Banking and The Management of Financial Institutions

Chapter 10
Banking and
the Management
of Financial
Institutions
The Bank Balance Sheet

Liabilities
10-2
Checkable deposits
Nontransaction deposits
Borrowings
Bank capital
2013 Pearson Education, Inc. All rights reserved.
The Bank Balance Sheet (contd)

Assets
10-3
Reserves
Cash items in process of collection
Deposits at other banks
Securities
Loans
Other assets
Table 1 Balance Sheet of All

Commercial Banks (items as a
percentage of the total, June 2011
10-4
Basic Banking: Cash Deposit
First National Bank

Assets
Vault
Cash
+$100
First National Bank
Liabilities
Checkable
deposits
+$100
Assets
Reserves
+$100
Liabilities
Checkable
deposits
+$100
Opening of a checking account leads to an increase

in the banks reserves equal to the increase in
checkable deposits
10-5
Basic Banking: Check Deposit

When a bank receives
First National Bank

Assets
Cash items in +$100
process of
collection
additional deposits, it
Liabilities
Checkable
deposits
gains an equal amount of reserves;
+$100
when it loses deposits,

it loses an equal amount of reserves
First National Bank

Assets
Reserves
10-6
+$100
Second National Bank
Liabilities
Checkable
deposits
+$100
Assets
Reserves
Liabilities
-$100
Checkable
deposits
-$100
Basic Banking: Making a Profit
First National Bank

Assets
Required
reserves
Excess
reserves
First National Bank
Liabilities
+$100 Checkable
deposits
+$90
+$100
Assets
Required
reserves
Loans
Liabilities
+$100 Checkable
deposits
+$100
+$90
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
10-7
General Principles of Bank

Management
10-8
Liquidity Management
Asset Management
Liability Management
Capital Adequacy Management
Credit Risk
Interest-rate Risk
Liquidity Management: Ample

Excess Reserves
Assets
Liabilities
Reserves
$20M Deposits
Loans
$80M Bank
Capital
$10M
Securities
$100M
$10M
Assets
Liabilities
Reserves
$10M Deposits
$90M
Loans
$80M Bank
Capital
$10M
$10M
Securities
Suppose banks 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
10-9
Liquidity Management: Shortfall

in Reserves
Assets
Liabilities
Reserves
$10M Deposits
Loans
$90M Bank
Capital
$10M
Securities
$100M
$10M
Assets
Reserves
Loans
Securities
Liabilities
$0 Deposits
$90M Bank
Capital
$10M
$90M
$10M
Reserves are a legal requirement and the shortfall

must be eliminated
Excess reserves are insurance against the costs
associated with deposit outflows
10-10
Liquidity Management: Borrowing
Assets
Reserves
Liabilities
$9M Deposits
$90M
Loans
$90M Borrowing
$9M
Securities
$10M Bank Capital
Cost incurred is the interest rate paid on the

borrowed funds
10-11
$10M
Liquidity Management: Securities

Sale
Assets
Reserves
Loans
Securities
Liabilities
$9M Deposits
$90M Bank Capital
$90M
$10M
$1M
The cost of selling securities is the brokerage and

other transaction costs
10-12
Liquidity Management: Federal

Reserve
Assets
Reserves
Liabilities
$9M Deposits
Loans
$90M Borrow from Fed
Securities
$10M Bank Capital
Borrowing from the Fed also incurs interest

payments based on the discount rate
10-13
$90M
$9M
$10M
Liquidity Management: Reduce

Loans
Assets
Reserves
Liabilities
$9M Deposits
Loans
$81M Bank Capital
Securities
$10M
$90M
$10M
Reduction of loans is the most costly way of

acquiring reserves
Calling in loans antagonizes customers
Other banks may only agree to purchase loans at a
substantial discount
10-14
Asset Management: Three Goals

1. Seek the highest possible returns on loans
and securities
2. Reduce risk
3. Have adequate liquidity
10-15
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
10-16
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
10-17
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
10-18
Capital Adequacy Management:

Preventing Bank Failure
High Bank Capital
Assets
Low Bank Capital
Liabilities
Assets
Reserves
$10M Deposits
$90M Reserves
$10M Deposits
Loans
$90M Bank Capital
$10M Loans
$90M Bank Capital
High Bank Capital

Assets
10-19
Liabilities
$10M Deposits
Loans
$85M Bank Capital
$4M
Low Bank Capital
Liabilities
Reserves
$96M
Assets
$90M Reserves
$5M Loans
Liabilities
$10M Deposits
$96M
$85M Bank Capital
-$1M

