The Economics of Banking

WHAT HAPPENS WHEN LOCAL BANKS STOP LOANING MONEY?

• In the recovery from the financial crisis of 2007–2009, banks had become extremely cautious in making
loans.
• Banks were turning away borrowers with flawed credit histories and avoiding industries that were hard hit
by the recession.
• As the value of real estate declined, the collateral that small businesses could use to borrow against also
declined.
Key Issue and Question

Issue: During and immediately following the 2007–2009 financial crisis, there was a sharp increase in the number of
bank failures.
Question: Is banking a particularly risky business? If so, what types of risks do banks face?
Understand bank balance sheets.

• The key commercial banking activities are taking in deposits from savers and making loans to households
and firms.
• A bank’s primary sources of funds are deposits, and primary uses of funds are loans, which are summarized
in the bank’s balance sheet.
Balance sheet A statement that shows an individual’s or a firm’s financial position on a particular day.

• The typical layout of a balance sheet is based on the following accounting equation:

• Assets = Liabilities + Shareholders’ equity.

Asset Something of value that an individual or a firm owns; in particular, a financial claim.
Liability Something that an individual or a firm owes, particularly a financial claim on an individual or a firm.
Bank capital The difference between the value of a bank’s assets and the value of its liabilities; also called
shareholders’ equity.
Bank Liabilities
Checkable Deposits
Checkable deposits Accounts against which depositors can write checks, also called transaction deposits.
• Demand deposits are checkable deposits on which banks do not pay interest.
• NOW (negotiable order of withdrawal) accounts are checking accounts that pay interest.
 • Checkable deposits are liabilities to banks and assets to households and firms.
Nontransaction Deposits
• The most important types of nontransaction deposits are savings accounts, money market deposit accounts
(MMDAs), and time deposits, or certificates of deposit (CDs).
• Checkable deposits and small-denomination time deposits are covered by federal deposit insurance.
• CDs of less than $100,000 are called small-denomination time deposits. CDs of $100,000 or more are called
large-denomination time deposits.
CDs worth $100,000 or more are negotiable, which means that investors can buy and sell them in secondary
markets prior to maturity.
Federal deposit insurance A government guarantee of deposit account balances up to $250,000.
Borrowings
• Banks often make more loans than they can finance with funds they attract from depositors.
• Bank borrowings include short-term loans in the federal funds market, loans from a bank’s foreign branches
or other subsidiaries or affiliates, repurchase agreements, and discount loans from the Federal Reserve
System.
• Although the name indicates that government money is involved, the loans in the federal funds market
involve the banks’ own funds. The interest rate on these interbank loans is called the federal funds rate.
• With repurchase agreements—otherwise known as “repos,” or RPs—banks sell securities, such as Treasury
bills, and agree to repurchase them, typically the next day. Repos are typically between large banks or
corporations, so the degree of counterparty risk is small.

Households hold less in

checking accounts
relative to other financial
assets than they once
did, partly due to the
wealth effect.

As wealth has increased

over time, households
have been better able to
afford to hold assets,
such as CDs, where their
money is tied up for a
while but on which they
earn a higher rate of
interest.

Bank Assets
Bank assets are acquired by banks with the funds they receive from depositors, with funds they borrow, with funds
they acquired initially from their shareholders, and with profits they retain from their operations.
Reserves and Other Cash Assets
Reserves A bank asset consisting of vault cash plus bank deposits with the
Federal Reserve.
Vault cash Cash on hand in a bank; includes currency in ATMs and deposits with other banks.
Required reserves Reserves the Fed requires banks to hold against demand deposit and NOW account balances.
Excess reserves Any reserves banks hold above those necessary to meet reserve requirements.
• Excess reserves can provide an important source of liquidity to banks, and during the financial crisis, bank
holdings of excess reserves soared.
• Another important cash asset is claims banks have on other banks for uncollected funds, which is called cash
items in the process of collection.
Securities
• Marketable securities are liquid assets that banks trade in financial markets.
• Banks are allowed to hold securities issued by the U.S. Treasury and other government agencies, corporate
bonds that received investment-grade ratings when they were first issued, and some limited amounts of
municipal bonds, which are bonds issued by state and local governments.
• Because of their liquidity, bank holdings of U.S. Treasury securities are sometimes called secondary reserves.
• In the United States, commercial banks cannot invest checkable deposits in corporate bonds or common
stock.
Loans
• The largest category of bank assets is loans. Loans are illiquid relative to marketable securities and entail
greater default risk and higher information costs.
• There are three categories of loans:
(1) loans to businesses—called commercial and industrial, or C&I, loans;
(2) consumer loans, made to households primarily to buy automobiles, furniture, and other goods; and
(3) real estate loans, including both residential and commercial mortgages.
• The development of the commercial paper market in the 1980s meant that banks also lost to that market
many of the businesses that had been using short-term C&I loans.
The Changing Mix of
Bank Loans, 1973–2010
The types of loans granted by banks have changed
significantly since the early 1970s.

