Bank Management - Snapshot

8/2/2019 Bank Management - Snapshot

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Bank Management Snap Shot

Chapter Objectives Explain what a balance sheet and a T-

account are.

Explain what banks do in five words

and also at length.

Describe how bankers manage their

banks balance sheets.

Explain why regulators mandate

minimum reserve and capital ratios.

Describe how bankers manage creditrisk.

Describe how bankers manage

interest-rate risk.

Describe off-balance sheet activities

and explain their importance.


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1. The Balance Sheet

Chapter Objectives

Explain what a balance sheet and a T-account are.

What is a balance sheet and what are the major typesof bank assets and liabilities?


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ASSETS = LIABILITIES + EQUITY

Uses of Funds =

Assets =

Resources =

Resources =

Sources of Funds

Debt Financing + Equity Financing

Borrowings + Ownership stakes

Lenders claims + Owners claims


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For banks


Assets:Reserves

Secondary reserves

Loans made to customersOther

Liabilities:Deposits owed to customers

Borrowings owed to debt financers

Equity:

Shareholders equity


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Key Takeaways

A balance sheet is a financial statement that lists what a company owns,

its assets or uses of funds, and what it owes, its liabilities or sources of

funds.

Major bank assets include reserves, secondary reserves, loans, and other

assets.

Major bank liabilities include deposits, borrowings, and shareholder

equity.


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2. Assets, Liabilities.

Chapter Objectives

Explain what banks do in five words and also at length.

In five words, what do banks do? Without a word

limitation, how would you describe what functions

they fulfill?


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For banks

ASSETS

Reserves: cash and deposits at the FedRequired reserves + excess reserves = total reserves

Secondary reserves: Government and liquidsecurities

Loans: commercial, consumer, to other banks viaFed Funds or check clearing

Collateralized: mortgage, auto, call loan, etc.

Other property, equipment, etc.


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For banks

LIABILITIES

Liabilities:Deposits

Transaction deposits: checking,

Non-transaction deposits: savings, Short term, Fixed etc

Time deposits: CDs

Borrowings

from banks via Fed Funds,

from Federal Reserve via discount window


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For banks

EQUITY

Equity:Shareholders equity

Common stock

Preferred stock

Retained earnings


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For banks


Assets:

Reserves: cash and deposits at the Fed

Required reserves + excess reserves =

total reserves

Secondary reserves Government and

liquid securities

Loans: commercial, consumer, to other

banks via Fed Funds or check

clearing

Collateralized: mortgage, auto, call

loan

Other property, equipment, etc

Liabilities:

Deposits

Transaction deposits: checking,

Non-transaction deposits: savings,Time deposits: CDs

Borrowings

from banks via Fed Funds,

from Federal Reserve via discount

window

Equity:

Shareholders equity

Common stock

Preferred stock

Retained earnings


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Asset transformation: Banks

Short-termdeposits/ Long-term deposits

Investors

Borrow short

Lend long

Intermediaries

Long-termloans

Entrepreneurs


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Asset transformation: Finance Companies

Buy bondsor finance

Savers/Investors

Borrow long

Lend short

Intermediaries

Short-termloans

Spenders/Entrepreneurs


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Asset transformation: Insurance

Prepayexpense

Savers/Investors

Intermediaries

Contingentliabilities

Spenders/Entrepreneurs


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Key takeaways Banks: lend (1) long (2) and (3) borrow (4) short (5).

Like other financial intermediaries, banks are in the business of

transforming assets, of issuing liabilities with one set of characteristics to

investors and of buying the liabilities of borrowers with another set of

characteristics.

Generally, banks issue short-term liabilities but buy long-term assets.

This raises specific types of management problems bankers must be

proficient at solving if they are to succeed.


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3. Bank Management Principles

Chapter Objectives

Describe how bankers manage their banks balance sheets.

Explain why regulators mandate minimum reserve and capital ratios.

