Key Banking Terms and Concepts Explained
Classified in Economy
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Asset Transformation
Asset transformation: Banks make profits by selling liabilities with one set of characteristics (risk, size, return, liquidity) and using the proceeds to buy assets with a different set of characteristics.
Example: Savings deposits held by one person can provide funds to the bank to give a loan to another person. The bank has transformed the savings account into a loan.
Haircut
Haircut: The excess amount of collateral above the amount of a loan.
Excess Reserves
Excess Reserves: Reserves in excess of required reserves.
Bank Holding Company
Bank Holding Company: A company that controls one or more banks, but does not necessarily engage in banking itself.
Examples: Berkshire, JPMorgan Chase
Subprime Mortgage
Subprime Mortgage: Mortgages made to borrowers with less-than-stellar credit records.
Easing of Monetary Policy
Easing of Monetary Policy: The lowering of the federal funds rate.
Federal Funds Rate
Federal Funds Rate: The interest rate on overnight loans of deposits at the federal reserve.
Shadow Banking System
Shadow Banking System: A system in which bank lending is replaced by lending via the securities market.
Sweep Account
Sweep Account: An arrangement whereby any balance above a certain amount that remains in a corporation's checking account at the end of the business day are “swept out” of the account and invested in overnight repos that pay the corporation interest.
Financial Engineering
Financial Engineering: The process of researching and developing new financial products and services that will meet customer needs and also prove profitable.
Financial Derivatives
Financial Derivatives: Instruments that have payoffs that are linked to previously issued securities; used as risk reduction tools.
Edge Act Corporation
Edge Act Corporation: A special subsidiary of a U.S. bank that is engaged primarily in international banking.
Securitization
Securitization: The process of transforming illiquid financial assets into marketable capital market instruments.
Off-Balance Sheet Activities
Off-Balance Sheet Activities: Bank activities that involve the trading of financial instruments and the generation of income from fees and loan sales, all of which affect bank profits but are not visible on bank balance sheets.
Micro-Prudential Supervision
Micro-Prudential Supervision
Hedge
Hedge: To protect oneself against risk.
Gap Analysis
Gap Analysis: A measurement of the sensitivity of bank profits to changes in interest rates, calculated by subtracting the amount of rate-sensitive liabilities from the amount of rate-sensitive assets.
Example: This calculation is -$30 million (= $20 million - $50 million). By multiplying the gap time the change in the interest rate, we can immediately obtain the effect on bank profits.
Liquidity Management
Liquidity Management: Acquisition of sufficiently liquid assets to meet the bank’s obligations to depositors.
Examples: Cash, Credit
Money Center Banks
Money Center Banks: Large banks in key financial centers (New York, Chicago, San Francisco).
ROE (Return on Equity)
ROE (Return on Equity): Net profit after taxes per dollar of equity capital.
Example: ROE = $10,000,000 / $20,000,000 = 50%
Required Reserve Ratios
Required Reserve Ratios: Reserves that are held to meet the Fed's requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves.
Example: If the reserve ratio is set to 10% and the bank has an amount of 1 million as deposited money, the reserve ratio of that amount is 100k.
Basel Committee on Banking Supervision
Basel Committee on Banking Supervision
Dual Banking System
Dual Banking System: Banks chartered by the federal government and banks chartered by the states operate side-by-side.
Example: National Banks
Interest Rate Risk
Interest Rate Risk: The possible reduction in returns associated with changes in interest rates.
Central Bank
Central Bank: The bank of banks.
Asset Price Bubble
Asset Price Bubble: Occur when asset prices in the stock and real estate markets are driven well above the assets’ fundamental economic values by investor psychology.
CDOs
CDOs
Political Business Cycle
Political Business Cycle: A business cycle caused by expansionary policies that are pursued prior to an election.
Central Bank Goal Independence
Central Bank Goal Independence
Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP)
Spot Transaction Rate
Spot Transaction Rate: Immediate (two-day) exchange of bank deposits.