fin 4030 chapter 19
formula for net interest margin
(interest revenues - interest expense)/assets
important functions of bank directors
- determine a compensation system for executives - ensure proper disclosure of the bank's financial condition and performance to investors - oversee growth strategies (ex. acquisitions) - oversee policies for changing the capital structure (raise capital or engage in stock repurchases) - assess the bank's performance and ensure that corrective action is taken if the performance is weak
most common methods of measuring interest rate risk
- gap analysis - duration analysis - regression analysis
methods used to reduce interest rate risk
- maturity matching - using floating rate loans - using interest rate futures contracts - using interest rate swaps - using interest rate caps
banks continually assess both
- overall compensation of their loan portfolios - economic environment
methods used to reduce market risk
- reduce the amount of transaction in which it serves as a guarantor for its clients or reduce the bank's investment in foreign debt securities that are subject to adverse events in a specified region - attempt to take some trading positions to offset some of its exposure to market risk - could sell some of its securities that are heavily exposed to market risk
what type of compensation programs may banks implement that provide bonuses to managers that satisfy bank goals
- the bonus associated with bank earnings - stock options that can be exercised after a few years
regression analysis formula
R= B0 + B1Rm + B2i + mu
the market for corporate control serves as
a form of governance because, bank managers recognize that they could lose their jobs if their bank is acquired
banks must be concerned about achieving
a reasonable return on their assets, which often conflicts with the liquidity objective
banks should diversify their loans to ensure that their customers
are not dependent on a common source of income
why do inside directors sometimes face a conflict of interest
because their decisions as board members may affect their jobs as managers
some loans to high-quality (low risk) customers are commonly offered at rates
below the prime rate
inside directors
board members who are also managers of the bank
how can they resolve cash deficiencies
by creating additional liabilities or by selling assets
market risk results from
changes in the value of securities due to changes in financial market conditions (int rate movements, exchange rate movements, and equity prices)
banks continually revise their estimate of market risk in response to
changes in their investment and credit positions and to changes in market conditions
during periods of rising interest rates, the cap provides
compensation that can offset the reduction in spread during such periods
during a period of rising interest rates, a banks net interest margin will likely
decrease if its liabilities are more rate sensitive than its assets
VaR method involves
determining the largest possible loss that would occur as a result of changes in the market prices based on a specified percent confidence level
duration gap
difference between the weighted duration of the bank's assets and the weighted duration of its liabilities, adjusted for the firm's asset size
outside directors
directors who aren't managers
many banks reduce their exposure to US economic conditions by
diversifying their loan portfolio internationally
exposure also changes over time in response to
economic conditions
the ability to securitize assets such as automobiles and mortgage loans can
enhance a bank's liquidity
the bank's asset also affects its
expenses
to implement their strategy, commercial banks rely heavily on
financial markets
banks can attempt to determine their interest rate risk by monitoring their gap over time
gap analysis
an alternative form of gap analysis
gap ratio
the increase in banks' exposure to market risk is also attributed to their
increased participation in the trading of derivative contracts
larger proportion of financing credit cards
increases exposure to credit risk
a bank's decisions on sources of funds will heavily influence its
interest expenses on the income statement
the difference in currency denominations creates
interest rate risk
a bank's asset structure will strongly influence
its interest revenue on the income statement
liquidity may lessen as economic conditions
lessen and demand for selling loans increases
what type of problems typically are preceded by other financial problems
liquidity problems
match each deposit's maturity with an asset of the same maturity
maturity matching
as banks pursue new services related to the trading of securities, they have become
much more susceptible to market risk
the difference between interest payments received and interest paid
net interest margin (spread)
ROE formula
net profit after taxes/equity also equals = (net profit after taxes/assets) x (assets/equity) or ROA x leverage measurement
commercial banks can obtain funds by packaging their their commercial loans with those
of other financial institutions and then selling securities that represent ownership of these loans
the possibility of prepayment makes it impossible to
perfectly match the rate sensitivity of assets and liabilities
for most banks, the duration gap is
positive
publicly traded banks are subject to
potential shareholder activism
a bank concerned with maximizing its returns could use most of its funds to
provide credit card and consumer loans
if a bank wants to minimize credit risk, it can use most of its funds to
purchase treasury securities
gap ratio formula
rate sensitive assets / rate sensitive liabilities
gap formula
rate-sensitive assets - rate-sensitive liabilities
financial futures contracts can
reduce the uncertainty about a bank's net interest margin
a bank can assess interest rate risk by determining how performance has historically been influenced by interest rate movements
regression analysis
banks employ credit analysts who
review the financial information of corporations applying for loans and evaluate their creditworthiness
agreements (for a fee) to receive payments when the interest rate for a particular security or index....
rises above a specified level during a specified time period
banks can eliminate loans that are causing excessive risk to their loan portfolios by
selling them in the secondary market
banks can ensure sufficient liquidity by using most of their funds to purchase
short-term treasury securities or other money market securities
a duration gap of zero suggests
that the bank's value should be insensitive to interest rate movements
if the bank decides to grant the loan, it can use its evaluation of the firm to determine
the appropriate interest rate
the process of securitization involves
the sale of assets by the bank to a trustee, who issues securities that are collateralized by the assets
the deposit rates will typically be more sensitive if
their turnover is quicker
why are outside directors generally expected to be more effective
they don't face a conflict of interests in serving shareholders
exposure is dependent on
types of loans a bank provides
allows banks to support long-term assets with short-term deposits without overly exposing themselves to interest rate risk
using floating-rate loans
an arrangement to exchange periodic cash flows based on specified interest rates
using interest rate swaps
banks commonly measure their exposure to market risk by applying the
value-at-risk (VaR) method
when do banks experience illiquidity
when cash outflows (due to deposit withdrawals, loans, etc) exceed cash inflows (new deposits, loan repayments, etc)
a bank measures the risk and then uses its assessment of future interest rates to decide
whether and how to hedge the risk
a bank can consider the measurement of its interest rate risk along with its forecast of interest rate movements to determine
whether it should consider hedging that risk
when a bank assesses a request for credit, it must decide
whether to require collateral that can back the loan in case the borrower is unable to make the payments
when a bank has foreign currency balances, the strategy of matching the overall interest rate sensitivity of assets to the of liabilities
will not automatically achieve a lower degree of interest rate risk