Learning Unit 18: Assets, Liabilities, and Capital Management

Learning Unit #18

Assets, Liabilities, and Capital Management

Objectives of Learning Unit

Since banks own and owe various types of financial instruments, it is crucial to manage their risk, liquidity, and return.

Asset, liability, & capital management Liquidity management Default risk management Interest rate risk management

Asset, Liability, & Capital Management Different types of assets and liabilities have

different liquidity, return, and risk. There is a trade off between profits and

risk/liquidity on any financial instruments. A bank must manage its assets and liabilities to

earn profits as much as possible while keep its risk low and liquidity high.

Asset, Liability, & Capital Management and Stakeholders Should a bank try to make as much profits as possible?

For any financial instrument, a saver can get a high return only if he takes a high risk and low liquidity, so as banks.

Should a bank take a high risk and low liquidity to achieve high profit? Or, it take a very low risk and get low profits?

High risk means that a bank may not get loaned money back and incur losses.

Low liquidity means that a bank may run out of cash on hand. Bank’s asset, liability & capital management affects both

depositors and shareholders of banks. Are depositors happy if their bank goes out of business because

it takes too much risk, or if their bank run out of cash when they need to get cash?

Are shareholders happy if their bank goes out of business, or if their bank make too little profits?

Three Types of Asset, Liability, & Capital Management

A bank must choose what kind of assets and liabilities it holds and how much of them. Three important considerations are their return, risk, and liquidity. Here, we explore how a bank manage its risk and liquidity and balance with its return. Liquidity management Default (credit) risk management Interest rate risk management

Liquidity Management A bank must maintain its liquidity to meet the

bank’s obligations to depositors. Depositors may withdraw any amount of funds any

time and the bank must be ready. Deposit outflows: Decreases in deposits when

depositors make withdrawals or demand payment. A bank must acquire sufficiently liquid assets.

Vault cash – ready to be dispensed Highly liquid securities (e.g. Treasury bills) – can

be sold immediately for cash. Loans, most profitable (high yield) assets for

banks, are not liquid at all.

Trade off between Liquidity and Profits Should a bank hold a lot of cash on hand and

loan very little deposited funds out? It will earn little profits, but can meet its obligation

to depositors always. Depositors are happy, but not shareholders.

Or, should a bank hold very little cash and loan most of deposited funds out? It will earn high profits, but may not be able to

meet its obligation to depositors sometime. Shareholders are happy, but not depositors.

Liquidity Management: Example Required reserves ratio is 10%. Initial balance sheet of BB&T.

Required Reserves =$11M (10% of $110M deposits) Excess Reserves = $9M ($20M-$11M)

Reserves $20MLoans $90MSecurities $10M

Deposits $110MCapital $10M

BB&T

Liquidity Management: Deposit Outflow

Mr. Gates withdraws $10M from BB&T. This transaction affects both reserves and deposits of

BB&T. T-account of this transaction:

Reserves -$10M Deposits -$10MBB&T

Liquidity Management: Effect of Deposit Outflow Balance sheet of BB&T after $10M withdrawal.

Both reserves and deposits are $10 M less than the initial.

As a result, BB&T’s required and excess reserves also change. Required Reserves =$10M (= 10% of $100M deposits) Excess Reserves = $0M (= $10 Reserves - $10 Required

Reserves) Although BB&T does not have any more excess reserves, it met

Mr. Gate’s request and still meets its reserve requirement.



BB&T

Liquidity Management: Deposit Outflow When Bank Hold No Excess Reserves Mr. Jobs withdraws $10M from BB&T after Mr. Gates.

T-account of this transaction:

Resulting balance sheet of BB&T:

Does BB&T have enough reserves to meet its requirement?

Reserves -$10M Deposits -$10MBB&T



BB&T

Liquidity Management: Effect of Deposit Outflow When Bank Hold No Excess Reserves Required Reserves =$9 M (10% of $90M deposits). With $0 of reserves, BB&T does not meet its legal

requirement of reserves.

The Fed can close BB&T if it does not meet its requirement,

BB&T must come up to $9 M of reserves. When a bank does not have excess reserves (or not

enough excess reserves), after deposit outflows the bank will be short of reserves and must take some actions to obtain enough reserves to meet its requirement.

