Mishkin Serletis The Economics of Money Banking and Financial

Assets • • • Reserves Cash Items in Process of Collection Deposits at Other

Liabilities • Demand Notice Deposits • Fixed-Term Deposits • Borrowings – overdraft loans (advances)

Balance Sheet of All Banks in Canada Copyright © 2014 Pearson Canada Inc. 13

Basic Banking: Making a Profit First Bank Assets Desired reserves Excess reserves First Bank Liabilities +$100 Chequable deposits +$90 +$100 Assets Liabilities Desired reserves +$10 Chequable deposits Loans +$100 +$90 • Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics • The bank borrows short and lends long Copyright © 2014 Pearson Canada Inc. 13 -5

General Principles of Bank Management • • • Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk Copyright © 2014 Pearson Canada Inc. 13 -6

Liquidity Management: Ample Reserves with deposit outflow of $10 million ↓ First Bank Assets First Bank Liabilities Reserves $20 M Deposits Loans $80 M Bank Capital $10 M Securities Assets $100 M $10 M Liabilities Reserves $10 M Deposits $90 M Loans $80 M Bank Capital $10 M Securities $10 M • If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet Copyright © 2014 Pearson Canada Inc. 13 -7

Liquidity Management: Shortfall in Reserves with deposit outflow of $10 million ↓ First Bank Assets First Bank Liabilities Reserves $10 M Deposits Loans $90 M Bank Capital $10 M Securities $100 M $10 M Assets Reserves Loans Securities Liabilities $0 Deposits $90 M Bank Capital $10 M $90 M $10 M • Reserves are a legal requirement and the shortfall must be eliminated • Excess reserves are insurance against the costs associated with deposit outflows Copyright © 2014 Pearson Canada Inc. 13 -8

Liquidity Management: Borrowing from other Banks First Bank Assets Reserves Liabilities $9 M Deposits $90 M Loans $90 M Borrowing $9 M Securities $10 M Bank Capital $10 M • Cost incurred is the interest rate paid on the borrowed funds Copyright © 2014 Pearson Canada Inc. 13 -9

Liquidity Management: Securities Sale First Bank Assets Reserves Loans Securities Liabilities $9 M Deposits $90 M Borrowing $0 M $1 M Bank Capital $10 M • The cost of selling securities is the brokerage and other transaction costs Copyright © 2014 Pearson Canada Inc. 13 -10

Liquidity Management: Bank of Canada Advances First Bank Assets Reserves Liabilities $9 M Deposits Loans $90 M Advances Bank of Canada Securities $10 M Bank Capital $90 M $9 M $10 M • Borrowing from the Bank of Canada also incurs interest payments based on the discount rate Copyright © 2014 Pearson Canada Inc. 13 -11

Liquidity Management: Reduce Loans First Bank Assets Reserves Liabilities $9 M Deposits Loans $81 M Advances Bank of Canada Securities $10 M Bank Capital $90 M $10 M • Reduction of loans is the most costly way of acquiring reserves • Calling in loans antagonizes customers • Other banks may only agree to purchase loans at a substantial discount Copyright © 2014 Pearson Canada Inc. 13 -12

Asset Management: Three Goals 1. Seek the highest possible returns on loans and securities

Asset Management: Four Tools • Find borrowers who will pay high interest rates and have low possibility of defaulting • Purchase securities with high returns and low risk • Lower risk by diversifying • Balance need for liquidity against increased returns from less liquid assets Copyright © 2014 Pearson Canada Inc. 13 -14

Liability Management • Recent phenomenon due to rise of money center banks • Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) • Checkable deposits have decreased in importance as source of bank funds Copyright © 2014 Pearson Canada Inc. 13 -15

Capital Adequacy Management • Bank capital helps prevent bank failure • The amount of capital affects return for the owners (equity holders) of the bank • Regulatory requirement Copyright © 2014 Pearson Canada Inc. 13 -16

Capital Adequacy Management: Preventing Bank Failure High Bank Capital Assets Low Bank Capital Liabilities Assets Liabilities Reserves $10 M Deposits $90 M Reserves $10 M Deposits Loans $90 M Bank Capital $10 M Loans $90 M Bank Capital High Bank Capital Assets $10 M Deposits Loans $85 M Bank Capital Copyright © 2014 Pearson Canada Inc. $4 M Low Bank Capital Liabilities Reserves $96 M Assets $90 M Reserves $5 M Loans Liabilities $10 M Deposits $96 M $85 M Bank Capital -$1 M 13 -17

Capital Adequacy Management: Returns to Equity Holders Copyright © 2014 Pearson Canada Inc. 13

