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Chapter 9 Notes (Part 2)

(expanded by R. Ledesma from the publisher’s PPT slides)

Banking and the Management of Financial Institutions

Trade-off Between Safety and Returns to Equity Holders (cont.)

In more uncertain times, bank managers might want to hold more capital to
protect the equity holders. Conversely, if they have confidence that loan losses
won’t occur, they might want to reduce the amount of bank capital, have a high
equity multiplier, and thereby increase the return on equity.
Bank Capital Requirements
Banks also hold capital because they are required by regulatory authorities. Because of the high
cost of holding capital, bank managers often want to hold less capital than is required by the
regulatory authorities.
Strategies for Managing Bank Capital
Suppose that as the manager of High Capital Bank you are concerned that the bank has a ratio
of bank capital to assets equal to 10 % ($10 M of capital and $100 M of assets), which is high
and is causing the return on equity to be too low. You think that the bank has a capital surplus
and should increase its equity multiplier to raise the return on equity.
To lower the amount of capital relative to assets and raise the equity multiplier (thereby
increasing the return on equity) (êcapital à é EM à é ROE), you can do any of the
following three things: (i) buying back some of the bank’s stocks, (ii) paying out higher
dividends to the bank’s stockholders (there by reducing the bank’s retained earnings), (iii) you
can keep the bank’s capital constant but increase the bank’s assets by acquiring new funds⎯say
by issuing CDs⎯and then seeking out loan business or purchasing more securities with these
new funds. It might enhance your standing with stockholders if you go for strategy (ii).
On the other hand, what if you were manager of Low Capital Bank which has low ratio of
bank capital to assets of 4 %? In this case, the bank is short on capital relative to assets and does
not have a sufficient cushion to prevent bank failure.
To raise capital (écapital à ê EM à ê ROE), you can: (i) have the bank issue equity
(common stock), (ii) reduce the bank’s dividends to shareholders, thereby increasing retained
earnings that it can put into its capital account, (iii) keep capital at the same level but reduce the
bank’s assets by making fewer loans or by selling off securities and then using the proceeds to
reduce it liabilities.
If the capital markets are tight or if shareholders don’t want lower dividend payments, then
you’re better off with strategy (iii) lending less, thus, reducing the size of the bank (ê loans à
êassets à ê EM).
Conclusion: A shortfall of bank capital is likely to lead to a bank reducing its assets and
therefore a contraction in lending.

How a Capital Crunch in the U.S. Caused a Credit Crunch in 2008 and 2009
It appears that the 2008-2009 credit crunch (a time when credit was hard to get) in the U.S.
was caused in part by a capital crunch, in which shortfalls of bank capital led to slower growth in
the U.S. economy. At the time, a major boom and bust in the U.S. housing market led to huge
losses for banks from their holdings of securities backed by residential mortgages.
These losses reduced bank capital and led to capital shortfalls: Banks had to either raise new
capital or restrict asset growth by cutting back on lending. Banks did try to raise new capital but
with the growing weakness of the economy, raising new capital was very hard so banks also
chose to tighten their lending standards and reduce lending. Both of these produced a weak U.S.
economy in 2008 and 2009.
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Managing Credit Risk

Banks must make successful loans that are paid back in full (and in the process subject their
institutions to as little credit risk as possible) if they are to earn high profits.
Adverse selection in loan markets happens because bad credit risks (those most likely to
default on their loans) are the ones who usually apply for loans: in other words, those who are
most likely to produce an adverse outcome (default) are the most likely to be selected from the
pool of loan applicants.
Since they are also the type of borrowers who are most likely to have very risky investment
projects (which, if successful, have much to gain), they are the most eager to obtains loans. But
from the banks’ standpoint, they are the least desirable because of the greater possibility of
default.
Moral hazard in loan markets exists because borrowers, after obtaining the loan, may have
incentives to engage in activities that are undesirable from the lender’s point of view (like a risky
investment which could prove hugely profitable to the borrower if successful but also makes it
more likely for the loan to be repaid) but which could subject the lender to the hazard of default.

