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3
Banking
Exam Date: 3/5/2018(Thur)
Time : 0930-1200
FTC 1404
Asymmetric information
Role of financial intermediaries
one party having insufficient knowledge about
the other party involved in a transaction to make accurate decision
Pooling saving ##
Safekeeping
Payments system access
Bookkeeping and accounting
Providing liquidity
Collecting and processing information
topic 1 - the economics of financial intermediation
Adverse selection problem and the possible solutions
Arises before the transaction occurs, for example:
Lenders need to know how to distinguish good credit risk from bad
- Disclosure of information
through government required disclosure and the private collection and production of information (credit rating agency)
- Collateral
something of value pledged by a borrower to lender
house serve as collateral for mortgages
- Net worth (Equity Capital)
take to the firm's net worth , sell it off and use the proceeds to recover some of the losses from the loan
Moral Hazard
It occurs after the financial transaction takes place
Moral Hazard
Equity Financing
In Equity Financing
Equity contract
Principal-agent problem.
The managers in control of the firm may act in their own interest rather than in the best interest of the stockholder
Managers have less incentive to maximize profits
Build luxurious offices for themselves
Debt Finance
Contractual agreement in which the borrower has agrees to repay the lender a fixed follar amounts at periodic intervals.
In Debt Finance
Debt contracts requires the borrowers to pay out a fixed amount and lets them keep any profits above this amount, the borrowers have an incentive to take an investment projects that are riskier than the lenders would like.
Encourage desirable behavior
covenants to encourage desirable behavior
Engage in desirable activities that make it more likely that the loan will be repaid.
A mrotgage load contract may require a borrower to carry life insurance that pays off the mortgage loan upon that person's death
Provide information
covenants to provide information
Provide information about its activities periodically, quarterly accounting and income reports. To monitor the firm and reduce moral hazard
Stipulate that the lender has the right to audit inspect the firm's books at any time
The Bank Balance Sheet
Total Assets = Total Liabilties + Capital
topic 2 - Management of financial instiutions: the bank balance Sheet
Assets
- A bank uses the funds that it has acquired by issuing liablities to purchase income-earning assets
- Referred to as uses of funds, and the interest payments earned on them are what enable banks to make profits.
Assets ##
Reserves ##
Banks hold some of the funds they acquire as deposits in an account at the FED (central Bank)
Deposits plus currency that is physically held by banks (vault cash)
Reserves currently do not pay any interest
Required reserves (RRR)
Excess reserves - the most liquid of all bank assets
Reserves##
Cash Item in Process of collection
Cash Item in Process of collection
崑Suppose that a check written on an account at another bank is deposited in your bank and the funds for this check have not yet been received ( collected) from the other bank
Securities
Income-earning asset (e,g, U.S. government)
Banks are not allowed to hold stock
Securities
Loan
Banks make their profits primarily by issuing loan
兆A loan is a liability for the individual or corporation receiving it but an assets for a bank because it provides income to the bank.
Loan
Other assets
Physical capital
Bank buildings, computers, etc.
Other Assets
Liabilities
A bank acquires funds by issuing (selling) liabilities, which are consequently also referred to as sources of funds.
The funds obtained from issuing liabilities are used to purchase income-earing assets.
Liabilties
Checkable Deposits
Write checks to third parties
Checkable Deposits
Non-trasaction Deposits
Primary source of bank funds
Saving accounts
Time deposits (Certificates of deposits, CDs)
Non-transaction Deposits
Borrowing
Borrowings
Borrowing from central bank, other banks and corporations
Central bank ( Fed ) discount loan
Other banks ( Fed funds market) inter-bank loan
meet the amount requires by the Fed
BAnk Capital (Chap3)
Bank's net worth
a drop in the value of its assets which could force the bank into insolvency
Bank Capital
Borrows short & lends long
Basics of Banking - "Borrows short & lends long"
Banks make profits by selling liabilities
Borrows short and lends long
makes long-term loans and funds them by issuing short-dated deposits
Liquidity Management
Eliminate reserve shortfall
- Borrowing them from other banks (HIBOR)
- Sell some of its securitites
- Borrowing from the Fed (central bank)
- Reducing its loans
Liquidity Management
##￥
Understanding risk
TOPIC 3 - Understanding risk
management of financial institutions
TOPIC 4 - management of financial institutions
Asset Management
Asset Management
- Find borrowers who will pay high interest rates and are unlikely to default on their loans
- Purchase securities with high returns and low risk
- Lower risk by diversification
purchasing many different types of assets
approving many types of loans
- Manage the liquidity of its assets so that it can satisfly its reserve requirements without bearing huge costs
Hold liquid securities even if they earn a somewhat lower return than other assets (loan)
Decide how much excess reserves must be held to avoid costs from a deposit outflow
It is not wise for a bank to be too conservative (by holding only excess reserves, losses are suffered because reserves earn no interest, while the bank's liabilities are costly to maintain
Liability Management
Liability Management
Liabilities on their balance sheets c仙ould provide them with reserves and liquidity
This led to
An expansion of overnight loans markets, such as the fed funds markets
The development of new financial instruments such as negotiable CDs
which enabled money center banks to acquire funds quickly
Attractive loan opportunity, it can acquire funds by selling a negotiable CD
If a bank has a reserve shortfall, funds can be borrowed from another bank in the Fed funds market without incurring high transaction costs
Capital Adequacy Management
The amount of capital they need to hold for three reason
- Bank capital helps prevent bank failture: a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors and so goes out of business.
