Lecturer: MBA. VU THI THUY LINH
Email: giabao245@yahoo.com.vn
Introduction to Commercial Bank
management
 Number of credit: 3
 Level: 4th year student
 Course duration: 45 sessions, 15 weeks
 Course objective: To provide students
with a conceptual framework necessary
for analyzing and comprehending the
current problems of commercial banks as
well as examining various aspects of
managing a commercial bank.
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Introduction to Commercial
Bank management
LEARNING OBJECTIVES
1. Understand and explain the basic concepts,
principles, terminology, and techniques for
managing commercial banks.
2. Understand the fundamentals of bank
regulation.
3. Use the proper techniques to evaluate the
financial performance of a bank.
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Introduction to Commercial
Bank management
LEARNING OBJECTIVES
4. Understand and explain the concepts and
techniques involved with managing interest rate
risk.
5. Understand and explain the concepts and
techniques involved with managing the cost of
funds, capital, and liquidity for commercial
banks.
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Introduction to Commercial
Bank management
Synopsis:
This course includes theory related to bank
management. The contents of this module are to
study the theory of commercial bank
management perspective, through the issue of
capital, assets, liabilities, business administration
banking and risk management of business banks,
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Readings
COURSE MATERIALS:
Bank Management, 6th edition, Koch, Timothy W., and S. Scott
MacDonald, South- Western/Cengage Learning, 2006.
Bank management & Financial services, 7th edition, Rose, Peter S.,
and Hudgins, Sylvia C., International Edition, 2008
 We will also look at:
 Circular No. 36/2014/TT-NHNN dated November 20, 2014 of the
State Bank of Vietnam stipulating minimum safety limits and ratios
for transactions performed by credit institutions and branches of
foreign banks 11/20/2014
 Basel Committee on Banking Supervision reforms - Basel III
 Newspapers, articles relating to banks and financial institutions
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Course Content
 Chapter 1: an overview of banks and the
financial services sector
 Chapter 2: own capital management, bank
management of assets and liabilities
 Chapter 3: Measuring and evaluating
bank performance – Risk management in
banking services
 Chapter 4: Resource management of
commercial bank
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CHAPTER 1: AN OVERVIEW OF BANKS
& THE FINANCIAL SERVICES SECTOR
Lecture Outline:
1. Powerful Forces Reshaping Commercial
Banks in Economic Integration Period
2. What Is a Bank?
3. The Financial System and Competing
Financial-Service Institutions
4. Old and New Services Offered to the
Public
5. Key Trends Affecting All Financial-Service
Firms
6. Organization
structure of banks
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CHAPTER 2: OWN CAPITAL MANAGEMENT,
BANK MANAGEMENT OF
ASSETS AND LIABILITIES
Lecture Outline:
1. Define and explain assets, liability and equity
capital management
2. Calculate capital adequacy ratio
3. Methods to increase the equity
Increase from external sources
Increase from internal sources
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CHAPTER 2: OWN CAPITAL MANAGEMENT, BANK
MANAGEMENT OF
ASSETS AND LIABILITIES
Lecture outline (cont-)
4. Liability Management
5. Alternative Nondeposit Funds Sources
6. Measuring the Funds Gap
7. Choosing Among Different Funds Sources
8. Determining the Overall Cost of Funds
9. Asset Management Strategy
10. Liabilities Management Strategy
11. The Asset - Liability Committee
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CHAPTER 3: MEASURING AND EVALUATING
BANK PERFORMANCE –
RISK MANAGEMENT IN BANKING SERVICES
Lecture outline
1. Components of the Income Statement: Revenues
and Expenses
2. Evaluating the Performance of Banks – key
Profitability Ratios
3. Measuring Credit, Liquidity and other Risks
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CHAPTER 3: MEASURING AND EVALUATING
BANK PERFORMANCE –
RISK MANAGEMENT IN BANKING SERVICES
Lecture outline
4. Market rate and interest rate risk
5. The goals of interest rate hedging
6. Interest sensitivity gap management techniques
7. Aggressive & eliminating interest-sensitive gap
management techniques
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1. Organizing and developing bank network
2. Human resource management
and development
3. Planning marketing strategy
Assessment Criteria
 Course requirements:
 Minimum class participation is 80%
 Pass all tests, exams, team assignments
papers and presentation.
 Active discussion
 Midterm exam:
 60 mins exam, written test
 Final exam:
 60 mins exam, comprehensive final exam
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Assessment Criteria
 Overall Course Grade
 Midterm test (25%)
 Teamwork on Assignments (15%)
 Presentation (10%)
 Comprehensive Final Exam (50%)
 Total: 100%
There will be NO MAKE-UP Exams!
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Assessments Guideline
 Team Assignment and Presentation
Each student will be assigned to a 5 person
team.
Each team’s quantitative score will be
based equally on the written report and the
class presentation.
Question and answer sessions are
important elements of any presentation
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Assignment Objectives
The purpose of this assignment
requires students to archive:
 Practical analysis skills
 Team work
 Searching, Citing & Reference
sources
 Writing and Presenting skills.
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Assignment Requirements
Word limit = 3000 (+/- 10%),
excluding Executive Summary,
Reference & Appendix.
Due Date: print out in submit in
class, Week 12 , late submission
will be penalized
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Submission Requirements
 Hard copy and soft copy of your
reports have to be submit in week 12
 15 minutes presentation in week 14
Subject to change when notified by
instructor.
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Writing Report
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Use size 13 font
Double space your work (or use at least 1.5 spacing)
Spell check your work / proofread your work
Cross-reference your work
Include sources for tables, charts, photos (basically
anything that isn’t your own)
Use business key terms and definitions
Include an Executive Summary
Meet internal deadlines
Include Harvard Citing & References
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CHAPTER 1: AN OVERVIEW OF BANKS
& THE FINANCIAL SERVICES SECTOR
Lecture Outline:
1. Powerful Forces Reshaping Commercial
Banks in Economic Integration Period
2. What Is a Bank?
3. The Financial System and Competing
Financial-Service Institutions
4. Old and New Services Offered to the
Public
5. Key Trends Affecting All Financial-Service
Firms
6. Organization
structure of banks
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Chapter 1: Overview of commercial bank management
KEY TERMS IN THIS CHAPTER
1.Nonbank banks
16. Underwriting
2.Currency exchange
17. The intermediation role
3.Discounting commercial
notes
18. The payments role
4. Savings deposits
19. The guarantor role
5. Demand deposit
20. The agency role
6. Trust services
21. The policy role
7. Financial advisory services
8. Cash management
servives
10. Equiment leasing services
11. Isurance policies
12. Retirement plans
13. Security brokerage
14. Offering deposist
COMMERCIAL BANKS IN
ECONOMIC INTEGRATION PERIOD
Powerful forces reshaping the banking industry:
 Higher earning but scale back the market share
 Consolidation between financial firms and larger
banks
 Globalization led to intensive competition
 Converging towards competitors, offering parallel
services
 Technological revolution produces and delivers
financial services electronically
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COMMERCIAL BANKS IN
ECONOMIC INTEGRATION PERIOD
 QUICK QUIZ?
1. What is a bank? How does a bank differ from most
other financial-service providers? (p 33-34)
2. What is happening to banking’s share of the financial
marketplace and why? (p32)
3. Which businesses are banking’s closest and toughest
competitors? What services do they offer that compete
directly with banks’ services? (p36)
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What is a bank?
