FIB2101 - E

Economics of Money and Banking

Instructor:
 Economics of Money and Banking

Chapter 3
Commercial banking
Instructor:

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 Learning Objectives

• Summarize the features of a bank balance sheet

• Identify the ways in which banks can manage their assets and liabilities to maximize profit
• Identify the ways in which banks can manage their assets and liabilities to maximize profit.

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OUTLINE

1 The bank balance sheet

2 Basic banking

3 General principles of banking management

4 Off-balance-sheet activities

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1. The bank balance sheet

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 1. The bank balance sheet

Total Total Bank

Assets Liabilities Capital

• Bank’s balance sheet is a list of its source of bank funds (liabilities and capital) and uses to which the
funds are put (assets)

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 1. The bank balance sheet

Assets Liabilities

• Reserves • Checkable deposits

• Cash items in process of collection • Non-transaction deposits
• Deposits at other banks • Borrowings
• Securities • Bank capital
• Loans
• Other assets

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 2. Basic banking
2.1 Cash deposit

• Example 1 : Jane opens a checking account at First National Bank with a $100. The T-account of the
bank of First National Bank:

Assets Liabilities

Reserves + $100 Checkable Deposits + $100

⮚ Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in
checkable deposits.

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 2. Basic banking
2.2 Check deposit

• Example 2 : If Jane opens her account with a $100 check written on an account at Second National
Bank, T-account of the bank of First National Bank :

Assets Liabilities

Cash items in + $100 Checkable Deposits + $100

process of collection

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 2. Basic banking
2.2 Check deposit

• Example 2 : In this case, if the two banks are in separate states, the First National Bank deposits the
check in its account at central bank, and central bank collects the funds from the Second National
Bank. The T-account of the bank of First National Bank :

Assets Liabilities

Reserves + $100 Checkable Deposits + $100

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 2. Basic banking
2.2 Check deposit

• Example 2 : In this case, if the two banks are in separate states, the First National Bank deposits the
check in its account at central bank, and central bank collects the funds from the Second National
Bank. The T-account of the bank of Second National Bank:

Assets Liabilities

Reserves - $100 Checkable Deposits - $100

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 2. Basic banking
2.3 Making a profit

• Example 3 : The First National Bank has just received $100 of checkable deposits. Required reserve
ratio is 10%. T-account of the First National Bank :

Assets Liabilities

Required Reserves +$10 Checkable Deposits +$100

Excess Reserves +$90

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 2. Basic banking
2.3 Making a profit

• Example 3 (cont) : Assuming that the First National Bank chooses to make loan instead of holding
any excess reserves. T-account of the First National Bank :

Assets Liabilities

Required Reserves +$10 Checkable Deposits +$100

Loans +$90

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 2. Basic banking
2.3 Making a profit

• The bank is making a profit because it holds ST liabilities and uses the proceeds to fund LT assets
Asset transformation: selling liabilities with one set of characteristics and using the proceeds to buy
assets with a different set of characteristics

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 3. General principles of bank management

Liquidity Management Capital Adequacy Management

1 4

Credit Risk
2 Asset Management 5

Interest-rate Risk
Liability Management 6
3

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 3. General principles of bank management
3.1 Liquidity management and the Role of Reserves

❖ Excess reserves:
• Example: Suppose that the First National Bank’s initial balance sheet is as follows:

Assets Liabilities

Reserves $20 mil Deposits $100 mil

Loans $80 mil Bank capital $10 mil

Securities $10 mil

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 3. General principles of bank management
3.1 Liquidity management and the Role of Reserves

❖ Excess reserves:
• Example (cont): If a deposit outflow of $10 mil occurs, First National Bank ‘s balance sheet becomes:

Assets Liabilities

Reserves $10 mil Deposits $90 mil

Loans $80 mil Bank capital $10 mil

Securities $10 mil

If a bank has ample excess reserves, a deposit outflow does not necessitate changes in
other parts of its balance sheet.

