Friday, February 27, 2009

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Figure 11.1Differences in Balance sheet of depository institutions and nonfinancial firms.

Depository Institutions

Assets Liabilities and equity

Loans deposits

Other financial

Other nonfinancial other liabilities and equity

Nonfinancial Institutions

Assets liabilities and equity

Deposits loans

Other financial assets

Other non financial other liabilities and equity

As we examine the structure of depository institutions and their financial statements,notice a distinguishing feature between them and nonfinancial firms illustrated in figure between them and nonfinancial firms illustrated in figure 11.1.Specifically,depository institutions major assets are loans (financial assets ) and their major liabilities are deposits.Just the opposite is true for nonfinancial firms,whose deposits are listed as assets on their balance sheets and whose loans are listed as liabilities.In contrast to depository institutions, nonfinancial firms’major assets are nonfinancial ( tangible ) assets such as buildings and machinery.Indeed,as illustrated in figure 11.2,depository institutions provide loans to and accept deposits form,nonfinancial firms ( and individuals ),while nonfinancial firms provide deposits to and obtain loans forms,depository institutions.

Figure 11.2 Interaction between Depository Institutions and non financial Firms



Our attention in this chapter focuses on the largest sector of the depository institutions group,commercialbank,and in particular : 1.the size,structure,and composition of this industry group,2.its balance sheets and recent trends,3.the industry’s recent performance and,4.its regulator.


Commercial banks represent the lsrgest group of depository institutions measured by assets size.They perform functions similar to those of savings institutions and credit unions—they accept deposits ( liabilities ) and make loans ( assets ).Commercial banks are distinguishable from savings institutions and credit unions,however in the size and composition of their loans and deposits.Specifically,while deposits are the major source funding ,commercial bank liabilities usually include several types of nondeposits sources such as subordinated notes and debentures.Moreover their loans are broader in range,including consumer, commercial, international and real estate loans.Commercial banks are regulated separately from savings institutions and credit unions.Within the banking industry,the structure and compotition of assets and liabilities also varies significantly for banks of different assets sizes.


How financial statements are used by regulators, stockholders, depositors, and creditors to evaluate bank performance.


Consider the aggregate balance sheet in table 11-2 and the percentage distributions( in figure 11.3) for all us commercial banks as of December 31,2001.The majority of the assets held by commercial banks are loans.Total loans amounted to $3823.2 billion or 58.2 % of total asset and fell into four broad classes : businees or commercial and industrial loans; commercial and residential real estate loans;individual loans, such as consumer loans for auto purchases and credit card loans ; and all other loans such as loans to emerging market countries.1 The reserver for loan and lease losses is a contra asset account representing an estimate by the bank’s management of the percentage of gross loans( and leases ) that will have to be “charged off” due to future defaults.
Investment securities consist of items such as interest bearing deposits purchased from other FIs,federal funds sold to other banks,repurchase agreements (RPs or repos),2 US Treasury and agency securities,municipal securities issued by states and political subdivisions, mortgage-backed securities and other debt andequity securities.In 2001,the investment portofolio totaled $ 1497,2 billion or 22,8 % of total assets.US government securities such as US Treasury bonds totaled $765.7 billion, with other securities making up the remainder.Investment securities generate interest income for the bank and are also used for trading and liquidity management purposes.Many investment securities held by banks are highly liquid,have low default risk and can usually be traded in secondary markets.

