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    Lecture 6

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    superztt
    This document discusses various aspects of bank performance and management. It covers topics such as liquidity management, asset management, liability management, capital adequacy management, credit risk management, interest rate risk management, and off-balance sheet activities. The key goals for banks are to seek profits while maintaining adequate liquidity and managing various risks like credit risk, interest rate risk, and capital levels. Ratios are also used to evaluate bank performance.

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    Lecture 6

    Uploaded by

    superztt
    16 views25 pages
    This document discusses various aspects of bank performance and management. It covers topics such as liquidity management, asset management, liability management, capital adequacy management, credit risk management, interest rate risk management, and off-balance sheet activities. The key goals for banks are to seek profits while maintaining adequate liquidity and managing various risks like credit risk, interest rate risk, and capital levels. Ratios are also used to evaluate bank performance.

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    This document discusses various aspects of bank performance and management. It covers topics such as liquidity management, asset management, liability management, capital adequacy management, credit risk management, interest rate risk management, and off-balance sheet activities. The key goals for banks are to seek profits while maintaining adequate liquidity and managing various risks like credit risk, interest rate risk, and capital levels. Ratios are also used to evaluate bank performance.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    16 views25 pages

    Lecture 6

    Uploaded by

    superztt
    This document discusses various aspects of bank performance and management. It covers topics such as liquidity management, asset management, liability management, capital adequacy management, credit risk management, interest rate risk management, and off-balance sheet activities. The key goals for banks are to seek profits while maintaining adequate liquidity and managing various risks like credit risk, interest rate risk, and capital levels. Ratios are also used to evaluate bank performance.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 25

    Measuring Bank

    Performance
    Chapter 10
    Basic Banking: Check Deposit
    When a bank receives
    additional deposits, it
    gains an equal amount of reserves;
    when it loses deposits,
    it loses an equal amount of reserves

    First National Bank Second National Bank


    Assets Liabilities Assets Liabilities
    Reserves +$100 Checkable +$100 Reserves -$100 Checkable -$100
    deposits deposits
    Basic Banking: Making a Profit
    First National Bank First National Bank
    Assets Liabilities Assets Liabilities
    Required +$10 Checkable +$100 Required +$10 Checkable +$100
    reserves deposits reserves deposits

    Excess +$90 Loans +$90


    reserves

    • Asset transformation: selling liabilities with one


    set of characteristics and using the proceeds
    to buy assets with a different set of
    characteristics
    • The bank borrows short and lends long
    General Principles of Bank
    Management
    • Liquidity Management
    • Asset Management
    • Liability Management
    • Capital Adequacy Management
    • Credit Risk
    • Interest-rate Risk
    Liquidity Management: Ample
    Excess Reserves
    Assets Liabilities Assets Liabilities
    Reserves $20 Deposits $100 Reserves $10 Deposits $90
    Loans $80 Bank $10 Loans $80 Bank $10
    Securities $10 Capital Securities $10 Capital

    • Suppose bank’s 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
    Liquidity Management:
    Shortfall in Reserves
    Assets Liabilities Assets Liabilities
    Reserves $10 Deposits $100 Reserves $0 Deposits $90
    Loans $90 Bank $10 Loans $90 Bank $10
    Securities $10 Capital Securities $10 Capital

    • Reserves are a legal requirement and the


    shortfall must be eliminated
    • Excess reserves are insurance against the costs
    associated with deposit outflows
    Asset Management: Three
    Goals
    • 1. Seek the highest possible returns on loans
    and securities
    • 2. Reduce risk
    • 3. Have adequate liquidity
    Asset Management: Four Tools
    • 1. Find borrowers who will pay high
    interest rates and have low possibility
    of defaulting
    • 2. Purchase securities with high returns and low
    risk
    • 3. Lower risk by diversifying
    • 4. Balance need for liquidity against increased
    returns from less liquid assets
    Liability Management
    • Recent phenomenon due to rise of money
    center banks
    • Expansion of overnight loan markets and new
    financial instruments (such as negotiable CDs)
    • Checkable deposits have decreased in
    importance as source of bank funds
    Capital Adequacy Management:
    Preventing Bank Failure
    High Bank Capital Low Bank Capital
    Assets Liabilities Assets Liabilities
    Reserves $10 Deposits $90 Reserves $10 Deposits $96

