Chapter 9
The Banking Firm
and the Management of
Financial Institutions

Commercial banks are the most important financial
intermediaries in the economy, so it is important to
understand how they operate, and understand bank
management.
THE BANK BALANCE SHEET


To understand how a bank operates, we first examine
a commercial bank's balance sheet, where:
Total Assets = Total Liabilities + Capital
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‫ميزانية البنك التجاري (‪)Balance Sheet‬‬
‫األصول‬
‫اإللتزامات‬
‫احتياطيات‬
‫(نقدية‪ ،‬ودائع لدى البنك المركزي)‬
‫ودائع‬
‫(جارية‪ ،‬ادخارية‪ ،‬ثابتة)‬
‫أدوات دين حكومية‬
‫(أذونات خزانة‪ ،‬سندات)‬
‫اقتراض‬
‫(من البنك المركزي‪ ،‬بنوك أخرى‪،‬‬
‫شركات قابضة‪ ،‬بنوك أجنبية)‬
‫قروض (استهالكية‪ ،‬عقارية‪ ،‬تجارية‪،‬‬
‫بنوك أخرى)‬
‫حقوق المساهمين‬
‫(رأس المال‪ ،‬أرباح محتفظ بها)‬
‫أصول ثابتة‬
‫(مباني‪ ،‬أثاث‪ ،‬أنظمة إلكترونية)‬
‫‪3‬‬
The Bank Balance Sheet
4
BANK LIABILITIES (Sources of Funds)
1. Checkable Deposits
Are bank accounts that allow owner of the account to write
checks to third parties. They include:
a. Demand deposits (non-interest-bearing checking)
b. Negotiable Order of Withdrawal (NOW) accounts
(interest-bearing checking)
c. Money market deposit accounts (MMDAs) - money
market mutual funds.
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
Checkable deposits are payable on demand, you can
write a check for any amount, including your entire
balance.

Checkable deposits are lowest cost source of funds
for a bank, sometimes zero (demand deposits).

Because people like the liquidity of checking
accounts, they are willing to give up interest for
convenience of checks.
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2. Nontransaction Deposits
Account owner is not allowed to write checks, but
receives interest rates higher than checkable deposits.
a. Savings accounts: funds can be added or withdrawn
from the account.
b. Time Deposit Accounts:
 Fixed maturity from several months to 10 years.
 Higher interest rates than saving accounts.
 Has penalties for early withdrawal.
 Less liquid.
 More costly source of funds for the bank.
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3. Borrowings
a. from other banks (interbank Market)
b. from the central bank (discount Window)
c. from parent companies (bank holding companies)
d. from corporations (repurchase agreements)
e. from foreign banks (Eurodollar deposits)
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4. Bank capital (Net Worth)

Net worth is the difference between total assets and
liabilities.

Consists of stocks and retained earnings.

Bank capital is a cushion against a drop in the value
of assets, to protect against bankruptcy (insolvency).
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BANK ASSETS (Uses of Funds):
Banks use their deposits to acquire income-earning
assets, to make profits, by earning more interest on
assets than they pay out on liabilities.
1. Reserves :
 Consists of deposits kept on account at the central
bank plus cash held at the bank.
 Some reserves are required by the central bank and
others ( called excess reserves) are voluntary.
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
Required Reserves: banks are required to hold a
percentage of certain deposits in an account at the
central bank.

Excess reserves: in addition to required reserves,
banks hold extra reserves for increased liquidity (to
meet demand for cash withdrawals and check
clearing).
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2. Cash Items in Process of Collection
Funds from checks written on other banks but are not
yet collected (received) from the other bank.
3. Deposits at Other Banks
Many (small) banks hold deposits at other (larger)
banks to use them in getting a number of services such
as: check collection, foreign exchange transactions, and
buying securities.
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4. Securities :

An important source of income to banks.

Made up entirely of government debt instruments
because commercial banks are not allowed to own
stocks.

Short term securities are highly liquid (go to the
market and sell it), thus are called secondary reserves.
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5. Loans :
Most bank profits come from Loans.
A loan is a liability for the borrower but an asset for the
bank because it generates income.
Loan Types:
a. Commercial loans to businesses
b. Real estate loans (mortgages, home improvement
loans)
c. Consumer loans (Cars, furniture)
d. Interbank loans (overnight loans to other banks through
the interbank market)
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


Loans are less liquid than other assets because they
are tied up for the length of the loan.
Loans are also more risky, have higher default risk
than securities.
Because loans are more risky and less liquid, they
earn more interest for banks.
6. Other Assets :
 Property, plant and equipment. Buildings, office
equipment, computer systems, etc.
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BASIC OPERATION OF A BANK
Banks make profits by selling liabilities with one set
of characteristics (liquidity, risk, and return) and
buying assts with different set of characteristics.
 This process is called “Asset Transformation.”
Example:
A savings deposit (liability) can be used by the bank
to make a loan (asset).
 The bank borrows short-term and lends long-term.

