Chapter 3

The Financial Institutions Industry

3.1 INTRODUCTION
◙ In financial economics, a financial institution acts as an
agent that provides financial services for its clients.
◙ Financial institutions generally fall under financial
regulation from a government authority.
Depository Institutions (DIs)
 DIs accept deposits from economic agents
(liability to them) and then on-lend these
funds to make direct loans or invest in
securities (assets)
 Income of DIs:
◦ Income generated from loans
◦ Income generated from investment in securities,
and
◦ Fee income
 BANKING SYSTEM

A banking system is a group or network of institutions

that provide financial services for us. These institutions
are responsible for operating a payment system,
providing loans, taking deposits, and helping with
investments.
Functions of Banking :
•To deposit funds and use our checking accounts
•Debit cards to pay our bills or make purchases
•Finance our cars and homes
•Distribute currency and establish money related
policies
Constituents of DIs
 DIs include:
◦ Commercial Banks
◦ Microfinance Institutions (MFIs)
◦ Saving Banks
◦ Credit unions
Asset/ Liability Problems of DIs
 Spread Income (margined Income)=
◦ Income from loan and Investment Less cost of its
funds (deposit and other sources)
 BANKING SYSTEM
• Conduct trades or deal with capital markets

• Obtain profit by charging more interests And

paying less interest on deposits
Types Of Banking or Financial Institutions
3.2 TYPES OF FINANCIAL INSTITUTIONS

◙ Common types of financial institutions include banks,

Insurance Co, Leasing Co, Investment Co, and Mutual
Funds.
Banks
◙ A bank is a commercial or state institution that provides
financial services, including
● issuing money in various forms,
● receiving deposits of money,
● lending money, and
● processing transactions and creating of credit.
TYPES OF FINANCIAL … CONT’D
Central Bank
☺A central bank, reserve bank or monetary authority,
is an entity responsible for the monetary policy of its
country.
☺Its primary responsibility include
→ maintain the stability of the national currency
and money supply,
→ controlling subsidized-loan interest rates, and
→ acting as a "bailout" lender of last resort to the
banking sector during times of financial crisis
TYPES OF FINANCIAL … Cont’d
Commercial Bank
☺A commercial bank accepts deposits from customers and
in turn makes loans.
☺Commercial banks also provide other services like
money transfer (both local and international), foreign
exchange services, etc.
Functions of Commercial Banks
1. Primary Functions (Accepting deposits and
lending money)
2. Secondary Functions (agency services and
general utility service)
Primary Functions of Comm. Banks
1. Accepting deposits
◦ Current or demand deposits
◦ Saving deposits
◦ Fixed or time deposits
2. Lending Money
◦ Overdrafts
◦ Cash credit
◦ Loans and Advances
◦ Discounting of bill of Exchange
Secondary Services of Comm. Banks
1. Agency services: as an agent banker renders
the following services
◦ Collection of cheques, drafts, and bill for their
customers
◦ The collection of standing orders, e.g., payment
of commercial gills, collection of dividend
warrants and interest coupons, payment of
insurance premiums, rents, etc
Secondary Functions:
Agency service (Cont’d)
◦ Conduct of stock exchange transaction such as
purchase and sale of securities for the customers,
◦ Acting as executor and trustee,
◦ Providing income tax services,
◦ Conduct of foreign exchange business
Secondary Functions :
2. General Utility service
 Safe keeping of valuables
 Issue of Commercial letters of credit and

