Session 5 · Banking
What banks do, how they make money, why they sometimes fail, and how we safeguard the system.
1) Intro Banks as “plumbing” for the economy
Banks move funds from savers to borrowers, run payments, and transform risk/maturity. When they work, they are invisible; when they don’t, everything else struggles.
Click to show more details (for FIN310)
- Three pillars: Intermediation • Payments • Safekeeping
- Three classic risks: Credit • Liquidity • Interest-Rate Risk
- Safety net: Capital, Liquidity buffers, Supervision, Deposit Insurance, Central-Bank backstops
- Jargon decoder: NIM, HQLA, LCR, TCE, OCI, HTM vs AFS, IOR
2) What Banks Do Transformations
Risk Transformation
Pool many risky loans ⇒ diversify idiosyncratic risk; screen/monitor borrowers.
Show simple example
If p(default)=2% per borrower, 1 borrower → 2% loss risk; 100 independent borrowers → variance shrinks dramatically; capital covers residual risk.
Maturity Transformation
Borrow short (deposits) and lend long (loans/securities).
Why it’s risky
Deposits can reprice/leave quickly while assets are fixed-rate and illiquid → duration gap. See IRR demo.
Liquidity Services
Checking/ATMs/wires/card rails keep payments flowing.
Student-life tie-in
- Direct deposit, debit cards, Zelle/ACH, ATM fees
- Overdraft vs. account alerts; fraud holds & provisional credit
3) Bank Balance Sheet (T-Accounts)
Assets
- Reserves at Fed / Cash
- Loans (retail, mortgage, commercial)
- Securities (Treasuries, MBS)
Liabilities & Equity
- Deposits (demand/time)
- Wholesale funding (repo, CP)
- Equity (capital)
Click to run a quick T-account shock
Explain it like I’m in FIN310
Make a $1,000 loan → bank credits a deposit to the borrower (liability +1,000) and records a loan (asset +1,000). If the bank keeps 10% as reserves, cash/reserves +100 and the rest is lent (still an asset). Equity changes ~0 at origination.
4) Deposits, Reserves & Money Creation
When a bank makes a loan, it typically credits a deposit—creating money. Constraints: capital, liquidity, regulation, demand for loans, and the cost of funding.
Simple Multiplier (toy)
What this ignores
- Capital ratios and risk-weights
- Liquidity coverage & stable funding
- Borrower demand & credit standards
Funding Cost vs. Lending Rate
Translate to English
Higher deposit rates without matching loan repricing will squeeze margins. See NIM below.
5) How Banks Earn Money (Net Interest Margin & fees)
Quick NIM Calculator
Where fees matter
Even small non-interest income helps ROA when margins are tight.
Fee Examples
- Payments/Interchange, Wealth/Advisory, Service fees
- Mortgage origination/servicing, Investment banking
Student-life tie-in
ATM fees, overdraft, statement fees; tips to avoid them: alerts, autopay, maintain minimums.
6) Core Risks
Credit Risk
Borrower defaults or deteriorates.
Simple credit math
Expected loss ≈ PD × LGD × EAD. Capital covers unexpected loss.
Liquidity Risk
Need cash now; assets not liquid or too costly to sell/pledge.
Funding mix matters
Stable core deposits vs. volatile wholesale funding changes outflow rates.
Interest-Rate Risk
Duration mismatch: deposits reprice fast, assets slow.
Hedge idea
Use swaps to pay fixed/receive floating to reduce positive duration gap.
Mini duration gap demo
Why students should care
When rates jump, bond prices fall. If assets are long and deposits are short, the bank’s value drops fast.
7) Capital & Liquidity Ratios
Capital (toy leverage)
Reality check
Risk-based capital (CET1/RWA) and buffers apply in practice; this is intuition only.
Liquidity (LCR-style intuition)
Translate
≥100% means enough liquid assets to survive modeled 30-day stress outflows.
8) Bank Runs & Backstops
- Run mechanics: concerns → withdrawals → asset sales (losses) → more concerns.
- Fire sale risk: long-duration assets sold into rising-rate markets ⇒ realized losses.
- Backstops: Deposit insurance, discount window, emergency facilities, communications.
Run stress toy
Explain the hint
Higher uninsured + lower liquidity = faster runs historically; communication and pledging collateral can help.
9) 2023 Lessons (SVB-style profile)
- Concentration: client base with correlated cash-flow cycles.
- High share of uninsured deposits ⇒ fast, digital outflows.
- Large fixed-rate securities at low yields ⇒ big unrealized losses when rates rose.
- Communication & risk governance gaps.
- Backstop design matters (collateral valuation, term, stigma).
Click for a 5-bullet student takeaway
- Don’t fund long fixed assets with hot money.
- Know your uninsured %, and pre-position collateral.
- Hedge duration when rates can rise.
- Explain your balance sheet clearly to depositors.
- Practice drills for outflow days.
10) Mini Tools
11) Quiz
Short check on balance sheets, risks, and ratios. Answers show after each choice.
Q1. A bank funds long-term fixed-rate mortgages mostly with demand deposits. Which risk is primary?
Q2. If HQLA = $200 and 30-day net outflows = $150, the coverage ratio (toy) is closest to:
Q3. Raising deposit rates quickly while loan rates reprice slowly will most directly squeeze:
12) Homework — Banking Risk Memo Due: Midterm 1
- Use the Run Risk Toy and Duration Gap demo with two scenarios: (a) rate shock up 150bp, (b) deposit outflow with uninsured share ↑ by 15pp.
- Write a 300–500 word memo: explain the bank’s vulnerabilities and two concrete mitigants (funding mix, hedging, asset mix, capital & liquidity steps).
- Optional: include a screenshot of your inputs and outputs.
Note: All calculators here are simplified to teach intuition (not regulatory calculations).