Assets and Liabilities of Banks and Its Reserves

The article is about major assets and liability categories on a Bank’s Balance sheet and also related to reserve created by Bank and their impact. Now our discussion continue with some heading and subheading format are following –

Content of Bank Balance sheet:

Bank as a financial institution is by definition a complex organization and for those who do not know its operation it is not easy to understand. The Balance sheet of Bank consists of two parts. The left-hand side or assets side shows the position of the bank, the right-hand side or liability shows the debts which are same as other corporate Balance sheet. The identical difference created by Bank Balance sheet to other Corporate Balance sheet is categories.

Shift on the assets side:

Generally three category assets are shown in the bank balance sheet, there are as flows:

Loans:Loan is major source of income for any commercial bank. That will remain in the books until the maturity, i.e ‘hold to maturity’. Thus the same will remain in the books at purchase price until they are paid. If, for instance, the loan backed by mortgage of  house  then  increases or decreases in value, will not affect the balance sheet total of the bank in any way.

Securities:In general excess fund bank invest in a security, is booked as ‘available for sale’. The same assets the bank may maintain until maturity, but that may be sale before maturity. A major part of the assets has been placed in that category so that the financial institutions have their hands free should a buyer make an interesting bid.

Cash: Cash is typically the number one assets on a commercial bank’s balance sheet, because it is the most liquid asset for bank. For a bank, cash represents the money generated from interest-bearing accounts or money placed into financial investments.

Further the Banks should classify their assets into the following broad groups, are as flows –

(i) Standard Assets
(ii) Sub-standard Assets
(iii) Doubtful Assets
(iv) Loss Assets

1. Standard Assets: Standard Asset is one which does not disclose any problems and which does not carry more than normal risk attached to the business.

2. Sub-standard Assets: The assets classified as sub-stander assets if, the current net worth of the borrowers / guarantors or the current market value of the security charged is not enough to ensure recovery of the dues to the banks in full and it remained non performing for a period less than or equal to 12 months.

3. Doubtful Assets: an asset is required to be treated as doubtful, if it has remained non performing for more than specified period. A loan classified as doubtful has all the weaknesses inherent as that classified as sub-standard.

4. Loss Assets: A loss asset is one where loss has been identified by the bank or internal or external auditors or by the Co-operation Department or by the Reserve Bank inspection but the amount has not been written off.

Shift on the Liability side:

Money deposited a bank by the depositorbecomes a liability of the bank. The bank has an obligation to pay the depositor the money deposited, on demand of the clients. The money deposited is an asset for the depositor.

Now consider the primary liability categories for a bank. Liabilities are, of course, what the bank owes. Being a representative bank, has three main categories of liabilities listed on the balance sheet at the right:

Transactions Deposits: In general the most important liability for bank is transactions deposits commonly known as checking accounts or checkable deposits. That make note, while checking accounts are assets for customers, they are liabilities for the Bank. The Bank owes these deposits to customers.

Other Types of Deposit: As a full-service bank, Bank has other types of deposits, too. Bank offers savings accounts,repurchase agreements, money market deposits,certificates of deposit, repurchase agreements, and a host of other accounts that find their way into the monetary aggregates.

Other Liabilities: Most banks also have a few other liabilities. Specifically Bank might borrow from sources other than typical household and business customers that provide deposits. Two common sources of funds are loans from other banks and loans from the Federal Reserve System.

Debt to Equity Ratio

The debt-to equity ratio is a financial ratio including the relative proportion of shareholders’ equity and debt used to finance a company’s assets. A measure of a company's financial leverage calculated by dividing its total liabilities by equity.

A high debt/equity ratio generally means that a company has been aggressive in financing its          growth with debt. This can result in of the additional interest expense. Hence a high debt-to-equity ratio result a lot of debt is used to finance for increase operation, therefore a huge interest burden generates and shareholders return reduce gradually.

The debt/equity ratio also depends on industry in which company operate. For example, capital-intensive industries, steel industries, cement industries generally maintain debt/equity ratio 2 or above. But in the case of commercial bank the same would be 8 or above.

The bank as a financial institution, they take investment from their customer and make loan to lender therefore generally the debt/equity is high.

Bank Reserve:

Bank reserve is the currency deposit which is not lent out by the banks to the clients. A small part of total deposit is held internally by the bank or deposit with the Reserve bank. The purpose of maintain the same by the financial institution is ensure that will be able to provide clients with cash upon deposit.

