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