banking and the management of financial institutions

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Chapter 13
Banking and the Management
of Financial Institutions
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Assets
•
Cash reserves
•
Deposits at Other Banks
•
Cash Items in Process of Collection
•
Securities
•
Loans
•
Fixed and Other Assets
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Liabilities I
•
Demand and Notice Deposits

•
Fixed – Term Deposits
•
Borrowings
–
Overdraft loans (advances)
–
Settlement balances
•
Bank capital
•
Reserves
–
Vault cash
–
Desired reserves
–
Banker’s risk
–
Desired reserve ratio
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Liabilities II
•
Cash Items in Process of Collection
–
Items in transit (bank float)
•

Deposits at Other Banks
–
Interbank deposits
•
Securities
–
Secondary reserves
•
Loans
•
Other Assets
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The Bank Balance Sheet
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Basic Banking I
•
Opening of a checking account leads to an increase in
the bank’s reserves equal to the increase in chequable
deposits
First Bank Business
Assets Liabilities Assets Liabilities
Loans +$100 Chequable
deposits
+$100 Chequable

Deposits
+$100 Bank Loans +$100
First bank makes a loan of $100 to a business and
credits the business's chequable deposit.
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Basic Banking II
First Bank Second Bank
Assets Liabilities Assets Liabilities
Reserves +$100 Chequable
deposits
+$100 Reserves -$100 Chequable
deposits
-$100
First Bank
Assets Liabilities
Cash items in
process of
collection
+$100 Chequable
deposits
+$100
When a bank receives
additional deposits, it
gains an equal amount
of reserves: when it
loses deposits, it loses
an equal amount of

reserves
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Basic Banking—Making a Profit
•
Asset transformation-selling liabilities with one set of
characteristics and using the proceeds to buy assets with a
different set of characteristics
•
The bank borrows short and lends long
First Bank First Bank
Assets Liabilities Assets Liabilities
Desired
reserves
+$100 Chequable
deposits
+$100 Desired
reserves
+$10 Chequable
deposits
+$100
Excess
reserves
+$90 Loans +$90
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Bank Management
•
Liquidity Management
•
Asset Management
•
Liability Management
•
Capital Adequacy Management
•
Credit Risk
•
Interest-rate Risk
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Liquidity Management and the Role of
Reserves
•
If a bank has ample excess reserves, a deposit outflow
does not necessitate changes in other parts of its
balance sheet
Assets Liabilities Assets Liabilities
Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank
Capital
$10M Loans $80M Bank Capital $10M
Securities $10M Securities $10M
with deposit outflow of $10

million
↓
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Liquidity Management: Shortfall in
Reserves
•
Reserves are now short of the desired amount and the
shortfall must be eliminated
•
Excess reserves are insurance against the costs
associated with deposit outflows
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank
Capital
$10M Loans $90M Bank Capital $10M
Securities $10M Securities $10M
with deposit outflow of $10
million
↓
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Liquidity Management: Borrowing
•
Cost incurred is the interest rate paid on the

borrowed funds
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M
Borrowing $9 million from other banks
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Liquidity Management: Securities Sale
•
The cost of selling securities is the brokerage and
other transaction costs
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M
Can meet shortfall by reducing loans by $9 million
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Liquidity Management:
Bank of Canada Advances
•
Borrowing from the Bank of Canada also incurs
interest payments based on the discount rate
Assets Liabilities
Reserves $9M Deposits $90M

Loans $90M Advance Bank of
Canada
$9M
Securities $10M Bank Capital $10M
Borrow $9 million from the Bank of Canada
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Liquidity Management: Reduce Loans
•
Reduction of loans is the most costly way of
acquiring reserves
•
Calling in loans antagonizes customers
•
Other banks may only agree to purchase loans at a
substantial discount
Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M
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Asset Management: Three Goals
•
Seek the highest possible returns on loans and
securities

•
Reduce risk
•
Have adequate liquidity
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Asset Management: Four Tools
•
Find borrowers who will pay high
interest rates and have low possibility
of defaulting
•
Purchase securities with high returns and low
risk
•
Lower risk by diversifying
•
Balance need for liquidity against increased
returns from less liquid assets
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Liability Management
•
Recent phenomenon due to rise of money
center banks
•

Expansion of overnight loan markets and new
financial instruments (such as negotiable CDs)
•
Checkable deposits have decreased in
importance as source of bank funds
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Capital Adequacy Management
•
Bank capital helps prevent bank failure
•
The amount of capital affects return for the
owners (equity holders) of the bank
•
Regulatory requirement
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Capital Adequacy Management: Preventing Bank Failure
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M

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Capital Adequacy Management: Returns to Equity Holders
EM x ROA ROE
capital equity
assets
assets
taxes after profit net
capital equity
taxes after profit net
Capital Equity
Assets
EM
capital equityof dollar per assetsof amount the :Multiplier Equity
the by expressed is ROE and ROA between ipRelationsh
capital equity
taxes after profit net
ROE
capital equityof dollar per taxes after profit net:Equity on Return
assets
taxes after profit net
ROA
assetsof dollar per taxes after profit net:Assets on Return
=
=
=
=
=

x
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Capital Adequacy Management: Safety
•
Benefits the owners of a bank by making their
investment safe
•
Costly to owners of a bank because the higher
the bank capital, the lower the return on
equity
•
Choice depends on the state of the economy
and levels of confidence
•
Bank capital requirement
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Strategies for Managing Bank Capital
Lowering Bank Capital:
•
Buying back some of Bank’s stock
•
Pay out higher dividend to shareholders
•
Acquire new funds and increase assets

Raising Bank Capital:
•
Issue more common stock
•
Reducing dividend to shareholders
•
Issue fewer loans or sell securities and use proceeds
to reduce liabilities
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Managing Credit Risk I
•
A major component of many financial
institutions business is making loans
•
To make profits, these firms must make
successful loans that are paid back in full
•
The concepts of moral hazard and adverse
selection are useful in explaining the risks
faced when making loans
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Managing Credit Risk II
•
Adverse selection is a problem in loan markets

because bad credit risks (those likely to
default) are the one which usually line up for
loans
•
Those who are most likely to produce an
adverse outcome are the most likely to be
selected