Chapter 9, 4th edition
Chapter 10, 3rd edition
Banking and the Management of
Financial Institutions
Depository Institutions: The Big Questions
• Where do commercial banks get their
funds and what do they do with them?
• How do commercial banks manage their
balance sheets?
• What risks do banks face?
Balance Sheet of Commercial Banks:
Assets, Liabilities, and Capital
• The balance sheet identity:
Bank Assets = [Bank Liabilities + Bank Capital]
• When one side changes, the other side must
change as well.
• A bank’s balance sheet lists sources of bank funds
(liabilities) and uses to which they are put (assets)
Balance Sheet of All Commercial Banks (items as a
percentage of the total, June 2011
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17-3
Table 1 Balance Sheet of All Commercial Banks (items
as a percentage of the total, June 2014)
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17-4
Liabilities – Sources of Funds
 Checkable Deposits: Referred to as transactions
deposits, includes all accounts that allow the
owner (depositor) to write checks to third parties;
─ Include non-interest earning checking accounts
(known as - demand deposit accounts),
─ Interest earning negotiable orders of withdrawal
(NOW) accounts, and
─ Money-market deposit accounts (MMDAs), which
typically pay the most interest among checkable
deposit accounts
─ About 11% of bank source of funds
Liabilities – Sources of Funds
 Non-transaction Deposits: generally a bank’s
highest cost funds.
 Banks want deposits which are more stable and
predictable and will pay more to attract such funds.
 Also the largest source of funds ~ 58%
Liabilities – Sources of Funds
 Borrowings:
 Banks borrow from:
─ the Federal Reserve System: discount loans
─ other banks: Fed funds and repos
─ Corporations: Repos and commercial paper
─ About 20% of bank source of funds
Bank Capital – Source of Funds
 Bank Capital: the source of funds supplied by the
bank owners,
─ either through purchase of ownership shares or
retained earnings
 Bank capital provides a cushion, thus capital
levels are important.
 About 11% of bank source of funds
 Currently a very important topic in bank regulation
Assets – Uses of Funds
 Reserves: funds held in account with the Fed
(vault cash and cash in the ATM machine is
included).
 Required reserves represent what is required by
law - reserve requirement or required reserve
ratios.
 Any reserves beyond this are called excess
reserves.
 About 19% of bank assets.
Assets – Uses of Funds
 Securities: includes U.S. government debt,
agency debt, municipal debt, and other
(non-equity) securities.
 About 19% of assets.
 Short-term Treasury debt (Treasury Bills) is
often referred to as secondary reserves
because of its high liquidity.
Assets – Uses of Funds
 Loans: business loans, auto loans, and
mortgages.
 Generally not very liquid.
 About 53% of bank assets.
 Most banks tend to specialize in either
consumer loans or business loans, and even
take that as far as loans to specific groups
(such as a particular industry).
Assets – Uses of Funds
 Other Assets: bank buildings, computer
systems, and other equipment.
Trend in Commercial Bank Liability
• Checkable Deposits (11%, up from 6% in
Dec 2008)
• Transactions deposit available on demand
• Have declined substantially in importance
• Transactions deposits were 61% of bank
funds in 1960.
Commercial Bank Liability Trend
• Nontransaction Deposits (55%)
• Borrowing (23%, around 31% in 2008)

Discount loans for the Fed

Reserves from other banks in the
Federal Funds Market (unsecured)

