Money, Banking, and Financial
Markets : Econ. 212
Stephen G. Cecchetti: Chapter 12
Depository Institutions: Banks and Bank
Management
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
The Balance Sheet of Commercial Banks
Assets: Uses of Funds

The asset side of a bank’s balance sheet includes cash,
securities, loans, and all other assets (which includes mostly
buildings and equipment).

Cash Items: The three types of cash assets are
1. reserves (which includes cash in the bank’s vault as well
as its deposits at the central bank –Federal reserve in
USA);
2.
cash items in the process of collections (uncollected funds
the bank expects to receive-checks);
3.
and the balances of accounts that banks hold at other
banks (correspondent banking).
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Securities: The second largest component of bank assets; in
USA these include U.S. Treasury securities and state and
local government bonds. Securities are sometimes called
secondary reserves because they are highly liquid and can
be sold quickly if the bank needs cash.

Loans: The primary asset of modern commercial banks;
includes:
1. business loans (commercial and industrial loans),
2. real estate loans,
3. consumer loans,
4. inter-bank loans, and
5. loans for the purchase of other securities.

The primary difference among the various types of
depository institutions is in the composition of their loan
portfolios.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Liabilities: Sources of Funds

Banks need funds to finance their operations; they get them
from different savers and from borrowing in the financial
markets.

Deposits: There are two types of deposit accounts,
transactions deposits (checkable deposits) and nontransactions deposits.
1.
Checkable deposits (or transactions deposits): A typical
bank will offer 6 or more types of checking accounts. In
recent decades these deposits have declined because these
accounts pay low interest rates and financial innovations
that relaxed the barriers between transactions and nontransaction deposits.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
2.

3.

Non-transactions Deposits: These include
• savings
• time deposits
Non-transactions deposits account for nearly two-thirds of all
commercial bank liabilities.
Certificates of deposit can be small ($100,000 or less) or large (more
than $100,000), and the large ones can be bought and sold in financial
markets.
Borrowings: The second most important source of bank funds; banks
borrow from
1. The Central Bank (discount loans)
2. Other banks
3. Banks can also borrow by using a repurchase agreement or REPO,
which is a short-term collateralized loan in which 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).
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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,
the bank sets aside to cover potential losses from defaulted
loans.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Bank Profitability

There are several basic measures of bank
profitability:
 return on assets (after tax net profit divided by its
total assets) and
 return on equity (after tax net profit divided by its
capital).
 Net interest income is another measure of
profitability; it is the difference between the
interest the bank pays and what it receives. Net
interest income can also be expressed as a
percentage of total assets; that is called net
interest margin, or the bank’s interest rate spread.
Net interest margin is an indicator of future
profitability as well as current profitability.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Off-Balance-Sheet Activities

Banks engage in these activities in order to generate fee
income; these activities include
1.
2.
3.

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.
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.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Bank Risk: Where It Comes from and What to Do About It


Liquidity Risk
Liquidity risk is the risk of a sudden demand for funds and it
can come from both sides of a bank’s balance sheet (deposit
withdrawal on one side and the funds needed for its offbalance sheet activities on the liabilities side).

If a bank cannot meet customers’ requests for immediate
funds it runs the risk of failure; even with a positive net
worth, illiquidity can drive a bank out of business.

One way to manage liquidity risk is to hold sufficient excess
reserves (beyond the required reserves mandated by the
Central Bank) to accommodate customers’ withdrawals.
However, this is expensive (interest is foregone).
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Two other ways to manage liquidity risk are adjusting assets
or adjusting liabilities.
1.
A bank can adjust its assets by selling a portion of its
securities portfolio, or by selling some of its loans, or by
refusing to renew a customer loan that has come due.

Banks do not like to meet their deposit outflows by
contracting the asset side of the balance sheet because doing
so shrinks the size of the bank.
2.
Banks can use liability management to obtain additional
funds by:
1.
2.
3.
borrowing from the Central Bank
borrowing from another bank, or by
attracting additional deposits (by issuing large CDs).
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Case 1: holding sufficient excess reserves.
- Given the following balance sheet of bank X.
- If RRR = 10%. This bank will be holding 5 million excess reserves.
- If this bank suffers a deposit outflow of 5. the bank will still be holding excess
reserves.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Case 2: holding insufficient excess reserves.
- Given the following balance sheet of bank Y.
- If RRR = 10%. This bank will be holding no excess reserves.
- If this bank suffers a deposit outflow of 5. the bank will have a liquidity
shortage of 5 million
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University


Credit Risk
This is the risk that loans will not be repaid and it can be
managed through diversification and credit-risk analysis.

Diversification can be difficult for banks, especially those that
focus on certain kinds of lending.