 Banks are the principal source of credit (loanable funds)
for millions of individuals and families and for many units
of government
 Worldwide banks grant more installment loans to
consumers (individuals and families) than any other
financial-service provider
 The assets held by U.S. banks represent about one-fifth
of the total assets
 In other nations banks hold half or more of all assets in
the financial system
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COMMERCIAL BANKS IN ECONOMIC
INTEGRATION PERIOD
 Today, there are seven trends which reshape the
banking industry:
 Service Proliferation (48-17 textbook)
 Rising competition
 Government Deregulation
 Rising Funding Costs
 An uncreasingly interest- sensitive mix of Funds
 Technological revolution produces and delivers
financial services electronically
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Chapter 1: Overview of commercial bank management
The many different roles banks play in the Economy (C1/8;
P36 -40)
The intermediation:
transforming savings
received primarily from
households into credit
and to make investment
The payments:
carrying out payments
for goods and service on
behalf of their
customers
The agency: acting on
behaif of customers to
manage and protect
their property or issue
and redeem their
securities
The guarantor:
standing behind their
customers to pay off
customer debts when
those customers are
unable to pay
The policy: serving as a
conduit for government
policy in attempting to
regulate the growth of
the economy and pursue
social goals
Chapter 1: Overview of commercial bank management
What are function of the modern bank? (C1/12; P40)
1.THE
TRUST
FUNCTION
2. THE
CREDIT
FUNCTION
3. THE
INVESTMENT/
PLANNING
FUNCTION
9. THE
INSURANCE
FUNCTION
8. THE
BROKERAGE
FUNCTION
7. INVESTMENT
BANKING OR
UNDERWRITING
FUNCTION
The modern
bank
6. THE CASH
MANAGEMENT
FUNCTION
4. THE
PAYMENTS
FUNCTION
5. THE THRIFT
OR SAVING
FUNCTION
What is a bank?
 Banks can be classified by:
1. The economic functions it serves: fund transfer and
payment functions
2. The services it offers: diversified financial services
providers
3. The legal basis for its existence


Providing loan in commercial or business nature
Qualified for deposit insurance administrated by the FDIC
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Chapter 1: Overview of commercial bank management(C1/12; P40)
Services banks have offered
throughout history
Services banks have developed
more recently
1. Carrying out currency exchanges
1. Granting consumer loans
2. Financial advising
2. Discounting commercial notes and
making bussiness loan
3. Cash Management
4. Offering equipment leasing
3. Offering savings deposits
4. Safekeeping of valuables
5. Making venture capital loans
6. Selling insurance services
5. Supporting Government activities with
credit
7. Selling retirement plans
8. Offering security brokerage investment
services
6. Offering checking accounts (demand
deposits
9. Offering mutual funds and annuities
10. Offering investment banking and
merchant banking service
7. Offering trust services
11. Convenience : the sum total of all bank
service
ROLES OF THE FINANCIAL SERVICE
SYSTEM
 The primary purpose of financial system is to encourage
saving and to transfer those savings to individuals and
institutions planning to invest and needing credit to do
so.
 This process of encouraging savings and transforming
savings into investment spending causes the economy to
grow, new jobs to be created, and living standards to
rise.
 Supporting services
 Payment services
 Risk protection services
 Liquidity services
 Credit services
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THE COMPETITIVE CHALLENGE FOR
BANKS
 Lately, the financial market share that banking comprised
has fallen
 Some authorities in the financial-services field fear that
this apparent erosion of market share may imply that
traditional banking is dying
 Other experts counter that banking is not dying but
changing by offering new services and changing its form
 The banking industry’s largest customers have found
ways around banks to obtain the funds that they need
(Ex: Borrowing in the open market)
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LEADING COMPETITORS WITH BANKS
 Saving associations: saving deposit, mortgage loans
and credits to individuals and families
 Credit unions: collect deposits and make loans to
members as non-profit associations of individuals
sharing common bond
 Money market funds: collect short-term funds to
invest in quality securities of short duration
 Mutual funds (investment companies): sell shares to
public to raise capital and invest in professional pool
of investment instruments
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LEADING COMPETITORS WITH BANKS
(CONT-)
 Hedge funds: sell shares mainly to upscale investors
in a board group of different kinds of assets
 Security brokers & dealers: buy and sell securities on
behalf of their customers and for their own accounts
 Investment banks: provide professional advices,
raising capital, M&A services
 Finance companies: offer loans to commercial
enterprises
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LEADING COMPETITORS WITH BANKS
(CONT)
 Financial holding companies: Highly diversified
financial service providers (credit cards, insurance,
securities)
 Life and property insurance: protect against risks to
people, property, manage pension plans and
retirement funds
 Mega banks can become conglomerate financial
service providers
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LEADING COMPETITORS WITH
BANKS (CONT)
 Financial-service providers are converging in terms
of the services they offer
 The U.S. Financial Services Modernization (GrammLeach-Bliley) Act of 1999 has allowed many different
types of financial firms to offer the public one-stop
shopping for financial services
 The challenge of differentiating banks from other
financial-service providers is difficult today
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Organization Structure of Community
Banks (C3/69; P97)
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Organization structure of larger banks
(C3/70; P98)
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STRUCTURE OF ELECTRONIC BANKS
(C3/77; P105)
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TWO NEW BANK ORGANIZATION
MODELS (C3/84; P112)
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Key Trends Affecting Financial Services
Firms (C1/20; P48)
 Service proliferation: provide both fee-income
services and financial services revenue
 Rising competition: parallel and diversified services
offerings lead to reduce operating costs
 Government deregulation: broadens the legal playing
fields for financial institutions in free marketplace
 Technological change and automation: deliver
products automatically besides brick & mortar model
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KEY TRENDS AFFECTING FINANCIAL
SERVICES FIRMS
 An increasing interest-sensitive mix of fund:
deregulation provides financial institutions with mix
sources of funds  more efficient fund management
techniques
 Consolidation: large banks expand regionally and
increase number of unit sold become larger
conglomerates financial holding
 Convergence: large banks expands from one product
line to other products lines
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Chapter 1: Overview of commercial bank management
Business banking Strategic planning, activities policy
goals determined that the bank must achieve in each time period affirmatively
The steps of the strategic planning process of the bank's business
Long term Business banking Strategic planning
1.
Goals
Objective about the product, business sector
Objectives in size and quality activities.
Objectives increase profits.
Objectives For foreign business development.
2. Based analyze to build strategic
Gather the information
Information system according to the chemical targets the needs analysis
Evaluation of the potential ability of the bank
Projected situations may have in the market, the favorable and difficult.
3. The policy for goals
Quick quiz
 Why are some banks reaching out to become one-
stop financial-service conglomerates? Is this a good
idea?
 What is a financial department store? A universal
bank? Why do you think these institutions have
become so important in the modern financial
system?
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Quick quiz
 Financial department store and universal bank refer
to the same concept. A financial department
store is an institution where banking, fiduciary,
insurance, and security brokerage services are
unified under one roof. A bank that offers all these
services is normally referred to as a universal
bank.
 These have become important because of
convergence and changes in regulations that have
allowed financial service providers to offer all
services under one roof
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Quick quiz
 What advantages can you see to banks affiliating
with insurance companies? Can you identify any
possible disadvantages to such an affiliation?
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CHAPTER 2: OWN CAPITAL MANAGEMENT,
BANK MANAGEMENT OF
ASSETS AND LIABILITIES
Lecture Outline:
1. Define and explain assets, liability and equity
capital management
2. Calculate capital adequacy ratio
3. Methods to increase the equity
Increase from external sources
Increase from internal sources
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Lecture outline (cont-)
4. Liability Management
5. Alternative Nondeposit Funds Sources
6. Measuring the Funds Gap
7. Choosing Among Different Funds Sources
8. Determining the Overall Cost of Funds
9. Asset Management Strategy
10. Liabilities Management Strategy
11. The Asset - Liability Committee
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Key Concepts
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Equity management
(C15/479;P507)
Definition
Capital refers principally to the funds contributed by
the owners of a financial firm – money invested is
placed at risk in the hope of earning a competitive
return.
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Equity management
Basic functions of equity
a. Security
Supplying resources to start a new financial firm, creating a
base of resources for future growth, providing a cushion of
protection against risk
b. Operating
Provides funds for the organization’s growth, development
of new services and facilities, expand into larger quarters or
build additional branch offices, keep pace with its
expanding market and follow its customers
c. Adjustment
Capital serves as a regulator of growth, helping to ensure
that growth is sustainable in the long run
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Key Risks i Ba ki g Fi a ial I stitutio s’
Management (C15/477; P505)
 Credit Risk: these defaulted loans and securities result in losses





that can eventually erode the bank’s capital
Liquidity Risk: The danger of running out of cash when cash is
needed to cover deposit withdrawals, meet credit request from
customers, suffer a loss.
