|Basic Investment Concepts for Banks|
It may be most helpful if you read this section in sequence, in its entirety. However, you can use this brief topic list to navigate within the section:
Debt and Equity
Fundamentally, a bank is a collection of contracts. Loans are contracts stipulating the terms at which a customer will repay money to a bank. Deposits are contracts that stipulate the terms at which a bank will compensate its customers for the use of their money. More generally, a bank can be thought of as two basic types of financial contracts, debt and equity. (Other types of contracts, which are more complex and not covered here, are known as “derivatives.”) Debt contracts are simply arrangements between two parties for the lending and borrowing of funds. Because they represent a commitment by one party to repay another, they are sometimes also called debt obligations. Loans and deposits are examples of debt contracts. Most debt contracts specify a date, known as the maturity date, on which the borrowed money must be repaid. Unlike debt, equity involves an ownership stake—rather than borrowing money, a firm may sell a share of itself to raise funds. Common stock is the most familiar type of equity contract.
An important distinction among financial contracts is between those that can be sold to other parties—so-called negotiable contracts—and those that cannot. Your checking account is an example of a non-negotiable contract: you can’t transfer ownership of it to anybody else. Contracts that are negotiable are known as securities. Securities can be either debt or equity. Bonds are the most common type of debt security. Stock is the most common (virtually the only) type of equity security.
When a firm initially creates a security, it receives funds from the other party in the contract. This is called issuing a security. For example, if a firm issues a $100 bond, it receives $100 from the person who initially buys the bond, and it agrees to repay the money along with interest at some future date. After that, the buyer of the bond may sell it to someone else at any time before the bond matures, and that person may sell it to someone else, and so on. That is what is meant by negotiability. However, the firm that issued the bond is not affected by these subsequent transactions. It simply pays the amount of the bond at maturity to the party who happens to hold it at that time.
The term financial instrument refers broadly to any financial contract although it is sometimes used more specifically to denote tradable contracts—such as securities. Banks’ balance sheets consist almost entirely of financial instruments of various types. As liabilities, banks issue instruments in the form of deposits and other types of debt. Bank owners also hold equity shares, which are, at least implicitly, financial instruments as well. As assets, the primary instruments that banks hold are loans and securities.
Typically, loans constitute the largest component of bank assets, with securities being the second largest. For the most part, commercial banks are prohibited by regulation from holding equity and debt securities issued by private corporations. Instead, they primarily hold debt securities issued by government entities. The most common types of government debt are obligations of the United States federal government, which, because they originate in the U. S. Treasury Department, are commonly known as “Treasury securities,” or simply Treasuries. The government issues securities with many different maturity dates. Those with maturities of less than a year are known as Treasury bills; those with maturities between one and ten years are Treasury notes; and those with maturities of over ten years are Treasury bonds.
The market for Treasuries is among the largest and most active securities markets in the world. On any given day, hundreds of billions of dollars worth of Treasuries change hands, mostly between financial institutions. One reason the demand for Treasuries is so large is that the U. S. government is perceived as extremely creditworthy—the idea that it would ever be unable to repay its debt is virtually unthinkable. Thus, Treasuries are often viewed as risk-free securities. Because of their low risk and high liquidity (i.e., the ease with which they can be sold to other parties), Treasury securities are often used as benchmarks when talking about the level of interest rates. For example, if a bank wants to know an appropriate interest rate to pay on its deposits, it may look at the current rate being paid on Treasuries with comparable maturities.
The graph below, known as a yield curve, shows the yields (effective interest rates) on Treasuries of different maturities on December 31, 2003 . Notice that longer-maturity Treasuries pay higher rates than those with shorter maturities. In other words, the yield curve slopes upward. This is a typical property of interest rates and it is the main reason that banks are able to earn profits. Banks hold assets (loans and securities) that tend to have long maturities on average. Mortgages, for example, often have maturities of thirty years. On the other hand, most bank liabilities are deposits with short maturities. Even the longest-maturity certificates of deposit rarely extend beyond five years. As a result, the interest rates that banks earn on their assets are typically three or four percentage points above those that they have to pay on their liabilities. This spread is known as the net interest margin (NIM) and is the most important determinant of bank profitability.
Banks’ ability to take advantage of the yield curve’s upward slope—to “borrow short and lend long”—does not come without risks. Indeed, unanticipated changes in interest rates represent a potential danger to all banks’ profitability and solvency. Ways of avoiding and coping with this danger will be the subject of the Market Risk sections of this course.
A thorough answer to this question is complex, but there are three general rules to keep in mind:
Presented below is information for a corporate bond purchased by Small Bank. The principal amount for this 10-year security is $1,000. The interest rate on the bond is 10 percent, meaning Small Bank receives $100 per year in interest income. At the end of 10 years, Small Bank receives its principal back. Currently, market rates are 10 percent. If Small Bank needed to sell the bond immediately after purchase, it could do so for $1,000, the present value in the table below.
Change the interest rate in the table (also known as the discount rate) to see what happens to the value of the bond.
When rates rise to 20 percent, the present value of the bond falls to $581. When rates fall, the present value of the bond rises to $1,386.
There is an inverse relationship between the market price of a fixed-rate financial instrument and market interest rates. As rates rise, prices fall. As rates fall, prices rise. Thus, all else being equal, as rates rise, the market value of a bank’s fixed-rate assets and liabilities tend to decline, and, as rates fall, the market value of a bank’s fixed-rate assets and liabilities tend to rise.