University of Pittsburgh Economics 280

Lecture Notes for Week  9

Prof. Du y Fall 1999

Note: There are no lecture notes for week 8 as the midterm examination was held during that week.
Banks borrow money in order to lend it; the di erence between the rate of interest that is paid to them and the rate they pay, less their working expenses, constitutes their pro t on this kind of transaction. Banking is negotiation between granters of credit and grantees of credit. Only those who lend the money of others are bankers; those who merely lend their own money are capitalists, but not bankers." Ludwig von Mises, The Theory of Money and Credit, 1934.

8 The Banking Business

This week we are going to examine in some detail the banking business. We will focus on how banks make pro ts, how they make loans, how they manage their asset portfolios and how they handle risk and liquidity considerations.

8.1 The Balance Sheet of a Bank

We begin by considering the balance sheet of a bank. A balance sheet is simply a listing of a rm's assets and liabilities. It is referred to as a balance sheet because, as we shall see, the accounting convention is such that the value of a rm's assets is balanced by the value of its liabilities. Recall that assets were de ned as anything of value that can be owned; a bank's assets consist of various funds and investments that a bank can claim to own these include funds lent to borrowers. By contrast, liabilities are de ned as things of value that are owed to someone else. A bank's liabilities are its sources of funds those funds the bank has acquired from savers so as to make investments or loans to borrowers. The consolidated balance sheet of all U.S. commercial banks for 1998 is given below. The average percentage of total assets or total liabilities that each balance sheet entry represents is also indicated. Consolidated Balance Sheet for All U.S. Commercial Banks Assets Liabilities Reserves 2 Checkable Deposits Cash in Process of Collection 2 Nontransaction Deposits Deposits at Other Banks 1 Large, Negotiable CDs Government Securities 23 Borrowings Loans 67 Miscellaneous Liabilities Miscellaneous Assets 5 Equity Capital Net Worth

13 37 13 17 11 9

On the asset side of the balance sheet, we have all of things that the bank owns. Bank reserves consist of vault cash plus required reserves at the Fed. At the end of every day, every bank is 1

required to maintain a certain percentage of its checkable deposits in the form of reserves held in accounts at the Fed; the exact percentage is known as the reserve requirement and is set by the Fed. Note that reserves, whether in the form of vault cash or balances held at the Fed pay no interest. Cash in process of collection consists of payments that banks are about to receive but have not yet received. For example, a bank that receives a check drawn on an account at another bank must wait for the check to clear to receive payment from the other bank; the payment is forthcoming and is thus considered an asset of the bank, even though it has not yet been received. Often banks, especially small banks, will maintain deposits at other banks, especially larger banks in exchange for the larger banks providing the smaller banks with certain kinds of assistance, e.g. access to securities markets at lower cost. Banks' primary assets are in the form of government securities and loans. Banks buy all kinds of U.S. Government and state and local securities, and they make many di erent kinds of loans to borrowers, including other banks. These investments are considered assets because they provide banks with a stream of payments over time the interest income earned on these assets. Miscellaneous assets would include such things as the building that houses the bank. On the liability side of the balance sheet, we have all of things that banks owe to others, or things for which banks are liable. A bank's primary liabilities consist of checkable deposits and nontransaction deposits. Checkable deposits include checking accounts that pay no interest, as well as negotiable order of withdrawal NOW accounts and money market accounts that pay interest. These are all account balances that are payable on demand to the depositor, or to anyone possessing a check written on the account. Hence checkable deposits are a liability of the bank. Similarly, nontransaction deposits, which include savings accounts, time deposits, small CDs and money market deposit accounts MMDAs, are account balances owed to depositors. However unlike checkable deposits, it is not possible to write checks on nontransaction deposits. Furthermore, one cannot demand part or all of the balance on such deposits prior to their maturity date without incurring some penalties. For these reasons, nontransaction deposits often pay higher interest rates than checkable deposits. Large, negotiable CDs are also nontransaction deposits, but these are negotiable; they can be bought and sold in secondary markets prior to maturity. Banks not only raise funds by issuing deposits, they can also raise funds by borrowing in the market just like any other borrower. Bank borrowings mainly consist of short term loans from other banks in a wholesale" money market known as the federal funds market. The interest rate on interbank borrowing and lending is a key interest rate known as the federal funds rate, currently 5.25. Banks participate as borrowers or as lenders in the federal funds market, and their role can change daily, depending on the in ow or out ow of funds that they face. For instance, bank A might nd that it has received a lot of new deposits today but does not have a lot of demand by its customers for new loans. It could use the new deposits to buy government securities, but it could also lend the new deposits to bank B, in another state or city, which is facing a high demand for loans, but does not have enough funds deposits to make these new loans bank loans to other banks in the federal funds market show up in the loans category under assets. Banks also borrow in the federal funds market to meet reserve requirements set by the Fed. In addition to borrowing in the federal funds market, banks can also borrow directly from the Fed, at a below market interest rate known as the discount rate. While banks always have this option, few banks exercise it; borrowing from the Fed at the below federal funds market discount rate set by the Fed currently 5.00 usually sends a bad signal that the bank is having trouble managing its liquidity, and cannot a ord to borrow from other banks at the market federal funds rate. Thus, 2