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 3. General principles of bank management
3.1 Liquidity management and the Role of Reserves

❖ Shortfall:
• Example: Suppose that the Second National Bank holds no excees reserves and its initial
balance sheet is as follows:

Assets Liabilities

Reserves $10 mil Deposits $100 mil

Loans $90 mil Bank capital $10 mil

Securities $10 mil

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 3. General principles of bank management
3.1 Liquidity management and the Role of Reserves

❖ Shortfall:
• Example (cont): When the Second National Bank suffers the $10 mil deposit, its balance sheet
becomes:

Assets Liabilities

Reserves $0 Deposits $90 mil

Loans $90 mil Bank capital $10 mil

Securities $10 mil

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 3. General principles of bank management
3.1 Liquidity management and the Role of Reserves

❖ Shortfall:
⮚ Excess reserves are insurances against the costs associated with deposit outflows.
⮚ Reserves are a legal requirement and the shortfall must be eliminated.

How can bank eliminate the shortfall

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 3. General principles of bank management
3.1 Liquidity management and the Role of Reserves

❖ Shortfall:
• Answer: To eliminate this short fall, bank has 4 basic options:

1. Borrowing from other banks or other corporations

2. Securities sale
3. Borrowing from central bank
4. Reducing loans

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 3. General principles of bank management
3.2 Asset management

❖ Three goals:

1. Seek the highest possible returns on loans and securities.

2. Reduce risk

3. Have adequate liquidity.

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 3. General principles of bank management
3.2 Asset management

❖ Four Tools:

1. Find borrowers who will pay high interest rates and have low possibility of defaulting.

2. Purchase securities with high returns and low risk.

3. Lower risk by diversifying.

4. Balance need for liquidity against increased returns from less liquid assets.

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 3. General principles of bank management
3.3 Liability management

• Large banks began to explore ways in which the liabilities could provide them with reserves
and liquidity.

• 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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 3. General principles of bank management
3.4 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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 3. General principles of bank management
3.4 Capital adequacy management

• How bank capital helps prevent bank failure:

o Example: Consider 2 banks with identical balance sheet, except that High Capital Bank has a
ratio of capital to assets of 10%, while Low Capital Bank has a ratio of 4%

High Capital Bank Low Capital Bank

Assets Liabilities Assets Liabilities

Reserces $10 mil Deposits $90 mil Reserces $10 mil Deposits $96 mil

Loans $90 mil Bank capital $10 mil Loans $90 mil Bank capital $4 mil

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 3. General principles of bank management
3.4 Capital adequacy management

• How bank capital helps prevent bank failure:

o Example: Suppose both banks suffer $5 mil of bad loans which are written off. The total
value of assets declines by $5 mil.

High Capital Bank Low Capital Bank

Assets Liabilities Assets Liabilities

Reserces $10 mil Deposits $90 mil Reserces $10 mil Deposits $96 mil

Loans $85 mil Bank capital $5 mil Loans $85 mil Bank capital $-1 mil

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 3. General principles of bank management
3.4 Capital adequacy management

• How the Amount of Bank Capital Affects Returns to Equity Holders:

Return on Assets Return on Equity

Relationship between ROA and ROE is expressed by

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 3. General principles of bank management
3.4 Capital adequacy management

• Trade-off between safety and returns to equity holders

▪ 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

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 3. General principles of bank management
3.5 Managing credit risk

• Screening and Monitoring

• Long-term customer relationships

• Loan commitments

• Collateral and compensating balances

• Credit rationing

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 3. General principles of bank management
3.6 Managing Interest-rate risk

• The riskiness of earnings and returns that is associated with changes in interest rates.

• If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce
bank profits, and a decline in interest rates will raise bank profits.

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 3. General principles of bank management
3.6 Managing Interest-rate risk

• The sensitivity of bank profits to changes in interest rates can be measured using:
1. Basic gap analysis:
(rate sensitive assets – rate sensitive liabilities) × Δ interest rates = Δ in bank profit

2. Duration analysis:

% Δ in market value of security ≈ - percentage point Δ in interest rate x duration in years

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 3. General principles of bank management
3.6 Managing Interest-rate risk

• The sensitivity of bank profits to changes in interest rates can be measured using:
1. Basic gap analysis:
(rate sensitive assets – rate sensitive liabilities) × Δ interest rates = Δ in bank profit

2. Duration analysis:

% Δ in market value of security ≈ - percentage point Δ in interest rate x duration in years

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 4. Off-balance-sheet activities

• Off-balance-sheet activities involve trading financail instruments and generating income from
fees and loan sales, activities that affect bank profits but do not appear on bank balance sheets.
✔Loan sales (secondary loan participation)
✔Generation of fee income (Examples: Servicing mortgage-backed securities, creating structured
investment vehicles)

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 Q&A
Thank you for your attention!

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