Chapter 9
Banking and
the Management
of Financial
Institutions
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9-2
Basic BankingCash Deposit
First National Bank
Assets
Vault
Cash
+$100
First National Bank
Liabilities
Checkable
deposits
+$100
Assets
Reserves
Liabilities
+$100 Checkable
deposits
+$100
Opening of a checking account leads to an
increase in the banks reserves equal to the
increase in checkable deposits
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Basic BankingCheck Deposit
When a bank receives
First National Bank
Assets
Cash items
in process
of collection
+$100
Checkable
deposits
+$100
gains an equal amount of reserves;
when it loses deposits,
it loses an equal amount of reserves
First National Bank
Assets
additional deposits, it
Liabilities
Second National Bank
Liabilities
Reserves +$100 Checkable
deposits
+$100
Assets
Reserves
-$100
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Liabilities
Checkable
deposits
-$100
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Basic BankingMaking a Profit
First National Bank
Assets
Required
reserves
Excess
reserves
Second 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
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Bank Management
Liquidity Management
Asset Management
Liability Management
Capital Adequacy Management
Credit Risk
Interest-rate Risk
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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
If a bank has ample excess reserves, a
deposit outflow does not necessitate changes
in other parts of its balance sheet
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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
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Liquidity Management: Borrowing
Assets
Reserves
Liabilities
$9M Deposits
$90M
Loans
$90M Borrowing
$9M
Securities
$10M Bank Capital
$10M
Cost incurred is the interest rate paid on the
borrowed funds
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9-9
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
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9-10
Liquidity Management:
Federal Reserve
Assets
Reserves
Liabilities
$9M Deposits
Loans
$90M Borrow from Fed
Securities
$10M Bank Capital
$90M
$9M
$10M
Borrowing from the Fed also incurs interest
payments based on the discount rate
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9-11
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
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9-12
Asset Management: Three Goals
Seek the highest possible returns on
loans and securities
Reduce risk
Have adequate liquidity
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9-13
Asset Management: Four Tools
Find borrowers who will pay high
interest rates and have low possibility
of defaulting
Purchase securities with high returns and
low risk
Lower risk by diversifying
Balance need for liquidity against
increased returns from less liquid assets
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9-14
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
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9-15
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
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Capital Adequacy Management:
Preventing Bank Failure When
Assets Decline
High Bank Capital
Assets
Liabilities
Low Bank Capital
Assets
Liabilities
Reserves
$10M Deposits
$90M Reserves
$10M Deposits
Loans
$90M Bank Capital
$10M Loans
$90M Bank Capital
High Bank Capital
Assets
Liabilities
Reserves
$10M Deposits
Loans
$85M Bank Capital
$96M
$4M
Low Bank Capital
Assets
$90M Reserves
$5M Loans
Liabilities
$10M Deposits
$96M
$85M Bank Capital
-$1M
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9-17
Capital Adequacy Management:
Returns to Equity Holders
Return on Assets: net profit after taxes per dollar of assets
net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital
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
Assets
EM =
Equity Capital
net profit after taxes
equity capital
ROE =
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9-18
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
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Credit Risk: Overcoming Adverse
Selection and Moral Hazard
Screening and information collection
Specialization in lending
Monitoring and enforcement of
restrictive covenants
Long-term customer relationships
Loan commitments
Collateral and compensating balances
Credit rationing
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Interest-Rate Risk
First National Bank
Assets
Rate-sensitive assets
Liabilities
$20M Rate-sensitive liabilities
$50M
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
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
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Interest Rate Risk: Gap Analysis
Basic Gap Analysis:
(rate-sensitive assets
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Interest Rate Risk: Duration Analysis
Duration Analysis:
%
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9-23
Off-Balance-Sheet Activities
Loan sales (secondary loan
participation)
Generation of fee income
Trading activities and risk management
techniques
Futures, options, interest-rate swaps,
foreign exchange
Speculation
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Off-Balance-Sheet Activities (contd)
Trading activities and risk management
techniques (contd)
Principal-agent problem
Internal Controls
Separation of trading activities and bookkeeping
Limits on exposure
Value-at-risk
Stress testing
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