Returns to Equity Holders
Return on Assets: net profit after taxes per dollar of assets
net profit after taxes
assets
Return on Equity: net profit after taxes per dollar of equity capital
ROA =
ROE =
net profit after taxes

equity capital
Relationship between ROA and ROE is expressed by the

Equity Multiplier: the amount of assets per dollar of equity capital
EM =
Assets
Equity Capital
net profit after taxes net profit after taxes

assets
equity capital
assets
equity capital
ROE = ROA EM
10-20

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
10-21
Application: How a Capital Crunch Caused a

Credit Crunch During the Global Financial
Crisis
Shortfalls of bank capital led to slower credit

growth
Huge losses for banks from their holdings of
securities backed by residential mortgages.
Losses reduced bank capital
Banks could not raise much capital on a

weak economy, and had to tighten their
lending standards and reduce lending.
10-22
Managing Credit Risk

Screening and Monitoring
Screening
Specialization in lending
Monitoring and enforcement of
restrictive covenants
10-23
Managing Credit Risk (contd)

Long-term customer relationships
Loan commitments
Collateral and compensating balances
Credit rationing
10-24
Managing Interest-Rate Risk

First National Bank
Assets
Rate-sensitive assets
Liabilities
$20M Rate-sensitive liabilities
Variable-rate and short-term loans
Variable-rate CDs
Short-term securities
Money market deposit accounts
Fixed-rate assets
$80M Fixed-rate liabilities
Reserves
Checkable deposits
Long-term loans
Savings deposits
Long-term securities
Long-term CDs
$50M
$50M
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
10-25
Gap and Duration Analysis

Basic gap analysis:
(rate sensitive assets - rate sensitive liabilities) x interest rates =

in bank
profit
Maturity bucked approach

Measures the gap for several maturity
subintervals.
Standardized gap analysis

Accounts for different degrees of rate sensitivity.
10-26
Gap and Duration Analysis

(contd)
%in market value of security - percentage point
in interest rate
x duration in years.
Uses the weighted average duration of a financial
institutions assets and of its liabilities to see how net
worth responds to a change in interest rates.
10-27
Off-Balance-Sheet Activities
Loan sales (secondary loan participation)
Generation of fee income. Examples:
Servicing mortgage-backed securities
Creating SIVs (structured investment vehicles)
which can potentially expose banks to risk, as it
happened in the global financial crisis
10-28
(contd)
Trading activities and risk management
techniques
Financial futures, options for debt instruments,
interest rate swaps, transactions in the foreign
exchange market and speculation.
Principal-agent problem arises
10-29
(contd)
Internal controls to reduce the principalagent problem
Separation of trading activities and bookkeeping
Limits on exposure
Value-at-risk
Stress testing
10-30

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Chapter 10

The Bank Balance Sheet

2013 Pearson Education, Inc. All rights reserved.

The Bank Balance Sheet (contd)

2013 Pearson Education, Inc. All rights reserved.

Table 1 Balance Sheet of All

2013 Pearson Education, Inc. All rights reserved.

Basic Banking: Cash Deposit

First National Bank

First National Bank

Opening of a checking account leads to an increase

2013 Pearson Education, Inc. All rights reserved.

Basic Banking: Check Deposit

First National Bank

gains an equal amount of reserves;

when it loses deposits,

First National Bank

Second National Bank

2013 Pearson Education, Inc. All rights reserved.

Basic Banking: Making a Profit

First National Bank

First National Bank

Asset transformation: selling liabilities with one set of

2013 Pearson Education, Inc. All rights reserved.

General Principles of Bank

2013 Pearson Education, Inc. All rights reserved.

Liquidity Management: Ample

Suppose banks required reserves are 10%

2013 Pearson Education, Inc. All rights reserved.

Liquidity Management: Shortfall

Reserves are a legal requirement and the shortfall

2013 Pearson Education, Inc. All rights reserved.

Liquidity Management: Borrowing

$10M Bank Capital

Cost incurred is the interest rate paid on the

2013 Pearson Education, Inc. All rights reserved.

Liquidity Management: Securities

The cost of selling securities is the brokerage and

2013 Pearson Education, Inc. All rights reserved.

Liquidity Management: Federal

$90M Borrow from Fed

$10M Bank Capital

Borrowing from the Fed also incurs interest

2013 Pearson Education, Inc. All rights reserved.

Liquidity Management: Reduce

$81M Bank Capital

Reduction of loans is the most costly way of

2013 Pearson Education, Inc. All rights reserved.

Asset Management: Three Goals

2013 Pearson Education, Inc. All rights reserved.

Asset Management: Four Tools

2013 Pearson Education, Inc. All rights reserved.

2013 Pearson Education, Inc. All rights reserved.

Capital Adequacy Management

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Capital Adequacy Management:

Low Bank Capital

$90M Bank Capital

$90M Bank Capital