Chapter 9: Banking and the Management of Financial Institutions

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 *set target goals for their asset growth and tried to acquire funds (by issuing securities) as they were needed

Other Assets

The physical capital (bank buildings, computers, and other equipment) owned by banks

Liabilities

a bank acquires funds by issuing (selling) liabilities, which are the sources of funds the bank uses The funds obtained from issuing liabilities are used to purchase income earning assets *Sources of funds:* Checkable deposits Nontranasction deposits Borrowings Bank capital

Managing Credit Risk: Collateral and compensating balances

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Managing Interest-Rate Risk

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Off-Balance-Sheet Activities

*Loan sales* (secondary loan participation) *Generation of fee income.* Examples: -Servicing mortgage-backed securities -Creating SIVs (structured investment vehicles) which can potentially expose banks to risk, as it happened in the global financial crisis

Application: How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis

*Shortfalls of bank capital led to slower credit growth:* -Huge losses for banks from their holdings of securities backed by residential mortgages. -Losses reduced bank capital *Banks could not raise much capital on a weak economy, and had to tighten their lending standards and reduce lending*

Asset Management

*Three goals:* Seek the highest possible returns on loans and securities. Reduce risk Have adequate liquidity Four Tools: 1) Find borrowers who will pay high interest rates and have low possibility of defaulting 2) Purchase securities with high returns and low risk 3) Lower risk by diversifying 4)Balance need for liquidity against increased returns from less liquid assets.

Loans

*a liability for the individual or corporation receiving it, but an asset to a bank b/c it provides income to the bank* - make profits primarily by issuing loans - loans are typically less liquid than other assets because they cannot be turned into Cash until the loan matures - loans have a higher probability of a default than other assets, -because of their lack of liquidity and their higher default risk, the bank earns is highest returns on loans *Categories:* Commercial & industrial (*Largest*) Real Estate Consumer Interbank Other -*53% of bank assets*

Borrowings

*obtain funds by borrowing from the Federal Reserve System, the Federal Home Loan banks and other banks and corporations* borrowings from the FED are called *discount loans* (also called advances ) - borrow reserves overnight in the fed funds market from other US banks and FIs -borrow in order to have enough deposits at the Federal Reserve to meet the amount required by the Fed *Other sources of borrowed funds:* - loans made to banks by their parent companies, loan arrangement with corporations, and borrowings of eurodollars *20% of bank liabilities*

Bank capital

*the banks net worth*=the difference between total assets and liabilities -Raised by selling new equity (stock) or from retained earnings - capital is the cushion against a drop in the value of assets, which could force the bank in solvency, which occurs when a bank has liabilities in excess of assets. The bank can be forced into liquidation

Nontransaction deposits

*the primary source of bank fund (58% of banks liabilities)* -owners cannot write checks on these types of deposits, but the interest rates paid on these deposits are usually higher than those on checkable deposit Two types *savings account*: -Once was the most important type of non transaction deposit. - funds can be added to or withdrawn from savings account at any time *time deposits (CDs)*: a fixed maturity length, ranging from several months to over 5 years, and assess substantial penalties for early withdrawal of funds *Small denomination* time deposits (less than $1000,000) -less liquid for the deposit other than passbook savings -earn higher interest rates -more costly source of funds for the bank *Large denomination* time deposits are available $100,000 or more and are typically bought by corporations or other banks -negotiable: like bonds, can be resold into sencondary market before they mature -held by corporations, money market mutual funds and other financial institutions -11% of liabilities

bank manager has four concerns:

1) To make sure that the bank has enough ready cash to pay its depositors when there are *deposit outflows*, when deposits are lost b/c depositors make withdrawals and demand payment -To keep enough cash in hand, the bank must engage in liquidity management, *the acquisition of assets that are liquid enough to meet the banks obligations to depositors* 2) Manager must pursue a low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings (*asset management*) 3) acquiring funds at low cost (*liability management*) 4) manager must decide the amount of capital the bank should maintain and then acquire the needed capital (*capital adequacy management*) *Credit risk*: the risk arising because borrowers may default *Interest-rate risk*: riskiness of earnings and returns on bank assets cased by interst rate changes

Asset transformation

Banks make profit by selling liabilities with one set if characteristics and using the proceeds to buy assets with a different set of characteristics *The bank borrows short and lends long* *EX: a savings deposit held by one person can provide funds that enable the bank to make a mortgage loan to another person* T account: a simplified balance sheet with lines in the form a T that lists only the changes that occur in balance sheet items starting with initial balance sheet position

