BEAM065: Bank Management

Dr Thaer Alhalabi
Week 5
Where do we currently stand?
• Week 1: The Global Banking Industry
• Week 2: Banking Regulation
• Week 3: Analysing Bank Performance and Risk
• Week 4: Managing Interest-Rate Risk
• Week 5: Managing Bank Funding Sources
• Week 7: Managing The Loan Portfolio
• Week 8: Coursework
• Week 9: International Banking
• Week 10: Governance and Stakeholder Monitoring
• Week 11: Revision for Final Assessment
Intended Learning Outcomes ILOs
The ILOs of this lecture are as follows:
• To understand why bank capital is important and how bank capital regulation can
affect bank conduct
• To critically evaluate the importance of different types of bank funding sources
• To identify the inter-linkages between liquidity management, interest rate risk
management, and capital management
• To discuss how the capital structure of a bank can affect its profitability
Agenda
• Introduction

• Liquidity Management

• Capital Management
Structure of The Lecture
• We will start the discussion with a brief introduction about Asset-Liability Management
(ALM), and Liquidity-Capital Management (LCM)

• We will then discuss the main features of liquidity management – because of the
importance of liquidity regulation for banks, we will also discuss recent developments
in international liquidity regulation

• Finally, we will talk about why bank capital is important and how banks can manage
their capital while ensuring that they comply with capital requirements
ALM and LCM
Bank financial management traditionally focusses on two aspects:
• Asset-Liability Management (ALM): assets and liabilities should be managed in an
integrated manner because maximising risk-adjusted returns of assets alone does not
ensure that profits are maximised: the cost of the funding sources needs to be
considered as well – as we studied in Week 4, if we want to reduce the funding gap or
the duration gap, we can increase or decrease the sensitivity to changes in interest
rates of assets, liabilities, or both
• Liquidity and Capital Management (LCM): bank runs can occur even when a bank is
liquid if customers (or other banks) believe that a bank is insolvent – to build trust in
their ability to repay its creditors, banks can keep their equity levels high, but holding
too much equity capital can be expensive
ALM and LCM
• ALM and LCM also exhibit important interdependencies
• For example, managing interest-rate risk may require changing the composition of
assets and liabilities (ALM)
• However, the average interest rate paid by a bank depends on its default risk which,
in turn, depends on its capital levels and its ability to meet short-term financial
obligations (LCM)
• Moreover, poor ALM can result in financial shocks that can affect a bank’s liquidity
and capital position, and it can thus lead to higher funding liquidity risk
• For example, if the bank’s duration gap is too large and there is an adverse shock in
interest rates, the market value of equity might drop considerably, and this can
potentially lead to a bank run if uninsured depositors and other unsecured creditors
believe that the bank might default
Agenda
• Introduction

• Liquidity Management

• Capital Management
Funding Liquidity Risk
• Similar to ALM, LCM requires the bank manager to understand the maturity structure
of assets and liabilities
• Banks must ensure that they have the funds needed to meet their financial obligations
• For this reason, the bank manager should strive to predict the daily cash inflows and
outflows deriving from customer deposit accounts and the likelihood that borrowers
might be unable to pay back the bank on time
• An unusually large amount of withdrawals of cash from depositors or unexpected
borrowers’ defaults can lead to a sudden need for cash for the bank
• We call this type of risk “funding liquidity risk” (see Week 3 material)
Liquidity and Profitability
• In income gap analysis we care about when an asset or liability reprices because we
are interested in the impact on net income – in liquidity management, we care
about the timing of the arrival of the cash flows, especially in the short-term,
although long-term stable funding sources are also important because they allow a
bank to sustain long-term growth
• Since many liabilities of the bank are short-term (e.g., customer deposits), a bank
with a sufficient level of cash reserves and marketable securities is relatively safer
than a bank with illiquid assets (e.g., long-term loans)
• However, liquid assets also tend to be less profitable than illiquid assets
• Thus, there is a trade-off between liquidity and profitability – the opportunity cost of
holding liquid assets must be weighed against its benefit (i.e., lower funding liquidity
risk)
Main Sources of Funding
• Cash reserves: banks are required to hold a certain amount of cash at the central bank to
limit their funding liquidity risk (see Week 1: Credit Multiplier) – banks can also hold more
cash than required (excess reserves)
• If cash reserves are insufficient and a bank needs to raise funds quickly it can raise funds:

1 On the interbank market from other financial institutions (e.g., Fed Funds in the US)

2 From the central bank, although there might be strings attached for some types of funding
(e.g., Targeted Longer-Term Refinancing Operations in the Eurozone that incentivises banks
to lend more to households and non-financial firms to boost lending in the real economy )

3 By selling liquid assets (e.g., government securities, which are typically very liquid)

4 By selling a portion of its loans to other institutions – loans are usually illiquid assets, but
some type of loans can be securitised (i.e., pooled and repackaged into securities sold to
investors)
Main Sources of Funding
• Let’s now look at the potential consequences of these alternative ways of raising funding

1 Sudden loan sales might damage a bank’s reputation (it raises questions about the bank’s
solvency), as well as (potentially) ruining the relationship with the borrowers (i.e.,
relationship lending)

2 Selling short-term government securities might alter the sensitivity to changes in interest
rates, and increase the bank’s exposure to interest rate shocks – RSA amount might
decrease (GAP ↓) and the duration of the assets might increase (DGap ↑)

3 Borrowing from the central bank (as a Lender of Last Resort) might be perceived as a
signal of liquidity/solvency problems (for more info on this, click here)

4 However, recently banks have been provided with long-term cheap funding from the
central banks, against adequate collateral (e.g. LTROs and TLTROs)
Some Important Ratios Related to
Bank Funding Liquidity
• We can use several measures of funding liquidity, for example

VR = (VL − LA)/(TA − LA)

• VL stands for volatile liabilities (e.g., interbank market loans and uninsured deposits), LA liquid
assets, and TA total assets

• If VR < 0 (VR > 0) the bank has an amount of volatile liabilities lower (higher) than that of liquid
assets, and thus its liquidity risk is low (high) – in other words, the larger the VR, the higher the
funding liquidity risk for the bank

• The volatility ratio (VR) is related to the liquidity gap:

LGAP = LA − VL

• “Liquidity gap” analysis is like the static gap analysis that we discussed in Week 4, but we consider
the impact on cash flows, rather than net income

• If the incremental gap for a certain maturity bucket is negative (e.g., LA = 50 and VL = 60), the bank
expects a net cash outflow for that bucket
Two Important Regulatory Ratios:
LCR and NSFR
• The importance of liquidity for a stable financial system has become evident during the
2007-2009 financial crisis
• To address this issue, the Basel Committee on Banking Supervision (BCBS) introduced
liquidity requirements for banks, the Liquidity Coverage Ratio (LCR) and the Net Stable
Funding Ratio (NSFR)
• The LCR is calculated as follows

• where HQLA stands for High-Quality Liquid Assets and TNCO stands for Total Net Cash
Outflow in the next 30 days, assuming a scenario of financial stress
• The NSFR is (ASF = Available amount of Stable Funding and RSF = Required amount of
Stable Funding)
The LCR and NSFR: Some
Clarifications
• For the LCR, the numerator consists of liquid assets, and the denominator considers
cash outflows and inflows from assets (fully performing loans), liabilities (e.g.,
deposits and wholesale funding), and OBS items (e.g., contingent liabilities such as
unused credit lines)
• For the NSFR, the numerator (ASF) is related to the funding sources available to the
bank (capital and liabilities), while the denominator (RSF) is related to the assets
that have to be funded, as well as OBS activities (e.g., unused credit lines)
• Thus, for the LCR, assets go in the numerator, while for the NSFR, they go into the
denominator!
• For the LCR, the denominator consists of expected net cash outflows, and the flow
could come from liabilities and/or assets, as well as OBS items
• For the NSFR, the numerator (ASF) can only be related to stable funding, i.e., capital
and liabilities, not assets
LCR: An Example
A bank that is funded solely by stable retail deposits has HQLA divided as follows:
• Level 1 assets: total market value equal to 160 (100% weight)
• Level 2A assets: total market value equal to 80 (85% weight)
• Level 2B assets: total market value of 40 (assume: 20 with 50% weight and 20 with 75%
weight)
Thus, the total value of HQLA (numerator of the LCR) is:
160 + 80 × 0.85 + 20 × 0.5 + 20 × 0.75 = 253
• Now, let’s calculate the denominator (TNCO), assuming an outflow of stable retail deposits
equal to 8000 and an inflow of 4000, with a “run-off factor” equal to 5% – Note: “the run-off
factor” is proportional to the volatility of the funding source (for more info, click here): (8000 −
4000) × 0.05 = 200
Thus, the LCR is equal to 253/200 = 1.265 (> 100%) – for more info, read ELE book
Agenda
• Introduction

