An Overview of Depository Institutions

An Overview of Depository Institutions

MATT BRIGIDA

Associate Professor of Finance (SUNY Polytechnic Institute)

A Depository Institution's Balance Sheet

$A \equiv L + E$

Off Balance Sheet Activities

• Loan Commitments & LOC
• Derivatives (IRS & CDS)

Liquidity Risk

Liquidity Risk is the risk that cash outflows exceed cash inflows.

Cash shortfalls can be solved via:

• Issuing additional liabilities
• Selling assets

Increasing Liabilities

• Increase deposit rates
• Deposit franchise
• Borrowing from Fed
• Uninsured and brokered deposits

Source: Kansas City Fed

Source: Kansas City Fed

Selling Assets

• Asset quality. However how does this affect returns?
• Securitization
• Repos
• ...assuming you can find a counterparty

Securitization

Securitization is a useful tool for managing liquidity. Securitization allows banks to package and sell loans, thereby generating cash.

Example: 2023 Regional Banking Crisis

• Interest rates rose along the term structure which caused losses on assets across the banking system
• Uninsured depositors pulled their deposits (89.3% of Signature Bank deposits were uninsured, 85% of SVB).
• Liquidity management must be done before the event

Managing Interest Rate Risk

Income Statement

$Net\ Interest\ Margin = \frac{Interest\ Income - Interest\ Expense}{Assets}$

Balance Sheet

Duration of assets vs liabilities (extent bank is immunized)

Interest Rates Rise Along the Term Structure

Income Statement

• Deposit rates increase less than interest rates ($\beta < 1$)
• Banks earn more interest from floating rate securities and new issuance
• NIM may increase

Balance Sheet

• Asset duration $>$ liabilities duration
• Market Value of Equity declines initially
• Retained earnings from increased NIM add to equity

Managing Effect of Rate Increase on Balance Sheet

• Matching Asset and Liability duration (Immunization)
• Originate/buy floating rate loans
• Swap fixed for floating. See this presentation on Interest Rate Swaps

Accounting Maneuvers

• Available for Sale securities are marked-to-market.
• Held to Maturitysecurities are at cost.
• $AFS \Rightarrow HTM$ during 2023 crisis (Granja 2023)
• Also see Repo 105

Interest Rates Fall Along the Term Structure

Income Statement

• Pay less on liabilities
• Earn less on assets
• NIM may decline

Balance Sheet

• Asset values increase and liability values slightly lower
• Market value of equity increases, though lower future retained earnings
• Prepayment Risk may limit asset increases and exacerbate lower NIM
• Logit models of prepayment risk

Hedging Prepayment Risk

Buy Principal-Only tranche of a CMO

Mortgage Servicing Rights

• Collect payments from homeowners and distribute to MBS owners
• Receive a fixed percent of mortgages underlying MBS

What if the term structure steepens or flattens?

Managing Default Risk

Default Risk

• Banks specialize in identifying credible borrowers
• Ex ante risk and reward

Mitigating Credit Risk

• Diversification
• CDS (lessens return)
• Moving assets off balance sheet

Bank Capital (Equity)

Bank Safety

Most simple way to increase bank safety is to increase bank capital

All Capital is Not the Same

• CET1
• Risk Based Capital

Stress Tests

CAMELS Rating

• Capital adequacy
• Assets
• Management capability
• Earnings
• Liquidity
• Sensitivity

Matt Brigida