Interest Rate Risk: Interest expenses will rise, squeezing the
spread between revenues and expenses thereby reducing net
income.
Operation Risk: due to breakdowns in quality control,
inefficiencies in producing and delivering services affect revenue,
cost and decrease value of owner’s investment in the bank
Exchange Risk: The risk of adverse price movements both the
buying and selling sides of this market.
Crime Risk: Fraud or embezzlement by employees or directors
can severely weaken a financial institution
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Defenses Against Risk
(C15/478;P504)
 Quality Management:
 Diversification:
+ Portfolio diversification
+ Geographic diversification
 Deposit Insurance
 Owners’ Capital
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Types of bank capital
1. Common stock : measured by the face value of
common equity shares outstanding
2. Preferred stock: measured by the face value of any
shares outstanding that promise to pay a fixed rate
of return
3. Surplus: the excess amout above each share of
stock’s face value paid in by the bank’s shareholder
4. Undivided profits: the net earning of the bank have
been retained in the bussiness rather than being
paid out as dividends
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Types of bank capital
5. Equity reserves: funds set aside for contingencies
such as legal action against the bank as well as
sinking fund to retire stock or debt in the future
6. Subordinated debentures: long term debt capital
contributed by outside investors, the claims of
depositors
7. Minority interest in consolidated subsidiaries: where
the bank holds ownership shares in other businesses
8. Equity commitment notes : which are debt
securities repayable only from the sale of stock
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Measuring the size of bank capital
1. Book or GAAP(Generally Accepted Accounting Principles)
Capital
GAAP = Book value Assets – Book value liabilities
GAAP is poor indicator of whether a bank has enough capital to
deal with its current exposure to risk
2. RAP(regulatory accounting principles) Capital
RAP = common stock, retained earnings, equity reserves +
Perpetual referred stock + Bad-debt reserves for losses on
loans and leases + Subordinated debentures convertible into
common stock + Miscellaneous items
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Measuring the size of bank capital
3. Market-value Capital (MVC)
MVC = MVA – MVL
A quick approximation of a bank’s market value capital
each day:
MVC = Current market price per share of stock
outstanding x Number of equity shares issued and
outstanding
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Component of equity
Tier-1 capital
(1) Charter capital (already allocated capital, contributed
capital):
(2) Reserve fund for supplementing charter capital:
(3) Professional development investment funds;
(4) Retained earnings accrued:
(5) Share premium
(6) Exchange differences derived from consolidation of
financial statements (consolidated)
Note: the tier 1 capital is the base of determining the
limitation of purchasing, investing into fixed assets of the
banks
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Component of equity
Tier 2 capital)
(15) 50% of increasing difference due to revaluation of
fixed assets according to the provisions of law.
(16) 40% of increasing difference due to revaluation of
capitals contributed for long-term investment according to
the provisions of law.
(17) The financial reserve funds
(18) General reserves
(19) Convertible bond, other debt instruments issued by
credit institutions satisfy the following conditions:
(20) Benefits of minority shareholders
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Equity’s characteristics
 Be the stable fund in the operation, can be used for long
term and does not have to pay back. Therefore, it is the
base for the growth of the banks.
 Account for small portion of the total capital (normally
10% to 15%). However, it keeps the important role since it
is the base to create the other funds and create the
reputation, reliability of the banks. Promotes public
confidence and reassures creditors.
 Decide the scope of operation. It is also the factor for
authorities to determine on prudent ratios (limitation of
taking deposit, limitation of loan out, limitation of investing
into fixed assets)
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Methods to increase the equity (C15/498, P526)
Increase from external sources
 Issue common shares
 Issue preferred shares
 Issue debt instruments (the minimum duration is 7
years)
 The other methods to increase the equity are
selling assets and leasing facilities, swapping
stocks for debt securities
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Methods to increase the equity
Increase from internal sources
 Mainly from increasing retained earning
 Internal capital growth rate =
100
 = ROE x Retention ratio
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Methods to increase the equity
Choosing sources of capital consider the relative
cost and risk of each capital source, overall risk
exposure, potential impact of each source on
returns to shareholders, government regulations,
the demands of investors in the private
marketplace
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INTERNAL CAPITAL GROWTH RATE
 Equity capital: 100 billion VND, the management
forecasts a return on equity of 20% for this year and
plans to pay the stockholders 50% of net earnings
generated. How much capital will increase from the
retained earnings?
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CHOOSE THE BEST ALTERNATIVE
FOR RAISING OUTSIDE CAPITAL
 The bank currently has 85,000 shares of common stock




out standing at a 1,000,000 VND/share par value. The
bank need increase 49 VND billion from outside capital.
In which 10 VND billion increased from retained earnings.
The Bank issue new equity share at 1,500,000 VND per
share of common stock
Issue preferred stock at 1,000,000 VND per share and
promise a 15% dividend
Issue bonds with a 12% percent coupon rate.
The estimated revenue is 5,200 VND billion and
operating expenses is 4,920 VND billion. The income tax
is 30%.
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Capital regulation (C15/482;
P510)
Reasons for Capital Regulation
Capital requirements today are set by regulatory agencies
and, for banks in more than 100 nations today, under rules
laid out in the Basel Agreement on International Bank
Capital Standards
The fundamental purposes of regulating capital are:
1. To limit the risk of failures
2. To preserve public confidence
3. To limit losses to the federal government arising from
deposit insurance claims.
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Capital adequacy ratio
To ensure the safety in the operation, credit institutions
need to maintain the capital adequacy ratio of 9% between
their own capital and their total risk-weighted assets
Individual capital adequacy ratio =
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Capital adequacy ratio







. Bank A currently has:
- Charter capital: 350 (in which contributed capital: 200)
- The charter capital supplementation reserve fund: 30
- The financial reserve fund: 30
- The operation development investment fund: 20
- Retained earnings: 10
- The credit balance of the account of fixed assets re-valuated: 50khh
- The credit balance of the account of investment securities re-valuated: 25
- Convertible bonds issued by the credit institution have the remaining term of 6 years:
15
- Other debt instruments have the remaining term of over 10 years: 15
- The bank A purchases shares of the enterprise B with the amount of investment: 100.
The book value of the enterprise B at the purchasing time: 50
- The bank A purchases shares of 4 credit unions with the total investment fund: 40
- Amounts contributed as capital to 3 other enterprises: 150 (Enterprise X: 45, Y: 50, Z:
55)
- The total risk-weighted assets: 1654
Calculate the own capital of Bank A and the capital adequacy ratio. Assess
the adequacy of bank A. (The maximum financial reserve fund is equal to 1.25% of
total risk-weighted assets)
Unit: VND Billion
70
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
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





Calculating Risk-Weighted Assets
Total risk-weighted assets are the total value of
assets determined based on the extent of risk and
the value of corresponding assets of off- balancesheet commitments determined based on the
extent of risk.
Assets determined based on the extend of risk shall
be calculated by multiplying the value of assets by
the corresponding risk co-efficient of assets.
Corresponding assets on off-balance-sheet
commitments determined based on the extent of
risk shall be calculated by multiplying the value of
off-balance-sheet commitments and a conversion
co-efficient and a risk co-efficient.
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Co-efficient and conversions of
odd-balance
–sheet
commitments
ASSETS
Assets with a 0% risk co-efficient
Assets with a 20% risk co-efficient
Assets with a 50% risk co-efficient
Assets with a 100% risk co-efficient
OFF BALANCE SHEET RISKY ASSETS
Conversion coefficient: 100%
Conversion coefficient:: 50%
Conversion coefficient 20%:
Risk coefficient of the value of assets corresponding to each offbalance sheet commitments
a/ Off-balance-sheet commitments the payment of which is guaranteed
by the Vietnamese Government or Stale Bank or wholly guaranteed
with cash, saving books, escrow deposits or valuable papers issued
by the Vietnamese Government or State Bank: 0%;
b/ Off-balance-sheet commitments secured with real estate: 50%;
c/ Interest-rate transaction contracts, foreign-currency transaction
contracts and other off-balance-sheet commitments: 100%.