the option to borrow funds from the Fed at the discount rate is rarely exercised; banks consider this option only as a last resort. If we sum up all of the assets on the one side and subtract from it the sum of all of the liabilities on the other side, we come up with the measure known as net worth, or the banking rm's equity capital. Net worth is de ned as: Net Worth = Assets , Liabilities : Net worth consists of capital contributed by the bank's shareholders plus accumulated, retained earnings. If assets exceed liabilities the usual case, then a banking rm is said to have a positive net worth. If liabilities exceed assets, the rm has a negative net worth and is considered bankrupt. By accounting convention, net worth is always listed as a liability of the rm | why? First, from an accounting perspective, a balance sheet must always balance, so that everything categorized as assets must add up to everything categorized as liabilities. Second, and more importantly, the net worth of a rm is its remaining value after all liabilities have been met. This remaining value accrues to the bank's owners, i.e., the shareholders in the bank. Hence net worth is properly viewed as the equity capital of the bank's owners, and is therefore considered a liability of the bank. Of course, since net worth is a residual amount, it is free to vary as the value of a bank's assets and liabilities change with changes in market conditions.

8.2 How Banks Make Pro ts

Let us now consider how an individual bank behaves, in particular, how it make pro ts. Suppose you have just moved to Pittsburgh, and you choose to open an interest bearing checking account at PittBankTM . You make a deposit of $1,000 in cash. What happens to the bank's balance sheet? We can illustrate what happens through the use of T accounts which are simpli ed balance sheets that note only changes in a bank's balance sheet and ignore all other unchanging components of the bank's balance sheet. Assuming that the reserve requirement that the Fed sets on checkable deposits is 5, here is what happens as the result of the $1,000 deposit you make in opening your account at PittBank. PittBank T Account Assets Liabilities Required Reserves $50 Checkable Deposits $1,000 Excess Reserves $950 Your $1,000 deposit shows up as a liability of the bank. On the asset side, the bank now has to keep 5 of $1,000 or $50 as required reserves at the Fed, and has $950 in excess reserves that it can lend out. Since PittBank is not earning any interest on these excess deposits, and is paying you interest on your checking deposit account, it makes sense for PittBank to lend some or all of these excess reserves out to borrowers. Suppose that PittBank makes loans in the amount of $950 using its excess reserves. Then the T account changes to: PittBank T Account Assets Liabilities Required Reserves $50 Checkable Deposits $1,000 Loans $950 3

What is PittBank's pro ts from accepting your deposit of $1,000 and making a loan of $950. Let's assume that the interest rate PittBank pays on checking deposits, ic = :01, and the interest rate it charges on the loan is il = :07. Furthermore, assume that the bank's costs of operation wages, equipment, rent, etc. amount to $6.50 per $1,000 of checkable deposits. The bank's pro ts on the deposit loan transactions described above can be calculated as follows: Bank Pro ts = :07$950 , :01$1; 000 , $6:50 = $50: Thus the bank makes $50 on your deposit of $1,000. This example illustrates the basic principle of the banking business: borrow at low rates and lend at high rates of interest. Making pro ts in banking however, is not necessarily as simple as this example might suggest. There are a host of issues that bank managers must consider on a day to day basis. We now turn to a discussion of some of these considerations.