While loans are the main revenue-generating assets for banks,investment securities provide banks with liquidity.Unlike manufacturing companies,commercial banks and other financial institutions are exposed to high levels of liquidity risk.Liqudity risk is the risk that arises when financial institution’s liability holders such as depositors demand cash for the financial claims they hold with the financial institutions.Because of the extensive levels of deposits held by banks( see below ), they must hold significant amounts of cash and investments securities to make sure they can meet the demand from their liability holders if and when they liquidate the claims they hold.
A major inference we can draw from this assets structure ( and the importance of loans in this assets structure ) is that the major risks faced by modern commercial bank managers are credit or default risk, liquidity risk, and ultimately, insolvency risk.Because commercial banks are highly leveraged and therefore hold little equity( see below ) compared to total assets, even a relatively small amount of loan defaults can wipe out the equity of a bank,leaving it insolvent.Losses such as those due to defaults are charged off against the equity ( stockholders’ stake) in a bank.Additions to the reserve for loan and lease losses accounts ( and,in turn, the expense account, “provisions for losses on loans and leases” .) to meet expected defaults reduce retained earnings and, thus , reduce equity of the bank.Unexpected defaults are meant to be written off against the remainder of the bank’s equity.We look at recent loan performance below.


Figure 11-4 shows broad trends over the 1951-2000 period in the four principal earningh assets areas of commercial banks : business loans ( or commercial and industrial loans ), securities,mortgages, and consumer loans. Although business loans were the major assets on bank balance sheet between 1965 and 1990, they have dropped in importance ( as a proportion of the balance sheet) since 1990.At the same time, mortgages have increased in importance.These trends reflect a number of long term and temporary influences.Important long term influences have been the growth of the commercial paper market and the public bond market ,which have become competitive and alternative funding sources to commercial bank loans for major corporations.Another factor has been the securization of mortgage loans,which entails the pooling and packaging of mortgage loans for sale in the form of bonds.


Commercial banks have two major sources of funds ( other than the provided by owners and stockholders) : 1.deposiits and 2.borrowed or other liability funds.As noted above, a major difference between banks and other firms is their high leverage or debt to assets ratio.For example,banks had an average ratio of equity to assets of9,1 % in 2001 ; this implies that 90,9 % of assets were funded by debt, either deposits or borrowed funds.
Note that in table 11.2,which shows the aggregate balance of US banks, in December 2001,deposits amounted to $4391.6 billion ( 66.9 % of assets) and borrowings and other liabilities were $1348.6 and $231.6 biilion( 20.5% and 3.5% of total assets),respectively.Of the total stock of deposits,transaction accouns represented 21% of total deposits or 1376.5 biilion.Transaction accounts are checkable deposits that either bear nointerest ( demand deposit ) or are interest bearing( most commonly called negotiable order of withdrawal accounts or NOW accounts).Since their introduction in 1980, interest bearing checking accounts, especially NOW accounts, have dominated the transaction accounts of banks.Nevertheless since limitations are imposed on the ability of corporations to hold such accounts,3 and NOW accounts have minimum balance requirements, nponinterest-bearing demand deposits are still held.The second major segment of deposits is retail or household savings and time deposits, normally individual account holdings of less than $100.000.Important components of bank retail savings accounts are small nontransactions accounts,which include passbook savings accounts and retail time deposits. Small nontransactions accounts compose 56 % of total deposit.However this disguises an important trendin the supply of this deposits to banks.Spesifically the amount held of retail savings and time deposit has been falling inrecent years,largely as a result of competition from money market mutual funds.4 these funds pay a competitive rate of interest based on wholesale money market rates by pooling and investing funds.while requiring relatively small-denomination investments.
The third major segment of deposits funds is large time deposits ($ 100.000 or more );5 $100.000 is the cap for explicit coverage under FDIC provided deposit insurance.These deposits amounted to $556.2 billion or approximately 12.7% of total deposits in December 2001.These are primarily negotiable certificates of deposit ( deposit claims with promised interest rates fixed maturities of at least 14 days) that can be resold to outside investors in an organized secondary market.As such, they are usually distinguished from retail time deposits by their negotiability and secondary market liquidity.
Nondeposit liabilities comprise borrowings and other liabilities that total 26.5 % of all bank liabilities or $1.580,2 billion.These categories include a broad array of instruments sauch as purchases of federal funds ( bank reserves ) on the interbank market and repurchase agreements ( temporary swaps of securities for federal funds ) at the short end of the maturity spectrum, to the issuance of notes and bonds at the longer end.
Overall, the liability structure of banks’balance sheets tends to reflect a shorter maturity structure than that of their asset portofolio.Further,relatively more liquid instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans.Thus,interest rate risk-or maturity mismatch risk-and liquidity risk are key exposure concerns for bank managers.


