FINN 3225 - Commercial Bank Management Lecture 10 - Effective Use of Capital UNC Charlotte November 3rd, 2014 (UNC Charlotte) FINN 3225 - Commercial Bank Management November 3rd, 2014 1 / 42
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 (UNC Charlotte) FINN 3225 - Commercial Bank Management November 3rd, 2014 2 / 42
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 (UNC Charlotte) FINN 3225 - Commercial Bank Management November 3rd, 2014 3 / 42
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 (UNC Charlotte) FINN 3225 - Commercial Bank Management November 3rd, 2014 4 / 42
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 (UNC Charlotte) FINN 3225 - Commercial Bank Management November 3rd, 2014 5 / 42
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 (UNC Charlotte) FINN 3225 - Commercial Bank Management November 3rd, 2014 6 / 42
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 (UNC Charlotte) FINN 3225 - Commercial Bank Management November 3rd, 2014 7 / 42
Panic Prevention vs. Moral Hazard (cont’d) Three main ways we can structure deposit insurance to reduce moral hazard: 1
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- Spring '14
- Fractional-reserve banking, Capital requirement