Chapter 13 Depository Institution Management and Performance Fundamental

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Chapter 13 Depository Institution Management and Performance

Chapter 13 Depository Institution Management and Performance

Fundamental Issues 1. What are the key sources of depository institution revenues and costs?

Fundamental Issues 1. What are the key sources of depository institution revenues and costs? 2. What are common measures of depository institution profitability? 3. How has the philosophy of depository institution management evolved? 4. What is the main determinant of depository institution performance? Copyright © 2004 South-Western. All rights reserved. 2

Sources of Depository Institution Revenues • Interest income: Ø Interest revenues that depository institutions

Sources of Depository Institution Revenues • Interest income: Ø Interest revenues that depository institutions derive from their holdings of loans and securities. • Noninterest income: Ø Revenues that depository institutions earn from sources other than interest income, such as trading profits or fees that they charge for services that they provide their customers. Copyright © 2004 South-Western. All rights reserved. 3

Sources of Commercial Bank Revenues Noninterest income has become a more important source of

Sources of Commercial Bank Revenues Noninterest income has become a more important source of bank revenues in recent years, although the majority of bank revenues continues to flow from their interest earnings. SOURCE: Federal Deposit Insurance Corporation. Copyright © 2004 South-Western. All rights reserved. Figure 13– 1 4

Depository Institution Operations Costs • Interest expense: Ø The portion of depository institution costs

Depository Institution Operations Costs • Interest expense: Ø The portion of depository institution costs incurred through payments of interest to holders of the institutions’ liabilities. • Loan loss reserves: Ø An amount of cash assets that depository institutions hold as liquidity that they expect to be depleted as a result of loan defaults. • Loan loss provisions: Ø An expense that depository institutions incur when they allocate funds to loan loss reserves. Copyright © 2004 South-Western. All rights reserved. 5

Commercial Bank Expenses Over half of the expenses of commercial banks are noninterest expenses

Commercial Bank Expenses Over half of the expenses of commercial banks are noninterest expenses on real resources such as labor and capital goods. Interest expenses on deposit funds and purchased funds account for nearly all remaining expenses, although expenses on loan loss provisions typically account for a small portion of total bank costs. SOURCE: Federal Deposit Insurance Corporation. Copyright © 2004 South-Western. All rights reserved. Figure 13– 2 6

Depository Institution Profitability • Return on assets: Ø A depository institution’s profit as a

Depository Institution Profitability • Return on assets: Ø A depository institution’s profit as a percentage of its total assets. • Return on equity: Ø A depository institution’s profit as a percentage of its equity capital. Copyright © 2004 South-Western. All rights reserved. 7

Commercial Banks’ Average Returns on Assets (a) and Equity (b) Figure 13– 3 Copyright

Commercial Banks’ Average Returns on Assets (a) and Equity (b) Figure 13– 3 Copyright © 2004 South-Western. All rights reserved. 8

Depository Institution Profitability • Net interest margin: Ø The difference between a depository institution’s

Depository Institution Profitability • Net interest margin: Ø The difference between a depository institution’s interest income and interest expenses as a percentage of total assets. Copyright © 2004 South-Western. All rights reserved. 9

Theories of Bank Management • Real bills doctrine: Ø A bank management philosophy that

Theories of Bank Management • Real bills doctrine: Ø A bank management philosophy that calls for lending primarily to borrowers who will use the funds to finance production or shipping of physical goods, thereby ensuring speedy repayment of the loans. Ø Self-liquidating loans. Ø Central Bank as lender of last resort. Copyright © 2004 South-Western. All rights reserved. 10

Theories of Bank Management (cont’d) • Shiftability theory: Ø A management approach in which

Theories of Bank Management (cont’d) • Shiftability theory: Ø A management approach in which depository institutions hold a mix of illiquid loans and more liquid securities that act as a secondary reserve held as a contingency against potential liquidity problems. Ø Secondary reserves v Securities that depository institutions can easily convert to cash in the event that such a need arises. Ø Primary reserves v Cash assets. Copyright © 2004 South-Western. All rights reserved. 11

Theories of Bank Management (cont’d) • Anticipated-income approach: Ø A depository institution management philosophy

Theories of Bank Management (cont’d) • Anticipated-income approach: Ø A depository institution management philosophy that calls for depository institutions to make loans more liquid by issuing them as installment loans that generate income in the form of periodic payments of interest and principal. • Conversion-of-funds approach: Ø A depository institution management philosophy under which managers try to fund assets of specific maturities by issuing liabilities with like maturities. Copyright © 2004 South-Western. All rights reserved. 12

