Ch 10 banking 2021 PDF

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Chapter 10 of Banking & Money...

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Money, Banking, and Financial Markets Chapter [ 10 ] 2nd Year

Mr. Ashraf Amin Page: fb/ashrafamincma

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Chapter 10: Ba Ban nkin king g an and d tthe he M Man an ana agem geme ent of F Fin in inan an anci ci cia al IIn nstit stituti uti utio ons Le Lear ar arni ni ning ng Ob Obje je jec ctive tives: s: 1. What is Bank Balance Sheet, what are its Basic Components? 2. What are the Basic Bank Operations? 3. What are the General Principles of Bank Management and the Basic Concern of any Bank Manager?

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Le Lear ar arni ni ning ng Ob Obje je ject ct ctive ive ives s 1: What is Bank Balance Sheet, what are its Basic Components?

The Ba Bank nk Ba Bala la lance nce S She he hee et A bank’s balance sheet is a list of the bank's Source of funds, or (liabilities) and uses of funds, or (assets). Bank Capital in defined as, Capital = Assets - Liabilities Note: Looking at the bank’s balance sheet shows us that banks make profits by charging an interest rate on their assets that exceeds the interest rate that they pay on their liabilities.

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Li Liab ab abil il ilit it itie ie iess (S (Sour our ources ces of F Funds unds unds): ): 1) Checkable Deposits: Checkable deposits are deposits in bank accounts that allow their owners to write checks. Note: Demand deposits = checking accounts that pay no interest. Characteristics: ▪ Checkable deposits are payable on demand: if the depositor requests a withdrawal or writes a check, the bank must pay immediately. ▪ Checkable deposits are a bank’s lowest-cost source of funds, since depositors are willing to accept a lower interest rate or no interest rate in exchange for the convenience of being able to write checks. 2) Nontransaction Deposits: ▪ Owners cannot write checks on nontransaction deposits. ▪ But they pay higher interest rates than checkable deposits. Non-transaction deposits include: • Savings deposits = funds can be withdrawn, without penalty, at any time. • Small denomination time deposits (under $100,000), such as (certificates of deposit or CDs) = have a fixed maturity, with penalty for early withdrawal. • Large denomination time deposits (over $100,000), such as (CDs) = also have a fixed maturity date, but they are negotiable, meaning that they can be resold in a secondary market. 3) Borrowings: Borrowings include: ▪ Borrowings from the Federal Reserve = discount loans. ▪ Borrowings from other banks = federal funds. ▪ Borrowings from non-bank corporations = repurchase agreements.

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4) Bank Capital: Capital = Assets - Liabilities = Net Worth. Note: Bank capital is a cushion against a drop in the value of the bank’s assets, since the bank becomes insolvent (bankrupt) if the value of its assets falls below the value of its liabilities (i.e., it owes more than it can repay).

Asse Assetts ((Use Use Usess o off Fun Funds) ds) ds):: 1) Reserves: Reserves include: The bank’s deposits at the Federal Reserve + Vault cash (currency that is physically held by the bank). Note: Reserves do not pay interest. Reserve is divided into: a) Required reserves: By law, the bank must hold a certain fraction (about 10%) of every dollar of checkable deposits it receives as reserves. 10% = required reserve ratio (set by central bank or Fed). b) Excess reserves: additional reserves held by the bank to meet its customers’ requests for withdrawals. 2) Cash Items in the Process of Collection: A check that had been deposited at the bank, but not yet collected from the check writer’s bank, is a cash item in the process of collection. 3) Deposits at Other Banks: Many small banks hold deposits at larger banks and in return, the large banks provide services such as check collection and help with securities purchases. This relationship between large and small banks is called correspondent banking. Mr. Ashraf Amin 5