Repurchase agreements
• Bank Capital (12%)
Balance Sheet of Commercial Banks:
Changes in Liabilities over time
•Transactions deposits were 61% of bank funds in 1960, 6.0% in 2008.
•Borrowings provided only 2% of bank funds in 1960, up to 31% in 2008.
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17-16
Balance Sheet of Commercial Banks:
Changes in Assets over time 1947-2006
Securities Down
Secondary Markets,
Increased Liquidity
Security holdings down from 70% in 1947 to 19% in 2014.
Loans( C&I, mortgage, and consumer loans) over 50%.
Basic Banking Transaction
Cash Deposit of $100 in First National Bank
First National Bank
Assets
Vault
Cash
+$100
First National Bank
Liabilities
Checkable
deposits
+$100
Assets
Reserves
Liabilities
+$100 Checkable
deposits
+$100
• The above example presents 2 ways to record the same
transaction.
• Opening of a checking account leads to an equal increase
in the bank’s reserves.
• NOTE: vault cash counts as reserves
Basic Banking Transaction
Check Deposit of $100 into FNB written on SNB
First National Bank
Assets
Reserves +$100
Second National Bank
Liabilities
Checkable
deposits
+$100
Assets
Reserves
-$100
Liabilities
Checkable
deposits
-$100
FNB gains reserves and SNB loses reserves
Basic Banking - Making a Profit
First National Bank
Assets
First National Bank
Liabilities
Required
reserves
+$10 Checkable
deposits
Excess
reserves
+$90
+$100
Assets
Liabilities
Required
reserves
+$10 Checkable
deposits
Loans
+$90
+$100
• 10% Reserve Requirement
• Bank use excess reserves to make loans or invest in bonds.
• Bank makes a profit because it borrows short (at a relatively
low interest rate) and lends long (at a relatively high interest
rate)
General Principles of Bank Management
• The basic operation of a bank -
• Make profits by:

Selling liabilities with one set of characteristics
(liquidity, risk ,size, return). [Source of Funds]

Buying assets with a different set of
characteristics. (liquidity, risk ,size, return).
[Use of Funds]

Process known as “asset transformation” also
referred to as maturity transformation
General Principles of Bank Management
How does a bank manage its assets and liabilities.
Four primary concerns:
1. Liquidity management
2. Asset management
─
─
Managing credit risk
Managing interest-rate risk
3. Liability management
4. Managing capital adequacy
Principles of Bank Management
Liquidity Management
Reserves requirement = 10%, Excess reserves = $10 million
Deposit outflow = $10 million
 With 10% reserve requirement, bank has excess reserves
of $1 million: no changes needed in balance sheet
Liquidity Management
No excess reserves -
Deposit outflow of $10 million
 With 10% reserve requirement, bank has $9
million reserve shortfall
Liquidity Management - Shortfall in Reserves:
Borrow from other banks or corporations.
Assets
Reserves
Liabilities
$9M Deposits
$90M
Loans
$90M Borrowing
$9M
Securities
$10M Bank Capital
• Other banks - Federal Funds Market
• Corporations - CP or Repo
• There’s a cost - interest rate paid on the
borrowed funds
$10M
Liquidity Management: Borrow from the Fed
Assets
Reserves
Liabilities
$9M Deposits
Loans
$90M Borrow from Fed
Securities
$10M Bank Capital
$90M
$9M
$10M
• There’s a cost - payments to Fed based on the
discount rate
Liquidity Management: Sell Securities
Assets
Reserves
Loans
Securities
Liabilities
$9M Deposits
$90M Bank Capital
$90M
$10M
$1M
• There are costs: transaction costs and possible
capital loss.
Liquidity Management: Reduce Loans
Assets
Reserves
Liabilities
$9M Deposits
Loans
$81M Bank Capital
Securities
$10M
$90M
$10M
• Reduction of loans is the most costly way of
acquiring reserves

Calling in loans (not renewing short-term loans)
antagonizes customers

Loans are not a liquid asset. Other banks may only agree
to purchase loans at a substantial discount
Asset Management
 Asset Management: the attempt to earn the
highest possible return on assets while
minimizing the risk.
1. Get borrowers with low default risk, paying
high interest rates
2. Buy securities with high return, low risk
3. Diversified portfolio
4. Manage liquidity
Asset Management - Credit Risk:
Overcoming Adverse Selection and Moral Hazard
• Screening and information collection
• Specialization in lending (e.g. energy sector)
• Diversification - by industry and geography
• Monitoring and enforcement of restrictive covenants
• Long-term customer relationships
• Collateral and compensating balances
Liability Management
 Managing the source of funds: from
deposits, to CDs, to other debt.
1. Important since 1960s
2. No longer primarily depend on deposits
3. More dependent on non-transactions deposits
and borrowing.
─
Growth in borrowing from 2% in 1960 to 31%
in 2008.
─
Negotiable CDs at 19%
Bank Capital (Equity)
• Assets – Liabilities = Net Worth
• Called Bank Capital.