travellers’ cheque,
 Collecting trade information from foreign

countries for their customers

 Arrange business tours
 etc
TYPES OF FINANCIAL … Cont’d

Investment Bank
☺Investment banks help companies & governments and
their agencies to raise money by issuing and selling
securities in the primary market.
☺They assist public and private corporations in raising
funds in the capital markets (both equity and debt), as well
as in providing strategic advisory services for mergers,
acquisitions and other types of financial transactions.
TYPES OF FINANCIAL … CONT’D
Saving Bank
☺A savings bank is a financial institution whose primary
purpose is accepting savings deposits. It may also
perform some other functions.
Micro Finance Bank
☺For the purpose of poverty reduction program, such kind
of banks is working in the different countries with the
contribution of UNOs or World Bank.
TYPES OF FINANCIAL … Cont’d
Islamic Bank
◘ Islamic banking refers to a system of banking or banking
activity that is consistent with Islamic law (Sharia)
principles and guided by Islamic economics.
◘ In particular, Islamic law prohibits usury, the collection
and payment of interest, also commonly called ‘riba’ in
Islamic discourse.
3.4 COMMERCIAL BANKS
 Represent the largest group of depository institutions
measured by asset size.
 Perform functions similar to those of savings institutions and
credit unions - they accept deposits (liabilities) and make
loans (assets).
 Loans are broader in range, including consumer, commercial,
international, and real estate.
 Regulated separately from savings institutions and credit
unions.
COMMERCIAL BANKS … CONT’D
 A bank is a commercial or state institution that provides
financial services, including issuing money in various forms,
receiving deposits of money, lending money and processing
transactions and the creating of credit.
 Some banks (called Banks of issue) issue banknotes as legal
tender.
 There are also financial institutions that provide selected
banking services without meeting the legal definition of a
bank.
COMMERCIAL BANKS … CONT’D
 Many banks offer ancillary financial services to
make additional profit; for example, most banks
also rent safe deposit boxes in their branches.
 Currently in most jurisdictions commercial banks

are regulated & require permission to operate.

 Operational authority is granted by bank

regulatory authorities which provides rights to

conduct the most fundamental banking services
such as accepting deposits & making loans.
COMMERCIAL BANKS … CONT’D
 A bank generates a profit from the differential between the
level of interest it pays for deposits and other sources of funds,
and the level of interest it charges in its lending activities. This
difference is referred to as the spread between the cost of
funds and the loan interest rate.
 Apart from the usual saving & loan services, CBs provide
other services like international banking, foreign exchange,
insurance, investments, wire transfers, etc.. However, lending
activities still provide the bulk of a commercial bank's income.
BANK SIZE & CONCENTRATION
 Community development banks: regulated banks that
provide financial services and credit to underserved
markets or populations.
 Federal funds market - an interbank market for short-term
borrowing and lending of bank reserves.
 Money center bank - a bank that relies heavily on
nondeposit or borrowed sources of funds
 Offshore Banks - banks located in jurisdictions with low
taxation and regulation. Many offshore banks are
essentially private banks.
BANK SIZE & CONCENTRATION
 Merchant banks were traditionally banks which engaged in
trade financing.
 The modern definition, however, refers to banks which
provide capital to firms in the form of shares rather than
loans.
 Unlike Venture capital firms, they tend not to invest in new
companies.
 The amount of capital a bank is required to hold is a function
of the amount and quality of its assets. Major Banks are
subject to the Basel Capital Accord promulgated by the Bank
for International Settlements.
BANK SIZE & ACTIVITIES
 Large banks have easier access to capital markets and can
operate with lower amounts of equity capital.
 Large banks tend to use more purchased funds (such as
fed funds) and have fewer core deposits
 Large banks are more diversified and generate more
noninterest income.
Chapter Preview
 Banks play an important role in channeling
funds (about $6 trillion annually) to finance
productive investment opportunities.

 They provide loans to businesses, finance

college educations, and allow us to purchase
homes with mortgages.
Chapter Preview
 We examine how banking is conducted to
earn the highest profits possible. In the
commercial banking setting, we look at
loans, balance sheet management, and
income determinants. Topics include:
◦ The Bank Balance Sheet
◦ Basics of Banking
◦ General Principles of Bank Management
◦ Off-Balance Sheet Activities
◦ Measuring Bank Performance
The Bank Balance Sheet
 The Balance Sheet is a list of a bank’s assets
and liabilities

 Total assets = total liabilities + capital

The Bank Balance Sheet
 A bank’s balance sheet lists sources of bank
funds (liabilities) and uses to which they are
put (assets)

