FINC 403

BANK MANAGEMENT

Session 3 – BANKS RISK MANAGEMENT

Lecturer: Dr. Lord Mensah, UGBS

Contact Information: [email protected]

College of Education
School of Continuing and Distance Education
2017/2018 – 2018/2019
 Session Overview
• The session seeks to equip students with
– various risk inherent in banking
– asset and liquidity management to control liquidity risk
– regulatory reserve requirement and bank failure
– risk inherent in off balance sheet activities

Slide 2
 Session Outline
The key topics to be covered in the session are as follows:
• Managing Liquidity risk
• Asset and Liability Management
• Bank Failure
• Credit Risk and Interest Rate risk
• Off-Balance Sheet Lending

Slide 3
 Reading List
• Log onto the UG Sakai LMS course site:
http://sakai.ug.edu.gh
• Watch the Videos for Session 3 – Bank risk
management
• Read Chapter 13 of Recommended Text – R. Glenn
Hubbard, (2007)
• Review Lecture Slides: Session 3 – Selecting A
Research Topic in relation to banking risk
management

Slide 4
Topic One

MANAGING LIQUIDITY RISK

Slide 5
 Managing Liquidity
• Liquidity risk: the likelihood of depositors collectively
withdrawing more funds than the banks has on hand
• Consequence: Banks will liquidate relatively illiquid
loans and possibly receive less than the full value of
the loans
– Reduce risk exposure without sacrificing too much
profitability.
• Minimize liquidity risk by holding more reserves
– Reduces profitability
Managing liquidity risk conti.
• Other strategies to reduce liquidity risk
– Asset and liability management practices
• Asset Management:
– Lend money to other banks through the central bank,
mostly one day at a time.
– Repurchase agreement for government securities
• Lending securities to other businesses and other banks
overnight
• Most banks use the combination
 Trade-Off
• The two strategies reflect the trade-off between
– the lower expected return and default risk of the central
bank funds
– the higher expected return and risk of interest rate interest
rate fluctuations in government securities market
Topic Two

ASSET AND LIABILITY

MANAGEMENT
Slide 9
 Liability management
• To operate profitably,
– banks must keep on hand enough cash or
– asset that are convertible to cash in order to meet
depositors withdrawals.
• More loan opportunities than deposits
– Decision to borrow additional funds to make loans
• Certificates of deposits
• Bank must preserve their ability to borrow so as to
use liability management
Example of Asset and liability Management
• Assume an initial BS of FCP of the form:
FCP
Assets (Millions) Liability(Millions)
Reserves GHS 50 Deposits GHS 200
Marketable securities 10 Net Worth 20
Loans 160

• Required 10% of deposits in reserve

Reserve=required reserve + excess reserve
GHS 50=GHS 20+ GHS 30
• Therefore, FCP large depositors can withdraw 15 millions,
without changing the entries on its BS
– with excess reserves the bank does not need to manage liquidity
actively
– Costly
 No excess reserve
• Making more loans to increase profitability
FCP
Assets (Millions) Liability(Millions)
Reserves GHS 20 Deposits GHS 200
Marketable securities 10 Net Worth 20
Loans 190

• FCP faces withdrawal of GHS 15 million, now

FCP
Assets (Millions) Liability(Millions)
Reserves GHS 5 Deposits GHS 185
Marketable securities 10 Net Worth 20
Loans 190
• To meet the central banks requirement, FCP needs a reserve
of 18.5 million
– Short 13.5 million, sell marketable securities or reduce loans
( reduction of assets)
• Increase liabilities, acquire reserves from other
banks, corporations or from the central bank
• New BS
FCP
Assets (Millions) Liability(Millions)
Reserves GHS 18.5 Deposits GHS 185
Marketable securities 10 Borrowing from other
Loans 190 banks and corporations GHS 6.75
Borrowing from the CB GHS 6.75
Net Worth 20

• FCP has managed its liquidity

Topic Three

BANK FAILURE

Slide 14
 Bank Failure
• If FCP is unable to manage liquidity it can fail
• Suppose, rumours are circulating that GHS 50 million
of FCP loans were made to friends of HFC, the
president, who have lost money in real estate
speculations.
• Angry depositors withdraw 18.5 immediately, leaving
FCP GHS 166.6 million in deposits
– It could hold 16.65 on its reserve
– The reserve has been wiped out
• BS looks like this:
FCP
Asset (Millions) Liablities(Millions)
Reserve GHS 0 Deposits GHS 166.5
Marketable securities 10 Borrowings 13.5
Loans 190 Net Worth 20

