Chapter 13 Banking and the Management of Financial Institutions

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Assets
Cash reserves Deposits at Other Banks Cash Items in Process of Collection Securities Loans Fixed and Other Assets

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Liabilities
Demand and Notice Deposits Fixed Term Deposits Borrowings
Overdraft loans (advances) Settlement balances Eurodollars

Bank capital
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The Bank Balance Sheet

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Basic Banking I
First bank makes a loan of $100 to a business and credits the business's chequable deposit.

First Bank

Business

Assets
Loans +$100

Liabilities
Chequable deposits +$100

Assets
Chequable Deposits +$100

Liabilities
Bank Loans +$100

Opening of a checking account leads to an increase in the banks reserves equal to the increase in chequable deposits
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Basic Banking II
First Bank Assets Cash items in process of collection +$100 Liabilities Chequable deposits +$100

When a bank receives additional deposits, it gains an equal amount of reserves: when it loses deposits, it loses an equal amount of reserves
Second Bank Assets Reserves -$100 Liabilities Chequable deposits -$100

First Bank Assets Reserves +$100 Liabilities Chequable deposits +$100

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Basic BankingMaking a Profit

First Bank Assets Liabilities Assets First Bank Liabilities

Desired reserves
Excess reserves

+$10 Chequable deposits

+$90

+$100

Desired reserves
Loans

+$10 Chequable deposits

+$90

+$100

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

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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 and the Role of Reserves

with deposit outflow of $10 million

Assets
Reserves Loans Securities

Liabilities
$20M Deposits $80M Bank Capital $10M $100M $10M

Assets
Reserves Loans Securities

Liabilities
$10M Deposits $80M Bank Capital $10M $90M $10M

If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet
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Liquidity Management: Shortfall in Reserves

with deposit outflow of $10 million

Assets Reserves Loans Securities Liabilities $10M Deposits $90M Bank Capital $10M $100M $10M Assets Reserves Loans Securities Liabilities $0 Deposits $90M Bank Capital $10M $90M $10M

Reserves are now short of the desired amount and the shortfall must be eliminated Excess reserves are insurance against the costs associated with deposit outflows
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Liquidity Management: Borrowing

Borrowing $9 million from other banks

Assets Reserves Loans $9M Deposits $90M Borrowing

Liabilities $90M $9M

Securities

$10M Bank Capital

$10M

Cost incurred is the interest rate paid on the borrowed funds

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Liquidity Management: Securities Sale

Can meet shortfall by reducing securities by $9 million

Assets Reserves Loans Securities $9M Deposits $90M Bank Capital $1M

Liabilities $90M $10M

The cost of selling securities is the brokerage and other transaction costs.
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Liquidity Management: Bank of Canada Advances

Borrow $9 million from the Bank of Canada

Assets Reserves Loans $9M Deposits $90M Advance Bank of Canada

Liabilities $90M $9M

Securities

$10M Bank Capital

$10M

Borrowing from the Bank of Canada also incurs interest payments based on the Bank Rate
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Liquidity Management: Reduce Loans

Assets Reserves Loans Securities $9M Deposits $81M Bank Capital $10M Liabilities $90M $10M

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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Asset Management: Three Goals

Seek the highest possible returns on loans and securities Reduce risk

Manage liquidity of assets so bank can pay depositors where there are deposit outflows

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Asset Management: Four Tools

Find borrowers who will pay high interest rates and have low possibility of defaulting Purchase securities with high returns and low risk Lower risk by diversifying

Balance need for liquidity against increased returns from less liquid assets
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Liability Management
Recent phenomenon due to rise of money center banks Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) Checkable deposits have decreased in importance as source of bank funds

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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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Capital Adequacy Management: Preventing Bank Failure

High Bank Capital Assets Reserves Liabilities $10M Deposits Assets $90M Reserves

Low Bank Capital Liabilities $10M Deposits $96M

Loans

$90M Bank Capital

$10M Loans

$90M Bank Capital

$4M

High Bank Capital Assets Reserves Loans Liabilities $10M Deposits $85M Bank Capital Assets $90M Reserves $5M Loans

Low Bank Capital Liabilities $10M Deposits $85M Bank Capital $96M -$1M

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Capital Adequacy Management: Returns to Equity Holders

Return on Assets :net profit after taxes per dollar of assets net profit after taxes ROA assets Return on Equity :net profit after taxes per dollar of equity capital net profit after taxes ROE equity capital Relationship between ROA and ROE is expressed by the Equity Multiplier : the amount of assets per dollar of equity capital Assets EM Equity Capital net profit after taxes net profit after taxes assets x equity capital assets equity capital ROE ROA x EM
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Capital Adequacy Management: Safety

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 Bank capital requirement
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Strategies for Managing Bank Capital

Lowering Bank Capital: Buying back some of Banks stock Pay out higher dividend to shareholders

Raising Bank Capital: Issue more common stock Reducing dividend to shareholders Issue fewer loans or sell securities and use proceeds to reduce liabilities
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Principles for Managing Credit Risk

Screening and Monitoring
Screening Specialization in Lending Monitoring and Enforcement of Restrictive Covenants

Long-term Customer relationships Loan Commitments Collateral and Compensating Balances

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Credit Rationing
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Interest Rate Risk If a financial institution has more interest rate sensitive liabilities than interest rate sensitive assets, a rise in interest rates will reduce the net interest margin and income
If a financial institution has more interest rate sensitive assets than interest rate sensitive liabilities, a rise in interest rates will raise the net interest margin and income
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Gap Analysis
The Gap is the difference between interest rate sensitive liabilities and interest rate sensitive assets
GAP = rate-sensitive assets rate-sensitive liabilities

GAP = RSA RSL

A change in the interest rate (i) will change bank income (I) depending on the Gap Income = GAP i
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Duration Analysis I
Owners and managers care not only about the change in interest rates on income but also on net worth of the institution Duration Analysis examines the sensitivity of the market value of the financial institutions net worth to changes in interest rates

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Duration Analysis II

%P = - DUR x [i/(1+i)]
Where: P is the market value %P = (Pt+1 Pt)/P DUR = duration i = interest rate

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Duration Analysis III

The Duration Gap can be calculated as: DURgap = Dura (L/A x DURL)
Where: Dura = average duration of assets

L = market value of liabilities

A = market value of assets Durl = average duration of liabilities

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Duration Analysis IV
The impact of the interest rate change on net worth (NW) as a percentage of assets can be calculated via: NW/A = -Durgap x i/(1+i)
Where: DURgap = duration gap i = interest rate change i = interest rate

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Duration Analysis V
Thus

NW/A = -Durgap x i/(1+i)

NW/A = -1.72 x 0.01/(1+0.10) = -0.016 = -1.6%

With assets = $100m, the fall in NW when the interest rises from 10% to 11% equals -1.6% of $100m = -$1.6M
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Off-Balance-Sheet Activities I
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 II
Trading activities and risk management techniques (continued)
Principal-agent problem Internal Controls
Separation of trading activities and bookkeeping Limits on exposure Value-at-risk Stress testing

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