Chapter 9

Banking and
the Management
of Financial
Institutions

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 Learning Objectives
• Summarize the features of a bank
balance sheet.

• Apply changes to a bank’s assets and

liabilities on a T-account.

• Identify ways in which banks can

manage their assets and liabilities to
maximize profit.

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 Learning Objectives

• List the ways in which banks deal with

credit risk.

• Examine off-balance sheet activities.

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 How Bank do Profit ?

1-Play the yield curve :

( Banks accepted shorter term deposits & make
longer Term Loans
Net Interest Rate Margin (NIM) : the difference
between the Interest that banks pay for Fund &
the interest Receive for do loans

2- By lower Transaction cost

3-Deal with A symmetric information

4- Earn profit from OFF Balance sheets

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 The Bank Balance Sheet

• Sources of fund (Liabilities):

1- Deposits
A- Transaction deposits
Checkable deposits
( No maturity – via checks - debit card – online
Transfer – 0% I.R)
Demand deposits
( no maturity – no checks services – debit card -
0% I.R)
–NOW accounts : ( Negotiable order withdraw )
(I.R > 0 % )

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 The Bank Balance Sheet

B- Non transaction deposits

- Passbook saving deposits
( no specific maturity date – small balances
Money market deposits
– ( low I.R – same as saving account but, have
limited checking services )
–Time deposits & CDs ( fixed Maturity – huge
source of fund – no checking services – penalty for
early withdraw – high I.R according to Maturity
time )

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 The Bank Balance Sheet

2-Borrowing
- Other banks
–From FED ( overnight loans – by discount rate )
- Overseas banks ( Eurodollars )

3- Capital
Come from owners around 10%

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 The Bank Balance Sheet

• Assets:
1-Reserves
A- Required(Legal)reserves B- Excess reserves
2-Cash items in process of collection:
– in the past , checks had to be physically moved
as they went (2-3 days ) through the collection
process . Now it is done electronically
3-Deposits at other banks
loans participation
corresponding Banks

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 The Bank Balance Sheet

4-Securities
– Treasury bills
– Bonds & Stocks

5-Loans
– Commercial
–Consumer & Industrial

6-Other assets ( physical assets)

–Fixed Assets

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 Basic Banking

• Cash Deposit:

First National Bank First National Bank

Assets Liabilities Assets Liabilities

Vault +$100 Checkable +$100 Reserves +$100 Checkable +$100

Cash deposits deposits

• Opening of a checking account leads to an increase

in the bank’s reserves equal to the increase in
checkable deposits.

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 Basic Banking

First National Bank Check Deposit:

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

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 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 and make
profits from the process of asset transformation

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 General Principles of Bank
Management

1-Liquidity Management

2- Asset Management

3- Liability Management

4- Capital Adequacy Management

5- Credit Risk

6- Interest-rate Risk

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 1- Liquidity Management and the
Role of Reserves
• Excess reserves:(role of reserves)

Assets Liabilities Assets Liabilities

Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank $10M Loans $80M Bank $10M
Capital Capital
Securities $10M Securities $10M

– Suppose a 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.

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 Liquidity Management and the Role
of Reserves
• Shortfall of reserves:

Assets Liabilities Assets Liabilities

Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank $10M Loans $90M Bank $10M
Capital Capital
Securities $10M Securities $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 and the Role
of Reserves
• Borrowing:

Assets Liabilities
Reserves $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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 Liquidity Management and the Role
of Reserves
• Federal Reserve:

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrow from Fed $9M
Securities $10M Bank Capital $10M

– Borrowing discount loans from the Fed also

incurs interest payments based on the discount
rate.

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 Liquidity Management and the Role
of Reserves
• Securities sale:

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M

– The cost of selling securities is the brokerage

and other transaction costs.

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 Liquidity Management and the Role
of Reserves
• Reduce loans:

Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $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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 2- Asset Management

Three goals:

1- seek the highest possible returns on loans and securities.

2- Reduce risk.

3- Have adequate liquidity.

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 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.

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 3- Liability Management
Involves Borrowing funds or attracting deposits when
Banks need Liquidity (Similar to Credit Card For
consumer )
(new school of Liquidity 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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 4- Capital Adequacy Management

• Bank capital serves as a cushion to the

bad shocks and 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

How Bank Capital Helps Prevent Bank Failure:

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 How the Amount of Bank Capital
Affects Returns to Equity Holders
In order to know whether a bank is managed well,
proper measures of bank profitability are needed.
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
ROE =
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 net profit after taxes assets
 
equity capital assets equity capital
ROE = ROA  EM

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 Capital Adequacy Management

• Trade-off between safety and returns

to equity holders:
– 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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 5- Managing Credit Risk
• Screening and Monitoring:
– Screening
– Specialization in lending (e.g. to local firms or to
firms in a particular industry)
– Monitoring and enforcement of
restrictive covenants
• Long-term customer relationships
• Loan commitments
• Collateral and compensating balances
• Credit rationing

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 6- Managing Interest-Rate Risk
– IN order to Managing I.R Risk , Banks

– Don’t Lend Longer Term Bonds

– Sell Long Term Loans

– Make Adjustable-rate loans

– Hedge against rate increases

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 Managing Interest-Rate Risk

• 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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 7- Off-Balance-Sheet Activities

• Services provided to customers for a fees, this

activities Don’t include the banks acquisition of
assets or liabilities, such as
A- Trust services :
Banks Manage money for customers , this is done by
trust department
B- line of credit:
Bank agree to loan a credit amount to customers at
an unspecified future date

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 Off-Balance-Sheet Activities

C- letters of credit :
Banks write letters that guarantee debts of its
customers, so they can complete business deals with
third parties
D- Investment Bank services :
advice & other assistance to companies or
government to issue or traded securities

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 Thanks for your
attention

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