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Salaar - FinanceSalaar - Finance
Capital MarketsCapital Markets
Spring Semester 2011Spring Semester 2011
Lahore School of EconomicsLahore School of Economics
Salaar farooq – Assistant Professor
Salaar - FinanceSalaar - Finance
Depository InstitutionsLearning Objectives
What is a depository institution?
How a DI generates income?
What is the Asset/Liability problem for DI’s?
What is Funding Risk?
What are DI’s funding sources?
What are Reserve Requirements?
Salaar - FinanceSalaar - Finance
Depository Institutions?
Include:
Institutions which take deposits
Deposits represent Liabilities (debt) for DI’s
Include:
Banks
Savings & Loan institutions
Savings Banks
Credit Unions
Salaar - FinanceSalaar - Finance
How do DI’s make money?
3 ways:
LoansMake direct loans to entities
Securities investmentsInvesting in securities & holding portfolios
FeesCharged to their customers
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Importance of DI’s?
Heavily regulated because:
Their role in financial systema) Creating the financial playing field
Principal means of making payments
a) Individuals & Businesses use for payments
Vehicle for Govt monetary policy
a) MP implemented through banking system
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Because of their importance,
Given special privileges
Access to Federal Deposit Insurance
Provision of liquidity in emergencies
Govt has interest in DI’s stability & survival…
Salaar - FinanceSalaar - Finance
Asset-Liability Problem of DI’s?
2 Main problems:
Funding Risk
Liquidity Risk
Salaar - FinanceSalaar - Finance
Asset-Liability Problem of DI’s?
Funding Risk:Illustrate using 100MM, 7% 1 & 10 yrs
Use of Spreads (DI’s make money)Difference between bid/ask or charging premiums
Gaps (Mismatches)Open positions created due to duration differences
Interest rate exposureFunding/Gapping activity resulting in interest rate risk
Salaar - FinanceSalaar - Finance
Asset-Liability Problem of DI’s?
Opportunities:
Interest Rate view Mgrs who have expectations of interest rate changes will seek to profit
from funding/gapping
If Interest rates riseWhat position should you have?
If interest rates fallWhat position should you have?
Salaar - FinanceSalaar - Finance
Asset-Liability Problem of DI’s?
Threats of positioning:
Adverse financial consequences If expectations are not realized, Huge losses can occur
No one can predict interest rates consistentlyHighly risky?
Becomes same as gamblingLong run losses highly likely?
Salaar - FinanceSalaar - Finance
Main goal of Mgmt:
Locking in the spread
Minimize interest rate exposure
Various financial instruments used to manage risk
Asset-Liability Problem of DI’s?
Salaar - FinanceSalaar - Finance
Liquidity Concerns of DI’s?
Balancing two activities:
Satisfy Withdrawals of customersLiquidity required
Provide Loans to customersLiquidity required
Salaar - FinanceSalaar - Finance
Liquidity Concerns of DI’s?
4 ways to solve liquidity issues:
Attract deposits
Increase borrowing (using security collateral)
Sell Securities on hand
Raise Funds in Money Markets
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Liquidity Concerns of DI’s?
Increase Borrowing using securities:
Discount window borrowing at Fed (last resort!)
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Liquidity Concerns of DI’s?
Sell securities it owns:
DI must invest in ST, liquid securities with low price risk and keep these in its inventory
E.g stocks?... No, Bonds? …. No
Solution: ?
Salaar - FinanceSalaar - Finance
Liquidity Concerns of DI’s?
Sell securities it owns:
DI must invest in ST, liquid securities with little price risk and keep these in its inventory
E.g stocks?... No, Bonds? …. No
Solution: ST, MM or debt obligations (fed funds)
Salaar - FinanceSalaar - Finance
Liquidity Concerns of DI’s?
SECONDARY RESERVES?
Securities held by a DI for the purpose of satisfying withdrawals or loans.
Disadvantage?
Lower yield
% of assets as secondary reserves depends on DI’s risk/return appetite
Salaar - FinanceSalaar - Finance
Liquidity Concerns of DI’s?
One more reason for holding liquid assets?
Salaar - FinanceSalaar - Finance
Liquidity Concerns of DI’s?
One more reason for holding liquid assets?
To fulfill Govt regulation!
In form of Reserve Requirements (discussed later)
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Commercial Banks?
3 Main Types:
Individual Banking
Institutional Banking
Global Banking
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Commercial Banks?
Individual Banking:
Consumer Lending
Residential Mortgage
Installment Loans
Credit Card financing
Car & Boat Financing
Brokerage services
Student Loans
S10
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Commercial Banks?
Institutional Banking:
Loans to Corporations
Loans to Insurance companies
Loans to Govts
Commercial Financing & Leasing
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Commercial Banks?
Global Banking:
Investment Banking business
Foreign Exchange products
Capital Markets products Corporate financing products (underwriting securities etc)
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Commercial Banks?
Banks as Dealers:
Investment Banking business
Foreign Exchange products
Capital Markets products Corporate financing products (underwriting securities etc)
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Commercial Banks?
How do Banks raise Funds?
3 Main Sources of Funds
Deposits
Non-Deposit Borrowing (M.MKts) - Debt
Common Stock & Retained Earnings
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Commercial Banks?
Reserve Requirement &
Borrowing at the Fed Funds Mkt?
Banks must maintain a %age of deposits with Fed %age is called Reserve Ratio (depends on deposit type)
The cash kept with Fed is called Required Reserve
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Reserve Requirements?Basic Computation:
Deposit Computation Period2 Week period where the average of the daily is taken to get RR (THR-WED)
Actual ReservesRR must be met by Actual Reserves at the Fed
Excess ReservesIf bank reserves exceed the RR at the Fed
Fed Funds Market & Fed FundsBanks short of RR borrow from Excess Reserves of other Banks
Called the Fed Funds rate
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Reserve Requirements?Fed Discount Window:
Fed is the Banker’s Bank – last resort
Charges DISCOUNT RATE (usually 50bp lower)
CollateralTreasury securities, Govt securities etc.
Heavily Discourages its useWill investigate if use becomes frequent
Salaar - FinanceSalaar - Finance
Depository InstitutionsSummary
What is a depository institution?
How a DI generates income?
What is the Asset/Liability problem for DI’s?
What is Funding Risk?
What are DI’s funding sources?
What are Reserve Requirements?