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
The process of asset transformation and providing
services is similar to the production process by firms.

If the bank produces at low cost and earns higher
return on its assets, then it makes profit, vice versa.

A tool used in analyzing bank operation is the
T-account: a simplified balance sheet that lists only
changes occurring in balance sheet items from a
transaction.
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Example

1. A person opens a checking account at “First
National Bank (FNB)” with $100 in cash. This
shows up as a liability on the bank balance sheet.

If the bank keeps the $100 as cash, this raises the
bank assets (excess reserves).
First National Bank
Assets
Liabilities
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
Since the cash (excess reserves) is part of the bank’s
reserves, we can rewrite the T-account as follows:
First National Bank
Assets
Liabilities
Result: opening a checking account with cash
increases the bank’s reserves equal to the increase in
checkable deposits.
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2. If a person opens a checking account with a $100
check written on her account at another bank
“Second National Bank (SNB).”
 FNB is owed $100 by SNB. This asset for FNB
appears in its T-account as cash items in process of
collection.
 FNB deposits the check in its account at the central
bank who transfers $100 of reserves from SNB to
FNB.
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First National Bank
Assets
Liabilities
The final balance sheet positions of the two banks are
as follows:
First National Bank
Assets
Liabilities
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Second National Bank
Assets
Liabilities
Result: when opening a checking account with a check,
the bank receiving the deposit (FNB) gains reserves
equal to the amount of the check, while the bank on
which the check is written (SNB) loses reserves by the
same amount.
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How the bank is making profit?



If FNB receives a $100 checkable deposit.
If the required reserve ratio is 10%.
The required reserves are $_____, and the excess reserves
are $_____. The T-account becomes:
First National Bank
Assets
Liabilities
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
If the FNB decides not to hold excess reserves, it
makes a loan of $____ (Why not $100?), the Taccount becomes:
FNB
Assets
Liabilities
If the bank charges 10% on loans, managing each
account costs $3 (pay tellers, pay for check clearing),
paying 5% interest on each account (with NOW
account). What is the bank's profit from these two
transactions?
Profit =
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GENERAL PRINCIPLES OF BANK MANAGEMENT
1. Liquidity Management:
Maintaining enough liquid assets to meet obligations to
depositors (deposit outflows) and to the central bank.
2. Asset Management:
Managing assets with low rate of default, and diversification
assets holdings.
3. Liability Management:
Acquiring funds at the lowest possible cost.
4. Capital Adequacy Management:
Maintaining the appropriate capital (or raising capital) to meet
central bank regulations and prevent bank failure (if capital
drops).
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FIRST: LIQUIDITY MANAGEMENT
Management of bank reserves. Two concerns:
1) excess reserves and 2) insufficient reserves.
Example (1): Bank holds excess reserves
Assume the bank's initial balance sheet is as follows:
First National Bank
Assets
Liabilities
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

If required reserve ratio is 10%, the required reserves
are: _________. But since the bank's total reserves
are ________, the excess reserves are ______.
If depositors withdraw $10 million, the bank's
balance sheet becomes:
First National Bank
Assets
Liabilities
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The bank lost $_____of deposits and
$______ of reserves. The required reserves
declined from $______ to $______ (Why?).
 Excess reserved declined from $______ to $______
(why?)


