Documente Academic
Documente Profesional
Documente Cultură
An Overview of the
Changing Financial-
Services Sector
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Key Topics
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Quick Quiz
• What is a bank? How does a bank differ
from most other financial-service
providers?
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• Underwriting Securities
• Offering Mutual Funds and Annuities
• Offering Merchant Banking Services
• Offering Risk Management and Hedging
Services
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Quick Quiz
Web Links
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Chapter Three
The Organization and
Structure of Banking
and the Financial-
Services Industry
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Key Topics
11%
Assets Held By Large
Banks
Assets Held By Medium
Banks
Assets Held By Small Banks
87%
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7%
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Quick Quiz
• What are the general trends in the size
distribution and asset concentration of
American banking industry?
• Describe differences between a typical
organizational structure of smaller
community bank and a larger money-center
bank.
• What trends are affecting the way banks
and their competitors are organized today?
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Not FDI C I ns ur ed 2%
St at e B anks 75%
Unit Banks
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Branch Banks
• Offer Full Range of Services from Several
Locations
• Senior Management at the Home Office
• Each Branch has its Own Management Team
with Limited Decision Making Ability
• Some Functions are Highly Centralized,
While Others are Decentralized
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Electronic Branches
• Internet Banking Services
• Automated Teller Machines (ATMs)
• Point of Sale (POS) Terminals
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Virtual Banks
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Board of Directors
Parent Company
Bank Branches
The bottom four levels have the same organizational form as the independent bank.
Board of Directors
Parent Company
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Bank Branches Bank Branches
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• Geographic Diversification
• Product Line Diversification
• Tax Sheltering
• Double Leveraging
• Source of Strength
• A Way Around Regulatory Restrictions
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Proponents Opponents
• Efficient Use of Scarce • Increased Bank
Resources Concentration
• Lower Prices for Services • Less Competition
• Geographic Diversification • Higher Prices for Services
• Efficient Flow of Credit in • Drain Resources from
the System Community
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Financial Holding
Company
Subsidiaries
Commercial Nonbank Thrift Company and Service
Banking Subsidiaries Companies
Company
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Bank Subsidiaries
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Quick Quiz
• Which type of corporations chartered for the
simple purpose of holding the stock of at least
one bank?
• What were the reasons for the Riegle Neal Act
of1994?
• When the banking industry moves toward
larger but fewer organizations, what is it
known as?
• What relationship appears to exist between
bank size, efficiency, and operating costs per
unit of service produced and delivered?
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Chapter Five
The Financial
Statements of Banks
and Their Principal
Competitors
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Key Topics
• An Overview of the Balance Sheets and Income
Statements of Banks and Other Financial Firms
• The Balance Sheet or Report of Condition
• Asset Items
• Liability Items
• Recent Expansion of Off-Balance Sheet Items
• The Problem of Book-Value Accounting and
"Window Dressing"
• Components of the Income Statement:
Revenues and Expenses
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Report of Condition
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C + S + L + MA = D + NDB + EC
C = Cash Assets
D = Deposits
NDB = Nondeposit
S = Security Holdings Borrowings
L = Loans EC = Equity Capital
MA = Miscellaneous Assets
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Cash Assets
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Investment Securities
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Loan Accounts
• The Major Asset
• Gross Loans – Sum of All Loans
• Allowance for Possible Loan Losses
▫ Contra Asset Account
▫ For Potential Future Loan Losses
• Net Loans
• Unearned Discount Income
• Nonperforming Loans
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Types of Loans
• Commercial and Industrial Loans
• Consumer Loans (Loans to Individuals)
• Real Estate Loans
• Financial Institution Loans