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Calculating Risk-Weighted Assets
On-balance sheet assets
Off-balance sheet assets
Assets
Book value Assets
Book value
1. Cash
100
1. Loan guarantee
400
2. Gold
30
- Secured by real estate
250
3. Gem
30
-Non secured
150
4. Deposits at SBV
20
2. Payment guarantee
200
5. Deposits at other banks
15
3. Contract performance
guarantee
100
6. Mortgage loans by real
estate
900
Bidding guarantee
50
7. Non mortgage loans
800
Irrevocable L/C
70
8. Loans to provinciallevel People’s Committees
20
Acceptances of bill of exchange
secured by escrow deposits
20
9. Capital contribution to
leasing company
40
Total
1240
Total
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The Marginal Cost Approach: Historical
Average Cost Approach
 Determines the Bank’s Cost of Funds by Looking at
the Past. It Looks at What Funds the Bank Has
Raised to Date and What those Funds Have Cost
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Figuring the overall cost of fund
 Weighted Average Interest Cost =
� �
�
�
�
 Break-even cost rate on borrowed funds invested in
earning assets =
�
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�
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Figuring the overall cost of fund
 Firefly Bank and Trust has received $800 million in total funding, consisting of $200
million in checkable deposit accounts, $400 million in time and savings deposits, $100
million in money market borrowings, and $100 million in stockholders’ equity. Interest
costs on time and savings deposits are 2.50 percent, on average, while noninterest
costs of raising these particular deposits equal approximately 0.50 percent of their
dollar volume. Interest costs on checkable deposits average only 0.75 percent because
many of these deposits pay no interest, but noninterest costs of raising checkable
accounts are about 2 percent of their dollar total. Money market borrowings cost
Firefly an average of 3.25 percent in interest costs and 0.25 percent in noninterest
costs. Management estimates the cost of stockholders’ equity capital at 13 percent
before taxes. (The bank is currently in the 35-percent corporate tax bracket.) When
reserve requirements are added in, along with uncollected dollar balances, these
factors are estimated to contribute another 0.75 percent to the cost of securing
checkable deposits and 0.50 percent to the cost of acquiring time and savings
deposits. Reserve requirements (on Eurodeposits only) and collection delays add an
estimated 0.25 percent to the cost of the money market borrowings.
 (a) Calculate Firefly’s weighted average interest cost on total volume funds raised,
figured on a before-tax basis?
 (b) If the bank's earning assets total $700 million, what is its break-even cost rate?
 (c) What is Firefly 's overall historical weighted average cost of capital?
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Figuring the overall cost of fund
 The holding company plans to raise $850 million in
short-term funds this week, of which about $835
million will be used to meet these new loan requests.
Fed funds are currently trading at 2.25%, negotiable
CDs are at 2.40%, and Eurodollar borrowings are at
2.30%.
 Noninterest costs are estimated at 0.25 % for Fed
funds and CDs; and 0.35 % for Eurodollar
borrowings
 Calculate the break – even cost rate of each
source of funds and make a management
decision on what sources to use.
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Components of a Bank Balance Sheet
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Report of Condition
 The Balance Sheet of a Bank Showing its Assets, Liabilities and Net
Worth at a given point in time
 May be viewed as a list of financial inputs (sources of funds) and
outputs (uses of funds)
 Asset = Liabilities + Equity capital
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The Balance Sheet (Report of Condition)
(continued)
For banks and other depository institutions the assets on the balance
sheet are of four major types:
 Cash in the vault and deposits held at other depository institutions (C)
 Government and private interest-bearing securities purchased in the
open market (S)
 Loans and lease financings made available to customers (L)
 Miscellaneous assets (MA)
Liabilities fall into two principal categories:
 Deposits made by and owed to various customers (D)
 Nondeposit borrowings of funds in the money and capital markets
(NDB)
 Equity capital represents long-term funds the owners contribute (EC)
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The Balance Sheet (Report of Condition)
(continued)
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The Balance Sheet (Report of Condition)
(continued)
 Cash assets (C) are designed to meet the financial firm’s need for






liquidity
Security holdings (S) are a backup source of liquidity and include
investments that provide a source of income
Loans (L) are made principally to supply income
Miscellaneous assets (MA) are usually dominated by fixed assets (plant
and equipment) and investments in subsidiaries (if any)
Deposits (D) are typically the main source of funding for banks
Nondeposit borrowings (NDB) are carried out mainly to supplement
deposits and provide the additional liquidity that cash assets and
securities cannot provide
Equity capital (EC) supplies the long-term, relatively stable base of
financial support upon which the financial firm will rely to grow and to
cover any extraordinary losses it incurs
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Asset of the banking firm
Cash Assets
• Account is Called Cash and Deposits Due from Bank
• Includes:
▫
▫
▫
▫
Vault Cash
Deposits with Other Banks (Correspondent Deposits)
Cash Items in Process of Collection
Reserve Account with the Federal Reserve
• Sometimes Called Primary Reserves
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Asset of the banking firm (Cont-)
Securities: The Liquid Portion
• Often Called Secondary Reserves
• Include:
▫ Short Term Government Securities
▫ Privately Issued Money Market Securities
 Interest Bearing Time Deposits
 Commercial Paper
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Exercise 1
Suppose that a bank holds cash in its vault of $1.4 million, short-term
government securities of $12.4 million, privately issued money market
instruments of $5.2 million, deposits at the Federal Reserve banks of
$20.1 million, cash items in the process of collection of $0.6 million, and
deposits placed with other banks of $16.4 million. How much in primary
reserves does this bank hold? In secondary reserves?
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Asset of the banking firm (CONT-)
Investment Securities
• These are the Income Generating Portion of Securities
• Taxable Securities
▫ U.S. Government Notes
▫ Government Agency Securities
▫ Corporate Bonds
• Tax-Exempt Securities
▫ Municipal Bonds
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Default risk ratings on
marketable investment securities
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Asset of the banking firm (CONT-)
Trading Account Assets
 Securities purchased to Provide Short-Term Profits from Short-Term
Price Movements
 When the Bank Acts as a Securities Dealer
 Valued at Market – FASB 115
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Asset of the banking firm (CONT-)
Federal Funds Sold and Reverse
Repurchase Agreements
 Includes mainly temporary loans (usually extended overnight, with the
funds returned the next day) made to other depository institutions,
securities dealers, or major industrial corporations
 The funds for these temporary loans often come from the reserves a
bank has on deposit with the Federal Reserve Bank in its district
 “Fed funds”
 Some of these temporary credits are extended in the form of reverse
repurchase (resale) agreements (RPs) in which the banking firm
acquires temporary title to securities owned by the borrower and holds
those securities as collateral until the loan is paid off
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Quick quiz
 Compare and contrast Fed funds transactions with RPs?
 What are the principal advantages to the borrower of funds under
an RP agreement?
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Asset of the banking firm (CONT-)
Types of Loans
 Commercial and Industrial Loans
 Consumer Loans (Loans to Individuals)
 Real Estate Loans
 Financial Institution Loans
 Foreign Loans
 Agriculture Production Loans
 Security Loans
 Leases
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Specific and General Reserves
• Specific Reserves
▫ Set Aside to Cover a Particular Loan
▫ Designate a Portion of ALL or
▫ Add More Reserves to ALL
• General Reserves
▫ Remaining ALL
• Determined by Management But Influenced by Taxes and
Government Regulation
• Loans to Lesser Developed Countries Require Allocated
Transfer Reserves
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Asset of the banking firm (CONT-)
Miscellaneous Assets
• Bank Premises and Fixed Assets
• Other Real Estate Owned (OREO)
• Goodwill and Other Intangibles
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Liabilities of the banking firm
Deposits
 Non interest-Bearing Demand Deposits
 Savings Deposits
 Now Accounts
 Money Market Deposit Accounts (MMDA)
 Time Deposits
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Liabilities of the banking firm (CONT-)
Nondeposit borrowings
 Fed Funds Purchased
 Securities Sold Under Agreement to Repurchase (Repurchase





Agreements)
Acceptances Outstanding
Eurocurrency Borrowings
Subordinated Debt
Limited Life Preferred Stock
Other Liabilities
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Liabilities of the banking firm (CONT-)
Equity Capital
• Preferred Stock
• Common Stock
▫
▫
▫
▫
▫
Common Stock Outstanding
Capital Surplus
Retained Earnings (Undivided Profits)
Treasury Stock
Contingency Reserve
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Off-Balance-Sheet Items
• Unused Commitments
• Standby Credit Agreements
• Derivative Contracts
▫ Futures Contracts
▫ Options
▫ Swaps
• OBS Transactions Exposure a Firm to Counterparty
Risks
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Liability Management
 The Bank Buys Funds in Order to Satisfy Loan
Requests and Reserve Requirements
 It is an Interest-Sensitive Approach to Raising Bank
Funds
 It is Flexible – The Bank Can Decide Exactly How
Much They Need and For How Long
 The Control Mechanism to Regulate Incoming Funds
is the Price of Funds
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Customer Relationship Doctrine
 The First Priority of the Bank is to Make Loans to All
Qualified Customers and If Funds are Not Available
the Bank Should Seek Out the Lowest Cost Source of
Funding to Meet Customers’ Needs.
