Chapter Objectives

• Explain what a balance sheet and a T-account are.

What is a balance sheet and what are the major types

of bank assets and liabilities?
 ASSETS = LIABILITIES + EQUITY

Uses of Funds = Sources of Funds

Assets = Debt Financing + Equity Financing

Resources = Borrowings + Ownership stakes

Resources = Lenders claims + Owners’ claims

 ASSETS = LIABILITIES + EQUITY

Assets: Liabilities:
Reserves Deposits owed to customers
Secondary reserves Borrowings owed to debt financers
Loans made to customers
Other Equity:
Shareholders’ equity
 Key Takeaways
 A balance sheet is a financial statement that lists what a company owns,
its assets or uses of funds, and what it owes, its liabilities or sources of
funds.
 Major bank assets include reserves, secondary reserves, loans, and other
assets.
 Major bank liabilities include deposits, borrowings, and shareholder
equity.
 Chapter Objectives
• Explain what banks do in five words and also at length.

In five words, what do banks do? Without a word

limitation, how would you describe what functions
they fulfill?
 ASSETS

Reserves: cash and deposits at the Fed

Required reserves + excess reserves = total reserves
Secondary reserves: Government and liquid
securities
Loans: commercial, consumer, to other banks via
Fed Funds or check clearing
Collateralized: mortgage, auto, call loan, etc.
Other property, equipment, etc.
 LIABILITIES

Liabilities:
Deposits
Transaction deposits: checking,
Non-transaction deposits: savings, Short term, Fixed
etc
Time deposits: CDs
Borrowings
from banks via Fed Funds,
from Federal Reserve via discount window
 EQUITY

Equity:
Shareholders’ equity
Common stock
Preferred stock
Retained earnings
 ASSETS = LIABILITIES + EQUITY
Assets: Liabilities:
Reserves: cash and deposits at the Fed Deposits
Required reserves + excess reserves = Transaction deposits: checking,
total reserves Non-transaction deposits: savings,
Secondary reserves Government and Time deposits: CDs
liquid securities Borrowings
Loans: commercial, consumer, to other from banks via Fed Funds,
banks via Fed Funds or check from Federal Reserve via discount
clearing window
Collateralized: mortgage, auto, call Equity:
loan
Shareholders’ equity
Other property, equipment, etc Common stock
Preferred stock
Retained earnings
 Key takeaways
• Banks: lend (1) long (2) and (3) borrow (4) short (5).
• Like other financial intermediaries, banks are in the business of
transforming assets, of issuing liabilities with one set of characteristics to
investors and of buying the liabilities of borrowers with another set of
characteristics.
• Generally, banks issue short-term liabilities but buy long-term assets.
• This raises specific types of management problems bankers must be
proficient at solving if they are to succeed.
 Chapter Objectives
• Describe how bankers manage their banks’ balance sheets.
• Explain why regulators mandate minimum reserve and capital ratios.

What are the major problems facing bank managers

and why is bank management closely regulated?
Bankers must manage their assets and liabilities to ensure

Liquidity Liquidity management

Profit Asset management
Profit Liability management
Financing Capital adequacy
management
Net deposit outflow (inflow) Sell (buy) assets
• high transaction costs
 Sell (extend) loans
Reserve ratio decreases • adverse selection
Sell (buy) securities
(increase)
Call in (extend) loans
 • high opportunity costs
Increase (decrease) reserves Increase (decrease) deposits
• high transaction costs and
 added operating costs
Borrow from discount window
(Fed)
in the cheapest way possible Borrow from (lend to) Fed Funds
(other banks)
• Risk vs. Return: Default rate vs. Interest earned

• Diversification: sectors, industries, markets,

regions

• Reserve decision: invest vs. reserve

• Actively try to attract deposits

• Sell large denomination (Saving Deposits) to

institutional investors

• Borrow from other banks in the overnight

federal funds market
 Net worth vs. profit
• ROA: net after-tax profit/assets
• ROE: net after-tax profit/equity (capital, net worth)
• Increased leverage (debt financing) increases assets (A = L + E)
• Increased leverage (risk) increases ROE (return)

Regulators in many countries have therefore found it prudent to

mandate capital adequacy standards to ensure that some
bankers are not taking on high levels of risk in the pursuit of
high profits.
Capital management to increase ROE:

• Buy (sell) the bank’s stock in the open market, reducing

(increasing) the number of shares outstanding, raising (decreasing)
capital and ROE.

• Pay (withhold) dividends, decreasing (increasing) capital and ROE.