• Foreign Loans
• Agriculture Production Loans
• Security Loans
• Leases
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Beginning ALL
+ Provision for Loan Loss (Income Statement)
= Adjusted Allowance for Loan Losses
- Actual Charge-Offs
+ Recoveries from Previous Charge-Offs
= Ending Allowance for Loan Losses
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• Specific Reserves
▫ Set Aside to Cover a Particular Loan
▫ Designate a Portion of ALL or
▫ Add More Reserves to ALL
• General Reserves
▫ Remaining ALL
• Determined by Management But Influenced
by Taxes and Government Regulation
• Loans to Lesser Developed Countries
Require Allocated Transfer Reserves
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Miscellaneous Assets
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Deposit Accounts
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Nondeposit Borrowings
• Fed Funds Purchased
• Securities Sold Under Agreement to
Repurchase (Repurchase Agreements)
• Acceptances Outstanding
• Eurocurrency Borrowings
• Subordinated Debt
• Limited Life Preferred Stock
• Other Liabilities
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Equity Capital
• Preferred Stock
• Common Stock
▫ Common Stock Outstanding
▫ Capital Surplus
▫ Retained Earnings (Undivided Profits)
▫ Treasury Stock
▫ Contingency Reserve
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Off-Balance-Sheet Items
• Unused Commitments
• Standby Credit Agreements
• Derivative Contracts
▫ Futures Contracts
▫ Options
▫ Swaps
• OBS Transactions Exposure a Firm to
Counterparty Risks
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Possible Issues
• The Problem with Book-Value Accounting
▫ Original (historical, book-value) cost
▫ Amortized cost
▫ Market-value
▫ Held-to-maturity and available-for-sale
securities
• Window Dressing
• Auditing Financial Statements
▫ Audit Committees
▫ Sarbanes-Oxley Accounting Standards Act
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Comparative
Balance Sheet
Ratios for
Different Size
Banks (FDIC,
2006)
Which accounts are most important on the asset side of a Call Report? Liability side?
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Quick Quiz
• Which are the principal accounts that
appear on a bank’s balance sheet (Report of
Condition)?
• What are primary reserves and secondary
reserves, and what are they supposed to
do?
• What are off-balance-sheet items, and why
are they important to some financial firms?
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Report of Income
Report of
Income for
BB&T
Corporation
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Income Statement
Comparative
Income Statement
Ratios for
Different Size
Banks (FDIC,
2006)
What are the most important revenue and expense items on the income statement
of a bank?
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Quick Quiz
• What accounts make up the Report of Income?
• What is the relationship between the provision
for loan losses on a bank’s Report of Income
and the allowance for loan losses on its Report
of Condition?
• Suppose a bank has an allowance for loan losses of
$1.25 million at the beginning of the year, charges
current income for a $250,000 provision for loan
losses, charges off worthless loans of $150,000,
and recovers $50,000 on loans previously charged
off. What will be the balance in the allowance for
loan losses at year-end?
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Chapter Six
Measuring and Evaluating the
Performance of Banks and
Their Principal Competitors
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Key Topics
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D1
P0
r-g
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Noninterest revenue
- PLLL
- Noninterest expenses Net Noninterest Income
Net Noninterest Margin
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Determinants of
ROE in a
Financial Firm
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A Variation on ROE
Net Income Pre-Tax Net Operating Income
ROE =
Pre-Tax Net Operating Income Total Operating Revenue
Total Operating Revenue Total Assets
Total Assets Total Equity Capital
ROE = Tax Management Efficiency
Expense Control Efficiency
Asset Management Efficiency
Funds Management Efficiency
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Breakdown of ROA
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Quick Quiz
• What individuals or groups are likely to be
interested in the banks’ level of profitability
and exposure to risk?
• What are the principal components of ROE, and
what does each of the these components
measure?
• Suppose a bank has an ROA of 0.80% and an
equity multiplier of 12x. What is its ROE?
Suppose this bank’s ROA falls to 0.60%. What
size equity multiplier must it have to hold its
ROE unchanged?
• What are the most important components of
ROA and what aspects of a financial
institution’s performance do they reflect?
