salaar - finance capital markets spring semester 2011 lahore school of economics salaar farooq –...

Salaar - FinanceSalaar - Finance

Capital MarketsCapital Markets

Spring Semester 2011Spring Semester 2011

Lahore School of EconomicsLahore School of Economics

Salaar farooq – Assistant Professor


Lecture

Depository InstitutionsDepository Institutions


Depository InstitutionsLearning Objectives

What is a depository institution?

How a DI generates income?

What is the Asset/Liability problem for DI’s?

What is Funding Risk?

What are DI’s funding sources?

What are Reserve Requirements?


Depository Institutions?

Include:


Depository Institutions?

Include:

Institutions which take deposits

Deposits represent Liabilities (debt) for DI’s

Include:

Banks

Savings & Loan institutions

Savings Banks

Credit Unions


How do DI’s make money?

3 ways:


How do DI’s make money?

3 ways:

LoansMake direct loans to entities

Securities investmentsInvesting in securities & holding portfolios

FeesCharged to their customers


Importance of DI’s?

Heavily regulated because:


Importance of DI’s?

Heavily regulated because:

Their role in financial systema) Creating the financial playing field

Principal means of making payments

a) Individuals & Businesses use for payments

Vehicle for Govt monetary policy

a) MP implemented through banking system


Because of their importance,

Given special privileges

Access to Federal Deposit Insurance

Provision of liquidity in emergencies

Govt has interest in DI’s stability & survival…


Asset-Liability Problem of DI’s?

2 Main problems:

Funding Risk

Liquidity Risk



Funding Risk:Illustrate using 100MM, 7% 1 & 10 yrs

Use of Spreads (DI’s make money)Difference between bid/ask or charging premiums

Gaps (Mismatches)Open positions created due to duration differences

Interest rate exposureFunding/Gapping activity resulting in interest rate risk



Opportunities:



Opportunities:

Interest Rate view Mgrs who have expectations of interest rate changes will seek to profit

from funding/gapping

If Interest rates riseWhat position should you have?

If interest rates fallWhat position should you have?



Threats of positioning:



Threats of positioning:

Adverse financial consequences If expectations are not realized, Huge losses can occur

No one can predict interest rates consistentlyHighly risky?

Becomes same as gamblingLong run losses highly likely?


Main goal of Mgmt:



Main goal of Mgmt:

Locking in the spread

Minimize interest rate exposure

Various financial instruments used to manage risk



Liquidity Concerns of DI’s?

Balancing two activities?



Balancing two activities:

Satisfy Withdrawals of customersLiquidity required

Provide Loans to customersLiquidity required



4 ways to solve liquidity issues?



4 ways to solve liquidity issues:

Attract deposits

Increase borrowing (using security collateral)

Sell Securities on hand

Raise Funds in Money Markets



Increase Borrowing using securities:

Discount window borrowing at Fed (last resort!)



Sell securities it owns:

DI must invest in ST, liquid securities with low price risk and keep these in its inventory

E.g stocks?... No, Bonds? …. No

Solution: ?



Sell securities it owns:

DI must invest in ST, liquid securities with little price risk and keep these in its inventory

E.g stocks?... No, Bonds? …. No

Solution: ST, MM or debt obligations (fed funds)



SECONDARY RESERVES?

Securities held by a DI for the purpose of satisfying withdrawals or loans.

Disadvantage?

Lower yield

% of assets as secondary reserves depends on DI’s risk/return appetite



One more reason for holding liquid assets?



One more reason for holding liquid assets?

To fulfill Govt regulation!

In form of Reserve Requirements (discussed later)


Commercial Banks?

3 Main Types:


Commercial Banks?

3 Main Types:

Individual Banking

Institutional Banking

Global Banking


Commercial Banks?

Individual Banking:

Consumer Lending

Residential Mortgage

Installment Loans

Credit Card financing

Car & Boat Financing

Brokerage services

Student Loans

S10


Commercial Banks?

Institutional Banking:

Loans to Corporations

Loans to Insurance companies

Loans to Govts

Commercial Financing & Leasing


Commercial Banks?

Global Banking:

Investment Banking business

Foreign Exchange products

Capital Markets products Corporate financing products (underwriting securities etc)


Commercial Banks?

Banks as Dealers:

Investment Banking business

Foreign Exchange products

Capital Markets products Corporate financing products (underwriting securities etc)


Commercial Banks?

How do Banks raise Funds?


Commercial Banks?

How do Banks raise Funds?

3 Main Sources of Funds

Deposits

Non-Deposit Borrowing (M.MKts) - Debt

Common Stock & Retained Earnings


Commercial Banks?

Reserve Requirement &

Borrowing at the Fed Funds Mkt?

Banks must maintain a %age of deposits with Fed %age is called Reserve Ratio (depends on deposit type)

The cash kept with Fed is called Required Reserve


Reserve Requirements?Basic Computation:

Deposit Computation Period2 Week period where the average of the daily is taken to get RR (THR-WED)

Actual ReservesRR must be met by Actual Reserves at the Fed

Excess ReservesIf bank reserves exceed the RR at the Fed

Fed Funds Market & Fed FundsBanks short of RR borrow from Excess Reserves of other Banks

Called the Fed Funds rate


Reserve Requirements?Fed Discount Window:

Fed is the Banker’s Bank – last resort

Charges DISCOUNT RATE (usually 50bp lower)

CollateralTreasury securities, Govt securities etc.

Heavily Discourages its useWill investigate if use becomes frequent


Depository InstitutionsSummary

What is a depository institution?

How a DI generates income?

What is the Asset/Liability problem for DI’s?

What is Funding Risk?

What are DI’s funding sources?

What are Reserve Requirements?


• END DI’s• Next Structure of Markets : Primary

salaar - finance capital markets spring semester 2011 lahore school of economics salaar farooq –...

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