Three Actions to Increase Reserves

A bank can take one of following actions to raise its reserves. Call loans Sell securities Borrow from the Fed or other banks

Getting more deposits will increase its reserves, but there is no control of deposits inflows by the bank (so a bank should not count on).

Call Loans Call Loans: A bank calls one of its customers and

ask to pay back his loan earlier (before its due). Example: Call Mr. Edwards to pay back $9 M

loans now. When Mr. Edwards pays back to BB&T in cash, Mr. Edwards no longer owes to BB&T, so BB&T’s loan

decreases by $9 M. BB&T has extra $9 M of reserves (cash).

T-accounts of this transaction:

Reserves +$9MLoans -$9M

BB&T

Effect of Calling Loans Once a loan is paid off, BB&T’s balance sheet

should be



BB&T

How much are required reserves? Does BB&T have enough reserves?

Sell Securities Sell securities: A bank sells its inventory of

securities in market at a market price. Example: BB&T sells $9 M of Treasury bills. When BB&T sells $9 M of Treasury bills to

Citibank, BB&T’s security holdings decreases by $9 M. BB&T has extra $9 M of reserves (Fed’s account).


Reserves +$9MSecurities -$9M

BB&T

Effect of Selling Securities Once securities are sold, BB&T’s balance sheet

should be



BB&T

How much are required reserves?

Does BB&T have enough reserves?

Borrow from the Fed or other Bank

Borrowings: A bank may borrow funds from the Fed (discount loan), other bank (federal funds), or corporations (e.g. repos).

Example: Borrow $9M of discount loan from the Fed. BB&T owes $9 M to the Fed (in borrowings). BB&T has extra $9 M of reserves (Fed’s account).


Reserves +$9M Borrowings +$9MBB&T

Effect of Borrowing from the Fed Once BB&T borrows from the Fed, BB&T’s

balance sheet should be

How much are required reserves? Does BB&T have enough reserves?


Deposits $90MBorrowings $9MCapital $10M

BB&T

Costs of Actions to Raise Reserves Although a bank may be able to obtain necessary

funds through calling loans, selling securities, or borrowing from the Fed or other bank, these actions are costly for the bank.

When a bank calls loans, it may jeopardize its customer relations (goodwill) and lower its revenue. Do you like your bank to call you every day and to ask

you to pay back your student loan early? A bank which frequently call loans may lose its customers over time and lower its revenue.

Bank may give a financial incentive to borrowers to pay back early (e.g. lower final payment or low interest rates on next loans).

More Costs of Actions to Raise Reserves When a bank sells its inventory of securities, it may

not be the right price. The bank may earn higher returns on securities if it holds

them until their maturities. When a bank borrows funds from the Fed, other

bank, or corporation, it must pay interest on borrowed funds. These interest rates are high relative to that of deposits. The Fed will not be happy if a bank frequently borrows

funds to meet its requirement. Eventually, the bank is not welcome to borrow.

Benefits and Costs of Excess Reserves Benefits of excess reserves:

If a bank has ample reserves, the bank can still meet the reserve requirement after deposit outflows and will not need to take costly transactions to increase reserves.

Excess reserves are insurance against the costs associated with deposit outflows.

Costs of excess reserves: Excess reserves do not earn revenues, but still cost

banks since it must pay interests on deposits. More excess reserves, less loans the bank makes.

Excess reserves mean lost opportunities to earn more revenues (and profits) from loans that could be made if no excess reserves.

Liquidity Management

A bank must maintain sufficient amount of excess reserves (highly liquid assets) to meet deposit outflows and still meet the reserve requirement in order to avoid costs associated with actions to increase reserves.

The higher the costs associated with deposit outflows, the more excess reserves banks will hold.

The more likely depositors withdraw from the banks, the more excess reserves banks should hold.

Default (Credit) Risk Management Like any financial instruments, loans are risky

and possibly default. A bank must hold sufficient amount of

capital to lessen the chance of becoming insolvent in case of default of its assets.

Insolvency: The value of assets falls below its liabilities.

Bankruptcy: A bank cannot meet its obligation to pay its depositors and creditors.

Bankruptcy vs. Insolvency Any business firms or individuals can be insolvent

any time, but are not necessarily bankruptcy. How much assets do you have? How much liabilities

do you have? Are you insolvent? Even insolvent, they can continue businesses as long

as they pay their due on time. When business firms or individuals cannot meet

their obligations, they default and declare bankruptcy. If you borrow too much and there is no way you can

pay back because your monthly income is less than monthly payment on loans and you do not have any valuable assets, what should you do?