• Liquidity Management

• Capital Management
Why Is Bank Capital Important?
• Bank capital is important for both regulators and managers, but they have different preferences
– while regulators aim to reduce the likelihood of bank failures, and thus might want to keep
capital ratios as high as possible, banks prefer low capital ratios to take advantage of the
positive impact of the equity multiplier on the ROE

• As you might remember from Week 3, if two banks with the same ROA but different equity
multipliers, the bank with the higher equity multiplier will have a higher ROE

• For this reason, bank regulation plays a key role in bank capital management: from the
perspective of the regulators, riskier banks should hold a higher amount of capital
Bank Capital from The Regulators’
Perspective
• If depositors believe that a bank might be insolvent, they might withdraw their money from the
bank and this might result in a default that could spread to other banks either through the
interbank market (credit channel) or via an information channel

• Contagion to other banks via the information channel occurs because of asymmetric
information – depositors know that banks tend to hold similar assets (e.g., securitised loans)
and to lend to each other, but they do not usually know which banks might be connected to the
bank in distress

• Thus, if a bank defaults, even banks that do not have any type of relationship with it might
experience a bank run – default risk for a bank can become systemic, especially when the bank
in distress is large
Bank Capital from The Regulators’
Perspective
Capital requirements are thus important for regulators because
• High bank capital ratios signal to the public that the bank will be able to pay back its creditors,
and thus they reduce the probability of a bank run
• It protects the deposit insurance fund: the higher the capital buffer the smaller the loss for the
insurance fund when a bank is liquidated
• Skin-in-the-game effect: all other things being equal, shareholders of banks with higher capital
ratios will lose more money if the bank defaults, and thus they will be incentivised to keep
business risk a relatively lower level
• The skin-in-the-game effect is the main rationale of capital requirements (see Week 2 material)
Bank Capital from The Bank
Managers’ Perspective
• A higher equity multiplier (total assets divided by equity) increases ROE
• Thus, bank shareholders and managers should prefer low levels of capital
• Bank managers can thus engage in regulatory arbitrage: if the regulatory capital does not
capture the actual risk of a certain asset category, bank managers might choose to invest in
assets for which the required level of regulatory capital is lower
• Thus, banks might be incentivised to invest in assets whose regulatory capital is relative low,
but with high expected returns
• Since usually high expected returns are attained investing in high-risk assets, this will result in
an actual level of bank risk which is higher than the one needed to satisfy the capital
requirements (prudential regulation)
Why Do Banks Tend to Hold Capital
Above The Regulatory Requirement?
There might be two main reasons for banks to hold capital in excess of the regulatory minimum:
1. because raising capital on the market is expensive; 2. because there might be other factors
that are more important than capital requirements
• If banks want to increase their capital levels, they can either retain earnings or they can raise
new equity capital on the market
• If banks are too close to the minimum threshold allowed by regulators, a sudden drop in
earnings might force them to look for new equity capital at short notice
• Since raising new equity capital is costly, holding capital well above the regulatory threshold
allows banks to reduce the chances of having to incur these costs
• As for 2., banks’ capital structure choices might be driven mainly by factors related to
managerial preferences, and monitoring from debtholders and bank shareholders
Why Do Banks Tend to Hold Capital
Above The Regulatory Requirement?
• Gropp and Heider (2010, link for the paper) investigate the importance of capital requirements
for banks’ capital structure decisions

