What Do Banks Do

What Banks Do

Balance Sheets General Principles of Bank Management Managing Credit Risk Managing Interest Rate Risk Off-Balance-Sheet Activities

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The last set of lectures argued that financial intermediaries were important for matching savers and investors. Now we take a closer look at banks, the most important financial intermediaries. Balance sheet

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A bank collects funds from savers and makes loans to borrowers. The funds it collects are its liabilities. The loans it makes are its assets. The two sides of a balance sheet must add up Liabilities Checkable deposits Payable on demand Used to be much more important Cost to bank: interest, customer service, check clearing Nontransactions deposits Savings accounts, CDs Higher interest than on checks, but not payable on demand Main source of funds 3

Borrowing From other banks (federal funds) From the Fed (discount window) From other corporations, e.g. bank holding companies Bank capital or net worth Difference between assets and other liabilities A cushion against insolvency

Assets Reserves and cash Required reserves (by Fed) Excess reserves (for deposit outflows) Cash items in process of collection Deposits at other banks (for check clearing, FX, securities transactions) 4

Securities US government and agencies State and local government Commercial paper and corporate bonds Subject to interest rate and default risk Loans Commercial and industrial (to businesses) Real estate (mortgages) Consumer Interbank (fed funds) Primary source of profit Less liquid than securities Subject to interest rate and default risk Other assets Buildings, land, computers, etc. 5

General Principles of Banking A bank’s main activity is asset transformation Can profit by solving asymmetric information problems Walter Wriston (Citicorp): “the business of banking is the production of information.” Four jobs Liquidity Management (deposit outflows) Asset Management (credit and interest rate risk) Liability Management (cost of acquiring funds) Capital Adequacy Management (avoid going broke)

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Liquidity Management Some deposits can be withdrawn at a moment’s notice. A bank must pay, or it will be closed. Banks hold enough excess reserves for normal deposit outflows. When they run short, they have 4 options (in order of increasing cost) Borrow fed funds from another bank Sell short-term government securities (secondary reserves) Borrow from the Fed (discount window) Call or sell loans Assets held in reserve don’t earn profit Banks balance cost of reserves (foregone profit) against cost of falling short. 7

Capital Adequacy A bank with negative net worth will be closed. Managers want enough capital to guard against worst-case losses on assets. But capital not loaned out earns no profit. The higher is bank capital, the lower is return on equity Net P rofits ROA = Assets

ROE =

Net P rofits Equity

EM =

Assets Equity

ROE = ROA × EM Must balance higher ROE against risk of bankruptcy. 8

Value at risk, stress testing Raising capital when short: sell stock, reduce dividends, increase assets

Liability management Compete for funds in CD market Borrow when attractive loan opportunities arise These sources of funds are subject to interest rate risk. Liability management is becoming more integrated with asset management

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Asset Management Interest rate risk Align duration of asset portfolio and liability portfolio Can buy or sell securities Or can hedge with interest rate swaps or other derivatives Credit risk Screening and monitoring Loan officers collect lots of information from applicants For a personal loan: income, assets, credit history, employment history, age, marital status, number of children, personal references For a business loan: profits, assets, liabilities, business plan, competitors, on-site inspection, etc. 10

Use a statistical model to compute a ‘credit score’ Also use judgment, subjective impression Loan officers are nosy Specialization in Lending Acquire special expertise in a particular location or industry Diversification v. information production Monitoring and enforcement Audits Checking accounts with the bank Long-term relationships Loan commitments: agree to provide funds up to a limit for a specified period of time in exchange for regular reports on firm’s books 11

Collateral and compensating balances Assets promised to the lender in the event of default Minimum account balance on deposits at the bank. Changes in collateral value or account balances also provide information on borrower’s status.

Credit rationing Deny loans even if applicant is willing to pay a high interest rate Or provide smaller loan amount than applicant requests Why? adverse selection

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All these activities address problems arising from informational asymmetries. May seem like big brother. But a kinder and gentler, well-intentioned big brother

Off-Balance-Sheet Activities Loan sales Fees for services such as FX transactions Collecting interest and principal on mortgage-backed securities Guarantees of debt (bankers acceptances) Backup lines of credit (overdraft privileges, letters of credit for commercial paper) 13

Trading activities Futures, options, swaps are not on the balance sheet. Often used for risk management, sometimes also for speculation Can be very profitable, but also risky, because large bets can be made Principal-agent problem within the bank Trader bets with someone else’s money; heads I win, tails they lose Not so problematic if traders are closely monitored Huge losses can occur otherwise Important to separate traders from bookkeepers. If one person does both, losses can be hidden, creating asymmetric information. 14

Rogue Traders Billionaire’s Club Yasuo Hamanaka, Sumitomo, -$2.6 billion Nick Leeson, Barings, -$1.3 billion Toshihide Iguchi, Daiwa Bank, -$1.1 billion Honorable mention to John Rusnak, Allied Irish Banks, -$691 million

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