Result:
If bank has excess reserves, a decline in deposits does
not necessitate (leads to) changes in other parts of its
balance sheet.
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Example (2): Bank holds no excess reserves
Assume the bank's initial balance sheet is as follows:
First National Bank
Assets
Liabilities
If depositors withdraw $10 million, the bank's balance sheet
becomes:
First National Bank
Assets
Liabilities
29
The bank lost $_____of deposits and $_____of reserves.
Total reserves declined from $______ to $_______.
Required reserves should be $______, but the bank has
$_____ reserves (is there a problem?)
To get funds to meet reserve requirements, the bank
has four options:
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1. Borrow from other banks
from the( -------)market charged by (------)rate
In this case the balance sheet becomes:
First National Bank
Assets
Liabilities
The cost of this activity is the interest paid on loans.
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2. Sell securities
Sell securities and deposit the revenues with the
central bank, the balance sheet becomes:
First National Bank
Assets
Liabilities
Selling securities has brokerage costs, they are low for
government securities because they are very liquid, but
may be high for other securities.
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3. Borrow from the central bank
Borrow from the C.B., the balance sheet is:
First National Bank
Assets
Liabilities
Two costs associated with borrowing from CB:
A. Direct Cost: The amount of interest paid on the loan
(Discount Rate).
B. Indirect Costs: 1) The CB discourages too much
borrowing, 2) the CB carefully examines the bank, and
3) the CB may close the discount window.
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4. Reducing Loans
The bank can reduce loans in two ways:
1) Not renewing short term loans ,and
2) Selling loans to other banks and deposit the
revenues with the CB.
The balance sheet become:
First National Bank
Assets
Liabilities
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This is the most costy way because:
1) Not renewing loans discourages future business with
borrowers.
2) Selling loans may require banks to sell them at lower
value to encourage other banks to buy them (why?).
3) The bank will give up potential interest on loans.
Result:
1) Excess reserves are insurance against the costs
associated with deposit outflows.
2) The higher the costs to provide required reserves, the
more excess reserves banks will want to hold.
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SECOND: ASSET MANAGEMENT
Banks manage their assets to maximize profits by:
1. Assess creditworthiness of potential borrowers to
avoid costly defaults.
(Banks usually conservative, default rate less than 1%).
2. Buying securities with high returns and low risks.
3. Diversify assets.
 Securities: Short (T-bill) and long term (Gov’t bond)
 Loan portfolio (commercial, Consumer, mortgage).
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4. Manage assets to ensure liquidity by holding
sufficient liquid assets in case of large deposit
outflows.

For example, T-Bills are so safe and liquid that they
are considered "secondary reserves."

The bank has to balance liquidity against increased
earnings from less liquid assets (like loans).
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Third: Capital Adequacy Management
Banks choose the amount of capital they hold for three
reasons:
1. It Helps Prevent Bank Failure:
Bank failure occurs when a bank cannot satisfy its
obligations to pay its depositors and creditors and so
goes out of business.
Example
Consider two banks, one with low capital to assets ratio
and the other high ratio.
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High Capital Bank
Assets
Liabilities
Low Capital Bank
Assets
Liabilities
39
If the two banks lose $ 5 million of their loans, their
assets and capital will decline too by the same amount.
The new balance sheets become as follows:
High Capital Bank
Assets
Liabilities
Low Capital Bank
Assets
Liabilities
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RESULT:
 The high capital bank is in a good situation because
its net worth (capital) is positive ($5 m.).

The low capital bank is in a bad situation because its
net worth is negative (-$1 m.).

The value of assets for low capital bank is less than
its liabilities, therefore it is insolvent (bankrupt):
Insolvent: It does not have enough assets to pay off holders
of its liabilities (depositors, creditors).
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2. It Affects Returns to Equity Holders
Bank owners need measures indicating if the bank is
being managed well or not.
Return on Assets (ROA):
ROA = net profit after taxes / assets
The ROA shows how efficiently a bank is being run by
indicating how much profits are generated on average
by each dollar of assets.
Return on Equity (ROE):
ROE = net profit after taxes / equity capital
The ROE shows how much the bank earns on equity
investment.
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Equity Multiplier (EM):
EM = assets / equity capital
It is the amount of assets per dollar of equity capital.
It shows the direct relationship between ROA and ROE:
ROE = ROA . EM
The formula shows what happens to the return on
equity when a bank holds a smaller amount of equity
capital for a given amount of assets.
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Example
The high capital bank: EM = $____ m. / $____ m.=
The low capital bank: EM = $____ m. / $____ m.=
If ROA is 1%, then:
ROE for the high capital bank = ____% X ___ = ____%
ROE for the low capital bank = ____% X ___ = ____%
Equity holders of the low capital bank are happier
because they have a return twice higher.
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Thus, bank owners don't like holding a lot of capital
( because it reduces ROE).
Result:
Given the ROA, the lower the bank capital, the higher
the ROE. This shows that there is a trade-off between
safety (the case of insolvency ) and returns (high
ROE).
3. Bank Capital Requirements
Banks hold capital because they are required by law
to do so.
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FOURTH: LIABILITY MANAGEMENT

Acquiring funds at the lowest possible cost.