Every bank should maintain required reserve according to the guideline provide by the Reserve Bank in the form of cash in vault or if the vault cash is insufficient to satisfy the requirement, in the form of balance maintained either directly in Reserve Bank or in any liquid form. The bank is responsible for satisfying its reserve balance requirement by holding balances on average over a 14-day maintenance period in an account at the Federal Reserve.

Do most banks keep only the required reserves?

The main operation of a bank or financial institution is generating fund from investors and lend to the lender which is main source of income for the bank. Therefore it is clear that if bank make excess reserve then a fund crises arise. Thus it is common trend for every bank make as minimum reserve which is provide clients daily cash requirement.

From the above it is clear that most of the bank maintain only required reserve which is specify by the Reserve Bank or daily cash requirement.

Now we come to the last part of the assignment, where the question is changing reserve requirements can impact the bank’s profitability. It is very simple to understand, that main source of income for bank or financial institution is interest of lending and source of fund is deposit from clients. Hence bank should maintain as minimum reserve.

In the given example a client deposit $10,000 in savings account and reserve requirement is change from 5% yesterday to 10% today therefore, maintainable reserve increase by $500. The deference between interest rate of savings account and loans is 9%. Thus the Bank compromise profit of $45 in this year because of change in maintainable reserve percentage.

Where to invest - Strategies to manage Portfolio worth $100000.

The article is about wealth management of client’s market portfolio. Each client has at least $100000 to invest in the portfolio. Most of this investment is long-term investment having at least 5 years par view. Our goal is to invest in such a way that maximizes return of the client at a possible minimum risk I.e. to create an optimal portfolio. This discussion will include following-

·         Investment alternatives including diversified asset mix-

In stock market, there are many alternate investment opportunities for a client such as stock bond derivatives etc. Now the process of determining which asset or which mix of assets is optimal for a client is professional one. This would depend upon various factors such as-

ü  Time horizon of a client

ü  Risk tolerance ability

ü  Expected prospect of economy at large

Time horizon of a client

 This is one of the key considerations for a portfolio manager for making an optimal portfolio. This is simply because every asset in a market has different maturity and payout times as compared to other. Now if a portfolio manager is known to a time horizon for a client he could categories assets in such period and according to payout preferences of client.

Risk tolerance ability

No matter how many assets you include in a portfolio it will not be a risk free one. Every asset has its own risk and reward pattern normally a high risky asset provide more return as compared to a low risky one. Now it depends upon clients risk tolerance ability for deciding which asset to include in his portfolio.

Expected prospect of economy at large

This is one of key factor for a portfolio. A better future economic prospect will always give client more confidence to invest in a high beta asset. Hence a standout economy will always attract more investors as compared to a vulnerable economy.

While one cannot recommend any particular asset for all possible situation one should know that a vast array of assets available for investment - including stocks and stock mutual funds corporate and municipal bonds bond mutual funds lifecycle funds exchange traded funds money market funds and treasury securities. Our discussion over here will put some light on this various alternatives-

ü  Stock- A stock is a smallest unit of ownership in a company. If someone own a share of a company he is a owner of that company for that part of share. Stocks have historically had been highest risk and highest returns awarding product among the major asset categories. As an asset category stocks most of the time provide greatest potential for growth. Stocks are very vulnerable. This vulnerability of stocks makes it very risky investment option for short run. History shows that even large companies stocks have lost money on an average about one out of every three years. These losses have been quite dramatic sometimes. However, investors who want to ride on volatility of stocks over long periods generally have been rewarded with strong positive returns. The common features of a stock are-

v  Stocks are an equity investment that provides a part of ownership of an entity to the investor i.e. an investor in stock will part of that entity’s earnings.

v  Stocks provide voting rights to an investor. However sometimes entity issues stocks without voting rights in alteration of some other benefits.

v  Stocks provide a chance to get dividend to the investor.

v  Stocks are liquid for the most part.

Based on this features stocks can be classified in two types-

v  Common Stocks- It represents majority of stocks held by the public. It carries a voting right and a dividend right.

v  Preferred Stocks- Despite its name preferred stocks carried fewer rights as compared to common stocks. Most of the time this type of stocks does not carry voting right.

Recommendation:- Investors having high risk apatite shall invest in stocks since does not provide any guarantee to return anything to investors. . In the given case most of the most of the clients are having long term per view hence stocks could be a better alternative as it provide high return long term basis as compared to others most of the time.

