Chapter 9

Banking and
the Management
of Financial
Institutions
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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—Check Deposit

First National Bank When a bank receives

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

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Basic Banking—Making a Profit

First National Bank Second National Bank

Assets Liabilities Assets Liabilities
Required +$100 Checkable +$100 Required +$100 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

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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 Assets Liabilities

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

• 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 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: 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:
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:
Federal Reserve

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

• Borrowing from the Fed also incurs interest

payments based on the discount rate

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Liquidity Management: 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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Asset Management: Three Goals

• Seek the highest possible returns on

loans and securities
• Reduce risk
• Have adequate liquidity

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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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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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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 Low Bank Capital

Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M

High Bank Capital Low Bank Capital

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

Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M

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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
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 aftertaxes assets
= ×
equity capital assets equity capital
R OE = R OA × EM

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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 Liabilities
Rate-sensitive assets $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 $50M
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
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Interest Rate Risk: Gap Analysis
Basic Gap Analysis:

(rate-sensitive assets − rate sensitive liabilities)

× Δ interest rates= Δ in bank profits

Maturity Bucket Approach

m easuresthe gap forseveralm aturity subintervals
Standardized G ap Analysis
accountsfordiffering degreesof rate sensitivity

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Interest Rate Risk: Duration Analysis

Duration Analysis:

%Δ m arket value of security≈

−percentage point Δ interest rate × duration in years

Usesthe weighted average duration of

a financialinstitution'sassetsand of itsliabilities
to see how net worth respondsto a change in
interest rates

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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 (cont’d)

• Trading activities and risk management

techniques (cont’d)
 Principal-agent problem
 Internal Controls
• Separation of trading activities and bookkeeping
• Limits on exposure
• Value-at-risk
• Stress testing

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