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Money & Banking ­ MGT411
VU
Lesson 24
BALANCE SHEET OF COMMERCIAL BANKS
Balance Sheet of Commercial Banks
Assets: uses of funds
Bank Capital and Profitability
Off-Balance-Sheet Activities
Bank Risk
Liquidity Risk
Credit Risk
Interest Rate Risk
Trading Risk
Other Risks
Liabilities: Sources of Funds
Checkable Deposits
Non-transactions Deposits
Borrowings
Discount loans
Federal funds market
Checkable deposits:
A typical bank will offer 6 or more types of checking accounts.
In recent decades these deposits have declined because the accounts pay low interest rates
Nontransactions Deposits:
These include savings and time deposits and account for nearly two-thirds of all commercial
bank liabilities.
When you place your savings in a Certificate of Deposit (CD) at the bank, it is as if you are
buying a bond issued by that bank
CDs can vary in terms of their value, the large ones can be bought and sold in financial markets
Borrowings:
Banks borrow from the central bank (discount loans)
They can borrow from other banks with excessive reserves in the inter-bank money market.
Banks can also borrow by using a repurchase agreement or repo, which is a short-term
collateralized loan
A security is exchanged for cash, with the agreement that the parties will reverse the transaction
on a specific future date (might be as soon as the next day)
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Money & Banking ­ MGT411
VU
Mechanics of an Overnight Repurchase Agreement
Day 1
Bank sells U.S. Treasury bill to pension fund in exchange for cash
U.S Treasury bill to pension fund
Pension
Bank
Fund
Cash to bank
Day 2
Bank repurchases U.S. Treasury bill from the pension fund in exchange
for cash plus interest
U.S. Treasury bill returned to bank
Pension
Bank
Fund
Cash + interest paid to pension fund
Bank Capital and Profitability
The net worth of banks is called bank capital; it is the owners' stake in the bank
Capital is the cushion that banks have against a sudden drop in the value of their assets or an
unexpected withdrawal of liabilities
An important component of bank capital is loan loss reserves, an amount the bank sets aside to
cover potential losses from defaulted loans
It is reduced by the defaulted loans written-off
There are several basic measures of bank profitability
Return on Assets,
ROA = Net profit after taxes
Total bank assets
It is a measure of how efficiently a particular bank uses its assets
A manager can compare the performance of bank's various lines of businesses by looking at
different units' ROA
The bank's return to its owners is measured by the Return on Equity
ROE = Net profit after taxes
Bank capital
ROA and ROE are related to leverage
A measure of leverage is the ratio of bank assets to bank capital. Multiplying ROA by this ratio
yields ROE
ROA x Bank Assets
Bank Capital
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Money & Banking ­ MGT411
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= Net profit after taxes x Bank Assets
Total bank assets
Bank Capital
= Net profit after taxes
= ROE
Bank Capital
Return on equity tends to be higher for larger banks, suggesting the existence of economies of
scale
Net interest income is another measure of profitability;
It is the difference between the interest the bank pays and what it receives
It can also be expressed as a percentage of total assets to yield (net interest margin). It is the
bank's interest rate spread
Well run banks have high net interest income and a high net interest margin.
If a bank's net interest margin is currently improving, its profitability is likely to improve in the
future.
Table: Profitability of U.S. Commercial Banks( in millions of $, except bottom four rows)
Items
1991
1996
2001
A. Interest income-interest expense (Net
$121,,288
$161,172
$210,809
interest income)
B. Other revenue
58,482
92,515
153,734
C. Operating costs
124,233
159,241
218,706
D. Gross profit (A+B-C)
55,537
94,446
145,837
E. Loan losses(provisions)
34,128
15,483
41,008
F. Net operating profit (D-E)
21,409
78,963
104,829
G. Realized capital gains from sale of real
2,971
530
4,434
estate
H. Net profits before taxes (F+G)
24,380
79,493
109,263
I. Assets
3,420,381
4,554,234
6,454,543
Net interest margin (A/I)
0.0355%
0.0354%
0.0327%
Return on assets (H/I) (ROA)
0.0071
0.0175
0.0169
Return on equity (ROE)
0.1258
0.2147
0.1860
Net interest income/ Total income [A/(A+B)]
0.6747
0.6353
0.5782
Off-Balance-Sheet Activities
Banks engage in these activities in order to generate fee income; these activities include
providing trusted customers with lines of credit
Letters of credit are another important off-balance-sheet activity; they guarantee that a customer
will be able to make a promised payment.
In so doing, the bank, in exchange for a fee, substitutes its own guarantee for that of the
customer and enables a transaction to go forward
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Money & Banking ­ MGT411
VU
Sale Contract
Buyer
Seller
(Importer)
(Exporter)
Deliver Goods
Request
Documents
Deliver
Present
for Credit
& Claim for
Letter of
Documents
Payment
Credit
Present
Documents
Importer's Bank
Exporter's Bank
Payment
(Issuing Bank)
(Advising Bank)
Send Credit
A standby letter of credit is a form of insurance; the bank promises that it will repay the lender
should the borrower default
Off-balance-sheet activities create risk for financial institutions and so have come under
increasing scrutiny in recent years
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY