3/21/2013 Banking notes

Interest rate risk
Bank
Asset                Liabilities
10 million         10 million
7 years               1/2 year

positive duration gap
When interest rate goes up, asset value and liabilities value both fall, but since asset maturity is longer, assets value falls more. Net equity is hurt.

Why does Wall Street lobby for low interest rate? Interest rate, asset value, liabilities value ,duration gap

Interest risk is a major concern of commercial banks because most commercial banks have positive duration gap.

Why is positive duration gap attractive to banks?
Yield curves typically slope upward, the cost of attracting loans (short term interest rate) will be very low, and if banks loan long-term, they can get higher interest rate.

2 risks banks will face
(1) interest rate risk
(2) reinvestment risk
After six months, the bank has to pay back its investors 10 million dollars, how bank continue to fund their investment?
a. attract new fund from others in order not to liquidate the investment (short-term commercial paper market)
b. if investors don't want to save money in the bank, the bank has to either liquidate the investment or borrow money at a higher cost. (that is, higher interest rate) Issue stock for example, go to the long term market.

Interest rate might change from time to time.
suppose bank earns 6% from investment, pay 2% for deposits, net is 400$
if investors don't save money in the bank and the bank goes to long-term market for loans, the interest rate will be higher, say 5%. Net is 100$
If interest rate jumps to 8%, bank has to pay 8% for the new fund. Bank loses money

Now Fed has a very low interest rate. If the interest rate goes up, Fed may not like it. Why?
Fed has 3 trillion dollars asset, most of which are long-term, on its balance sheet. If it decides to increase interest rate, the value of its portfolio will plummet.

So the Fed faces problem in interest rate policy. IF it is low, it cannot stifle inflation, but if interest rate increases, its asset will blow. 

Government can tax to compensate the loss of the assets. 
Treasury's assets are mostly short-term. 
IF the Fed really raise the interest rate, the Fed will see its assets value plummet and the government has to pay more interest for its short-term debt. In this case, the Fed cannot be very independent. 

  Maybe the solution is to borrow long-term money. 

How do banks do about these risks Use derivative
Futures market

What is a Bank? Financial intermediary and payment service
(1) Financial intermediary:
take deposits & make loans
(2) provide payment services
there must first be a reliance on commodity money, then the evolvement contains three steps
(a) payment system emerges
the development of money transfer services
(b) the emergence of inside money (any debt that is used as money)
assignable and negotiable
(c) system of clearing

banking seems to emerge for the ease of transfer services particularly by the international merchants and traders. (Counting and transporting are very inconvenient)
Demand deposit lowers transaction costs. (Using balance sheet lowers the transaction cost of transferring money)
People use various institutions to protect their golds. Goldsmiths