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Types of Deposit Accounts
 Transaction (Payment or Demand) Deposits
 Making Payment on Behalf of Customers
 One of The Oldest Services
 Provider is Required to Honor Any Withdrawals




Immediately
Nontransaction (Savings or Thrift) Deposits
Longer-Term
Higher Interest Rates Than Transaction Deposits
Generally Less Costly to Process and Manage
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Interest Rates on Deposits Depend
On:
 The Maturity of the Deposit
 The Size of the Offering Institution
 The Risk of the Offering Institution
 Marketing Philosophy and Goals of the Offering
Institution
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Non-deposit sources of bank fund
 Federal Funds Market
 Federal Reserve Bank
 Negotiable CDs
 Commercial Paper
 Repurchase Agreements
 Long Term Sources
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Repurchase Agreements
 Involves the Temporary Sale of High-Quality Assets
(usually Government Securities) Accompanied by an
Agreement to Buy Back Those Assets On a Specific
Future Date At a Predetermined Price or Yield
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Negotiable CD
 An Interest-Bearing Receipt Evidencing the Deposit
of Funds in the Bank for a Specified Period of Time
for a Specified Interest Rate. It is Considered a
Hybrid Account Since it is Legally a Deposit
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Factors to consider
 The Relative Costs of Raising Funds From Each




Source
The Risk of Each Funding Source
The Length of Time for Which Funds are Needed
The Size of the Institution
Regulations Limiting the Use of Various Funding
Sources
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Quick Quiz
• Which are the principal accounts that appear on a bank’s
balance sheet (Report of Condition)?
• What are primary reserves and secondary reserves, and
what are they supposed to do?
• What are off-balance-sheet items, and why are they
important to some financial firms?
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Asset – Liability Management
Evolution
 In the 1940s and the 1950s, there was an abundance of funds in
banks in the form of demand and savings deposits. Hence, the focus
then was mainly on asset management
 But as the availability of low cost funds started to decline, liability
management became the focus of bank management efforts
 In the 1980s, volatility of interest rates in USA and Europe caused
the focus to broaden to include the issue of interest rate risk. ALM
began to extend beyond the bank treasury to cover the loan and
deposit functions
 Banks started to concentrate more on the management of both sides
of the balance sheet
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Asset – Liability Management (ALM)
 Commercial banks manage their asset and liability
portfolio as an integrated decision
 ALM provide financial institutions with both
defensive and offensive weapon to archive objectives
and minimize risks
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ALM in Banking & Financial Services
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Asset Management Strategy
 Assets management controls the allocation of
incoming funds by deciding:
 Target borrower
 Terms of loans
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Liability Management Strategy
 Liability management strategy monitors the mix and
cost of their deposit and non-deposit liabilities
 The key control was PRICE, which are the interest
rate and other terms offered on deposits and other
borrowings
 Raise the offer rate
 Reduce the offer rate
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Fund Management Strategy
 This is a balanced approach to ALM that stresses
following objectives
 Management should impose the highest control over
volume, mix, costs and return of both assets and
liability
 Consistent coordination between asset management
and liability management to maximize profits and
reduce risk exposure
 Revenues and costs arise from both sides of the
balance sheet
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The Asset - Liability Committee (ALCO)
 ALCO, consisting of the bank's senior management (including




CEO) should be responsible for ensuring adherence to the limits
set by the Board
Is responsible for balance sheet planning from risk - return
perspective including the strategic management of interest rate
and liquidity risks
The role of ALCO includes product pricing for both deposits and
advances, desired maturity profile of the incremental assets and
liabilities,
It will have to develop a view on future direction of interest rate
movements and decide on a funding mix between fixed vs
floating rate funds, wholesale vs retail deposits, money market vs
capital market funding, domestic vs foreign currency funding
It should review the results of and progress in implementation of
the decisions made in the previous meetings
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Risks managed by ALM
 Liquidity Risk:

arises from funding of long term assets by
short term liabilities, thus making the liabilities subject to refinancing
Currency Risk:
The increased capital flows from different
nations following deregulation have contributed to increase in the volume
of transactions. Dealing in different currencies brings opportunities as
well as risk
 Interest
a
Rate Risk:
Interest Rate risk is the exposure of
nk’s financial conditions to adverse movements of interest rates
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Interest Rate Risk: One of The Greatest
ALM Challenges
 Financial institutions must face the most damaging
form of risk which is interest rate risk
 When interest rate fluctuates:
 Interest income on loans & securities change
 Interest costs on borrowing change
 Market value of assets and liabilities change
  Interest rate affects both balance sheet and income
statement of financial firms. Excessive interest rate risk can
pose a significant threat to a bank’s earnings and capital base.
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Price Risk & Reinvestment Risk
 Price risk arises when the interest rates increases,
the value of bonds and fix rate loans fall  potential
trading losses
 Reinvestment risk arises when market interest rate
falls, financial institutions have to invest incoming
funds in lower yielding earning assets lowering
expected future income
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The Measurement of Interest Rate
 Interest rate is defined as the ratio of the fees we
must pay to obtain credit divided by the amount of
credit obtained
 One of the most popular of measuring interest rate
is the Yield to Maturity (YTM)
g
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Bank Discount Rate
 Bank discount rate is often quoted on short-
term loans and money market security
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Bank Discount Rate Vs. YTM
Bank Discount Rate
 Based on 360 days per
year
 Ignore the effects of
compounding interest
 Use face value to
calculate its rate of
return
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YTM
 Based on 365 days per
year
 Interest income is
compounded
 Use purchase price of a
financial instrument
122
Convert Discount Rate to YTM
1. Suppose T-bill can be purchased as $96 and it
has a face value of $100 to be paid on the
maturity date. If the security matures in the
next 90 days, what’s its interest rate
measured by bank discount rate?
2. What is the equivalent YTM?
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Discount Rate & YTM Example
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The Components of Interest Rates
 The interest rate movement is determined by
supply and demand credits
 Interest rate includes risk free rate and risk
premium rate
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Risk Premiums
 Financial institutions often charge risk premium to
reduces following exposures
 Default risk
 Liquidity risk
 Call risk
 Inflation risk premium
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Yield Curve
 Yield curve is the graph of how interest rates
vary with different maturities of loans viewed at
a single point of time (other things remain the
same)
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Types of Yield Curve
 Upward sloping: long-term interest rate exceed
short-term interest rate
 Downward sloping: short-term interest rate exceed
long-term interest rate
 Horizontal or Flat yield curve: short-term interest
rate and long-term interest rate about the same
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Yield Curve & Maturity Gap
 Assets of banks tend to have longer maturities than
its liabilities  Positive maturity gap
 If the yield curve is upward slopping: interest
revenue is higher than interest expense  positive
Net Interest Margin (NIM)
 If the yield curve is downward slopping or horizontal
sloping: interest revenue is higher than interest
expense  small or even negative NIM
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Hedging FIX Net Interest Margin
 Stabilize NIM will help the banks to stabilize net
earning
 However, if interest rate fluctuates frequently,
the NIM will be squeezed
 The gap between interest revenue & interest
expenses is never constant
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CHAPTER 3: MEASURING AND EVALUATING
BANK PERFORMANCE –
RISK MANAGEMENT IN BANKING SERVICES
Lecture outline
1. Components of the Income Statement: Revenues
and Expenses
2. Evaluating the Performance of Banks – key
Profitability Ratios
3. Measuring Credit, Liquidity and other Risks
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Lecture outline
4. Market rate and interest rate risk
5. The goals of interest rate hedging
6. Interest sensitivity gap management techniques
7. Aggressive & eliminating interest-sensitive gap
management techniques
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COMPONENTS OF INCOME STATEMENT
(Reports of Income)
A bank income statement, or Report of Income, indicates:
- The amount of revenue received
- Expenses incurred
Over a specific period of time.
