FM 3

Banks
Fintech and Financial Markets

Banks: Their importance
• Key intermediaries between savers and borrowers • The risks to economies of
• Monetary Policy implemented through banks banks making mistakes is
• Hold assets of retail depositors large
• Must be responsible
• Bankers driven by self
• Participants in payments systems interest or by incompetence
• Responsible for transaction settlement
• Facilitate much of economic activity can make mistakes with
• Almost everything must go through banks catastrophic impact
• Key investors in Government Securities • GFC
• Key source of financing the government • Barings Bank
• Make loans to companies • SVB
• Allocation of resources • Banks are hence heavily
• Key conduit for Foreign Exchange regulated
• Fractional Reserve Banking creates fiat money
Some accounting and ALM
• Liabilities: What is owed • Bank A:
• Gets Rs 100 in deposits @5%
• Equity • Liabilities = Rs 100
• Deposits • Can be withdrawn anytime
• Makes Loans of Rs 100 @10%
• Assets: What is owned • Generally long term
• Loans Made • Assets = Rs 100
• Investments Made • What happens if the depositors

want their money back?
• Cash balances including • Bank goes under as it has no
reserves money to pay, even though it is
solvent and profitable [5%
• Assets = Liabilities spread]
• Assets = Liabilities
Asset Liability Management is crucial in Banking: Banking = = Risk Management

How can the Bank ensure repayment of
depositors
• Key Assumption:
• Not all depositors will want their money back at the same time
• Solutions:
• Keep reserves – regulatorily mandated
• Invest in assets that can be sold quickly without much loss
• Government Securities
• Borrow from other Banks
• Interbank money market
• Borrow from the Central Bank
• Discount window lending
Fractional Reserve Banking
Event Bank A Assets Bank A Liabilities Bank B Assets Bank B Liabilities
Despositor deposits Reserves = 20 Deposits = 100 Reserves = 0 Deposits =0
Rs 100 in Bank A Excess Res = 80
Bank Makes Loan of Reserves = 20 Deposits = 100
excess reserves to Loans= 80
borrower
Borrower Reserves = 20 Deposits = 100 Reserves = 16 Deposits =80
withdraws from Loans = 80 Excess Res = 64
Bank A and
deposited with B
• From stage 1 to stage 3, total amount of money in the banking system has gone up from
Rs 100 to Rs 180
• Money has “magically” been created
Reserves
• CRR in India
Reserves in Cash • Incremental/Total
Reserves in • SLR in India

Securities • Can be specified as AFS/HTM
Increases in reserve requirements decreases funds available for lending – economic

slowdown
Decreasing reserve requirements are expansionary

How do Banks Make Money?
Own Account
Trading &
Investment
Trading for Customer
Account
Fee Income
Net Interest Margin

The Bankers incentives
Bank Wins:
Make large
Cheap
Funds
bonuses /
Other benefits
Take
Enormous Bank Loses:
Risk Move to
Poor
Regulations
another bank
Bank regulation is important!

Assets
• A bank is a listed entity
• Its managers need to try and do the best for shareholders while
making sure the bank remains a going concern
• Loans to the Government = 7%
• Loans to a trading company = 10%
• Managers would like to earn risk premiums
• Lend as much as they can to the trading company
• If the trading company goes bust
• Bank cannot recover loan
• Bank cannot repay depositors beyond reserves
Equity: Risk Weighted Assets
Asset Value Risk Risk Weight Risk Weighted
Value
Excess Reserves 1000 Low 0 0
Government Securities 1000 Low 0 0
AAA Corporate Loans 1000 Moderate 100% 1000
BBB Corporate Loans 1000 High 120% 1200
Personal Loans 1000 High 130% 1300
Total 5000 2500
• Equity required by bank = 9% of Risk Weighted Assets = 225

• Capital Adequacy Ratio: Tier 1 and Tier 2
• Equity should be able to withstand a significant losses, so depositors are not hit
The Importance of Liquidity Assessment
Open Market Operations
• Open Market Operations
• To suck out excess reserves that may otherwise go into making loans CB sells
government securities to banks
• This removes excess reserves which cannot be lent onwards
• To add to excess reserves so that banks have excess reserves, CB buys
government securities
• This adds excess reserves so that banks can then lend
• Repo: CB does a spot buy forward sell of securities: Equivalent to lending
to Banks against their securities holdings
• Banks can lend these funds onwards
• Reverse Repo: CB does a spot sell forward buy. This is equivalent to
borrowing from the banks reducing
Impact of RBI Operations
Central Bank
Reverse
Repo Banking System
Repo Central Bank
Banking System
Cash Securities
Other Liquidity Adjustment Operations
• Banks have access to
• Borrowing from Central Bank
• Discount Window
• Marginal Standing Facility
• Lending to Central bank
• Standing Deposit Facility
• Note that RBI fixes Repo and Reverse Repo rates: These are policy
rates
• RBI also does variable repo and reverse repo operations to aggressively
manage liquidity
Deposit Insurance
• Bank managers have an incentive to take risky bets
• Their financing comes from deposits that do not want their funds
used this way
• How to manage
• Capital Adequacy & Other regulation
• Glass Steagall
• Deposit Insurance
• DICGC in India – deposits upto Rs 500,000
• FDIC in the US - Deposits up to USD 250,000
• This allows small depositors to be protected
Bank Failures

FM 3

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FM 3

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Banks

Fintech and Financial Markets

• Investments Made • What happens if the depositors

Asset Liability Management is crucial in Banking: Banking = = Risk Management

Reserves in • SLR in India

Increases in reserve requirements decreases funds available for lending – economic

Decreasing reserve requirements are expansionary

Net Interest Margin

Bank regulation is important!

• Equity required by bank = 9% of Risk Weighted Assets = 225

Repo Central Bank

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