FIN320 Midterm Study Guide （need to complete within 5 hours）

Introduc)on to Banking

Professor Lamont Black FIN320 Week 2

Fintech •  Peer-to-peer lending (marketplace lending)

–  Online loans funded by individuals

•  Crowdfunding –  Startups funded by a large group of investors –  Ini)al coin offerings (ICOs)

•  Collateral?

•  SoFi and TwiLer (new CEO)

•  Same informa)on? (FICO score) – asymmetric informa.on

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Financial System and Economic Performance

•  Financial development can promote economic development –  Efficient alloca)on of resources

•  History of U.S. –  Treasury Secretary Alexander Hamilton –  Bank of the United States in 1791

•  Private corpora)on with stock sold to public –  Stock and bond markets in NY, Boston, Philadelphia –  Establishment of other private banks

•  World Bank and emerging markets

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Fig 9.1: Finance and GDP

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Transac)on Costs, Adverse Selec)on, and Moral Hazard

•  Connec)ng borrowers + savers is not that easy

•  Problems facing small investors –  Transac)on costs (e.g., online stock commissions) –  Scale ($1000 bond) [see StockPile] –  Contrac)ng fees (legal) –  Informa.on costs (determining creditworthiness)

•  How financial intermediaries reduce transac)on costs –  Banks and mutual funds for small investors –  Economies of scale

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Problems of Adverse Selec)on and Moral Hazard

•  Financial health of borrower is cri)cal

•  Asymmetric informa)on: one party has beLer informa)on than the other

•  Adverse selec.on –  low-risk vs. high-risk borrowers (lemons problem)

•  Moral hazard – how borrowers use the funds (principal – agent)

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Solving Adverse Selec)on •  Regulatory informa)on disclosure (SEC)

–  Limited for small firms –  Does not capture “soh informa)on”

•  Collateral and Net Worth –  Skin in the game

•  Rela.onship banking (financial intermediaries) –  Local knowledge and exper)se –  Personal interac)ons –  Repeated business –  “Assess credit risk on the basis of private informa)on”

•  Contrast to securi)za)on (originate-to-distribute)

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Solving Moral Hazard

•  Good governance –  Aligning incen)ves of owners and managers –  Boards of directors (independent) –  Incen)ve pay (op)ons)

•  Bond covenants

•  How financial intermediaries reduce moral hazard –  Venture capital firms (large ownership stake) –  Private equity (restructure management)

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Banks and Informa)on

•  Banks screen borrowers to solve adverse selec)on

•  Banks monitor borrowers to solve moral hazard

•  This is screening and monitoring 9

Conclusions about Structure of U.S. Financial System

1.   Loans from financial intermediaries are the most important source of funds for small to medium-sized firms (SMEs).

2.  The stock market is a less important source of external funds to corpora)ons that is the bond market.

3.  Debt contracts usually require collateral or restric.ve covenants.

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Fig 9:2: Sources of Funds for SMEs

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Fig 9.3: Sources of Funds for Corpora)ons

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Good Time to Buy Bonds?

•  Beware interest rate risk

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Ch 10: The Economics of Banking

•  “Small Businesses Flock to the Bank of Bird-in- Hand” – Community banks – Vs. Global banks – Loans for less than $1 million

•  When does local maLer?

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The Bank Balance Sheet

•  Assets = Liabili)es + Shareholders’ Equity

•  Key asset = Loans •  Key liability = Deposits •  Shareholders’ Equity is Bank Capital

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Bank Liabili)es

•  Checkable deposits •  Nontransac)on deposits

–  Like 1-year Cer)ficate of Deposit (CD)

•  FDIC deposit insurance up to $250K!

•  Borrowings –  Federal funds market –  Repurchase agreements (repos) – [liquidity crisis]

•  Deposit or money market mutual fund (MMMF)?

