lecture 4_part 2

8/13/2019 Lecture 4_Part 2

1/29

Financial Institution Management

Lecture 4

Part II

Bank Balance Sheet and BasicManagement Principles


2/29

Main Contents Bank balance sheet

Liabilities

Assets Basic banking

General principles of bank management Liquidity management

Asset management Liability and capital adequacy management


3/29

4.2 Bank Balance Sheets


4/29

Bank Balance Sheet

Banks take deposits from the public and lend out

to earn interests.

All business activities are reflected in the banks

balance sheet(). A balance sheet

includes a list of liabilities ()and assets(). Liabilities: sources of funds

Assets: uses of funds


5/29

Liabilities of a Bank

Liabilities: Checkable deposits

CDs are Bank accounts that allow the owner to write checks to thirdparties.The deposits are payable on demand; that is, if a depositorshows up at the bank and requests to withdraw, or if a person who

receives a check written on an account from the bank, presents that

check at the bank, the bank must pay them immediately.


6/29

Liabilities of a Bank Liabilities (Continued):

Non-transaction deposits:

Owners can not write checks on non-transaction deposits, but theinterest rates paid on these deposits are usually higher than checkable

deposits. Two basic types of non-transaction deposits:

Saving accounts()

Time deposits()


7/29

Liabilities of a Bank Liabilities (Continued):

Borrowings: Banks also obtain funds by borrowing from the central bank,

other banks and corporations.

Bank capital (equities): Another important source of bank funds is from

the contribution of shareholders of the bank. The bank raises money from

shareholders by issuing new stocks.


8/29

Assets of a Bank Assets:

Reserves(): All banks must hold some of the funds to meet

its obligations when deposits are withdrawn. The required reserved ratio () are determined by the

central banks. In HK, now the ratio is 18%. Sometimes, banks hold

additional reserves, called excess reserves. Reserves do not bring

interest incomes to banks.


9/29

Assets of a Bank Assets (Continued)

Loans: Banks make their profits primarily by issuing loans. Loans are

less liquid and bear a probability of default.

Securities: Banks also use the funds to buy securities, such as government

and corporate bonds, corporate stocks.


10/29

4.3 Basic Banking


11/29

Basic Banking

The basic operation of a bank. Banks make profits by selling liabilities with one set of

characteristics and uses the proceeds to buy assets with a different

set of characteristics.

For example, a saving deposit held by one person can provide

funds to enable the bank to make a mortgage loan to another

person. This process is often referred to as asset transformation.


12/29

Basic Banking: Cash Deposit

We also can use the balance sheet to analyze the

operation of a bank.

Example I: First National Bank opens today andJane Brown is its first customer. She opens a

checking account with $100 bill. The bank uses it

as a reserve.

Assets Liabilities

Reserve $100 Checkable deposit $100


13/29

Basic Banking: Check Deposit

Example II: If Jane opens her account in First

National Bank with a check written on account at

Second National Bank, then

First National Bank Second National Bank

Assets Liabilities Assets Liabilities

Reserves $100 Checkabledeposits

$100 Reserves -$100 Checkabledeposits

-$100


14/29

Basic Banking

Bank can rearrange its balance sheet to make a

profit.

Example III: Because the reserve pays no interest,the First National Bank decides to make a loan to

someone else. But the required reserve ratio is

10%.

Assets Liabilities



Loan $90


15/29

4.4 Banking ManagementPrinciples


16/29

General Principles of Bank Management

Bank managers usually have four concerns: Liquidity management: A bank must keep enough cash on hand

and buy sufficiently liquid assets to make sure the bank has enough

ready cash to pay its depositors.

Asset management: A bank must pursue a low level of risk by

acquiring assets with low default rate and diversifying asset

holdings

Liability management: Acquire funds at low cost

Capital adequacy management: A bank mustprepare enough

capital.


17/29

Liquidity Management and Role of

Reserves

First National Bank (10% required reserve ratio):

Assets Liabilities

Reserve $20M Deposit $100MLoans $80M Bank Capital $10M

Securities $10M

Now a bank is experiencing a deposit outflow of

$10M. A lot of customers show up to withdraw

their money.


18/29


Reserves

Balance sheet after the outflow:

Assets Liabilities

Reserve $10M Deposit $90MLoans $80M Bank Capital $10M

Securities $10M

Conclusion: If a bank has ample excess reserves, a

deposit outflow does not necessitate changes in

other parts of its balance sheet.


19/29


Reserves

If a bank holds insufficient excess reserves, the

situation is quite different. For example, before the

outflow, the bank makes additional loans of $10M,instead of holding it as excess reserves.

Assets Liabilities

Reserve $10M Deposit $100M

Loans $90M Bank Capital $10M

Securities $10M


20/29


Reserves

When a deposit outflow of 10M occurs:

Assets Liabilities

Reserve $0M Deposit $90M

Loans $80M Bank Capital $10M

Securities $10M

Reserve cannot match the requirement.


21/29


Reserves

There are four options to fix the reserve shortfall

in the last slide:

Borrowing from other banks or companies Sell securities

Borrow from the central bank

Call in/sell off loans


22/29

Asset-Liability Management

Asset and liability managements are two sides of a

coin for the management of a modern bank.

Asset management emphasizes how to makehighest possible return using banks funds.

Liability management emphasizes how to reduce

the financial costs when a bank seeks for liabilities.


23/29

Asset Management

To maximize its profits, a bank must

simultaneously seek the highest returns possible

on loans and securities, reduce risk, and makeadequate liquidity by holding liquid assets. Find borrowers who will pay high interest rates and unlikely to

default.

Purchase securities with high returns and low risk. Diversification.

Manage liquidity


24/29

Liability Management

On the other hand, banks are also actively seekingcheapest possible liabilities. Before the 1960s, this part was widely ignored. The primary

source for banks funds was checkable deposits, which by lawcould not pay any interests. So banks could not compete with oneanother to attract these deposits by paying interests on them.Meanwhile, the interbank loan market was not well established. Itlimited the source of liabilities for a bank.

Nowadays, because of the mature markets for NegotiableCertificate Deposits and overnight interbank loans, banks havemore flexibilities to manage their liabilities to seek for a cheapestfinancing way.


25/29

Capital Adequacy Management

Bank also need sufficient capital to prevent bank

failure.

High Capital Bank Low Capital Bank

Reserve $10M Deposit $90M Reserve $10M Deposit $96M

Loans $90M Capital $10M Loans $90M Capital $4M

Consider a situation in which both banks lend atelecom company $5M and lose all of them.


26/29


The balance sheets will look like:High Capital Bank Low Capital Bank

Reserve $10M Deposit $90M Reserve $10M Deposit $96M

Loans $85M Capital $5M Loans $85M Capital $-1M

Low Capital Bank can not absorb the loss using its

capital. It will be forced to shut down and gobankruptcy.


27/29


Bank manager also need to pursue a good return

on the capital because the manager is elected by

the board of directors and should be on behalf ofthe interests of shareholders.

Two measures of banks profitability: ROA (Return of Assets):

ROE (Return of Equity):


28/29


If define the equity multiplier(EM)

then

Bank manager faces a tradeoff: the stockholders

want to put less capital to enjoy a high ROE; toolittle capital would enlarge the danger of

bankruptcy.


29/29


Measures to increase the ratio of capital: Issuing new equity

Reducing dividends to shareholders

Reducing the assets by making fewer loans or by selling off

securities

Measures to decrease the ratio of capital: Buying back some of the stock

Paying out higher dividends to shareholders

Issuing more deposits

lecture 4_part 2

Documents