The attempts of financial institutions to overcome adverse selection and moral hazard
problems help explain a number of principles for managing credit risk: (i) screening and
monitoring, (ii) establishment of long-term customer relationships, (iii) loan commitments, (iv)
collateral and compensating balance requirements, and (v) credit rationing.

Screening & Monitoring

Asymmetric information is present in loan markets because lenders have less information
about the investment opportunities of borrowers than borrowers do. This situation leads to two
information-producing activities by banks and other financial institutions⎯screening and
monitoring.

Screening
Adverse selection in loan markets requires banks or lenders to screen out bad credit risks from
the good ones so that loans are profitable to them. To do this effectively, lenders must collect
reliable information from prospective borrowers. Effective screening and information collection
together from an important principle of credit risk management.
When you take out a car loan or a mortgage for a home, you will be asked to fill out forms
requiring you to spill out a lot of your private information to the bank or the lender.
You will be asked about your salary, bank accounts, assets (such as cars, stocks or insurance
policies), outstanding loans, credit card, loan or credit card record (payment histories,
bankruptcies, of any), work history and who your employers have been, criminal record, health
record, military service record. You will also likely to be asked about your age, marital status,
and number of children or dependents.
All of these information will be utilized by the lender to evaluate how good a credit risk you
are by calculating (in the U.S.) your credit score, a statistical measure derived from your answers
that predicts whether you are more or less likely to have problems paying your loan payments.
Deciding on whether you are a good or bad credit risk is not entirely scientific. Sometimes a
lender must also use judgment. E.g., the loan officer who decides on whether to grant you a loan
or not might talk to your employer(s) or the references you supplied. Or the loan officer could
also size you up by your looks (appearance) or demeanor.
The same process of screening and collecting information applies when it comes for the bank
to decide whether or not to grant a business loan (to a company or business). The lender collects
information about the company’s profits and losses (income), and about its assets and liabilities,
its likely future success or future plans, purpose of the loan, and the competition in the industry.
The loan officer might also visit the factory of the company to get a firsthand look at its
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operations (or if it even has one). In short, whether it’s a personal or business loan, bankers or
lenders have to be nosy.

Specialization in Lending
Although puzzling, the fact is banks often specialize in lending to local firms or firms in
particular industries, such as energy or construction or mining (puzzling because this means
banks are not diversifying their loan portfolio, exposing themselves to more risk).
But in another sense, it also makes sense. By lending to local firms instead of faraway firms,
bank are better able (easier) to collect information, hence, better able to screen out bad credit
risks. Also, by concentrating their lending on firms in specific industries, banks become more
knowledgeable about these industries and are better able to predict which firms will make timely
payments on their loans.

Monitoring and Enforcement of Restrictive Covenants

To reduce moral hazard (after a loan is made to a borrower), banks can manage credit risks by
writing provisions (restrictive covenants) into loan contracts that restrict borrowers from
engaging in risky activities.
By monitoring borrowers’ activities to see whether they are complying with the restrictive
covenants and by enforcing the covenants if they are not, lenders can make sure that borrowers
are not taking risks at their expense. The need for banks/lenders to engage in screening and
monitoring explains why they spend so much money on auditing and information-collecting
activities.

