Monetary Economics (ECS3701) (11) Banking and the management of Financial Institutions

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ECS 3701Monetary Economics

Errol Goetsch 078 573 5046 [email protected] 082 770 4569 [email protected]

www.facebook.com/groups/ecs3701

Boston | UNISA 2015Unit 3 - 08 An Economic Analysis of Financial Structure

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Unit 1 – Introduction01 Why study money, banking, financial markets02 Overview of the financial system03 What is Money?Unit 2 – Financial Markets04 Understanding interest rates05 The behaviour of interest rates06 The risk and term structure of interest ratesUnit 3 – Financial Institutions08 An economic analysis of financial structure09 Financial crises in advanced economies10 Financial crises in emerging economies11 Banking and management of financial institutionsUnit 4 – Central banking and monetary policy14 Central banks: a global perspective15 The money supply process16 Tools of monetary policy17 The conduct of monetary policy: strategy & tacticsUnit 6 – Monetary theory20 Quantity theory, inflation and demand for money21 The IS curve24 Monetary policy theory25 The role of expectations in Monetary Policy26 Transmission mechanisms of Monetary Policy

11.0 The circular flowMoney / financial markets in the circular flow11.1 The Bank Balance SheetAssets and liabilities in a T-accountBank Operation11.2 8 Principles of Bank ManagementThe 4 areas(1) Liquidity Management – dep. outflow w/ reserves(1) Liquidity Management – dep. outflow w/o reserves(1) Liquidity Management – borrow / sell securities(1) Liquidity Management – borrow / sell debt(2) Asset Management(3) Liability Management(4) Capital adequacy management(4) Capital adequacy management - example11.3 Solving Asymmetric Information Problems7 methods11.4 Managing Interest Rate RiskVolatility and mismatchGap analysisDuration Analysis11.5 Off-balance sheet activitiesInnovation in banking incomeManaging risk of innovations

Monetary EconomicsUnits 1 - 6

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Goods Market

Make

Use

Imports

Exports Exports

ImportsFactor Market

Producers

Consumers

Supply

Demand

Lenders(surplus units)

Firms

Households

Government

Foreign Sector

Borrowers(deficit units)

Firms

Households

Government

Foreign Sector

Financial Intermediaries

Financial Markets

Money Money

Securities SecuritiesMoney

Securities

Credit / Interest Rate

11.0 The Financial SystemMoney in the Circular Flow

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Total Assets = Total Liabilities + Capital

Liabilities = Sources of CapitalAssets = Uses of Capital

Chequeable DepositsBank accounts to issue cheques / payable on demand

Reserves & 3 Cash itemsCash held at SARB or in vault = RR + ER

Non-transaction depositssavings accounts / time depositsSmallLarge

SecuritiesDebt instruments / bonds

BorrowingsLoans from SARB (discount loans), other banks, firms

LoansCommercial / IndustrialReal estateConsumerInterbankOther

Other assetsphysical capital

Total 100%Total 100%

CapitalNet worth (A – L), from equity or retained earnings

Asset Transformation

11.1 The Bank Balance SheetAssets and Liabilities in a T-account

Sources of Income Used to buy income-earning assets

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T-account Analysis:Deposit of R100 cash into First BankAssets Liabilities

Vault Cash + R100 Chequable Deposits + R100(=Reserves)(% Required + 1 - % Excess Reserves)

Deposit of R100 cheque into First BankAssets Liabilities

Cash items in process Chequable Deposits + R100of collection + R100

First Bank Second BankAssets Liabilities Assets Liabilities

Chequable ChequableReserves Deposits Reserves Deposits+ R100 + R100 – R100 – R100Conclusion: When bank receives deposits, reserves + by equal amount; when bank loses deposits, reserves - by equal amount

11.1 The Bank Balance SheetBank Operation

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1. Liquidity Management (ready cash for withdrawals)

2. Asset Management

Managing Credit Risk (few defaults)

Managing Interest-rate Risk (diversified portfolios)

3. Liability Management (low cost funding)

4. Capital Adequacy Management

11.2 Principles of Bank Management4 areas of Bank Management

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Liquidity ManagementDesired reserve ratio = 10%, Excess reserves = R10 millionAssets LiabilitiesReserves R20 million Deposits R100 millionLoans R80 million Bank Capital R 10 millionSecurities R10 million

Deposit outflow of R10 millionAssets LiabilitiesReserves R10 million Deposits R 90 millionLoans R80 million Bank Capital R 10 millionSecurities R10 millionWith 10% desired reserve ratio, bank still has excess reserves of R1 million: no changes needed in balance sheet

11.2 Principles of Bank Management(1) Liquidity Management – deposit outflow

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No excess reservesAssets LiabilitiesReserves R10 million Deposits R100 millionLoans R90 million Bank Capital R 10 millionSecurities R10 million

Deposit outflow of R 10 millionAssets LiabilitiesReserves R 0 million Deposits R 90 millionLoans R90 million Bank Capital R 10 millionSecurities R10 million

