9.6 Off the Balance Sheet #Notebook

 9.6 Off the Balance Sheet #Notebook

Banks charge customers all sorts of fees, and not just the little ones. They charge fees for loan guarantees, backup lines of credit, foreign exchange transactions and, also sell some of their loans to investors. 

Suppose A bank might discount the $100,000 note of Citi Corp. for 1 year at 8%. 

From the present value formula that on the day it is made...

The loan is worth PV = FV/(1 + i) = 100,000/1.08 = $92,592.59. 

Then, the bank might sell it for 100,000/1.0785 = $92,721.37 and pocket the difference. 

Banks often sell loans with a guarantee or stipulation that they will buy them back if the borrower defaults, but it very costly. Although loans and fees can help keep up bank revenues and profits, they must carefully manage the credit risks.

Banks and intermediaries also take off balance-sheet positions in derivatives markets or even futures.

Suppose bankers sell futures contracts on U.S. Treasuries. If interest rates increase, the price of bonds will decrease. The bank can then effectively buy bonds in the open market at less than the contract price, make good on the contract, and pocket the difference.

Bankers can also hedge their bank’s interest rate risk by engaging in interest rate swaps, like agree to pay a fixed 6% on a $100 million notational principle (or $6 million) every year for 10 years in exchange for a promise to pay to back LIBOR plus+ 3%. 

Banks and intermediaries sometimes speculate in derivatives and the foreign exchange markets to make money. However, with the potential for high returns comes high levels of risk. 

Internal controls to prevent risking too much of the capital, called value at risk and stress testing.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.

9.4 Credit Risk #Notebook

 9.4 Credit Risk #Notebook

Financial intermediaries use the application only as a starting point. Typically do two things:

I. Make the application a binding part of the financial contract.

II. Verify the information with disinterested third parties. Financial intermediaries can also buy credit reports from professional report providers like Equifax, Experian, and Trans Union.

Insurance companies regularly share information with each other so that risky applicants can’t take advantage of them easily.

To improve the screening acumen, many financial intermediaries specialize by making loans to only one or a few types of borrowers, by insuring automobiles in a handful of states.

Specialization also helps to keep monitoring costs to a minimum. To reduce moral hazard, intermediaries have to pay attention to what borrowers and people who are insured do and know what sort of restrictive covenants (aka loan covenants) to build into their contracts. 

Loan covenants include the types of information to be provided in reports, inspections, limitations on account withdrawals. Insurance companies also build covenants into their contracts and investigate claims that seem fishy to reduce moral hazard.

However, specialization has its costs. Issuing too many policies, or making too many loans will lead to overspecialize and hurting their asset management.

Forging long-term relationships with customers can help financial intermediaries to manage their credit risks such as lending with better assurance.

One way that lenders create long-term relationships with businesses is by providing loan commitments, promises to lend $x at y interest for z years, arrangements called lines of credit.

Bankers also often insist on collateral, assets pledged by the borrower for repayment of a loan, the collateral is called compensating or compensatory balances. 

Credit rationing is another tool to combat asymmetric information.

However, in 2007–2008, banks and other lenders are not perfect screeners, under competitive pressure, they lend to borrowers they should not have. 

External political or societal pressures induce bankers to make loans they normally wouldn’t. Such excesses are always reversed eventually because the lenders suffer from high levels of non-performing loans.

In the crisis of 2007, why didn’t the government immediately intervene by guaranteeing the subprime mortgages?

Directly bailing out the subprime lenders by guaranteeing mortgage payments would cause moral hazard to skyrocket, because the borrowers might be more likely to default by rationalizing that the crime is a victimless one and the lenders would learn that they can make crazy loans to anyone because Uncle Sam(=The US government) will prevent their fall.

Reference
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.

9.3 Bank Management Principles #Notebook

 9.3 Bank Management Principles #Notebook

Bankers must manage their assets and liabilities to ensure three conditions:

1. Liquidity management. Has enough reserves to pay for outflows.

2. Asset management, earns profits by own a portfolio of remunerative assets. Liability management, to obtain its funds cheaply.

3. Capital adequacy management, sufficient net worth, or equity capital for regulatory.

To earn profits and manage liquidity and capital, banks face two major risks: 

1.Credit risk, the risk of borrowers defaulting on the loans and securities it owns.

2. Interest rate risk, the risk that interest rate changes will decrease the returns on its assets. 

The financial panic of 2008 reminded bankers that they also can face liability and capital adequacy risks if financial markets become less liquid or seize up completely.

＊In a bank's T-account, only equity capital can be negative.

An example of T-account...

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.