• Their findings suggest that the main drivers of banks’ capital structure are similar to those of
non-financial firms, which is consistent with the view that regulatory capital requirements might
not the main driver of bank capital structure choices

• However, banks that are already close to the regulatory threshold seem to behave differently
Why Do Banks Tend to Hold Capital
Above The Regulatory Requirement?
• Capital requirements bear an impact on banks’ investment and financial policies (e.g., there
might be restrictions on dividends and share repurchases if a bank is under-capitalised), and
they can limit bank assets’ growth
• To understand why this is the case, let’s see how the Total Capital Ratio (TCR) is calculated
according to the original Basel Accord:

and

• Note that Tier 1 ratio was increased to 6% in Basel III following the 2008 financial crisis, and it
was scheduled for implementation in years 2013-2015 (Naceur et al., 2018).
• Where Tier 1 consists of equity and disclosed reserves, while Tier 2 consists of other types of
capital, e.g., hybrid capital and undisclosed reserves
Capital Requirements and The
Sustainable Growth Rate
• Banks assess the RWA using two approaches: (i) standardised approach, and (ii) internal
rating-based model. In the latter, the banks determines the riskiness of the assets.
• If a bank wants to increase the amount of Risk-Weighted Assets (RWA), it also needs to
increase its Total Capital (Tier 1 and/or Tier 2)
• Because of capital requirements, a bank should limit its asset growth to some percentage of its
retained earnings plus some new external capital
• Koch and MacDonald (2015) introduce a simple formula to allow for the impact of capital
requirements on “sustainable assets growth” (∆TA/TA1, where ∆TA = TA2 − TA1)

• where EQ stands for equity capital, ROA Returns on Assets, DR the ratio of cash dividends
divided by net income, and EC “external capital”
Example: TCR Calculation
You have to calculate the TCR for a bank with the following items:
• Cash (0% risk-weight): 100
• Mortgage loans (50%): 800
• Unsecured commercial loans (100%): 1500
• Thus, the RWA is: (100 × 0) + (800 × 0.5) + (1500 × 1) = 1, 900
• The total amount of regulatory capital is: 0.08 × 1, 900 = 152, of which at least 50% (76) should
consist of Tier 1 capital
Example: Sustainable Asset Growth
Rate Calculation
A bank has ROA equal to 1.2%, the dividend payout ratio is 35%, the capital requirement is 8%,
and the bank managers do not want to seek external funding via new equity issues. Then, the
sustainable growth rate is:Cash (0% risk-weight): 100

• Therefore, the bank can increase its assets by no more than 9.75% during this time period
Example: Sustainable Asset Growth
Rate Calculation
• You can also set a certain sustainable growth rate, and then you can decide how to fund it – for
example, assume that ROA = 1.07%, DR = 0.4, ∆TA/TA1 = 12%, TA2 = 112, 000, and EQ1/TA1
= 8%
• Then, the required increase in equity capital (∆EC) is equal to
 Capital Management: Comparing
Alternative Options
If a bank wants to increase its asset growth beyond the sustainable growth rate, it has several options
• 1) Issue new equity capital: this might be expensive especially for smaller banks

• 2) Reduce the payout ratio: this would increase the amount of internal funding, which is the
preferred source of funding according to the “pecking order theory”

• 3) Sell risky assets and replace them with marketable securities: marketable securities tend to have
a lower risk-weight – however, marketable securities are usually less profitable than assets with
higher risk-weights (e.g., commercial loans), so banks would have to try and engage in regulatory
arbitrage (see above)
Capital Management: Comparing
Alternative Options
• If a bank doesn’t want to make any changes to the capital mix (i.e., issue new equity or reduce the
payout ratio) or the composition of its assets (i.e., replace risky assets with liquid securities), it can
try to reduce its asset growth rate (∆TA/TA1)

• However, this might come at a price, because it will decrease the ROE, and thus shareholders might
punish the bank by selling their shares on the stock market

• In theory, a bank might also try to move on-balance sheet items off its balance sheet – however,
current regulations try to prevent banks from doing this by requiring that OBS risk to be incorporate
in the calculation of RWA
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