Lecture_10 - FINN 3225 Commercial Bank Management Lecture...

FINN 3225 - Commercial Bank
Management
Lecture 10 - Effective Use of Capital
UNC Charlotte
November 3rd, 2014
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Bank Capital’s Importance
Remember that there is a trade-off between liquidity
and profitability
More capital means less risk because we can cushion the
volatility of earnings, restrict growth opportunities, and
lower the probability of bank failures
Reduces expected returns to shareholders (equity is more
expensive than debt)
Regulators want to ensure safety and soundness of
financial system by preventing bank failures
Bankers prefer higher leverage so that they can
increase profitability
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Bank Runs
Liquidity problems arise when deposit drains are
abnormally large and unexpected
Concerns over a bank’s solvency relative to other banks
Failure of a related bank leading to concerns of the
solvency of other banks
Sudden changes in investor preferences regarding holding
nonbank financial assets relative to deposits
Large number of depositors withdrawing at the
same time could trigger a bank run that forces the
bank into insolvency
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Bank Runs (cont’d)
Bank runs are lessened by depositor insurance with
the FDIC
$ 250,000 insured per individual per institution
and the discount window
Primary credit for generally sound depository institutions
Secondary credit for DIs that do not qualify for primary
credit
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Deposit Insurance
First deposit insurance was instituted in 1933 at
$ 2,500
Most recently updated in 2008 to cover $ 250,000
FDICIA passed in 1991 to restructure bank
insurance fund
Financial crisis again depleted the FDIC’s Deposit
Insurance Fund reserves, causing a deficit of
$ 20.86B in the first quarter of 2010
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Causes of Fund Insolvencies
There are two main views why depository funds
became insolvent
1
The financial environment
1980s saw a dramatic rise in interest rates, a collapse in oil,
real estate, and other commodity prices, and increased
financial service competition
2000s saw a collapse of the housing market and a rise in
unemployment
2
Moral hazard
Banks are able to make riskier investments because
depositors have no incentive to restrict such behavior
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Panic Prevention vs. Moral Hazard
Without actuarially fair priced deposit insurance,
depository institutions have an incentive to take risk
at the expense of depositors
Mispriced deposit insurance still did a good job from
1945-1980
Important that we strike a balance between
disincentivizing moral hazard risk and still protecting
against bank runs
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Panic Prevention vs. Moral Hazard
(cont’d)
Three main ways we can structure deposit insurance
to reduce moral hazard:
1