To eliminate shortfall of no reserves: acquire reserves by borrowing from the FED

Assets | Liabilities *Reserves* $9mil *Deposits* $90mil *Loans* $90mil *Borrowings from FED* $9mil *Securities* $10mil *Bank Capital* $10mil -cost associated with discount loans is the interst that must be paid to the FED (*discount rate*)

Capital Adequacy Management: Trade-off between safety and returns to equity holders

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

T-account: bank holds insufficient excess reserves

makes additonal $10mil in loans, so that it holds no excess reserves *Inital*: Assets | Liabilities *Reserves* $10mil *Deposits* $100mil *Loans* $90mil *Bank Capital* $10mil *Securities* $10mil Assets | Liabilities *Reserves* $0mil *Deposits* $90mil *Loans* $80mil *Bank Capital* $10mil *Securities* $10mil *problem because the requirement of reserves went to $0*

To eliminate shortfall of no reserves: reducing loans its loans

reduced by this amount and depositing $9mil it then receives with the FED increase reserves by $9mil Assets | Liabilities *Reserves* $9mil *Deposits* $90mil *Loans* $81mil *Bank Capital* $10mil *Securities* $1mil -sell loans to other banks, costly b/c other banks do not know how risky these loans are and may not be willing to buy at full value *cosliest way of acquiring reserves when a deposit outflow exists* *excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with d.o, the more the excess reserves a bank will want to hold*

Managing Interest-Rate Risk:Gap Anaylisis

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Managing Credit Risk: Credit rationing

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Managing Credit Risk: Long-term customer relationships

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Managing Credit Risk:Loan commitments

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Deposits at other banks

- many small banks hold deposits in larger banks in exchange for a variety of services, including check collection, foreign exchange transactions and help with securities purchases (called *correspondent banking*) -cash items

the banks costs of maintaining checkable deposits include :

-interest payments -the costs incurred in servicing these accounts (processing, preparing, and sending out monthly statements) -providing efficient teller (human or otherwise) -maintaining an impressive building -conveniently located branches -advertising and marketing aimed at inciting customers to deposit their funds in the bank

Securities

-made up entirely of debt instruments for commercial banks, b/c banks are not allowed to hold stock *account for 19% of bank assets* -provide commercial banks with almost 10% of their revenue 3 Categories: *US government*: -Most liquid b/c they can be easily traded and converted to cash with low transaction costs -because of high liquidity, short term US securities are called* secondary reserves* *State and local government*: -More likely to do business with banks that hold their securites -less marketable (*less liquid*) and riskier than US govt, b/c of default risk - some possibility exist that the issuer of the securities may not be able to make its interest payments or pay back the face value of the securites when they mature *other securities*

Capital Adequacy Management: How the Amount of Bank Capital Affects Returns to Equity Holders

A basic measure of profitibiltiu is *Return on Assets* (ROA), the net profit after taxes per dollar of assets *ROA = net profit after taxes/assets* -a bank owner care about is how much the bank is earning on their equity investment; the *Return on equity* (ROE); net profit after taxes per dollar of equity *ROE: = net profit after taxes/equity capital* There is a direct relationship between the ROA and ROE The Equity Multiplier, or the amount of assets per dollar of equity capital *EM = Assets/Equity Capital* *ROE= ROA x EM*

Cash items in process of collection

A check written on an account at another bank is deposited in your bank, and the funds for the check have not yet been received from the other bank -classified as a *cash item* -it is an asset for your bank b/c it is a claim on another bank for funds that will be paid in a few days

T-account: if National Bank received an extra $100 of checkable deposits

Assets | Liabilities *Required Reserves* -$10 *Checkable deposits* -$100 *Excess reserves* +$90 bank is obligated to keep a fraction of its checkable deposits

T-account: if bank chooses to not hold any excess and to make loans instead

Assets | Liabilities *Required Reserves* -$10 *Checkable deposits* -$100 *Loans*+$90

To eliminate shortfall of no reserves: sell securities

Assets | Liabilities *Reserves* $9mil *Deposits* $90mil *Loans* $90mil *Bank Capital* $10mil *Securities* $1mil

To eliminate shortfall of no reserves: borrow from other corporations

Assets | Liabilities *Reserves* $9mil *Deposits* $90mil *Loans* $90mil *Borrowings from Corp* $10mil *Securities* $10mil *Bank Capital* $10mil *the cost of this activity is the interest rate on these borrowings, such as the federal rate*

