Chapter 12

Depository Institutions: Banks and Bank Management

Facts of Financial Structure

1. Stocks are not the most important source of external financing for businesses.

2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.

3. The financial system is among the most heavily regulated sectors of economy.

Facts of Financial Structure

4. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets.

5. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.

6. Only large, well-established corporations have easy access to securities markets to finance their activities.

Facts of Financial Structure

7. Collateral is a prevalent feature of debt contracts for both households and businesses.

8. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers.

• To minimize the moral hazard problem

Transactions Costs

Financial intermediaries make profits by reducing transactions costs

1. Take advantage of economies of scale (example: mutual funds)

2. Develop expertise to lower transactions costs• Also provides investors with liquidity

Tools to Help Solve Adverse Selection (Lemons) Problems

Private Production and Sale of Information• Companies collect and sell information about firms in order to

minimize asym. Info

• Free-rider problem interferes with this solution• People take advantage on information that they did not pay for

• Example: • I pay for information that allows me to distinguish good firms from bad

ones

• However, other investors can see my behavior and follow suit

Government Regulation to Increase Information

For example, annual audits of public corporations Minimizes but does not eliminate the problem

Tools to Help Solve Adverse Selection (Lemons) ProblemsFinancial Intermediation

Avoid free-rider problem by making private loans Example:

• Used car dealers act as intermediaries between people who want to buy/sell used cars

• The dealers examine the cars (info) and then sell the cars at a higher price

– NO free rider problem because the dealer produces the information and is the only one to benefit from it (charging higher price)

What happens to the dealer if it sells lemons at the higher price?

LOSSES REPUTATIONAL CAPITAL

Total Bank Assets = Total Bank Liabilities + Bank Capital

The Bank Balance Sheet

The Balance Sheet is a list of a bank’s assets and liabilities

Total assets = total liabilities + capital

A bank’s balance sheet lists

Sources of bank funds (liabilities, deposits)

Uses to which they are put (assets, loans)

Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers

The Bank Balance Sheet: Liabilities (a)

Checkable Deposits

Includes all accounts that allow the owner (depositor) to write checks to third parties• Non-interest earning checking accounts (known as DDAs)

• Interest earning negotiable orders of withdrawal (NOW) accounts

• Money-market deposit accounts (MMDAs)

– Typically pays the most interest among checkable deposit accounts

Checkable deposits are a bank’s lowest cost funds

Depositors want safety and liquidity and will accept a lesser interest return from the bank in order to achieve such attributes

The Bank Balance Sheet: Liabilities (b)

Nontransaction Deposits: The overall primary source of bank liabilities

(61%) Accounts from which the depositor cannot write

checks; • Savings accounts

• Time deposits (also known as CDs)

Generally a bank’s highest cost funds • Banks want deposits which are more stable and predictable

– Achieve this by paying more to the depositors in order to achieve such attributes

The Bank Balance Sheet: Liabilities (c)

Borrowings

Banks obtain funds by borrowing from the Federal Reserve System, other banks, and corporations

• these borrowings are called: discount loans/advances (from the Fed),

• fed funds (from other banks)

• Repurchase agreements

– “Repos” from other banks and companies

• Commercial paper and notes

– From other companies and institutional investors

The Bank Balance Sheet:

Bank Capital

The source of funds supplied by the bank owners• Directly through purchase of ownership shares

• Indirectly through retention of earnings

– The portion of funds which are earned as profits but not paid out to owners as dividends

Since assets minus liabilities equals capital, capital is seen as protecting the liability suppliers from asset devaluations or write-offs Capital is also called the balance sheet’s “shock absorber,” thus

capital levels are important

Bank Risk

Liquidity Risk the risk of a sudden demand for liquid funds

Credit Risk a bank’s loans will not be repaid

Interest-Rate Risk bank's liabilities tend to be short-term, while its assets tend to

be long-term. This mismatch between the maturities of the two sides of the

balance sheet creates interest-rate risk.

Bank Risk

Trading Risk If the price at which an instrument is purchased differs from

the price at which it is sold, the risk is that the instrument may go down in value rather than up.

Foreign exchange risk holding assets denominated in one currency and liabilities

denominated in another

Bank Risk

Bank Risk

Bank Risk

Bank Risk

Basics of Banking

T-account Analysis:

Deposit of $100 cash into First National Bank

First National BankAssets Liabilities

Vault cash +$100 Checkabledeposits

+$100

First National BankAssets Liabilities

Cash items inprocess ofcollection

+$100 Checkabledeposits

+$100

Basics of Banking

Conclusion: When bank receives deposits, reserves by equal amount; when bank loses deposits, reserves by equal amount

First National BankAssets Liabilities

Reserves +$100 Deposits +$100

Deposit of $100 check

Basics of Banking

This simple analysis gets more complicated when we add bank regulations to the picture.

Example If we return to the $100 deposit, recall that banks must

maintain reserves, or vault cash. This changes how the $100 deposit is recorded.

Basics of Banking

T-account Analysis:

Deposit of $100 cash into First National Bank

First National Bank Assets Liabilities

Required reserves Excess reserves

+$10 +$90

Checkable deposits

+$100

Basics of Banking

As we can see, $10 of the deposit must remain with the bank to meeting federal regulations. Reserve requirements

Now, the bank is free to work with the $90 in its asset transformation functions. The bank loans the $90 to its customers.

