Chapter 10Banking and the Management of Financial Institutions

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The Bank Balance SheetLiabilitiesCheckable depositsNontransaction depositsBorrowingsBank capital

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The Bank Balance Sheet (contd)AssetsReservesCash items in process of collectionDeposits at other banksSecuritiesLoans Other assets

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Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2011

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Basic Banking: Cash DepositOpening of a checking account leads to an increase in the banks reserves equal to the increase in checkable deposits

First National BankFirst National BankAssetsLiabilitiesAssetsLiabilitiesVault Cash+$100Checkable deposits+$100Reserves+$100Checkable deposits+$100

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Basic Banking: Check Deposit

First National BankSecond National BankAssetsLiabilitiesAssetsLiabilitiesReserves+$100Checkable deposits+$100Reserves-$100Checkable deposits-$100

First National BankAssetsLiabilitiesCash items in process of collection+$100Checkabledeposits+$100

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Basic Banking: Making a ProfitAsset transformation: selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristicsThe bank borrows short and lends long

First National BankFirst National BankAssetsLiabilitiesAssetsLiabilitiesRequired reserves+$100Checkable deposits+$100Required reserves+$100Checkable deposits+$100Excess reserves+$90Loans+$90

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General Principles of Bank ManagementLiquidity ManagementAsset ManagementLiability ManagementCapital Adequacy ManagementCredit RiskInterest-rate Risk

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Liquidity Management: Ample Excess ReservesSuppose banks required reserves are 10%If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet

AssetsLiabilitiesAssetsLiabilitiesReserves$20MDeposits$100MReserves$10MDeposits$90MLoans$80MBank Capital$10MLoans$80MBank Capital$10MSecurities$10MSecurities$10M

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Liquidity Management: Shortfall in ReservesReserves are a legal requirement and the shortfall must be eliminatedExcess reserves are insurance against the costs associated with deposit outflows

AssetsLiabilitiesAssetsLiabilitiesReserves$10MDeposits$100MReserves$0Deposits$90MLoans$90MBank Capital$10MLoans$90MBank Capital$10MSecurities$10MSecurities$10M

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Liquidity Management: BorrowingCost incurred is the interest rate paid on the borrowed funds

AssetsLiabilitiesReserves$9MDeposits$90MLoans$90MBorrowing$9MSecurities$10MBank Capital$10M

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Liquidity Management: Securities SaleThe cost of selling securities is the brokerage and other transaction costs

AssetsLiabilitiesReserves$9MDeposits$90MLoans$90MBank Capital$10MSecurities$1M

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Liquidity Management: Federal ReserveBorrowing from the Fed also incurs interest payments based on the discount rate

AssetsLiabilitiesReserves$9MDeposits$90MLoans$90MBorrow from Fed$9MSecurities$10MBank Capital$10M

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Liquidity Management: Reduce LoansReduction of loans is the most costly way of acquiring reservesCalling in loans antagonizes customersOther banks may only agree to purchase loans at a substantial discount

AssetsLiabilitiesReserves$9MDeposits$90MLoans$81MBank Capital$10MSecurities$10M

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Asset Management: Three Goals1. Seek the highest possible returns on loans and securities2. Reduce risk3. Have adequate liquidity

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Asset Management: Four Tools1. Find borrowers who will pay high interest rates and have low possibility of defaulting2. Purchase securities with high returns and low risk3. Lower risk by diversifying4. Balance need for liquidity against increased returns from less liquid assets

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Liability ManagementRecent phenomenon due to rise of money center banksExpansion 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 ManagementBank capital helps prevent bank failureThe amount of capital affects return for the owners (equity holders) of the bankRegulatory requirement

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Capital Adequacy Management: Preventing Bank Failure

High Bank CapitalLow Bank CapitalAssetsLiabilitiesAssetsLiabilitiesReserves$10MDeposits$90MReserves$10MDeposits$96MLoans$90MBank Capital$10MLoans$90MBank Capital$4M

High Bank CapitalLow Bank CapitalAssetsLiabilitiesAssetsLiabilitiesReserves$10MDeposits$90MReserves$10MDeposits$96MLoans$85MBank Capital$5MLoans$85MBank Capital-$1M

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Capital Adequacy Management: Returns to Equity Holders

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Capital Adequacy Management: SafetyBenefits the owners of a bank by making their investment safeCostly to owners of a bank because the higher the bank capital, the lower the return on equityChoice depends on the state of the economy and levels of confidence

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Application: How a Capital Crunch Caused a Credit Crunch During the Global Financial CrisisShortfalls of bank capital led to slower credit growthHuge losses for banks from their holdings of securities backed by residential mortgages.Losses reduced bank capital Banks could not raise much capital on a weak economy, and had to tighten their lending standards and reduce lending.

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Managing Credit RiskScreening and MonitoringScreeningSpecialization in lendingMonitoring and enforcement of restrictive covenants

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Managing Credit Risk (contd)Long-term customer relationshipsLoan commitmentsCollateral and compensating balancesCredit rationing

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Managing Interest-Rate RiskIf 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

First National BankAssetsLiabilitiesRate-sensitive assets$20MRate-sensitive liabilities$50MVariable-rate and short-term loansVariable-rate CDsShort-term securitiesMoney market deposit accountsFixed-rate assets$80MFixed-rate liabilities$50MReservesCheckable depositsLong-term loansSavings depositsLong-term securitiesLong-term CDsEquity capital

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Gap and Duration AnalysisBasic gap analysis:(rate sensitive assets - rate sensitive liabilities) x interest rates = in bank profitMaturity bucked approachMeasures the gap for several maturity subintervals. Standardized gap analysisAccounts for different degrees of rate sensitivity.

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Gap and Duration Analysis (contd)% in market value of security - percentage point in interest rate x duration in years.

Uses the weighted average duration of a financial institutions assets and of its liabilities to see how net worth responds to a change in interest rates.

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Off-Balance-Sheet ActivitiesLoan sales (secondary loan participation)Generation of fee income. Examples:Servicing mortgage-backed securitiesCreating SIVs (structured investment vehicles) which can potentially expose banks to risk, as it happened in the global financial crisis

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Off-Balance-Sheet Activities (contd)Trading activities and risk management techniques Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market and speculation.Principal-agent problem arises

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Off-Balance-Sheet Activities (contd)Internal controls to reduce the principal-agent problemSeparation of trading activities and bookkeepingLimits on exposureValue-at-riskStress testing

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