banking and the management of financial institutions

Cash reserves Deposits at Other Banks Cash Items in Process of Collection Securities Loans Fixed and Other Assets Demand and Notice Deposits Fixed – Term Deposits Borrowings Overdraft loans (advances) Settlement balances Bank capital Reserves Vault cash Desired reserves Banker’s risk Desired reserve ratio Cash Items in Process of Collection Items in transit (bank float) Deposits at Other Banks Interbank deposits Securities Secondary reserves Loans Other Assets

Chapter 13

Banking and the Management

of Financial Institutions

• Cash reserves

• Deposits at Other Banks

• Cash Items in Process of Collection

• Securities

• Loans

• Fixed and Other Assets

Liabilities I

• Demand and Notice Deposits

• Fixed – Term Deposits

– Desired reserve ratio

Liabilities II

• Cash Items in Process of Collection

– Items in transit (bank float)

• Deposits at Other Banks

The Bank Balance Sheet

Basic Banking I

• Opening of a checking account leads to an increase

in the bank’s reserves equal to the increase in

chequable deposits

First bank makes a loan of $100 to a business and

credits the business's chequable deposit.

Basic Banking II

of reserves: when it loses deposits, it loses

an equal amount of reserves

Basic Banking—Making a Profit

• 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

Desired

reserves +$100 Chequable deposits +$100 Desired reserves +$10 Chequable deposits +$100Excess

Liquidity Management and the Role of

Reserves

• If a bank has ample excess reserves, a deposit

outflow does not necessitate changes in other parts

of its balance sheet

Liquidity Management: Shortfall in

Reserves

• Reserves are now short of the desired amount and

the shortfall must be eliminated

• Excess reserves are insurance against the costs

associated with deposit outflows

Liquidity Management: Borrowing

• Cost incurred is the interest rate paid on the

borrowed funds

Borrowing $9 million from other banks

Liquidity Management: Securities Sale

• The cost of selling securities is the brokerage and

other transaction costs

Liquidity Management:

Bank of Canada Advances

• Borrowing from the Bank of Canada also incurs

interest payments based on the discount rate

Borrow $9 million from the Bank of Canada

Liquidity Management: Reduce Loans

• 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

Asset Management: Three Goals

• Seek the highest possible returns on loans and securities

• Reduce risk

• Have adequate liquidity

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

• Checkable deposits have decreased in

importance as source of bank funds

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

Capital Adequacy Management: Preventing Bank Failure

High Bank Capital Low Bank Capital

High Bank Capital Low Bank Capital

Capital Adequacy Management: Returns to Equity Holders

capital equity

assets assets

taxes after

profit

net capital

equity

taxes after

profit net

Capital Equity

Assets EM

capital equity

of dollar per

assets

of amount the

: Multiplier Equity

the by

expressed is

ROE and

ROA between

ip Relationsh

capital equity

taxes after

profit

net ROE

capital equity

of dollar per

taxes after

profit net

: Equity on

taxes after

profit

net ROA

assets

of dollar per

taxes after

profit net

: Assets on

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

Strategies for Managing Bank Capital

Lowering Bank Capital:

• Buying back some of Bank’s stock

• Pay out higher dividend to shareholders

• Acquire new funds and increase assets

Raising Bank Capital:

• Issue more common stock

• Reducing dividend to shareholders

• Issue fewer loans or sell securities and use

proceeds to reduce liabilities

Managing Credit Risk I

• A major component of many financial

institutions business is making loans

• To make profits, these firms must make

successful loans that are paid back in full

• The concepts of moral hazard and adverse

selection are useful in explaining the risks

faced when making loans

Managing Credit Risk II

• Adverse selection is a problem in loan markets because bad credit risks (those likely to

default) are the one which usually line up for loans

• Those who are most likely to produce an

adverse outcome are the most likely to be

selected

Managing Credit Risk III

• Moral hazard is a problem in loan markets

because borrowers may have incentives to

engage in activities that are undesirable from the lenders point of view

• Once a borrower has obtained a loan, they are

more likely invest in high-risk investment

projects that might bring high rates of return if successful

• The high risk, however, makes it less likely the

loan will be repaid

Managing Credit Risk IV

• To be profitable, lending firms must overcome adverse selection and moral hazard problems

• Attempts by the lending institutions to solve the problems explains a number of principles for

managing risk

Principles for Managing Credit Risk

• Screening and Monitoring

– Screening

– Specialization in Lending

– Monitoring and Enforcement of Restrictive Covenants

• Long-term Customer relationships

• Loan Commitments

• Collateral and Compensating Balances

• Credit Rationing

Interest Rate Risk

• If a financial institution has more interest rate

sensitive liabilities than interest rate sensitive

assets, a rise in interest rates will reduce the net interest margin and income

• If a financial institution has more interest rate

sensitive assets than interest rate sensitive

liabilities, a rise in interest rates will raise the net interest margin and income

Gap Analysis

• The Gap is the difference between interest rate

sensitive liabilities and interest rate sensitive assets

GAP = rate-sensitive assets – rate-sensitive liabilities

GAP = RSL – RSA

• A change in the interest rate (Δi) will change bank

income (depending on the Gap

Income = GAP  i

• Owners and managers care not only about the change in interest rates on income but also on net worth of the institution

• Duration Analysis examines the sensitivity of the market value of the financial institution’s net

worth to changes in interest rates

Duration Analysis I

%ΔP = - DUR x [Δi/(1+i)]

Where: P is the market value

%ΔP = (Pt+1 – Pt)/P DUR = duration

i = interest rate

Duration Analysis II

The Duration Gap can be calculated as:

DURgap = Dura – (L/A x DURL)

Where: Dura = average duration of assets

L = market value of liabilities

A = market value of assets Durl = average duration of liabilities

Duration Analysis III

The impact of the interest rate change on net

worth (NW) as a percentage of assets can be

calculated via:

Δ NW/A = -Durgap x Δi/(1+i)

Where: DURgap = duration gap

Δi = interest rate change

i = interest rate

Duration Analysis IV

Δ NW/A = -1.72 x 0.01/(1+0.10) = -0.016 = -1.6%

With assets = $100m, the fall in NW when the

interest rises from 10% to 11% equals -1.6% of

$100m = -$1.6M (found earlier)

Duration Analysis V

Off-Balance-Sheet Activities I

• Loan sales (secondary loan participation)

• Generation of fee income

• Trading activities and risk management

techniques

– Futures, options, interest-rate swaps, foreign

exchange – Speculation