Real estate loans have grown from less than one-third of

bank loans in 1973 to two-thirds of bank loans in 2010.

Commercial and industrial (C&I) loans have fallen from

more than 40% of bank loans to less than 20%.

Consumer loans have fallen from more than 27% of all

loans to about 20%.

Other Assets

Other assets include banks’ physical assets, such as

computer equipment and buildings. This category also includes collateral received from borrowers who have
defaulted on loans.

Bank Capital
• Bank capital, also called shareholders’ equity, or bank net worth, is the difference between the value of a
bank’s assets and the value of its liabilities.
• In 2010, for the U.S. banking system as a whole, bank capital was about 12% of bank assets.
• A bank’s capital equals the funds contributed by the bank’s shareholders through their purchases of stock
the bank has issued plus accumulated retained profits.
• Note that as the value of a bank’s assets or liabilities changes, so does the value of the bank’s capital.
a. Use the entries to construct a balance sheet similar to the one in Table 10.1, with assets on the left side of the
balance sheet and liabilities and bank capital on the right side.
b. The bank’s capital is what percentage of its assets?
Describe the basic operations of a commercial bank.

The Not-So-Simple Relationship between Loan Losses and Bank Profits

• During the term of the loan, if the bank decides that the borrower is likely to default, the bank must write
down or write off the loan.
• Banks set aside part of their capital as a loan loss reserve to anticipate future loan losses and avoid large
swings in its reported profits and capital from write-offs.
• During the financial crisis of 2007–2009, banks set aside enormous loan loss reserves as they anticipated
write-downs on mortgage-related loans.
• The SEC has argued that banks will sometimes increase their loan loss reserves more than is justified during
an economic expansion, when defaults are relatively rare. The banks can then draw down the reserves
during a recession, evening out their reported profits.
• If true, this practice would amount to “earnings management,” which is prohibited under accounting rules
because it may give a misleading view of the firm’s profits.
Bank Capital and Bank Profits

Net interest margin The difference between the interest a bank receives on its securities and loans and the interest
it pays on deposits and debt, divided by the total value of its earning assets.

• An expression for the bank’s total profits earned per dollar of assets is called return on assets.

Return on assets (ROA) The ratio of the value of a bank’s after-tax profit to the value of its assets.

After-tax profit
ROA = 
Bank assets
To judge how a bank’s managers are able to earn on the shareholder’s investment, we use the return on equity.

Return on equity (ROE) The ratio of the value of a bank’s after-tax profit to the value of its capital.

After-tax profit
ROE = 
Bank capital
• ROA and ROE are related by the ratio of a bank’s assets to its capital:

Bank assets
ROE = ROA  ×
Bank capital
• Managers of banks and other financial firms may have an incentive to hold a high ratio of assets to capital.

• The ratio of assets to capital is one measure of bank leverage, the inverse of which (capital to assets) is called
a bank’s leverage ratio.
Leverage A measure of how much debt an investor assumes in making an investment.
Bank leverage The ratio of the value of a bank’s assets to the value of its capital, the inverse of which (capital to
assets) is called a bank’s leverage ratio.
• A high ratio of assets to capital—high leverage—is a two-edged sword: Leverage can magnify relatively small
ROAs into large ROEs, but it can do the same for losses.
• Moral hazard can contribute to high bank leverage.
• If managers are compensated for a high ROE, they may take on more risk than shareholders would prefer.
• Federal deposit insurance has increased moral hazard by reducing the incentive depositors have to monitor
the behavior of bank managers.
• To deal with this risk, government regulations called capital requirements have placed limits on the value of
the assets commercial banks can acquire relative to their capital.
Explain how banks manage risk.
Managing Liquidity Risk

Liquidity risk The possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a
reasonable cost.
• Banks reduce liquidity risk through strategies of asset management and liquidity management.
• Asset management involves lending funds in the federal funds market, usually for one day at a time.
• A second option is to use reverse repurchase agreements, which involve a bank buying Treasury securities
owned by a business or another bank while at the same time agreeing to sell the securities back at a later
date, often the next morning. These very short term loans can be used to meet deposit withdrawals.
• Liability management involves determining the best mix of borrowings from other banks or businesses using
repurchase agreements or from the Fed by taking out discount loans.
Managing Credit Risk

