Chapter 9: Bank Management

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 credit risk.• Describe how bankers manage interest rate risk.• Describe off-balance sheet activities and explain their importance.

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 types of bank assets and liabilities?

• Liabilities – money that companies borrow in order to buy assets

• Equity (Net Worth or Capital) – residual that makes the two sides of the equation balance (banks have little)– A company is economically viable if what it owns exceeds the value of

what it owes (Equity is positive)– A company is not economically viable if the value of what it owes

exceeds the value of what it owns. (Equity is negative)

• The value of assets and liabilities (equity) fluctuates due to changes in interest rates and asset prices

1. The Balance Sheet

1. The Balance SheetFor banks

• Reserves: In this context, cash funds that bankers maintain to meet deposit outflows and other payments

• Required reserves: A minimum amount of cash funds that banks are required by regulators to hold

• Secondary reserves: Noncash, liquid assets, like government bonds, that bankers can quickly sell to obtain cash

AssetsAssets

• Commercial banks own – Reserves of cash and deposits with the Fed– Secondary reserves of government and other

liquid securities– Loans to businesses, consumers, and other banks– Other assets, including buildings, computer

systems, and other physical stuff

LiabilitiesLiabilities

• The right-hand side of the balance sheet lists a bank’s liabilities or the sources of its fund

• Deposits:– Transaction deposits: negotiable order of

withdrawal accounts and money market deposit accounts

– Non-transaction deposits: savings, negotiable certificates of deposit

– Time deposits

• A corporate entity than owns one or more banks and banking-related subsidiaries

Bank Holding Company

LiabilitiesLiabilities

T-AccountsT-Accounts

• Asset transformation and balance sheets provide us with only a snapshot view of a financial intermediary’s business– Intermediaries, like banks, are dynamic places

where changes constantly occur• The easiest way to analyze this dynamism is

via so-called T-accounts– Simplified balance sheets that list only changes in

liabilities and assets

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?

Bank management risksBank management risks

• While earning profits and managing liquidity and capital, banks face two major risks:– Credit risk - The risk of borrowers defaulting on

the loans and securities it owns– Interest rate risk - The risk that interest rate

changes will decrease the returns on its assets and/or increase the cost of its liabilities

3. Bank Management PrinciplesLiquidity management

Net deposit outflow (inflow)

Reserve ratio decreases (increase)

Increase (decrease) reserves

in the cheapest way possible

Sell (buy) assets• high transaction costsSell (extend) loans• adverse selectionSell (buy) securitiesCall in (extend) loans• high opportunity costsIncrease (decrease) deposits• high transaction costs and

added operating costsBorrow from discount window

(Fed)Borrow from (lend to) Fed

Funds (other banks)

3. Bank Management PrinciplesAsset management

• Entails the usual trade-off between risk and return

• Bankers should diversify, make loans to a variety of different types of borrowers,– Preferably in different geographic regions

• Bankers need secondary reserves, some assets that can be quickly and cheaply sold to bolster reserves if need be

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 risk managing• Asymmetric information• Adverse selection• Moral hazard

4. Credit RiskManaging asymmetric information

Screening create information/reduce asymmetry

reduce adverse selection embed information in binding contract

third-party verification

Specialization maximize efficiency of screeningIncrease efficiency create exposure to systemic risk

Long-term loan commitments (line of credit)reduce moral hazard other business services

4. Credit RiskManaging asymmetric information

Securitize collateralreduce moral hazard compensatory balances

loan covenants

Credit rationing no credit at any interest ratereduce adverse selection limit creditreduce moral hazard

5. Interest-Rate Risk

• 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, and the change in interest rates.

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?

6. Off the Balance Sheet

• Banks and other financial intermediaries take off-balance-sheet positions in derivatives markets, including futures and interest rate swaps– Use derivatives to hedge their risks

• Try to earn income should the bank’s main business suffer a decline if, say, interest rates rise

– Hedge their interest rate risk by engaging in interest rate swaps

– Speculate in derivatives and the foreign exchange markets, hoping to make a big killing

6. Off the Balance SheetThe 2008 Crisis: Credit default swaps

“Credit default swaps, which were invented by Wall Street in the late 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 revenue behind 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 (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss.”The New York Times, as quoted in Times Topics

6. Off the Balance SheetThe 2008 Crisis: Credit default swaps

“The market for the credit default swaps has been enormous. Since 2000, 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 totally unregulated.…

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