There is usually a close correlation between the size of the
principal items on a bank’s balance sheet and its income
statement:
- Assets on the balance sheet account for the majority of
operating revenues
- Liabilities generate most of a bank’s operating expenses
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COMPONENTS OF INCOME STATEMENT
(Reports of Income)
 The principal source of a bank revenue generally is
-
-
the interest income generated by earning assets:
Mainly its loans (L)
Security investments (S)
Miscellaneous assets (M) generating revenue
(including any income earned by subsidiaries of the
bank or rental income from property that it owns)
Income from fiduciary activities, fee income, etc…
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COMPONENTS OF INCOME STATEMENT
(Reports of Income)
 The major expenses incurred in generating this revenue
-
include:
Interest paid out to depositors (D)
Interest owed on nondeposit borrowings (NDB)
The cost of equity capital (D)
Salaries, wages, and benefits paid to bank employees (SWB)
Overhead expenses associated with the bank`s physical plant
(O)
Funds set aside for possible loan losses (PLL)
Taxes owed (T)
Miscellaneous expenses (ME)
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COMPONENTS OF INCOME STATEMENT
(Reports of Income)
Net income = Total
revenue items – Total
expense items
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COMPONENTS OF INCOME STATEMENT
(Reports of Income)
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COMPONENTS OF INCOME STATEMENT
(Reports of Income)
Banks which are interested in increasing their net
income have a number of possible options:
1) Increase the average yield on each assets held
2) Redistribute their earning assets toward those
assets with higher average yield
3) Reduce their interest or non interest expenses on
deposits, nondeposit borrowings, and owners’
capital
4) Shift their funding sources toward less-costly
deposits and other borrowings, and owners’ capital
5) Find ways to reduce their employee, overhead,
loan-loss, and miscellaneous operating expenses.
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COMPONENTS OF INCOME STATEMENT
(Reports of Income)
Net Interest Income
Provision for Loan Loss
Net Income After PLL
+/- Net Noninterest Income
Net Income Before Taxes
Taxes
+/- Security losses or gains
Net Income
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 Total interest income: $290
 Total interest expense: 205
 Total noninterest income: 27
 Total noninterest expenses: 40
 Provision for loan losses: 10
 Income taxes: 15
 Dividends to common stockholders: 11
Please calculate the net income after taxes, increases
in bank’s undivided profits
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141
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIONS IN BANKING
1. RETURN ON EQUITY CAPITAL (ROE)
�
=
�
�
�
�
ROE, is a measure of the rate of return flowing to the bank’s
shareholders. It approximates the net benefit that the
stockholders have received from investing their capital in the
bank (i.e., placing their fund at risk in the hope of earning a
suitable profit)
For example, Hana Bank reports total equity capital of $120
million and net income after taxes of $17 million. What is the
bank’s ROE?
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142
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIOS IN BANKING
2. RETURN ON ASSETS (ROA)
�
� =
ROA is primarily an indicator of managerial efficiency , it
indicates how capably the management of the bank has
been in converting the institution’s assets into net earnings.
For example, Hana Bank holds total assets of $1,320
million, with net income after taxes of $17 million. What is
the bank’s ROA?
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143
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIOS IN BANKING
3. NET INTEREST MARGIN (NIM)
�
�
�
=
�
−�
�
The net interest margin measure how large a spread
between interest revenues and interest costs management
has been able to achieve by close control over the bank’s
earning assets and the pursuit of the cheapest sources of
funding.
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144
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIOS IN BANKING
3. NET INTEREST MARGIN (NIM)
For example, suppose a large international bank records $4
billion in interest revenues from its loans and security
investment and $2.6 billion in interest expenses paid out to
contract deposits and other borrowed funds. If the banks
holds $40 billion in total assets, its net interest margin is:
a) 3.5 %
b) 4 %
c) 4.5 %
d) 5 %
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145
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIOS IN BANKING
4. NON INTEREST MARGIN (NM)
−
=
The noninterest margin, in contrast, measures the amount of
noninterest revenues stemming from deposit service charges and other
services fees the bank has been able to collect (call fee income)
relative to the amount of noninterest costs incurred (including salaries
and wages, repair and maintenance costs on bank facilities, and loanloss expenses). For most banks, the noninterest margin is
negative – noninterest cost generally out trip fee income, though
bank fee income has been rising rapidly in recent years as a
percentage of all bank revenues.
MBA Vũ Thị Thùy Linh
146
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIOS IN BANKING
5. NET PROFIT MARGIN (NPM)
=
�
�
MBA Vũ Thị Thùy Linh
�
�
147
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIOS IN BANKING
6. EARNINGS PER SHARE OF STOCK (EPS)
Earnings per share of stock ��
=
�
EPS provides a direct measure of the returns flowing to the
bank’s owners – its stockholders – measured relatively to the
number of shares sold to the public.
MBA Vũ Thị Thùy Linh
148
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIOS IN BANKING
Using the information below for ML Bank, calculate the bank’s
ROE, ROA, net interest margin, net noninterest margin, net
profit margin, EPS.
Interest income: $ 1,875 mil. Noninterest income: $501 mil
Interest expenses: $1,210 mil. Noninterest expenses: $685 mil
Total assets: $15,765 mil.
Security gain (losses): $21 mil
Total liabilities: $15,440 mil.
Taxes: $16 mil
Provision for Loan losses:$381 mil
Shares of common stock outstanding: 145,000 mil
MBA Vũ Thị Thùy Linh
149
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIOS IN BANKING
7. EARNINGS SPREAD
�
=
−
−
Earnings spread (or simply the spread) measures the effectiveness of the
bank’s intermediation function in borrowing and lending money and also the
intensity of competition in the bank’s market area. Greater competition tends
to squeeze the difference between average asset yields and average liability
costs. If other factor are held constant, the bank’s spread will decline as
competition increase, forcing management to try to find other ways (such as
generating fee income from new services) to make up for an eroding
earnings spread.
MBA Vũ Thị Thùy Linh
150
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIOS IN BANKING
8. ASSET UTILIZATION RATIO
=
�
−
Another useful measure of profitability is the operating – income (or
asset utilization) ratio. This earnings measure can be broken down into
two important components, the average interest return on assets and
the average noninterest-generating assets has grown and may loans
have turned sour, more and more bank have shifted their attention to
increasing noninterest income from fee. These fees boost total revenue
and help to raise net income flowing to bank stockholders.
MBA Vũ Thị Thùy Linh
151
EVALUATING BANK PERFORMANCE
KEY PROFITABILITY RATIOS IN BANKING
8. EARNINGS BASE RATIO
Earnings base in assets =
−
In a bank whose earnings base is falling, management and
staff must generally work harder just to sustain the current
level of earnings.
MBA Vũ Thị Thùy Linh
152
EVALUATING BANK PERFORMANCE
USEFUL PROFITABILITY FORMULAS
It easy to see that ROE and ROA – two of the most popular
bank profitability measures in use today – are closely
related. Both use the same numerator: net income after
taxes. Therefore, these two profit indicators can be linked
directly:
Return on equity capital (ROE) =
�
×
=
=
� ×
�
MBA Vũ Thị Thùy Linh
�
�
�
�
�
�
�
153
EVALUATING BANK PERFORMANCE
USEFUL PROFITABILITY FORMULAS
Leverage ratio =
=
�×
�
�
�
�
A bank’s return to its shareholders is highly sensitive to how the bank’s
assets are financed – whether more debt (including deposits) or more
owners’ capital is used. Even a bank with a low ROA can achieve a
relatively high ROE through heavy use of debt (leverage) and minimal
use of owners’ capital.
