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Chapter4

CommercialBank’sSourcesandUsesofFunds

LectureObjectives

1.

TodescribetheProfitandLossAccountandBalanceSheetofacommercialbank2.

Toidentifythesourcesandusesoffundsofcommercialbanks3.

Toexplainthegoalsandmanagementstrategiesofcommercialbanks4.

Todefinefundsmanagement5.

ToreviewthelatestperformanceofHongKongbankingsectorCommercialBank’s

ProfitandLossAccount

InterestIncome–InterestExpenses=NetInterestIncome(Spread)CommercialBank’s

ProfitandLossAccount

NetInterestIncome–Provisionforloanlosses+Non-interestIncome(Fees)–Non-interestExpenses(Overheads)=Incomebeforetaxesandinvestmentgain/(loss)CommercialBank’s

BalanceSheetAssets:CashAmountsduefromfinancialinstitutionsTradebillsAdvancesandloanstocustomersInvestmentFixedAssetsCommercialBank’s

BalanceSheetLiabilities:AmountsduetofinancialinstitutionsDepositsfromcustomersCertificatesofdepositsProvisionsforloanlossCommercialBank’s

BalanceSheetShareholders’Funds:SharecapitalReservesCommercialBank’s

SourcesandUsesofFundsAcommercialbank’smainsourcesoffundscomefromthecustomers’deposits,theissueofcertificatesofdeposit,thesharecapitalcontributedbythebank’sshareholdersandthereservesfromtheretainedprofits.CommercialBank’s

SourcesandUsesofFundsAcommercialbank’smainusesoffundsareforlendingtocustomersandinvestments.Butacommercialbankhastokeepsubstantialfundsintheformofcashandshort-terminvestmentsasliquidassets.CommercialBank’s

SourcesandUsesofFundsTheprofitabilityofacommercialbankdependsonthecompositionofitsbalancesheetandtheefficiencyofitsoperation.Nowadaysthereisatrendtoincreasethenon-interestincomebecausekeencompetitionamongcommercialbankshasdecreasedtheSpread.

CommercialBank’s

SourcesandUsesofFundsItisvitalforbankstomaintainsufficientcashandnear-liquidfundstorepaydepositors.However,theproblemofmaintainingassetsintheformofcashornear-liquidfundisthatthemoreliquiditis,thelowerrateofinterestitearns.Thehighestratesofinterestarechargedforthemostilliquidassets,i.e.advancesandloanstobusinessandpersonalcustomers.Liquidity(L)versusProfitability(P)AssetsPeriodBorrowersYieldCash--NilMoneyatcall1-14daysMoneymarket1%-2%Billsdiscounted1-6monthsBusinesscustomers3%-4%Investment6months–5yearsCapitalmarket5%-6%AdvancesandLoans1day–30yearsBusinessandPersonalCustomers7%-10%LPGoalsofaCommercialBankIncreasedshareholders’wealthMaximumnetearningsIncreasedrateofgrowthImprovedservicestothepublicCommercialBank’sFinancialManagementManagementofAssets:MaximizeyieldsavailableSatisfytheliquidityneedsandregulationsManagementofLiabilities:MinimizecostsoffundsraisedPromotethegrowthintotalfundsavailableCommercialBank’sFinancialManagementManagementofCapital:Minimizetheowners’totalinvestmentinthefirmMinimizeriskexposureSatisfythegovernment’sregulationsMarketingPolicies:Identifyconsumers’needsDevelopnewproducts,pricingandpromotioncampaignsExpenseControl:IncreaseefficiencyintheuseofresourcesNewmoney-savingmethodsCommercialBank’sRiskManagementThefocusoftheassetsandliabilitiesmanagementofcommercialbanksisalwaysinthereductionofinterest-raterisk,liquidityrisk,creditriskandforeignexchangerisk.CommercialBank’sRiskManagementFundsmanagementistheprocessofmanagingthespreadbetweeninterestearnedandinterestpaidwhileensuringadequateliquidity.Asoundbasisforevaluatingfundsmanagementrequiresunderstandingthebank,itscustomermix,thenatureofitsassetsandliabilities,aswellastheeconomicenvironment.LiquidityAbankhasadequateliquiditywhenitcanobtainsufficientfunds,eitherbyincreasingliabilitiesorbyconvertingassetsintocash,promptlyandatareasonablecost.Liquidityismetthroughholdinghighqualityshort-termassets(liketreasurybills).Thepriceofliquidityistheincomenotearnedfromnotholdinglowerqualitylonger-termassets(likesomelong-termcommercialloans).InterestRateRiskManagementTheinterestrateriskmanagementisachievedthroughtheasset-liabilitymanagementofacommercialbank.Managementmustconsiderthecostofmaintainingliquidity.Changesinmoneymarketconditionsmaycauseadeteriorationinabank’scapacitytoborrowatafavourableinterestrate.Therefore,seasonalandcyclicalfactorsmayalsocauseanincreaseinloandemandandadecreaseindepositsoranincreaseindepositsandadecreaseinloandemand.Asaresult,theinterestratemarginsandincomemayfluctuate.PerformanceoftheHongKongbankingsectorin2003

