Archive

Archive for September, 2011

TSX trading near 2-year low… 11000 next downside target?

September 29, 2011 Leave a comment

Daily Chart:

Weekly chart:

Advertisements

Funding sources for banks – Wholesale Funding… writing so I can remember (hopefully)

September 27, 2011 1 comment

In the previous post I wrote about the ‘primary’ source of funding for Banks i.e. Demand Deposits… In this post I will enumerate on Wholesale Funding sources. The level of detail might be random because my goal is to get a basic understanding and then try to look at the Euro crisis from this understanding… and also refer to it later. There are many blogs and sites that have done a fantastic job of explaining the details and the mechanics.

Wholesale Funding

There are many types of Wholesale Funding sources available to a commercial bank:

– Interbank Market at or near the Central Bank’s overnight target rate

– REPO (Repurchase Agreement) – “…is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate…”

– Central Bank – various programs and facilities since the 2008 financial crisis

– Central Bank Discount Window at the Discount Rate

The Central bank becomes the clichéd ‘lender of last resort’ when wholesale funding disappears.

Typical characteristics of wholesale funding:

– usually very sensitive to interest rate fluctuations and hence more expensive

– Less stable than demand deposits. The risk of wholesale funding is that can disappear anytime as is happening for some of the European banks and is also what exacerbated the 2008 financial crisis.

Q – What does a bank’s balance sheet look like when any of the wholesale funding sources are present?

– The economic effect of wholesale funding is identical to the bank receiving a loan from another financial institution. As far as the balance sheet goes, a matching asset and liability are created which expands the bank’s balance sheet.

Raise Capital

There is one more avenue a commercial bank can pursue and that is to raise capital by issuing Bonds, Debentures, Preferred shares, Common Shares, etc. Typically raising capital is the last resort and/or is reserved for long term investments or long term projects (e.g. new building)

Q – What happens to a bank’s balance sheet when a bank raises capital by issuing bonds or stock?

Let’s say, the Bank (from previous post) raises capital by issuing $100 of equity, the balance sheet looks like

A = Loan + Reserves + Cash = 90 + 10 + 100 = 200

L+E = Deposit + Equity = 100 + 100 = 200

(assume, $100 deposit, $90 loan and $10 reserves)

Q – Now, what can the bank do with the $100 capital? Can the bank lend it to a borrower?

– Yes

Q Does the bank have to maintain a reserve on the full $200 or only on the $100?

– The bank needs to maintain reserves against the deposits so only on $100.

Q – Why and how does a bank hold government securities?

– The bank lends money to the government by buying government issued securities – this shows as an asset on the banks BS

Funding sources for banks – Demand Deposits… writing so I can remember (hopefully)

September 24, 2011 3 comments

Yesterday morning, I was reading a post on FTAV about Greek depositors fleeing Greek banks and with the Fed’s announcement of Operation Twist, I realized that I need to refresh my understanding of “how banks work”… and particularly the funding sources of a bank and eventually the role of central bank…

There are two primary source of bank funding:

– Demand Deposits (cheapest source of funding)

– Wholesale Funding – from other banks and providers of capital

In this post my goal is to get a basic understanding of Demand Deposits:

Q – How does a bank fund itself by using demand deposits? What does a bank’s balance sheet look like when I deposit $100?

In a fractional reserve banking system, a demand deposit is a bank’s liability to the depositor… the depositor can withdraw for his/her deposit at anytime. A bank can then loan out a portion of the deposit to a credible borrower (companies, persons, other banks, etc)… the portion of the deposit that is not lent is considered reserves… reserves appear as an asset on a bank’s balance sheet…

At Initiation, t = 0

Asset = Loan + Reserves = 90 + 10

Liability +Equity = Deposit = 100

In future, t = 1

Scenario A – Bank makes profit on the loan

The bank makes money by making a profit on the loan (assume bank does not have to pay interest to the depositor), let’s say the bank makes 5% on the loaned amount.

A = Loan + Reserves + Cash = 90 + 10 +5 = 105

L + E = Deposit + Profit (Retained Earning) = 100 + 5 = 105

Scenario B – Bank makes a loss on the loan

The bank loses $5 on the loan because the borrower will not be able to payback.

A = Loan + Reserves + Cash = 85 + 10 = 95

L + E = Deposit + Loss (Retained Earning) = 100 = 95

In this scenario, if the depositor demands his money, he must be paid $100 or the bank must go bankrupt. The bank has only $95 in assets…where and how does the bank get the ‘extra’ $5?

– The bank can fund the $5 in one or more of following ways:

– get more deposits

– borrow short-term money from other banks

– borrow from central

– raise capital in the open market (bonds, stocks, etc)

– Or the bank declares bankruptcy

– If this scenario happened after Scenario A, then the bank would have just enough ($5 profit cancels the $5 loss) to cover the deposit

Note that reserves only apply to demand deposits… The reserves ratio requirements imposed by some central banks create a ceiling on the amount that can be lent given a deposit amount… but if a bank has more credible borrowers than can be met by the level of its deposits, then the bank can fund these loans by raising capital or with wholesale funding…

Next post will be about wholesale funding…

Return

September 23, 2011 1 comment

End of summer, start of autumn, return from hiatus… Actually, after CFA L2, I was super busy at work with an overseas project and I also moved homes so didn’t get any time to blog… I recently read this post which has inspired and motivated me to restart/resume/continue blogging… particularly this comparison:

Writing Is Like Working Out: Like working out, writing gets more and more difficult each day you skip. And if you skip a week or more, the mob euphemism “ForgetAboutIt” becomes quite literal. First you forget about your ideas, then you forget how to string them together into any coherent or entertaining thread, then you just say ‘forget it’ and saddle up on the couch for some despondent channel surfing. You stare at your Twitter or Facebook streams waiting for something to inspire you, and when it does, you might re-Tweet or Like it, or maybe you just let it pass as you search for something even more inspiring. Then the nights and weeks have passed and you haven’t even tried to get back into the swing.