Reserves

All banks hold some of the funds they acquire as deposits in an account at the Fed -consists of these deposits plus currency that is physically held by banks (called *vault cash* b/c it is stored in bank vaults) -reserves earn a low interest rate, banks hold them for two reasons 1) *Required reserves* are held b/c of *reserve requirements*, the regulation that for every dollar of checkable deposits, a certain fraction must be kept as reserves 2) banks hold additional reserves, called *Excess Reserves*, b/c they are the most liquid of all bank assets Bank can use them to meet obligations when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account

T-account : If Jane open the account with $100 on an account at another bank, Second National Bank

Assets | Liabilities *Cash items in process* $100 *Checkable deposits* +$100 *Final balance sheet* *First National* Assets | Liabilities *Reserves* +$100. *Checkable deposits* +$100 *Second National* Assets | Liabilities *Reserves* -$100. *Checkable deposits* -$100 *when a bank receives additional deposits, it gains an equal amount if reserves;; when it loses deposits, it loses an equal amount of reserves*

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

Off-Balance-Sheet Activities: Trading activities and risk management techniques

Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market and speculation Principal-agent problem arises Internal controls to reduce the principal-agent problem: -Separation of trading activities and bookkeeping -Limits on exposure -Value-at-risk -Stress testing

Liquidity Management and the Role of Reserves

Initial balance sheet Assets | Liabilities *Reserves* $20mil *Deposits* $100mil *Loans* $80mil *Bank Capital* $10mil *Securities* $10mil *if a deposit outflow of $10mill occurs*: Assets | Liabilities *Reserves* $10mil *Deposits* $90mil *Loans* $80mil *Bank Capital* $10mil *Securities* $10mil the bank loses $10mill and & $10mil of reserves *if a bank has ample excess reserves, a deposit outflow does not necessitate in other parts of its balance sheet*

T-account for a bank & reserves

Jane opens a checking account with a $100 bill now has a checkable deposit at the bank: shows on liabilities side The bank has her $100 in its vault so the banks assets rise by $100 increase Assets. | Liabilities *Vault Cash* +100 *Checkable deposits* +$100 *Reserves* Assets | Liabilities *Reserves* +100. *Checkable deposits* +$100 *an increase in the banks reserves equal to the increase in checkable deposits*

General Principles of Bank Management

Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk

Managing Credit Risk: Screening and Monitoring

Screening Specialization in lending Monitoring and enforcement of restrictive covenants

Capital Adequacy Management: How Bank Capital Helps Prevent Bank Failure:

Two banks with identical balance sheets, High Capital has a ratio of capital to assets of 10%, while Low Capital Bank has ratio of 4% *High Capital Bank* Assets | Liabilities *Reserves* $10mil *Deposits* $90mil *Loans* $90mil *Bank Capital* $10mil *Low capital Bank* Assets | Liabilities *Reserves* $10mil *Deposits* $96mil *Loans* $90mil *Bank Capital* $4mil *a bank maintains capital to lessen the chance that it will become insolvent*

Assets

a bank uses the funds that is has acquired by issuing liabilities to purchase income earning assets; *uses of funds* -the interest payments earned on them are what enable banks to make profits

The bank balance sheet

a list of the banks assets and liabilities *Total assets = total liabilities + capital* -list of sources of bank funds(liabilities and capital) and uses to which the funds are put (assets) - banks obtain funds by borrowing and by issuing other liabilities, such as deposits - banks make profit by earning interest on their asset holding of securities and loans that is higher than the interest and other expenses on their liabilities

Checkable deposits

bank accounts that allow the owner of the account to write checks to third parties -includes all accounts on which check can be drawn -accounts for 11% of bank liabilities *once were the most important source of bank funds, but the advent of new, more attractive financial instruments, such as money market deposit accounts, they share of checkable deposits in total bank liabilities has shrunk* -payable on demand; if a depositor shows up at the bank and requests payment by making a withdraw, the bank must pay the depositor immediately -if a person who receives a check written on an account from a bank present that check at the bank, the bank must pay the funds out asap (or credit them to the persons account) *an asset for the depositor b/c it is part of his/her wealth* the depositor can withdraw funds and the bank is obligated to pay, *checkable deposits are a liability for the bank*

Capital Adequacy Management: Bank Capital Requirements

bank hold capital because they are required to do so -b/c of high cost of holding capital, managers want to hold less bank capital relative to assets than is required