Banking and Financial Institutions Lecture

Banking and Financial Institutions

• The lecture is about banking and managing financial institutions
• The lecturer is Dr. Rania Anis, a lecturer of economics at the Faculty of Economic Studies and Political Science, Alexandria University.

Lecture Outline

• Summarize the features of a bank balance sheet
• Identify ways in which banks can manage assets and liabilities to maximize profit

What do we mean by "The Bank Balance Sheet"?

• A list of the bank's assets and liabilities
• Total assets equal total liabilities plus capital
• The balance sheet shows sources of bank funds (liabilities) and how they are used (assets)

The Bank Balance Sheet (Liabilities)

• A bank acquires funds by issuing (selling) liabilities (e.g., deposits)

• The funds are used to purchase income-earning assets

• Checkable deposits (transaction deposits, or demand deposits):

  • Bank accounts allowing account holders to write checks to third parties.
  • Include all deposits that can be drawn on with a check (e.g. checking account)
  • The lowest-cost source of funds because banks do not pay interest
  • A medium of exchange, considered part of M1.

• Non-transaction deposits (e.g., savings accounts & time deposits):

  • Owners cannot write checks; non-transaction deposits are the primary source of bank funds
  • Typically pay a higher interest rate than checkable deposits
  • Savings accounts: most common type, funds can be withdrawn or added at any time; interest and transactions recorded in a passbook
  • Time deposits (CDs): fixed maturity (several months to over five years)
    • Earliest withdrawals before maturity subject to penalties
    • Small denomination: less liquid, under $100,000, earn higher interest but high-cost funding source
      • Larger denomination: over $100,000, liquid, bought by banks & corporations and sold in secondary market before maturity

• Borrowing:

  • Represents 30% of bank liabilities
  • Banks borrow from: central banks (discounted loans), other banks, corporations (repurchase agreements).
  • Overnight loans in the federal funds market ensure banks satisfy reserve requirements at the central bank.

• Bank capital:

  • The bank’s net worth (total assets minus total liabilities)
  • Increased by selling new equity or retained earnings
  • Acts as a cushion against asset value declines, preventing insolvency (liabilities exceeding assets).

The Bank Balance Sheet (Assets)

• Bank assets are the uses of funds. Interest earned on assets enables banks to profit

• Reserves:

  • Funds held in bank vaults or at the central bank
  • Deposits + currency held by banks
  • Low-interest rate, held for liquidity reasons
  • Two types:
    • Required reserves: held due to regulations (e.g., 10% of checkable deposits)
    • Excess reserves: most liquid, used to meet obligations.

• Cash items in process of collection:

  • Checks written on an account at another bank, not yet collected
  • Considered an asset as a claim on another bank

• Deposits at other banks:

  • Small banks hold deposits at larger banks for various services (e.g. checking, FX, securities).
  • Part of the correspondent banking system
  • Collectively, reserves, cash items in process of collection, and deposits are called cash items

• Securities:

  • Important income-earning assets for banks
  • Commercial banks cannot hold stock; securities are debt
  • Classification:
    • U.S. government and agency securities (highly liquid, secondary reserves)
    • State and local government securities (less marketable, higher risk)
    • Other securities

• Loans:

  • Commercial and industrial loans
  • Real estate loans
  • Account for over 50% of bank revenue-assets(for bank), liability (for borrower)
  • Less liquid, cannot be turned into cash until maturity

• Other assets:

  • Physical capital (bank buildings, computers, other equipment)

General Principles of Bank Management

• A bank manages its assets and liabilities to maximize profit. There are four primary concerns:

1. Liquidity Management: maintaining sufficient cash for depositors' withdrawals
2. Asset Management: acquiring assets with low default risk and diversifying holdings.
3. Liability Management: acquiring funds at the lowest possible cost.
4. Capital Adequacy Management: maintaining and acquiring sufficient capital to cover potential losses.

• Additional concerns of bank management:
  • Credit risk: risk that borrowers might default
  • Interest-rate risk: risk that changes in interest rates affect bank earnings.