 Banks invest these liabilities (sources) into

assets (uses) in order to create value for their
capital providers
 The Bank Balance Sheet
Lowest cost
source of
funds--
payable on
demand
Pay no
interest
Deposit
Secondary
with no
reserves
check
writing
Discount loans
74% of Fed Funds,
Assets
Corporate Loans
have grown by
factor of 10 since
1960 as % of Liab

Bank Equity = Assets - Liabilities,

listed as Liab because Bank owes this
to owners. Also includes Loan
Flow of funds (tab down to commercial banks)
Loss
http://www.federalreserve.gov/releases/z1/current/z1r-4.pdf
Reserves
Basics of Banking
Asset transformation is, for example, when a
bank takes your savings deposits and uses the
funds to make, say, a mortgage loan.
Banks tend to “borrow short and lend long” (in
terms of maturity).
Basics of Banking
 T-account Analysis:
◦ Deposit of $100 cash into First National Bank
Basics of Banking
 Deposit of $100 check

 Conclusion: When bank receives deposits,

reserves  by equal amount; when bank loses
deposits, reserves  by equal amount
Basics of Banking
 Conclusion: When bank receives deposits, reserves
 by equal amount; when bank loses deposits,
reserves  by equal amount
 Basics of Banking– Required
Reserves
 Deposit of $100 cash into First National
Bank assuming Required Reserve ratio of
10%

─ $10 of the deposit must remain in reserves to

meet federal regulations (10% reserve req.).
─ Now, the bank is free to work with the $90 in its
asset transformation function. In this case, the
bank loans the $90 to its customers.
Basics of Banking
 Loaning out excess reserves
General Principles
of Bank Management
Now let’s look at how a bank manages its
assets and liabilities. The bank has four
primary concerns:
1. Liquidity management
2. Asset management
◦ Managing credit risk
◦ Managing interest-rate risk
3. Liability management
4. Managing capital adequacy
 Principles of Bank Management
Liquidity Management
Reserves requirement = 10%, Excess reserves = $10 million
Assets Liabilities
Reserves $20 million Deposits $100 million
Loans $80 million Bank Capital $10 million
Securities $10 million Deposit outflow
- 10 m Deposit outflow of $10 million - 10 m
Assets Liabilities
Reserves $10 million Deposits $90 million
Loans $80 million Bank Capital $10 million
Securities $10 million

• With 10% reserve requirement, bank still has excess reserves

of $10 million: no changes needed in balance sheet
 Liquidity Management
No excess reserves
Assets Liabilities
Reserves $10 million Deposits $100 million
Loans $90 million Bank Capital $10 million
Securities - 10 m $10 million - 10 m
Deposit outflow of $10 million
Assets Liabilities
Reserves $0 million Deposits $90 million
Loans $90 million Bank Capital $10 million
Securities $10 million
 With 10% reserve requirement, bank has $9 million
reserve shortfall
Liquidity Management
1. Borrow from other banks or corporations
Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans $90 million Borrowings $9 million +9m

Securities $10 million Bank Capital $10 million

2. Sell securities
Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans $90 million Bank Capital $10 million
Securities - 9m $1 million 1
7
-
4
1
Liquidity Management
3. Borrow from Fed
Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans $90 million Discount Loans $9 million +9m

Securities $10 million Bank Capital $10 million

4. Call in or sell off loans

Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans - 9m $81 million Bank Capital $10 million
Securities $10 million

 Conclusion: Excess reserves are insurance against above

4 costs from deposit outflows
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
17-42
Asset Management
 Asset Management: the attempt to earn the
highest possible return on assets while
minimizing the risk.
1. Get borrowers with low default risk, paying high
interest rates
2. Buy securities with high return, low risk
3. Diversify
4. Manage liquidity
Liability Management
 Liability Management: managing the
source of funds, from deposits, to CDs,
to other debt.