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Bank Risks
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Credit Risk
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Liquidity Risk
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Off-Balance-Sheet Risk
The Volatility in Income and Market Value of
Bank Equity that May Arise from
Unanticipated Losses due to OBS Activities
(activities that do not have a balance sheet
reporting impact until a transaction is
affected)
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Operational Risk
Uncertainty Regarding a Financial
Firm’s Earnings Due to Failures in
Computer Systems, Errors, Misconduct
by Employees, Floods, Lightening
Strikes and Similar Events or Risk of
Loss Due to Unexpected Operating
Expenses
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Reputation Risk
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Capital Risk
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Appendix: UBPR
The Uniform Bank Performance
Report Provided by U.S. Federal
Regulators so that Analysts Can
Compare the Performance of One
Bank Against Another
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Chapter Seven
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Key Topics
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Asset-Liability Management
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• Price Risk
▫ When Interest Rates Rise, the Market Value
of the Bond or Asset Falls
• Reinvestment Risk
▫ When Interest Rates Fall, the Coupon
Payments on the Bond are Reinvested at
Lower Rates
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n
CFt
Market Price
t 1 (1 YTM)
t
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Yield Curves
• Graphical Picture of Relationship Between
Yields and Maturities on Securities
• Generally Created With Treasury Securities
to Keep Default Risk Constant
• Shape of the Yield Curve
▫ Upward – Long-Term Rates Higher than Short-
Term Rates
▫ Downward – Short-Term Rates Higher than Long-
Term Rates
▫ Horizontal – Short-Term and Long-Term Rates
the Same
• Shape of the Yield Curve and a Maturity Gap
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Quick Quiz
• What forces cause interest rates to change?
• What makes it so difficult to correctly forecast
interest rate changes?
• What is the yield curve, and why is it important
to know about its shape and slope?
• What is the goal of hedging?
• First National Bank of Bannerville has posted interest
revenues of $63 million and interest costs from all of its
borrowings of $42 million. If this bank possesses $700
million in total earning assets, what is First National’s
net interest margin? Suppose the bank’s interest
revenues and interest costs double, while its earning
assets increase by 50%. What will happen to its net
interest margin?
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Relative
Dollar IS Gap
Interest-
Sensitive Gap Bank Size
Interest InterestSensitiveAssets
Sensitivity
InterestSensitiveLiabilities
Ratio
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• Asset-Sensitive • Liability-
Bank Sensitive Bank
▫ Interest Rates Rise ▫ Interest Rates Rise
NIM Rises NIM Falls
▫ Interest Rates Fall ▫ Interest Rates Fall
NIM Falls NIM Rises
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Cumulative Gap
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Quick Quiz
• Commerce National Bank reports interest-sensitive assets of
$870 million and interest-sensitive liabilities of $625 million
during the coming month. Is the bank asset sensitive or
liability sensitive? What is likely to happen to the bank’s net
interest margin if interest rates rise? If they fall?
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n n
(1 YT M) t * CFt
t (1 YT M) t * CFt
t
D t 1 t 1
n Current MarketValue or P rice
(1 YT M)
t 1
CFt
t
McGraw-Hill/Irwin
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P i
-D*
P (1 i)
McGraw-Hill/Irwin
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Convexity
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Where:
wi = the dollar amount of the ith asset divided by total assets
DAi = the duration of the ith asset in the portfolio
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Where:
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio
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Duration Gap
TL
D DA - DL *
TA
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i i
NW - D A * * A - - D L * * L
(1 i) (1 i)
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Quick Quiz
• What is duration? How is a financial
institution’s duration gap determined?
• What are the advantages of using duration as
opposed to interest-sensitive gap analysis?
• Suppose that a thrift institution has an average
asset duration of 2.5 years and an average
liability duration of 3.0 years. If the thrift holds
total assets of $560 million and total liabilities
of $467 million, does it have a significant
leverage-adjusted duration gap? If interest
rates rise, what will happen to the value of its
net worth?
