Chapter 9 Banking and the Management of Financial Institutions

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Chapter 9 - Banking and the Management of
Financial Institutions
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Banking and the Management of Financial
Institutions

• The Bank Balance Sheet
• Basic Banking
• General Principles of Bank Management
• Managing Credit Risk
• Managing Interest Rate Risk
• Off-Balance-Sheet Activities

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The Bank Balance Sheet

• Total Assets Total Liabilities Capital
• Liabilities
• Source of funds a bank uses to purchase assets
• Deposits are the largest liability
• Checkable Deposits
• Nontransaction Deposits Saving Accounts and
  CDs
• Borrowings Discount Loans
• Bank Capital

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The Bank Balance Sheet

• Assets Uses of funds
• Reserves
• Cash Items in the Process of Collection Checks
• Deposits at Other Banks
• Securities
• Loans
• Other Assets Physical Capital

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Balance Sheet
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Basic Banking

• Profit occurs from selling liabilities with one
  sets of characteristics and using the proceeds to
  buy assets with a different set of
  characteristics
• Characteristics include maturity, risk, size, and
  return
• Asset Transformation
• T-Accounts
• Simplified balance sheet that organizes assets
  and liabilities

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Basic Banking - Cash Deposit

• Opening of a checking account leads to an
  increase in the banks reserves (vault cash)
  equal to the increase in checkable deposits

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Basic Banking - Check Deposit
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Basic Banking - Making a Profit

• Reserve Rate is 10
• Asset transformation-selling liabilities with one
  set of characteristics and using the proceeds to
  buy assets with a different set of
  characteristics
• The bank borrows short and lends long
• Checking accounts are short term and loans are
  long term

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Bank Management

• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Interest-rate Risk

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Liquidity Management

• The acquisition of sufficiently liquid assets to
  meet the banks obligations to depositors
• A bank manager needs to be able to provide
  liquidity services to cover liabilities

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Liquidity Management Ample Excess Reserves

• Required reserve rate is 10
• If a bank has ample excess reserves, a deposit
  outflow does not necessitate changes in other
  parts of its balance sheet
• A 10 million dollar withdraw effects deposits
  and excess reserves

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Liquidity Management Shortfall in Reserves

• Reserves are a legal requirement and the
  shortfall must be eliminated
• Excess reserves are insurance against the costs
  associated with deposit outflows
• After the 10 million dollar withdraw banks need
  to restructure their balance sheets

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Shortfalls in Reserves

• Reserve shortfalls are 9 million and need to be
  recovered by either of the following
• Borrow from banks or corporations
• Sell securities
• Borrow from the Federal Reserve
• Reduce loans

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Liquidity Management Borrowing

• Cost incurred is the interest rate paid on the
  borrowed funds

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Liquidity Management Securities Sale

• The cost of selling securities is the brokerage
  and other transaction costs

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Liquidity Management Federal Reserve

• Borrowing from the Fed also incurs interest
  payments based on the discount rate

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Liquidity Management Reduce Loans

• Reduction of loans is the most costly way of
  acquiring reserves
• Calling in loans antagonizes customers
• Other banks may only agree to purchase loans at a
  substantial discount

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Liquidity Management

• Excess Reserves
• Are insurance against the costs associated with
  deposit outflows. The higher the costs
  associated with deposit outflows, the more excess
  reserves banks will want to hold.

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Asset Management Three Goals

• Seek the highest possible returns on loans and
  securities
• Reduce risk
• Have adequate liquidity

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Asset Management Four Tools

• Find borrowers who will pay high interest rates
  and have low possibility of defaulting
• Seek out corporations and publicly advertise
  their rates
• Purchase securities with high returns and low
  risk
• Lower risk by diversifying
• Purchase long and short term U.S. Treasury and
  municipal bonds (Avoid the real estate problems
  of the 1980s)
• Balance need for liquidity against increased
  returns from less liquid assets

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Liability Management

• Prior to the 1960s liabilities were seen as
  fixed
• They were mostly zero-interest checkable deposits
• Overnight loans did not exist between banks
• Recent phenomenon due to rise of money center
  banks
• Expansion of overnight loan markets and new
  financial instruments (such as negotiable CDs)
• The source of additional liabilities have lead to
  checkable deposits decreasing in importance as a
  source of bank funds