The value of the bank to its owners.
• In Jan 2007, commercial bank capital was
$860 billion equal to 8.8% of total assets of
$9.77 Trillion)
• June 2011 bank capital at 12% of assets
Capital Adequacy Management
• Bank capital is a cushion that helps
prevent bank failure.

As banks write down assets, bank capital
takes a hit.
• Regulatory requirement – regulators
set minimum capital requirements.
Capital Adequacy Management
High Capital bank has a 10% capital ratio.
Low Capital bank has a 4% capital ratio.
Capital Adequacy Management: Preventing
Bank Failure When Assets Decline
Scenario: Borrower defaults on $5 million loan and
minimum capital requirement is 5%.
High Bank Capital
Assets
Low Bank Capital
Liabilities
Assets
Liabilities
Reserves
$10M Deposits
$90M Reserves
$10M Deposits
Loans
$90M Bank Capital
$10M Loans
$90M Bank Capital
High Bank Capital
Assets
$10M Deposits
Loans
$85M Bank Capital
$4M
Low Bank Capital
Liabilities
Reserves
$96M
Assets
$90M Reserves
$5M Loans
Liabilities
$10M Deposits
$96M
$85M Bank Capital
-$1M
Capital Adequacy Management: Return to Equity Holders
Return on Assets: net profit after taxes per dollar of assets
net profit after taxes
assets
Return on Equity: net profit after taxes per dollar of equity capital
ROA =
ROE =
net profit after taxes
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
EM =
Equity Capital
net profit after taxes net profit after taxes
assets


equity capital
assets
equity capital
ROE = ROA  EM
Capital Adequacy Management
Tradeoff between safety (high capital) and
ROE
If Equity Capital ↑ => EM ↓ => ROE ↓
Prudent to hold equity capital. Unfortunately,
banks aren’t very prudent.
Banks required to hold capital to meet
minimum capital requirements imposed by
regulators.
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17-37
Basic Strategies for Managing Capital
What should a bank manager do if she feels
the bank is holding too little capital (i.e., the
capital ratio is too low)?
 Issue stock to attract new capital
 Decrease dividends to increase retained
earnings which adds to equity
 Slow asset growth (retire debt)
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17-38
Basic Strategies for Managing Capital
What should a bank manager do if she feels
the bank is holding too much capital?
 Use equity capital to buy or retire stock
 Increase dividends to reduce retained
earnings
 Increase asset growth using debt (like CDs)
Equity Multiplier and Capital Ratio
Total Assets CapitalRatio  Equity Capital
EM 
Assets
Equity Capital
• EM is actually a measure of leverage
• EM = 10, means $1 of equity supports
$10 in assets. The bank borrows $9.
• EM = 25, means $1 of equity supports
$25 in assets. The bank borrows $24.
• EM is the inverse of the capital ratio
Bank Profitability
ROA is typically 1.2 to 1.3%
ROE is 10 to 12 times ROA.
Let’s take a look:
https://www2.fdic.gov/qbp/2014dec/cb1.html
Bank Capital
• Currently, U.S. commercial banks combine
about $1.5 trillion in bank capital (equity) with
$11.0 trillion of borrowed funds to purchase
$12.5 trillion in assets.
• Ratio of Assets/Equity = 12.5/1.5 = 8.33
(down from over 11) Flip: 1.5/12.5 = 12%
• Government guarantees contributes to banks
ability to hold so much debt.
Leverage of Various Financial Institutions prior to
Financial Crisis
Assets
Liabilities
$Trillion
$Trillion
Equity
$Trillion
Leverage
Assets/Equity
Commercial
Banks
10.8
9.7
1.1
9.8(10.2%)
Savings Inst.
1.91
1.68
.23
8.4(11.9%)
Credit Unions 0.75
.66
.09
8.4(11.9%)
Investment
Banks
5.4
5.23
.17
31.7
GSEs
Overall
1.63
20.5
(1/31.7) = 3.15%
1.56
18.8
.067
1.7
24.7(4.0%)
12.2(8.2%)
Suppose banks are required to maintain a capital ratio of 10%.
Assume times are good and loan portfolio increases by $1.
National Capital Bank – January
Assets
Cash
$10
Loans/Securities $90
Total
$100
Liabilities
Debt
Equity Capital
Total
$90
$10
$100
National Capital Bank – June
Assets
Cash
$10
Loans/Securities $91
Total
$101
Liabilities
Debt
$90
Equity Capital
$11
capital ratio is 10.89% > 10%
National Capital Bank – December
Assets
Cash
Loans
Total
$10
$100
$110
Liabilities
Debt
Equity Capital
Total
$99
$11
$110
The mechanism works in reverse when times are bad.
Loan portfolio decreases by $1.
De-leveraging the balance sheet
National Capital Bank - January
Assets
Cash
$10
Loans/Securities $90
Liabilities
Debt
Capital
$90
$10
National Capital Bank – June
Assets
Liabilities
Cash
$10
Debt
Loans/Securities $89
Capital
capital ratio is 9.09% < 10%
$90
$9
National Capital Bank – December
Assets
Cash
$10
Loans/Securities $80
Total
$90
Liabilities
Debt
Capital
Total
$81
$9
$90
Bank does not have to de-leverage if it can raise more equity
capital and pay off some debt
National Capital Bank – June
Assets
Cash
$10
Loans/Securities $89
capital ratio is = 10%
Liabilities
Debt
Capital
$89.1
$9.9
9-46
How a Capital Crunch Caused a Credit
Crunch in 2008
 Housing boom and bust led to large bank
losses (including losses on SIVs which had to be
recognized on the balance sheet).
 Value of assets reduced.
 The losses reduced bank capital.
 Banks required to rebuild capital – a capital
crunch!
How a Capital Crunch Caused a Credit
Crunch in 2008
 Banks had two option: (1) raise new capital
or (2) reduce lending.
 Guess which route they chose?
 Why would banks be hesitant to raise new
capital (equity) during an economic
downturn and a financial crisis?
Banks Must also Manage Interest-Rate
Risk:
• Bank assets don’t match liabilities
• Banks “borrow short” and “lend long”
• Creates a maturity mismatch
Managing Interest Rate Risk
• In addition to the borrow/short lend/long
mismatch, banks also have a mismatch
between assets and liabilities that are interestrate sensitive and non-interest rate sensitive.
• For example,
• Deposit rates tied to market rates (interest rate
sensitive cost)
• long-term fixed rate loan ( Non-interest rate
sensitive income)
Managing Interest Rate Risk
• What happens if interest rate rise?

