MGT411 - Money & Banking - Lecture Handout 24

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  • 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)

Sources of Funds

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
  • 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
  • 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

ROA x1

  • 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
interest income)
$121,,288 $161,172 $210,809
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 estate 2,971 530 4,434
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

Sale Contract

  • 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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