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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