1. Important since 1960s

2. No longer primarily depend on deposits
3. When see loan opportunities, borrow or issue CDs
to acquire funds
Capital Adequacy Management
1. Bank capital is a cushion that prevents bank
failure. For example, consider these two
banks:
Capital Adequacy Management
What happens if these banks make loans or
invest in securities (say, subprime mortgage
loans, for example) that end up losing money?
Let’s assume both banks lose $5 million from
bad loans.
Capital Adequacy Management
 Impact of $5 million loan loss

Conclusion: A bank maintains reserves to

lessen the chance that it will become
insolvent.
Capital Adequacy Management
So, why don’t banks hold want to hold a lot of
capital??
2.Higher is bank capital, lower is return on
equity
◦ ROA = Net Profits/Assets
◦ ROE = Net Profits/Equity Capital
◦ EM = Assets/Equity Capital
◦ ROE = ROA  EM
◦ Capital , EM , ROE 
Capital Adequacy Management
3. Tradeoff between safety (high capital) and
ROE
4. Banks also hold capital to meet capital
requirements. The Basel Committee on
Banking Supervision sets minimum capital
requirements — the ratio of bank capital to
risk weighted assets.
The Practicing Manager:
Strategies for Managing Capital: what should a
bank manager do if she/He feels the bank is
holding too much capital?
 Sell or retire stock
 Increase dividends to reduce retained

earnings
 Increase asset growth via debt (like CDs)
The Practicing Manager:
Reversing these strategies will help a manager
if she/he feels the bank is holding too little
capital?
 Issue stock
 Decrease dividends to increase retained

earnings
 Slow asset growth (retire debt)
How a Capital Crunch Caused a
Credit Crunch in 2008
The slowdown in growth of credit triggered a
crunch in 2007—credit was hard to get. What
caused the credit crunch?
Housing boom and bust led to large bank

losses, including losses on SIVs (structured

investment vehicles)— which had to be
recognized on the balance sheet.
The losses reduced bank capital.
How a Capital Crunch Caused a
Credit Crunch in 2008
Banks were forced to either (1) raise new capital
or (2) reduce lending.
Guess which route they chose?
Why would banks be hesitant to raise new
capital (equity) during an economic downturn?
Off-Balance-Sheet Activities
1. Loan sales (secondary loan participation)
2. Fee income from
◦ Foreign exchange trades for customers
◦ Servicing mortgage-backed securities
◦ Guarantees of debt
◦ Backup lines of credit
3. Trading Activities and Risk Management Techniques
◦ Financial futures and options
◦ Foreign exchange trading
◦ Interest rate swaps
 All these activities involve risk and potential conflicts
 What's a C.D.O. (Collateralized debt obligations)?
Measuring Bank Performance
Much like any business, measuring bank
performance requires a look at the income
statement. For banks, this is separated into
three parts:
Operating Income
Operating Expenses
Net Operating Income

Note how this is different from, say, a

manufacturing firm’s income statement.
Banks’ Income Statement (a)
Banks’ Income Statement (b)
 Recent Trends in Bank Performance
Measures (a)
 ROA = Net Profits/
Assets
 ROE = Net Profits/
Equity Capital
 NIM = [Interest
Income – Interest
Expenses]/ Assets

 http://www2.fdic.g
ov/qbp/
 Recent Trends in Bank Performance
Measures (b)
 ROA = Net
Profits/ Assets
 ROE = Net
Profits/ Equity
Capital
 NIM = [Interest
Income – Interest
Expenses]/ Assets
Chapter Summary
 The Bank Balance Sheet: we reviewed the
basic assets, liabilities, and bank capital that
make up the balance sheet
 Basics of Banking: we examined the

accounting entries for a series of simple bank

transactions
Chapter Summary (cont.)
 General Principles of Bank Management: we
discussed the roles of liability, reserves,
asset, and capital adequacy management for
a bank
 Off-Balance Sheet Activities: we briefly

reviewed some of the (risky) activities that

banks engage in that don’t appear on the
balance sheet or income statement
Chapter Summary (cont.)
 Measuring Bank Performance: we reviewed
the income statement for a banking
organization and key ratios commonly used
for measuring and comparing bank
performance