1
BANKING OPERATIONS AND
MANAGEMENT
______________________
1
Marijana Ćurak - University of Split, Faculty of Economics
Undergraduate study program: Business study
Financial institutions and markets
Academic year 2014/2015
10/21/2014
These lecture slides are based on the
books:
Heffernan, S. (2005): Modern Banking, John
Wiley & Sons
Mishkin F. S., Eakins, S. G. (2012): Financial
Markets + Institutions, Addison Wesley
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
2
AGENDA
Banking operations – Types of Banking
The bank balance sheet
Basic banking
The general principles of bank management
Measuring bank performance
Financial innovation
Review points
Marijana Ćurak - University of Split, Faculty of Economics
3
10/21/2014
2
BANKING OPERATIONS
They depend on types of banks:
Universal banks
Commercial banks
Investment banks
Financial conglomerates
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
4
UNIVERSAL BANKS (1)
Universal banks offer the full range of
banking services, together with non-banking
financial services, under one legal entity
The banks have direct links between banking
and commerce through cross-shareholdings
and shared directorships
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
5
FINANCIAL ACTIVITIES OF UNIVERSAL BANKS (1)
Intermediation and liquidity via deposits and loans;
a byproduct is the payments system
Trading of financial instruments (e.g., bond, equity,
currency) and associated derivatives
Proprietary trading, that is, trading on behalf of the
bank itself, using its own trading book
Stockbroking
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Marijana Ćurak - University of Split, Faculty of Economics
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3
FINANCIAL ACTIVITIES OF UNIVERSAL BANKS (2)
Corporate advisory services, including mergers
and acquisitions
Investment management
Bancassurance
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
7
UNIVERSAL BANKS (2)
Germany is the home of universal banking (the
German hausbank)
Though German banks may own commercial
concerns, the sum of a bank’s equity
investments (in excess of 10% of the
commercial firm’s capital) plus other fixed
investments may not exceed the bank’s total
capital
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
8
UNIVERSAL BANKING (3)
In addition to a German bank lending to
commercial firms, it will also exert
influence through the Supervisory Board
Most of the shareholder seats are held by
bank executives because the bank
normally has a large shareholding
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
9
4
COMMERCIAL AND INVESTMENT
BANKS (1)
These terms originated in the United States,
though they are used widely in other countries
Under Glass Steagall Act (1933) commercial
banks were not allowed to underwrite securities
with the exception of municipal bonds, US
government bonds and private placements
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
10
COMMERCIAL AND INVESTMENT
BANKS (2)
Investment banks were prohibited from
offering commercial banking services
The objectives of the Act were twofold:
to discourage collusion among firms in the
banking sector
to prevent another financial crisis of the sort
witnessed between 1930 and 1933
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
11
COMMERCIAL BANKS (1)
Financial institutions that accept deposits
and make loans
Provide payment mechanism
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Marijana Ćurak - University of Split, Faculty of Economics
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5
COMMERCIAL BANKS (2)
Commercial banks offer
wholesale and
retail banking services
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
13
WHOLESALE BANKING
Typically involves offering intermediary, liquidity
and payment services to large customers such
as big corporations and governments
They offer business current accounts, make
commercial loans, participate in syndicated
lending and are active in the interbank markets
to borrow/lend from/to other banks
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
14
RETAIL BANKING
It offers the same services to numerous
personal banking customers and small
businesses
Retail banking is largely intrabank: the
bank itself accepts deposits and makes
many small loans
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
15
6
INVESTMENT BANKS (1)
Underwriting
Mergers and acquisitions
Trading – equities, fixed income (bonds),
proprietary
Fund management
Consultancy
Global custody
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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INVESTMENT BANKS (2)
Nor do investment banks offer liquidity as a service in
the same way as a standard bank
They contribute to increased liquidity in the system by
arranging new forms of finance for a corporation, but
this is quite different from meeting the liquidity demands
of depositors
Indeed, the functions of the investment bank differ so
much from the traditional bank that the term ‘‘bank’’
may be a misnomer
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
17
FINANCIAL CONGLOMERATE
Firm that undertakes at least two of five
financial activities:
intermediary/payments
insurance
securities/corporate finance
fund management and
advising on or selling investment products to
retail customers
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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7
TOP BANKS IN THE WORLD IN 2014 (1)
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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Source:
http://www.relbanks.com/worlds-top-banks/assets
(Accessed: October 18, 2014)
TOP BANKS IN THE WORLD IN 2014 (2)
For the third year in a row, Industrial &
Commercial Bank of China (ICBC) is the largest
bank in the World with assets of $3.182 trillion
Four of the top 10 banks are Chinese financial
institutions
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
20
Source:
http://www.relbanks.com/worlds-top-banks/assets
(Accessed: October 18, 2014)
TOP BANKS IN THE WORLD IN 2014 (3)
The Top 50 banks include:
10 Chinese banks
6 US banks
5 Japanese banks
5 French banks
5 UK banks
4 banks from Australia
3 from Canada and
3 from Germany
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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Source:
http://www.relbanks.com/worlds-top-banks/assets
(Accessed: October 18, 2014)
8
THE BANK BALANCE SHEET (1)
A bank’s balance sheet is list of its sources
of fund (liabilities) and uses to which the
funds are put (assets)
It has characteristics that:
Total assets = total liabilities + capital
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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THE BANK BALANCE SHEET (2)
Banks obtain funds by issuing liabilities such as
deposits, issuing of securities and by borrowing
They use the funds to acquire assets such as
loans and securities
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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LIABILITIES (1)
Demand deposits
Deposits that are payable on demand – if a depositor
shows up at the bank and request payment by
making a withdrawal, the bank must pay the
depositor immediately
They are usually the lowest cost source of bank funds
because depositors are willing to forgo some interest
to have access to a liquid asset
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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9
LIABILITIES (2)
Non-transaction deposits
Primary source of bank funds
The interest rates paid on these deposits are usually higher that
those on checkable deposits
Saving accounts
Funds that can be added or withdrawn at any time
Transactions and interest payments are recorded in a monthly
statement or in a passbook held by the owner of the account
Time deposit (certificates of deposit or CDs)
They have a fixed maturity length, ranging from several months to over
five years
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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LIABILITIES (3)
Borrowings
Borrowing from central bank, other banks and
corporations
Bank capital
Bank’s net worth
It equals the difference between total assets and
liabilities
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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ASSETS
Reserves
Required reserves
Excess reserves
Cash items in process of collection
Deposits at other banks
Securities
Loans
Other assets (the physical capital – bank
buildings, computers, and other equipment)
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
27
10
BASIC BANKING (1)
Banks make profits by charging an interest
rate on their asset holdings of loans and
securities that is higher than the interest
and other expenses on their liabilities
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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BASIC BANKING (2)
Process of asset transformation – banks
make profits by selling liabilities with one
set of characteristics (a particular
combination of liquidity, risk, size, and
return) and using the proceeds to buy
assets with a different set of
characteristics
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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BASIC BANKING (3)
The bank “borrows short and lends long”
because it makes long-term loans and
funds them by issuing short-dated
deposits
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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11
BANKING FIRM MODEL – INTERMEDIARY (1)
31
Source: Heffernan, 2005.
Marijana Ćurak - University of Split, Faculty of Economics
BANKING FIRM MODEL – INTERMEDIARY (2)
S
D
: supply of deposits curve
S
L
: supply of loans curve
D
L
: demand for loans curve
0T: volume of loans supplied by customers
i
∗
: market interest rate in the absence of the
intermediation costs
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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BANKING FIRM MODEL – INTERMEDIARY (3)
i
L
− i
D
: bank interest differential between the
loan rate (i
L
) and the deposit rate (i
D
) which
covers
the cost of the bank's intermediation
the cost of capital
the risk premium charged on loans
tax payments and
the institution’s profits
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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12
BANKING FIRM MODEL – FEE BASED
FINANCIAL PRODUCTS (1)
34
Izv. prof. dr. sc. Marijana Ćurak, Katedra za financije
Ekonomski fakultet, Sveučilište u Splitu
Source: Heffernan, 2005.
BANKING FIRM MODEL – FEE BASED
FINANCIAL PRODUCTS (2)
P: price for fee based services
Q: quantity demanded and supplied in
equilibrium
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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GENERAL PRINCIPLES OF BANK MANAGEMENT (1)
The bank manager has four main
concerns:
To make sure that the bank has enough ready
cash to pay its depositors when there are
deposit outflows (that is when deposits are
lost because depositors make withdrawals and
demand payment). To keep enough cash on
hand, the bank must engage in liquidity
management.
