Theories of Banking

Siklos, Chapter 17

Overview
y Multiple Expansion of Deposits
y The deposit multiplier

y Banks as Profit Maximizing Firms y Liquidity Management y Asset and Liability Management y Managing Interest Rate Risk
y Gap and Duration Analysis

y Principal-Agent Model

A Simplified Balance Sheet

Assets CUR=Cash RES=Target reserves L=Loans SEC= Securities

Liabilities DEP=Deposits ADV=Bank of Canada Advances CAP= Equity/Capital

INTER=Interbank deposits

Multiple Expansion of Deposits

y Based on the assumption of a reserve requirement. No

longer formally exists in Canada BUT banks need to keep reserves y Reserve target and Excess reserves: the starting point of the multiple expansion approach y A Banking system with a single bank vs. multiple banks: does it make a difference? Not really. y Initial assumptions:
y banks maintain target reserves at all times y there are no cash drains in the banking system

The Deposit Multiplier

y The basic theory predicts that inflows or

outflows of funds lead to deposits in the banking system to rise or fall by a multiple of the original change y The basic theory also has implications for changes in the money supply which is linked to CUR and DEP

Notation
TR | total reserves M1 | money supply rr | reserve requirements ER ! er (R) v DEP | excess reserves which are a negatively related to the opportunity cost of holding money, R. cur | constant fraction of deposits he ld by the public in the form of cash

Total Reserves TR ! RES  ER

TR ! rr EP  er (R )DEP
Money S ly

M 1 ! CUR  DEP

The deposit multiplier is the eventual change in deposits that results from a $1 increase in banks reserves.

(M 1 ! (CUR  (DEP
CUR cur ! DEP

Multiple Deposit Expansion: The Basics

No cas rain or excess reserves:
An increase in excess reserves or currency drain reduces the size of the money multiplier.

1 (DEP ! v (RES rr Excess reserves, no cas

rain:

1 (DEP ! v (RES rr  er (R ) Cas rain, no excess reserves: 1 (DEP ! v (RES rr  cur

Multiple Deposit Expansion: Examples

y y

Effect of a currency drain reduces multiplier Effect of an increase in R reduces excess reserve ratio increases the multiplier. Effect of a change in the composition of deposits different deposits may have different target reserves which also can affect the multiplier Transfer of deposits among different types of financial institutions can affect multiplier if, for regulatory or other reasons, target reserves differ across institution types

A Simple Theory of the Banking Firm

y Assumes there is a behavioural relationship between

DEP and other economic variables such as interest rates, income and wealth y Assumes that the objective of the banking firm is to maximize profits MR=MC is the required condition y Profits are the difference between Revenues and Costs which are assumed, for simplicity, to be a function of Deposits, asset returns and deposit costs

Notation
RDEP | interest rate on deposits Ra | yield on alternative financial instruments DEP ! DEP (RDEP , Ra ) | the amount of deposits is a function of the interest on deposits and the yield on alternative financial instruments. Ra  RDEP | interest rate spread osts = RDEP v DEP evenue = Ra v DEP

Profit Maximization of the Banking Firm

Interest rate MCDEP ACDEP Ra
MR =MC

Profit:

Spread

?Ra  RDEP Av DEP

ARDEP RDEP MRDEP DEP* Deposits

Applications of the Banking Firm Model

y Helps explain the spread and its link to the

degree of competitiveness in the financial sector y Helps explain how the banking firm reacts to changing costs or technological developments y Is more useful as a pedagogical device than in practice

The Impact of Government Regulations and the Role of Competition on the Market for Deposits
Interest rate
Ra R*a 1 3 Ra 4

MC AC MR=AR (Competitive Case)

RDEP

R*DEP RDEP

AR
RDEP 2

MR(Monopoly power Case)

DEP DEP* DEP

Deposits

Asset and Liability Management

Asset Management 1.Get borrowers with low default risk, paying high interest rates 2.Buy securities with high return, low risk 3.Diversify 4.Manage liquidity Liability Management 1.Important since 1960s 2.Banks no longer primarily depend on deposits 3.When see loan opportunities, borrow or issue CDs to acquire funds

Managing Credit Risk

Solving Asymmetric Information Problems 1.Screening 2.Monitoring and Enforcement of Restrictive Covenants 3.Specialize in Lending 4.Establish Long-Term Customer Relationships 5.Loan Commitment Arrangements 6.Collateral and Compensating Balances 7.Credit Rationing