Commercial bank equity capital ( 9,1 % of totalliabilities and equity in December 2001) consist mainly of common and preferred stock( listed at par value),surplus or additional paid in capital and retained earnings. 6.Surplus or additional paid in capital shows the difference between the stock’s par value and what the original stockholders paid when they bought the newly issued shares. Regulators require banks to hold a minimum level of equity capital to act as a buffer against losses from their on-and off balance sheet activities.Because of the relatively low cost of deposit funding,banks tend to hold equity close to the minimum levels set by regulators.This impacts banks’exposure to risk and their ability to grow –both onand off the balance sheet-over time.

Off-Balance sheet Activities
The balance sheet itself does not reflect the total scope of bank activities.Banks conduct many fee related activities off the balance sheet.Off Balance Sheet ( OBS ) activities are becoming increasingly important, in terms of their dollar value and the income they generate for banks-especially as the ability of banks to attract high quality loan apliicants and deposits becomes ever more difficult.OBS activities include issuing various types of guarantees ( such as letters of credit ), which often have a strong insurance underwriting element and making future commitmens to lend.Both service generate additional fee income for banks.OBS activities also involve engaging in derivative transactions—futures,forwards,options,and swaps.
Under current accounting standards,such activities are not shown on the current balance sheet.Rather,an item or activity is an OBS asset if, when a contingent event occurs, the item or activity moves onto the asset side of the balance sheet or an income item is realized on the income statement.Conversely,an item or activity is an OBS liability if,when a contingent event occurs, the item or activity moves onto the liability side of the balance sheet or an expense item is realized on the income statement
By undertaking OBS activities, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business.At the same time,they can avoid regulatory costs or taxes since reserve requirements and deposit insurance premiums are not levied on off balance sheet activities.Thus banks have both earnings and regulatory “tax avoidance” incentives to undertake activities off their balance sheets.
OBS activities,however can involve risks that add to the overall insolvency exposure of a financial intermediary (FI).Indeed, the failure of the UK investments bank Barings and banksruptcy of Orange County in California in the 1990s have been linked to FIs’ OBS activities in derivatives.More recently the1997-1998 Asian crisis l;eft banks that had large positions in the asian related derivative securities markets with large losses. For example, Chase Manhattan Corp. announced a 1998 third quarter earnings decrease of 15 %, due to losses in global market, including derivative securities.In the news box 11.1 highlights Enron’s search for new lines of credit shortly before it declared bankruptcy in December 2001.Banks that lent funds from these OBS lines received little, if any, of them back.However OBS activities and instruments have both risk reducing as well as risk increasing attributes and when used appropriately,they can reduce or hedge an FIs interest rate,credit,and foreign exchange risks.
We show the notional or face, value of bank OBS activities ,and their distribution and growth for 1992 to 2001in table 11.3.Notice the relative growth in the notional value of OBS activities in table 11.3.By year end 2001,the notional value of OBS bank activities was $51.409,9 billion compared to the $ 6569,2 billion value of on balance sheet activities.It should be noted that the notional or face value of OBS activities does not accurately reflect the risk to the bank undertaking such activities.The potensial for the bank to gain or lose on the contract is based on the possible change in the market value of the contract over the life of the contract rather than the notional or face value of the contract,normally less than 3 % of the of the notional value an OBS contract.7.The market value of a swap (today) is the difference between the present value of the cash flows (expected) to be received minus the present value of cash flows expected tobe paid.
The use of derivative contracts accelerated during the 1992-2000 period and accounted for much of the growth in OBS activity ( see figure 11-5).Figure 11.5 shows that this growth has occurred for all types of derivative contracts: futures and forwards, swaps, and options.The significant growth in derivative securities activities by commercial banks has been a direct response to the increased interst rate risk, credit risk, and foreign exchange risk exposures they have faced, both domestically and internationally.In particular, these contract offer banks a way to hedge these risks without having to make extensive changes on the balance sheet.
Although the simple notional dollar value of OBS items overestimates their risk exposure amounts,the increase in these activities is still nothing short of phenomenal.8.this overestimation of risk exposure occurs because the risk exposure from a contingent claim ( such as an option ) is usually less than its face value. Indeed, this phenomenal increase has pushed regulators into imposing capital requirements on such activities and into explicitly recognizing an FI’s solvency risk exposure from pursuing such activities.As noted in table 11.3 and figure 11.5,major types of OBS activities for US banks include loan commitments,letter of credit, loans sold,and derivative securities.A loan commitment is a contractual commitment to loan a certain maximum amount to a borrower at given interest rate terms over some contractual period in the future (e.g.,one year).Letters of credit are essentially guarantees that FIs sell to under write the future performance of the buyers of the guarantees.Commercial letters of credit are used mainly to assist a firm in domestic and international trade.The FIs role is to provide a formal guarantee that it will pay for the goods shipped or sold if the buyer of the goods defaults on its future payments.Standby letter of credit cover contingencies that are potentially more severe, less predictable or frequent and not necessarily trade related.Loans sold are loans that the FI originated and then sold to other investors that ( in some cases ) can be returned to the originating institution in the future if the credit quality of the loans deteriorates.Derivative securities are futures, forwards, swap, and option positions taken by the bakn for hedging snd other purposes.