Theories of Bank Management (cont’d) • Asset-liability management approach: Ø A depository institution management

Theories of Bank Management (cont’d) • Asset-liability management approach: Ø A depository institution management philosophy that emphasizes the simultaneous determination of both the asset and the liability sides of the institution’s balance sheet. • Gap management: Ø A technique of depository institution asset-liability management that focuses on the difference (“gap”) between the quantity of assets subject to significant interest rate risk and the amount of liabilities subject to such risk. Copyright © 2004 South-Western. All rights reserved. 13

Bank Syndicated Lending in Total and As a Share of Total Corporate Financing SOURCE:

Bank Syndicated Lending in Total and As a Share of Total Corporate Financing SOURCE: Bank for International Settlements, Quarterly Banking Profile, various issues. Copyright © 2004 South-Western. All rights reserved. Figure 13– 4 14

Duration Gap Analysis • Duration gap: Ø The average duration of a depository institution’s

Duration Gap Analysis • Duration gap: Ø The average duration of a depository institution’s assets minus the average duration of its liabilities. Copyright © 2004 South-Western. All rights reserved. 15

Depository Institution Market Structure • Market structure: Ø The organization of the loan and

Depository Institution Market Structure • Market structure: Ø The organization of the loan and deposit markets in which depository institutions interact. • Market concentration: Ø The degree to which the few largest depository institutions dominate loan and deposit markets. Copyright © 2004 South-Western. All rights reserved. 16

Perfect Competition Versus Monopoly • Value-at-risk model: Ø A statistical framework for evaluating how

Perfect Competition Versus Monopoly • Value-at-risk model: Ø A statistical framework for evaluating how changes in interest rates and financial instrument prices are likely to affect the overall value of a portfolio of financial assets. • Normal profit: Ø A profit level just sufficient to compensate depository institution owners for holding equity shares in the depository institution instead of purchasing ownership shares of other enterprises. Copyright © 2004 South-Western. All rights reserved. 17

Monopolistic versus Perfectly Competitive Loan Markets Figure 13– 5 Copyright © 2004 South-Western. All

Monopolistic versus Perfectly Competitive Loan Markets Figure 13– 5 Copyright © 2004 South-Western. All rights reserved. 18

Monopoly Profits • Supranormal profits: Ø Levels of profit above those required to induce

Monopoly Profits • Supranormal profits: Ø Levels of profit above those required to induce depository institution owners to hold shares of ownership in those institutions instead of shares of other businesses. Copyright © 2004 South-Western. All rights reserved. 19

Does Market Concentration Matter? • Structure-conduct-performance (SCP) model: Ø A theory of depository institution

Does Market Concentration Matter? • Structure-conduct-performance (SCP) model: Ø A theory of depository institution market structure in which the structure of loan and deposit markets influences the behavior (conduct) of depository institutions in those markets, thereby affecting their performance. Copyright © 2004 South-Western. All rights reserved. 20

The Structure-Conduct-Performance Model Figure 13– 6 Copyright © 2004 South-Western. All rights reserved. 21

The Structure-Conduct-Performance Model Figure 13– 6 Copyright © 2004 South-Western. All rights reserved. 21

Does Market Concentration Matter? • Efficient structure theory: Ø A theory of depository institution

Does Market Concentration Matter? • Efficient structure theory: Ø A theory of depository institution market structure in which greater market concentration and higher depository institution profits arise from the fact that a few depository institutions can operate more efficiently in loan and deposit markets as compared with a large number of institutions. Copyright © 2004 South-Western. All rights reserved. 22

The Efficient Structure Theory Figure 13– 7 Copyright © 2004 South-Western. All rights reserved.

The Efficient Structure Theory Figure 13– 7 Copyright © 2004 South-Western. All rights reserved. 23

Notional Value of Credit Derivatives Held by U. S. Banks SOURCE: Office of the

Notional Value of Credit Derivatives Held by U. S. Banks SOURCE: Office of the Comptroller of the Currency, Bank Derivatives Report, various issues. Copyright © 2004 South-Western. All rights reserved. Figure 13– 8 24

Global Distribution of the Notional Value of Credit Derivatives among Contract Counterparties SOURCE: Bank

Global Distribution of the Notional Value of Credit Derivatives among Contract Counterparties SOURCE: Bank for International Settlements. Copyright © 2004 South-Western. All rights reserved. Figure 13– 9 25

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