money, banking, and financial markets : econ. 212

Economics of International Finance Economics of International Finance Prof. M. El-Sakka Prof. M. El-Sakka CBA. Kuwait University CBA. Kuwait University

Money, Banking, and Financial Money, Banking, and Financial Markets : Econ. 212Markets : Econ. 212

Stephen G. Cecchetti: Stephen G. Cecchetti: Chapter 12Chapter 12

Depository Institutions: Banks and Bank Depository Institutions: Banks and Bank ManagementManagement


The Balance Sheet of Commercial BanksThe Balance Sheet of Commercial Banks

Assets: Uses of FundsAssets: Uses of Funds The asset side of a bank’s balance sheet includes cash, The asset side of a bank’s balance sheet includes cash,

securities, loans, and all other assets (which includes mostly securities, loans, and all other assets (which includes mostly buildings and equipment).buildings and equipment).

Cash Items:Cash Items: The three types of cash assets are The three types of cash assets are 1.1. reservesreserves (which includes cash in the bank’s vault as well (which includes cash in the bank’s vault as well

as its deposits at the central bank –Federal reserve in as its deposits at the central bank –Federal reserve in USA); USA);

2.2. cash items in the process of collectionscash items in the process of collections (uncollected funds (uncollected funds the bank expects to receive-checks); the bank expects to receive-checks);

3.3. and the balances ofand the balances of accounts that banks hold at other accounts that banks hold at other banksbanks (correspondent banking). (correspondent banking).


SecuritiesSecurities: The second largest component of bank assets; in : The second largest component of bank assets; in USA these include U.S. Treasury securities and state and USA these include U.S. Treasury securities and state and local government bonds. Securities are sometimes called local government bonds. Securities are sometimes called secondary reservessecondary reserves because they are highly liquid and can because they are highly liquid and can be sold quickly if the bank needs cash.be sold quickly if the bank needs cash.

LoansLoans: The primary asset of modern commercial banks; : The primary asset of modern commercial banks; includes: includes:

1.1. business loansbusiness loans (commercial and industrial loans), (commercial and industrial loans), 2.2. real estate loansreal estate loans, , 3.3. consumer loansconsumer loans, , 4.4. inter-bank loansinter-bank loans, and , and 5.5. loans for the purchase of other securitiesloans for the purchase of other securities..

The primary difference among the various types of The primary difference among the various types of depository institutions is in the composition of their loan depository institutions is in the composition of their loan portfolios.portfolios.


Liabilities: Sources of FundsLiabilities: Sources of Funds Banks need funds to finance their operations; they get them Banks need funds to finance their operations; they get them

from different savers and from borrowing in the financial from different savers and from borrowing in the financial markets.markets.

Deposits:Deposits: There are two types of deposit accounts, There are two types of deposit accounts, transactionstransactions deposits (checkable deposits) and deposits (checkable deposits) and non-non-transactionstransactions deposits. deposits.

1.1. Checkable deposits Checkable deposits ((or transactions depositsor transactions deposits): A typical ): A typical bank will offer 6 or more types of checking accounts. In bank will offer 6 or more types of checking accounts. In recent decades these deposits have recent decades these deposits have declineddeclined because these because these accounts pay low interest rates and financial innovations accounts pay low interest rates and financial innovations that relaxed the barriers between transactions and non-that relaxed the barriers between transactions and non-transaction deposits.transaction deposits.


2.2. Non-transactions DepositsNon-transactions Deposits: These include : These include • savingssavings• time depositstime deposits

Non-transactions deposits account for nearly Non-transactions deposits account for nearly two-thirdstwo-thirds of all of all commercial bank liabilities. commercial bank liabilities.

3.3. Certificates of depositCertificates of deposit can be small ($100,000 or less) or large (more can be small ($100,000 or less) or large (more than $100,000), and the large ones can be bought and sold in financial than $100,000), and the large ones can be bought and sold in financial markets.markets.

BorrowingsBorrowings:: The second most important source of bank funds; banks The second most important source of bank funds; banks borrow fromborrow from

1.1. The Central BankThe Central Bank (discount loans) (discount loans)

2.2. Other banksOther banks

3.3. Banks can also borrow by using a repurchase agreementBanks can also borrow by using a repurchase agreement or or REPOREPO, , which is a short-term collateralized loan in which a security is which is a short-term collateralized loan in which a security is exchanged for cash, with the agreement that the parties will reverse exchanged for cash, with the agreement that the parties will reverse the transaction on a specific future date (might be as soon as the next the transaction on a specific future date (might be as soon as the next day).day).


Bank Capital and ProfitabilityBank Capital and Profitability

The net worth of banks is called bank capital; it is the The net worth of banks is called bank capital; it is the owners’ stake in the bank. Capital is the owners’ stake in the bank. Capital is the cushioncushion that banks that banks have against a sudden drop in the value of their assets or an have against a sudden drop in the value of their assets or an unexpected withdrawal of liabilities.unexpected withdrawal of liabilities.