What are the major problems facing bank managers

and why is bank management closely regulated?


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Bankers must manage their assets and liabilities to ensure

Liquidity

Profit

Profit

Financing

Liquidity management

Asset management

Liability management

Capital adequacy

management


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Liquidity management

Have enoughreserved to satisfy

deposit outflows

Use efficientlyenough to earn

profit


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Asset and Liability management

Profit

Investments

Financing


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Capital adequacy management

Have enough toprotect against

bankruptcy orregulation

Use efficientlyenough to earn

profit


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Bank management risks

Profit

Default

Capitaladequacy

Interestrate

Liquidity


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Liquidity managementNet deposit outflow (inflow)

Reserve ratio decreases

(increase)

Increase (decrease) reserves

in the cheapest way possible

Sell (buy) assets

high transaction costs

Sell (extend) loans

adverse selectionSell (buy) securities

Call in (extend) loans

high opportunity costs

Increase (decrease) deposits

high transaction costs andadded operating costs

Borrow from discount window

(Fed)

Borrow from (lend to) Fed

Funds (other banks)


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Asset management

Risk vs. Return: Default rate vs. Interest earned

Diversification: sectors, industries, markets,

regions

Reserve decision: invest vs. reserve


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Liability management

Actively try to attract deposits

Sell large denomination (Saving Deposits) to

institutional investors

Borrow from other banks in the overnight

federal funds market


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Net worth vs. profit

ROA: net after-tax profit/assets

ROE: net after-tax profit/equity (capital, net worth)

Increased leverage (debt financing) increases assets (A = L + E)

Increased leverage (risk) increases ROE (return)

Regulators in many countries have therefore found it prudent to

mandate capital adequacy standards to ensure that some

bankers are not taking on high levels of risk in the pursuit of

high profits.


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Capital management to increase ROE:

Buy (sell) the banks stock in the open market, reducing(increasing) the number of shares outstanding, raising (decreasing)

capital and ROE.

Pay (withhold) dividends, decreasing (increasing) capital and ROE.

Increase (decrease) the banks assets (with capital and ROA held

constant), increasing (decreasing) ROE.


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They must feel the thrill of totting up

a balanced book

A thousand ciphers neatly in a row.

When gazing at a graph that shows

the profits up

Their little cup of joy should overflow!

- Robert B. and Richard M. Sherman, from

A British Bank from Mary Poppins (1964)


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Key Takeaways

Bankers must manage their banks liquidity (reserves regulatory and to

conduct business effectively), capital (adequacy regulatory and to buffer

against negative shocks), assets, and liabilities.

There is an opportunity cost to holding reserves, which pay no interest,

and capital, which must share the profits of the business.

While bankers left to their own judgments would hold reserves > 0 and

capital > 0, they might not hold enough to prevent bank failures at what

the government or a countrys citizens deem an acceptably low rate.

That induces government regulators to create and monitor minimumrequirements.


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4. Credit Risk

Chapter Objectives

Describe how bankers manage credit risk.

What is credit risk and how do bankers manage it?


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4. Credit Risk

Managing asymmetric information

A banker is a fellow who lends his umbrella

when the sun is shining and wants it back

the minute it begins to rain.

- Mark Twain (1835-1910)


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4. Credit Risk

No matter how good bankers are at asset, liability,

and capital adequacy management, they will be

failures if they cannot manage credit risk

Managing credit riskmanaging

Asymmetric information Adverse selection

Moral hazard


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4. Credit Risk


Screening create information/reduce asymmetry

reduce adverse selection embed information in binding contract

third-party verification

Specialization maximize efficiency of screening

Increase efficiency create exposure to systemic risk

Long-term loan commitments (line of credit)

reduce moral hazard other business services


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4. Credit Risk


Securitize collateral

reduce moral hazard compensatory balances

loan covenants

Credit rationing no credit at any interest rate

reduce adverse selection limit credit

reduce moral hazard


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4. Credit Risk

Key Takeaways

Credit risk is the chance that a borrower will default on a loan by not fully

meeting stipulated payments on time.