    Loans $90 Bank $10 Loans $90 Bank $4


    Capital Capital

    High Bank Capital Low Bank Capital


    Assets Liabilities Assets Liabilities
    Reserves $10 Deposits $90 Reserves $10 Deposits $96

    Loans $85 Bank $5 Loans $85 Bank -$1


    Capital Capital
    Application: How a Capital
    Crunch Caused a Credit Crunch
    During the Global Financial Crisis
    • Shortfalls of bank capital led to slower credit
    growth
    o Huge losses for banks from their holdings of
    securities backed by residential mortgages.
    o Losses reduced bank capital
    • Banks could not raise much capital on a weak
    economy, and had to tighten their lending
    standards and reduce lending.
    Capital Adequacy
    Management: Safety
    • Benefits the owners of a bank by making their
    investment safe
    • Costly to owners of a bank because the higher
    the bank capital, the lower the return on
    equity
    • Choice depends on the state of the economy
    and levels of confidence
    Capital Adequacy
    Management
    • Bank capital helps prevent bank failure
    • The amount of capital affects return for the
    owners (equity holders) of the bank
    • Regulatory requirement
    Managing Credit Risk
    • Screening and Monitoring
    o Screening
    o Specialization in lending
    o Monitoring and enforcement of
    restrictive covenants
    Managing Credit Risk
    (cont’d)
    • Long-term customer relationships
    • Loan commitments
    • Collateral and compensating balances
    • Credit rationing
    Managing Interest-Rate Risk
    First National Bank
    Assets Liabilities
    Rate-sensitive assets $20 Rate-sensitive liabilities $50
    Variable-rate and short-term Variable-rate CDs
    loans
    Short-term securities Money market deposit
    accounts
    Fixed-rate assets $80 Fixed-rate liabilities $50
    Reserves Checkable deposits
    Long-term loans Savings deposits
    Long-term securities Long-term CDs
    Equity capital

    • 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
    • Basic gap analysis:
    (rate sensitive assets - rate sensitive liabilities) * 
     interest rates = 
     in bank profit
    • Maturity bucked approach
    o Measures the gap for several maturity
    subintervals.
    • Standardized gap analysis
    o Accounts for different degrees of rate
    sensitivity.
    Duration Gap Analysis
    Duration Gap Analysis
    (cont’d)
    • Strong Assumptions.
    o Yield curve is flat.
    o Yield curve is unchanging.
    o Formula works for “small” changes in interest
    rates.
    o Duration is an estimate
    • Solutions (beyond our scope and not without their
    own flaws).
    o Value at Risk (VaR).
    o Scenario Analysis.
    o Derivatives
    Off-Balance-Sheet
    Activities
    • Loan sales (secondary loan participation)
    • Generation of fee income. Examples:
    o Servicing mortgage-backed securities
    o Creating SIVs (structured investment
    vehicles) which can potentially expose
    banks to risk, as it happened in the global
    financial crisis
    Off-Balance-Sheet
    Activities (cont’d)
    • Trading activities and risk management
    techniques
    o Financial futures, options for debt
    instruments, interest rate swaps, transactions
    in the foreign exchange market and
    speculation.
    o Principal-agent problem arises
    Off-Balance-Sheet
    Activities (cont’d)
    • Internal controls to reduce the principal-agent
    problem
    o Separation of trading activities and
    bookkeeping
    o Limits on exposure
    o Value-at-risk
    o Stress testing
    Basic Financial Ratios

    EM = Assets/ Bank Capital

    Leverage Ratio = Bank Capital/Assets

    NonInterest Expense
    ER 
    Interest Income  NonInterest Income - Interest Expense

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