Establishment of Long-term Customer Relationships

If a prospective borrower has a savings or checking account or other loans with the bank, a
loan officer can look at past activity on the accounts and learn quite a bit about the borrower. The
balances in the checking or savings account can tell the banker how liquid the potential borrower
is and at what time of year the borrower has a strong need for cash.
A review of the checks the borrower has written reveals the borrower’s suppliers. If the
borrower has previously borrowed, the bank would have a record of loan payments. Thus long-
term customer relationships reduce the costs of information gathering/collection and make it
easier to screen out bad credit risks.
Long-term relationships also benefit the customer. A firm with previous relationship will find
it easier to get a loan with a low interest rate because the bank finds it easier to determine if the
borrower is a good credit risk and incurs fewer costs in monitoring the borrower.
A long-term relationship has another advantage for the bank. If a borrower wants to preserve
a long-term relationship with the bank because it will be easier to get future loans at low interest
rates, then the borrower has an incentive to void risky activities that would upset the bank even if
restrictions on these activities are not specified in the loan contract. E.g., if a bank doesn’t like
what a borrower is doing (even if the borrower is not violating any restrictive covenant), it can
threaten the borrower not to have new loans in the future.
Thus, long-term customer relationships enable banks to deal with even unanticipated moral
hazard contingencies.
Loan Commitments
Banks also create long-term relationships and gather information by issuing loan
commitments to commercial customers. A loan commitment is a bank’s commitment (for a
specified future period of time) to provide a firm with loans up to a given amount at an interest
rate that is tied to some market interest rate.
The advantage for the firm is that it has a source of credit when it needs it. The advantage for
the bank is that the loan commitment promotes a long-term relationship, which in turn facilitates
information collection (before agreeing on a loan commitment, the bank can collect information
on the creditworthiness of a borrower).
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In addition, provisions in the loan commitment agreement require that the firm continually
supply the bank with information about the firm’s income, asset and liability position, business
activities, and so on. A loan commitment arrangement is a powerful method for reducing the
bank’s costs for screening and information collection.

Collateral and Compensating Balance Requirements

Collateral, which is property promised to the lender as compensation if the borrower defaults,
lessens the consequences of adverse selection because it reduces the lender’s losses in the case of
a loan default. It also reduces moral hazard because the borrower has more to lose from a default.
One particular form of collateral required when a bank makes commercial loans is called
compensating balances. A firm receiving a loan must keep a required minimum amount of funds
in a checking account at the bank.
For example, a business receiving a $10 M loan may be required to keep compensating
balances of at least $1 M in its checking account at the bank. This $1 M in compensating
balances can be taken by the bank to make up some of the losses on the loan if the borrower
defaults.
Compensating balances also help increase the likelihood that a loan will be paid off. They do
this by helping the bank monitor the borrower and consequently reduce moral hazard. How so?
Specifically, by requiring the borrower to use a checking account at the bank, the bank can
observe the firm’s check payment practices, which may yield a great deal of information about
the borrower’s financial condition.
For example, a sustained drop in the borrower’s checking account balance may signal that the
borrower is having financial trouble, or account activity may suggest that the borrower is
engaging in risky activities: perhaps a change in suppliers means that the firm is pursuing new
lines of business. Any significant change in the borrower’s payment procedures is a signal to the
bank that it should make inquiries.
Compensating balances therefore make it easier for banks to monitor borrowers more
effectively and are another important credit risk management tool.

Credit Rationing
Credit rationing is another way for banks to deal with adverse selection and moral hazard.
Credit rationing is refusing to make loans even though borrowers are willing to pay the stated
interest rate or even a higher rate. Two forms of credit rationing: (i) when a lender refuses to
make a loan of any amount to the borrower even if the borrower is willing to pay a higher
interest rate; (ii) when a lender is willing to make a loan but restricts the size of the loan to less
than the borrower would like.
In the case of the first type of credit rationing or (i), why doesn’t the lender just make the loan
at a higher interest rate even if the potential borrower is a credit risk?
The answer is that adverse selection prevents this solution because it is precisely those firms
and individuals with the riskiest investment projects who would be applying and be willing to
pay the higher interest rate. The more likely outcome is that the borrower would not succeed and
the loan not repaid.
So charging a higher interest rate just makes adverse selection worse for the lender⎯that is, it
increases the likelihood that the lender is lending to a bad credit risk. The lender would therefore
not make any loans at a higher interest rate. Instead, it would engage in the first type of credit
rationing ((i) above) and would turn down loans.
When banks and other lending institutions grant loans to borrowers but not in amounts as large
as borrowers would want, banks may be said to engage in the second type of credit rationing ((ii)
above) to guard against moral hazard. If banks find it necessary to do this sometimes, it’s
because the larger the loan, the greater is the incentive of a borrower to engage in risky activities
that make it less likely for the loan to be repaid.
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More borrowers are able to repay loans that are smaller in amounts than when they are larger.
Thus, it is no wonder that banks/lenders ration credit by providing borrowers with smaller loans
than they seek.