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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13
GENERAL PRINCIPLES OF BANK MANAGEMENT (2)
The bank manager has to take an acceptably low
level of risk by acquiring assets that have a low rate
of default and by diversifying asset holdings – asset
management
To acquire funds at low cost – liability management
The manager must decide the amount of capital the
bank should maintain and then acquire the needed
capital – capital adequacy management
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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LIQUIDITY MANAGEMENT (1)
Although more liquid assets tend to earn lower returns,
banks still desire to hold them
Banks hold excess and secondary reserves because they
provide insurance against the cost of a deposit outflow
The higher the costs associated with deposit outflows,
the more excess reserves banks will want to hold
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
38
LIQUIDITY MANAGEMENT (2)
When a deposit outflow occurs, holding excess
reserves allows the bank to escape the costs of:
Borrowing from other banks or corporations
Selling securities
Borrowing from the central bank
Calling in or selling off loans
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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14
ASSET MANAGEMENT (1)
Banks manage their assets to maximize
profits by seeking the highest returns
possible on loans and securities while at
the same time trying to lower risk and
making adequate provisions for liquidity
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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ASSET MANAGEMENT (2)
Banks try to find borrowers who will pay high
interest rates and unlikely to default on their
loans
They try to purchase securities with high returns
and low risk
They must attempt to lower risk by diversifying
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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ASSET MANAGEMENT (3)
Bank must manage the liquidity of its assets so
that it can satisfy its reserve requirements
without bearing huge costs
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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LIABILITY MANAGEMENT
Large banks actively seek out sources of funds
by issuing liabilities such as negotiable CDs or by
actively borrowing from other banks or
corporations
Importance of asset-liability management (ALM)
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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CAPITAL ADEQUACY MANAGEMENT (1)
Banks manage the amount of capital they hold
to
prevent bank failure (situation in which the bank
cannot satisfy its obligations to pay its depositors and
other creditors and so goes out of business)
meet bank capital requirements set by the regulatory
authorities
the amount of capital affects returns for the owners
(equity holders) of the bank
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
44
CAPITAL ADEQUACY MANAGEMENT (2)
They do not want to hold too much capital
because by so doing they will lower the returns
to equity holders
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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16
OFF BALANCE-SHEET ACTIVITIES (1)
The activities involve trading financial
instruments and generating income from fees
and loan sales, activities that affect bank profits
but do no appear on bank balance sheets
Off-balance-sheet activities have been growing
in importance for banks
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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OFF BALANCE-SHEET ACTIVITIES (2)
Generation of fee income
The fees that banks receive for providing specialized
services to their customers, such as making foreign
exchange trades on customer’s behalf, servicing a
mortgage-backed security by collecting interest and
principal payments and then paying them out
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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OFF BALANCE-SHEET ACTIVITIES (3)
Trading activities and risk management
techniques
In order to manage interest-rate risk banks trade in
derivatives market
Bank engaged in international banking also conduct
transitions in the foreign exchange market
All transactions in these markets are off-balance-
sheet activities because they do not have a direct
effect on the bank’s balance sheet
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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17
MEASURING BANK PERFORMANCES
Bank’s income statements
Operating income – the income that comes
form a bank’s ongoing operations
Operating expenses – the expenses incurred
in conducting the bank’s ongoing operations
Net operating income – Operating income –
operating expenses
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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MEASURES OF BANK PERFORMANCE (1)
Return on assets
Divides the net income of the bank by the
amount of its assets
It is a useful measure of how well a bank
manager is doing on the job because it
indicates how well a bank’s assets are being
used to generate profits
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
50
MEASURES OF BANK PERFORMANCE (2)
Return on equity (ROE)
Divides the net income of the bank by the
amount of its capital
It shows how much the bank is earning
bank’s owners equity investment
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Marijana Ćurak - University of Split, Faculty of Economics
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18
MEASURES OF BANK PERFORMANCE (2)
Net interest margin (NIM)
The difference between interest income and
interest expenses as a percentage of total
assets
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
52
FINANCIAL INNOVATION AND THE GROWTH OF
THE SHADOW BANKING SYSTEM
Shadow banking system – the system in which
bank lending has been replaced by lending via
the securities market
A change in the financial environment have
stimulated a search by financial institutions for
innovations that are likely to be profitable
The process of financial engineering
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
53
RESPONSE TO CHANGES IN DEMAND
CONDITIONS – INTEREST RATE VOLATILITY
Adjustable-rate mortgages
Mortgage loans on which the interest rate
changes when a market interest rate changes
Financial derivatives
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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19
RESPONSE TO CHANGES IN DEMAND
CONDITIONS – INFORMATION TECHNOLOGY
Bank credit and debit cards
Electronic banking
Electronic payment
E-money
Junk bonds
Commercial paper market
Securitization
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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REVIEW POINTS (1)
There are various bank operations
depending on type of banks:
Universal banks
Commercial banks
Investment banks
Financial conglomerates
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
56
REVIEW POINTS (2)
Fields of bank management:
Liquidity management
Asset management
Liability management
Capital adequacy management
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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20
REVIEW POINTS (3)
Banks response to changes in changes in
their business environment by various
innovations
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
58
REFERENCES
Heffernan, S. (2005): Modern Banking, John
Wiley & Sons
Mishkin F. S., Eakins, S. G. (2012): Financial
Markets + Institutions, Addison Wesley
Marijana Ćurak - University of Split, Faculty of Economics
59
10/21/2014
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