Default Risk Management: Example Required reserve ratio is 10%. Initial balance sheet of First Home federal Bank:

Is FHF solvent or insolvent? Total assets are $130 M. Total liabilities are $100 M (Capital is not a liability!). So, FHF is solvent!



FHF

Default Risk Management: Default and Accounting Transactions A borrower defaults $20M loan from FHF.

$20 M loan will no longer be paid back. FHF must reduce its loans by $20 M on its balance sheet since it

is no longer note “receivable”. $20 M loan will not be back, that means, FHF lost it

permanently. It must report this loss on its income statement. When a firm makes profits, any profits not distributed as

dividends are added to “Retained earnings,” a part of owners’ equity. Conversely, if a bank makes losses, any losses must be reflected in capital (owners’ equity) by subtracting loss amount (defaulted loan value) from its capital (retained earnings).

Writing off: this process of reducing loan amount on book and realizing loss to reflect a loan default on accounting book.

Default Risk Management: Effect of Default T-account of $20M loan write-off:

Resulting balance sheet of FHF:

Is FHF solvent or insolvent? With $110M total assets and $100M total liabilities, FHF is still solvent.

Loans -$20M Capital -$20MFHF



FHF

Default Risk Management: Large Default

Instead of $20 M of loan, $40M of loan from FHF is defaulted. Then, T-account should look as

Resulting balance sheet of FHF:

Loans -$40M Capital -$40MFHF


Deposits $100MCapital -$10M

FHF

Default Risk Management: Effect of Large Default Now, total assets of FHF are $90M, while total liabilities of

FHF are $100 M. FHF is insolvent!

Because FHF did not have large enough capital to write off a large defaulted loan, it becomes insolvent.

Although FHF is insolvent, it can still run its banking business as usual. FHF needs to make profits over time to make up this loss and

eventually will have enough assets to pay back all liabilities. If depositors decide to withdraw all deposits from FHF,

then FHF will not have enough assets to meet its obligation (Bank failure). FHF must declare bankruptcy! E.g. IndyMac Bank of CA in 2008. How to prevent depositors to withdraw funds out of FHF (so FHF

can avoid bankruptcy)?

Capital Adequacy Management and Default Risk Management A bank must hold adequate amount of capital in

case of loan default and avoid insolvency. A bank can raise its capital by issuing more stocks. A bank can increase its capital by retaining its profits

rather than distributing them as dividends. The government must set some mechanism to

discourage depositors from withdrawing funds from insolvent banks. FDIC [Learning Unit 20]

A bank must reduce default risk on loans.

Bank Capital Requirement

Bank failure is costly to shareholders, FDIC (even government in case of S&Ls), community (limit availability of loans), and the whole economy.

Bank capital requirement: the government sets minimum amount of capital that each bank must hold, based on amount of its assets and their risk. Basel Accord: International standardized risk-based

capital requirement [Learning Unit 20]

Managing Default (Credit) RiskA bank can reduce risk on loans through Screening and monitoring Long-term customer relationship Loan commitments: Bank’s commitment to provide a

firm with loans up to a given amount (line of credit). Collateral and compensating balance: A firm receiving

a loan must keep a required minimum amount of funds at the bank.

Credit rationing: Refusing to make loansAll of these actions reduce the problems of adverse selection and moral hazard arisen from asymmetric information, faced by banks.

Screening & Monitoring

Adverse selection in loan requires that lenders screen out the bad credit risks from the good ones.

If someone wants to borrow your money, what do you do first (beside say no)?

Effective screening and information collection are two important parts of default risk management. They are achieved through Loan application (information collection) Background check (information verification) Credit score (risk assessment)

Screening & Monitoring Specialization in Lending: A bank may specialize

in lending to local firms or to firms in particular industries, because it is easier to collect information and to develop expertise. Ex. Mortgage loans to households who purchase

houses locally Monitoring and Enforcement of Restrictive

Covenants: A bank must monitor borrowers to adhere the restrictive covenants (what borrowers can do and not to do) on loan contracts in order to prevent or minimize costs of moral hazard. Ex. Foreclosure of house if not paid on time

Long-term Customer Relationship Bank accumulates information of borrowers

through its long-term customer relationships. Detail financial information of potential borrowers Behavior information of potential borrowers (Big

spender? Gambler?) These information helps bank to make better decision

by reducing asymmetric information. Your bank knows a lot of your finance:

How much you earn each month. Where you work (if your salary is directly deposited at

your bank). How you spend your money.