Principles of Bank Management

Liquidity Management
Desired reserve ratio = 10%, Excess reserves = $10 million Assets Liabilities Reserves $20 million Deposits $100 million Loans $80 million Bank Capital $ 10 million Securities $10 million Deposit outflow of $10 million Assets Reserves $10 million Loans $80 million Securities $10 million Liabilities Deposits Bank Capital

$ 90 million $ 10 million

With 10% desired reserve ratio, bank still has excess reserves of $1 million: no changes needed in balance sheet

Liquidity Management
No excess reserves Assets Reserves Loans Securities $10 million $90 million $10 million Liabilities Deposits Bank Capital $100 million $ 10 million

Deposit outflow of $ 10 million Assets Reserves Loans Securities $ 0 million $90 million $10 million Liabilities Deposits Bank Capital $ 90 million $ 10 million

Liquidity Management
1. Borrow from other banks or corporations Assets Reserves Loans Securities $ 9 million $90 million $10 million Liabilities Deposits Borrowings Bank Capital $ 90 million $ 9 million $ 10 million

2. Sell Securities Assets Reserves Loans Securities $ 9 million $90 million $ 1 million Liabilities Deposits Bank Capital $ 90 million $ 10 million

Liquidity Management
3. Borrow from Bank of Canada Assets Securities $10 million Reserves $ 9 million Loans $90 million 4. Call in or sell off loans Assets Reserves $ 9 million Loans $81 million Securities $10 million Liabilities Bank Capital Deposits Advances $ 10 million $ 90 million $ 9 million

Liabilities Deposits Bank Capital

$ 90 million $ 10 million

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

Managing Interest Rate Risk

First Bank Assets
Rate-sensitive assets Variable-rate loans Short-term securities Fixed-rate assets Reserves Long-term bonds Long-term securities $80 m $20 m

Liabilities
Rate-sensitive liabilities $50 m Variable-rate CDs Overnight funds Fixed-rate liabilities Chequable deposits Savings deposits Long-term CDs Equity capital $50 m

Managing Interest-Rate Risk

Gap Analysis
= rate-sensitive assets rate-sensitive liabilities = $20 $50 = $30 million When R o 5%: 1. Income on assets = + $1 million (= 5% v $20m) 2. Costs of liabilities = +$2.5 million (= 5% v $50m) 3. (Profits = $1m $2.5m = $1.5m = 5% v ($20m $50m) = 5% v (GAP) (Profits = (i v GAP GAP

Duration Analysis
%( value $ (% point(R) v (DUR) Example: R o 5%, duration of bank assets = 3 years, duration of liabilities = 2 years; %( assets = 5% v 3 = 15% %( liabilities = 5% v 2 = 10% If total assets = $100 million and total liabilities = $90 million, then assets q$15 million, liabilitiesq$9 million, and bank s net worth qby $6 million
A positive gap means that income from asset increases more than that from liabilities when there is an increase in interest rates.

Duration Gap
Duration Ga

(Net Wort (Net Wort Example

durGAP ! durA A L  durL (Assets - (Lia ilities - % oint(R v ?durA A  durLLA

dur AP ! durA A L  durL ! 3 $100mil $90mil  2 ! 1.333 " 0 (Net (Net (Net orth = - (

v ?durA A  durLLA

orth = -(0.05) v [3($100mil)-2($90mil)] orth =-0.05 v [$300mil-$180mil]=-$6mil

A positive duration gap means that asset values change more than that of liabilities when there is a change in interest rates.

Strategies to Manage Interest-rate Risk

1. 2. 3.

Rearrange balance-sheet Interest-rate swap Hedge with financial futures

Off-Balance-Sheet Activities
1.Loan sales 2.Fee income from A. Foreign exchange trades for customers B. Servicing mortgage-backed securities C. Guarantees of debt D. Backup lines of credit 3.Trading Activities A. Financial futures B. Financial options C. Foreign exchange D. Swaps

Risk Management

Principal-Agent Problem Traders have incentives to take big risks Risk Management Controls 1. Separation of front and back rooms 2. Value-at-risk modeling 3. Stress testing Regulators encouraging banks to pay more attention to risk management