ü  Bonds - Bond is a debt security under which issuer owes a debt obligation to the holder of the security. So you can easily say it is a form of loan. Hence most of the time bond carries a coupon rate associate with it. Investor of a bond earns interest at the periodic intervals at this rate. Bonds most of the time has a defined terms and maturity after which bonds are redeemed. However there are some irredeemable bonds which have perpetual succession. Following are the main features of a bond-

v  Bonds carry a coupon rate

v  Bonds have a defined maturity

v  Quality of bond depends upon credit rating of particular agency and credit quality of that particular bond.

Based on this features bonds can be of various types some of the key bonds types are-

§  Fixed rate bond – carries a fixed coupon rate.

§  Floating rate bond- Coupon rate depends upon a factor of market.

§   Zero coupon bonds- Does not pay regular interest interests are rolled up and pays at the maturity.

§  Convertible bonds- carry an opportunity for investor to convert into common stocks at maturity.

§   Exchangeable bonds- allows for exchange to shares of an entity other than issuer.

§  Inflation indexed bonds- Cover inflation factor over a longer period.

§  Assets backed security and mortgage backed security- backed up pool of assets or income from mortgage.

§  Subordinate bonds- having lower priority as compared to other in terms of liquidity.

Recommendation:- Risk averse investors looking for safety of capital. So it will be better for them to invest in bonds. In addition, the investors who prefer a known periodic payment structure for a limited time frame would be better off investing in bonds. However investors having large amount would not be advised to invest in bonds only.

ü  Derivatives -

A security whose price is derived from one or more underlying assets. Actually, derivatives are contracts only. Its value is determined by fluctuation of assets based on which the contract is made. Derivatives are often used to hedge risks. Most derivatives are marketed through over the counter or through an exchange. Most common types of derivatives are -

v  Futures – Standardized contract between two parties to buy or sell a security at pre determined rate in the future. Actually to be précised it is like betting person buy it (call long) has upside betting whereas persons sell it (call short) done downside betting based on a strike price.

v  Forwards – Same as future contract with only difference is that it is non-standardized.

v  Options – A security, which provides an investor a right but not obligation to buy or sell security at a specified rate at pre, determined future time. To be precise options are betting with an option to investor not to pay anything even if he loose bet.

v  Swaps – It is a derivative where both parties exchange cash flows from their financial instruments.

In recent times, derivatives are grown like anything. Over the past 30 years it has grown up to 800 pounds in the financial market. The graph bellow will explain it better-

 

Recommendations - Derivatives are mainly used for hedging risks and speculation purposes. Such as if you invest in a stock of particular company you would face risk of declining in stock price in order to reduce such risk you can sell a future of that company. Further buying stocks would involve a high investment however buying derivatives will involve premium only which is relatively very small as compared to stock price so investors having lesser capital but conviction about a particular company could take a exposure using derivative.

In the given case, since investors have longer period for investment it would be better for them to invest in stocks. However this would involve high risk now derivative can be used to hedge this risks. Further investor with short amount of fund as compared to other can take position at desired stocks. However since this would be speculation one need to be highly convicted to do so. And speculations are not always allowed in market.

ü  Diversified Investment -

Investment always carried some risk. Moreover, if you invest in a single asset that risk always gets higher. This is simply because a single asset always more vulnerable as compared to a brunch of assets. Diversification is the process of allocation of fund among different assets category. Now even if a particular asset is not performing as expected other assets of the portfolio will most often cover that adversely effected asset. The goal of diversification is to maximize earnings at lowest possible risks. This is popularly known as optimal portfolio.

Now to judge which product shall include in your portfolio would involve professional expertise of stock market. There are well known theory used to do this. Those ares-

Modern portfolio theory (MPT) – IT is an assertions of MPT that portfolio assembled with dissimilar product will trend to have a lower level of risk as compared to a portfolio with similar product. This theory states that every sector of a market does fall dramatically at a given single time so if one have diversified sector investment it will reduce risks.

Mean variance portfolio theory - It is mainly a mathematical comparisons between portfolio’s risks and returns. Variance denotes to risks whereas mean denotes to return over here.