Loan Commitments Loan commitment: A bank’s commitment to

provide a customer with loans up to a given amount at an interest rate that is tied to some market interest rate. Business loans: a bank pre-approve a loan up to

certain amount and a firm can get it any time. Home equity line of credit: use real estate as collateral,

a household can borrow up to a pre-approved amount. Credit card: you can borrow up to credit limit and its

interest rate is determined by xx% above the prime rate.

Loan commitments promote a long-term relationship with customers and facilitate information collection.

Collateral and Compensating Balance Collateral: property that is pledged to the lender to

guarantee payment in the event that the borrower is unable to make debt payments. If you get an auto-loan when you purchase your car, your car is

most likely a collateral for the auto-loan. All mortgage loans require real estates (land and house) as

collateral. Collateral not only reduce loss in event of default, but also reduce

moral hazard (borrowers are more likely to pay back their loans in order to keep their properties).

Compensating balance: when a bank makes a loan to its customer, it requires the customer to maintain minimum balance in its account. It is one type of collateral, because the bank can seize it if the

borrower defaults.

Credit Rationing

Credit rationing: a bank refuses to make or extend loans to borrowers, who are willing to pay the stated interest rate or even a higher rate. A bank refuses to make loans of any amount to

potential borrowers as a way of weeding risky borrowers with adverse selection.

A bank restricts the size of the loan to less than the borrower would like in order to minimize the moral hazard problem.

Interest Rate Risk of Bank

Interest rate risk: A price of security may change and its total rate of return when the market interest rate changes. [Learning Unit #10]

Since a bank holds a variety of financial instruments with different maturities, any changes in market interest rates have an effect on bank’s financial condition.Most of bank’s assets and liabilities are

financial instruments with maturity!

Measuring Interest Rate Risk of Bank

A change in market interest rate affects Bank’s revenue and cost: Interest rates on some

assets and liabilities may change as market interest rate changes, affecting its revenue and cost.

Value of bank’s assets and liabilities: Depending on maturity, value of assets and liabilities change as market interest rates change.

Two methods to measure bank’s exposure to interest rate risk: Gap analysis to measure its effect on bank’s profits Duration analysis to measure its effect on values of

bank’s assets and liabilities

Gap Analysis Gap analysis measures the sensitivity of bank

profits to changes in market interest rates.

Gap = the amount of rate-sensitive assets minus the amount of rate-sensitive liabilities.

Profit = Gap x i

where Profit is a change in bank’s profits i is a change in market interest rate

Rate Sensitive and Fixed Rate Assets and Liabilities Rate sensitive assets and liabilities are those financial

instruments whose interest rates change as a market interest rate changes. Examples of rate sensitive assets: Adjustable rate mortgage

loans, credit card loans Examples of rate sensitive liabilities: money market accounts,

checkable deposits (with variable rate) Fixed rate assets and liabilities are those financial

instruments whose interest rates do not change when a market interest rate changes. Examples of fixed rate assets: Fixed rate mortgage loans, auto-

loans, student loans, Treasury securities, Reserves (0% always) Examples of fixed rate liabilities: CDs, checkable deposits (with

no interest)

Gap Analysis: Example A bank has the following rate-sensitive and fixed-

rate assets and liabilities:

The Gap of the bank is -$300M = $200M of rate sensitive assets - $500M of rate sensitive liabilities.

If the market interest rates increase by 5%, then its profits will decrease by $15M.

Profit = -$300M x 5% = -$15M

Rate-sensitive $200MFixed-rate $800M

Rate-sensitive $500MFixed-rate $500M

Duration Analysis Duration analysis measures the sensitivity of

market values of total assets, liabilities, and net worth to changes in market interest rates.

%(Market value of asset) = -%i x (Duration of asset)

where %(Market value of asset) is a percentage change

in market value of assets, %i is a percentage change in interest rate

Duration Duration: a weighted average number of years of

cashflows from a financial instrument. Weights are present values of cashflows.

