Chapter 6 Banking the Management of Financial Institutions

Chapter 6 Banking & the Management of Financial Institutions 1

In this Chapter Because banking system plays a major role in channeling funds from the savers/lenders to investors/borrowers, it is important to study: • How do the financial institutions do the business to maximize their profit. • How and why financial institutions make loans. • How they earn funds and manage their assets and liabilities. To understand the functioning of the banking system, we study…. 2

In this Chapter • The Bank Balance Sheet • Basic Banking • General Principles of Bank Management including risk management. • Risk & Interest Rate Risk 3

The Bank Balance Sheet • To understand how banking works we start by looking at the bank balance sheet. • The bank balance sheet is a list of the bank assets (what bank owns) and liabilities (what it owes) where: Total assets = total liabilities + bank’s capital (net worth). • Banks make profits by receiving interest rates on their asset holdings of securities and loans that is higher than the expenses of their liabilities. 4

The Bank Balance Sheet –Liabilities: • Liabilities are source of funds a bank uses to purchase assets. • Banks obtain funds by borrowing and by issuing (selling) other liabilities such as deposits. • Liabilities include: 1. Checkable deposits 2. Non-transaction deposits 3. Borrowings 4. Bank capital 5

The Bank Balance Sheet –Liabilities 1. Checkable deposits include: – non-interest bearing checking account (demand deposits), – interest-bearing accounts such as negotiable (NOW) accounts. – money market deposit accounts (MMDAs). 6

The Bank Balance Sheet –Liabilities 2. Non-transaction deposits. – main source of bank funds. – checks can’t be written on them. – the interest rates paid are higher than those on checkable deposits. • They include: 1. Saving accounts 2. Time deposits 7

The Bank Balance Sheet –Liabilities 3. Borrowings, from: – the central bank, – other commercial banks, – Corporations 4. Bank Capital (net worth) = total assets - total liabilities – Bank capital is raised by selling new equity (stock) or retained earnings. 8

The Bank Balance Sheet –Assets • The funds obtained from issuing liabilities are used to acquire income- earning assets such as securities and loans. • Banks assets are referred to the uses of funds, and the interest payments earned on them are what enable banks to make profit. • Assets include: – Reserves – Cash items in process of collection – Deposits at other banks – Securities – Loans – Other assets 9

The Bank Balance Sheet –Assets 1. Reserves include: – what banks keep with central bank, – currency (papers and coins) kept in the bank vaults • Reserves are held for two reasons: – required reserves are required by regulations. – excess reserves: to meet obligations when funds are withdrawn. 10

The Bank Balance Sheet –Assets 2. Loans – Banks make their profits primarily by issuing loans. – Because of the lack of liquidity and higher default risk, the bank earns its highest return on loans. 3. Cash items in process of collection – When a check written on an account at another bank is deposited in your bank and the funds for this check has not been collected from the other bank, it is an asset for your bank because it is a claim on another bank for funds that will be paid within a few days. 11

The Bank Balance Sheet –Assets 4. Securities – A bank’s holdings of securities are an important income-earning asset. 5. Deposits at other banks (corresponding banking) – Small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions, and help with securities purchase. 6. Other Assets – The physical capital owned by the banks such as bank buildings, computer, and other equipments. 12

Table 1: Balance Sheet of All Commercial Banks (items as a percentage of the total, 13

Bank Management • In general terms, banks make profits by selling liabilities with one set of characteristics (a particular combination of maturity, liquidity, risk, size, and return) and using the proceeds to buy assets with a different set of characteristics. • This process is often referred to as asset transformation. 14

Bank Management For example, a saving deposit held by one person can provide the funds that enable the bank to make a mortgage loan to another person. • The process of transforming assets and providing a set of services (check clearing, record keeping, credit analysis, and so forth) is like any other production process in a firm. • If the bank produces desirable services at low cost and earns reasonable income on its assets, it earns profits; if not, the bank suffers losses. 15

Bank Management To make the analysis of the operation of a bank more concrete, let us use a tool called T-account. • For example, if you have just opened a checking account with a $100 bill. • You have a $100 checkable deposit at a bank (the First Bank), which shows up as a $100 liability on the bank balance sheet. • The bank now put your $100 bill into its vault so that the bank’s assets rise by the $100 increase in vault cash. 16

Basic Banking: Cash Deposit 17

Basic Banking: Check Deposit Alternatively, suppose you had opened the account with a $100 check written on an account at another bank (the Second Bank), we would get the same result. • The initial effect on the T-account of your bank (the First Bank) is as follows: 18

