Commercial Bank Lecture n. 3 PDF

COMMERCIAL Dr. Marco Conti BANK  Commercial Bank Balance Sheet Contents Commercial Bank Management The importance of Commercial Banks Depository institutions play a key role in channeling funds. From Savers (surplus units) to Borrowers (deficit units)...

COMMERCIAL Dr. Marco Conti BANK  Commercial Bank Balance Sheet Contents Commercial Bank Management The importance of Commercial Banks Depository institutions play a key role in channeling funds. From Savers (surplus units) to Borrowers (deficit units) Banks take in funds by accepting deposit Banks use the funds mainly to grants loans The importance of Commercial Banks Commercial Banks are the oldest and most diversified of all financial intermediaries Banks are important in the money supply process The importance of Commercial Banks Commercial Banks make money by providing loans and earning interest income from those loans. Banks earn a profit on the The types of loans a CB can “spread” issue vary mortgages, auto loans, business loans and personal loans.  How a Commercial Bank works? The amount of money erned by Commercial Bank is determined by the spread betwee the interes it pays on deposits an the interest it earns on loans it issues, which is known as net interest income. Net Interest Income Assignment #7  Customer purchases a 5Y Cash Deposit for 10.000$ from a Alfa Bank at an annual interest rate of 2%  Alfa Bank offers a 5Y auto loan for 10.000$ at an annual interest rate of 5% How much is the Net Interest Income? The Commercial Bank Balance Sheet The Commercial Bank Balance Sheet is a list of a bank’s Assets and Liabilities Assets = Liabilities + Capital A Bank’s BS lists sources of bank funds (liabilities) and uses to whicth they are put (assets) The Commercial Bank Balance Sheet A Bank Balance Sheet is a statement of its Assets, Liabilities and Capital at a given point in time Assets are what it owns: Loans, securities (Earning Assets) Liabilities are what it owes: Deposit Capital (Net worth) is the difference between its assets and liabilities Commercial Bank Liabilities  Transaction Deposits  Non-Transaction Deposits (Cash Deposit)  Non-Deposit Borrowing (Bonds, Fed Funds)  Other Liabilities (Derivative) Wells Fargo - 2021 Consolidated Balance Sheet  Transaction Deposits  A transaction deposit is a bank deposit that has immediate and full liquidity, Commercial with no delays or waiting periods. Bank  A checking account, for example, is a Liabilities common transaction deposit account and the account holder is allowed to withdraw the amount at any time.  Non-Transactions Deposits  A deposit that cannot to be Commercial withdrawn or transferred to third Bank parties using some means of instruction Liabilities (such as checks, telephone, transfers).  Non-transaction deposits  Time/term deposits: With a term deposit, you lock away an amount of money for an agreed length of time (the ‘term’) – that means you can’t access the money until the term is up. In return, Commercial you’ll get a guaranteed rate of interest for the term you select. Bank  Savings deposits: A savings deposit is a Liabilities bank account designed for saving. Interest is paid on the money in the account while still giving access to the savings when needed.  Non-deposit Borrowing Borrowing from the central bank  Discount loans, discount window Commercial  Pay interest at the discount rate Bank  Borrowing from other banks’ excess Liabilities reserve  Overnights loans between banks  Pay interest at federal fund rate   The discount window is a central bank lending facility meant to help commercial banks manage short-term liquidity needs. The term discount rate can refer to either the interest rate that the Federal Reserve charges banks for short term loans or the rate used to discount future cash flows in discounted cash flow (DCF) analysis.  With a discount loan the lender calculates the Commercial interest and other related charges and discounts them Bank from the face amount before lending to the borrower. However, the borrower has to pay back the whole Liabilities amount – the principal, the related charges and the interest.  An overnight loan is a loan that a bank makes to another bank for a short period of time. Commercial Bank Assets  Cash Assets  Loans  Securities  Other Assets Wells Fargo 2021 Consolidated Balance Sheet  Most of banks’ assets are in form of income- earning assets or earning assets (85%)  Loan  Securities However, banks are subjected to maintains portion Commercial of their source of funds (liabilities) in form of non- Bank Assets interest earning legal reserves:  Coin and currency in banks  Bank’s deposit balance at the central bank  Cash Assets  Vault cash - Currency and coins at bank  to meet public’s demand  to meet reserve required  Deposits with Federal Reserve Bank (central bank)  to meet reserve required Commercial  to facilitate check clearing process Bank Assets  Deposits with other banks  Correspondent banking – smaller banks maintain deposits in larger banks in return of services e.g. check collection, investment counsel, and transaction in securities and foreign currency  Loans  Real Estate Loans: collateralized by property (real estate),  Ex. Mortgage  Securitization – banks bundle many real Commercial estate loans into the package and issue the securities based on this package to Bank Assets investors  Business Loans:  Regular installment loans  Lines of credit (subject to compensating balance)   Auto loan is a loan that person takes out in order to purchase a motor vehicle. Auto loans are typically structured as installment loans and are secured by the value of vehicle being purchased.  