Chapter banking firm and bank management

Chapter: The banking
firm
and Bank
management
In this chapter we examine how
banks operate to earn the highest
profits possible: how and why they
make loans, how they acquire funds
and manage their assets and
liabilities and how they earn income.


The bank balance sheet




Bank balance sheet is a list of the
bank’ assets and liabilities.
Characteristics :
Total assets = total liabilities +
capital.


Liabilities








Checkable deposits: are bank accounts that allow the owner
of the account to write checks to third parties. Checkable
deposits include all accounts on which check can be drawn:
Checkable deposits and money market deposit accounts
are payable on demand.
A checkable deposit is an asset for the depositor and a
liability for the bank.
Non transaction deposits:
Types: - saving accounts
- Time deposit.
Borrowings:
Banks obtain funds by borrowing from the Fed, other banks
and corporations.
Borrowings from the Fed are called discount loans.
Bank capital :
Bank capital is the bank’s net worth, which equals the
difference between total assets and liabilities.


Assets









Reserves: are deposits in an account at the Fed plus
currency that is physically held by banks (vault cash).
Bank hold reserves for two reasons:
- By law:
- Protect them from large depositors'
withdrawal.
Cash items in process of collection.
Deposits at other banks.
Securities:
-> US government and agency securities
-> State and local government securities.
->Other securities.
Loans :
Other assets :


General principle of bank
management.


The bank manager has four primary
concerns
- Liquidity management;
- Asset management ;
- Liability management ;
- Capital adequacy
management

Liquidity management and the
role of reserves


If a bank has ample reserves, a deposit
outflow does not necessitate changes
in other parts of its balance sheet.
Conclusion: Excess reserves are
insurance against the costs associated
with deposit outflows. The higher the
costs associated with deposit outflows,
the more excess reserves bank will
want to hold.


Asset management




Three goals of bank:
-> seek the highest returns possible on loans and
securities
-> reduce risk
-> make adequate provision for liquidity by holding
liquid assets.
Four basic ways to accomplish bank’s goals.
(1) Try to find borrowers who will pay high interest rate
and are unlikely to default on their loans.
(2) Try to purchase securities with high return and low

risk
(3) Attempt to lower risk by diversifying.
(4) Manage the liquidity of its assets so that it can satisfy
its reserve requirements without bearing huge costs.


Liabilities management


Capital adequacy
management




Banks have to make decisions about the
amount of capital they need to hold for three
reasons :
(1) Prevent bank failure
(2) Amount of capital effects returns for the
owners of the bank.
(3) A minimum amount of bank capital is
required by regulatory authorities
How bank capital helps prevent bank failure.
Conclusion : A bank maintains bank capital to
lessen the chance that it will become insolvent.


How the amount of bank
capital affects returns to

equity holders





ROA : Return on assets.
net profit after taxes
ROA = --------------------------------assets
Assets
EM =
------------------Equity capital.
Net profit after taxes
Net profit after taxes
Assets
-------------------------- = -------------------------- x
-------------------Equity Capital
Assets
Equity
capital
or
ROE = ROA x EM
=> Given the return on assets, the lower the bank capital, the
higher the return for the owners of the bank.
Trade - off between safety and returns to equity holders
Bank capital requirements.


Off - Balance - Sheet
Activities








Off – trade balance sheet activities involve trading
financial instruments and generating income from
fees and loan sales, activities that affect bank
profit but do not appear on bank balance sheets.
Loan sales :
A loan sale (secondary loan participation)
involves a contract that sells all or part of the
cash stream from a specific loan and thereby
removes the loan from the bank’s balance sheet.
Generation of fee income
Trading activities and risk management
techniques


Measuring bank
performance
Bank’s Income statement :
+ Operating income : is the income that comes from a bank’s ongoing
operations.
+ Operating expenses : are the expenses incurred in conduction the bank’s
ongoing operations.
+ Income :


Measures of bank performance
Net income
ROA = -------------------Assets
Net income
ROE = -----------------Capital
NIM ( Net interest margin )




interest income - interest expenses
NIM = -------------------------------------------------------assets
Recent trends in bank performance measures


Financial innovation
A change in the financial environment will stimulate a search
by financial institutions for innovations that are likely to be
profitable.
There are three basic types of financial innovation :

Responses to changes in demand conditions.
+ Adjustable - rate mortgages : are mortgage loans on which the
interest rate changes when a market interest rate ( usually the
treasury bill rate ) changes.
 Responses to changes in supply conditions.
+ Bank credit and debit cards.
+ Electronic banking facilities
 Avoidance of existing regulations.
+ Reserve requirements:

+ Restrictions on interest paid on deposits
-> Eurodollars and bank commercial paper.
-> NOW Accounts, ATS accounts and overnight repos


Insurance Companies
Fundamentals of Insurance
(1) There must be a relationship between the insured ( the party
covered by insurance ) and the beneficiary ( the party who
receives the payment should a loss occur )
(2) The insured must provide full and accurate information to the
insurance company.
(3) The insured is not to profit as a result of insurance coverage.
(4) If a third party compensates the insured for the loss, the
insurance company’s obligation is reduced by the amount of
the compensation.
(5) The insurance company must have a large number of insured
so that the risk can be spread out among different policies.
(6) The loss must be quantifiable
(7) The insurance company must be able to compute the
probability of the loss’s occurring.
 Adverse Selection and Moral Hazard in Insurance.



Insurance Companies:
Major Employer


Selling Insurance

Number of Life Insurance
Companies
in the U.S., 1950–1994


Types of Insurance
Life insurance
 Property & casualty insurance
 Health insurance



Life Insurance


Term Life



Whole Life



Universal Life



Annuities



Assets and Liabilities of Life
Insurance Companies


Expected Life of Persons at
Various Ages


Annual Premiums


Distribution of Life
Insurance Company


Mortgage Investment


Property and Casualty
Insurance
 Today

Property Insurance
Named-peril policies
All-risk policies

Casualty Insurance

 Reinsurance


Insurance Management


Screening



Risk-Based Premium



Restrictive Provisions



Prevention of Fraud



Cancellation of Insurance



Deductibles



Coinsurance



Limits on the Amount of Insurance