- The amount of capital affects returns for the owner (equity holders) ofthe bank
- A minimun amount of bank capital (bank capital requirements) is required by regulatory authorities (legal requirement)
Bank Capital Helps Prevent Bank Failure
When the bank capital decrease to zero or below, the bank will be collapsed
Four solutions
- Reducing its loans
- Sell some securities
- Borring from the Fed (Central bank)
- Borrowing from other banks (LIBOR, HIBOR)
How bank capital helps prevent bank failure ##
Amount of bank capital affects Return to Equity holders
ROA (return on assets)= net profit after taxes/assets
ROE (return on equity)= net profit after taxes/equity capital
EM (equity multiplier) = assets/euquity capital
ROE=ROA*EM
Debt-to-Equity ratio
How the Amount of bank capital affects returns to Equity holder ##
The equity holdrs in the Low Capital Bank are clearly a lot happier than the equity holders in the High Capital Bank because they are earing more than twice as high a return
Given the ROA, the lower the bank capital,
the higher the return for the owners of the bank
Trade-off Between Safety and REturns to Equity Holders
credit risks management ##
TOPIC 5 - credit risks management
Business of financial institutions will make loans. Therefore, their major risk with loans is the borrower will not repay.
This situation is called Credit risk
It also occurs Adverse selection and Moral hazard
Adverse selection
Those with the highest credit risk have the biggest incentives to borrow from others. (high risk--> high interest)
Moral hazard
The borrower has an incentive to engage in risky project to produce the highest payoff
Solutions------> ##
Screening and Monitoring
This situation leads to two information-producing activties by banks
Screening and Monitoring
Screening(AS)
Bank screen out the bad credit risks from the good ones so loads will be peofitable.
Collect reliable information from potential borrowers
Screening
Process
Process
The borrower fill out forms that elicit a great deal of information about your personal finances.
The bank uses this information to evaluate how good a credit risk you are by calculating your "credit score" - a ststistical measure derived from your answers that predicts whether you are likely to have trouble making your loan payments.
A loan officer is to decide whether you should be given the loan, it will collect your personal references or call your employer.
Monitoring (MH)
Monitoring
After a loan has obtained, the borrower may have an incentive to take on risky activities that make it less likely that the loan will be paid
Include restrivtive covenants in loan contract which prevent borrowers from from engaging in very risky activities.
By monitoring borrowers' activities to see whwther they are complying with the restrictive covenants and by enforcing the covenants if they are not, bank managers can make sure that borrowers are not taking on risks at the institution's expense
Long-Term customer Relationship ##
Long-Term customer Relationship
An additional way for banks managers to obtain information about borrowers is to establish long-term customer relationships.
Check at past activity in the accounts and learn quite a bit about the borrower.
The balances in the checking and saving accounts tells the loan office how liquid the potential borrower is and at what times of the year the borrower has a strong need for cash.
If the borrower has borrowed previously from the bank, the institution has a record of the loan payment. The cost of monitoring long-term customers are lower than those for new customers.
A firm with a previous relationship will find it easier to obtain a loan at low interest rate baceuse the bank has an easier time determining if 茂the potential borrower is a good credit risk or not
Collateral
Collateral , which is property promised to the lender as compensation if the borrower defaults, lessens the consequences of adverse selection because it reduce the lender's losses in the case of a loan default.
Compensating Balance
Compensating Balance ##
A firm receiving a loan must keep a required minium amount of funds in a checking account at the bank.
