Management of Banking and Financial Institutions Chapter 9

Overview § § § The Bank Balance Sheet Asset Management Liability Management Capital Adequacy Management Managing Interest Rate Risk Financial Innovations

How do banks make money? § Take in liabilities with certain characteristics § Short term § Low interest rate § Liquid deposits § Convert to loans with different characteristics § Long term § Higher Interest Rate § Less liquid loans § Total Assets = Total Liabilities + Bank Capital

Liabilities § Checkable deposits § Nontransaction deposits § CDs, savings accounts § Borrowings § § § Fed Reserve Bank to bank Parent Company Repurchase agreements (Repos) Eurodollars § Bank Capital (Net worth) § Stock

Assets § Cash items § Reserves: Required and Excess § Cash items in process of collection § Deposits at other banks § Securities (10% of revenue) § Federal, state, and local § Loans (over 50% of revenue) § Illiquid, long term, so higher interest § Other Assets (physical capital)

The T-account § Accounting scheme § Role of reserves § Reserve ratio § Excess reserves § Liquidity § What to do when reserves get too low? § § Borrow (Fed or other banks) Sell securities Call loans Balance!

Asset management § ‘Borrow short and lend long’ § High return § Low cost and low risk § Liquidity (enough deposit outflows) § Examples § Long term loans to reliable customers § Reliable high interest securities § Diversify

Liability Managment § Demand deposits § before 1960, over 60% of inflow from dd § Now only 9%!!! § Loans § 1960 was 2%, 2002 was 42%, now 56% § CDs especially § Savings accounts § Banks now manage their liability side! § E. g. control size based on how many loans they thing they can make

Bank Capital Adequacy Mgmt § Capital (on liability side) is net worth § Prevents insolvency (bank failure) § Satisfies regulators (8% min) § How do they do reduce (increase) BC? § Buy (sell) stock § Increase (decrease) dividends § Increase (decrease) assets relative to BC, e. g. borrow or loan more money

Tradeoff: Safety vs. Profits § How to balance § Good times, keep K low § Bad times, keep K high § Savings and loan crisis, require more K § But couldn’t increase K because couldn’t sell stock! § Had to lower lending (increase in relative K)

Tradeoff: safety vs. profits § Return on assets (ROA) - “Measure of efficiency” § Net profits after taxes/assets § Return on equity (ROE) - “Profitability measure” § Net profits after taxes/equity (bank) capital § Equity Multiplier (EM) § ROE/ROA § How much a return on assets translates into a return on equity

Managing Credit Risk § How do banks get high interest, honest customers? § § § Screen/monitor (covenants, specialize, size etc. ) Long-term relationships Compensating balances Collateral Lines of credit Restrict credit (example: adj. rate mortgages)

Managing Interest Rate Risk § Changing interest rates affect assets and liabilities § Affects variable AND fixed assets/liabilities § A change in IR affects variable rates and hence directly affects cash flow into assets and payments to liabilities § A change in IR affects fixed rated by its relative gain or loss, e. g. what the bank COULD be making (or losing) if the asset or liability wasn’t fixed

Gap Analysis § Measures sensitivity to interest rates § For Variable Interest Assets and Liabilities ∆ Profits = (var. assets - var. loans)(%point∆ir) § What if… § A bank has more variable liabilities than assets § The interest rate decreases

Duration Analysis § Duration measures a weighted lifetime average of the ‘stream of payments’ § Applies to fixed interest assets/liabilities $ ∆ Net worth = (-1)(∆I)(Da)(Fixed. A) - (-1)(∆I)(Dl)(Fixed. L) § What if… § Duration of liabilities is more than assets § Interest rate decreases

Strategies to manage IR risk § Diversify! § Stay ahead of the curve § Financial Derivatives (innovations) § § Forwards Futures Options Swaps

Off Balance Sheet Activities § Income from these has doubled since 1980 § Loan Sales § Ginnie Mae, Fannie Mae, Freddie Mac § Generate Fees § § Foreign exchange trading charges Bankers acceptances (like a co-signer) Lines of credit Servicing securitization of mortgages § Trading Activities § Futures, options, interest-rate swaps

Trading Risk Management § Barings, now Societe Generale § Value at risk § Probability of maximum loss in a given time period § Example § max possible loss in 1 month= 1 million § Loss that big could only happen every two years § Value at risk is 1/24 at 1 million dollars § Stress testing (looking for ‘domino effects’)