• Increase (decrease) the bank’s assets (with capital and ROA held
constant), increasing (decreasing) ROE.
 Key Takeaways
 Bankers must manage their bank’s liquidity (reserves – regulatory and to
conduct business effectively), capital (adequacy – regulatory and to buffer
against negative shocks), assets, and liabilities.
 There is an opportunity cost to holding reserves, which pay no interest,
and capital, which must share the profits of the business.
 While bankers left to their own judgments would hold reserves > 0 and
capital > 0, they might not hold enough to prevent bank failures at what
the government or a country’s citizens deem an acceptably low rate.
 That induces government regulators to create and monitor minimum
requirements.
 Chapter Objectives
• Describe how bankers manage credit risk.

What is credit risk and how do bankers manage it?

A banker is a fellow who lends his umbrella
when the sun is shining and wants it back
the minute it begins to rain.
- Mark Twain (1835-1910)
No matter how good bankers are at asset, liability,
and capital adequacy management, they will be
failures if they cannot manage credit risk …

Managing credit risk  managing

• Asymmetric information
• Adverse selection
• Moral hazard
Screening create information/reduce asymmetry
reduce adverse selection embed information in binding contract
third-party verification

Specialization maximize efficiency of screening

Increase efficiency create exposure to systemic risk

Long-term loan commitments (line of credit)

reduce moral hazard other business services
Securitize collateral
reduce moral hazard compensatory balances
loan covenants

Credit rationing no credit at any interest rate

reduce adverse selection limit credit
reduce moral hazard

 
 Key Takeaways
 Credit risk is the chance that a borrower will default on a loan by not fully
meeting stipulated payments on time.
 Bankers manage credit risk by screening applicants (taking applications
and verifying the information they contain), monitoring loan recipients,
requiring collateral like real estate and compensatory balances, and
including a variety of restrictive covenants in loans.
 They also manage credit risk by trading off between the costs and benefits
of specialization and portfolio diversification.
 Chapter Objectives
• Describe how bankers manage interest-rate risk.

What is interest rate risk and how do bankers

manage it?
Financial intermediaries are exposed to interest rate risk
because their assets and liabilities are exposed to
interest rate risk.

Interest rate risk is determined by

the value of risk-sensitive assets,
the value of risk-sensitive liabilities, and
the change in interest rates.
 Basic Gap Analysis

CP = (Ar – Lr) x ∆i

• CP: changes in profitability

• Ar: risk-sensitive assets
• Lr: risk-sensitive liabilities
• ∆i: change in interest rates
 Strategy Implications

Interest rates are expected to fall:

duration of liabilities short (borrow short) and
duration of assets long (lend long).

Interest rates are expected to rise:

duration of liabilities long (borrow long) and
duration of assets short (lend short).
 Key Takeaways
 Interest rate risk is the chance that interest rates may increase, decreasing
the value of bank assets.
 Bankers manage interest-rate risk by performing analyses like basic gap
analysis, which compares a bank’s interest rate-risk sensitive assets and
liabilities, and duration analysis, which accounts for the fact that bank
assets and liabilities have different maturities.
 Such analyses combined with interest rate predictions tell bankers when
to increase or decrease their rate-sensitive assets or liabilities and
whether to shorten or lengthen the duration of their assets or liabilities.
 Bankers can also hedge against interest-rate risk by trading derivatives,
like swaps and futures, and engaging in other off-balance sheet activities.
 Chapter Objectives
• Describe off-balance sheet activities and explain their importance.

What are off balance sheet activities and why do

bankers engage in them?
 Hedge credit risk

Diversify revenue
 service fees
 loan origination fees
 sell loans (provide loan
guarantees)
“Credit default swaps, which were invented by Wall Street in the
late 1990's, are financial instruments that are intended to cover
losses to banks and bondholders when a particular bond or
security goes into default -- that is, when the stream of revenue
behind the loan becomes insufficient to meet the payments that
were promised.
Credit default swaps are a type of credit insurance contract in
which one party pays another party to protect it from the risk of
default on a particular debt instrument. If that debt instrument (a
bond, a bank loan, a mortgage) defaults, the insurer compensates
the insured for his loss.”
The New York Times, as quoted in Times Topics
“Even before the market linkages among banks, other financial institutions
and non-financial businesses are fully re-established, we will need to start
unwinding the massive sovereign credit and guarantees put in place
during the crisis, now estimated at $7 trillion. The economics of such a
course are fairly clear. The politics of draining off that much credit support
in a timely way is quite another matter.”

Alan Greenspan, Chairman,

U.S. Federal Reserve 1987-2006
In The Economist, December 18, 2008
 Hedge interest rate risk

 Derivatives trading
 Interest rate swaps
 Currency trading
 Trading on account
 Key takeaways
• Off-balance sheet activities like fees, loan sales, and derivatives
trading help banks to manage their interest-rate risk by providing
them with income that is not based on assets (and hence is “off”
the balance sheet).
• Derivatives trading can be used to hedge or reduce interest-rate
risks but can also be used by risky bankers or rogue traders to
increase risk to the point of endangering a bank’s capital cushion
and hence its economic existence.