An important component of An important component of bank capitalbank capital is is loan loss reservesloan loss reserves, , the bank sets aside to cover potential losses from defaulted the bank sets aside to cover potential losses from defaulted loans. loans.


Bank ProfitabilityBank Profitability

There are several basic measures of bank There are several basic measures of bank profitability: profitability: return on assetsreturn on assets (after tax net profit divided by its (after tax net profit divided by its

total assets) and total assets) and return on equityreturn on equity (after tax net profit divided by its (after tax net profit divided by its

capital).capital). Net interest incomeNet interest income is another measure of is another measure of

profitability; it is the difference between the profitability; it is the difference between the interest the bank pays and what it receives. Net interest the bank pays and what it receives. Net interest income can also be expressed as a interest income can also be expressed as a percentage of total assetspercentage of total assets; that is called net ; that is called net interest margininterest margin, or the bank’s , or the bank’s interest rate spreadinterest rate spread. . Net interest margin is an indicator of Net interest margin is an indicator of future future profitability profitability as well as as well as currentcurrent profitabilityprofitability..


Off-Balance-Sheet ActivitiesOff-Balance-Sheet Activities Banks engage in these activities in order to generate Banks engage in these activities in order to generate fee fee

incomeincome; these activities include ; these activities include

1.1. providing trusted customers with providing trusted customers with lines of creditlines of credit..

2.2. Letters of creditLetters of credit are another important off-balance-sheet are another important off-balance-sheet activity; they guarantee that a customer will be able to make a activity; they guarantee that a customer will be able to make a promised payment. In so doing, the bank, in exchange for a promised payment. In so doing, the bank, in exchange for a fee, substitutes its own guarantee for that of the customer and fee, substitutes its own guarantee for that of the customer and enables a transaction to go forward.enables a transaction to go forward.

3.3. A standby letter of creditA standby letter of credit is a form of insurance; the bank is a form of insurance; the bank promises that it will repay the lender should the borrower promises that it will repay the lender should the borrower default.default.

Off-balance-sheet activities create Off-balance-sheet activities create risk for financial risk for financial institutions and so have come under increasing scrutiny in institutions and so have come under increasing scrutiny in recent years.recent years.


Bank Risk: Where It Comes from and What to Do About ItBank Risk: Where It Comes from and What to Do About It

Liquidity RiskLiquidity Risk Liquidity risk is the risk of a Liquidity risk is the risk of a sudden demand for fundssudden demand for funds and it and it

can come from both sides of a bank’s balance sheet (deposit can come from both sides of a bank’s balance sheet (deposit withdrawal on one side and the funds needed for its off-withdrawal on one side and the funds needed for its off-balance sheet activities on the liabilities side).balance sheet activities on the liabilities side).

If a bank cannot meet customers’ requests for immediate If a bank cannot meet customers’ requests for immediate funds it runs the funds it runs the risk of failurerisk of failure; even with a positive net ; even with a positive net worth, illiquidity can drive a bank out of business.worth, illiquidity can drive a bank out of business.

One way to manage liquidity risk is to hold One way to manage liquidity risk is to hold sufficient excess sufficient excess reservesreserves (beyond the required reserves mandated by the (beyond the required reserves mandated by the Central Bank) to accommodate customers’ withdrawals. Central Bank) to accommodate customers’ withdrawals. However, this is expensive (interest is foregone).However, this is expensive (interest is foregone).


Two other ways to manage liquidity risk are Two other ways to manage liquidity risk are adjusting assetsadjusting assets or or adjusting liabilitiesadjusting liabilities..

1.1. A bank can adjust its assets by A bank can adjust its assets by selling a portionselling a portion of its of its securities portfolio, or by securities portfolio, or by selling some of its loansselling some of its loans, or by , or by refusing to renewrefusing to renew a customer loan that has come due.a customer loan that has come due.

Banks do not like to meet their deposit outflows by Banks do not like to meet their deposit outflows by contracting the asset side of the balance sheet because doing contracting the asset side of the balance sheet because doing so shrinks the size of the bank.so shrinks the size of the bank.

2.2. Banks can use Banks can use liability managementliability management to obtain additional to obtain additional funds by: funds by:

1.1. borrowing from the Central Bank borrowing from the Central Bank 2.2. borrowing from another bank, or by borrowing from another bank, or by 3.3. attracting attracting additional depositsadditional deposits (by issuing large CDs). (by issuing large CDs).


Case 1: holding sufficient excess reserves.Case 1: holding sufficient excess reserves.

