CHAPTER

19
Bank
Management

© 2003 South-Western/Thomson Learning

Chapter Objectives
 Describe the underlying goal of bank
management
 Discuss how banks manage liquidity
 Evaluate how banks manage interest rate risk
 Look at the techniques to manage credit risk
 Explain how banks manage capital
Goal of Bank Management

 The underlying goal of bank management is

to maximize the wealth of the bank’s
shareholders
 Maximizing the share price
 Agency costs
 Investor costs incurred to promote managers’ interest
in serving investors’ interest
 Managers need incentives to seek shareholder’s best
interests
 Takeover target if stock price undervalued
Risks Faced By Banks

Liquidity
Value of
Risk
Bank Value
Related to
Cash Flows
Interest Rate and
Risk Risk of
Cash Flows

Capital or Market Credit Risk

Insolvency Risk
Risk
Managing Liquidity Risk

 Risk of variability of return impacted by cost

of providing liquidity for deposit outflows
and/or loan demand
 Maintain liquid assets and ability to borrow in
financial markets
 Securitizing loans provide liquidity
 Must forecast future cash flows
Managing Liquidity

 Use of securitization to boost liquidity

 Selling off loans to trustee
 Mortgage and automobile loans
 Trustee issues securities collateralized by the assets
 Loan payments pass through to holders of securities
 Securitization turns future cash flows into
immediate cash
 Risk level related to guarantee provided to trust
Managing Interest Rate Risk

 Risk of variability of returns caused by

changing market interest rates
 Interest rate risk comprised of price risk and
reinvestment risk
 Price risk = variability of returns caused by
varying prices of assets
 Security and loan values vary inversely with
changes in market rates
Managing Interest Rate Risk

 Reinvestment risk = variability of return

caused by changing interest rates on the
reinvested coupon of securities or loans
 Reinvestment risk and price risk cause
realized returns to vary from expected
 Price risk and reinvestment risk have an
opposite impact on realized return when
market interest rates change
Managing Interest Rate Risk

 Causes variability in net interest income (NII)

and net interest margin (NIM)
 NII = interest income - interest expense
 NIM = NII/assets
 Varying interest rates impact value of
financial assets, liabilities, and reinvestment
returns
 Varying interest rates cause repricing of loans,
securities, and deposits impacting NII
Measuring Interest Rate Risk

 $GAP measurement
 Duration measurement
 Regression analysis
 Benefits and limitations of each
 $GAP easily constructed
 Duration measure more accurate
 Regression depends on future consistent
relationship of variables
GAP Measurement

 $GAP = rate sensitive or repriceable

assets (RSA) for a time period - rate
sensitive liabilities (RSL)
 Measures varied repriceability of
interest-bearing assets, liabilities, and the
cash flows of each
 $GAP ratio = RSA - RSL
 +$GAP = asset sensitive position
 -$GAP = liability sensitive position
GAP, Varying Rates, NII AND NIM

+ $GAP - $GAP 0 $GAP

RSA > RSL RSA< RSL RSA = RSL

 Interest  Interest  Interest

Rates Rates Rates
 Net Interest  Net Interest Stable Net
Income Income Interest Inc.
Duration Measurement

 Adds consideration of cash flow, time

value, and repricing
 Duration = sum of discounted, time-
weighted cash flows divided by the price
of security or loan
 Duration measures time-weighted
maturity
 Duration a better measure of risk than
$GAP
Managing Interest Rate Risk

 Duration measurement
 Captures different degrees of sensitivity to interest
rate changes
 E.g. a 10-year zero coupon bond is more interest-
sensitive than a 10-year coupon bond
 Shorter maturities; lower duration
 Coupon interest and loan payments shorten duration
 Duration of each type of bank asset and liability is
determined
 DURGAP = DURAS – [DURLIAB x LIAB/AS]
 Managing Interest Rate Risk
 Regression analysis
Estimates the historical relation between interest rates
and bank performance
R=B +BR +Bi+u
0 1 m 2

 B2 = interest rate coefficient

 Positive coefficient suggests that past performance is
positively affected by rising interest rates
 Research suggest the opposite is true
 Banks and S&L’s tend to have a negative gap
 NII and NIM adversely impacted with increasing interest rates
Managing Interest Rate Risk
 Determining whether to hedge interest rate risk
 Banks often use all three methods
 Banks use their analysis of gap with interest rate forecasts
to make their hedging decision
 Methods of reducing interest rate risk
 Maturity matching of loans and deposits
 Using floating-rate loans
 Using interest rate futures contracts
 Using interest rate swaps
 Using interest rate caps
Managing Interest Rate Risk

 Methods of reducing interest rate risk

 Maturity matching
 Match each deposit’s maturity with an asset of the same
maturity
 Difficult to implement
 Lots of short-term deposits
 Using floating-rate loans
 Often increases credit risk and liquidity risk
Managing Interest Rate Risk
 Methods of reducing interest rate risk
 Using interest rate futures contracts
 E.g. sale of T-bond futures by negative GAP bank to hedge
interest rate increase results in a futures gain, offsetting adverse
effects on NII
 Hedging locks in NIM and negates benefit of falling rates. What
about futures options?
 Using interest rate swaps
 Arrangement to exchange periodic cash flows based on specific
interest rates
 Fixed loan interest-for-floating for negatively GAP bank to reduce
GAP exposure
 Using interest rate caps
Managing Credit Risk

