Introduction to Finance - Chapter 8: Banking

Introduction to Finance - Chapter 8: Banking (Core) Services

• Commercial banks are the second tier in two-tier banking systems
• They manage accounts, deposits, credits/loans and other financial services for companies and households.

Balance Sheet of Banks

• Assets:

  • Cash and Cash Equivalents
  • US Treasuries
  • Municipal Bonds
  • Asset-Backed Securities
  • Loans (commercial and industrial, real estate, residential mortgages, home equity loans, commercial mortgages, consumer loans, credit cards, auto loans, interbank loans)

• Liabilities and Equity:

  • Checkable Deposits
  • Non-Transaction Deposits
  • Borrowings from Other Banks
  • Bank Capital

Balance Sheet - Assets and L&E

• Assets: represent resources owned by a firm, bought to increase value and benefit operations; use of capital
• Liabilities and Equity (L&E): total liabilities show total money owed to creditors; equity represents capital provided by owners with reinvested profits, source of capital

Services of Commercial Banks

• Core bank services:

  • Payment service
  • Gathering deposits
  • Giving loans

• Additional non-bank services:

  • Leasing
  • Factoring
  • Intermediation of Financial Services (insurance, security, foreign exchange)
  • Financial Services connected to core services (credit cards)
  • Asset management (investment funds)
  • Other services.

Loans (3.1 LOANS)

• Loan vs Credit:

  • Credit: The creditor provides a line of credit; the borrower withdraws up to a limit within maturity; no actual monetary exchange, only the opportunity for it.
  • Loan: The lender provides agreed money; the borrower repays the money with interest; money is actually disbursed.

• Loan vs Credit (Examples):

  • Credit (overdraft): Bank grants withdrawal limit, charges a fee for offering the limit (money withdrawn or not).
  • Loan (mortgage): Bank gives agreed capital, automatically disburses the money, borrower pays back with interests.

Why We Need Credit/Loan

• Cause for loan (long term):

  • Activities that cannot be funded by own capital, or are not funded by own capital, for example, long-term investment.

• Cause for loan (short term):

  • Securing liquidity, bridging short-term cash inflow/outflow gaps, for example overdraft (withdraw money from current account up to limit).

Categorization of Loans

• Unsecured and secured loan: (secured loans include collateral, like assets; unsecured loans do not).
• Maturity: (short, medium, long term).
• The way money is provided: (loan, credit, guarantee).
• Technical form: (open-end, closed-end).
• Interest payment: (fixed or floating).

Unsecured and Secured Loans

• Unsecured loan: No collateral, only borrower income; higher risk for lender, losses not compensated; higher interests.
• Secured loan: Borrower pledges asset (collateral) for the loan; Less risk for the lender, lower interests, lender possess asset in case of default.

Interest Payment

• Fixed: Interest rate is fixed for the loan period.
• Floating: Interest rate changes over the lifespan of the loan, based on benchmark (e.g., inflation, interbank rates).

Technical Form of Loans

• Open-end loan: Revolving credit with a predetermined spending limit; flexible use and repayment up to the limit (e.g., credit cards, overdraft).
• Closed-end loan: Funds a specific purpose for a time, often installment loans with regular payment schedules (e.g., mortgages)

Bank Guarantees and Letters of Credit

• Not actual loans; Promise from financial institution to make payment for a third party (if the bank's client fails).
• Purpose: Strengthen market participant trust, usually for international trade.

How Letter of Credit Works

• The bank provides guarantee to seller (requires security and collects fee)
• Transaction executed;seller delivers appropriate documents to the bank.
• Bank pays seller instead of buyer.
• Buyer pays the bank

Process of Lending

• Loan application
• Analysis of creditworthiness (5C's - Character, Capacity, Capital, Collateral, Conditions)
• Credit proposal
• Contract
• Disbursement
• Monitoring
• Repayment
• Collection and handling repayment problems.

Analysis of Creditworthiness (5C's)

• Character: Firm/person history, management characteristics.
• Capacity: Borrower's ability to repay (loan-to-income).
• Capital: Borrower's own capital invested.
• Collateral: Asset to compensate bank in default.
• Conditions: How borrower intends to use money.

Leasing (5. LEASING)

• A contract where a lessor (financial institution) purchases an asset; lessee (borrower) gains use and possession; lease payments, can have ownership at contract end.
• The financial institution funds the asset, the lessee has use of it.

Process of Leasing

• Lessee chooses asset
• Financial institution buys/acquires the asset and takes ownership
• Lessor grants possession and permits use to lessee; collects lease payments.

Types of Lease

• Capital lease
• Operating lease
• Leaseback

Capital vs Operating Lease

• Capital Lease: Long-term funding, ownership transferred to lessor or lessee at the end buying asset. Usually for investments in long-term assets.
• Operating Lease: Shorter term; lessee doesn't receive ownership; often used to obtain temporary use or multiple times for many clients.

Leaseback

• Firms with liquidity problems may sell assets to financial institutions, leasing them back immediately.
• The firms keeps the asset and gets money immediately.
• Ownership returned to the firm at the end.

Lease vs Loan

• Lease: Financials Institutions have ownership
• Loans: Borrower is the owner
• Lease protections for financial institutions

Deposits (6. DEPOSITS)

• Checkable deposits: Allow depositors to withdraw money at will (e.g. checking accounts).
• Non-transaction deposits: Savings, time deposits (CDs); CDs have higher interest but have penalties for early withdrawal.