commercial bank


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commercial bank

  1. 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 ______ IntermediariesSecondary 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. 1
  2. 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 2
  3. 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 AssetsCash 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 3
  4. 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 banks 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 4
  5. 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) 5
  6. 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 6
  7. 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 = 5mNote: 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) 7
  8. 8. SummaryIf bank decides to maintains low liquidity, bank will facehigher risk but have more opportunity to get higher returnAggressive liability management can be dangerous, becausea bank’s assets typically have longer maturities than itsliabilities. If interest rates rise sharply, banks can suffersevere losses.Bank capital provides a cushion that protects a banksowners from potential bank insolvencyhigher bank capital ratio, implies a lower risk of insolvency,but also a lower rate of return. 8