The overdraft allows the account holder to continue withdrawing money even Commercial when the account has no funds in it or has insufficient funds to cover the amount of Bank Assets the withdrawal.  Marketable securities are defined as any unrestricted financial instrument that can be bought or sold on a public stock exchange or a public bond exchange include common stock, commercial paper. Commercial Bank Capital  Common stock  Preferred stock  Retained earnings  Additional paid-in capital  Accumulated other comprehensive income (loss) Wells Fargo 2021 Consolidated Balance Sheet  Common stock Common stock is a form of corporate equity ownership. This type of share gives the stockholder the right to share in the profits of the company, and to vote on matters of corporate policy and the composition of the members of the board of directors Commercial Bank Capital Preferred stock Preferred stock is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument  Retained earnings Retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. Cumulative other comprehensive Commercial income or (loss) Bank Capital Accumulated other comprehensive income (OCI) includes unrealized gains and losses reported in the equity section of the balance sheet that are netted below retained earnings. Commercial Bank Management  Liquidity Management  Liability Management  Capital Management 20-minute coffee break Commercial Bank Management Commercial banks strive to:  Earn solid profits  Maintain extremely low exposure to the possibility of becoming insolvent.  Maintain high liquidity (the ability to immediately meet currency withdrawals) by managing liquidity and capital  Banks must have emergency plans The to meet large reserve withdrawals, so Importance banks need to hold liquid assets like Treasury bills. of Liquidity If a bank is exposed to large deposit outflows and can obtain reserves only at substantial cost, it could find itself in serious trouble, even if it has a relatively large capital account. Wells Fargo 2021 Consolidated Balance Sheet Liquidity The Liquidity-Risk Trade-off  If bank decides to maintains high Management liquidity, bank will face less risk, but bank will get lower return  If bank decides to maintains low liquidity, bank will face higher risk, but bank will have a change to get higher return Higher liquidity means bank will hold more excess reserve (no return) and more marketable securities (low return) rather than lending the loan (higher return) Liquidity Management With a reserve requirement of 10%, the bank has no excess reserves What if depositors withdraw $20 million? Liquidity Management If depositors withdraw $20 million,  Deposit decreases to $380 million  Reserves also decreases to $20 million However, required reserve ratio is 10%, bank need to maintain reserves at  $38 million → bank need to find more reserve for $18 million  Bank has marketable securities (liquid assets) only $10 million that is not  enough → bank need to find other funds Liquidity Management the bank has $10 million excess reserves Its assets are split between high return loans & low return securities Liquidity Management If depositors withdraw $20 m, then the balance sheet changes  Deposit decrease to $380 million  Reserves decrease to $30 million With 10% required reserve ratio, bank has to maintain $38 million reserve → bank need more $8 million Bank have lots of marketable securities to be liquidated and change to reserve → no problem Liquidity If bank decides to maintains low liquidity, bank will face higher risk Management but have more opportunity to get higher return. If bank decides to maintains high liquidity, bank will face lower risk and get lower return  Indicators of Bank Liquidity Liquidity  The ratio of bank loans to total assets Management Higher ratio → lower liquidity  The ratio of securities to total assets Higher ratio → higher liquidity  The ratio of demand deposit to total deposits Higher ratio → Bank need to maintain more liquidity Assignment #8 Calculates the Indicators of Bank Liquidity for Wells Fargo: loans to total assets securities to total assets Wells Fargo 2021 Consolidated Balance Sheet  Banks look for good lending Liability opportunities and then search for the funds to finance these loans Management When