 Variability of return caused by delayed or

nonpayment of loan/security interest or
principal
 Bank assembles portfolio of various types of
loans seeking maximum net return per level of
risk
 Loan/security mix varies with desired risk
level and economic conditions
Measuring Credit Risk

 Calculate Expected Loss Rate Per Type Of

Loan and Total Loan Portfolio
 Higher Default Premiums Charged For
Higher Expected Loss Rate
 Collateral may reduce expected loss rate
 Prime Plus Loan Pricing based on risk
profile
Diversifying Credit Risk

 Assemble loan portfolio of diverse Borrowers

using portfolio theory:
 Varied income or employment
 Geographic locations
 Industries
 Reduce total portfolio credit risk via
diversification
 Avoid concentration of loans
 Nationwide banking = diversification
Managing Credit Risk
 Diversifying credit risk
 International diversification of loans
 May not help if the bank accepts loans from areas with very
high credit risk
 LDC’s in early 1980’s; Asian crises, 1997; Argentina, 2001
 Selling loans
 Problem loans can be removed from the bank’s assets
 Selling price reflects expected default risk
 Revising the loan portfolio in response to economic
conditions
Managing Market Risk
 Market risk results from the changes in value
of securities due to changes in financial market
conditions such as interest rates, exchange
rates, and equity prices
 Banks have increased exposure to derivatives
and trading activities
 Measuring market risk: Banks commonly use
value-at-risk (VAR), which involves determining
the largest possible loss that would occur in the
event of an adverse scenario
Managing Market Risk

 Measuring market risk

 Bank revisions of market risk measurements
 When changes in market conditions occur, such as
increasing volatility, banks revise their estimates of
market risk
 How J.P. Morgan assesses market risk
 Calculates a 95 percent confidence interval for the
expected maximum one-day loss due to:
 Interest rates
 Exchange rates
 Equity prices
 Commodity prices
 Correlations between these variables
Managing Market Risk

 Methods of reducing market risk

 Reduce involvement in activities that cause high
exposure
 Take offsetting trading positions
 Sell securities that are heavily exposed to market
risk
Operating Risk

 Operating risk is the variability of returns that

may result from a failure in a bank’s general
business operations
 Processing and sorting information
 Executing transactions
 Maintaining relationships with clients
 Dealing with regulatory issues
 Legal issues
 Use of insurance, contracts, and other pure
risk management techniques
Bank Capital Management

 Bank capital = bank net worth

 Purpose of bank capital
 Absorbs losses on assets
 Provides base for leveraging debt
 Is a source of funds
 Serves to maintain confidence of financial markets

 Regulators specify minimum capital per

riskiness of assets
 ROE = ROA x leverage measure
Management Based on Forecasts

 Some banks position themselves to benefit

form expected changes in the economy
 If managers expect a strong economy they
may shift toward riskier loans and securities
 Inaccurate forecasts have less effect on more
conservative banks
Bank Restructuring to Manage Risks
 Decisions are complex because they affect
customers, employees, and shareholders
 Bank acquisitions
 Common form of restructuring
 Quick way of achieving growth
 Advantages:
 Economies of scale, diversification
 Managerial advantages
 Disadvantages
 Purchase price may be too high; selling shareholder benefit
 Employee morale
Bank Restructuring to Manage Risks

 Are bank acquisitions worthwhile?

 Studies show that the market reacts neutrally or
negatively to news of a bank acquisition
 May be due to:
 Intra-market versus out-of-market merger
 Pessimism over whether efficiencies will be achieved
 Personnel clashes
 Price may be too high; selling shareholder capture added value
Integrated Bank Management

 Bank management of assets, liabilities, and

capital is necessarily integrated
 An integrated management approach is also
necessary to manage
 Liquidity risk,
 Interest rate risk,
 Credit risk
 Operating risk
 Capital or insolvency risk
Examples of Bank Mismanagement
 Penn Square Bank
 Aggressive lending, concentrated in energy loans
 Limited diversification
 Energy sector problems caused defaults
 The bank provided new loans, part of which were
used to pay off old loans, recording them as “paid”
rather than overdue
 Could not continue this practice, so the bank failed
in 1982
Examples of Bank Mismanagement
 Continental Illinois Bank
 Provided loans in the energy sector originated by
Penn Square—financial market lost confidence
 Bank of New England
 Concentrated on real estate loans in 1980s
 Overbuilding and reduced economic growth
resulted in defaults
 Even though other New England banks were
affected, the Bank of New England was more
exposed because of heavy concentration in real
estate
Examples of Bank Mismanagement

 Implications of bank mismanagement

 Preceding examples should not imply that being
ultraconservative is preferred
 In a competitive environment, a bank may fall
behind
 A proper balance between risk and return should
be maintained