4) Securities: Bank holdings of government securities (Treasury bills) are sometimes call its “secondary reserves” because of its high liquidity. 5) Loans: Loans are the most important source of bank income and they include: • Commercial and industrial loans. • Real estate loans (mortgages). • Consumer loans. • Interbank loans. 6) Other Assets: Physical assets owned by banks such as buildings and land, computers and office equipment, etc. Concept Check: Learning Objective 1 1) Which of the following statements is false? A) A bank's assets are its uses of funds. B) A bank issues liabilities to acquire funds. C) The bank's assets provide the bank with income. D) Bank capital is recorded as an asset on the bank balance sheet. Answer: 2) Which of the following statements are true? A) Checkable deposits are payable on demand. B) Checkable deposits do not include NOW accounts. C) Checkable deposits are the primary source of bank funds. D) Demand deposits are checkable deposits that pay interest. Answer: 3) Because ________ are less liquid for the depositor than ________, they earn higher interest rates. A) money market deposit accounts; time deposits B) checkable deposits; passbook savings C) passbook savings; checkable deposits D) passbook savings; time deposits Answer: 4) The largest percentage of banks' holdings of securities consist of A) Treasury and government agency securities. B) tax-exempt municipal securities. C) state and local government securities. D) corporate securities. Answer: 5) Bank reserves include A) deposits at the Fed and short-term treasury securities. B) vault cash and short-term Treasury securities. C) vault cash and deposits at the Fed. D) deposits at other banks and deposits at the Fed. Answer: 6) Secondary reserves are so called because A) they can be converted into cash with low transactions costs. B) they are not easily converted into cash, and are, therefore, of secondary importance to banking firms. C) 50% of these assets count toward meeting required reserves. D) they rank second to bank vault cash in importance of bank holdings. Answer: 7) Bank's make their profits primarily by issuing A) equity. B) negotiable CDs. C) loans. D) NOW accounts. Answer: 8) When a new depositor opens a checking account at the First National Bank, the bank's assets …….. and its liabilities ……….. A) increase; increase B) increase; decrease C) decrease; increase D) decrease; decrease Answer:

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Le Lear ar arni ni ning ng Ob Obje je jec ctive tives s 2 : What are the Basic Bank Operations?

Basic Operation of a Bank: T-accounts By looking at bank's balance sheets, we can see that banks sell liabilities and use the proceeds to acquire assets. For example, a bank will accept a savings deposit from one customer and use the proceeds to make a mortgage loan to another customer. This process is called asset transformation. By engaging in asset transformation, the bank hopes to profit by charging a higher interest rate on its assets (such as loans) than it must pay on its liabilities (such as saving deposit).

➢ Bank operations can be illustrated with the help of a T-account.

Example 1: (cash deposit) Suppose a customer deposits a $100 bill into his or her checking account at First National Bank. The bank puts the $100 bill in its vault and adds $100 to the customer’s checking account balance as follows,

The $100 deposit shows up as a new liability on First National Bank’s balance sheet, while the extra $100 in vault cash adds to First National Bank’s reserves and therefore shows up as a new asset. Hence, the T-account looks like this:

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Note: Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits

Example 2: (check deposit) Now suppose that instead of depositing a $100 bill, First National Bank’s customer deposits a check for $100 written on an account at Second National Bank. The initial effect of this transaction can be shown in a T-account for First National Bank as follows:

First National Bank then deposits the check in its account at the Fed. The Fed transfers $100 from second National Bank’s account to First National Bank’s account. Now we can draw T-accounts for both First National Bank and Second National Bank as follows:

Thus, when a bank receives additional deposits, it gains an equal amount of reserves. And when a bank loses deposits, it loses an equal amount of reserves.

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Example 3: (making a profit) Consider First National Bank’s situation after it receives $100 in checkable deposits and hence $100 in additional reserves. By law, First National Bank must hold 10%, or ($10 = 0.1 x $100), as required reserves. The remaining $90 is excess reserves.

First National Bank will decide to use all of the $90 excess reserve to make a new loan to one of its other customers (new borrower).

• If First National Bank charges a 10% interest rate on this loan, its revenues increase by $90×10%, or $9. • If First National Bank pays only 5% on its checking account balances, its costs increase by $100×5%, or $5. • Hence, First National Bank makes a profit from this process of asset transformation.

