final report
menmen03
Lecture3-Banks-Jun24.pptxFinancial Institutions & Market
FIN 353 –Summer 2019
Snow Han
SFSU
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Types of Banks
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Agenda
Traditional business - Balance Sheet
Performance - Income statement
*non traditional business Off –Balance Sheet activities
*Measuring bank performances
*Asset Management /Liability Management
we examine how banking is conducted to earn the highest profits possible.
In the commercial banking setting, we look at the bank’s balance sheet, balance sheet management, Off-Balance Sheet Activities, and how to Measuring Bank Performance
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The Bank Balance Sheet
The Balance Sheet is a list of a bank’s assets and liabilities
Total assets = total liabilities + capital
Use of Fund = Source of Fund
Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers (shareholder) & debt holder
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Sources of Capital
Liability
Debt claim
Deposit
Borrowing
Equity
Ownership claim
Stock
Retained earnings
Source: Liabilities
Liabilities come from
Deposits (Various Deposits)
a. Checkable Deposits / Demand Account
you can demand at any time
b. Non Transaction Deposits/ non-checkable account
you can’t write checks
b.1. Savings
b.2. Time deposit (fixed maturity)
Borrowing
from Federal Reserve Systems (central bank), other banks, Federal Home Loan Banks (FHLBank System), or other companies
Checkable Deposits/ Demand Account accounts that allow the owner (depositor) to write checks to third parties
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Source: Capital
Bank Capital
the source of funds supplied by the bank owners
About 11% of assets.
Raised by selling equity or retained earnings from previous operation.
Bank Balance Sheet
Source: Liabilities
Liabilities come from
Deposits (Various Deposits)
a. checking account
you can write checks
Checkable Deposits / Demand Account
demand at any time
b. saving account
you can’t write checks
Non Transaction Deposits/ non-checkable Account
b.1. Savings
b.2. Time deposit (fixed maturity)
Checkable Deposits/ Demand Account accounts that allow the owner (depositor) to write checks to third parties
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accounts that allow the depositor to write checks to third parties
Depositor can demand the money at any time
non-interest earning checking accounts (reserve)
money-market deposit accounts (MMDAs) (no reserve requirement)
interest earning negotiable orders of withdrawal (NOW) accounts (reserve)
For depositor - safe and liquid, but offer low or no interest rate.
Lowest cost funds for bank
Make up about 2% of bank liabilities, >50% of banks’ operating expenses
Source: Liabilities
- Checkable Deposits
Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks.
The amount of net transaction accounts subject to a reserve requirement ratio of 3 percent was set under the Monetary Control Act of 1980 at $25 million. This "low reserve tranche" is also adjusted each year (see table of low reserve tranche amounts and exemption amounts since 1982). Net transaction accounts in excess of the low reserve tranche are currently reservable at 10 percent.
It used to be the most important source of bank money during the 1960s.
MMDAs & checking accounts are payable on demand, that is if the depositor show up at the bank and request their money by making a withdraw, the bank must pay them immediately, Similarly for receiving a check. If someone present the check at a bank and ask for payment, the bank must pay the money immediately
Asset for depositor but liability for banks
Effective April 24, 1986, money market deposit accounts (MMDA), which had previously been subject to full reserve requirements, were made subject to the transitional phase-in program of the Monetary Control Act. In addition, the order of application of the exemption applied to reservable liabilities was changed. These actions reduced required reserves by about $260 million.
Investors can let go some interest benefit in exchange for the liquidity
NOW accounts are essentially checking accounts where you earn interest on the money you have deposited. With a NOW account, the bank or credit union has the right to require at least seven days written notice of a withdrawal, though this is rarely done.
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Source: Liabilities - other deposits
Nontransaction Deposits (a.k.a. non-checkable deposits):
Can’t write check for purchase/transaction
accounts from which the depositor cannot write checks
savings accounts (you can withdraw your money at any time subject to restrictions)
time deposits (certificates of deposit - CDs)
a. < $100,000 /$250,000
b. >= $100,000 / $250,000
No immediate liquidity for depositor, but higher interest rates
Highest cost of funding, but most stable for bank
primary source of bank liabilities (69%)
Saving accounts were once the most common type of non transaction
make up to six pre-authorized transfers or withdrawals
For time deposits, the maturities ranges from several months to five years. You can not withdraw early unless you pay significant penalty.
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Borrowings:
from central banks, other banks, FHLBank system, or other companies
discount loans/advances (from the Fed)
fed funds (from other banks)
interbank offshore dollar deposits (Eurodollars from other banks)
From bank holding companies (parent companies)
Advances / loans from FHLBank to support housing mortgage
Other arrangement with companies: repurchase agreements (e.g.: “repos”)
make up 12-18% of bank liabilities
Source: Liabilities
- borrowings
A bank holding company is a company that controls one or more banks, but does not necessarily engage in banking itself. – e.g: morgan Stanley (subject to Fed supervision). Banks – also subject to FDIC
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Bank Balance Sheet
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Usage: Assets
How banks use their money?
