Banking and Financial Institutions Management PDF

Banking and the Management of Financial Institutions DR. Rania Anis Lecturer of economics –Faculty of Economic Studies and Political Science –Alexandria University The Economics of Money & Banking Lecture (8) Dr. Rania Anis Faculty of Economic Studies and Political...

Banking and the Management of Financial Institutions DR. Rania Anis Lecturer of economics –Faculty of Economic Studies and Political Science –Alexandria University The Economics of Money & Banking Lecture (8) Dr. Rania Anis Faculty of Economic Studies and Political Science Alexandria University 2 Lecture Outline 1. Summarize the features of a bank balance sheet. 2. Identify ways in which banks can manage their assets and liabilities to maximize profit. 3 What do we mean by “The Bank Balance Sheet”? A list of the bank’s assets and liabilities. As the name implies, this list balances (i.e) it has the characteristic that total assets = total liabilities + capital A bank’s balance sheet is also a list of its sources of bank funds (liabilities) and uses to which the funds are put (assets). 4  The Bank Balance Sheet First: Liabilities: A bank acquires funds by issuing (selling) liabilities, such as deposits, which are the sources of funds the bank uses. The funds obtained from issuing liabilities are used to purchase income-earning assets. The bank liabilities consists of: 1. Checkable deposits 2. Non-transaction deposits 3. Borrowings 4. Bank capital 5 Bank Liabilities (1) Checkable Deposits These are also called “transaction deposits” or “demand deposits” or “current account”. These are bank accounts that allow the owner of the account to write checks to third parties. include all deposits on which a check can be drawn. These are non-interest checking account, so they are the lowest –cost source of bank funds because the bank doesn't pay interest on it. These are considered as a medium of exchange, so they are considered as a part of narrow definition of money M1 6 Bank Liabilities (2) Non-transaction Deposits Non-transaction deposits are the primary source of bank funds. Owners cannot write checks on non- transaction deposits, but the interest rates paid on these deposits are usually higher than those on checkable deposits. There are two basic types of non-transaction deposits: savings accounts time deposits (also called certificates of deposit, or CDs). What are these two basic types?? 7 First: Saving deposits : They are the most common type of “non-transaction” deposits. The funds in these deposits can be drawn or the owner can add to it at any time where the transaction and interest are recorded in a passbook held by the owner. Banks pay interest on saving deposits. Second: Time deposits : These deposits have a fixed maturity length range from several months to more than 5 years. Early drawn( before maturity) from time deposits are subject to substantial penalties. In USA , there are two types of time deposits : (a) small denomination time deposits which has denomination less than $100,000 and less liquid than saving deposits and earn higher interest and a high-cost source of funds. (b) Large denomination time deposits which has denomination more than $100,000 and bought by banks and corporations and can be sold in secondary market before maturity. 8 Bank Liabilities (3) Borrowing Represent 30% of bank liabilities. Bank borrows from: (a) central bank ( discounted loans) (b) other banks (c) corporations : this loan is called repurchase agreement. Banks borrow overnight loans in the federal funds market to satisfy the reserve requirements at the central bank. *Overnight loans are loans that a bank makes to another bank for a short period of time. 9 Bank Liabilities (4) Bank Capital It is the bank net worth which = Total assets – liabilities. Capital can be raised by selling new equity (stocks) or from retained earnings (profits). Bank capital is a cushion against a drop in the value of its assets which could force the bank into insolvency (a case where liabilities in excess of assets). 10  The Bank Balance Sheet Second: Assets: Bank assets are thus naturally referred to as uses of funds, and the interest payments earned on them are what enable banks to make profits. The bank assets consists of: Reserves Cash items in process of collection Deposits at other banks Securities Loans Other assets 11  Bank Assets (1) Reserves Reserves are funds that the bank keeps in its vault or at the central bank. Reserves are deposits + currency that is physically held by banks Although reserves earn a low interest rate, banks hold them for two reasons (2 types of reserves) 1- required reserves which are held as reserve requirements because the regulation that for every dollar of checkable deposits at a bank, a certain fraction (10 cents, for example) must be kept as reserves. This fraction (10% in the example) is called the required reserve ratio 2-excess reserves : because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account. 12 Bank Assets (2) Cash items in the process of collection (a)They are checks written on an account at another bank and not collected yet. (b)It can be classified as an asset for the bank because it is a claim on another bank. 13 Bank Assets (3) Deposits at other banks Many small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions, and help with securities purchases. This is an aspect of a system called correspondent banking. Collectively, reserves, cash items in process of collection, and deposits at other banks are referred to as cash items. 14 Bank Assets (4) Securities A bank’s holdings of securities are an important income-earning asset. Securities are made up entirely of debt instruments for commercial banks, because banks are not allowed to hold stock These securities can be classified into three categories: 1. U.S. government and agency securities are the most liquid because they can be easily traded and converted into cash with low transaction costs. Because of their high liquidity, short-term U.S. government securities are called secondary reserves. 2. state and local government securities are more likely to do business with banks that hold their securities 3. other securities. State and local government and other securities are both less marketable (less liquid) and riskier than U.S. government securities, primarily because of default risk: Some possibility exists that the issuer of the securities may not be able to make its interest payments or pay back the face value of the securities when they mature. 15 Bank Assets (5) Loans Banks provide commercial and industrial loans to individuals or to corporations and provide real estate loans Loans produces more than 50% of the bank revenue. Loans are assets for the bank but a liability for the borrower. Loans are the less liquid than other assets because they can not be turned into cash until their maturity. 16 Bank Assets (6) Other Assets The physical capital that is owned by banks such as: ✓ bank buildings, ✓computers, and ✓other equipment 17 Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2014) 18 General Principles of Bank Management A bank manages its assets and liabilities to earn the highest possible profit so the bank manager has four primary concerns. 1. The first is to make sure that the bank has enough ready cash to pay its depositors when there are deposit outflows—that is, when deposits are lost because depositors make withdrawals and demand payment. To keep enough cash on hand, the bank must engage in liquidity management, the acquisition of sufficiently liquid assets to meet the bank’s obligations to depositors. 2. Second, the bank manager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings (asset management). 3. The third concern is to acquire funds at low cost (liability management). 4. Finally, the manager must decide the amount of capital the bank should maintain and then acquire the needed capital (capital adequacy management). 19 General Principles of Bank Management In addition to these four general principles of bank management: 1. Liquidity Management 2. Asset Management 3. Liability Management 4. Capital Adequacy Management There is two additional concerns of bank management which are: 1. Credit Risk : the risk arising because borrowers may default 2. Interest-rate Risk: the riskiness of earnings and returns on bank assets that results from interest-rate changes. 20