Chapter 4 Commercial Bank’s Sources and Uses of Funds Lecture Objectives 1. To describe the Profit and Loss Account and Balance Sheet of a commercial bank

Chapter 4 Commercial Bank’s Sources and

Uses of Funds Lecture Objectives 1. To describe the Profit and Loss Account and Ba

lance Sheet of a commercial bank2. To identify the sources and uses of funds of co

mmercial banks3. To explain the goals and management strategies

of commercial banks4. To define funds management5. To review the latest performance of Hong Kon

g banking sector

Commercial Bank’sProfit and Loss Account

Interest Income

– Interest Expenses

= Net Interest

Income (Spread)

Commercial Bank’sProfit and Loss Account

Net Interest Income– Provision for loan losses+ Non-interest Income (Fees)– Non-interest Expenses (Overheads)= Income before taxes and investment gain / (loss)

Commercial Bank’sBalance Sheet

Assets :CashAmounts due from

financial institutionsTrade billsAdvances and loans to

customersInvestmentFixed Assets


Liabilities :Amounts due to

financial institutionsDeposits from

customersCertificates of depositsProvisions for loan loss


Shareholders’ Funds :Share capitalReserves

Commercial Bank’sSources and Uses of Funds

A commercial bank’s main sources of funds come from the customers’ deposits, the issue of certificates of deposit, the share capital contributed by the bank’s shareholders and the reserves from the retained profits.


A commercial bank’s main uses of funds are for lending to customers and investments. But a commercial bank has to keep substantial funds in the form of cash and short-term investments as liquid assets.


The profitability of a commercial bank depends on the composition of its balance sheet and the efficiency of its operation. Nowadays there is a trend to increase the non-interest income because keen competition among commercial banks has decreased the Spread.


It is vital for banks to maintain sufficient cash and near-liquid funds to repay depositors. However, the problem of maintaining assets in the form of cash or near-liquid fund is that the more liquid it is, the lower rate of interest it earns. The highest rates of interest are charged for the most illiquid assets, i.e. advances and loans to business and personal customers.

Liquidity (L) versus Profitability (P)

Assets Period Borrowers YieldCash - - Nil

Money at call

1-14 days Money market

1%-2%

Bills discounted

1-6 months Business customers

3%-4%

Investment 6 months – 5 years

Capital market

5%-6%

Advances and Loans

1 day – 30 years

Business and Personal Customers

7%-10%

L P

Goals of a Commercial Bank

Increased shareholders’ wealth

Maximum net earningsIncreased rate of growthImproved services to the

public

Commercial Bank’s Financial Management

Management of Assets :

Maximize yields available

Satisfy the liquidity needs and regulations

Management of Liabilities :

Minimize costs of funds raised

Promote the growth in total funds available

Commercial Bank’s Financial Management

Management of Capital :

Minimize the owners’ total investment in the firm

Minimize risk exposure

Satisfy the government’s regulations

Marketing Policies :Identify consumers’ needsDevelop new products,

pricing and promotion campaigns

Expense Control :Increase efficiency in the use

of resourcesNew money-saving methods

Commercial Bank’s Risk Management

The focus of the assets and liabilities management of commercial banks is always in the reduction of interest-rate risk, liquidity risk, credit risk and foreign exchange risk.

Commercial Bank’s Risk Management

Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. A sound basis for evaluating funds management requires understanding the bank, its customer mix, the nature of its assets and liabilities, as well as the economic environment.

Liquidity

A bank has adequate liquidity when it can obtain sufficient funds, either by increasing liabilities or by converting assets into cash, promptly and at a reasonable cost. Liquidity is met through holding high quality short-term assets (like treasury bills). The price of liquidity is the income not earned from not holding lower quality longer-term assets (like some long-term commercial loans).

Interest Rate Risk Management

The interest rate risk management is achieved through the asset-liability management of a commercial bank. Management must consider the cost of maintaining liquidity. Changes in money market conditions may cause a deterioration in a bank’s capacity to borrow at a favourable interest rate. Therefore, seasonal and cyclical factors may also cause an increase in loan demand and a decrease in deposits or an increase in deposits and a decrease in loan demand. As a result, the interest rate margins and income may fluctuate.

Performance of the Hong Kong banking sector in 2003

The Hong Kong economy was marked by continuing deflation, declining property prices, and historically high unemployment and personal bankruptcies in 2003. The economic conditions were aggravated by the SARS outbreak.


The declining loan demand resulted in a highly liquid banking sector, with the Hong Kong dollar interest rates dropped to a new low. The one-month HIBOR fell to an annual average of 0.92% and the one-month time deposit rate fell to an annual average of 0.07%. But the best lending rate remained unchanged at 5.00%, resulting in a widening interest rate spreads. The spread between the average best lending rate and the average one-month HIBOR widened to 408 basis points.


However, the pre-tax operating profits of retail banks increased by 5.3% due to gains in treasury operations (foreign exchange trading), increased income from fees and commissions, and reduced bad debt provisions and operating expenses.


Retail banks’ total lending fell modestly by 0.6% and property lending decreased by 2% in 2003. The holding of negotiable debt instruments excluding negotiable certificate of deposits, by retail banks grew by 13.3% in 2003. The increase was largely in corporate debt instruments and floating rate notes denominated in foreign currencies.