8.3 Liquidity Management

One of the most important management problems a bank faces is the need to remain relatively liquid in its portfolio of assets so as to cope with unanticipated changes in its liabilities. In essence, the problem is one of maintaining su cient reserves, without foregoing to much in lost interest income. The problem of liquidity management used to be much more di cult than it is today. In the past, banks were occasionally subject to bank runs in which depositors arrived en masse, over a short interval of time to withdrawal all of their deposits. The impetus to a run on a bank could be anything, but was most often associated with a downturn in economic activity that led to expectations that one or more banks might fail. Very often, this kind of fear spread in a kind of contagion e ect, so that even healthy banks experienced bank runs. Today, runs on banks are less common though they still occur because of increased bank regulation, and because of the universal adoption of Federal Deposit Insurance, through the FDIC, which insures all checkable deposits at banks up to $100,000. Now if a bank fails, its depositors deposit accounts are guaranteed up to the $100,000 amount. Nevertheless, the problem of liquidity management remains. We can illustrate the problem again using T accounts and our simple example. Suppose that PittBank lends out only $900 of the amount you initially deposited with them, choosing to maintain some excess reserves in the amount of $50. The T account now looks like this: PittBank T Account Assets Liabilities Required Reserves $50 Checkable Deposits $1,000 Excess Reserves $50 Loans $900 Now suppose you wrote a check on the account for $50. The recipient of the check takes it to his bank, and this bank demands payment from PittBank. The result is that PittBank's excess reserves are reduced to $0, and its liabilities are also reduced by $50 to $950. The balance sheet balances and the reserve requirement is being met: 4

PittBank T Account Assets Liabilities Required Reserves $50 Checkable Deposits $950 Excess Reserves $0 Loans $900 In fact, the reserve requirement is more than being met. The amount of required reserves on checkable deposits of $950, given a reserve requirement of 5 is $47.50. So we would rearrange the T account given above as follows: PittBank T Account Assets Liabilities Required Reserves $47.50 Checkable Deposits $950 Excess Reserves $2.50 Loans $900 Now suppose we return to the original situation, where the bank had $50 in required reserves and $50 in excess reserves. Suppose that instead of writing a check on your deposit account for $50, you instead wrote a check on this account for $100. In this case, since the bank will more than exhaust its excess reserves, it will have to use its required reserves to settle the check with the other bank.1 The resulting T account looks like this: PittBank T Account Assets Liabilities Required Reserves $0 Checkable Deposits $900 Excess Reserves $0 Loans $900 While both assets and liabilities balance, the bank now has insu cient required reserves. The reserve requirement of 5 on checkable deposits of $900 implies that the bank must have required reserves of $45 on hand at the end of the day. How does the bank get these required reserves? There are several ways. First, the bank could borrow the $45 amount from another bank in the federal funds market. Second, the bank could sell some of its assets e.g. loans or securities so as to increase its required reserves. Third, the bank could borrow from the Fed at the discount window recall that this third option is typically regarded as a last resort option. Let us suppose for illustration purposes that it borrows $45 in the federal funds market. The new T account looks like this: PittBank T Account Assets Liabilities Required Reserves $45 Checkable Deposits $900 Excess Reserves $0 Borrowings $45 Loans $900
1

In practice, of course, banks have a lot more reserves on hand than are illustrated in this example.

