What Do Banks Do

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What Banks Do

Balance Sheets

General Principles of Bank Management

Managing Credit Risk

Managing Interest Rate Risk

Off-Balance-Sheet Activities

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The last set of lectures argued that financial

intermediaries were important for matchingsavers and investors.

Now we take a closer look at banks, the most

important financial intermediaries.

Balance sheet

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A bank collects funds from savers and makes

loans to borrowers.

The funds it collects are its liabilities.

The loans it makes are its assets.

The two sides of a balance sheet must add

up

Liabilities

Checkable deposits

Payable on demand

Used to be much more important

Cost to bank: interest, customer service,check clearing

Nontransactions deposits

Savings accounts, CDs

Higher interest than on checks, but notpayable on demand

Main source of funds

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Borrowing

From other banks (federal funds)

From the Fed (discount window)

From other corporations, e.g. bank holding

companies

Bank capital or net worth

Difference between assets and other

liabilities

A cushion against insolvency

Assets

Reserves and cash

Required reserves (by Fed)

Excess reserves (for deposit outflows)

Cash items in process of collection

Deposits at other banks (for check clearing,

FX, securities transactions)

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Securities

US government and agencies

State and local government

Commercial paper and corporate bonds

Subject to interest rate and default risk

Loans

Commercial and industrial (to businesses)

Real estate (mortgages)

Consumer

Interbank (fed funds)

Primary source of profit

Less liquid than securities

Subject to interest rate and default risk

Other assets

Buildings, land, computers, etc.

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General Principles of Banking

A banks main activity is asset transformation

Can profit by solving asymmetric informa-

tion problems

Walter Wriston (Citicorp): the business of

banking is the production of information.

Four jobs

Liquidity Management (deposit outflows)

Asset Management (credit and interest raterisk)

Liability Management (cost of acquiring

funds)

Capital Adequacy Management (avoid

going broke)

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Liquidity Management

Some deposits can be withdrawn at a mo-

ments notice.

A bank must pay, or it will be closed.

Banks hold enough excess reserves for normal

deposit outfl

ows.When they run short, they have 4 options (in

order of increasing cost)

Borrow fed funds from another bank

Sell short-term government securities

(secondary reserves)

Borrow from the Fed (discount window)

Call or sell loans

Assets held in reserve dont earn profit

Banks balance cost of reserves (foregone

profit) against cost of falling short.

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Capital Adequacy

A bank with negative net worth will be

closed.

Managers want enough capital to guard

against worst-case losses on assets.

But capital not loaned out earns no profit.

The higher is bank capital, the lower is

return on equity

ROA =Net Profits

Assets

ROE=Net Profits

Equity

EM=Assets

Equity

ROE= ROAEM

Must balance higher ROE against risk of

bankruptcy.

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Value at risk, stress testing

Raising capital when short: sell stock,

reduce dividends, increase assets

Liability management

Compete for funds in CD market

Borrow when attractive loan opportunities

arise

These sources of funds are subject to

interest rate risk.

Liability management is becoming more

integrated with asset management

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Collateral and compensating balances

Assets promised to the lender in the event

of default

Minimum account balance on deposits at

the bank.

Changes in collateral value or accountbalances also provide information on

borrowers status.

Credit rationing

Deny loans even if applicant is willing to

pay a high interest rate

Or provide smaller loan amount than

applicant requests

Why? adverse selection

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All these activities address problems arising

from informational asymmetries.

May seem like big brother.

But a kinder and gentler, well-intentioned

big brother

Off-Balance-Sheet Activities

Loan sales

Fees for services such as

FX transactions

Collecting interest and principal on

mortgage-backed securities

Guarantees of debt (bankers acceptances)

Backup lines of credit (overdraft priv-

ileges, letters of credit for commercialpaper)

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Trading activities

Futures, options, swaps are not on the

balance sheet.

Often used for risk management, some-

times also for speculation

Can be very profitable, but also risky,

because large bets can be made

Principal-agent problem within the bank

Trader bets with someone elses money;

heads I win, tails they lose

Not so problematic if traders are closely

monitored

Huge losses can occur otherwise

Important to separate traders from book-

keepers.

If one person does both, losses can behidden, creating asymmetric information.

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Rogue Traders Billionaires Club

Yasuo Hamanaka, Sumitomo, -$2.6 billion

Nick Leeson, Barings, -$1.3 billion

Toshihide Iguchi, Daiwa Bank, -$1.1

billion

Honorable mention to John Rusnak, Allied

Irish Banks, -$691 million

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What Do Banks Do