investors with the ability to diversify even small investments. </li></ul></ul><ul><li>Information Services : </li></ul><ul><ul><li>Collecting and processing large amounts of standardized financial information. </li></ul></ul>
  39. 41. Information Asymmetries in the Stock Market <ul><li>If you can’t tell the difference between the two firms’ prospects, you will be willing to pay a price based only on the firms’ average quality. </li></ul><ul><li>The result is that the stock of the good company will be undervalued. </li></ul><ul><li>Since the managers know their stock is worth more than the average price, they won’t issue the stock in the first place. </li></ul><ul><li>That leaves only the firm with bad prospects in the market. </li></ul>
  40. 42. Information Asymmetries and Information Costs <ul><li>Asymmetric information for issuers of financial instruments </li></ul><ul><ul><li>Borrowers who want to issue bonds and/or firms that want to issue stock </li></ul></ul><ul><ul><ul><li>know much more about their business prospects and their willingness to work than potential lenders or investors </li></ul></ul></ul><ul><ul><ul><li>Adverse Selection for lenders </li></ul></ul></ul><ul><li>Solving the Adverse Selection Problem </li></ul><ul><ul><li>Disclosure of Information </li></ul></ul><ul><ul><li>Collateral and Net Worth </li></ul></ul>
  41. 43. Information Asymmetries and Information Costs <ul><li>Moral Hazard in Debt Finance </li></ul><ul><ul><li>Occurs because debt contracts allow owners to keep all the profits in excess of the loan payments </li></ul></ul><ul><ul><ul><li>they encourage risk taking </li></ul></ul></ul><ul><ul><li>a good legal contract can solve the moral hazard problem that is inherent in debt finance. </li></ul></ul><ul><ul><ul><li>Bonds and loans often carry restrictive covenants </li></ul></ul></ul><ul><li>Moral Hazard in equity contracts </li></ul><ul><ul><li>principal-agent problem </li></ul></ul><ul><ul><ul><li>The separation of ownership from control. </li></ul></ul></ul><ul><ul><li>When the managers of a company are the owners, the problem of moral hazard in equity financing disappears. </li></ul></ul>
  42. 44. The Negative Consequences of Information Costs <ul><li>Adverse Selection: </li></ul><ul><ul><li>Lenders can’t distinguish good from bad credit risks, which discourages transactions from taking place. </li></ul></ul><ul><li>Solutions: </li></ul><ul><ul><ul><li>The pledging of collateral to insure lenders against the borrower’s default </li></ul></ul></ul><ul><ul><ul><li>Requiring borrowers to invest substantial resources of their own </li></ul></ul></ul><ul><ul><ul><li>Government-required information disclosure </li></ul></ul></ul><ul><ul><ul><li>Private collection of information </li></ul></ul></ul>
  43. 45. The Negative Consequences of Information Costs <ul><li>Moral Hazard : </li></ul><ul><ul><li>Lenders can’t tell whether borrowers will do what they claim they will do with the borrowed resources </li></ul></ul><ul><ul><ul><li>Borrowers may take too many risks. </li></ul></ul></ul><ul><li>Solutions: </li></ul><ul><ul><ul><li>Forced reporting of managers to owners </li></ul></ul></ul><ul><ul><ul><li>Requiring managers to invest substantial resources of their own </li></ul></ul></ul><ul><ul><ul><li>Covenants that restrict what borrowers can do with borrowed funds </li></ul></ul></ul>
  44. 46. Financial Intermediaries and Information Costs <ul><li>The problems of adverse selection and moral hazard make direct finance expensive and difficult to get. </li></ul><ul><li>These drawbacks lead us immediately to indirect finance and the role of financial institutions. </li></ul><ul><li>Much of the information that financial intermediaries collect is used to reduce information costs </li></ul><ul><ul><li>Minimizes the effects of adverse selection and moral hazard </li></ul></ul><ul><ul><ul><li>Screening and Certifying to Reduce Adverse Selection </li></ul></ul></ul><ul><ul><ul><li>Monitoring to Reduce Moral Hazard </li></ul></ul></ul>