11.2 Principles of Bank Management(1) Liquidity Management – no excess reserves

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1. Borrow from other banks or corporations (cost = i)Assets LiabilitiesReserves R 9 million Deposits R 90 millionLoans R90 million Borrowings R 9 millionSecurities R10 million Bank Capital R 10 million

2. Sell Securities (transaction costs)Assets LiabilitiesReserves R 9 million Deposits R 90 millionLoans R90 million Bank Capital R 10 millionSecurities R 1 million

11.2 Principles of Bank Management(1) Liquidity Management – 1) Borrow from banks or 2) Sell equities

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3. Borrow from SARB (cost = repo rate)Assets LiabilitiesSecurities R10 million Bank Capital R 10 millionReserves R 9 million Deposits R 90 millionLoans R90 million Advances R 9 million

4. Call in or sell off loans (cost = customer + loss)Assets LiabilitiesReserves R 9 million Deposits R 90 millionLoans R81 million Bank Capital R 10 millionSecurities R10 million

Conclusion: excess reserves are insurance against above 4 costs from deposit outflows

11.2 Principles of Bank Management(1) Liquidity Management – 3) Borrow from SARB or 4) Call in or sell the Loans

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Asset Management1. Get high-paying borrowers with low default risk2. Buy securities with high return, low risk3. Diversify4. Manage liquidity

Liability Management1. Important since 1960s2. Banks no longer primarily depend on deposits3. When see loan opportunities, borrow or issue CDs to acquire funds

11.2 Principles of Bank Management(2) Asset and (3) Liability Management

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1. Bank capital is a cushion that helps prevent bank failure2. The higher is bank capital, the lower is return on equity

ROA = Net Profits after Taxes (NPAT) / Assets = net profit per R spentROE = Net Profits after Taxes / Equity (Bank) Capital = profit per R invested EM = Assets / Equity CapitalROE = ROA / EM

3. Tradeoff between safety (high capital) and ROE4. Banks also hold capital to meet capital requirements5. Managing Capital:

A. Reduce capital by buying back sharesB. Change dividends to change retained earningsC. Change asset growth

11.2 Principles of Bank Management(4) Capital Adequacy Management

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How bank capital prevents bank failure

Assets Liabilities

Reserves 10mLoans 90m

Deposits 90mB Capital 10m

Assets Liabilities



High-Cap Bank Low-Cap Bank

Assets Liabilities



Assets Liabilities


Deposits 96mB Capital -1m

High-Cap Bank Low-Cap Bank

If both lose 5m to bad debt…

11.2 Principles of Bank Management(4) Capital Adequacy Management - example

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1. Screening

2. Specialise in Lending

3. Monitoring and Enforcement of Restrictive Covenants

4. Establish Long-Term Customer Relationships

5. Loan Commitment Arrangements

6. Collateral and Compensating Balances

7. Credit Rationing

11.3 Managing Credit Risk7 solutions for Asymmetric Information problems

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First BankAssets LiabilitiesRate-sensitive assets R20 m Rate-sensitive liabilities R50 m

Variable-rate loans Variable-rate CDsShort-term securities Overnight funds

Fixed-rate assets R80 m Fixed-rate liabilities R50 mReserves Chequable depositsLong-term bonds Savings depositsLong-term securities Long-term CDs

Equity capital

11.4 Managing Interest Rate RiskSolving volatility and mismatch problems

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GAP = rate-sensitive assets – rate-sensitive liabilities

= R20 – R50 = – R30 million

When i ↑ 5%:

1. Income on assets = + R1 million

(= 5% x R20m)

2. Costs of liabilities = +R2.5 million

(= 5% x R50m)

3. ∆Profits = R1m – R2.5m = –R1.5m

= 5% x (R20m – R50m) = 5% x(GAP)

∆ Profits = ∆ i x GAP

11.4 Managing Interest Rate RiskGap Analysis

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Duration Analysis% ∆ value – (% point ∆ i) x (DUR)

Example: i ∆ 5%, duration of bank assets = 3 years, duration of liabilities = 2 years; % ∆ assets = –5% x 3 = –15%% ∆ liabilities = –5% x 2 = –10%

If total assets = R100 million and total liabilities = R90 million, then assets - R15 million, liabilities -R9 million, and bank’s net worth - by R6 millionStrategies to Manage Interest-rate Risk1. Rearrange balance-sheet2. Interest-rate swap3. Hedge with financial futures

11.4 Managing Interest Rate RiskDuration Analysis

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1. Loan sales2. Fee income from

A. Foreign exchange trades for customersB. Servicing mortgage-backed securitiesC. Guarantees of debtD. Backup lines of credit

3. Trading ActivitiesA. Financial futuresB. Financial optionsC. Foreign exchangeD. Swaps

11.5 Off-balance sheet activitiesInnovations in banking income

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Principal-Agent Problem

Traders have incentives to take big risks

Risk Management Controls

1. Separate of front and back rooms

2. Model value-at-risk / mark to market

3. Stress test

Regulators encouraging banks to pay more attention to risk management

11.5 Off-balance sheet activitiesManaging risks of innovations in banking income

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Monetary Economics (ECS3701) (11) Banking and the management of Financial Institutions

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