- Given the following balance sheet of bank X. - Given the following balance sheet of bank X. - If RRR = 10%. This bank will be holding 5 million excess reserves. - If RRR = 10%. This bank will be holding 5 million excess reserves. - If this bank suffers a deposit outflow of 5. the bank will still be holding excess - If this bank suffers a deposit outflow of 5. the bank will still be holding excess reserves.reserves.


Case 2: holding insufficient excess reserves.Case 2: holding insufficient excess reserves.

- Given the following balance sheet of bank Y. - Given the following balance sheet of bank Y. - If RRR = 10%. This bank will be holding no excess reserves. - If RRR = 10%. This bank will be holding no excess reserves. - If this bank suffers a deposit outflow of 5. the bank will have a liquidity - If this bank suffers a deposit outflow of 5. the bank will have a liquidity shortage of 5 millionshortage of 5 million


Credit RiskCredit Risk This is the risk that loans will not be repaid and it can be This is the risk that loans will not be repaid and it can be

managed through managed through diversificationdiversification and and credit-risk analysiscredit-risk analysis..

DiversificationDiversification can be difficult for banks, especially those that can be difficult for banks, especially those that focus on certain kinds of lending.focus on certain kinds of lending.

Credit-risk analysis Credit-risk analysis produces information that is very similar produces information that is very similar to the bond-rating systems and is done using a combination of to the bond-rating systems and is done using a combination of statistical models statistical models and and information specific information specific to the loan to the loan applicant.applicant.

Lending is plagued by adverse selection and moral hazard, Lending is plagued by adverse selection and moral hazard, and financial institutions use a variety of methods to mitigate and financial institutions use a variety of methods to mitigate

these problemsthese problems..


Interest-Rate RiskInterest-Rate Risk The two sides of a bank’s balance sheet often do not match up The two sides of a bank’s balance sheet often do not match up

because liabilities tend to be short-term while assets tend to because liabilities tend to be short-term while assets tend to be long-term; this creates interest-rate risk.be long-term; this creates interest-rate risk.

In order to manage interest-rate risk, the bank must In order to manage interest-rate risk, the bank must determine how sensitive its balance sheet is to a change in determine how sensitive its balance sheet is to a change in interest rates; interest rates; gap analysisgap analysis highlights the gap or difference highlights the gap or difference between the between the yield on interest sensitive assets yield on interest sensitive assets and the yield on and the yield on interest-sensitive liabilitiesinterest-sensitive liabilities..

Multiplying the gap by the projected change in the interest Multiplying the gap by the projected change in the interest rate rate yields theyields the change in the bank’s profitchange in the bank’s profit..

Gap analysis can be further refined to take account of Gap analysis can be further refined to take account of differences in the maturity of assets and liabilities.differences in the maturity of assets and liabilities.


Banks can manage interest-rate risk by Banks can manage interest-rate risk by matchingmatching the interest- the interest-rate sensitivity of assets with the interest-rate sensitivity of rate sensitivity of assets with the interest-rate sensitivity of liabilities, but this approach increases credit risk.liabilities, but this approach increases credit risk.

Bankers can use derivatives, like Bankers can use derivatives, like interest-rate swapsinterest-rate swaps, , to manage interest-rate risk.to manage interest-rate risk.

Trading RiskTrading Risk Banks today hire traders to actively buy Banks today hire traders to actively buy and sell securitiesand sell securities, ,

loans, and derivatives loans, and derivatives using a portion of the using a portion of the bank’s capital bank’s capital in in the hope of making additional profits.the hope of making additional profits.

However, trading such instruments is risky (the price may go However, trading such instruments is risky (the price may go

down instead of up); this is called trading risk or market risk.down instead of up); this is called trading risk or market risk.


Managing Managing trading risk is a major concern for today’s trading risk is a major concern for today’s banks, banks, and bank risk managers place limits on the amount of risk and bank risk managers place limits on the amount of risk any individual trader is allowed to assume.any individual trader is allowed to assume.

Banks also need to hold more capital if there is more risk in Banks also need to hold more capital if there is more risk in their portfolio.their portfolio.

Other RisksOther Risks Banks that operate internationally will face Banks that operate internationally will face foreign exchange foreign exchange

riskrisk (the risk from unfavorable moves in the exchange rate) (the risk from unfavorable moves in the exchange rate) and and sovereign risk sovereign risk (the risk from a government prohibiting (the risk from a government prohibiting the repayment of loans).the repayment of loans).

Banks manage their foreign exchange risk by attracting Banks manage their foreign exchange risk by attracting deposits denominated in the same currency as the loans and deposits denominated in the same currency as the loans and by using by using foreign exchange futures and swaps to hedge foreign exchange futures and swaps to hedge the the risk.risk.


Banks manage Banks manage sovereign risk by diversificationsovereign risk by diversification, by refusing , by refusing to do business in a particular country or set of countries, and to do business in a particular country or set of countries, and by using derivatives to hedge the risk.by using derivatives to hedge the risk.