Banks use their capital (money) in order to create value for their capital providers (shareholder) & debt holder
In other words, to earn income
Assets reflect the bank’s operation , and how it makes money
Cash and Reserves
Securities (bonds) - investment
Loans (various loans)
Other assets
Bank Balance Sheet
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Usage: Assets – Reserve
Reserves:
funds physically held in the bank’s account with the Fed
a.k.a. Vault cash/reserves/fed funds – most liquid
Two types of reserves
1. Required reserves:
represent what is required by law under current required reserve ratios , which is a certain fraction of the deposits the bank get
0, 3% , 10%
2. Excess Reserves: Any reserves beyond this amount.
Why banks hold reserves?
First, regulation reasons, second, cushion for banks to meet its obligation when depositor come to the bank to withdraw money or when a check is written on an account
https://www.federalreserve.gov/monetarypolicy/reservereq.htm
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Usage: Assets – cash
Cash items in Process of Collection:
checks deposited at the bank
funds from other bank have not yet been transferred.
Deposits at Other Banks:
usually deposits from domestic banks (local) at international banks (large)
referred to as correspondent banking
Small banks’ assets in exchange for services (e.g.: foreign exchange transaction, assistance with securities purchases)
Sometimes checks can take days to transfer.
Generally speaking, the reasons domestic banks employ correspondent banks include limited access to foreign financial markets and the inability to service client accounts without opening branches abroad. Correspondent banks can act as intermediaries between banks in different countries or as an agent to process local transactions for clients when they are traveling abroad Most international wire transfers are executed through the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network. Knowing there is not a working relationship with the destination bank, the originating bank can search the SWIFT network for a correspondent bank that has arrangements with both banks.
Upon finding a correspondent bank having arrangements with both sides of the transfer, the originating bank sends the transferred funds to its nostro account held at the correspondent bank. The correspondent bank deducts its transfer fee, usually $25 to $75, and transfers the funds to the receiving bank in Japan. In transactions such as this, the correspondent bank adds value in two ways. It alleviates the need for the domestic bank to establish a physical presence abroad and saves the work of setting up direct arrangements with other financial institutions around the world.
Not a recent development, but unique to the U.S.
Many small banks need “large bank” services
Large banks provide these services
In return, small banks deposit money with large banks
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Usage: Assets – cash items
Reserves, Cash items in Process of Collection, and Deposits at Other Banks are collectively referred to as Cash Items in our balance sheet
Account for 16% of assets
The most liquid assets of a bank
Usage: Assets – securities (investment)
Securities (all debts):
U.S. government bond securities (t-bills, t-bonds, t-notes)
agency debt ?
municipal debt
other (non-equity) securities (e.g. commercial papers)
-* structured debt instrument
Short-term Treasury debt (t-bills) is a secondary reserve because of its high liquidity.
These make-up about 22% of assets (10% of commercial banks’ revenue)
banks are only allowed to hold debt-securities (commercial banks, S&L , credit union – thrifts)
So securities will be all debt instruments
Are bonds default free???
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Usage: Assets – Loans
Loans:
commercial loans, real estate mortgages, consumer loans, interbank loans (federal funds)
Not very liquid- wait till maturity or sell
Not very safe – default risk
THUS, BANKS Charge higher interest rate
a bank’s primary income-earning assets
Generate More than half of banks’ revenue (highest return)
About 53% of assets
Differences in the balance sheets of different depository institutions is primarily in the type of loans in which they specialize
S&L and mutual savings banks, specialize in residential mortgage / house mortgage, while credit union specialize in consumer/car loans
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Usage: Assets - others
Other Assets:
bank buildings, computer systems, and other equipment.
Bank Balance Sheet
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Bank Balance Sheet
Asset Transformation
Asset transformation is, for example, when a bank takes your savings deposits and uses the funds to make, say, a mortgage loan
So now you’re asset (deposits) is transformed into the bank’s assets (mortgage loan)
Deposits are relatively short term (< = 10 years), while mortgage loans are long term (30, even 50 years)
Banks tend to “borrow short and lend long” (in terms of maturity).
T- Accounts Analysis
1. Deposit of $100 cash into First National Bank (checking account)
2. withdrawal of $100 cash from First National Bank (checking account)
When bank receives deposits, reserves by equal amount; when bank loses deposits, reserves by equal amount
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T- Accounts Analysis
3. Deposit of $100 checks into First National Bank from Second National Bank
When bank receives deposits, reserves by equal amount; when bank loses deposits, reserves by equal amount
Later, for first national bank, the cash arrives;
So Cash item in process of collection reduce by 100, vault cash increase by 100
We could combine the two steps for first national bank in to one.
When bank receives deposits, reserves by equal amount; when bank loses deposits, reserves by equal amount
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Reserve Requirement
This simple analysis gets more complicated when we add bank regulations to the picture.
