Financial Markets and Institutions

Lecture 7: Depository Institutions

Dr. Mary Dawood

Lecturer in Economics

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 Outline

The Depository Institutions

The Bank’s Balance Sheet
Bank Balance Sheet
Bank Liabilities: Sources of Funds
Bank Assets: Uses of Funds
Basic Bank Operations
Cash Deposit
Cheque Deposit
Cash Withdrawal
Making Loans
Purchase of Securities
Composite Bank Operation
Measuring Bank Profitability
Risk Management

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 The Depository Institutions1

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 Commercial Banks

Banks are profit-seeking financial institutions

Their main operations are:

▶ pooling the savings of individuals and corporations in the form
of (on-demand, saving, time) deposits

▶ using pooled funds to grant credit to consumption and

production units

▶ investing the rest in securities issued by gov and corporations in

order to make profits

To satisfy the needs of savers and borrowers banks “borrow short

and lend long ” ⇒ Asset Transformation Process: transforming
short-term deposits into long-term loans

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 Commercial Banks

To make profits banks borrow at low i, as the funds are short-term,

and lend at high i, as the funds are long-term

Bank Profit = lending rate – deposit rate

To prevent banks from lending all their deposits (causing

insolvency in case of withdrawals), central bank imposes a
“required reserve ratio” that is to be kept in bank’s vault

For more precaution against deposit withdrawals, banks also keep

voluntary reserves “excess reserves” in their vault

The remainder of deposits after subtracting all reserves are used to

make loans and invest in securities

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 The Bank’s Balance Sheet2

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 Bank Balance Sheet

The balance sheet is an accounting record in the shape of a

T-account, which lists:
▶ assets side of all bank properties and uses of funds
▶ liabilities side of all bank sources of funds
▶ bank capital, which reflects the bank’s net worth

Banks invest their liabilities (sources) into assets (uses) in order to

create value for their capital providers

Banks obtain funds from individual depositors and businesses, and

by borrowing from other financial institutions and through the
financial market

Balance sheet identity: Total Assets = Total Liabilities + Capital

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 Bank Balance Sheet

The difference between a bank’s assets and liabilities is bank

capital, or net worth

▶ net worth is the value of the bank to its owners

▶ is obtained by selling stocks or from previous retained earnings
▶ provides protection against a sudden drop in the value of assets
(e.g. due to loan defaults) or unexpected withdrawals
▶ it provides some insurance against insolvency

Bank’s profits come from service fees + difference between what it

pays for its liabilities and the return it receives on its assets

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 Bank Balance Sheet

Assets Liabilities

Reserves Checkable deposits

Cash in process of collection Non-transaction deposits

Securities Borrowings

Loans Bank Capital

Other assets

Total Assets Total Liabilities

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 Bank Liabilities: Sources of Funds

The sources of funds that a bank can obtain include:

▶ internal funds: bank capital

▶ external funds: liabilities towards others, which consist of:

1. Checkable deposits

2. Non-transaction deposits

3. Borrowings

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 Bank Liabilities: Sources of Funds

1. Checkable deposits
bank accounts that allow depositors to write cheques on them
to third parties
can be withdrawn on demand without notice
pay no (very low) interest, as they are the riskiest funds

2. Non-transaction deposits
are the primary source of bank funds, as they are the safest
funds which can be used in interest-baring investments
pay interests because they have specific maturity dates (the
longer the maturity the higher the interest)
include: some saving deposits, time deposits, and CDs

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 Bank Liabilities: Sources of Funds

3. Borrowings
Banks can issue and sell long-term bonds to obtain funds from:
▶ other banks which have excess reserves in interbank market
▶ central bank, called discount loans
▶ repurchase agreements (repos) in financial market

eg

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 Bank Assets: Uses of Funds

The asset side of the balance sheet shows what banks do with the
funds they raise

Assets can be divided into four broad categories:

1. Cash items

2. Securities

3. Loans

4. Other assets: e.g. buildings, computers, equipment, etc.

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 Bank Assets: Uses of Funds

1. Cash Items reserves dont pay interest as they come from total depositts

a) Reserves
CB requires a ratio of deposits to be held as reserves in
vault cash or as deposits at the central bank
Banks can also voluntarily keep excess reserves in their vault
Cash is most liquid assets, but does not generate any return

b) Cash items in process of collection: cheques written on

another bank take time to be collected from the other
account ⇒ uncollected funds

c) Deposits at other banks: usually deposits from small banks

at larger banks (referred to as correspondent bank deposits)