TheHongKongeconomywasmarkedbycontinuingdeflation,decliningpropertyprices,andhistoricallyhighunemploymentandpersonalbankruptciesin2003.TheeconomicconditionswereaggravatedbytheSARSoutbreak.PerformanceoftheHongKongbankingsectorin2003

Thedecliningloandemandresultedinahighlyliquidbankingsector,withtheHongKongdollarinterestratesdroppedtoanewlow.Theone-monthHIBORfelltoanannualaverageof0.92%andtheone-monthtimedepositratefelltoanannualaverageof0.07%.Butthebestlendingrateremainedunchangedat5.00%,resultinginawideninginterestratespreads.Thespreadbetweentheaveragebestlendingrateandtheaverageone-monthHIBORwidenedto408basispoints.PerformanceoftheHongKongbankingsectorin2003

However,thepre-taxoperatingprofitsofretailbanksincreasedby5.3%duetogainsintreasuryoperations(foreignexchangetrading),increasedincomefromfeesandcommissions,andreducedbaddebtprovisionsandoperatingexpenses.PerformanceoftheHongKongbankingsectorin2003

Retailbanks’totallendingfellmodestlyby0.6%andpropertylendingdecreasedby2%in2003.Theholdingofnegotiabledebtinstrumentsexcludingnegotiablecertificateofdeposits,byretailbanksgrewby13.3%in2003.Theincreasewaslargelyincorporatedebtinstrumentsandfloatingratenotesdenominatedinforeigncurrencies.PerformanceoftheHongKongbankingsectorin2003

Theliquidityofretailbanksremainedhighandtheloan-to-depositratiodippedto49.6%.Buttheassetqualityofbanksimprovedin2003astheclassifiedandnon-performingloanratiosdroppedto3.91%and3.16%respectively.Tutorial

StudytheBalanceSheet:AllAuthorizedInstitutions.1.WhatarethelargestitemsintheLiabilitiesandAssets?2.

DiscussthecharacteristicsofthesourcesandusesoffundsoftheauthorizedinstitutionsinHongKong.Tutorial

StudytheProfitandLossAccountsandBalanceSheetsoftheHongkongandShanghaiBankingCorporationLtd.,StandardCharteredBankLtd.andBankofChinaHongKongLtd.fortheyear2003,comparetheirstrengthsandweaknesses.PerformanceoftheHongKongBankingSectorin2003PerformanceIndicator20022003ReturnonAssets(BeforeTax)0.91%0.93%NetInterestMargin1.52%1.41%BaddebtchargetoaverageTotalAssets0.24%0.24%LoantoDepositRatio(HongKongdollar)88.5%81.5%ThelargestitemsofliabilitiesandassetsLiabilitiesDepositsfromcustomersCapital,ReservesandotherliabilitiesAmountduetoAuthorizedInstitutionsinHongKongAssetsLoansandadvancestocustomersGovernmentbills,notesandbondsAmountduefromAuthorizedInstitutionsinHongKongSourcesandUsesofFundsofAuthorizedInstitutionsinHongKongThefinancialintermediationfunctionsprevail.Themainsourceoffundiscustomers’depositsandthemainuseoffundisloansandadvancestocustomers.TheHKDdepositsareconcentratedinafewbigbankslikeHSBC,HangSengBank,BankofChina,StandardCharteredBank,etc.OtherbankshavetoborrowHKDfundsfromthebigbanksthroughtheinterbankmarket.Therefore,AmountduetoAIsandandAmountduefromAIsarealsoimportantsourceanduseoffunds.SourcesandUsesofFundsofAuthorizedInstitutionsinHongKongCapitalandreservesareimportantsourcesoffund.ThetraditionalpracticeisforbanksinHongKongtoreservealargerportionoftheprofitsasreservesforfuturebusinessexpansion.Governmentbills,notesandbondsarehighqualityshort-termassetswhichthebanksholdtoearninterestwhileatthesametimetomaintainliquidity,becausetheinvestmentcanbeconvertedintocashquickly.ComparetheProfitandLossAccountsofHSBC,SCandBOCfortheYear2003(HKD’million)ItemsHSBCSCBOCInterestIncome55,7704,79017,759InterestExpense17,0321,8224,888NetInterestIncome38,7382,96812,871Non-interestIncome22,6271,1564,385OperatingExpenses24,0242,6645,660OperatingProfitBeforeProvisions37,3412,08911,596ProvisionforBadandDoubtfulDebts3,3865361,671ComparetheProfitandLossAccountsofHSBC,SCandBOCfortheYear2003(%ofTotalIncome)ItemsHSBCSCBOCInterestIncome71%81%80%Non-interestIncome29%19%20%InterestExpense22%31%22%OperatingExpenses31%45%26%ProvisionsforBadandDoubtfulDebts4%9%8%ComparetheBalanceSheetsofHSBC,SCandBOCfortheYear2003(HKD’million)ItemsHSBCSCBOCTotalAssets2,148,741120,282762,586Advancestocustomers815,00459,744300,094Cashandshort-termfunds359,1377,524134,106Long-termInvestment399,64223,500172,518FixedAssets34,87588417,582Lendingtobanks113,32213,35478,240ComparetheBalanceSheetsofHSBC,SCandBEAfortheYear2003(HKD’million)ItemsHSBCSCBOCTotalLiabilities2,009,883112,567

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