Bank Management

General Principles

Primary Concerns of the Bank Manager

• Deposit outflows must match deposit inflows.– To keep enough cash on hand, the bank manager

must engage in liquidity management.

• Risk levels must be acceptably low.– To keep risk low, the bank manager must engage

in asset management by acquiring assets that have a low rate of default and by holding a portfolio that is well diversified.

Primary Concerns of the Bank Manager

• Funds must be acquired at low cost.– To increase profits by acquiring funds at low

cost, the bank manager engages in liability management.

• Capital must meet regulatory standards.– To maintain and acquire capital, the bank

manager engages in capital adequacy management.

Liquidity Management

• Financial institutions face liquidity management problems because the volume of cash flowing in rarely matches exactly the volume of cash flowing out.

• In addition, some liabilities are payable immediately upon demand, resulting in the outflow of cash with little or no notice. And...

Liquidity Management

• Financial institutions are sensitive to interest rate movements, which affect the flow of savings they attract from the public and the earnings from the loans and securities they acquire.

Liquidity Management

• Liquidity managers usually meet their institutions’ cash needs through two methods:– Asset management or conversion; ie., the

selling of selected assets.– Liability management; ie., the borrowing of

enough liquidity to cover a financial institution’s cash demands as they arise.

Sources and Uses of Funds Method

• To estimate the financial institution’s future liquidity needs, the bank manager could use the sources and uses of funds method.– The institution’s estimated liquidity deficit or

surplus equals the estimated change in liquidity sources minus the estimated change in liquidity uses.

Sources and Uses of Funds Method: Example

Planning Estimated Change in Estimated Change in EstimatedInterval Funds Sources in Funds Uses Surplus/ Deficit

Tomorrow +$25 million +$20 million +$5 millionNext Day -$10 million +$10 million -$20 million

The bank manager could invest the $5 million surplus overnight in order to earn interest income, and then the next day must borrow $20 million from some other institution.

The Structure of Funds Method

• To estimate the financial institution’s future liquidity needs, the bank manager could use the structure of funds method. – The institution’s liabilities are divided into

categories based on their estimated probability of leaving the institution. Funds are then allocated to cover those liabilities according to the likelihood that they will leave.

The Structure of Funds Method: Example

• Some funds received may be “hot money” that are highly sensitive to changes in interest rates.– 90% or more of these funds should be covered

with holdings of liquid assets or borrowings.

• Other funds are “core” funds that are highly stable.– Only 10% of these funds might be covered 10%.

The Structure of Funds Method: Example

Estimated liquidity need = 0.90 x (“Hot money” funds) + 0.10 x (“Core” funds) + Estimated new loan demand from customers

= 0.90 x ($60 million) + 0.10 x ($100 million) + $36 million = $100 million

The liquidity manager would want to make sure that $100 million was available in some combination of holdings of liquid assets and borrowing capability.

Liquidity Indicators• Liquidity indicators supply bank managers with

signs that a liquidity problem is developing. They include:– Ratio of cash to total assets.– Ratio of “hot money” assets to “hot money” liabilities.– Cost of borrowing for liquidity needs relative to the

cost other institutions face.– Monitoring the intentions of the bank’s biggest

customers.

Liquidity Management and the Role of Reserves

Assets Liabilities

Reserves $20 Deposits $100Loans $80 Bank Capital $ 10Securities $10

Let the bank’s reserve requirement be 10% of deposits or $10.

Under these circumstances, an unexpected deposit outflow of $10 presents no problems for the bank. Why?

Liquidity Management and the Role of Reserves

Assets Liabilities

Reserves $10 Deposits $ 90Loans $80 Bank Capital $ 10Securities $10

The bank loses $10 of deposits and $10 of reserves, but sincerequired reserves are now 10% of $90, it still has $1 in excess reserves.

If a bank has ample reserves, a deposit outflow does not necessitatechanges in other parts of its balance sheet.

Liquidity Management and the Role of Reserves

Assets Liabilities

Reserves $10 Deposits $100Loans $90 Bank Capital $ 10Securities $10

Let the bank’s reserve requirement be 10% of deposits or $10.

Under these circumstances, an unexpected deposit outflow of $10 does present a problem for the bank. Why?

Liquidity Management and the Role of Reserves

Assets Liabilities

Reserves $ 0 Deposits $ 90Loans $90 Bank Capital $ 10Securities $10

After the withdrawal of $10 in deposits, the bank needs $9 in reserves, but it has none.

To eliminate the shortfall, the bank could sell assets or borrow

Liquidity Management and the Role of Reserves

Assets Liabilities

Reserves $ 9 Deposits $ 90Loans $90 Borrowings $ 9Securities $10 Bank Capital $ 10

If the bank borrows $9 from other banks or corporations, the bankincurs the cost associated with the borrowing.