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Concept Check: Learning Objective 2 9) When a $10 check written on the First National Bank of Chicago is deposited in an account at Citibank, then A) the liabilities of the First National Bank increase by $10. B) the reserves of the First National Bank increase by $ 10. C) the liabilities of Citibank increase by $10. D) the assets of Citibank fall by $10. Answer: 10) When Jane Brown writes a $100 check to her nephew and he cashes the check, Ms. Brown's bank ________ assets of $100 and ________ liabilities of $100. A) gains; gains B) gains; loses C) loses; gains D) loses; loses Answer: 11) When you deposit $50 in currency at Old National Bank, A) its assets increase by less than $50 because of reserve requirements. B) its reserves increase by less than $50 because of reserve requirements. C) its liabilities increase by $50. D) its liabilities decrease by $50. Answer: 12) Holding all else constant, when a bank receives the funds for a deposited check, A) cash items in the process of collection fall by the amount of the check. B) bank assets increase by the amount of the check. C) bank liabilities decrease by the amount of the check. D) bank reserves increase by the amount of required reserves. Answer: 13) When you deposit $50 in your account at First National Bank and a $100 check you have written on this account is cashed at Chemical Bank, then A) the assets of First National rise by $50. B) the assets of Chemical Bank rise by $50. C) the reserves at First National fall by $50. D) the liabilities at Chemical Bank rise by $50. Answer: 14) When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank chooses not to hold any excess reserves but makes loans instead, then, in the bank's final balance sheet, A) the assets at the bank increase by $800,000. B) the liabilities of the bank increase by $1,000,000. C) the liabilities of the bank increase by $800,000. D) reserves increase by $160,000. Answer: 15) When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank chooses not to make any loans but to hold excess reserves instead, then, in the bank's final balance sheet, A) the assets at the bank increase by $1 million. B) the liabilities of the bank decrease by $1 million. C) reserves increase by $200,000. D) liabilities increase by $200,000. Answer: 16) With a 10% reserve requirement ratio, a $100 deposit into New Bank means that the maximum amount New Bank could lend is A) $90. B) $100. C) $10. D) $110. Answer: 17) A deposit outflow results in equal reductions in A) loans and reserves. B) assets and liabilities. C) reserves and capital. D) assets and capital. Answer: Mr. Ashraf Amin 10

Le Lear ar arni ni ning ng Obj Obje ecti ctive ve ves s 3: What are the General Principles of Bank Management and the Basic Concern of any Bank Manager?

General Principles of Bank Management. A bank manager has many basic concerns: 1) Liquidity management = making sure that the bank has enough cash to cover depositors’ requests for withdrawals (deposit outflows). 2) Asset management = acquiring assets with the highest return and the lowest risk.

1) Li Liqui qui quidi di dity ty M Ma ana nage ge geme me ment: nt: To illustrate the basic principles of liquidity management, let’s consider two examples of how a bank can cope with deposit outflows.

Example 1: (The case of sufficient or ample excess reserve) Suppose that the required reserve ratio is 10%, but that First National Bank (FNB) holds some excess reserves as well. FNB balance sheet is:

Required reserve is $100×10%, or $10. So FNB has $10 in excess reserves. Now suppose that FNB experiences a deposit outflow, either because one of its customers withdraws $10 or because one of its customers writes a check for $10 on his or her account. We know from our previous analysis that, as a result of this transaction, FNB loses $10 in deposits and $10 in reserves. Mr. Ashraf Amin 11

FNB’s balance sheet is now:

Required reserve is $90×10%, or $9. • So FNB is still meeting its reserve requirement and, in fact, still has $1 in excess reserves. Conclusion: this bank prefer liquidity over lower profit (higher liquidity + low profit + low risk)

Example 2: (The case of insufficient or shortfall in excess reserve) Now suppose that the required reserve ratio is 10%, but FNB bank holds no excess reserves. This time, FNB’s balance sheet is:

Required reserve is $100×10%, or $10. Hence, excess reserve is $0. • If FNB experiences a $10 deposit outflow, it loses $10 in deposits and $10 in reserves. Mr. Ashraf Amin 12

Now FNB’s balance sheet is:

In this case the bank is in a very bad financial position because no money exists in reserve, means the bank suffers from a shortage in reserve. By law, FNB must hold $90×10%, or $9, in required reserves. But right now it has no reserves at all (shortfall in reserve by $9). Hence, FNB’s manager must take action to obtain $9 in reserves.