General Principles of Bank Management

Liquidity management

Asset management Managing credit risk Managing interest-rate risk

Liability management

Managing capital adequacy

Principles of Bank Management

Liquidity ManagementReserves requirement = 10%, Excess reserves = $10 million

Assets Liabilities

Reserves $20 million Deposits $100 million

Loans $80 million Bank Capital $10 million

Securities $10 million

Principles of Bank Management

With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet

Deposit outflow of $10 millionAssets Liabilities

Reserves $10 million Deposits $90 million

Loans $80 million Bank Capital $10 million

Securities $10 million

Liquidity Management

With 10% reserve requirement, bank has $9 million reserve shortfall

No excess reservesAssets Liabilities

Reserves $10 million Deposits $100 million

Loans $90 million Bank Capital $10 million

Securities $10 million

Deposit outflow of $10 millionAssets Liabilities

Reserves $0 million Deposits $90 million

Loans $80 million Bank Capital $10 million

Securities $10 million

Liquidity Management

1. Borrow from other banks or corporationsAssets Liabilities

Reserves $9 million Deposits $100 million

Loans $90 million Borrowings $9 million

Securities $10 million Bank Capital $10 million

2. Sell securitiesAssets Liabilities

Reserves $9 million Deposits $90 million

Loans $90 million Bank Capital $10 million

Securities $1 million

Liquidity Management

Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows

3. Borrow from FedAssets Liabilities

Reserves $10 million Deposits $90 million

Loans $90 million Discount Loans $9 million

Securities $10 million Bank Capital $10 million

4. Call in or sell off loansAssets Liabilities

Reserves $9 million Deposits $90 million

Loans $81 million Bank Capital $10 million

Securities $10 million

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

Capital Adequacy Management

Bank capital is a cushion that prevents bank failure

The higher the bank capital, the lower the 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

Tradeoff between safety (high capital) and ROE

Banks also hold capital to meet capital requirements

Strategies for Managing Capital Sell or retire stock Change dividends to change retained earnings Change asset growth

Banks' Income Statement

Financial Development and Economic GrowthFinancial repression leads to low growth

Poorly developed economic systems are more susceptible to financial crises

Free market economies are better than government run enterprises

Why?1. Poor legal system2. Weak accounting standards 3. Government directs credit4. Financial institutions nationalized5. Inadequate government regulation

Result of most financial crises is the inability of markets to channel funds from savers to productive investment opportunities (borrowers).

Financial Crises and Aggregate Economic Activity

Factors Causing Financial Crises

1. Increases in Interest Rates

2. Increases in Uncertainty

3. Asset Market Effects on Balance Sheets• Stock market effects on net worth

• Unanticipated deflation

• Cash flow effects

4. Bank Panics5. Government Fiscal Imbalances

Chapter 11

The Economics of Financial Intermediation

Roles of Financial Intermediaries

1. Pooling Savings:• Accepting resources from a large number of small savers/lenders in order to provide

large loans to borrowers.

2. Safekeeping and Accounting:• Keeping depositors’ savings safe, giving them access to the payments system, and

providing them with accounting statements that help them to track their income and expenditures.

3. Providing Liquidity: • Allowing depositors to transform their financial assets into money quickly, easily, and

at low cost.

4. Risk sharing: • Providing investors with the ability to diversify even small investments.

5. Information Services: • Collecting and processing large amounts of standardized financial information.

Information Asymmetries in the Stock Market

• If you can’t tell the difference between the two firms’ prospects, you will be willing to pay a price based only on the firms’ average quality.

• The result is that the stock of the good company will be undervalued.

• Since the managers know their stock is worth more than the average price, they won’t issue the stock in the first place.

• That leaves only the firm with bad prospects in the market.

Information Asymmetries and Information Costs

Asymmetric information for issuers of financial instruments Borrowers who want to issue bonds and/or firms that want to issue stock

• know much more about their business prospects and their willingness to work than potential lenders or investors

• Adverse Selection for lenders

Solving the Adverse Selection Problem Disclosure of Information Collateral and Net Worth

Information Asymmetries and Information Costs

Moral Hazard in Debt Finance

Occurs because debt contracts allow owners to keep all the profits in excess of the loan payments

• they encourage risk taking

a good legal contract can solve the moral hazard problem that is inherent in debt finance.

• Bonds and loans often carry restrictive covenants

Moral Hazard in equity contracts principal-agent problem

• The separation of ownership from control.

When the managers of a company are the owners, the problem of moral hazard in equity financing disappears.

The Negative Consequences of Information Costs

Adverse Selection:

• Lenders can’t distinguish good from bad credit risks, which discourages transactions from taking place.

Solutions:

The pledging of collateral to insure lenders against the borrower’s default Requiring borrowers to invest substantial resources of their own Government-required information disclosure Private collection of information

The Negative Consequences of Information Costs

Moral Hazard: • Lenders can’t tell whether borrowers will do what they claim they will do with

the borrowed resources• Borrowers may take too many risks.

Solutions:

• Forced reporting of managers to owners

• Requiring managers to invest substantial resources of their own

• Covenants that restrict what borrowers can do with borrowed funds

Financial Intermediaries and Information Costs

The problems of adverse selection and moral hazard make direct finance expensive and difficult to get.

These drawbacks lead us immediately to indirect finance and the role of financial institutions.

Much of the information that financial intermediaries collect is used to reduce information costs

Minimizes the effects of adverse selection and moral hazard

• Screening and Certifying to Reduce Adverse Selection

• Monitoring to Reduce Moral Hazard