Liquidity Management and the Role of Reserves

Assets Liabilities

Reserves $ 9 Deposits $ 90Loans $90 Securities $ 1 Bank Capital $ 10

If the bank sells securities, the bank incurs the costs associatedwith the sale. These costs include brokerage and other transactionscosts as well as the loss of future income.

Liquidity Management and the Role of Reserves

Assets Liabilities

Reserves $ 9 Deposits $ 90Loans $90 Discount Loan $ 9Securities $10 Bank Capital $ 10

If the bank borrows from the Federal Reserve, it also incurs costs.The bank must pay the discount rate charged on Fed loans, andthe bank risks losing its privilege of borrowing from the Fed, if itborrows too often.

Liquidity Management and the Role of Reserves

Assets Liabilities

Reserves $ 9 Deposits $ 90Loans $81 Securities $10 Bank Capital $ 10

If the bank calls or sells some loans, the bank incurs the costs associated with the reduction of loans. This is the costliest way of acquiring reserves.

Liquidity Management: Conclusion

• 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.

Bank Management II

General Principles

Asset Management

• To maximize profits, a bank must simultaneously seek the highest returns possible on loans and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets.

Asset Management

• Four basic methods of asset management:– Find borrowers who will pay high interest rates

and are unlikely to default.– Purchase securities with high returns and low

risk.– Lower risk by diversifying.– Manage the liquidity of its assets so that it can

satisfy its reserve requirements without incurring large costs.

Liability Management

• Today, banks regularly engage in liability management.– When a bank finds an attractive loan

opportunity, it can acquire funds by selling negotiable CDs.

– If it has a reserve shortfall, it can borrow from other banks in the federal funds markets.

Raising Funds for a Financial Institution

• Factors to be considered:– The relative cost of raising funds from each source.– The risk (volatility or dependability) of each fund’s

source.– The length of time (maturity) for which a source of

funds will be needed.– The size and market access of the financial

institution attempting to raise funds.– Laws and regulations that limit access to funds.

Relative Cost Factor

• The relative cost factor is important because, other things remaining the same, a financial institution would prefer to borrow from the cheapest sources of funds available.

• Also, if an institution is to maintain consistent profitability, its cost of fund raising must be kept below the returns earned on the sales of its services.

Pooled-Funds Approach: Example

Sources of New Funds Volume of New Interest Costs & OtherFunds Generated Expenses

Incurred

Deposits $200 $20 Money Market Borrowing $ 50 $ 5 Equity Capital $ 50 $ 5

Total New Funds $300 $30

Estimated overall cost of funds for the institution is:

Pooled All Expected Fund Raising = Fund Raising Costs = $30 = 10% Expense Total New Funds $300

Pooled-Funds Approach: Example

If only $250 of the $300 in funds raised can be used to invest in new loans and investments, the estimated overall cost of funds changes.

Estimated overall cost of funds for the institution is:

Pooled All Expected Fund Raising = Fund Raising Costs = $30 = 12% Expense Total New Funds $250

Now the bank must earn at least 12% on its loans and other earning assets just to cover its fund-raising costs. When it could use all the funds raised for loans and other investments, it only needed to earn 10% to cover the fund-raising costs.

Capital Adequacy

• Functions of bank capital:– Help to prevent bank failure– Affects returns for equity holders– Required by regulatory authorities

Capital and Bank Failure

High Capital Bank Low Capital Bank Assets Liabilities Assets Liabilities

Reserves $10 Deposits $90 Reserves $10 Deposits $96Loans $90 Bank K $10 Loans $90 Bank K $ 4

Assume that both banks write off $5 of their loan portfolio. Totalassets decline by $5, and bank capital, which equals assets minusliabilities, also declines by $5.

Capital and Bank Failure

High Capital Bank Low Capital Bank Assets Liabilities Assets Liabilities

Reserves $10 Deposits $90 Reserves $10 Deposits $96Loans $85 Bank K $ 5 Loans $85 Bank K - $ 1

After the write-off, the high capital bank still has a positive net worth, but the low capital bank is insolvent. It does not havesufficient assets to pay off its creditors. Regulators will now closethe bank and sell its assets.

A bank maintains bank capital to lessen the chance that it will become insolvent.

Bank Capital and Returns to Owners

A basic measure of bank profitability is return on assets = ROA

ROA = Net profit after taxes/assets.

This measure provides information on how efficiently a bank is being run because it indicates how much profit is generated on average by each dollar of assets.

Bank Capital and Returns to Owners

Another measure of bank profitability is return on equity = ROE

ROE = Net profit after taxes/Equity capital.

This measure provides information on how much the bank is earning on the investors’ equity investment.

