banking and the management of financial institutions

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banking and the management of financial institutions

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Cash reserves Deposits at Other Banks Cash Items in Process of Collection Securities Loans Fixed and Other Assets Demand and Notice Deposits Fixed – Term Deposits Borrowings Overdraft loans (advances) Settlement balances Bank capital Reserves Vault cash Desired reserves Banker’s risk Desired reserve ratio Cash Items in Process of Collection Items in transit (bank float) Deposits at Other Banks Interbank deposits Securities Secondary reserves Loans Other Assets

Copyright  2011 Pearson Canada Inc. 13 - 1 Chapter 13 Banking and the Management of Financial Institutions Copyright  2011 Pearson Canada Inc. 13 - 2 Assets • Cash reserves • Deposits at Other Banks • Cash Items in Process of Collection • Securities • Loans • Fixed and Other Assets Copyright  2011 Pearson Canada Inc. 13 - 3 Liabilities I • Demand and Notice Deposits • Fixed – Term Deposits • Borrowings – Overdraft loans (advances) – Settlement balances • Bank capital • Reserves – Vault cash – Desired reserves – Banker’s risk – Desired reserve ratio Copyright  2011 Pearson Canada Inc. 13 - 4 Liabilities II • Cash Items in Process of Collection – Items in transit (bank float) • Deposits at Other Banks – Interbank deposits • Securities – Secondary reserves • Loans • Other Assets Copyright  2011 Pearson Canada Inc. 13 - 5 The Bank Balance Sheet Copyright  2011 Pearson Canada Inc. 13 - 6 Basic Banking I • Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in chequable deposits First Bank Business Assets Liabilities Assets Liabilities Loans +$100 Chequable deposits +$100 Chequable Deposits +$100 Bank Loans +$100 First bank makes a loan of $100 to a business and credits the business's chequable deposit. Copyright  2011 Pearson Canada Inc. 13 - 7 Basic Banking II First Bank Second Bank Assets Liabilities Assets Liabilities Reserves +$100 Chequable deposits +$100 Reserves -$100 Chequable deposits -$100 First Bank Assets Liabilities Cash items in process of collection +$100 Chequable deposits +$100 When a bank receives additional deposits, it gains an equal amount of reserves: when it loses deposits, it loses an equal amount of reserves Copyright  2011 Pearson Canada Inc. 13 - 8 Basic Banking—Making a Profit • Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics • The bank borrows short and lends long First Bank First Bank Assets Liabilities Assets Liabilities Desired reserves +$100 Chequable deposits +$100 Desired reserves +$10 Chequable deposits +$100 Excess reserves +$90 Loans +$90 Copyright  2011 Pearson Canada Inc. 13 - 9 Bank Management • Liquidity Management • Asset Management • Liability Management • Capital Adequacy Management • Credit Risk • Interest-rate Risk Copyright  2011 Pearson Canada Inc. 13 - 10 Liquidity Management and the Role of Reserves • If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet Assets Liabilities Assets Liabilities Reserves $20M Deposits $100M Reserves $10M Deposits $90M Loans $80M Bank Capital $10M Loans $80M Bank Capital $10M Securities $10M Securities $10M with deposit outflow of $10 million ↓ [...]... = Equity Capital net profit after taxes net profit after taxes assets = x equity capital assets equity capital ROE = ROA x EM Capital Adequacy Management: Safety • Benefits the owners of a bank by making their investment safe • Costly to owners of a bank because the higher the bank capital, the lower the return on equity • Choice depends on the state of the economy and levels of confidence • Bank capital... The cost of selling securities is the brokerage and other transaction costs $90M $10M Liquidity Management: Bank of Canada Advances Borrow $9 million from the Bank of Canada Assets Reserves Liabilities $9M Deposits Loans $90M Advance Bank of Canada Securities $10M Bank Capital • Borrowing from the Bank of Canada also incurs interest payments based on the discount rate $90M $9M $10M Liquidity Management: ... -$1M Capital Adequacy Management: Returns to Equity Holders Return on Assets :net profit after taxes per dollar of assets net profit after taxes assets Return on Equity :net profit after taxes per dollar of equity capital net profit after taxes ROE = equity capital Relationsh ip between ROA and ROE is expressed by the ROA = Equity Multiplier : the amount of assets per dollar of equity capital Assets... rate-sensitive liabilities GAP = RSL – RSA • A change in the interest rate (Δi) will change bank income (∆Ι) depending on the Gap ∆Income = GAP × ∆i Duration Analysis I • Owners and managers care not only about the change in interest rates on income but also on net worth of the institution • Duration Analysis examines the sensitivity of the market value of the financial institution’s net worth to changes in... from the lenders point of view • Once a borrower has obtained a loan, they are more likely invest in high-risk investment projects that might bring high rates of return if successful • The high risk, however, makes it less likely the loan will be repaid Managing Credit Risk IV • To be profitable, lending firms must overcome adverse selection and moral hazard problems • Attempts by the lending institutions. .. P is the market value %ΔP = (Pt+1 – Pt)/P DUR = duration i = interest rate Duration Analysis III The Duration Gap can be calculated as: DURgap = Dura – (L/A x DURL) Where: Dura = average duration of assets L = market value of liabilities A = market value of assets Durl = average duration of liabilities Duration Analysis IV The impact of the interest rate change on net worth (NW) as a percentage of assets... Reduction of loans is the most costly way of acquiring reserves • Calling in loans antagonizes customers • Other banks may only agree to purchase loans at a substantial discount $90M $10M Asset Management: Three Goals • Seek the highest possible returns on loans and securities • Reduce risk • Have adequate liquidity Asset Management: Four Tools • Find borrowers who will pay high interest rates and have... sensitive assets, a rise in interest rates will reduce the net interest margin and income • If a financial institution has more interest rate sensitive assets than interest rate sensitive liabilities, a rise in interest rates will raise the net interest margin and income Gap Analysis • The Gap is the difference between interest rate sensitive liabilities and interest rate sensitive assets GAP = rate-sensitive... Buying back some of Bank’s stock • Pay out higher dividend to shareholders • Acquire new funds and increase assets Raising Bank Capital: • Issue more common stock • Reducing dividend to shareholders • Issue fewer loans or sell securities and use proceeds to reduce liabilities Managing Credit Risk I • A major component of many financial institutions business is making loans • To make profits, these firms... instruments (such as negotiable CDs) • Checkable deposits have decreased in importance as source of bank funds Capital Adequacy Management • Bank capital helps prevent bank failure • The amount of capital affects return for the owners (equity holders) of the bank • Regulatory requirement Capital Adequacy Management: Preventing Bank Failure High Bank Capital Assets Low Bank Capital Liabilities Assets . 2011 Pearson Canada Inc. 13 - 1 Chapter 13 Banking and the Management of Financial Institutions Copyright  2011 Pearson Canada Inc. 13 - 2 Assets • Cash. other banks Copyright  2011 Pearson Canada Inc. 13 - 13 Liquidity Management: Securities Sale • The cost of selling securities is the brokerage and other

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