02 Classes 3

1. The banking system

Information Classification: Limited Access

The banking system

Information Classification: Limited Access

Banking basics
Since the beginning of time

• Roots traced back to 2000 B.C.

– Depositories for valuables, location for lending

• Modern banking has roots back to the renaissance era

– Business conducted on a “bench”, roots of the word “bank”

– Banca Monte dei Paschi (est. 1472) is oldest bank in existence

• Oldest US bank from 1784

– Bank of New York (started by Alexander Hamilton)

– Bank of Massachusetts (acquired by Bank of America)

– State Street Bank founded in 1792

– Bank of America was founded as Bank of Italy in San Francisco

• Commercial, savings and loans, GSIBs, Large banks, regional banks, community banks

• U.S. banks have $23 trillion in assets

• Global banking assets $180 trillion

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Information Classification: General
Bank balance sheet basics
Think in opposites

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Information Classification: General
Banks are the most complicated balance sheets
400 pages of financial statements and explanations

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Information Classification: General
Balance Sheet
The basics

• Bank’s balance sheet is the mirror image of its customers’ balance

sheets

• Cash asset for client = funding liability for bank

• Lending liability (loan) for client = loan asset for bank
• Management task is to manage credit risk, duration risk, liquidity
demand, regulatory requirements
• Balance sheet is organized to maximize positive net interest margin

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Information Classification: General
Liabilities
Retail and institutional Deposits

• Deposits (generally lowest cost of funding)

– Checking/demand deposits (often interest free)
– Must make funds available upon demand
– Multiple ways to access funds, including writing a check

– Savings and time deposits (more expensive cost of funds)

– Less liquid, withdrawal limits, limited access points
– Interest bearing accounts, Certificates of deposit (CDs)
– Jumbo CDs and brokered deposits via secondary markets

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Information Classification: General
Bank depositors leave money on the table
Record spread to market rates

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Information Classification: General
Liabilities
Borrowing from other financial institutions

• Debt
– Short term and long term
• Commercial paper
• Repo – collateralized lending (sell security /gets funding)
• Fed Funds market
• Federal Home Loan Bank Advances
• Fed discount window (stigma lending)
_____________________________________
All are more expensive forms of funding

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Information Classification: General
Assets
The importance of loans

Loans are primary revenues for most banks Top 20 banks = 57% total assets

• Business lending Large banks still dominate (common size assets)

Large banks % assets Small banks % assets
– Commercial and industrial (C&I) 100%

75%
• Consumer lending
– Credit card 50%

– Student loans
25%
– Auto loans
0%
Jan-00 Aug-04 Mar-09 Oct-13 May-18 Dec-22
• Real estate
– Residential real estate (not securitized) Small bank lending pick up
– Commercial real estate Small bank lending picks up
• Office, warehouses, shopping centers, Large banks % loans Small banks % loans

apartment, restaurants, etc 100%

• Multifamily
75%
Total loans % total

– Home equity
50%

25%

0%
Jan-00 Aug-04 Mar-09 Oct-13 May-18 Dec-22

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Information Classification: General
Lending strengths and weaknesses
Big banks own the consumer / small banks dominate CRE

Consumer needs big banks Generally stable C&I lending

C&I generally proporionate tro assets
Big banks fund consumer
Large banks % C&I Small banks % C&I Foreign banks % C&I
Large banks % consumer Small banks % consumer Foreign banks % consumer
100%
100%

Total loans % total

75%
Total loans % total

75%

50% 50%

25% 25%

0% 0%
'00 '04 '09 '14 '19 '24 '00 '04 '09 '14 '19 '24

Small banks own CRE lending

Small banks dominate CRE
Large banks % CRE Small banks % CRE Foreign banks % CRE
100%
Total loans % total

75%

50%

25%

0%
'04 '08 '12 '16 '20 '24

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Information Classification: General
Securities growing importance
QE impacted asset growth strategies

Securities investments grow Security ownership impacted by pandemic QE

• Securities investments Securities % total credit

– U.S. Treasuries
– Mortgage backed securities
– Agency securities
32%
• Available for sale
• Held till maturity

28%
Varying degrees of importance

JPM NII % total Citizens NII% total JPM Trading % Total Citizens trading % total

80%

60% 24%

40%

20%

20%
0%
'00 '04 '09 '14 '19 '24
'11 '13 '15 '18 '20 '22

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Information Classification: General
Higher for longer hurts all around
Not the way the banks planned

59 Source: FDIC
Information Classification: General
Capital and reserves
Buffers against hard times

• Traditional capital= stockholders equity

– Paid in capital + retained earnings

• Regulatory capital allows additional forms of capital (subordinate to depositors)

– Noncumulative preferred stock
– Certain subordinate debt
– TARP assets (previously)
• Capital requirements are generally held against risk weighted assets
• Reserves requirements is cash held at Fed
– Prior to 2020 RR = 10%, now 0%
• Excess reserves held at Fed
– Interest on excess reserves (IORB) only paid since GFC (2008)

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Information Classification: General
The business of banking
Capital transformation

• First national bank receives $100 deposit

Assets Liabilities
Vault cash +100 Checkable deposit +100
Interest paid is $5%
Operating costs = $4
• 10% reserve requirement Required reserves pay 0%

Assets Liabilities Car loan must pay 10% to

break even

Required reserve $10 Checkable deposit +100

Excess reserve $90

• Customer wants a car loan

Assets Liabilities
Required reserve $10
Checkable deposit +100
Car loan $90

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Information Classification: General
 The business of banking
Liquidity management (conservative)

• First national Initial balance sheet

• 10% reserve requirement

Assets Liabilities
Bank maintained $10 in excess
Required reserve $10 Checkable deposit $100 Reserves
Excess reserves $10
Loans $80 Withdrawal reduced cash assets
Bank capital $10
Securities $10
Lowered required reserves by $1

Reduced excess reserves by $9

Checking client withdraws $10
Maintaining excess reserves
Assets Liabilities Was conservative bank management

Required reserve $9 Checkable deposit $90

Excess reserves $1
Loans $80 Bank capital $10
Securities $10

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Information Classification: General
 The business of banking
Liquidity management (aggressive)

• First national Initial balance sheet • $10 withdrawal

Assets Liabilities Assets Liabilities

Reserve $10 Checkable deposit $100 Reserve $0 Checkable deposit $90
Loans $90 Bank capital $10 Loans $90 Bank capital $10
Securities $10 Securities $10

Option 1 borrow from funds market Option 2 sell securities

Assets Liabilities Assets Liabilities
Reserve $9 Checkable deposit $90 Reserve $9 Checkable deposit $90
Loans $90 Fed funds $9 Loans $90 Bank capital $10
Securities $10 Bank capital $10 Securities $1

Option 3 borrow from Fed Option 4 sell loans

Assets Liabilities Assets Liabilities
Reserve $9 Checkable deposit $90 Reserve $9 Checkable deposit $90
Loans $90 Discount window $9 Loans $81 Bank capital $10
Securities $10 Bank capital $10 Securities $10
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Information Classification: General
Outcome of reserve shortfalls
Withdrawal had a domino effect given aggressive BS management

• Withdrawal drained all reserves, bank did not maintain excess reserves
• Borrowing from fed funds market more expensive, anchored by policy rates
– Wide variety of fed funds rates based on borrower credit profile
• Selling securities
– Transaction costs
– Potential losses
– Must be available for sale
• Borrowing from Fed
– More expensive form of funding
– Discount rate stigma
• Selling loans
– Transaction cost, potential losses

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– Illiquid market for loans
Information Classification: General
 The business of banking
Capital adequacy

• High capital bank • Low capital bank

Assets Liabilities Assets Liabilities

Reserve $10 Checkable deposit $90 Reserve $10 Checkable deposit $96
Loans $90 Bank capital $10 Loans $90 Bank capital $4

Loan loss of $5

Assets Liabilities Assets Liabilities

Reserve $10 Checkable deposit $90 Reserve $10 Checkable deposit $96
Loans $85 Bank capital $5 Loans $85 Bank capital ($1)

Low capital bank is now insolvent, will be taken over by FDIC

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Information Classification: General
 Bank capital
Regulators prefer more capital, Investors want less capital

Return on Assets (ROA): Return on Equity (ROE):

After tax profit /Assets (loans and investments) After tax profit / Capital (Equity)

Indicates bank efficiency in profits per asset Measures shareholders return

Equity Multiplier:
Assets / Capital (Equity)
How many assets per equity unit

After tax profits After tax profits Assets

= X
Equity capital Assets Equity capital

ROE = ROA X EM

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Information Classification: General
ROE examples
High capital vs low capital bank

• Both banks generate $1 in after tax income

• High capital bank • Low capital bank

– ROA = 1/100 =1% - ROA = 1/100 = 1%

X X
- EM = 100/4 = 25
– EM = 100/10 = 10
- ROE = 25 x 1% = 25%
– ROE = 10 x 1 = 10%

• Low capital shareholders are happier

• Risks
• Higher risk of failure
• More capital provides buffer during uncertainty
• Growing list of regulation requires holdings more capital
• Excess capital can be used to pay dividends, share buybacks, expand
loan portfolio
• Inadequate capital can result in equity capital raise (add-on), dividend
reductions, shrink balance sheet (sell loans, reduce deposits)

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Information Classification: General
The SVB panic
A March (10th -2023) to remember

• Warning signs
• Massive deposit growth
• Concentration to tech sector and VC firms
• Excessive large amount of uninsured depositors
• 98% uninsured vs 42% industry average
• S&P downgrade
• Capital raise announcement ($2 bln and bond sales)

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Information Classification: General
Fast failure
Limited options

Low cash / reserve levels

Disproportionate amount of securities as assets (60% of credit vs 30% avg)
Growing proportion of securities classified as HTM

March 8, 2023 capital raise announcement, bank failed March 10th

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Information Classification: General
Systemic risk concerns emerge
Market worries of contagion spike

Immediate reactions across assets Many many dominos

• SVB fails in a week

• FRC and signature bank follow
shortly
• Credit Suisse gets caught in falling
confidence
• Fed, Treasury and FDIC rush to
support system
• Uninsured depositors bailed out of
SVB failure, creating moral hazard
• Investors start to aggressively
price rate cuts on growing
recession concerns

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Information Classification: General
One year later – NY community bank
CRE concerns re-emerge

NYCB idiosyncrasy No so wound up

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Information Classification: General