BANK MANAGEMENT

1
CHAPTER 19

• BANK MANAGEMENT

2
The Banking Dilemma

• What is the banking dilemma?
• Balancing the interests of shareholders,
  depositors and regulators
• The tradeoff between profitability and
  safety/risk
• As risk ? profitability ______________ and
• vice versa. Why?

3
Bank Capital

• Primary capital includes
• common stock.
• common surplus.
• retained earnings.
• perpetual preferred stock.
• loan loss reserves.
• debt securities with a mandatory conversion to
  common stock.

4
Bank Capital

• Secondary capital includes
• subordinated notes and debentures.
• sinking fund preferred stock.
• Bank capital ratios computed as
• primary capital/ total assets.
• total capital/ total assets.
• Why is bank capital so important? Lets see...

5
Bank Capital

• Bank capital is important because it
• Promotes confidence in the banking system
• Provides protection to uninsured depositors and
  creditors
• Serves as a base to raise deposits
• Absorbs losses on assets (loans)

6
Bank Capital
7
Bank Capital

• Bottomline
• The more risky the banks assets, the more
  capital the bank is required to hold
• This ensures that depositors are adequately
  protected from potential losses

8
Bank Risk

• Thus far we have established that a bank
• faces a tradeoff between profitability and risk
• must maintain capital levels commensurate with
  their risk levels
• Since risk is so important, what are the primary
  risks faced by a bank?
• Default/credit risk (Chapter 17)
• Liquidity risk
• Interest rate risk

9
Default Risk

• What is default risk?
• Measuring Default Risk
• Recall that in Chapter 16 we talked about loan
  evaluation and pricing-- bank assesses potential
  for loss on the loan and charges a default risk
  premium for high risk borrowers.

10
Default Risk

• Managing Default Risk
• Develop clear loan policy
• Assemble diverse loan portfolio
• varied income, employers
• varied geographic regions
• varied industries
• Avoid concentration of loans
• Develop clear guidelines for handling troubled
  loans

11
Liquidity Risk

• What is liquidity risk?
• There is a tradeoff between liquidity and
  profitability. Explain
• Measuring liquidity
• Establish desired levels for key liquidity ratios
• Establish desired level for each liquid asset

12
Liquidity Risk

• Liquidity Management Strategies
• 1. Asset Management bank relies on managing
  its assets to provide liquidity
• Bank establishes desired level of liquid assets
  (depending on risk tolerance of bank)
• Bank loans are made after absolute liquidity
  needs are met.
• After loan demand is satisfied, funds are
  allocated to investments

13
Liquidity Risk

• 2. Liability Management bank relies on its
  liabilities to provide liquidity
• Assumes that the bank may raise sufficient
  amounts of funds by paying the market rate.
• LM supplements asset management, but does not
  replace it.

14
Interest Rate Risk

• What is interest rate risk?
• Why is it important for banks to manage this
  risk?

15
Interest Rate Risk

• Measuring Interest Rate Risk
• Example
• Asset
• 1-year 1,000 loan at 9
• Liabilities
• 3-month 500 CD at 5
• 6-month 500 CD at 6
• Total Assets Total Liabilities 1000
• How are the banks cashflows affected by changes
  in interest rates?

16
Interest Rate Risk (assume no change in interest
rates)
17
Interest Rate Risk (assume interest rates fall
by 1)
18
Interest Rate Risk (assume interest rates rise
by 1)
19
Interest Rate Risk

• Bottomline implications
• Using short-term deposits to finance long-term
  assets exposes the bank to interest rate risk
• Bank gains when rates fall but loses when rates
  rise
• Since bank cannot predict interest rates
  perfectly, they must find a way to manage this
  risk

20
Interest Rate Risk

• Another method for Measuring Interest Rate Risk
  is GAP Analysis
• Bank identifies rate sensitive assets (RSAs)
• such as.
• Bank identifies rate sensitive liabilities (RSLs)
  
• such as..

21
Interest Rate Risk

• GAP RSA - RSL
• Positive GAP RSA RSL
• What happens to the banks net interest income if
  interest rates fall?
• What happens if interest rates increase?

22
Interest Rate Risk

• Negative GAP RSA
• What happens to the banks net interest income if
  interest rates increase?
• What happens when interest rates fall?

23
Interest Rate Risk

• Zero GAP RSA RSL
• What happens to the banks net interest income if
  interest rates increase?
• What happens when interest rates fall?

24
Interest Rate Risk

• GAP Analysis can also be used to manage interest
  rate risk
• Depends on
• a. Banks risk tolerance
• -risk averse prefer MGAP 0
• b. Banks forecast of interest rates
• - if rates are expected to rise prefer______ GAP
• - if rates are expected to fall prefer_______ GAP
• (Note bank does not have complete control-
  market/consumers also play a role)

25
Interest Rate Risk

• Other methods for managing interest rate risk
  include
• a. Duration matching
• b. Hedging

26
In Summary...

• Banks face a tradeoff between profitability and
  risk.
• Banks must hold capital consistent with their
  risk levels.
• Banks face three primary types of risK default,
  liquidity, and interest rate risk.
• Each type of risk must be properly measured and
  managed for the bank to be successful.