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Rise-Fall-Rise of the Checking Account

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Bank Assets •  Reserves and other cash assets

–  Vault cash and Fed reserves –  Required reserves vs. Excess reserves

•  Securi)es –  Treasuries and other bonds –  No common stock of corpora)ons (vs. universal)

•  Loans –  Commercial and industrial loans (C&I) –  Consumer loans (personal and auto) –  Real estate loans (residen)al and commercial)

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Fig 10.1: Mix of Bank Loans 1973-2016

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Bank Capital

•  Bank Capital is shareholders’ equity or net worth (assets – liabili)es)

•  Capital is cri)cal to absorbing asset losses

•  Required capital ra.os are the most important form of bank regula)on

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Assets (uses of funds) Blank Blank Liabili.es + Bank capital (sources of funds) Blank Blank Blank

Blank Blank (Percentage of total assets)

Blank Blank (Percentage of total liabili.es plus capital)

Blank

Reserves and other cash assets Blank 10.6% Deposits Blank Blank 74.8%

Securi)es Blank 22.0 Checkable deposits Blank 12.1 Blank

U.S. government 4.4 Blank Nontransac)on deposits Blank 62.7 Blank

Mortgage-backed securi)es (MBS) 12.5 Blank Small-denomina)on )me deposits (CDs less than $100,000) plus savings deposits

56.2 Blank Blank

State and local government and other securi)es

5.1 Blank Blank Blank Blank Blank

Loans Blank 58.8 Blank Blank Blank Blank Commercial and industrial 12.3 Blank Large-denomina)on )me deposits (CDs greater

than $100,000) 6.5 Blank Blank

Real estate (including mortgages) 29.1 Blank Blank Blank Blank Blank

Consumer 9.7 Blank Borrowings Blank Blank 8.2 Interbank 1.2 Blank From banks in the U.S. Blank 0.5 Blank Other loans 6.5 Blank Other borrowings Blank 7.7 Blank Trading assets Blank 1.1 Other liabili)es Blank Blank 4.3 Other assets Blank 7.5 Bank capital (or shareholders’ equity) Blank Blank 12.7

Basic Opera)ons of a Commercial Bank

•  T-account for a $100 deposit

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Blank WELLS FARGO Blank Blank

Assets Blank Liabili.es Blank

Vault cash +$100 Checkable deposits +$100

Blank Blank Blank Blank

Blank WELLS FARGO Blank Blank

Assets Blank Liabili.es Blank

Required reserves +$10 Checkable deposits +$100

Excess reserves +$90 Blank Blank

Blank Blank Blank Blank

Blank WELLS FARGO Blank Blank

Assets Blank Liabili.es Blank

Reserves +$10 Checkable deposits +$100

Securi)es +$30 Blank Blank

Loans +$60 Blank Blank “the spread”

Bank Capital and Bank Profit

•  Net interest margin (NIM) is the difference between interest received on securi)es and loans and interest paid on deposits and debt, divided by total value of earning assets

•  Return on assets (ROA) is ra)o of aher-tax profit to bank assets

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After tax profit ROA

Bank assets −

=

Return on Equity

•  Return on equity (ROE) is ra)o of aher-tax profit to bank equity (capital)

•  Leverage is the ra)o of assets to capital

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After tax profit ROE

Bank capital −

=

Bank assets ROE ROA

Bank capital = ×

Leverage and Profitability

•  Leverage magnifies gains and losses

•  Managers of banks may have an incen)ve to use high leverage. –  Incen)ve pay for performance – Take on risk

•  Gambling with insured deposits

•  Capital requirements limit leverage

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10.4 Trends in US Commercial Banking

•  Early history of US Banking –  Na)onal banks –  Dual banking system

•  Bank panics, Federal Reserve, and FDIC

•  Interstate branch deregula)on and the rise of na)onwide banking

•  Expanding the boundaries of banking –  Off-balance sheet ac)vi)es –  Electronic-mobile banking

•  Crisis and TARP 26

TARP Recipients

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Bank Amount of Treasury investment

JPMorgan Chase $25 billion

Ci)group Inc. 25 billion

Wells Fargo & Company 25 billion

Bank of America Corpora)on 10 billion

Goldman Sachs 10 billion

Morgan Stanley 10 billion

PNC Financial Services Group, Inc. 8 billion

U.S. Bancorp 7 billion

SunTrust Banks, Inc. 5 billion

Capital One Financial Corpora)on 4 billion