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Chapter Eight
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
8-147
Key Topics
• The Use of Derivatives
• Financial Futures Contracts: Purpose and
Mechanics
• Short and Long Hedges
• Interest-Rate Options: Types of Contracts
and Mechanics
• Interest-Rate Swaps
• Regulations and Accounting Rules
• Caps, Floors, and Collars
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Derivatives
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and
TL
D DA - DL *
TA
Recall what happens when interest rates rise? Fall?
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▫ Forward Contracts
Terms are negotiated between parties
Do not necessarily involve standardized assets
Require no cash exchange until expiration
No marking to market
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Borrowing Costs and Futures Contracts and
Declining Asset Values then Purchase Similar
Contracts Later
Avoiding Lower Than Use a long Hedge: Buy
Expected Yields from Futures Contracts and
Loans and Securities then Sell Similar
Contracts Later
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Basis Risk
The basis is the cash price of an asset minus
the corresponding futures price for the
same asset at a point in time
▫ For financial futures, the basis can be calculated as
the futures rate minus the spot rate
▫ It may be positive or negative, depending on whether
futures rates are above or below spot rates
▫ May swing widely in value far in advance of contract
expiration
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i
Ft F0 -D F0 N
McGraw-Hill/Irwin
(1 i)
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TL
(D A - D L * ) * TA
TA
D F * Price of the Futures Contract
McGraw-Hill/Irwin
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Quick Quiz
• What are financial futures contracts? Which
financial institutions use futures and other
derivatives for risk management?
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Types of Options
• Put Option
▫ Gives the Holder of the Option the
Right to Sell the Financial Instrument
at a Set Price
• Call Option
▫ Gives the Holder of the Option the
Right to Purchase the Financial
Instrument at a Set Price
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Quality Swap
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Further…
• Firms with a negative GAP can reduce risk
by making a fixed-rate interest payment in
exchange for a floating-rate interest receipt
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Netting
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Currency Swap
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Quick Quiz
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Chapter Nine
Key Topics
• The Securitization Process
Securitization of Loans
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Securitization Process
• Originator – Bank or Lender Who Makes the
Loan
• Issuer – Special Purpose Entity That Issues
the Securities
• Credit Rating Agency – Rates the Securities
• Security Underwriter or Investment Banker
Helps Issue Securities
• Trustee – Makes Sure Issuer Fulfills All
Their Obligations
• Servicer- Collects Payments on the
Securitized Loans
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Advantages of Securitization
• Diversifies a Bank’s Credit Risk Exposure
• Creates Liquid Assets Out of Illiquid Assets
• Transforms These Assets into New Sources
of Capital
• Allows the Bank to Hold a More
Geographically Diversified Loan Portfolio
• Allows the Bank to Better Manage Interest
Rate Risk
• Allows the Bank to Generate Fee Income
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Quick Quiz
• What does securitization of assets mean?
Loan Sales
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Servicing Rights
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• Assignments
▫ Ownership of the Loan is Transferred to the
Buyer of the Loan. The Buyer Has a Direct Claim
Against the Borrower.
• Loan Strip
▫ Short-Dated Pieces of Longer Term Loans,
Maturing in a Few Days or Weeks
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Advantages of SLCs
Structure of SLCs
Three Essential Elements:
• Commitment From Issuer
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Credit Derivatives
• Over-the-Counter Financial Agreements
Offering Protection to a Designated
Beneficiary in Case of Default on a Loan,
bond, or Other Debt Instruments
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Credit Swaps
• Two Lenders Agree to Swap a Portion of
Their Customer’s Loan Payments
• Can Help Each Lender Further Spread Out
Their Risk
• Variation is a Total Return Swap Where the
Dealer Guarantees Parties a Specific Rate of
Return
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Credit Options
Guards Against Losses in Value of a Credit
Asset or Helps Offset Higher Borrowing
Costs Due to Changes in Credit Ratings of
the Borrower
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Chapter Eleven
Liquidity
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Liquid Asset
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Legal Reserves
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Any deficit above 4% may be assessed an interest penalty equal to the Federal
Reserve’s discount (primary credit) rate at the beginning of the month plus 2
percentage points applied to the amount of the deficiency.
