Chapter 9 Banking and the Management of Financial

Chapter 9 Banking and the Management of Financial Institutions

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Basic Banking—Cash Deposit First National Bank Assets Vault Cash +$100 First National Bank Liabilities Checkable deposits +$100 Assets Reserves Liabilities +$100 Checkable deposits +$100 • Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 3

Basic Banking—Check Deposit First National Bank Assets Cash items in process of collection Liabilities +$100 Checkable deposits +$100 First National Bank Assets Second National Bank Liabilities Reserves +$100 Checkable deposits +$100 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Assets Reserves -$100 Liabilities Checkable deposits -$100 4

Basic Banking—Making a Profit First National Bank Assets Required reserves Excess reserves Second National Bank Liabilities +$100 Checkable deposits +$100 +$90 Assets Required reserves Loans Liabilities +$100 Checkable deposits +$100 +$90 • 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 5

Bank Management • Liquidity Management • Asset Management • Liability Management • Capital Adequacy Management • Credit Risk • Interest-rate Risk Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 6

Liquidity Management: Ample Excess Reserves Assets Liabilities Reserves $20 M Deposits Loans $80 M Bank Capital $10 M Securities $100 M $10 M Assets Liabilities Reserves $10 M Deposits $90 M Loans $80 M Bank Capital $10 M Securities • If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 7

Liquidity Management: Shortfall in Reserves Assets Liabilities Reserves $10 M Deposits Loans $90 M Bank Capital $10 M Securities $100 M $10 M Assets Reserves Loans Securities Liabilities $0 Deposits $90 M Bank Capital $10 M $90 M $10 M • Reserves are a legal requirement and the shortfall must be eliminated • Excess reserves are insurance against the costs associated with deposit outflows Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8

Liquidity Management: Borrowing Assets Reserves Liabilities $9 M Deposits $90 M Loans $90 M Borrowing $9 M Securities $10 M Bank Capital $10 M • Cost incurred is the interest rate paid on the borrowed funds Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 9

Liquidity Management: Securities Sale Assets Reserves Loans Securities Liabilities $9 M Deposits $90 M Bank Capital $90 M $1 M • The cost of selling securities is the brokerage and other transaction costs Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10

Liquidity Management: Federal Reserve Assets Reserves Liabilities $9 M Deposits Loans $90 M Borrow from Fed Securities $10 M Bank Capital $90 M $9 M $10 M • Borrowing from the Fed also incurs interest payments based on the discount rate Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11

Liquidity Management: Reduce Loans Assets Reserves Liabilities $9 M Deposits Loans $81 M Bank Capital Securities $10 M $90 M $10 M • 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 substantial discount Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 12

Asset Management: Three Goals • Seek the highest possible returns on loans and securities

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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14

Liability Management • Recent phenomenon due to rise of money center banks • Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) • Checkable deposits have decreased in importance as source of bank funds Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 15

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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 16

Capital Adequacy Management: Preventing Bank Failure When Assets Decline High Bank Capital Assets Liabilities Low Bank Capital Assets Liabilities Reserves $10 M Deposits $90 M Reserves $10 M Deposits Loans $90 M Bank Capital $10 M Loans $90 M Bank Capital High Bank Capital Assets Liabilities Reserves $10 M Deposits Loans $85 M Bank Capital Copyright © 2007 Pearson Addison-Wesley. All rights reserved. $96 M $4 M Low Bank Capital Assets $90 M Reserves $5 M Loans Liabilities $10 M Deposits $96 M $85 M Bank Capital -$1 M 17

Capital Adequacy Management: Returns to Equity Holders Copyright © 2007 Pearson Addison-Wesley. All rights

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 equity • Choice depends on the state of the economy and levels of confidence Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 19

Credit Risk: Overcoming Adverse Selection and Moral Hazard • Screening and information collection • Specialization in lending • Monitoring and enforcement of restrictive covenants • Long-term customer relationships • Loan commitments • Collateral and compensating balances • Credit rationing Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 20

Interest-Rate Risk First National Bank Assets Rate-sensitive assets Liabilities $20 M Rate-sensitive liabilities $50 M Variable-rate and short-term loans Variable-rate CDs Short-term securities Money market deposit accounts Fixed-rate assets $80 M Fixed-rate liabilities Reserves Checkable deposits Long-term loans Savings deposits Long-term securities Long-term CDs $50 M Equity capital • 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 raise bank profits Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 21

Interest Rate Risk: Gap Analysis Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22

Interest Rate Risk: Duration Analysis Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 23

Question #1 a Gap Analysis • Suppose that you are the manager of a bank that has $15 million of fixed-rate assets, $30 million of rate-sensitive assets, $25 million of fixed-rate liabilities, and $20 million of rate-sensitive liabilities. Conduct a gap analysis for the bank, and show what will happen to bank profits if interest rates rise by 5%. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 24

Question #1 b Gap Analysis • What actions could you take to reduce the

Question #2 a Duration Analysis • Suppose that you are the manager of a bank whose $100 billion of assets have an average duration of four years and whose $90 billion of liabilities have an average duration of six years. Conduct a duration analysis for the bank, and show what will happen to the net worth if interest rates rise by 2 percentage points. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 26

Question #2 b Duration Analysis • What actions could you take to reduce the

Off-Balance-Sheet Activities • Loan sales (secondary loan participation) • Generation of fee income • Trading activities and risk management techniques Futures, options, interest-rate swaps, foreign exchange Speculation Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 28

Off-Balance-Sheet Activities (cont’d) • Trading activities and risk management techniques (cont’d) Principal-agent problem Internal Controls • Separation of trading activities and bookkeeping • Limits on exposure • Value-at-risk • Stress testing Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 29