Banks also face Banks also face operational riskoperational risk, the risk that their computer , the risk that their computer system may fail or that their buildings may burn down.system may fail or that their buildings may burn down.

To manage operational risk the bank must make sure that its To manage operational risk the bank must make sure that its computer systems and buildings are sufficiently robust to computer systems and buildings are sufficiently robust to withstand potential disasters.withstand potential disasters.


Lessons of Chapter 12Lessons of Chapter 12

Bank assets equal bank liabilities plus bank capital.Bank assets equal bank liabilities plus bank capital. Bank assets are the uses for bank funds.Bank assets are the uses for bank funds.

They include reserves, securities, and loans.They include reserves, securities, and loans. Over the years, securities have become less important and mortgages more Over the years, securities have become less important and mortgages more

important as a use for bank funds.important as a use for bank funds. Banks liabilities are the sources of bank funds.Banks liabilities are the sources of bank funds.

They include transactions and nontransactions deposits, as well as borrowings They include transactions and nontransactions deposits, as well as borrowings from other banks.from other banks.

Over the years, transactions deposits have become increasingly less important Over the years, transactions deposits have become increasingly less important as a source of bank funds.as a source of bank funds.

Bank capital is the contribution of the bank’s owners; it acts as a cushion against Bank capital is the contribution of the bank’s owners; it acts as a cushion against a fall in the value of the bank’s assets or a withdrawal of its liabilities.a fall in the value of the bank’s assets or a withdrawal of its liabilities.

Banks make a profit for their owners. Measures of a bank’s profitability include Banks make a profit for their owners. Measures of a bank’s profitability include return on assets (ROA), return on equity (ROE), net interest income, and net return on assets (ROA), return on equity (ROE), net interest income, and net interest margin.interest margin.

Banks’ off-balance-sheet activities have become increasingly important in recent Banks’ off-balance-sheet activities have become increasingly important in recent years. They include:years. They include:

loan commitments, which are lines of credit that firms can use whenever loan commitments, which are lines of credit that firms can use whenever necessary.necessary.

letters of credit, which are guarantees that a customer will make a promised letters of credit, which are guarantees that a customer will make a promised payment.payment.


Banks face several types of risk in day-to-day business. They include:Banks face several types of risk in day-to-day business. They include: Liquidity risk – the risk that customers will demand cash immediatelyLiquidity risk – the risk that customers will demand cash immediately Liability-side liquidity risk arises from deposit withdrawals.Liability-side liquidity risk arises from deposit withdrawals. Asset-side liquidity risk arises from the use of loan commitments to borrow.Asset-side liquidity risk arises from the use of loan commitments to borrow. Banks can manage liquidity risk by adjusting either their assets or their Banks can manage liquidity risk by adjusting either their assets or their

liabilities.liabilities. Credit risk – the risk that customers will not repay their loans. Banks can Credit risk – the risk that customers will not repay their loans. Banks can

manage credit risk by:manage credit risk by: diversifying their loan portfolios.diversifying their loan portfolios. using statistical models to analyze borrowers’ creditworthiness.using statistical models to analyze borrowers’ creditworthiness. monitoring borrowers to ensure that they use borrowed funds properly.monitoring borrowers to ensure that they use borrowed funds properly.

Interest-rate risk – the risk that a movement in interest rates will change the Interest-rate risk – the risk that a movement in interest rates will change the value of the bank’s assets more than the value of its liabilities.value of the bank’s assets more than the value of its liabilities.

When a bank lends long and borrows short, increases in interest rates will When a bank lends long and borrows short, increases in interest rates will drive down the bank’s profits.drive down the bank’s profits.

Banks use a variety of tools, such as gap analysis, to assess the sensitivity of Banks use a variety of tools, such as gap analysis, to assess the sensitivity of their balance sheets to a change in interest rates.their balance sheets to a change in interest rates.

Banks manage interest-rate risk by matching the maturity of their assets and Banks manage interest-rate risk by matching the maturity of their assets and liabilities and using derivatives like interest-rate swaps.liabilities and using derivatives like interest-rate swaps.

Trading risk – the risk that traders who work for the bank will create losses on Trading risk – the risk that traders who work for the bank will create losses on the bank’s own account. Banks can manage this risk using complex statistical the bank’s own account. Banks can manage this risk using complex statistical models.models.

Other risks banks face include foreign exchange risk, sovereign risk, and Other risks banks face include foreign exchange risk, sovereign risk, and operational risk.operational risk.


Key Terms

•capital gain capital loss

•Consol current yield

•default risk holding period return

•inflation risk inflation-indexed bonds

•interest-rate risk investment horizon

•Perpetuity pure discount bond

•stripped bond tax incentive

•U.S. Treasury bill (T-bill) yield to maturity

•yield on a discount basis zero-coupon bond

money, banking, and financial markets : econ. 212

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