Repeated reserve deficits lead to increased regulatory scrutiny, possibly damaging its
efficiency.
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Sweep Account
• Volume of Legal Reserves Held at the Fed
Has Declined in Recent Years Largely Due to
Sweep Accounts
Quick Quiz
• What are the principal differences among asset
liquidity management, liability management,
and balanced liquidity management?
• What guidelines should management keep in
mind when it manages a financial firm’s
liquidity position?
• What is money position management?
• What is the principal goal of money position
management?
• What factors should a money position manager
consider in meeting a deficit in a depository
institution’s legal reserve account?
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Chapter Twelve
Key Topics
• Types of Deposit Accounts Offered
• Lifeline Banking
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Recent Trends
Transaction Deposit
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Core Deposits
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Estimating
Unit Price Operating Planned
Overhead
Charged the Expense Profit from
Expense
Customer = Per Unit of + + Each
Allocated to
for Each Deposit Service Unit
the Deposit
Service Service Sold
Function
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Conditional Pricing
• Schedule of Fees were Low If Customer
Stayed Above Some Minimum Balance -
Fees Conditional On How the Account Was
Used
• Conditional Pricing Based On One or More
Of the Following Factors
▫ The Number of Transactions Passing Through the
Account
▫ The Average Balance Held in the Account During
the Period
▫ The Maturity of the Deposit
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Relationship Pricing
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Quick Quiz
• What are the major types of deposit plans offered
today?
• What are core deposits, and why are they so
important?
• How has the composition of deposits changed in
recent years?
• A bank determines from an analysis of its cost-
accounting figures that for each $500 minimum-
balance checking account it sells, account
processing and other operating costs will average
$4.87 per month and overhead expenses will urn
an average of $1.21 per month. The bank hopes to
achieve a profit margin over these particular costs
of 10 percent of total monthly costs. What monthly
fee should it charge a customer who opens one of
these checking accounts?
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Key Topics
• The Many Tasks of Capital
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Types of Capital
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Quick Quiz
• What forms of capital are in use today? What
are the key differences between the different
types of capital?
• What are the most important and least
important forms of capital held by U.S.-insured
banks? How do small banks differ from large
banks in the composition of their capital
accounts and in the total volume of capital they
hold relative to their assets?
• What is the rationale for having the government
set capital standards for financial institutions
as opposed to letting the private marketplace
set those standards?
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Tier 1 Capital
• Common Stock and Surplus
• Undivided Profits
• Qualifying Noncumulative Preferred Stock
• Minority Interests in the Equity Accounts of
Consolidated Subsidiaries
• Selected Identifiable Intangible Assets Less
Goodwill and Other Intangible Assets
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Tier 2 Capital
• Allowance for Loan and Lease Losses
• Subordinated Debt Capital Instruments
• Mandatory Convertible Debt
• Cumulative Perpetual Preferred Stock with
Unpaid Dividends
• Equity Notes
• Other Long Term Capital Instruments that
Combine Debt and Equity Features
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Basel II
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• Well Capitalized
• Adequately Capitalized
• Undercapitalized
• Significantly Undercapitalized
• Critically Undercapitalized
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Quick Quiz
• What are the most popular financial ratios
regulators use to assess the adequacy of bank
capital today?
• First National Bank reports the following items
on its balance sheet: cash, $200m; U.S.
government securities, $150m; residential real
estate loans, $300m; and corporate loans,
$350m. Its off-balance sheet items include
standby credit letters, $20m, and long-term
credit commitments to corporations, $160m.
What are First Nation’s total risk-weighted
assets? If the bank reports Tier 1 capital of
$30m and Tier 2 capital of $20m, does it have
a capital deficiency?
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