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I’m working on a accounting discussion question and need an explanation and answer to help me learn.

1:  Which relationship would you expect to exist between measures of corruption and living standards at the country level? Explain by which channel corruption might affect living standards.

2: Many policymakers in developing countries have proposed the implementation of a system of deposit insurance similar to the system that exists in the United States. Explain why this might create more problems than solutions in the financial system of a developing country.

References:

The Economics of Money, Banking, and Financial Markets text

Part 3: Financial Institutions Introduction

Part 3.8: An Economic Analysis of Financial Structure

Part 3.9: Banking and the Management of Financial Institutions

The Economics of Money, Banking, and
Financial Markets
Business School Edition, Fifth Edition
Chapter 9
Banking and the
Management of Financial
Institutions
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Preview
• This chapter examines how banks attempt to maximize
their profits.
• Although the discussion that follows focuses primarily on
commercial banks, many of the same principles apply to
other financial intermediaries as well.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (1 of 2)
• Summarize the features of a bank balance sheet.
• Apply changes to a bank’s assets and liabilities on a Taccount.
• Identify ways in which banks can manage their assets and
liabilities to maximize profit.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (2 of 2)
• List the ways in which banks deal with credit risk.
• Apply gap and duration analysis and identify interest-rate
risk.
• Examine off-balance sheet activities.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
The Bank Balance Sheet (1 of 2)
• Liabilities:
– Checkable deposits
– Nontransaction deposits
– Borrowings
– Bank capital
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
The Bank Balance Sheet (2 of 2)
• Assets:
– Reserves
– Cash items in process of collection
– Deposits at other banks
– Securities
– Loans
– Other assets
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Table 1 Balance Sheet of All Commercial Banks
(Items as a Percentage of the Total, June 2017 (1 of
2)
Assets (Uses of Funds)*
Blank
Reserves and cash items
14% Checkable deposits
11%
Securities
Blank
Nontransaction deposits
Blank
U.S. government and agency
15
Savings deposits
49
State and local government and other
securities
6
Small denomination time deposits
2
Blank
Blank
Large-denomination time deposits
10
Blank
Blank
Borrowings
17
Blank
Blank
Bank capital
11
Liabilities (Sources of Funds)
Blank
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Table 1 Balance Sheet of All Commercial Banks
(Items as a Percentage of the Total, June 2017 (2 of
2)
Assets (Uses of Funds)*
Blank
Liabilities (Sources of Funds)
Blank
Loans
Blank
Blank
Blank
Commercial and industrial
13
Blank
Blank
Real estate
26
Blank
Blank
Consumer
8
Blank
Blank
Interbank
1
Blank
Blank
Other
9
Blank
Blank
Other assets (for example, physical
capital)
8
Blank
Blank
100
Total
100
Total
*In order of decreasing liquidity.
Source: Federal Reserve Bank of St. Louis, FRED database:
http://www.federalreserve.gov/releases/h8/current/ and
https://www.federalreserve.gov/releases/H6/current.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Basic Banking (1 of 3)
• Cash Deposit:
First
National
Bank
Blank
Blank
Blank
First
National
Bank
Blank
Blank
Blank
Assets
Blank
Liabilities
Blank
Assets
Blank
Liabilities
Blank
Vault
cash
+$100
Checkable
deposits
+$100
Reserves
+$100
Checkable
deposits
+$100
• Opening of a checking account leads to an increase in the
bank’s reserves equal to the increase in checkable
deposits.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Basic Banking (2 of 3)
First National Bank
Check Deposit:
Blank
Blank
Blank
Assets
Blank
Liabilities
Blank
Cash items in process of
collection
+$100
Checkable +$100
deposits
When a bank receives
additional deposits, it
gains an equal amount of
reserves; when it loses
deposits, it loses an equal
amount of reserves.
Second National
Bank
Blank
Blank
Blank
Blank
Assets
Blank
Liabilities
Blank
+$100
Reserves
−$100
Checkable
deposits
−$100
First National Bank Blank
Blank
Blank
Assets
Blank
Liabilities
Reserves
+$100
Checkable
deposits
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Basic Banking (3 of 3)
• Making a profit:
First National Blank
Bank
Blank
Blank
First National Blank
Bank
Blank
Liabilities
Blank
Liabilities
Blank
Assets
Required
reserves
+$10 Checkable
deposits
+$100
Required
reserves
+$10 Checkable
deposits
+$100
Excess reserves
+$90 Blank
Blank
Loans
+$90 Blank
Blank
Assets
Blank
Blank