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 Bank Assets: Uses of Funds

2. Securities

Securities are the second largest component of bank assets

Banks can invest in:

▶ government securities (T-bills / T-bonds)
▶ corporate bonds only certain types of banks can use this
▶ other (non-equity) securities

A substantial portion (especially T-bills) are very liquid - can be

sold quickly and at low cost if the bank needs cash

Securities can, therefore, be referred to as secondary reserves

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 Bank Assets: Uses of Funds

3. Loans
are the primary assets (source of bank profits), accounting for
over 50% of total assets

Loans can be divided into four main categories:

a) Business loans called commercial and industrial (C&I) loans
b) Real estate loans called mortgages
c) Consumer loans, like car and credit card loans
d) Interbank loans

Loan types differ in their level of liquidity

They are subject to default risk, thus require high interest

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 Bank Assets: Uses of Funds

3. Loans (cont.)
Main difference between various kinds of depository institutions
is the composition of their loan portfolios
▶ Commercial banks make loans primarily to businesses
▶ Savings banks provide mortgages to individuals
▶ Credit unions specialise in consumer loans

Commercial banks became more involved in real estate loans

The creation of mortgage-backed securities (MBS) meant that

banks could sell the mortgage loans they made

However, since the financial crisis, banks seem to have reduced

their real estate exposure

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 Bank Assets: Uses of Funds

Securitisation of Mortgages
▶ Securitisation is the process of pooling various assets that
generate a stream of payments and transform them into a
security (e.g. bond) that gives the holder a claim on those
payments (instead of coupons)

▶ Securitization of mortgages developed because of the problems

of dealing with single mortgages: high default risk, low liquidity

▶ MBS: mortgages are packed together to form a pool, and then

one or more debt obligations are issued backed by the cash flows
generated from the pool of mortgage loans

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 Bank Assets: Uses of Funds

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 Basic Bank Operations3

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 Basic Bank Operations

The main bank operation is asset transformation by which banks

borrow short (deposits) and lend long (credit)

Banks also trade in securities and may borrow from CB, other
banks or corporations

Each of these operations affects either or both sides of the bank

balance sheet so as to restore its balance

We want to investigate the effect of some basic bank operations:

▶ cash and cheque deposit
▶ deposit withdrawals
▶ making loans
▶ investing in securities

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 Cash Deposit

when a bank receives cash deposits of £1000:

▶ liability side (deposits) ↑

▶ assets side (reserves) ↑

Assets Liabilities

Reserves +1000 Deposits +1000

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 Cheque Deposit

when a bank receives cheque deposits of £1000:

▶ deposits ↑

▶ cash in process of collection ↑

Assets Liabilities

Cash in Process +1000 Deposits +1000

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 Cash Withdrawal

when a client withdraws £100 from his account:

▶ deposits ↓

▶ reserves ↓

Assets Liabilities

Reserves −100 Deposits −100

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 Making Loans

when a bank extends a loan of £1000:

▶ loans ↑

▶ reserves ↓

Assets Liabilities

Reserves −1000

Loans +1000

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 Purchase of Securities

when a bank purchases securities of £500:

▶ securities ↑

▶ reserves ↓

Assets Liabilities

Reserves −500

Securities +500

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 Composite Bank Operation

when a bank receives a deposit of £1000, keeps RR of 10%

and ER of 20%, and gives the rest out as loans

Assets Liabilities

Required Reserves +100 Deposits +1000

Excess Reserves +200

Loans +700

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 Measuring Bank Profitability4

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 Measures of Profitability
profit=lending rate-deposit rate+fEES
There are three main measures of bank profitability:
1. return on assets (ROA)
2. return on equity (ROE)
3. net interest margin

The first two are key financial ratios used to evaluate performance
of firms in general, while the third is an industry-specific metric

Another important measure for banks is the loan-to-assets ratio:

▶ banks with a high ratio derive more income from loans, while
banks with low ratio derive more income from more-diversified,
non-interest-bearing sources, e.g. asset trading
▶ banks with lower ratios may fare better when interest rates are
low or credit is tight during economic downturns

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 Measures of Profitability
if ROA is 7,for every pound/dollar it made 70 cents profits

Return on assets (ROA)

▶ ROA is a measure of how efficiently a particular bank uses its
assets

▶ It is calculated as the ratio of net after-tax income to total bank

assets
net after-tax profits
ROA =
total bank assets
▶ It indicates the per-pound profit a bank earns on its assets