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Liability Management

• Changes since 1960
• CD holdings and bank borrowings have increased
  from 2 to 42 (of liabilities) by 2005
• Banks have been able to hold more assets in loans
• 46 to 66 by 2005

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Capital Adequacy Management

• Bank capital helps prevent bank failure
• The amount of capital affects return for the
  owners (equity holders) of the bank
• Regulatory requirement

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Preventing Bank Failures

• Bank Capital Total Assets Liabilities
• When a bank defaults on a loan it lowers assets
  and bank capital
• This leads to a lower net worth and in some cases
  even a negative net worth
• Insolvent Negative Net Worth
• Government regulation forces the bank to close

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Preventing Bank Failure When Assets Decline
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Capital Adequacy Management Returns to Equity
Holders
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Capital Adequacy Management Returns to Equity
Holders
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Example Do Banks Want to Hold Capital

• High Capital Bank
• 100 Million in Assets and 10 Million in Equity
  (Bank Capital)
• Equity Multiplier 100/10 10
• Low Capital Bank
• 100 Million in Assets and 4 Million in Equity
• Equity Multiplier 100/4 25
• Return on Assets 2 (each bank ran equally)
• High Capital ROE 2 x 10 20
• Low Capital ROE 2 x 25 50

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Capital Adequacy Management Safety and Tradeoffs

• Benefits the owners of a bank by making their
  investment safe
• Costly to owners of a bank because the higher the
  bank capital, the lower the return on equity
• Choice depends on the state of the economy and
  levels of confidence

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Strategies for Managing Bank Capital

• How to increase the equity multiplier (reduce
  capital)
• Reduce the amount of capital holdings
• Pay out higher dividends from retained earnings
• Increase banks assets through loans
• Managers often times choose the second option
• Shareholders see more money
• Less effort

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Strategies for Managing Bank Capital

• How do you go about decreasing EM or increasing
  bank capital
• Issue equity
• Reducing bank dividends
• Reduce the banks assets
• Issuing equity is often the easiest solution, but
  often times a bank with a low net worth is forced
  into restricting asset growth

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Application to the 1980s

• The 80s were accompanied by a booming economy
  followed by a bust in the real estate market
• Banks experienced huge losses on real estate
  loans leading to a large fall in bank capital
• Government was also increasing the required
  amount of capital a bank must hold
• Banks couldnt raise capital and were forced to
  slow asset growth by restricting lending Credit
  Crunch

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Credit Risk Overcoming Adverse Selection and
Moral Hazard

• Screening and information collection
• Specialization in lending
• Monitoring and enforcement of restrictive
  covenants
• Long-term customer relationships
• Loan commitments
• Collateral and compensating balances
• Credit rationing

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Interest Rate Risk

• The impact of variable interest rates
• As interest rates become more volatile a bank
  needs to manage not only their assets and
  liabilities but their relative make up of each

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Interest-Rate Risk

• If a bank has more rate-sensitive liabilities
  than assets, a rise in interest rates will reduce
  bank profits and a decline in interest rates will
  raise bank profits

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Interest Rate Risk

• What happens when the interest increases by 5?
• Assets 20 million are interest rate sensitive
• Assets increase by 20 x .05 1 million
• Liabilities 50 million are interest rate
  sensitive
• Liabilities increase by 50 x .05 2.5 million
• The impact of the 5 change is
• 1 million less 2.5 million or -1.5 million

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Interest Rate Risk Gap Analysis
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Interest Rate Risk Duration Analysis
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Interest Rate Risk Duration Analysis

• Assume
• The banks average assets holdings are 3 years and
  liability holdings are 2 years
• The banks has 100 million in assets and 90
  million in liabilities
• Suppose interest rates increase by 5
• The market value of assets falls by 15 (-5 x 3
  years) or 15 million
• The MV of liabilities falls by 10 (-5 x 2
  years) or 9 million
• Net worth
• Before 100 - 90 10 million
• Now 85 - 81 4 million
• Change is 6 million or 15 - 9

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Off-Balance-Sheet Activities

• Loan sales (secondary loan participation)
• Generation of fee income
• Trading activities and risk management techniques
• Futures, options, interest-rate swaps, foreign
  exchange
• Speculation

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Off-Balance-Sheet Activities (contd)

• Trading activities and risk management techniques
  (contd)
• Principal-agent problem
• Internal Controls
• Separation of trading activities and bookkeeping
• Limits on exposure
• Value-at-risk
• Stress testing