Blank
• Asset transformation: selling liabilities with one set of
characteristics and using the proceeds to buy assets with a
different set of characteristics
• The bank borrows short and lends long
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
General Principles of Bank Management
• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Interest-rate Risk
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Liquidity Management and the Role of
Reserves (1 of 6)
• Excess reserves:
Assets
Blank
Liabilities
Blank
Assets
Blank
Liabilities
Blank
Reserves
$20M Deposits
$100M
Reserves
$10M
Deposits
$90M
Loans
$80M Bank Capital
$10M
Loans
$80M
Bank Capital
$10M
Securities
$10M Blank
Securities
$10M
Blank
Blank
Blank
– Suppose a bank’s required reserves are 10%.
– If a bank has ample excess reserves, a deposit outflow
does not necessitate changes in other parts of its
balance sheet.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Liquidity Management and the Role of
Reserves (2 of 6)
• Shortfall:
Assets
Blank
Liabilities
Blank
Assets
Blank
Liabilities
Reserves
$10M Deposits
$100M
Reserves
Loans
$90M Bank Capital
$10M
Loans
$90M
Bank Capital
$10M
Securities
$10M Blank
Securities
$10M
Blank
Blank
Blank
$0 Deposits
Blank
$90M
– Reserves are a legal requirement and the shortfall
must be eliminated.
– Excess reserves are insurance against the costs
associated with deposit outflows.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Liquidity Management and the Role of
Reserves (3 of 6)
• Borrowing:
Assets Blank
Liabilities Blank
Reserves
$9M Deposits
$90M
Loans
$90M Borrowing
$9M
Securities
$10M Bank Capital
$10M
– Cost incurred is the interest rate paid on the borrowed
funds
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Liquidity Management and the Role of
Reserves (4 of 6)
• Securities sale:
Assets Blank
Liabilities Blank
Reserves
$9M Deposits
$90M
Loans
$90M Bank Capital
$10M
Securities
$1M
Blank
Blank
– The cost of selling securities is the brokerage and other
transaction costs.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Liquidity Management and the Role of
Reserves (5 of 6)
• Federal Reserve:
Assets Blank
Liabilities Blank
Reserves
$9M Deposits
$90M
Loans
$90M Borrow from Fed
$9M
Securities
$10M Bank capital
$10M
– Borrowing from the Fed also incurs interest payments
based on the discount rate.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Liquidity Management and the Role of
Reserves (6 of 6)
• Reduce loans:
Assets Blank
Liabilities Blank
Reserves
$9M Deposits
$90M
Loans
$81M Bank Capital
$10M
Securities
$10M
Blank
Blank
– Reduction of loans is the most costly way of
acquiring reserves.
– Calling in loans antagonizes customers.
– Other banks may only agree to purchase loans at a
substantial discount.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Asset Management (1 of 2)
Three goals:
1. Seek the highest possible returns on loans and
securities.
2. Reduce risk.
3. Have adequate liquidity.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Asset Management (2 of 2)
Four Tools:
1. Find borrowers who will pay high
interest rates and have low possibility
of defaulting.
2. Purchase securities with high returns and low risk.
3. Lower risk by diversifying.
4. Balance need for liquidity against increased returns
from less liquid assets.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Liability Management
• Recent phenomenon due to rise of money center banks
• Expansion of overnight loan markets and new financial
instruments (such as negotiable CDs)
• Checkable deposits have decreased in importance as
source of bank funds.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Capital Adequacy Management (1 of 4)
• Bank capital helps prevent bank failure.
• The amount of capital affects return for the owners (equity
holders) of the bank.
• Regulatory requirement
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Capital Adequacy Management (2 of 4)
How Bank Capital Helps Prevent Bank Failure:
High Capital
Bank
Blank
Blank
Blank
Low Capital
Bank
Blank
Blank
Blank
Assets
Blank
Liabilities
Blank
Assets
Blank
Liabilities
Blank
Reserves
$10 million
Deposits
$90 million
Reserves
$10 million
Deposits
$96 million
Loans
$90 million
Bank capital
$10 million
Loans
$90 million
Bank capital
$ 4 million
High Capital
Bank
Blank
Blank
Blank
Low Capital
Bank
Blank
Blank
Blank
Assets
Blank
Liabilities
Blank
Assets
Blank
Liabilities
Blank
Reserves
$10 million
Deposits
$90 million
Reserves
$10 million
Deposits
$96 million
Loans
$85 million
Bank capital
$ 5 million
Loans
$85 million
Bank capital
−$ 1 million
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Capital Adequacy Management (3 of 4)
How the Amount of Bank Capital Affects Returns to Equity
Holders:
Return on Assets: net profit after taxes per dollar of assets