▶ This is less important to bank owners than the return on their

own investment

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 Measures of Profitability

Return on equity (ROE)

▶ ROE is a measure of how efficiently a particular bank uses its
capital

▶ It is calculated as the ratio of net after-tax income to bank

capital
net after-tax profits
ROE =
bank capital
▶ ROA and ROE are related to leverage, i.e. the ratio of bank
assets to bank capital
bank assets
ROE = ROA ×
bank capital

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 Measures of Profitability

Net Interest Margin

▶ The net interest income is related to the fact that banks pay
interest on their liabilities and receive interest on their assets

▶ Deposits and bank borrowing generate interest expenses;

securities and loans generate interest income

▶ The difference between the two is net interest income

▶ Net interest income expressed as a percentage of total assets is

the net interest margin
net interest income
NIM =
total bank assets

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 Risk Management5

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 Ranking of options which banks can use
1)attract deposits
2)sell securities
Types of Bank Risk 3)interbank
4)sell loans/call-in loans
5)central bank(lender of last resirt)

Banking is risky because depository institutions are highly

leveraged and due to the nature of their activities

Banks are exposed to several types of risk during their operation:

1. Liquidity risk

2. Credit risk

3. Interest-rate risk

4. Trading risk

5. Other risks

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 Types of Bank Risk

1. Liquidity risk
It is the risk of sudden withdrawals of large deposits, i.e. sudden
demand for liquid funds

Even if a bank has positive net worth, illiquidity can still drive it
out of business

The riskiest are checkable deposits which can be withdrawn at

any time without notification ⇒ pay little or no interest

The safest are time deposits as the bank knows in advance

when they will mature ⇒ pay higher interest

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 Types of Bank Risk

1. Liquidity risk (cont.)

The bank can manage liquidity risk by:
▶ holding sufficient excess reserves
▶ adjusting its assets or its liabilities

Example: assume the following balance sheet of a bank holding

£5 million ER, with 10% RR

Assets Liabilities
Reserves 15 million Deposits 100 million
Loans 100 million Borrowings 30 million
Securities 35 million Bank Capital 20 million

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 Types of Bank Risk

1. Liquidity risk (cont.)

On the asset side, a bank has several options:
▶ sell a portion of its securities portfolio

▶ sell some of its loans to other banks

▶ refuse to renew a customer loan that has come due

(calling-in loans) limitig loans a customer can take is call in loans

Banks prefer to adjust the liability side

▶ borrow either from the central bank or from another bank

▶ attract additional deposits

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 Types of Bank Risk

2. Credit risk
It is the risk that a bank’s loans will not be repaid, also called
default risk

i.e. the borrowers fail to meet their obligations towards the bank

To manage credit risk, banks use a variety of tools:

▶ diversify asset portfolio, i.e. make a variety of different loans
to spread the risk (difficult for specialized banks)

▶ require collateral and compensating balances

▶ check the creditworthiness of borrowers

▶ monitor borrowers to reduce moral hazard

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 Types of Bank Risk

3. Interest-rate risk
A bank’s liabilities tend to be short-term, while assets tend to
be long term

The mismatch between the two sides of the balance sheet

creates interest-rate risk

If a bank has more rate-sensitive liabilities than assets, an

increase in i will cut into bank’s profits

To manage interest-rate risk, banks need to:

▶ closely match maturity of rate-sensitive assets & liabilities

▶ use derivatives (interest-rate swaps, options, futures)

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 Types of Bank Risk

4. Trading risk
Banks hire traders to actively buy and sell securities, loans, and
derivatives using a portion of the bank’s capital

The possibility of losses when buying and selling financial

instruments is called trading risk, or market risk

Traders normally share in the profits, but banks pay for losses
⇒ moral hazard as traders take more risk than banks would

Thus, the bank needs to:

▶ limit degree of risk any individual trader is allowed to assume
▶ closely monitor traders and the changes in financial markets

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 Types of Bank Risk
Ranking of options which banks can use
1)attract deposits
2)sell securities
3)interbank
5. Other risks 4)sell loans/call-in loans
5)central bank(lender of last resirt)
Foreign exchange risk
▶ comes from holding assets denominated in one currency and
liabilities denominated in another

Sovereign risk
▶ arises from government intervention in bank operations

Operational risk
▶ failure in computer system, fire, strike, etc.

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