Other Fee Generating Activities
Commercial banks engage in other fee generating activities that cannot easily be identified from analyzing their on and off balance sheet accounts.Two of these include trust services and correspondent banking.

Trust service. The trust department of a commercial bank holds and manages assets for individuals or corporations.Only the largest banks have sufficient staff to offer trust services.Individuals trusts represent about one half of all trust assets managed by commercial banks.These trusts include estate assets and assets delegated to bank trust

Transactions account
The sum of noninterest bearing demand deposits and interest bearing checking accounts.

NOW account
An interest- bearing checking account.

Negotiable CDs
Fixed maturity interst bearing deposits with face values of $ 100.000 or more that canbe resold in the secondary market.

Off Balance Sheet (OBS) Assets
When an event occurs this item moves onto the asset side of the balance sheet or income is realized on the income statement.

Off Balance Sheet Liability
When an event occurs this item moves onto the liability side of the balance sheet or an expense is realized on the income statement.

Table 11.2 Balance sheet


Total cash assets $391,0
US government securities $765,7
Federal Funds and repurchase agreement $317,6
Other $431,9

Investment Security $1497,2
Interbank Loans $117,2
Loans excluding interbank $3778,1
Commercial and industrial $982,5
Real estate $1803,6
Individual $631,2
All other $360,8

Less: Reserve for loan losses $72,1

Total loans $3823,2
Other assets $857,8

Total assets $6569,2

Transaction accounts $1376,5
Nontransaction Acoount $3051,5

Total Deposit $4391,6
Borrowings $1348,6
Other liabilities $231,6

Total liabilities $5971,8
Equities $597,4

Table 11.1.Products sold by US Financial Services Industry


Institutions Payment Savings Fiduciary Lending Issuance of Insurance and
Risk Mngmnt
Service products Services Business Consumer Equity Debt Products


Depository Institutions
Insurance Companies
Finance Companies
Securities Firms
Pension Funds
Mutual Funds

Depository Intitutions
Insurance Companies
Finance Companies
Securities Firms
Pension Funds
Mutual Funds

*Minor Involvement
+Selective Involvement via affiliates

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