net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital
net profit after taxes
ROE =
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
EM =
Equity Capital
net profit after taxes net profit after taxes
assets
=
ï‚´
equity capital
assets
equity capital
ROE = ROA ï‚´ EM
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Capital Adequacy Management (4 of 4)
• Trade-off between safety and returns to equity holders:
– Benefits the owners of a bank by making their
investment safe
– Costly to owners of a bank because the higher the
bank capital, the lower the return on equity
– Choice depends on the state of the economy and
levels of confidence
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Application: Strategies for Managing Bank
Capital
• As the manager of the First National Bank, you have to
make decisions about the appropriate amount of bank
capital to hold in your bank.
• Our discussion of the strategies for managing bank capital
leads to the following conclusion, which deserves
particular emphasis: a shortfall of bank capital is likely to
lead a bank to reduce its assets and therefore is likely to
cause a contraction in lending.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Application: How a Capital Crunch Caused a
Credit Crunch During the Global Financial Crisis
• Shortfalls of bank capital led to slower credit growth:
– Huge losses for banks from their holdings of securities
backed by residential mortgages.
– Losses reduced bank capital
• Banks could not raise much capital on a weak economy
and had to tighten their lending standards and reduce
lending.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Managing Credit Risk (1 of 2)
• Screening and Monitoring:
– Screening
– Specialization in lending
– Monitoring and enforcement of
restrictive covenants
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Managing Credit Risk (2 of 2)
• Long-term customer relationships
• Loan commitments
• Collateral and compensating balances
• Credit rationing
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Managing Interest-Rate Risk
Blank
First National Bank
Assets
Rate-sensitive assets
Blank
$20 million
Variable-rate and
short-term loans
Blank
Short-term securities
Blank
Fixed-rate assets
$80 million
Blank
Blank
Liabilities
Rate-sensitive liabilities
Variable-rate CDs
Money market deposit
accounts
Fixed-rate liabilities
Blank
$50 million
Blank
Blank
$50 million
Reserves
Blank
Checkable deposits
Blank
Long-term loans
Blank
Savings deposits
Blank
Long-term securities
Blank
Long-term CDs
Blank
Blank
Equity capital
Blank
Blank
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Gap and Duration Analysis (1 of 2)
• Basic gap analysis:
(rate sensitive assets – rate sensitive liabilities) × Δ
interest rates = Δ in bank profit
• Maturity bucked approach:
– Measures the gap for several maturity subintervals
• Standardized gap analysis:
– Accounts for different degrees of rate sensitivity
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Gap and Duration Analysis (2 of 2)
% Δ in market value of security H− percentage point Δ in
interest rate × duration in years.
• Uses the weighted average duration of a financial
institution’s assets and of its liabilities to see how net worth
responds to a change in interest rates.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Off-Balance-Sheet Activities (1 of 3)
• Loan sales (secondary loan participation)
• Generation of fee income. Examples:
– Servicing mortgage-backed securities
– Creating SIVs (structured investment vehicles), which
can potentially expose banks to risk, as it happened in
the global financial crisis
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Off-Balance-Sheet Activities (2 of 3)
• Trading activities and risk management techniques:
– Financial futures, options for debt instruments, interest
rate swaps, transactions in the foreign exchange
market, and speculation
– Principal-agent problem arises
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Off-Balance-Sheet Activities (3 of 3)
• Internal controls to reduce the principal-agent problem:
– Separation of trading activities and bookkeeping
– Limits on exposure
– Value-at-risk
– Stress testing
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Rogue Traders and the Principal–Agent
Problem
• The demise of Barings, a venerable British bank more than
a century old, is a sad morality tale of how the principal–
agent problem operating through a rogue trader can take a
financial institution that has a healthy balance sheet one
month and turn it into an insolvent tragedy the next.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Copyright
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.

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