Managing Interest Rate Risk

Interest rate risk is the riskiness of earnings and returns that is associated with changes in
interest rates.
Consider the balance sheet of First National Bank below.

A total of $20M of the bank’s assets are rate-sensitive, with interest rates that change
frequently or at least once a year, while $80M of its assets are fixed-rate, with interest rates that
remain unchanged for a long period (over a year).
On the liabilities side, the bank has $50M of rate-sensitive liabilities and $50M of fixed-rate
liabilities.
Suppose that interest rates rise by 5 percentage points on average from $10 % to 15 %. The
income (cash inflow) on the assets increases by $1M (= 0.05 x $20M) while the payments on the
liabilities (cash outflow) increase by $2.5M (= 0.05 x $50M). Thus, the bank’s profits decline by
$1.5M (= $1M − $2.5M).
Conversely, if interest rates fall by 5 percentage points, the bank’s profits increase by $1.5M
(prove this to yourself). Conclusion: If 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.

Gap and Duration Analysis

The sensitivity of bank profits to changes in interest rates can be measured more directly using
gap analysis, in which the amount of rate-sensitive liabilities is subtracted from the amount of
rate-sensitive assets. From the example,

gap = rate-sensitive assets − rate-sensitive liabilities

gap = $20M − $50M = − $30M
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By multiplying the gap times the change in the interest rates, we can immediately obtain the
effect on bank profits. For example, when interest rates rise by 5 percentage points,

Δ bank profits = (gap)(Δ interest rates)

Δ bank profits = (− $30M)(+ 0.05)
= − $1.5M
Conversely, when interest rates drop by 5 percentage points,

Δ bank profits = (− $30M)(− 0.05)

= $1.5M
The above is an example of what is known as basic gap analysis, which can be refined in two
ways.

Clearly not all assets and liabilities in the fixed-rate category have the same maturity. One
refinement, the maturity bucket approach, is to measure the gap for several maturity subintervals
(called maturity buckets) so that effects of interest rate changes over a multiyear period can be
calculated. The second refinement, the
standardized gap analysis, accounts for the differing degrees of rate sensitivity for different rate-
sensitive assets and liabilities.
An alternative method for measuring interest-rate risk, called duration analysis, examines the
sensitivity of the market value of the banks total assets and liabilities to changes in interest rates.
It uses the weighted average duration of a financial institution’s assets and of its liabilities to see
how net worth responds to a change in interest rates. (Duration measures the average lifetime of
a security’s stream of payments (how long before the loans are paid off entirely.)
Suppose the average duration of a bank’s assets is 3 years (i.e., the average lifetime of the
stream of payments is 3 years), whereas the average duration of its liabilities is 2 years. Assume
that a bank has $100M of assets and, say, $90M of liabilities, so its bank capital is 10% of assets
(or 10M). With a 5-percentage point increase in interest rates, the market value of the bank’s
assets falls by 15% (= − 5% x 3 years) (the loans become less valuable if sold in the market after
the drop in interest rates). That is a decline of $15M on assets of $100M. However, the market
value of liabilities falls by 10% (= − 5% x 2 years), a decline of $9M on the $90M of liabilities
(securities like bonds drop in price with a rise in interest rates).
The net result is that the net worth (the market value of assets minus the liabilities) has
decreased by $6M, or 6% of the total original asset. Similarly, a 5-percentage point decline in
interest rates increases the net worth by 6% of the total value.
Both duration analysis and gap analysis indicate that the bank will suffer if interest rates rise
but will gain if interest rates fall. To lower interest rate risk, (i) shorten the duration of assets,
and (ii) shorten the duration of liabilities. Thus, duration analysis and gap analysis are useful
tools for informing a bank manager of the institution’s degree of exposure to interest-rate risk.