The liquidity of retail banks remained high and the loan-to-deposit ratio dipped to 49.6%. But the asset quality of banks improved in 2003 as the classified and non-performing loan ratios dropped to 3.91% and 3.16% respectively.

Tutorial

Study the Balance Sheet: All Authorized Institutions.

1.What are the largest items in the Liabilities and Assets ?

2. Discuss the characteristics of the sources and uses of funds of the authorized institutions in Hong Kong.

Tutorial

Study the Profit and Loss Accounts and Balance Sheets of the Hongkong and Shanghai Banking Corporation Ltd., Standard Chartered Bank Ltd. and Bank of China Hong Kong Ltd. for the year 2003, compare their strengths and weaknesses.

Performance of the Hong Kong Banking Sector in 2003

Performance Indicator 2002 2003

Return on Assets (Before Tax) 0.91% 0.93%

Net Interest Margin 1.52% 1.41%

Bad debt charge to average Total Assets

0.24% 0.24%

Loan to Deposit Ratio (Hong Kong dollar)

88.5% 81.5%

The largest items of liabilities and assets

Liabilities• Deposits from

customers• Capital, Reserves and

other liabilities• Amount due to

Authorized Institutions in Hong Kong

Assets• Loans and advances to

customers• Government bills,

notes and bonds• Amount due from

Authorized Institutions in Hong Kong

Sources and Uses of Funds of Authorized Institutions in Hong Kong

The financial intermediation functions prevail. The main source of fund is customers’ deposits and the main use of fund is loans and advances to customers.

The HKD deposits are concentrated in a few big banks like HSBC, Hang Seng Bank, Bank of China, Standard Chartered Bank, etc. Other banks have to borrow HKD funds from the big banks through the interbank market. Therefore, Amount due to AIs and and Amount due from AIs are also important source and use of funds.

Sources and Uses of Funds of Authorized Institutions in Hong Kong

Capital and reserves are important sources of fund. The traditional practice is for banks in Hong Kong to reserve a larger portion of the profits as reserves for future business expansion.

Government bills, notes and bonds are high quality short-term assets which the banks hold to earn interest while at the same time to maintain liquidity, because the investment can be converted into cash quickly.

Compare the Profit and Loss Accounts of HSBC, SC and BOC for the Year 2003 (HKD’million)

Items HSBC SC BOC

Interest Income 55,770 4,790 17,759

Interest Expense 17,032 1,822 4,888

Net Interest Income 38,738 2,968 12,871

Non-interest Income 22,627 1,156 4,385

Operating Expenses 24,024 2,664 5,660

Operating Profit Before Provisions

37,341 2,089 11,596

Provision for Bad and Doubtful Debts

3,386 536 1,671

Compare the Profit and Loss Accounts of HSBC, SC and BOC for the Year 2003 (% of Total Income)

Items HSBC SC BOC

Interest Income 71% 81% 80%

Non-interest Income 29% 19% 20%

Interest Expense 22% 31% 22%

Operating Expenses 31% 45% 26%

Provisions for Bad and Doubtful Debts

4% 9% 8%

Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (HKD’million)

Items HSBC SC BOC

Total Assets 2,148,741 120,282 762,586

Advances to customers 815,004 59,744 300,094

Cash and short-term funds 359,137 7,524 134,106

Long-term Investment 399,642 23,500 172,518

Fixed Assets 34,875 884 17,582

Lending to banks 113,322 13,354 78,240

Compare the Balance Sheets of HSBC, SC and BEA for the Year 2003 (HKD’million)

Items HSBC SC BOC

Total Liabilities 2,009,883 112,567 705,228

Current, Savings and Other Deposits

1,669,704 73,767 600,826

Borrowing from banks 68,111 10,924 41,347

Debt Securities - 6,062 2,432

Shareholders’ Funds 138,858 7,715 57,358

Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (HKD’million)

Special Items HSBC SC BOC

Assets

HKSAR Government Certificates of Indebtedness

85,294 ? 31,460

Liabilities

HKSAR currency notes in circulation

85,294 ? 31,460

Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (%)

Items HSBC SC BOC

Advances to Customers / Total Assets

38% 50% 39%

Long-term Investment (Approximately) / Total Assets

19% 20% 23%

Cash and Short-term Funds / Total Assets

17% 6% 18%

Fixed Assets / Total Assets 2% 1% 2%

Lending to Banks / Total Assets

5% 11% 10%

Compare the Balance Sheets of HSBC, SC and BOC for the Year 2003 (%)

Items HSBC SC BOC

Customers’ Deposits and Debt Securities / Total Liabilities

83% 71% 86%

Shareholders’ Funds / Total Liabilities

7% 7% 8%

Borrowing from Banks / Total Liabilities

3% 10% 6%

Loans to Deposits 49% 81% 50%

Cash and Short-term Funds / Customers’ Deposits

22% 10% 22%

Documents

Chapter 4 Commercial Bank’s Sources and Uses of Funds Lecture Objectives 1. To describe the Profit and Loss Account and Balance Sheet of a commercial bank