• When the bank reduces the value of loans on its books to

GHS 140 million
– Net worth –GHS 30 million
– Convince other banks or the central to lend it funds or have to
close its doors
– Central bank will take control and decides to liquidate it or
merge it with other banks
Topic Four

CREDIT AND INTEREST RATE RISK

Slide 17
Relationship Between Banks
and Borrowers
• Banks are concerned about credit risk, the risk that
borrowers might default.
– which arises because of problems of adverse selection and
moral hazard
• Moral hazard exist in bank loan markets because
borrowers have an incentive,
– once they obtained a loan, to use the proceeds for
purposes that are detrimental to the bank
Methods to Reduce Credit Risk
• Diversification of loans:
– Banks can reduce credit risk by holding a diversified
portfolio of loans
• Credit-risk analysis:
– Banks can also reduce credit risk by performing credit-risk
analysis
– The bank examines the borrower’s likelihood of repayment
and general business conditions that might influence the
borrower’s ability to repay the loan.
Methods to Reduce Credit Risk conti.
• Requiring collateral:
– assets pledged to the bank in the event that the borrower
defaults
• Credit rationing
– To reduce adverse selection and moral hazard problems
banks sometimes practice credit rationing
– which case the size of a borrower’s loan is limited or the
borrower is simply not allowed to borrow any amount at
the going interest rate.
Methods to Reduce Credit Risk conti.
• Restrictive covenants in loan agreements
– To reduce the costs of moral hazard banks monitor
borrowers and place restrictive covenants in loan
agreements
• Long-term relationship with the borrower
– One of the best ways for a bank to gather information
about a borrower’s prospects or to monitor a borrower’s
activities is for the bank to have a long-term relationship
with the borrower
 Interest rate risk
• Banks suffer interest rate risk if market interest rate
changes cause profits to fluctuate.
– Arise in the market interest rate lowers the present value
of the outstanding amount of loan
• Bank are affected by interest rate when
– they raise funds primarily through short-term deposits to
finance loans or
– purchase of securities with longer maturities
 Duration
• Banks must first compare the interest sensitivity of
the values of different asset and liabilities
• Example:

FCP
Assets (Millions) Liability(Millions)
Fixed rate Asset GHS 350 Fixed-rate liabilities GHS 230
Reserves Checkable deposits
Long term marketable Saving deposits
securities Long-term CDs
Long term loans Variable-rate liabilities 230
Variable rate asset 150 Short-term CDs
Floating rate loans Money market deposit accounts
Short-term securities Federal Funds
Net Worth 40
GHS 500 GHS 500
 Duration continue
• To evaluate their exposure to interest rate risk, banks
measure the duration of their assets and liabilities,
– which is the responsiveness of the assets’ or liabilities’ market
value to a change in the market interest rate.
• To assess banks exposure to interest rate risk, its
managers calculate
– the average duration for assets and average duration of
liabilities
– The difference is known as the duration gap, which measures
the bank’s vulnerability to fluctuations in interest rates
• Reducing the size of the duration gap helps banks to
minimize interest rate risk.
 Duration continue
• A measure of the responsiveness of the values V of
asset and liabilities to the changes in interest rate i:
V  i 
 d  
V  1  i 
• The relationship between interest rate and market
value is negative, d indicate the durations
• Net Worth (NW) is
NW  A  L
 A   L 
   
A    L
 A   L 
• Where A is the Asset and L is the Liabilities
• Substitute

A  i  L  i 
 d A   and  d L  
A  1 i  L  1 i 
• d A and d L represent the duration for asset and
liabilities respectively
• Hence:  i 
NW    d A A  d L L   
 1  i 
• The first term in parenthesis represents the duration
gap faced by institutions, and that is

L
Gap  d A  d L  
 A
 Methods to Reduce Interest
Rate Risk
• Floating-rate debt: Banks can reduce the risk of
interest rate fluctuations through the use of floating-
rate debt,
– with the loan interest rate being variable.
• Interest rate swap: Banks can also reduce their
exposure to interest rate (and exchange rate) risk by
using swaps
– that is exchanges the expected future return on one
financial instrument for the expected future return on
another.
• Futures and options contracts: Futures and options
contracts also offer ways for banks to hedge their
exposure to interest rate risk.
Exposure to Risk in Banking Contracts
Topic Five

OFF BALANCE LENDING

Slide 31
 Off-Balance-Sheet Lending
• Off-balance-sheet lending: banks do not hold as
assets the loans they make.
• Examples: standby letter of credit, loan commitment,
and loan sale
• Off-balance-sheet activities have become important
in generating banks’ profits.
• Off-balance-sheet activities have expanded in recent
years