Deposit of $100 cash into First National Bank (assume 10% reserve ratio with checkable accounts)
Bank is free to work with the $90. The bank loans the $90 to its customers
$10 of the deposit must remain with the bank to meeting federal regulations.
Bank is free to work with the $90
The bank loans the $90 to its customers
What will happen if the depositor come in and ask for his 100 dollars?
The bank have to give it immediately, - manage a bank
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Off-Balance-Sheet Items
Off-balance-sheet items are contingent assets and liabilities that may affect a commercial bank’s balance sheet and/or income statement
OBS items become on-balance-sheet items only if some future event occurs
Loan commitments
Letters of credit
commercial letters of credit
standby letters of credit
Loans sold
Derivative contracts
OBS ACTIVITIES
LOAN COMMITMENT - Commitment to future lending
up-front fees are charged for making funds available
commitment fees are charged on the unused portion of a loan commitment
Fixed interest term
LETTER OF CREDITS
Commercial letter of credit
Standby letter of credit
LOANS SOLD
With vs. without recourse
DERIVATIVES
Hedging vs. speculating
Loan commitment - The bank must stand ready to supply the contractual amount at anytime over the commitment period.
Only when the borrower actually draws on the commitment do the loans made under the commitment appear on the balance sheet
Commercial letters of credit—
client buys goods and services
bank promises to pay seller on behalf of client
seller presents bank with draft
Standby letters of credit—
bank guarantees client’s financial performance of some contract
client’s counterparty relies on bank’s creditworthiness, not borrower’s
beneficiary presents draft to bank if client does not perform
Common uses of SLCs—
securities offerings
credit enhancement of other debts
completion of projects
Loans sold:
No recourse – if the loan the bank sold should go bad, the buyer of the loan must bear the full risk
With Recourse
– if the loan the bank sold should go bad, the buyer could put the loan back to the bank
- the loan sales always presents a contingent credit risk to the seller (bank)
In Reality, the recourse or nonrecourse nature of the loan sales is quite ambiguous
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Other Fee-BASED SERVICES
Non-traditional services
Correspondent banking (item 3): sale of bank services to other financial institutions
Trust services: management of client wealth eg: assist in the management of pension fund
Non-banking financial services: investments and insurance (BHC)
TRUST services
Only the largest bank has sufficient staff to offer trust services
As fiduciary, bank manages assets for beneficiary
Over half of individuals’ assets are managed by bank trust services
Trust function is strictly segregated from other bank functions
Common trust services—
administration of estates
management of pension assets
registration and transfer of securities
administration of bond indenture
Glass Steagell Act – separate investment, insurances and traditional banking services
Investment services, insurance, and other financial products
Deregulation (Gramm-Leach- Bliley Act - 1999) allows these services, provided clients clearly understand they are not covered by deposit insurance
E.g: BOA & Merrill Lynch
Banks can compete directly with mutual funds and securities firms
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Relationship between balance sheet & Income statement
Traditional business for banks are reflected in their balance sheet
Take deposit & borrowing
make loans and purchase securities (investments)
Interest expenses – from 1. deposit & borrowing
Interest income – from 2. securities and loans
Interest expenses, interest incomes, and other non-interest income and expenses (such as salaries, overheads…etc.) are reported in income statement
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Banks’ Income Statement (a)
The Income Statement
Interest income (II) is the sum of interest and fees earned on all assets.
Interest on loans, interest earned on investment securities
Interest expense (IE) is the sum of interest paid on all interest bearing liabilities.
Interest paid on deposits,
payment for federal funds, repurchase agreements, and borrowed money (borrowings)
Gross interest income minus gross interest expense is labeled net interest income
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The Income Statement – non traditional services
Non-Interest Income (NII) includes:
Fiduciary activities – trust service (i.e. asset management)
Deposit service charges
Trading, venture capital and securitization income
*Investment banking, advisory, brokerage and underwriting fees and commissions
*Insurance commission fees and income
Net servicing fees
Other net gains (losses) e.g: capital gains from securities transaction
Non-Interest Expense (NIE) consists of:
Personnel, occupancy and other operating expenses
Intangible amortizations and goodwill impairment
Gross non-interest income minus gross non-interest expense is labeled net non-interest income
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Banks’ Income Statement (a)
Banks’ Income Statement (b)
The Income Statement
Net interest income = Interest income (II) – Interest expense (IE)
Net noninterest income = Noninterest income (NII) – Noninterest expense (NIE)
Income before taxes and extraordinary items (EBTEI) = Net interest income + Net noninterest income – Provision for loan losses
Net income = EBTEI – income taxes – extraordinary items
All together,
Net income = (II-IE) + (NII – NIE) - Provision for loan losses – income taxes – extraordinary items
Net interest margin is interest income minus interest expense divided by earning assets
Net non-interest margin is non-interest income minus non-interest expense divided by earning assets
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