Financial Institution Management

Lecture 4 Part II Bank Balance Sheet and Basic Management Principles

Main Contents

Bank balance sheet

Liabilities Assets

Basic banking General principles of bank management

Liquidity management Asset management Liability and capital adequacy management

4.2 Bank Balance Sheets

Bank Balance Sheet

Banks take deposits from the public and lend out to earn interests. All business activities are reflected in the banks balance sheet (). A balance sheet includes a list of liabilities () and assets ().

Liabilities: sources of funds Assets: uses of funds

Liabilities of a Bank

Liabilities:

Checkable deposits

CDs are Bank accounts that allow the owner to write checks to third parties. The deposits are payable on demand; that is, if a depositor shows up at the bank and requests to withdraw, or if a person who receives a check written on an account from the bank, presents that check at the bank, the bank must pay them immediately.

Liabilities of a Bank

Liabilities (Continued):

Non-transaction deposits:

Owners can not write checks on non-transaction deposits, but the interest rates paid on these deposits are usually higher than checkable deposits. Two basic types of non-transaction deposits: Saving accounts () Time deposits ()

Liabilities of a Bank

Liabilities (Continued):

Borrowings: Banks also obtain funds by borrowing from the central bank, other banks and corporations. Bank capital (equities): Another important source of bank funds is from the contribution of shareholders of the bank. The bank raises money from shareholders by issuing new stocks.

Assets of a Bank

Assets:

Reserves (): All banks must hold some of the funds to meet its obligations when deposits are withdrawn.

The required reserved ratio () are determined by the central banks. In HK, now the ratio is 18%. Sometimes, banks hold additional reserves, called excess reserves. Reserves do not bring interest incomes to banks.

Assets of a Bank

Assets (Continued)

Loans: Banks make their profits primarily by issuing loans. Loans are less liquid and bear a probability of default. Securities: Banks also use the funds to buy securities, such as government and corporate bonds, corporate stocks.

4.3 Basic Banking

Basic Banking

The basic operation of a bank.

Banks make profits by selling liabilities with one set of characteristics and uses the proceeds to buy assets with a different set of characteristics. For example, a saving deposit held by one person can provide funds to enable the bank to make a mortgage loan to another person. This process is often referred to as asset transformation.

Basic Banking: Cash Deposit

We also can use the balance sheet to analyze the operation of a bank. Example I: First National Bank opens today and Jane Brown is its first customer. She opens a checking account with $100 bill. The bank uses it as a reserve.
Assets Liabilities

Reserve

$100

Checkable deposit

$100

Basic Banking: Check Deposit

Example II: If Jane opens her account in First National Bank with a check written on account at Second National Bank, then
First National Bank Assets Liabilities Second National Bank Assets Liabilities

Reserves

$100

Checkable deposits

$100

Reserves

-$100 Checkable deposits

-$100

Basic Banking

Bank can rearrange its balance sheet to make a profit. Example III: Because the reserve pays no interest, the First National Bank decides to make a loan to someone else. But the required reserve ratio is 10%.
Assets Reserve $100 Reserve $10 Loan $90 Liabilities Checkable deposit $100 Checkable deposit $100

4.4 Banking Management Principles

General Principles of Bank Management

Bank managers usually have four concerns:

Liquidity management: A bank must keep enough cash on hand and buy sufficiently liquid assets to make sure the bank has enough ready cash to pay its depositors. Asset management: A bank must pursue a low level of risk by acquiring assets with low default rate and diversifying asset holdings Liability management: Acquire funds at low cost Capital adequacy management: A bank must prepare enough capital.

Liquidity Management and Role of Reserves

First National Bank (10% required reserve ratio):

Assets Reserve $20M Loans $80M Securities $10M Liabilities Deposit $100M Bank Capital $10M

Now a bank is experiencing a deposit outflow of $10M. A lot of customers show up to withdraw their money.

Liquidity Management and Role of Reserves

Balance sheet after the outflow:

Assets Reserve $10M Loans $80M Securities $10M Liabilities Deposit $90M Bank Capital $10M

Conclusion: If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet.

Liquidity Management and Role of Reserves

If a bank holds insufficient excess reserves, the situation is quite different. For example, before the outflow, the bank makes additional loans of $10M, instead of holding it as excess reserves.
Assets Reserve $10M Loans $90M Securities $10M Liabilities Deposit $100M Bank Capital $10M

Liquidity Management and Role of Reserves

When a deposit outflow of 10M occurs:

Assets Reserve Loans Securities $0M $80M $10M Liabilities Deposit $90M Bank Capital $10M

Reserve cannot match the requirement.

Liquidity Management and Role of Reserves

There are four options to fix the reserve shortfall in the last slide:

Borrowing from other banks or companies Sell securities Borrow from the central bank Call in/sell off loans

Asset-Liability Management

Asset and liability managements are two sides of a coin for the management of a modern bank. Asset management emphasizes how to make highest possible return using banks funds. Liability management emphasizes how to reduce the financial costs when a bank seeks for liabilities.

Asset Management

To maximize its profits, a bank must simultaneously seek the highest returns possible on loans and securities, reduce risk, and make adequate liquidity by holding liquid assets.

Find borrowers who will pay high interest rates and unlikely to default. Purchase securities with high returns and low risk. Diversification. Manage liquidity

Liability Management

On the other hand, banks are also actively seeking cheapest possible liabilities.

Before the 1960s, this part was widely ignored. The primary source for banks funds was checkable deposits, which by law could not pay any interests. So banks could not compete with one another to attract these deposits by paying interests on them. Meanwhile, the interbank loan market was not well established. It limited the source of liabilities for a bank. Nowadays, because of the mature markets for Negotiable Certificate Deposits and overnight interbank loans, banks have more flexibilities to manage their liabilities to seek for a cheapest financing way.

Capital Adequacy Management

Bank also need sufficient capital to prevent bank failure.

High Capital Bank Reserve $10M Loans $90M Deposit $90M Capital $10M Low Capital Bank Reserve $10M Deposit $96M Loans $90M Capital $4M

Consider a situation in which both banks lend a telecom company $5M and lose all of them.

Capital Adequacy Management

The balance sheets will look like:

High Capital Bank Reserve $10M Loans $85M Deposit $90M Capital $5M Low Capital Bank Reserve $10M Deposit $96M Loans $85M Capital $-1M

Low Capital Bank can not absorb the loss using its capital. It will be forced to shut down and go bankruptcy.

Capital Adequacy Management

Bank manager also need to pursue a good return on the capital because the manager is elected by the board of directors and should be on behalf of the interests of shareholders. Two measures of banks profitability:

ROA (Return of Assets):

ROE (Return of Equity):

Capital Adequacy Management

If define the equity multiplier (EM) then

Bank manager faces a tradeoff: the stockholders want to put less capital to enjoy a high ROE; too little capital would enlarge the danger of bankruptcy.

Capital Adequacy Management

Measures to increase the ratio of capital:

Issuing new equity Reducing dividends to shareholders Reducing the assets by making fewer loans or by selling off securities

Measures to decrease the ratio of capital:

Buying back some of the stock Paying out higher dividends to shareholders Issuing more deposits