Asset or Liability Problem of DI
Primary liability (source of funds) : Deposits
Primary asset (use of funds) : Investments, Loans
(a) the difference between the interest for deposit and loans is income
(b) seek a positive spread (spread income) : interest rate income
Example : Deposits 3% and the loans 7% so the spread is positive of 4%
Risks
(a) credit risk/depository risk
(b) regulatory risk : government regulation
(c) funding risk : Interest rate risk
 

Example
T = 0
(a) Raise $100Million with maturity of 1 year pay 7% interest
(b) Invest in $100Million in T-bonds 30 years at 9%

       |----------|----------|----------|……………………………………………………|
      0           year1       year2       year3                                                                        year30

First year
Spread = +2%

Second year (if after one year, interest rate decrease to 5%)
Spread = +4%

Third year (if after one year, interest rate increase to 9%)
Spread = 0%

Conclusion
The lower the interest rate, better off because spread bigger that means bigger income
The higher the interest rate, worse off

Asset or Liability Management
Lock in a spread as best as possible (immunize)
 

II
Commercial Banks
National Bank : Chartered by the Federal government (OCC) – must be member of Federal Reserve System
State-chartered bank
(a) may elect to join Federal Reserve System
(b) dual banking system
 
 

(A)
Bank Services
Individual banking
Institutional banking
Global banking
 

(B)
Bank Funding
Deposits
Non-deposits
(a) Reserve in the Federal Funds Market    ** important
(b) From Federal Reserve through the discount window   ** important
(c) By issuance of securities in the debt market
Common stock and retained earnings

1. Reserve Requirements and Borrowing in the Federal Funds Market (Money Market)
(a) Reserve ratios : all banks must maintain a specified percentage of their deposits in a non-interest bearing account at one of
      the 12 Federal Reserve Banks
(b) Required reserve : Dollar amount based on reserve ratios (established by Federal Reserve Board)
(c) Excess amount : if actual reserves exceed required reserve
  Banks : incentive to manage their reserves to satisfy reserve requirements as precisely as possible
  Banks temporarily short of their required reserve can borrow reserves from banks that have excess reserves
(d) Federal Funds Market : the market where banks can borrow or lend reserves
(e) Federal Funds Rate : interest charged to borrow in this market, maintained by the market (if reserved ratios increased,
     Federal Fund Rate increases)
(f) Federal indirectly controls Federal Fund Rate
  Federal Fund Rate vs. T-bills

2.  Borrowing at the Federal Discount Window
Federal Reserve Board : the bankers’ bank, the bank of last resort
Banks temporarily short of funds can borrow from the Federal at its discount window
Discount rate : the interest rate that Federal charges at the discount window
Directly control and implement monetary policy
Good banks won’t uses discount window
.
3.  Open Market Operations (FOMC – Federal Open Market Committee)
Buy or sell treasury : change money supply
Buy treasury ---   Money supply increases ---   Demand decreases ---   interest rate decreases
Sell treasury ---  Money supply decreases ---   Demand increases ---   interest rate increases

Money center banks
Raise most of their funds from the domestic and international money markets

Regional Banks
  Rely primarily on deposits for funds
 

(C )
Federal Deposit insurance
In 1933, FDIC created to prevent bank run
Currently cover $100,000 per account
Protect small investors
Problem : inventive problem (moral hazard)
     Definition : the incentives of one party to a transaction to engage in activities detrimental to the other party
No bank discipline
Market discipline : investors take the money away from a bad mutual fun company to another investment place. Don’t
     care much about bank since it’s insured by FDIC up to $100,000 per account, just make sure that the deposits/savings
     are less than $100,000
Bad management bank usually bid risky project that promise a higher return
 

(D)
Regulation
FRB (Federal Reserve Board), FDIC (insurance project), OTS (Treasury), OCC (national bank) supervise the federal level
FDIC collect a flat premium, charge different premiums determine by the quality of the banks, if the quality is good, charge
     less premium. By penalizing the firms, moral hazard will reduce.
(a) regulation of interest rates
  prohibit the payment of interest on demand account (checking account)
  regulation Q : impose a ceiling on maximum
  interest rate paid by banks on deposits
          (i) disintermediation (after 1966) : withdrew money from D (bank) and should invest in mutual fund
          (ii) phase out in 1986
(b) geographical regulation
     (i) each state has the right to set its own rules on the intrastate branch banking
  statewide banking
  limited branch
  example : Texas is nationwide branching
     (ii) Interstate bank expansion is only permissible at the Bank Holding Company (BHC) level. Example: NationsBank HQ in
          North Carolina
     (iii) Out of state, BHC must acquire an existing bank operating in the state like Chase bought out Texas Commerce
(c) Permissible activities for commercial bank
     (i) activities of banks and BHCs are regulated by FRB
     (ii) Glass Steagull Act of 1933
  Prohibit banks from engaging in securities market activities (in the USA) ? largest bank in US is Citicorp
  Separation from commercial bank from investment bank
  Barrier between the two are being eroded : Citicorp and Traveler’s’ Group agree to merge, allowed by USA
              Reserve Board, oppose Glass Steagull Act of 1933
(d) Capital Requirements
  Highly leveraged institutions, a lot of debt
  Concern about potential insolvency
  Basle Accord on risk based capital requirement in Jun 1988 to standardize back capital requirements internationally
          banks for internationally settlement
  In 1989, Federal adopted guidelines for capital adequacy based on the credit risk of the asset held by banks
  Risk based capital requirements
          (i) The minimum core (TIER I) capital requirement is 4% of bank issue assets
          (ii) The minimum total capital (TIER I AND II) is 8% of the risk weighted assets
          (iii) Moratorium (Early 80’s) many people need a lot of job ? problem : consider credit risk only (no interest rate risk)
 

III
Savings and Loans (S & L) associations
Provide funds for financing the purchase of a home
At the federal level
(a) primary regulator (charter) : OTS (Officer Trift Supervisor) in Treasury
(b) Insurance : SAIF (Savings Association Insurance Fund) in FDIC
  Asset : mortgage (30 years) MBS
  Lialibilites : deposits
  Lend long and borrowing short
  Maturity mismatch (funding problem)
 

S & L Crisis
(a) Early 80’s : interest rate risk (high inflation) 1981, T bills gave 16% interest rate
(b) Late 80’s : Default risk because of mismanagement
  Gam St. Germain Act of 1982
  Allows S & L to expand products to relieve the problems with high interest
  Make commercial and industrial loans
 Cost a multi billion dollars to taxpayers
 

IV
Savings banks
Similar to S & L (much older)
Most are mutually owned
Insured by either BIF or SAIF
 

V
Credit Unions
Smallest and newest of DI
Serve the members’ savings and borrowing needs
Members deposits --- shares
Federal regulatory agency : National Credit Union Administration (NCUA)
Insurance NCUSIF (National Credit Union Shares Insurance Fund) up to $100,000 in NCUA