Bank Capital and Returns to Owners

There is a direct relationship between the return on assets and thereturn on equity. This relationship is determined by the equity-multiplier (EM). EM is the amount of assets per dollar of equity capital.

EM = Assets/equity capital

Net profit after taxes Net profit after taxes x Assets Equity capital Assets equity capital

ROE = ROA x EM

=

Bank Capital and Returns to Owners

We can use the ROE formula to examine what happens to the returnon equity when a bank holds a smaller amount of assets per dollar of capital. Let each bank receive a return on assets equal 1%.

ROE = ROA x EM

High Capital Bank ROE = 1% x 100/10 = 10%

Low Capital Bank ROE = 1% x 100/4 = 25%

Given the return on assets, the lower the bank capital, the higher thereturn for the owners of the bank.

Trade-off between Safety and Return

• Bank capital reduces the likelihood of bankruptcy, but it is costly because as bank capital rises, return on equity falls.

• Bank managers must determine how much safety they are willing to trade off against the lower return on equity.

• The more uncertain the times, the larger the amount of capital held.

Bank Capital and Returns to Owners

Another commonly watched measure of bank performance is calledthe net interest margin (NIM), the difference between interest incomeand interest expenses as a percentage of total assets.

NIM = interest income - interest expensesassets

If a bank manager has done a good job, the bank will have high profits and low costs. This is reflected in the spread between interest earned and interest costs.

Bank Capital Requirements

• Basle Agreement– An agreement among the central banks of leading

industrialized nations, including the nations of Western Europe, the United States, and Japan, to impose common capital requirements on all their banks in order to control bank risk exposure and avoid giving one nation’s banks an unfair advantage over another nation’s banks. It provides minimum capital standards.

Basle Agreement• The Basle Agreement (1998) stipulates that banks in

all participating nations must have a minimum ratio of total capital to risk-weighted assets and other related risk-exposed items of 8 percent.

• Risk weighted assets are determined by classifying each of the bank’s assets listed on its balance sheet into categories based on risk exposure and then multiplying each category by a fractional risk weight ranging from 0 for cash and government securities to 1 for commercial loans and other high risk assets.

Basle Agreement: Example

Total risk-weighted assetson a bank’s balance sheet

0 x (Cash and U.S. government securities) + 0.2 x(Other types of government securities and interbankdeposits) + 0.5 x (Residential mortgage loans,government revenue bonds and selected types ofmortgage backed securities) + 1 x (Commercialand consumer loans and other assets of the highestrisk exposure).

=

Basle Agreement

• The Basle Agreement was unique in also including off-balance sheet commitments that banks make to their largest customers, as well as commitments banks make to hedge themselves against risk.

• The amount of each off-balance sheet item is multiplied by a fractional amount know as its “credit-equivalent” value, which is, in turn, multiplied by a fractional risk weight based on its assumed degree of risk exposure.

Basle Agreement: Example

Total risk-weighted assetson and off a bank’s balance sheet

=Total risk-weighted assets on a bank’s balance sheet

x Total risk-weightedoff-balance sheet items

Basle Agreement

• To determine a bank’s total capital, its longer-maturity liabilities and its equity are classified into two broad categories:– Tier-one or permanent core bank capital which

includes:• Tangible equity including common stock + perpetual preferred

stock + retained earnings + capital reserves less intangibles.

– Tier-two or supplemental capital which includes:• Subordinated capital notes and debentures over 5 years to

maturity +limited-life preferred stock + loan loss reserves.

Basle Agreement

• The Basle Agreement requires each bank in all participating countries to achieve and hold the following capital minimums:– Tier-one capital divided by total risk-weighted on and off

balance sheet items must equal at least 4%.

– Total tier-one plus tier two capital divided by total risk-weighted on and off balance sheet items must equal no less than 8%.

• A bank with a 4% tier-one capital ratio and a 5% tier-two capital ratio would have a ratio of total capital to risk-weighted on and off balance sheet items of 9%.

Basle Agreement

• In the U.S. and selected other countries, a bank that holds more than the required minimum amounts of capital is allowed to expand its services and service facilities with few or no regulatory restrictions imposed.

• But, if bank capital drops below the minimum percentage, regulatory restrictions become increasingly stiff.

Off Balance-Sheet Activities

• Loan sales or secondary loan participation– A contract that sells all or part of the cash

stream from a specific loan and thereby removes the loan from the bank’s balance sheet.

• Banks earn profits by selling loans for an amount slightly greater than the amount of the original loan.

– Institutions are willing to buy them at the high price because of the high interest rates associated with the loans.

Off Balance-Sheet Activities

• Generation of Fee Income– Banks charge fees for specialized services such

as:• Making foreign exchange trades

• Servicing a mortgage-backed security by collecting interest and principal payments and then paying them out, and providing lines of credit.