Basic Banking: Check Deposit • If the central bank transfers the $100 of reserves from the Second Bank to the First Bank and the final balance sheet position of the two banks are as follows: First National Bank Assets Reserves +$100 Second National Bank Liabilities Checkable deposits +$100 Assets Reserves Liabilities -$100 Checkable deposits -$100 • To make a profit, bank rearranges its balance sheet when it experiences a change in its deposits. 19

Basic Banking: Making a Profit • As we know, the bank obliged to keep a certain fraction of its checkable deposits as required reserves. • This fraction is called required reserves ratio (RRR). • If the required reserves ratio is 10%, the First Bank required reserves have increased by $10. 20

Basic Banking: Making a Profit • To make a profit, the bank must put to productive use all or part of the $90 of excess reserves it has available. • If the bank decides not to hold any excess reserves but to make loans instead. The T-account then looks like this: 21

Basic Banking: Making a Profit • The bank now is making profit because it holds short term liabilities such as checkable deposits and uses the proceeds to buy longer-term assets such as loans with higher interest rates. • The above discussion has shown you how a bank operates. Now let us see how a bank manages its assets and liabilities to earn the highest profit. 22

Bank Management • Asset Management • Liability Management • Capital Adequacy Management • Credit Risk Management • Interest-rate Risk 23

Asset Management: 3 Goals • To maximize its profits, a bank must simultaneously seek: 1. The highest possible returns on loans and securities 2. Reduce risk 3. Have adequate liquidity • To achieve these three goals, banks conduct asset management in the following 4 ways: 24

Asset Management: 4 Tools 1. Find borrowers who will pay high interest rates and have low possibility of defaulting. – Loans officers engage in screening of the potential borrowers to reduce the adverse selection process. 2. Purchase securities with high returns and low risk 3. Lower risk by diversifying – making different types of loans to different types of customers. 4. Balance need for liquidity against increased returns from less liquid assets (such as loans) to avoid huge costs of deposit outflow. – banks will hold securities that are more liquid even if they earn somewhat lower return than other assets. 25

Liability Management • Banks aggressively set target goals for their asset growth and tried to acquire funds by issuing liabilities as they were needed. • For example, when a bank finds an attractive loan opportunity it can acquire funds by selling negotiable CDs or through borrowing from the central bank fund market. Because of the increased flexibility and importance of liability management, most banks now manage both sides of the balance sheet together in an asset-liability management (ALM) committee. 26

Capital Adequacy Management • Banks have to make decisions about the amount of capital they need to hold for three reasons. (1) Bank capital helps prevents bank failure, a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors. (2)The amount of capital affects returns for the owners (equityholders) of the bank. (3) A minimum amount of bank capital (bank capital equirements) is required by regulatory authorities. 27

Preventing Bank Failure 1. To learn that the bank is managed efficiently, its owners use the return on assets (ROA) as a measure of bank profitability. – ROA indicates how much profits are generated on average by each dollar of assets. ROA measures how efficiently the bank is run 2. To learn how much the bank is earning on their equity investment, bank owners measure the return on equity (ROE), the net profit after taxes per dollar of equity (bank) capital. ROE measures how well the owners are doing on their investment The relationship between ROA & ROE is determined by the equity multiplier (EM). • Given the return on assets, the lower the bank capital the higher the returns for the owners of the bank. 28

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How much Capital a bank should hold? Choice depends on the state of the economy and levels of confidence. Managers must decide how much higher safety they are willing to trade off against the lower return on equity that comes with higher capital. – Unsure times (more possibility of losses on loans) managers hold more capital to protect the equity holders. – Good times (confidence on more gains) they reduce the amount of capital, have a high EM, and thereby increase the ROE. 30

Credit Risk Management Banks and other financial institutions make loans that must be paid back in full. • The possibility of default subjects the financial institutions to credit risk. • The economic concepts of adverse selection and moral hazard provide a framework for understanding the principles that financial institutions have to follow to reduce credit risk and make successful loans. 31

Credit Risk Management Adverse selection in loan markets occurs because bad credit risks (the most likely to default on their loans) are the ones who usually line up for loans. • Borrowers with very risky investment projects have much to gain if their projects are successful. However, they are the least desirable borrowers because of the greater possibility that they will be unable to pay back their loans. 32

Credit Risk Management • Moral hazard exists in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lenders point of view. In such situations, it is more likely that the lender will be subjected to the hazard of default. • To be profitable, financial institutions must overcome the adverse selection and moral hazard problems that make loan defaults more likely. 33