Credit-risk analysis produces information that is very similar
to the bond-rating systems and is done using a combination of
statistical models and information specific to the loan
applicant.

Lending is plagued by adverse selection and moral hazard,
and financial institutions use a variety of methods to mitigate
these problems.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University


Interest-Rate Risk
The two sides of a bank’s balance sheet often do not match up
because liabilities tend to be short-term while assets tend to
be long-term; this creates interest-rate risk.

In order to manage interest-rate risk, the bank must
determine how sensitive its balance sheet is to a change in
interest rates; gap analysis highlights the gap or difference
between the yield on interest sensitive assets and the yield on
interest-sensitive liabilities.

Multiplying the gap by the projected change in the interest
rate yields the change in the bank’s profit.

Gap analysis can be further refined to take account of
differences in the maturity of assets and liabilities.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Banks can manage interest-rate risk by matching the interestrate sensitivity of assets with the interest-rate sensitivity of
liabilities, but this approach increases credit risk.
 Bankers can use derivatives, like interest-rate swaps,
to manage interest-rate risk.


Trading Risk
Banks today hire traders to actively buy and sell securities,
loans, and derivatives using a portion of the bank’s capital in
the hope of making additional profits.

However, trading such instruments is risky (the price may go
down instead of up); this is called trading risk or market risk.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Managing trading risk is a major concern for today’s banks,
and bank risk managers place limits on the amount of risk
any individual trader is allowed to assume.

Banks also need to hold more capital if there is more risk in
their portfolio.


Other Risks
Banks that operate internationally will face foreign exchange
risk (the risk from unfavorable moves in the exchange rate)
and sovereign risk (the risk from a government prohibiting
the repayment of loans).

Banks manage their foreign exchange risk by attracting
deposits denominated in the same currency as the loans and
by using foreign exchange futures and swaps to hedge the
risk.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Banks manage sovereign risk by diversification, by refusing
to do business in a particular country or set of countries, and
by using derivatives to hedge the risk.

Banks also face operational risk, the risk that their computer
system may fail or that their buildings may burn down.

To manage operational risk the bank must make sure that its
computer systems and buildings are sufficiently robust to
withstand potential disasters.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Lessons of Chapter 12






Bank assets equal bank liabilities plus bank capital.
Bank assets are the uses for bank funds.

They include reserves, securities, and loans.

Over the years, securities have become less important and mortgages more
important as a use for bank funds.
Banks liabilities are the sources of bank funds.

They include transactions and nontransactions deposits, as well as borrowings
from other banks.

Over the years, transactions deposits have become increasingly less important
as a source of bank funds.
Bank capital is the contribution of the bank’s owners; it acts as a cushion against
a fall in the value of the bank’s assets or a withdrawal of its liabilities.
Banks make a profit for their owners. Measures of a bank’s profitability include
return on assets (ROA), return on equity (ROE), net interest income, and net
interest margin.
Banks’ off-balance-sheet activities have become increasingly important in recent
years. They include:

loan commitments, which are lines of credit that firms can use whenever
necessary.

letters of credit, which are guarantees that a customer will make a promised
payment.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University





Banks face several types of risk in day-to-day business. They include:

Liquidity risk – the risk that customers will demand cash immediately

Liability-side liquidity risk arises from deposit withdrawals.

Asset-side liquidity risk arises from the use of loan commitments to borrow.

Banks can manage liquidity risk by adjusting either their assets or their
liabilities.
Credit risk – the risk that customers will not repay their loans. Banks can
manage credit risk by:

diversifying their loan portfolios.

using statistical models to analyze borrowers’ creditworthiness.

monitoring borrowers to ensure that they use borrowed funds properly.
Interest-rate risk – the risk that a movement in interest rates will change the value
of the bank’s assets more than the value of its liabilities.

When a bank lends long and borrows short, increases in interest rates will
drive down the bank’s profits.

Banks use a variety of tools, such as gap analysis, to assess the sensitivity of
their balance sheets to a change in interest rates.

Banks manage interest-rate risk by matching the maturity of their assets and
liabilities and using derivatives like interest-rate swaps.
Trading risk – the risk that traders who work for the bank will create losses on
the bank’s own account. Banks can manage this risk using complex statistical
models.
Other risks banks face include foreign exchange risk, sovereign risk, and
operational risk.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Key Terms
•capital gain
capital loss
•Consol
current yield
•default risk
holding period return
•inflation risk
inflation-indexed bonds
•interest-rate risk
investment horizon
•Perpetuity
pure discount bond
•stripped bond
tax incentive
•U.S. Treasury bill (T-bill)
yield to maturity
•yield on a discount basis
zero-coupon bond
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University