Bankers manage credit risk by screening applicants (taking applications

and verifying the information they contain), monitoring loan recipients,

requiring collateral like real estate and compensatory balances, and

including a variety of restrictive covenants in loans.

They also manage credit risk by trading off between the costs and benefits

of specialization and portfolio diversification.


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5. Interest-Rate Risk

Chapter Objectives

Describe how bankers manage interest-rate risk.

What is interest rate risk and how do bankers

manage it?


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Financial intermediaries are exposed to interest rate risk

because their assets and liabilities are exposed to

interest rate risk.

Interest rate risk is determined by

the value of risk-sensitive assets,

the value of risk-sensitive liabilities, andthe change in interest rates.


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Basic Gap Analysis

CP = (Ar Lr) x i

CP: changes in profitability

Ar: risk-sensitive assets

Lr: risk-sensitive liabilities

i: change in interest rates


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Interestrates rise:

Asset valuesincrease

Interestrates fall:

Asset valuesdecrease

Interest

rates rise:Liability values

decrease

Interest

rates fall:Liability values

increase


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If A > L andinterest ratesrise,

Profitabilityrises

If A < L andinterest ratesrise,

Profitability falls

If A > L and

interest ratesfall,

Profitability falls

If A < L and

interest ratesfall,

Profitabilityrises


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To account for differences in maturities of assets andliabilities,

duration is used to estimate sensitivity to interest rate

changes:

%P = -%i x d

%P: percentage change in market value

%i: change in interest (NOT decimalized, i.e., represent

5% as 5 not .05. Also note the negative sign. The sign is

negative because, as we learned interest rates andprices are inversely related.)

d: duration (years).


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Strategy Implications

Interest rates are expected to fall:

duration of liabilities short (borrow short) and

duration of assets long (lend long).

Interest rates are expected to rise:duration of liabilities long (borrow long) and

duration of assets short (lend short).


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Key Takeaways Interest rate risk is the chance that interest rates may increase, decreasing

the value of bank assets.

Bankers manage interest-rate risk by performing analyses like basic gap

analysis, which compares a banks interest rate-risk sensitive assets and

liabilities, and duration analysis, which accounts for the fact that bankassets and liabilities have different maturities.

Such analyses combined with interest rate predictions tell bankers when

to increase or decrease their rate-sensitive assets or liabilities and

whether to shorten or lengthen the duration of their assets or liabilities.

Bankers can also hedge against interest-rate risk by trading derivatives, likeswaps and futures, and engaging in other off-balance sheet activities.


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6. Off the Balance Sheet

Chapter Objectives

Describe off-balance sheet activities and explain their importance.

What are off balance sheet activities and why do

bankers engage in them?


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Hedge credit risk

Diversify revenue service fees

loan origination fees

sell loans (provide loan

guarantees)


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The 2008 Crisis: Credit default swaps

Credit default swaps, which were invented by Wall Street in thelate 1990's, are financial instruments that are intended to cover

losses to banks and bondholders when a particular bond or

security goes into default -- that is, when the stream of revenuebehind the loan becomes insufficient to meet the payments that

were promised.

Credit default swaps are a type of credit insurance contract in

which one party pays another party to protect it from the risk of

default on a particular debt instrument. If that debt instrument (abond, a bank loan, a mortgage) defaults, the insurer compensates

the insured for his loss.

The New York Times, as quoted in Times Topics


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The market for the credit default swaps has been enormous. Since2000, it has ballooned from $900 billion to more than $45.5 trillion

roughly twice the size of the entire United States stock market.

Also in sharp contrast to traditional insurance, the swaps are totallyunregulated.

The swaps' complexity and the lack of information in an unregulated

market added to the market's anxiety. Bond insurers like MBNA

and Ambac that had written large amounts of the swaps saw their

shares plunge in late 2007..