Credit Risk: Overcoming Adverse Selection and Moral Hazard • The attempts of financial institutions to solve these problems help explain a number of principles for managing credit risk such as: (1) screening and monitoring, – Screening – Specialization in lending – Monitoring and enforcement of restrictive covenants (2) establishment of long-term customer relationships, (3) loan commitments, (4) collateral and compensating balance requirements, (5) credit rationing. 34

Credit Risk: Screening and Monitoring • Adverse selection in loan markets requires that lenders screen out the bad credit risks from the good ones so that loans are profitable to them. • To accomplish effective screening, lenders must collect reliable information from prospective borrowers. • Effective screening together with information collection form an important principle of credit risk management. 35

Credit Risk: Screening and Monitoring • The lender uses the information collected from the various forms the borrowers filled in to evaluate how good a credit risk you are by calculating your credit score, a statistical measure derived from your answers that predicts whether you are likely to have trouble making your loan payments. • Deciding on how good a risk you are cannot be entirely scientific. Personal judgment of the loan officer that is based on the experience and other factors is also important. 36

Credit Risk: Screening and Monitoring • Once a loan has been made, the borrower has an incentive to engage in risky activities that make it less likely that the loan will be paid off. • To reduce this moral hazard, financial institutions (the lenders) should write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities. 37

Credit Risk: Screening and Monitoring: Specializing in lending • Banks often specialize in lending to local firms or to firms in particular industries. • To do the screening effectively to avoid bad credit risk, it is easier for the bank to collect information about local firms and determine their Credit worthiness than doing the same thing for firms far away. • Similarly, by concentrating its lending on firms at specific industries, the bank becomes more knowledgeable about these industries and is therefore better able to predict which firms will be able to make timely payments on their debts. 38

Credit Risk: Screening and Monitoring: Monitoring & Enforcement of Restrictive covenants • To reduce moral hazard, financial institutions (the lenders) should write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities. • By monitoring borrowers activities to see whether they are complying with the restrictive covenants and by enforcing the covenants if they are not, lenders can make sure the borrowers are not taking on risks at their expense. The need for banks and other financial institutions to engage in screening and monitoring explains why they spend so much money on auditing and informationcollecting activities. 39

Credit Risk: Long-Term Customer Relationship • Another principle of credit risk management is to establish a long-term relationship with customers. • This allows banks and other financial institutions to obtain information about their borrowers. • If a prospective borrower has had an account with or loans from a bank over a long period of time, a loan officer can look at past activity on the accounts and learn quite a bit about the borrower. 40

Credit Risk: Long-Term Customer Relationship • The long-term customer relationships reduce the costs of information collection and make it easier to screen out bad credit risks. LT customer relationships enable banks to deal with even unanticipated moral hazard contingencies. • The borrower has the incentive to avoid risky activities that would upset the bank in order to preserve a long-term relationship with the bank, which will make it easier to get future loans at low interest rates. This behavior benefits both the bank and the customer. 41

Credit Risk: Loan Commitments • Banks also create long-term relationships and gather information by issuing loan commitments to commercial customers. • A loan commitment is a bank’s commitment for a specified future period of time to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate. • The majority of commercial and industrial loans are made under the loan commitment arrangement. 42

Credit Risk: Loan Commitments The advantage for the firm is that it has a source of credit when it needs it. • The advantage for the bank is that the loan commitment promotes a long-term relationship, which in turn facilitates information collection. • A loan commitment agreement is a powerful method for reducing the bank’s costs for screening and information collection. 43

Credit Risk: Collateral & Compensating Balances • Collateral requirements for loans are important credit risk management tools. • Collateral is property promised to the lender as compensation if borrower defaults. • It lessens the consequences of adverse selection because it reduces the lender’s losses in the case of loan default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for it losses on the loan. 44

Credit Risk: Collateral & Compensating Balances • One particular form of collateral required when a bank makes commercial loans is called compensating balances. • Compensating balances means that when a firm receives a loan it must keep a required minimum amount of funds in a checking account at the bank. • By requiring the borrower to use a checking account at the bank, the bank can observe the firm’s check payment practices, which may yield a great deal of information about the borrower’s financial condition. 45

Managing Interest Rate Risk • Interest-rate risk refers the risk of earnings and returns that is associated with changes in interest rates. • Rate-sensitive: when interest rates change frequently (at least once a year). • Fixed-rate: when interest rates remain unchanged for a long period (over a year) The conclusion is that 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 increase bank profits. 46