Recommendations:-

 As it is always assumed that investors are risk averse, hence always want to reduce risk. Diversification is one of the best strategies to reduce risk of investment. Putting a small part of your money at different sector will help you survive in crisis. Below graph shows most recommended diversification sectoral analysis in US market-

In the given case, investors have at least $100000 to invest for a relatively long time. Based on recent market scenario it is always better to diversify your fund. Using the recommendation shown in picture above funds could be diversified.

·         Account management strategy -

As we discussed earlier main work of a portfolio manager to decide where to invest. Based on way of operation these strategies can broadly be divided in two parts- Active strategy and passive strategy.

Active Strategy

Active managers attempts to find best deals in financial market. In active strategy managers try to pick attractive stocks bonds mutual funds and other securities. It involves deciding when to in out in a particular product or a market sector. Market efficiency is one of the most controversial term in finance. Active managers decisions based on a idea that market are not efficient. Hence there is always a gap between fair value and actual value. Active managers job is to identify those products with the gap and invest their. However, this strategy involves high quality analysis of financial data and much other information.

Benefits of active strategy-

In naked eye the main benefit of active strategy is that it gives a chance to select variety of securities to invest instead of investing in a particular market sector. However following key benefits of this could be-

ü  Take better advantage of inefficient market

ü  Helps to manage volatility by investing in less risky high quality stocks

ü  Provide investors a chance to invest in high beta stocks in order to earn more

ü  Some investors may find a particular stock is more suited to their goal as compared to whole market investment.

There is a humor in market that market is highly inefficient and a good manager can always outperformed market. But all this depends upon manager of portfolio. Hence one of the key disadvantage of active strategy is fund manager may make bad investments or follow an unsound theory.

Passive Strategy -

In this strategy manager invests in a sector of market and does not bother about choosing a particular financial product. Under this, normally investments are long term in nature. Most common example of it could be indexed product. This concept is based on following ideas-

v  Investor wants to invest for long term

v  Markets are efficient. And even if it is inefficient it will not be so for longer period and market will be equilibrium again

v  Capital asset pricing model (CAPM)- This denotes that at equilibrium every investor will hold an market portfolio and a riskless asset.

Mutual funds are created based on this strategy.

Active VS Passive

A recent market research shows that 20 years from 1984 to 2004 average stock investors earn returns only 3.7% whereas S&P500 returned 13.2%. This tells you the story at large. Many economists believe that passive strategy will effective irrespective of market condition. However, a detail analysis of both the strategy could be as follows-

ü  Passive management carries lesser costs as compared to active management.

ü  Active management is more risky than passive management

ü  Passive management provide a detailed diversification as compared to active

So considering above it could be said that passive strategy is more influential as compared to active strategy. However, for a good active manager market provides lots of oppournity to outperform. Chart bellow will show how passive strategy outperformed active strategy-

 

·         The state of economic effect on asset management-

 It has been often said that the best test of asset management team lies on uncertain economy. At this time even some senior team gets panic. Therefore, economy does play major role in assets management decision. If an economy is in a booming situation, its average return gets increases hence job of a asset manager gets relatively easier.

 Benefits of a good economic situation -

v  Stable interests rate provide a believe to investor for recovering his investment with good return.

v  Creates new oppournities for managers to invest in better securities.

v  As GDP grows faster investors has more money in hand to invest as compared to downtrend economy.

v  Demand of the products increases hence price also gets increases resulting better return oppournities for investors.

Adverse effect of poor economy in asset management-

v  Short of money for investors

v  Managers lack motivation

v  Expose managers towards significant risks.

The latest example of economy crisis is famous global recession occurred in 2008-09 season. The effect is such worse that economy is recovering from it in 2013. It leads to a situation where investors not willing to invest a penne even the price of stocks at the markets are significantly low. So one of major adverse effect of it in confidence of investors.

·         Impact of tax to provide optimal financial outcome -

 Tax is a deduction from income. Hence we can say return in a tax free economy or in a tax free security will be higher as compared to economy or security which carry tax. So for an investor after tax return will always be the criteria for decision making. Now for example if a person from tax-free economy invests same amount (say $10000) as like a person from economy with tax. Return of return is 10%. Tax rate 30%

v  For person of tax free economy-

Investment- $10000

Return on investment- 1000/10000 = 10%

v  For person of who give tax

Investment - $10000

Return on investment- 1000(1-0.3)/10000 = 7%

Above example proves that tax reduces income. So for a person with tax consequences shall always consider after tax return for investment decision i.e. for comparing with cost of investment.