Credit risk The risk that borrowers might default on their loans.
Diversification
• By diversifying, banks can reduce the credit risk associated with lending too much to a single borrower,
region, or industry.
Credit-Risk Analysis
Credit-risk analysis The process that bank loan officers use to screen loan applicants.
• Banks often use credit-scoring systems to predict whether a borrower is likely to default. Historically, the
high-quality borrowers paid the prime rate. Today, most banks charge rates that reflect changing market
interest rates instead of the prime rate.
Prime rate Formerly, the interest rate banks charged on six-month loans to high-quality borrowers; currently, an
interest rate banks charge primarily to smaller borrowers.
Collateral
• Collateral, or assets pledged to the bank in the event that the borrower defaults, is used to reduce adverse
selection.
• A compensating balance is a required minimum amount that the business taking out the loan must maintain
in a checking account with the lending bank.
Credit Rationing
Credit rationing The restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the
given interest rate.
• Loan and credit limits reduce moral hazard by increasing the chance a borrower will repay.
• If the bank cannot distinguish the low- from the high-risk borrowers, high interest rates risk dropping the
low-risk borrowers out of the loan pool, leaving only the high-risk borrowers—a case of adverse selection.
Monitoring and Restrictive Covenants
• Banks keep track of whether borrowers are obeying restrictive covenants, or explicit provisions in the loan
agreement that prohibit the borrower from engaging in certain activities.
Long-Term Business Relationships
• The ability of banks to assess credit risks on the basis of private information on borrowers is called
relationship banking.
 • By observing the borrower, the bank can reduce problems of asymmetric information. Good borrowers can
obtain credit at a lower interest rate or with fewer restrictions.
Managing Interest-Rate Risk
Interest-rate risk The effect of a change in market interest rates on a bank’s profit or capital.
A rise (fall) in the market interest rate will lower (increase) the present value of a bank’s assets and liabilities.

Measuring Interest-Rate Risk: Gap Analysis and Duration Analysis

Gap analysis An analysis of the difference, or gap, between the dollar value of a bank’s variable-rate assets and the
dollar value of its variable-rate liabilities.
• Gap analysis is used to calculate the vulnerability of a bank’s profits to changes in market interest rates.
• Most banks have negative gaps because their liabilities—mainly deposits—are more likely to have variable
rates than are their assets—mainly loans and securities.
Duration analysis An analysis of how sensitive a bank’s capital is to changes in market interest rates.
• If a bank has a positive duration gap, the duration of the bank’s assets is greater than the duration of the
bank’s liabilities. In this case, an increase in market interest rates will reduce the value of the bank’s assets
more than the value of the bank’s liabilities, which will decrease the bank’s capital.

Reducing Interest-Rate Risk

• Banks with negative gaps can make more adjustable-rate or floating-rate loans. That way, if market interest
rates rise and banks must pay higher interest rates on deposits, they will also receive higher interest rates on
their loans.
• Banks can use interest-rate swaps in which they agree to exchange, or swap, the payments from a fixed-rate
loan for the payments on an adjustable-rate loan owned by a corporation or another financial firm.
• Banks have available to them futures contracts and options contracts that can help hedge interest-rate risk.
FINANCIAL INTERMEDIATION
• The mechanism whereby surplus funds from ultimate savers are matched to deficits incurred by ultimate
borrowers

• The process by which ultimate savers are matched to ultimate borrowers.

• Saving = Income – Consumption

• Typically decisions to save are made independently of decisions to invest

• Financial intermediaries are institutions that borrow funds from people who have saved and make loans to
other people.

• Financial asset transformation

• More important source of finance than financial markets, engage in process of indirect finance.

Chanelling of Funds

• In a simple economy we have firms and households

• Households are the savers and firms are the investors.

• The mechanism by which households save is by demanding securities from firms

• The mechanism by which firms invest is by supplying securities to households

• These securities are claims to the assets of the firm

Direct Finance

• Lending and borrowing can occur as a result of direct transacting.

• But there are costs associated with direct finance

• Search costs – searching for potential transactors

• Verification costs – costs in evaluating investment proposals

 • Monitoring costs – costs of monitoring the actions of borrowing

• Enforcement costs – costs of enforcing contracts

Efficient Direct Finance

• Some of these costs can be reduced through the organisation of a market.

• Direct financing requires the existence of an efficient securities market.

• However not all costs are minimised through a securities market.

• An additional issue is that the maturity period of finance for the firm is long term.

• The maturity period of the household is mostly short term.

• The maturity mismatch of households and firms provide the incentive for the development of intermediated
finance.