Help increase the likelihood that a loan will be paid of. They do this by helping the bank monitor the borrower and consquently minimize moral hazard
Make it easier for banks to monitor borrowers more effectively
interest-rate risk ##
The riskness of earning and returns that is associated with changes in interest rates
TOPIC 6-
interest-rate risk
Less than one year and variable rate mortgages
+
RSA
Securities
Loans
Fixed rates * %(Given)
RSL
Money market
Fed fund
Checkable deposits *% (Given)
Saving deposits *% (Given)
Calculation
If RSL > RSA , interest rate ^ --> Net income v
If RSL > RSA , interest rate v --> Net income ^
Income gap analysis (GAP)
Sensitivity of bank income to changes in interest rate is gap analysis (Income gap analysis)
GAP = RSA - RSL Basis point
#I = GAP * #i n basis point
--> 0.n%
#I = change in bank income
#i = change in interest rate
Income Gap Analysis
The money market
TOPIC 7 -
the money market
Common characteristics ##
- Sold in large denominations
- Low default risk
- One year or less of mature date
- An active secondary market
- wholesale markets
Why do we need the money market
To provide short-term loans and to accept short-term deposits
- Reserve requirement
- Interest-rate regulation
Why do we need the money market ##
The purpose of the Money Markets
Provide a low-cost source of funds to a firm
The purpose of the Money Markets
Participates in the Money Markets
Participates in the Money Markets
U.S. Treasury Department
is unique because it is always a demander of money market funds and never a supplier
Federal Reserve system
Responsibility for the money supply makes it the single most influential perticipant in the U.S. money market
Commercial Banks
Hold a larger percentage of U.S. government securities than any ohter group of financial institutions
The major issuer of negotiable certificates of deposit
Money market instruments
Money market instruments ##
Treasury Bills
Treasury Bills##
91-day 182-day 12-month maturities
Virtually zero default risk
The risk of unexpected changes in inflation is low because of the term to maturity
Very close to risk-free
The interest rate earned on Treasury bill securities is among the lowest in the economy
cal
Cal
Annualized yield = i yt = (F-P)/P*365/n
AP
Discount yield = i=(F-P)/F*360/n
DF
D<A
F=Face value
P=Purchase price
n=number of days until maturity
Negotiable Certificates Deposit
Bank-issued security that documents a deposit and specifies the interest rate and the maturity date
As opposed to a demand deposit
Denominations of nedotiable CDs range from
$100,000 to 10 million
Negotiable Certificates of Deposit
Commercial Paper
Commercial Paper ##
Unsecured promissory notes
Issued by large corporations with very good credit standings to raise short-term funds
Credit rating of the issueing company is of particular importance in determining the marketability of a commercial paper issue
Ｔｈｅ ｂｅｔｔｅｒ ｔｈｅ ｃｒｅｄｉｔ ｒａｔｉｎｇ ｏn a commercial paper issue, the lower the interest rate in the issue
Issued on a discounted basis (Like T-Bills)
Non Bank corporations use commercial paper extensively to finance the loans that they extend to their customers
regulation of banking
TOPIC 8 - regulation of banking
The risks faced by banks
- Liquidity Risk
The risk that bank will have insufficient funds to meet all damands for deposit withdrawal
"Borrow shout and lend long"
- Price risk
The possibility of asset prices changing in such a manner that the value of the assets are reduced
price change ( e.g. treasury securities)
- Default risk
The risk of loans not being repaid
influenced by the economic cycle for domestic lending and country-specific risks in the case of international lending
- Fraud and mismanagement
When bankers amke unauthorized or ummonitored loan to associates or relative, especially related to the purchase of property and businesses at inflated prices
Arguments for bank regulation
##
Argument for bank regulation
##
Reasons for regulating bank ##
To prevent bank runs
To prevent bank runs
Banks have liabilities that are very short-term (demand doposit) whilst their assets (mortgage loan) have a much longer term to maturity. This exposes the bank to a potential liquidity problem.
Whem a bank suffers a very large withdrawal of deposits (known as run) in a short space of time, then a solvent bank may become insolvent.
Bank runs are contagious
A run on one bank, which may be justified if the bank has been imprudent, may lend to a run on solvent banks bacause depositors are unable to distinguish between solvent and insolvent
This run mentaliy can quickly spread throughout the banking system
Where many banks are affected, the financial system may well collapse (systemic risk)
Bank runs are contagious
Lack of financial sophistication of the general public
Lacks the expertise to differentiate between safe and risk assets. This is worsened by the lack of information available for depositors to make adequate risk assessmens of bank
Deposits are held by almost everyone in developed economies and the public has come to expect some form of protection from government
Lack of financial sophistication of the general public
The central position of bank in the financial system
Only source of finance for a large number of borrowers (general public)
The central position of bank in the financial system
Manage the payments syatem.
If the banking system is trouble, the resultion financial disruption would be more serious than it would be with failure of other sectors of the economy
Costs of regulation ##
Costs of regulation
##
There are costs or negative effects associated with regulation
Including
The real resource costs incurred by the regulator and regulated
Regulator (employing staff to monitor banks)
Regulated (banks employing staff to produce
returns required by the regulator)
The danger that regulation is excessive, thus reducing competition and slowing the pace of financial innovation.
Increase the costs of entry into or exit from the market. This could have the effect of reducing competition making the existing firms less efficient.
summary
Summary
##
Perhaps the most convincing one is the lack of expertise and knowledge possessed by the individual depositor to assess the quality of the bank
Be argued that retail banking should be subject to fairly rigorous control whereas wholesale banking should be subject to a much lighter measure of prudential control.
Deposit Insurance
Deposit insruance provides a guarantee to depositors that in the event of bank failture, they will receive a proportion of their deposit from the deposit insurance funds.
HKD $500,000