Of course, these borrowings are costly; the bank must pay the federal funds rate of interest. Thus we see that having su cient excess reserves is a consideration that bank managers must consider carefully. Having too much excess reserves reduces the banks pro ts because it reduces the amount the can be lent out $900 rather than $950. On the other hand, having a su cient level of excess reserves can help the bank avoid costs associated with becoming more liquid | i.e. borrowing on the federal funds market, selling securities or loans at unfavorable prices, or borrowing at the Fed's discount window. A bank's equity capital is the same as its net worth. You can think of net worth as the capital contributed by the bank's shareholders plus accumulated, retained earnings. The issue in bank capital management is for the bank to maintain su ciently high equity capital as a protection against unanticipated losses from the bank's portfolio of assets. That is, the bank wants to maintain a reasonable ratio of assets to equity capital; it wants to be well capitalized." In pursuit of this goal, the bank faces a dilemma; its shareholders would prefer that the bank raise most of its funds through deposit issue or debt nancing rather than through equity issue. That is, the stockholders want to maximize their return on equity ROE, which is de ned as follows: ts After Tax ROE = Pro Equity Capital You can see from this expression that the more equity capital a bank has, the lower will be each stockholder's return on equity. We can see the dilemma a bank faces, by considering another return measure the bank's return on assets, ROA, which is de ned as: ts After Tax ROA = Pro Total Assets : The ROE is related to the bank's ROA in the following manner: Total Assets : ROE = ROA  Equity Capital Given the bank's choice of assets, the return on these assets, the ROA, will be largely determined by market forces that are beyond the bank's control. Taking the return on assets as given, the bank must still decide on the appropriate ratio of Total Assets to Equity Capital. To protect against unanticipated losses on its assets that could bring about closer regulatory scrutiny or even cause the bank to go bankrupt, e.g. bad real estate loans or negative rates of return on securities, the bank will want to keep the ratio of its total assets to equity capital rather low. On the other hand, the bank's stockholders will want the bank to make the ratio of total assets to equity capital as high as possible, since the higher is this ratio, the greater will be the stockholder's return on equity. Hence the bank faces a bit of a dilemma. The resolution of this dilemma the choice of the ratio of total assets to equity capital requires that the bank carefully weighs the bene ts and costs from choosing a particular ratio of total assets to equity capital. The choice of this ratio is not entirely up to the bank alone. It is also subject to regulatory restrictions. One measure that regulatory authorities consider is a bank's leverage ratio, de ned as 6

8.4 Capital Management

follows:

The leverage ratio is just the inverse of the assets equity ratio. It is a measure of how leveraged or how exposed a bank is to potential losses on assets. Banks with leverage ratios of 5 are classi ed as well capitalized," while banks with leverage ratios below 2 are subject to regulatory supervision and restrictions designed to increase their capitalization.

Capital : Leverage Ratio = Equity Total Assets

8.5 Credit Risk Management

Another management issue banks face is to decide which loan applicants are acceptable credit risks. Here, there are no simple mechanical rules that can be applied. The two problems that arise in credit risk management are the problems of adverse selection and moral hazard that we have previously discussed. A bank that charges a really high interest rate on a loan may still attract loan customers, but these customers will be adversely selected from the pool of all loan customers; they will tend to be those who cannot get loan contracts at lower rates of interest, or who have projects that they expect will earn a much higher rate of return than the already high rate of interest. This pool of customers is a relatively more risky pool than the one a bank might attract if the interest rate was lower. Thus, the adverse selection issue for a bank concerns the decision as to what interest rate to o er its customers on a loan contract. The moral hazard issue in banking is that loan recipients may not have the proper incentives toward the goal of ultimately repaying their loans; those who receive borrowed funds may become careless with those funds if they do not stand to lose anything if the borrowed funds cannot be repaid. The aim of credit risk management is to reduce or mitigate both the problems of adverse selection and moral hazard. There are several di erent techniques that bank managers use in attempting to manage credit risk. Credit risk analysis. Banks will examine a borrower's likelihood of repayment by gathering information about the borrower's past credit history and by inquiring into the nature and purpose of the loan. On the basis of this kind of credit-risk analysis, a bank's loan o cers can screen out bad credit risks, and make loans only to those who appear to be credit worthy. Credit-risk analysis thus helps to reduce, though not eliminate the adverse selection problem. Collateral requirements. In agreeing to make a loan, a bank will often require a borrower to pledge some collateral or personal assets that the bank can claim in the event that the borrower defaults on the loan. For example, if you were to take out a loan to start a small business, say a co ee house, you would need to secure that loan in part by o ering some collateral, pledging the equity value in your home for example. Collateral requirements help to mitigate the moral hazard problem, since if borrowers have some personal assets at stake, they are more likely to try to make good on their loan contract with the bank. Credit Rationing. Another way in which banks handle the problems of adverse selection and moral hazard is by rationing credit to borrowers. We have already noted that high interest rates will tend to attract bad credit risks the adverse selection problem. To combat this problem, banks can instead choose to o er somewhat lower interest rates, and then ration credit denying credit to some borrowers. This strategy will help the bank attract low-risk 7