In fact, the ROE – ROA relationship illustrates quite clearly the
fundamental trade – off bank managers face between risk and return.
MBA Vũ Thị Thùy Linh
154
EVALUATING BANK PERFORMANCE
USEFUL PROFITABILITY FORMULAS
For example, a bank whose ROA is projected to be about
1% this year will need $10 in assets for each $1 in capital
in order to achieve a 10% ROE. Tat is, following equation:
ROE =
�x
�
�
$
= %×
$
�
=
%
If however, the bank’s ROA is expected to fall to 0.5%, a 10% ROE is
attainable only if each $1 of capital supports $20 in assets. In other
words:
$
= %
= .5% ×
$
MBA Vũ Thị Thùy Linh
155
EVALUATING BANK PERFORMANCE
USEFUL PROFITABILITY FORMULAS
For example, a bank whose ROA is projected to be about
1% this year will need $10 in assets for each $1 in capital
in order to achieve a 10% ROE. Tat is, following equation:
ROE =
�x
�
�
$
= %×
$
�
=
%
If however, the bank’s ROA is expected to fall to 0.5%, a 10% ROE is
attainable only if each $1 of capital supports $20 in assets. In other
words:
$
= %
= .5% ×
$
MBA Vũ Thị Thùy Linh
156
EVALUATING BANK PERFORMANCE
INTERPRETING PROFITABILITY RATIOS
Risk – Return Trade – Offs for a Bank
Ratio of Total
Assets to Total
Equity Capital
5:1
10:1
15:1
20:1
ROE with an ROA of
0.5%
1.0%
1.5%
2.0%
2.5%
5.0%
7.5%
10.0%
5.0%
10.0%
15.0%
20.0%
7.5%
15.0%
22.5%
30.0%
10.0%
20.0%
30.0%
40.0%
Clearly, as earning efficiency represented by ROA declines, the bank
must take on more risk in the form of higher leverage to have any
chance of achieving its desired rate of return to its shareholders.
MBA Vũ Thị Thùy Linh
157
EVALUATING BANK PERFORMANCE
INTERPRETING PROFITABILITY RATIOS
A&B Bank holds total assets of $1.69 billion and equity
capital of $139 million and has just posted an ROA of
0.0076. What is the bank’s ROE?
1) Suppose A&B Bank find its ROA climbing by 50 percent,
with assets and equity capital unchanged. What will
happen to its ROE.
2) On the other hand, suppose the bank’s ROA drop by 50
percent. IF total assets and equity capital hold their present
positions. What chance will there be in ROE”
3) If ROA at A&B Bank remains fixed at 0.0076 but both
total assets and equity capital double. How does ROE
change?
MBA Vũ Thị Thùy Linh
158
EVALUATING BANK PERFORMANCE
INTERPRETING PROFITABILITY RATIOS
Suppose a bank is projected to achieve a 1.25 percent ROA
during the coming year. What must its ratio of total assets
to equity capital be if it is to achieve its targets ROE of 12
percent?
1) If the bank’s ROA unexpectedly fall to 0.75 percent,
what assets-to-capital ratio must it then have to reach a
12 percent ROE
2) If ROA next year reaches to 1.5 percent, achieving a 12
percent ROE will require what total-assets-to-equitycapital ratio for a bank?
MBA Vũ Thị Thùy Linh
159
EVALUATING BANK PERFORMANCE
INTERPRETING PROFITABILITY RATIOS
Another highly useful profitability formula focusing upon ROE
is:
=
×
�
�
×
�
�
�
ROE = Net profit margin x Assets utilization ratio x Equity
multiplier
Each component of this simple equation is a telltale indicator
of different aspect of the bank’s operations.
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160
Breaking Down ROE
ROE = Net Income/ Total Equity Capital
ROA =
Net Income/Total Assets
Equity Multiplier =
Total Assets/Equity Capital
Net Profit Margin =
Asset Utilization =
Net Income/Total Operating Revenue Total Operating Revenue/Total Assets
MBA Vũ Thị Thùy Linh
161
EVALUATING BANK PERFORMANCE
INTERPRETING PROFITABILITY RATIOS
reflects
The bank’s net profit margin (NPM)
effectiveness of expense management (cost control) and
service pricing policies
reflects
The bank’s degree of assets utilization
portfolio
management policies (especially the mix and yield o the
bank’s assets)
reflects
The bank’s equity multiplier
leverage or
financing policies : the sources chosen to fund the bank
(debt or equity)
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162
Determinants of ROE in a Financial Firm
MBA Vũ Thị Thùy Linh
163
EVALUATING BANK PERFORMANCE
INTERPRETING PROFITABILITY RATIOS
Grand Dell Bank reports total operating revenues of $135
million, with total operating expenses of $121 million, and
owes taxes of $2 million. It has total assets of $1.17 billion
and total liabilities of $989 million. What is the banks ROE?
1) How will the ROE for Grand Dell Bank change if total
operating expenses, taxes, and total operating revenues
each grow by 10 percent while assets and liabilities remain
fixed?
MBA Vũ Thị Thùy Linh
164
EVALUATING BANK PERFORMANCE
INTERPRETING PROFITABILITY RATIOS
1) Hana Bank presents us with the figures below for the
year just concluded. Please determine the net profit
margin, equity multiplier, assets utilization, and ROE.
Net income after taxes
$16 million
Total operating revenues
$215 million
Total assets
$1,250 million
Total equity capital
$111 million
2) Suppose you found that Hana Bank had total liabilities of
$1,475 million, equity capital of $140 million, total
noninterest income of $88 million, total interest income of
$155 million, and after tax net income of $24 million. What
would its NPM, AU, EM and ROE be?
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165
EVALUATING BANK PERFORMANCE
VALUE OF THE BANK’S STOCK
1) Bank stock may pay dividends of varying amount.
Value of the bank’s stock (Po) =
∞
= ෍
=
E
�
ℎ
� �
+
Where E(Dt) represents stockholder dividends expected to be
paid future periods, discounted by a minimum acceptable rate
of return (r)
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166
EVALUATING BANK PERFORMANCE
VALUE OF THE BANK’S STOCK
3) The two bank stock price formulas discussed above assume that
bank will possibly pay dividends indefinitely into the future. Most
capital market investors have a limited time horizon, however, and
plan to sell the bank’s stock at the end of their planned investment
horizon.
In this case the current value of the bank’s stock is determine from:
=
+
+
+
+ …+
�
+ �
+ �
Where we assume the investor will hold the bank’s stock for n
periods, receiving the stream of dividends , ,…., , and sell stock
for price
at the end of the planned investment horizon.
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167
EVALUATING BANK PERFORMANCE
VALUE OF THE BANK’S STOCK
3) Most capital market investors have a limited time horizon,
however, and plan to sell the bank’s stock at the end of their
planned investment horizon. In this case the current value of
the bank’s stock is determine from:
=
+
=
$5
+
+
+ …+
+
�
+
+ �
+ �
For example, suppose investor expect the bank pay a $5
dividend at the end of period 2, and then plan to sell the stock
for a price of $150. If the relevant discount rate is 10 percent,
the current value of the bank’s stock should approach:
+
$
+
+
$ 5
+
MBA Vũ Thị Thùy Linh
= $136.78
168
EVALUATING BANK PERFORMANCE
VALUE OF THE BANK’S STOCK
2. Suppose that stock brokers have projected that Hana Bank
will pay a dividend of $3 per share on its common stock at the
end of the year; a dividend of $4.5 per share is expected for the
next year, and $6 per share in the following year. The riskadjusted cost of capital for the bank is 12 percent. If an
investor holding Hana’s stock plans to hold that stock for only
three years and hopes to sell it at a price of $60 per share,
what should the value of the banks stock be today’s market?