Deposit cost based on flexible short-term
interest rates rise.

Loan revenues based on fixed interest rate
remain fixed.

Profit reduction
Interest-Rate Risk – Simple Gap Analysis
First National Bank
Assets
Rate-sensitive
assets(RSA)
Liabilities
$20M Rate-sensitive
liabilities (RSL)
Variable-rate and short-term
loans
Variable-rate CDs
Short-term securities
Money market deposit
accounts
Fixed-rate assets
$80M Fixed-rate liabilities
Reserves
Checkable deposits
Long-term loans
Savings deposits
Long-term securities
Long-term CDs
$50M
$50M
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
Interest Rate Risk: Gap Analysis
• Basic Gap Analysis
• (RSA – RSL) x Δ interest rate = Δ bank
profits
Managing Interest-Rate Risk
Basis Gap Analysis
GAP = rate-sensitive assets – rate-sensitive liabilities
=
$20
–
$50 = –$30 million
When i  5%:
1. Income on assets = + $1 million
(= 5%  $20m)
2. Costs of liabilities = +$2.5 million
(= 5%  $50m)
3. Profits = $1m – $2.5m = –$1.5m
= 5%  (GAP) = 5%  ($20 - $50) = .05x -$30 =-$1.5
4. Profits = i  GAP
Off-Balance-Sheet Activities
1. Loan sales
2. Fee income from
─
─
─
─
Foreign exchange trades for customers
Servicing mortgage-backed securities
Guarantees of debt
Backup lines of credit
3. Trading Activities and Risk Management Techniques
─ Financial futures and options
─ Foreign exchange trading
─ Interest rate swaps
 All these activities involve risk and potential conflicts