Michael Lewitt, September 16, 2008, The New York Times, as quoted in

Times Topics


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Even before the market linkages among banks, other financial institutions

and non-financial businesses are fully re-established, we will need to start

unwinding the massive sovereign credit and guarantees put in place

during the crisis, now estimated at $7 trillion. The economics of such a

course are fairly clear. The politics of draining off that much credit support

in a timely way is quite another matter.

Alan Greenspan, Chairman,

U.S. Federal Reserve 1987-2006

In The Economist, December 18, 2008


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Hedge interest rate risk

Derivatives trading Interest rate swaps

Currency trading

Trading on account


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Key takeaways

Off-balance sheet activities like fees, loan sales, and derivatives

trading help banks to manage their interest-rate risk by providingthem with income that is not based on assets (and hence is off

the balance sheet).

Derivatives trading can be used to hedge or reduce interest-rate

risks but can also be used by risky bankers or rogue traders to

increase risk to the point of endangering a banks capital cushionand hence its economic existence.


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Bank Management - Snapshot

Chapter Summary A balance sheet is a financial statement

that lists what a company owns, its assets

or uses of funds, and what it owes, its

liabilities or sources of funds.

Major bank assets include reserves,

secondary reserves, loans, and other

assets.

Major bank liabilities include deposits,

borrowings, and shareholder equity.

Banks: lend (1) long (2) and (3) borrow (4)

short (5).

Like other financial intermediaries, banks

are in the business of transforming assets,of issuing liabilities with one set of

characteristics to investors and of buying

the liabilities of borrowers with another

set of characteristics.


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Chapter 9 Bank Management

Chapter Summary Generally, banks issue short-term

liabilities but buy long-term assets.

This raises specific types of management

problems bankers must be proficient at

solving if they are to succeed.

Bankers must manage their banks

liquidity (reserves regulatory and to

conduct business effectively), capital

(adequacy regulatory and to buffer

against negative shocks), assets, and

liabilities.

There is an opportunity cost to holding

reserves, which pay no interest, andcapital, which must share the profits of

the business.


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Chapter 9 Bank ManagementChapter Summary

While bankers left to their own judgmentswould hold reserves > 0 and capital > 0,

they might not hold enough to prevent

bank failures at what the government or a

countrys citizens deem an acceptably low

rate.

That induces government regulators tocreate and monitor minimum

requirements.

Credit risk is the chance that a borrower

will default on a loan by not fully meeting

stipulated payments on time.

Bankers manage credit risk by screening

applicants (taking applications and

verifying the information they contain),

monitoring loan recipients, requiring

collateral like real estate and

compensatory balances, and including a

variety of restrictive covenants in loans.


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Chapter Summary They also manage credit risk by trading off

between the costs and benefits of

specialization and portfolio diversification.

Interest rate risk is the chance that

interest rates may increase, decreasing

the value of bank assets.

Bankers manage interest-rate risk by

performing analyses like basic gap

analysis, which compares a banks interest

rate-risk sensitive assets and liabilities,

and duration analysis, which accounts for

the fact that bank assets and liabilities

have different maturities. Such analyses combined with interest rate

predictions tell bankers when to increase

or decrease their rate-sensitive assets or

liabilities and whether to shorten or

lengthen the duration of their assets or

liabilities.


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Chapter Summary Bankers can also hedge against interest-

rate risk by trading derivatives, like swaps

and futures, and engaging in other off-

balance sheet activities.

Off-balance sheet activities like fees, loan

sales, and derivatives trading help banks

to manage their interest-rate risk byproviding them with income that is not

based on assets (and hence is off the

balance sheet).

Derivatives trading can be used to hedge

or reduce interest-rate risks but can also

be used by risky bankers or rogue tradersto increase risk to the point of

endangering a banks capital cushion and

hence its economic existence.

Documents

Bank Management - Snapshot