Capital Adequacy Management: Safety • Benefits the owners of a bank by making their investment safe • Costly to owners of a bank because the higher the bank capital, the lower the return on equity • Choice depends on the state of the economy and levels of confidence Copyright © 2014 Pearson Canada Inc. 13 -19

Strategies for Managing Bank Capital Lowering Bank Capital: • Buying back some of Bank’s stock • Pay out higher dividend to shareholders • Acquire new funds and increase assets Raising Bank Capital: • Issue more common stock • Reducing dividend to shareholders • Issue fewer loans or sell securities and use proceeds to reduce liabilities Copyright © 2014 Pearson Canada Inc. 13 -20

Application: How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis • Shortfalls of bank capital led to slower credit growth – Huge losses for banks from their holdings of securities backed by residential mortgages – Losses reduced bank capital • Banks could not raise much capital on a weak economy, and had to tighten their lending standards and reduce lending Copyright © 2014 Pearson Canada Inc. 13 -21

Managing Credit Risk • A major component of many financial institutions business is making loans • To make profits, these firms must make successful loans that are paid back in full • The concepts of moral hazard and adverse selection are useful in explaining the risks faced when making loans Copyright © 2014 Pearson Canada Inc. 13 -22

Managing Credit Risk: Adverse Selection • Adverse selection is a problem in loan markets because bad credit risks (those likely to default) are the one which usually line up for loans • Those who are most likely to produce an adverse outcome are the most likely to be selected Copyright © 2014 Pearson Canada Inc. 13 -23

Managing Credit Risk: Moral Hazard • Moral hazard is a problem in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lenders point of view • Once a borrower has obtained a loan, they are more likely invest in high-risk investment projects that might bring high rates of return if successful • The high risk, however, makes it less likely the loan will be repaid Copyright © 2014 Pearson Canada Inc. 13 -24

Managing Credit Risk (cont’d) • To be profitable, lending firms must overcome adverse selection and moral hazard problems • Attempts by the lending institutions to solve the problems explains a number of principles for managing risk Copyright © 2014 Pearson Canada Inc. 13 -25

Managing Credit Risk (cont’d) • Screening and Monitoring – Screening – Specialization in Lending – Monitoring and Enforcement of Restrictive Covenants • Long-term customer relationships • Loan commitments • Collateral and compensating balances • Credit rationing Copyright © 2014 Pearson Canada Inc. 13 -26

Interest Rate Risk • If a financial institution has more interest rate sensitive liabilities than interest rate sensitive assets, a rise in interest rates will reduce the net interest margin and income • If a financial institution has more interest rate sensitive assets than interest rate sensitive liabilities, a rise in interest rates will raise the net interest margin and income Copyright © 2014 Pearson Canada Inc. 13 -27

Managing Interest-Rate Risk First National Bank Assets Rate-sensitive assets Liabilities $20 M Rate-sensitive liabilities $50 M Variable-rate and short-term loans Variable-rate CDs Short-term securities Money market deposit accounts Fixed-rate assets $80 M Fixed-rate liabilities Reserves Checkable deposits Long-term loans Savings deposits Long-term securities $50 M Long-term CDs Equity capital Copyright © 2014 Pearson Canada Inc. 13 -28

Gap Analysis • The Gap is the difference between interest rate sensitive liabilities and interest rate sensitive assets GAP = rate-sensitive assets – rate-sensitive liabilities GAP = RSA – RSL • A change in the interest rate (Δi) will change bank income ( I) depending on the Gap I = GAP i Copyright © 2014 Pearson Canada Inc. 13 -29

Duration Analysis (cont’d) • Owners and managers care not only about the change in interest rates on income but also on net worth of the institution • Duration Analysis examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates Copyright © 2014 Pearson Canada Inc. 13 -30

Duration Analysis (cont’d) %ΔP = - DUR x [Δi/(1+i)] Where: P is the market

Duration Analysis (cont’d) The Duration Gap can be calculated as: DURgap = Dura – (L/A x DURL) Where: Dura = average duration of assets L = market value of liabilities A = market value of assets Durl = average duration of liabilities Copyright © 2014 Pearson Canada Inc. 13 -32

Off-Balance-Sheet Activities • Loan sales (secondary loan participation) • Generation of fee income • Trading activities and risk management techniques – Futures, options, interest-rate swaps, foreign exchange – Speculation Copyright © 2014 Pearson Canada Inc. 13 -33

Off-Balance-Sheet Activities (cont’d) • Trading activities and risk management techniques – Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market and speculation – Principal-agent problem arises Copyright © 2014 Pearson Canada Inc. 13 -34

Off-Balance-Sheet Activities (cont’d) • Internal controls to reduce the principal-agent problem – Separation of trading activities and bookkeeping – Limits on exposure – Value-at-risk – Stress testing Copyright © 2014 Pearson Canada Inc. 13 -35