a large bank finds a profitable lending opportunity, it can:  “buy” federal funds  issue negotiable CDs  issue repurchase agreements or Bonds  Borrow Eurodollars  Obtain funds through the commercial paper market Certificates of deposit CDs. They are guaranteed by banks, cannot be redeemed before their maturation date, and can usually be sold in highly liquid secondary markets. Along with U.S. Treasury bills, they are considered a low-risk, low-interest security. Repurchase agreement (Repo) They are a short-term agreement to sell securities in order to buy them back at a slightly higher price. Eurodollar Eurodollar refers to U.S. dollar-denominated deposits at foreign banks or at the overseas branches of American banks. Eurodollars are not subject to regulation by the Federal Reserve Board, such deposits can pay higher interest. Commercial paper CPs are an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts payable and inventories and meeting short-term liabilities. Wells Fargo - 2021 Consolidated Balance Sheet Liability Aggressive liability management allows Management banks to make profitable loans that they would otherwise have to turn down. Aggressive liability management can be dangerous, because a bank’s assets typically have longer maturities than its liabilities If interest rates rise sharply, banks can suffer severe losses  Bank capital provides a financial cushion so that transitory adverse developments will not cause Capital insolvency Bank capital also protects bank managers and Management owners from their own mistakes and from various risks:  Default risk → Borrowers do not pay back their loans  Interest-rate risk → When interest rate changes  Liquidity risk → Depositors will withdraw the fund  Foreign exchange rate risk → When exchange rate change  Country risk → Risk that fund or assets in other countries cannot be mobilized to home country  Management risk → Employees will engage in activities involving enormous risk   Commercial bank raise the funds from accepting deposit and use the funds in granting the loan  Bank earn interest rate spread between deposit rate and loan rate and also earn the service fees  If bank faces daily shortage in reserve, bank can Summary borrow from Fed at discount rate or borrow from other banks at Fed fund rate  Loans are most-income-earning assets of the banks  Banks are subjected to maintains portion of their source of funds in form of non-interest-earning legal reserves (currency and deposit at Fed)   Smaller banks maintain deposits in larger banks in return of services e.g. check collection, investment counsel, and transaction in securities and foreign currency → Correspondent banking system Summary  Bank may bundle many real estate loans into the package and issue the securities based on this package to investors → securitization  Bank becomes insolvency if total asset is less than total liability or negative net worth (equity)   If bank decides to maintains low liquidity, bank will face higher risk but have more opportunity to get higher return  Aggressive liability management can be dangerous, because a bank’s assets typically have longer maturities than its liabilities. If Summary interest rates rise sharply, banks can suffer severe losses.  Bank capital provides a cushion that protects a bank's owners from potential bank insolvency higher bank capital ratio, implies a lower risk of insolvency, but also a lower rate of return 15 minutes to rearrange notes Home Assignment #9 - Bank's Income Statement Reports these transactions in the bank's income statement. 1. The Bank has business loans for $100,000,000 at an interest rate of 7%. 2. The Bank has mortgages for $50,000,000 at an interest rate of 5%. 3. The Bank has car loans for $30,000,000 at an interest rate of 10%. 4. The Bank has deposits for $150,000,000 at an interest rate of 2%. 5. The FED granted the Bank a facilitated loan for 50,000,000 at an interest rate of 1%. 6. The Bank has operating costs of $5,000,000 Calculate: - the net interest income - the gross income - the net income (tax at 27.5%) Practice n.1 Commercial Bank Dr. Marco conti  Evaluation – Grading System  10% Attendance & Participation  15% Assignments  25% Midterm Exam Commercial Bank  20% Paper Asset Management Company  30% Final Exam Workshop 1 – Commercial Bank Assemble the first bank board. 1. Each Group must choose a public commercial bank to analyze. 2. Each Group must make the appointments of: Chair Chief executive officer (CEO) Chief financial officer (CFO) Chief operating officer (COO) HR Manager ESG Manager (only for groups of 6 students) 3. Each member should address one aspect of the bank that they will then present in the workshop: Chair: History and outlook CEO: Analysis of the 2021, 2022 and 2023 Income Statement and Profitability of the bank CFO: Analysis of the 2021, 2022 and 2023 Balance Sheet and Solvency of the bank COO: Growth Strategies HR: Skills demand and job opportunities ESG Manager: ESG analysis