CB Balance Sheets OBS Items

Financial Markets and Institutions: Lecture 6

Anurag Singh

Instituto Tecnológico Autónomo de México (ITAM)

Spring 2021

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CB Balance Sheets OBS Items

The Course Outline

Introduction and Motivation

Types of Financial Institutions

Risk: Types of Risk and Measuring the Risk

Managing Risk

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CB Balance Sheets OBS Items

The Course Outline

Introduction and Motivation

Types of Financial Institutions

Depository Institutions

Finance Companies

Securities Firms and Investment Banks

Mutual Funds and Hedge Fund Companies

Insurance Companies

Risk: Types of Risk and Measuring the Risk

Managing Risk

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Topic to be Covered Today

Financial Intermediation & Financial Institutions: An Overview

Commercial Banks (CB)

Size, Structure and Composition of Commercial Banking Industry

Financial Statement Analysis of Commercial Banks

Balance Sheet

Off-Balance-Sheet (OBS) Assets and Liabilities

Income Statements

Financial Statement Analysis Using A Return on Equity Framework

Regulation

Industry Performance

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Balance Sheets: Liabilities and Equity Capital

Deposits

Deposits
Demand Deposits: Transaction accounts held by individuals,
corporations, partnerships, and governments (pay no explicit interest)
NOW Accounts: Corporations hold minimum balance accounts, called
negotiable order of withdrawal (NOW) accounts, that pay some interest

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Balance Sheets: Liabilities and Equity Capital

Deposits

Deposits
MMDAs: Banks offer Money market deposit accounts (MMDAs) so as
to remain competitive with money market mutual funds such as
Vanguard and Fidelity (pay higher rates on MMDAs than on NOW
accounts)
Other Savings Deposits
Deposits in Foreign Offices: Corporations that need to do
international transactions and activities
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Balance Sheets: Liabilities and Equity Capital

Deposits

Deposits
Retail CDs: Fixed-maturity instruments with face values under
$100,0001
Wholesale CDs: Negotiable instruments that allows depositors to
liquidate their position in these CDs by selling them in the secondary
market rather than having to hold them to maturity or early cash in
1
offers an interest rate premium in exchange for the customer agreeing to leave a lump-sum deposit untouched for a
predetermined period of time
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Balance Sheets: Liabilities and Equity Capital

Borrowed Funds

Borrowed Funds
Federal Funds Purchased and RPs:
Bank that purchases fed funds shows them as a liability on its balance
sheet
The RP market is a highly liquid and flexible source of funds for banks
needing to increase their liabilities and to offset deposit withdrawals
(collateralized fed funds transaction)
Can be rolled over each day if the counterparty is willing

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Balance Sheets: Liabilities and Equity Capital

Borrowed Funds

Borrowed Funds
Other Borrowed Funds:
Banker’s acceptances (BAs)
Commercial paper
Medium-term notes
Discount window loans
Subordinated Notes and Debentures: 5 to 7 year range
Other Liabilities: Accrued interest, deferred taxes, dividends payable
etc

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Balance Sheets: Liabilities and Equity Capital

Equity Capital

Equity Capital
Preferred Stocks
Common Stocks
Surplus and Additional Paid-in Capital
Retained Earnings
Regulations require banks to hold a minimum level of equity capital to
act as a buffer against losses from their on- and off-balance-sheet assets

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Off-Balance-Sheet Assets and Liabilities

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Off-Balance-Sheet Assets and Liabilities

Off-balance-sheet (OBS) items are contingent assets and liabilities

that may affect the future status the balance sheet

Generally invisible to readers (sometimes present in footnotes)

Major categories:
Loan commitments
Letters of credit
Loans sold
Derivative securities

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Off-Balance-Sheet Assets and Liabilities

Loan commitments

Most commercial and industrial loans are made by firms that take
down (or borrow against) prenegotiated lines of credit or loan
commitments
Contractual commitment by a bank to loan to a customer a certain
maximum amount (say, $10 million) at given interest rate terms (say,
12 percent) over a period of time (say, 5 years) over which the
borrower has the option to take down this loan
FI charges up-front fee, commitment fee (for any unused commitment
balances at the end of the period)
Only when the borrower actually draws on the commitment do the
loans made under the commitment appear on the balance sheet

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Off-Balance-Sheet Assets and Liabilities

Commercial Letters of Credit and Standby Letters of Credit

Commercial letters of credit are widely used in both domestic and

international trade
In a shipment of goods between a U.S. importer and a foreign
exporter, the bank’s role is to provide a formal guarantee that
payment for goods shipped or sold will be forthcoming regardless of
whether the buyer of the goods defaults on payment
Standby letters of credit perform an insurance function similar to
commercial letters of credit (not necessarily trade related)
FI may guarantee that a real estate development will be completed in
some interval of time

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Off-Balance-Sheet Assets and Liabilities

Loans Sold

Loans that a bank has originated and then sold to other investors that
may be returned (sold with recourse) to the originating institution in
the future if the credit quality of the loans deteriorates
Banks operate more as loan brokers than as traditional asset
transformers
When loan is sold with recourse, loan sales present a long-term
off-balance-sheet or contingent credit risk to the seller
Buyer of the loan holds an option to put the loan back to the seller,
which the buyer can exercise should the credit quality of the
purchased loan materially deteriorate

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Off-Balance-Sheet Assets and Liabilities

Derivative Contracts

Banks take futures, forward, swap, and option positions for hedging
and other purposes
Credit risk and default risks—counterparty to one of these contracts
may default on payment obligations
Default risk is much more serious for forward contracts
(non-standard) than for futures contracts (standardized)
Standardized option contracts are virtually default risk free
Specialized options, such as interest rate caps, some elements of
default risk exist
Swaps are OTC instruments normally susceptible to default risk

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Question

(Discuss) Going back to the balance sheet of “Heartland Bank and

Trust” and ”Bank of America” from the slides, Can we calculate
“Return on Assets”? What about “Return on Equity”?
(Discuss) Do we need more information to calculate ROA and ROE?
What is equity to asset ratio (shareholder equity ratio) for two
banks?2
Let us say that the regulation needs banks to have a minimum of
12% of their assets funded by equity. Do both the banks follow?
(Discuss) Let us say “Bank of America” is a representative large bank
and “Heartland Bank and Trust” is a representative small bank.
What might be the reason for one bank to have higher ratio than the
other (as observed)?
2
The shareholder equity ratio shows how much of the company’s assets are funded by equity shares. The lower the ratio
result, the more debt a company has used to pay for its assets.
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