Bank Fundamentals

Class 3- Chapter 7

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 Why are Banks important and
supported by the Government?
 Essential to efficient functioning of the financial
system
 Deposits are mostly in banks and they are significant
component of the money supply for the central bank
 Payment services
 Support sectors of economy that are deemed
important: Housing, Farms, Consumers,
Small/Medium business below investment grade
 Deal with problems of adverse selection and moral
hazard

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 What do banks do?

 Intermediary between suppliers (depositors) and

users (borrowers) of funds
 Take deposits and make loans
 Maturity intermediation – deposits are more short
term, loans are longer term
 Denomination intermediation – deposits small

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 Needs of suppliers

 Liquidity, short term

 Small units
 Payments
 Security
 Income – deposits, investments, loans

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 Needs of users

 Short and long term

 Large units (house, building, acquisition)
 Minimize expense
 Payments

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 What are alternatives to banks?
Shadow banking
 Deposits – Schwab, TD Ameritrade
 Loans – Lending Tree, direct

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 Why do banks have such a large
share of deposits
 Security:
– bank license
– FDIC insurance
– Allowed to use “bank” in name
 Convenience
 Payments

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 Asymmetric information – define
why a problem
 Information not even
 Can lead to wasted outcomes
 Adverse selection

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 Solution to Adverse Selection:
Information before loan
 Financial history of borrower
– Credit score
– Financial statement analysis
 Collateral evaluation: appraisal
 Industry knowledge
 Statistical history by type of loan
 Models to predict loss potential
 Pricing model to assume return justifies risk

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 Moral Hazard – after loan made

 “Its” not my money

 Therefore will take more risk
 Examples

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 Moral Hazard – Solutions

 Monitoring: financial statements, bank statement

 Down payment
 Covenants: restrict other debt, use of money
 Collateral

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 Bank advantages in addressing
Adverse Selection and Moral
Hazard
 Need highly trained professional staff
 Need risk and pricing models
 Therefore banker have economies of scale to reduce
cost of information gathering and monitoring
 Banks also have loan portfolios sufficient to diversify
risk

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 Bank advantages in funding

 Other large firms can gather information and monitor

performance
 Banks fund through deposits
 Other firms fund through borrowing from the market
at higher rates than deposits
 Pricing advantage for banks, especially for lower risk
loans

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 Types of banks

 Community
 Retail
 Wholesale
 Regional/Super Regional
 Money Center

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Bank Balance Sheet

Assets Liabilities

Cash – 10% Deposits – 77%

Securities – 20% Borrowings – 12%

Loans – 55%

Other – 15% Equity – 11%

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 Bank Income Statement

 Net interest income

 Non interest income
 Non interest expense
 Tax
 Net Income

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 Key Risks

 Credit
 Liquidity
 Interest rate
 Operation
 Reputation

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 Regulation

 Office of Controller of the Currency (OCC)

 FDIC
 Federal Reserve
 State banking

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Simple Deposit Multiplier

Deposits = Money Supply=deposit x 1

Required Reserve
Ratio

A deposit goes through the economy several time

and increases money supply
Can also work in reverse

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