borrowers. On the other hand, there may still be some low-risk borrowers who are denied credit, because it is often di cult to separate between low-risk and high-risk borrowers, even after a credit-risk analysis has been performed. Banks also ration credit as a means of combating the moral hazard problem. By limiting the size of a bank loan, perhaps below the amount requested by the borrower, the bank reduces the chance and costs of moral hazard, and increases the likelihood that the borrower can and will repay the loan. Credit cards issued by banks provide a simple example. All credit cards have a certain credit limit. The reason for this limit is quite simple. Suppose there was no limit on a credit card. One might then be tempted to spend millions of dollars, without regard to your ability to repay. Limiting the amount that individuals can borrow thus reduces the banks exposure to the moral hazard problem in bank lending. Monitoring and Restrictive Covenants. Banks often engage in monitoring of the activities of loan recipients to ensure that the borrowed funds are being put to good use. Furthermore, banks often include restrictive covenants in their loan agreements that stipulate exactly what the borrowed funds will be used for. If a lender deviates from these restrictive covenants, the loan contract is considered to have been breached, and the bank can take the lender to court. Monitoring and restrictive covenants work to reduce the moral hazard problem.

8.6 Interest Rate Risk Management

Note: We did not have time to cover this material in class, so it is optional reading. Bank managers also have to be concerned about their exposure to interest rate risk. In recent years, interest rates have uctuated a lot more than they have historically, making interest rate risk management a greater concern of banks than it had been in the past. The problem of interest rate risk is perhaps best illustrated by a simple example. Suppose the balance sheet of PittBank was as follows. Balance Sheet for PittBank Assets millions Liabilities millions Fixed Rate Assets $350 Fixed Rate Liabilities $230 Reserves Checkable Deposits Long Term Securities Savings Deposits Fixed Rate Loans Long Term CDs Variable Rate Assets $130 Variable Rate Liabilities $230 Short Term Securities Short-Term CDs & MMDAs Variable Rate Loans Federal Funds Credit Card Debt Net Worth $40 Here we have aggregated many di erent types of assets and liabilities into one of two di erent types: those which are subject to xed rates of interest and those which are subject to variable rates of interest. Fixed interest rate assets and liabilities tend to be long term assets or liabilities or those that earn or pay zero interest. Variable interest rate assets and liabilities tend to be short term assets or liabilities, or those that have built in variable rates of interest, for example variable rate mortgages. 8

Now consider what happens to PittBank if short-term interest rates were to rise. Since PittBank has $230 million in short term variable interest rate liabilities, but only $130 million in short term, variable interest rate assets, it stands to loose $100 million for an increase of 1 percentage point in short term interest rates. Thus, PittBank is exposed to substantial interest rate risk as the result of its lopsided holdings of more variable rate liabilities than variable rate assets. On the other hand, if short term interest rates were to fall, PittBank could make substantial pro ts, given its relatively low investment in variable rate assets and its higher reliance on variable rate liabilities as a source of funds. In attempting to put together the right mix of xed and variable interest rate assets and liabilities so as to minimize interest rate risk what should a bank manager do? Many banks attempt to control for uctuations in interest rates by engaging in a process called GAP management. This involves matching assets and liabilities by maturity, and managing the extent of the gap" between assets and liabilities of similar maturities. An example will serve to illustrate how gap management works. Suppose PittBank set some targets for its asset and liability management, classifying its assets and liabilities by their maturity dates as in the following table. Gap Management by PittBank Maturity Assets Liabilities 0 6 months 40 50 7 12 months 30 20 13 24 months 20 20 25 ? months 10 10 100 100 In this example, PittBank has matched its mix of assets and liabilities for maturities of 13 months and higher. For maturities of 0 6 months, it has 10 more liabilities than assets, and for maturities of 7 12 months, it has 10 more assets than liabilities. The strategy here is that PittBank can borrow short- term funds with 0 6 month maturities at su ciently low interest rates that it can nance some additional loans and other assets with 7 12 month maturities. While this arrangement may turn out to be quite pro table, the mismatch between short-term assets and liabilities implies that PittBank is still exposing itself to some interest rate risk, although the exposure is not too great; if short-term interest rates were to rise, then PittBank's pro ts would get squeezed, and could perhaps become negative. Every bank faces this dilemma: it must decide what mismatch of funds, if any, may desirable by comparing the extra pro ts it might earn with the potential loss should short term interest rates change.