If all cashflows come at its maturity like zero-coupon bonds, then its duration will be the same as its maturity. A zero-coupon bond with 10 year maturity has 10

year of duration. If some cashflows come before its maturity like coupon

bonds, then its duration will be less than its maturity. If one instrument pays out $500 one year later and

another $500 two years later, then the duration is about 1.5 years.

Duration Analysis: Example A bank has the following balance sheet:

where Duration of total assets = 5 years Duration of total liabilities = 3 years

Note: In this class a duration information is given.

Total assets $200M Total Liab. $180MCapital $20M

Book Value

Duration Analysis: Example If the market interest rates increase by 5%, then

%(Market value of total assets) = - 5% (of interest rate increase) x 5 (years of duration) = -25%%(Market value of total liab.) = - 5% (of interest rate increase) x 3 (years of duration) = -15%

Note: There is a minus sign in front of interest rate change in the formula.A percentage change in value of total liabilities is computed in the

same manner as a percentage change in value of total assets.The formula is not applied to compute a percentage change in

value of capital!

Market Values of Balance Sheet Although a change in market interest rates does

not affect the book values of assets and liabilities, their market values are affected. Book values of assets and liabilities are historical

costs of those assets and liabilities, so they do not change.

When a bank has to sell its assets, it may not be able to sell them at their book value, but at on-going market prices.

Duration analysis measures market values of bank’s assets and liabilities, not book values. It tells how much actually banks can get if it liquidates

all assets and liabilities today.

Market Values of Total Assets and Total Liabilities: Example Duration analysis indicates that a market value

of total assets is 25% less than the book value of total assets.

Market value of total assets = $200M (of book value of total assets) – 25% x $200M = $150M

A market value of total liabilities is 15% less than the book value of total liabilities.

Market value of total liabilities = $180M (of book value of total liabilities) – 15% x $180M

= $153M

Net Worth

Net worth: Market value of capital Net worth = Market value of total assets minus Market value of total liabilities

Net worth = $150M (of total assets) - $153M (of total liabilities) = -$3M

Market value of the balance sheet:

Total assets $150M Total Liab. $153MCapital -$3M

Market Value

Interest Rate Risk of Bank Most banks have a negative gap because they

tend to have large amount of fixed-rate assets (e.g. securities, most loans, reserves).

When the market interest rates increase, most banks experience a fall of their profits, or even losses.

All banks have longer duration on their assets than their liabilities because they provide asset transformation services to make profits.

When the market interest rates increase, net worth of all banks decreases or even becomes negative (insolvency!).

Interest Rate Risk Management

Banks can reduce their exposure to the interest rate risk by Increasing gapReducing duration of assets and increasing

duration of liabilities

Interest Rate Risk Management: Increasing Gap Banks increase their gaps by

Obtaining more rate-sensitive assetsMake more adjustable-rate mortgage loans and

credit card loans Holding less fixed-rate assets

Sell fixed-rate loans (loan sales of off-balance sheet activity)

Issuing more fixed-rate liabilities Issue more fixed-rate CDs

Engaging in derivative tradingSwap fixed-rate assets with variable-rate assets Issue futures or purchase call options

Interest Rate Risk Management: Changing Durations Reducing duration of assets by

Making more short-term loans Purchasing more short-term securities

Increasing duration of liabilities by Issuing more long-term CDs Issuing long-term bonds

These actions to affect durations of assets and liabilities may reduce bank’s revenues and increases bank’s costs, resulting in lower profits. Like liquidity management and default risk

management, there is a trade-off between safety and profits.

Assets, Liabilities, and Capital Management and Bank’s Profits Banks can reduce their default (credit) risk and

interest rate risk and increase their liquidity by obtaining particular assets or liabilities.

Banks’ actions to reduce risk and increase liquidity tend to reduce their profits.

Assets, liabilities, and capital management must balance between risk and profits. Some banks are more on safe side with low profits. Other banks aim for high profits with high risk. Their choices are affected by shareholders of banks,

depositors of banks, creditors of banks, CEO of banks, and government regulators.

Disclaimer

Please do not copy, modify, or distribute this presentation without author’s consent.

This presentation was created and owned byDr. Ryoichi Sakano

North Carolina A&T State University

Economy & Finance

Learning Unit 18: Assets, Liabilities, and Capital Management