FNB has three options: Option 1: Borrow reserves as a discount loan from the Federal Reserve or borrow from another bank in the federal funds market. In this case, FNB’s balance sheet becomes:

Noteimp: The cost of choosing this option is the interest rate on the borrowing.

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Option 2: Sell securities, the bank sells $9 worth of securities. In this case, FNB’s balance sheet becomes:

Noteimp: The cost of choosing this option is the brokerage cost of selling securities. Also, the bank no longer gets the interest paid by the securities it sold. Option 3: Reduce its loans or calling in loans of ($9). In this case, FNB’s balance sheet becomes:

This third option may be the most costly of all, since it might antagonize ‫ىعادى‬- ‫ يخاصم‬the bank’s customers who want to borrow. Also, the bank no longer gets the interest that would have been paid by the borrower. Conclusion: this bank prefers higher profit over liquidity (lower liquidity + high profit + high risk) Note: the bank may only agree to purchase loans at a substantial discount. • Comparing examples 1 and 2 illustrates why a bank might hold some excess reserves even though reserves do not pay interest. Mr. Ashraf Amin 14

• If the bank does not hold excess reserves, it must meet deposit outflows by borrowing, selling securities, or reducing its loans. • All of these options are costly; so excess reserves provide insurance against the cost associated with deposit outflow. The higher the cost associated with deposit outflow, the more excess reserve bank will want to hold. Concept Check: Learning Objective 3 18) Bankers' concerns regarding the optimal mix of excess reserves, secondary reserves, borrowings from the Fed, and borrowings from other banks to deal with deposit outflows is an example of A) liability management. B) liquidity management. C) managing interest rate risk. D) managing credit risk. Answer: 19) If, after a deposit outflow, a bank needs an additional $3 million to meet its reserve requirements, the bank can A) reduce deposits by $3 million. B) increase loans by $3 million. C) sell $3 million of securities. D) repay its discount loans from the Fed. Answer: 20) A bank with insufficient reserves can increase its reserves by A) lending federal funds. B) calling in loans. C) buying short-term Treasury securities. D) buying municipal bonds. Answer: 21) Of the following, which would be the first choice for a bank facing a reserve deficiency? A) Call in loans B) Borrow from the Fed C) Sell securities D) Borrow from other banks Answer: 22) ________ may antagonize customers and thus can be a very costly way of acquiring funds to meet an unexpected deposit outflow. A) Selling securities B) Selling loans C) Calling in loans D) Selling negotiable CDs Answer: 23) If a bank needs to acquire funds quickly to meet an unexpected deposit outflow, the bank could A) borrow from another bank in the federal funds market. B) buy U.S. Treasury bills. C) increase loans. D) buy corporate bonds. Answer: 24) As the costs associated with deposit outflows ________, the banks willingness to hold excess reserves will ________. A) decrease; increase B) increase; decrease C) increase; increase D) decrease; not be affected Answer:

Concept Check Answers 1- D

2- A

3- C

4- A

5- C

6- A

7- C

8- A

9- C

10- D

11- C

12- A

13- C

14- B

15- A

16- A

17- B

18- B

19- C

20- B

21- D

22- C

23- A

24- C

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Not Note: e: Asse Assett Ma Mana na nagem gem gemen en entt : Asset Management has three Goals, 1) Seek the highest possible returns on loans and securities. 2) Reduce risk. 3) Have adequate liquidity.

The bank must hold a mix of assets that provides the highest return with the lowest risk.

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