For example: Options to obtain sources of
funds from either accepting deposits ( interest
rate paid), or borrowing ( interest rate
charged).
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Managing Risks
1) Interest Rate Risk
High volatility in interest rates makes banks exposed to
interest- rate risk:
The riskiness of earnings and returns that is associated
with changes in interest rates.
First National Bank
Assets
Liabilities
Rate-sensitive Assets
Rate-sensitive Liabilities
Fixed -rate Assets
Fixed-rate Liabilities
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Example:
First National Bank
Assets
Liabilities
Rate Sensitive Assets (RSA) 20 Rate Sensitive Liabilities (RSL) 50
-Short Term Loans
10
- Money Market Deposits Acc 50
-Short Term Securities 10
Fixed Rate Assets (FRA)
-Long Term Loans
60
-Long Term Securities 20
80 Fixed Rate Liabilities (FRL)
-Checkable Deposit Acc 30
-Saving Acc
10
-Capital
10
50
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Example:
If interest rate rises from 10% to 15% ( Δ = __%)
Δ Profit = Δ income – Δ cost
Δ income = Δ interest X rate sensitive assets
= __% X $ ___ million = $ ___ million
Δ cost = Δ interest X rate sensitive liabilities
= __% X $ ___ million = $ ___ million
Δ Profit =
For your own assignment:
What if interest rate falls by 5%?
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Gap Analysis
- Sensitivity of bank profits to changes in interest rates.
- It can be measured using the gap analysis by
subtracting the amount of rate sensitive liabilities
from the amount of rate sensitive assets.
- Gap = RSA – RSL = ____ – ____ = $ ____ million
Δ profit = Δ interest X Gap
Δ profit = __% X $___ million = $___ million
Result
If a bank has more rate-sensitive liabilities than assets, a
rise in interest rates reduces bank profits, while a
decline in interest rates raises profits.
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Duration Analysis
- Examines the sensitivity of market value of the bank's
total assets and liabilities to changes in interest rates.
- Uses the average duration of assets and liabilities to
measure the change in net worth for a given change in
the interest rate.
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Example: Assuming average duration of assets 3 years
and liabilities 2. The value of assets is $100 million
and value of liabilities is $90 million. If interest rate
rises by 5%.
Δ Net Worth = Δ $ assets - Δ $ Liabilities
% Δ Assets = - Δ interest X Average Asset duration
= ____% X _____= ____%
Δ $ Assets = % Δ Assets X $ Assets
= _______% X $______ = $_______
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% Δ Liab’s = - Δ interest X Average Liab’s duration
= ____% X _____= ____%
Δ $ Liab’s = % Δ Liab’s X $ Liab’s
= _______% X $______ = $_______
Δ Net Worth = $ _____ - $ ______ = $ _______
For your own assignment:
What if interest rate falls by 5%?
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2)Managing Credit Risk
1. Screening and Monitoring
a- Screening (screen out bad credit risks)
Through collecting information about the borrowers
for evaluations.
b- Specialization in Lending
Doing so, will ease up the process of screening out
the bad borrowers , but it squeezes the ability
diversifying risks.
c- Monitoring and Enforcement of Restrictive Covenants
monitoring the activities made by borrowers through
enforcing the borrowers to write a provision into the
loan contract.
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2. Long-Term Customer Relationships
This reduces; costs of information collection, and
makes it easier to screen out bad credit risks
3. Loan Commitments
The bank makes a commitment to firms in providing
a loan in the future if needed. Such method promotes
long term relationship which reduces costs of
information collection and costs of screening
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4. Collateral & Compensating Balances
Collateral: a property promised to lender as
compensation if the borrower defaults.
Compensating Balances: the required minimum amount
of funds kept (by the firm receiving the loan) in the
checking Acc.
5. Credit Rationing
This is when the bank limits the supply of loans
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Off-Balance-Sheet Activities
1. Loan sales
Income generated from loan sales
2. Generation of Fee income from
A. Foreign exchange (FROX) trades for customers
fees charged when trading in FROX on the behalf of customers
B. Servicing mortgage-backed securities
issued by firms through banks, so banks take fees for such action
C. Guarantees of debt
Banks usually issue acceptances and guarantees to customers (
firms mostly) but with fees
D. Backup lines of credit
Proving a loan in the future based on the “loan commitment”, or
standby letter of credit
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3. Trading Activities and Risk Management Techniques
“ income generated from trading in such activities is
recorded at off-balance sheet “
A. Financial futures
B. Financial options
C. Foreign exchange or forward exchange
D. Swaps (currency or interest rate)
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