MBA Vũ Thị Thùy Linh
169
MEASURING RISK IN BANKING
Bankers are concerned with six main types of risk:
1. Credit risk
2. Liquidity risk
3. Market risk
4. Interest rate risk
5. Earning risk
6. Solvency risk
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170
MEASURING RISK IN BANKING
1. Credit risk
The probability that some of a bank’s assets, especially its loans , will
decline in value and perhaps become worthless is known as credit
risk.
Because banks hold little owners’ capital relative to the aggregate
value of their assets, only a relatively small percentage of total loans
needs to turn bad in order to push any bank to the brink of failure.
2. Liquidity risk
Bankers are also very concerned about the danger of not having
sufficient cash and borrowing capacity to meet deposit withdrawals,
net loan demand, and other cash needs. Face with liquidity risk, a
bank may be forced to borrow emergency funds at excessive cost to
cover its immediate cash needs, reducing its earnings.
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MEASURING RISK IN BANKING
3. Market risk
Volatile changes in interest rate have created havoc for managers of
bank assets portfolios, particularly for those responsible for bank
investment in government bonds and other marketable securities.
When interest rates catapulted to record levels a few year ago, the
market value of bank-held bonds plummeted, forcing many banking
firms to accept substantial losses on any securities that had to be sold
– a potent example of what financial analyst call market risk.
4. Interest rate risk
The impact of changing interest rates on a banks margin of profit is
usually called interest rate risk.
With more volatile market rates in recent years, banks have develop
several ways to defend their earnings margins against interest rate
changes including interest rate swaps and financial futures contracts.
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172
MEASURING RISK IN BANKING
5. Earnings risk:
The risk to the bank’s bottom line – its net income after all expenses
are covered – is known as earnings risk. Earnings may decline
unexpectedly due to factors inside the bank or due to external
factors, such as changes in economic conditions or changes I laws
and regulations.
6. Solvency risk
Bankers must be directly concerned about risks to their institutions’
long run survival, usually called solvency risk.
If the bank takes on an excessive number of bad loans or if a large
portion of its security portfolio declines in market value, generating
serious capital losses, may be overwhelmed. If investors and
depositors become aware of the problem and begin to withdraw their
funds, the regulators may have no choice but to declare the bank
insolvent and close its doors.
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MEASURING RISK IN BANKING
Other forms of risk in banking: Certainly credit, liquidity, market,
interest rate, …, and solvency risk are not the only forms of risk
affecting banking today. Banks of all sizes and shapes also face
several other important types of risk:
- Inflation risk: the probability that an increasing price level for goods
and services (inflation) will unexpected erode the purchasing power
of bank earnings and the return to its shareholders.
- Currency or exchange rate risk – the probability that fluctuations in
the market value of foreign currencies will create losses for the
bank by altering the market values of its assets and liabilities.
- Political risk – the probability that changes in government laws or
regulations, at home or abroad, will adversely affect the bank’s
earnings, operations, and future prospects.
- Crime risk – the possibility that bank owners, employees, or
customers may choose to violate the law and subject the bank to
loss from fraud, theft, or other illegal acts.
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174
MEASURING RISK IN BANKING
Credit risk
CREDIT DERIVATIVES
Credit derivative – financial contracts offering protection to
the beneficiary in case of loan default – can be helpful in
reducing a bank exposure to credit risk and, in some cases,
interest rate risk as well.
1. CREDIT SWAP
2. CREDIT OPTION
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175
MEASURING RISK IN BANKING
Credit risk
CREDIT SWAP
Credit swap – two lenders simply agree to exchange a portion
of their customers’ loan repayment.
For example, Bank A&B may find a swap leaders, such as a
large insurance company, that agrees to draw up a credit swap
contract between the two banks. Bank A then transmits an
amount (perhaps $100 million) in interest and principal
payments that is collects from its credit customers to the dealer.
Bank B also sends $100 million worth of the loan payments its
customers make up to the same dealer. The swap dealer will
ultimately pass these payments along to the other bank that
signed the swap contract.
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176
MEASURING RISK IN BANKING
Credit risk
CREDIT SWAP
Usually the dealer levies a slight fee for the service of bringing
these two swap partners together. The swap dealer may also
guarantee each swap partner’s performance under the
agreement in return for an additional charge.
Loan principal and
Interest payments
Loan principal and
Interest payments
Credit Swap
Intermediary
BANK A
Loan principal and
Interest payments
MBA Vũ Thị Thùy Linh
BANK B
Loan principal and
Interest payments
177
MEASURING RISK IN BANKING
Credit risk
CREDIT SWAP
Example of a Total Return Swap
Principal + Interest payments + Price
BANK A
(The Swap Beneficary)
Loan
Extended
Total return from the Loan
LIBOR + Fixed Rate Spread
BANK B
Any Depreciation in the Value of
Principal the Loan
and interest
payments
Business Loan
Customer
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178
MEASURING RISK IN BANKING
Credit risk
CREDIT OPTIONS
Another popular credit-risk derivative today is the credit
option, which guards against losses in the value of a credit
assets or helps to offset higher borrowing cost that may occur
due to changes in credit ratings.
Pays Option Fee
BANK
Receives Payment if Credit Costs Rise above
Option Dealer or
Other Financial
Intermediary
Prespecified Levels or Credit Standing
(rating) Deteriorates below Certain
prespecified Levels
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179
MEASURING RISK IN BANKING
Credit risk
CREDIT OPTIONS
For example, a bank worried about default on a large $100
million loan it has just made might approach an options dealer
about an option contract that pays off if the loan declines
significantly in value or completely turns bad. If the bank’s
borrowing customer pays off as promised, the bank collects the
loan revenue it expected to gather in and the option issued by
the dealer (option writer) will go unused. The Bank involved
will, of course, lose premium id paid to the dealer writing the
option.
Many banks will take out similar credit options to protect the
value of securities held in their investment portfolio should the
securities' issuer fail to pay or should the securities decline
significantly in value due to a change in credit standing.
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180
MEASURING RISK IN BANKING
Credit risk
CREDIT OPTIONS
For example, a bank may fear that its credit raring will be
lowered just before it plans to issue it plans to issue some
long-term notes or bonds to raise new capital. This would force
the bank to pay a higher interest rate for its borrowed funds.
One possible solution is for the bank to purchase a call option
on the default risk interest spread prevailing in the market for
debt securities similar in quality securities
Similar in quality to its own securities at the time it need to
borrow money.
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181
MEASURING RISK IN BANKING
Credit risk
CREDIT OPTIONS
What type of credit derivative contract would you recommend for
each of situations described below?
a) A bank is about to make a $50 million project loan to develop a
new gas field and is concerned about the risk involved if
petroleum geologist’s estimates of the field’s potential yield turn
out to be much too high and the borrowing developer cannot
repay.
b) A bank holding company plans to offer new capital notes in the
open market next month, but knows that the company’s credit
rating is being reevaluated by two credit-rating agencies. The
holding company wants to avoid paying sharply higher credit cost
if its rating is lowers by the investigation credit–rating agencies.
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182
MEASURING RISK IN BANKING
Credit risk
 CREDIT OPTIONS
C. First National Bank of Ashton serves a relatively limited geographic
are centered upon a moderate-sized metropolitan area. It would like to
diversify its loan income based upon loans from other market areas it
does not presently serve, but does not wish to make loans itself in
these other market areas due to its lack of familiarity with loan markets
outside the region it has served for many years. Is there a credit
derivative contract that could help the bank achieve the loan portfolio
diversification it seeks?
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183
MEASURING RISK IN BANKING
Liquidity risk
 THE DEMAND FOR AND SUPPLY OF BANK LIQUIDITY
Demand for spendable funds come from two sources:
(1) Customer withdrawing money from bank’s deposits
(2) Credit requests from customers the bank wishes to keep, either in
the form of new loan request, renewals of expiring loan
agreements, or drawing upon existing credit lines
Important element in the supply of bank liquidity is
(1) Receipt of new customers deposits, both from newly opened
accounts and from new deposits placed in existing accounts
(2) Customers repaying their loans
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184
MEASURING RISK IN BANKING
Liquidity risk
 THE DEMAND FOR AND SUPPLY OF BANK LIQUIDITY
These various sources of liquidity demand and supply come together to determine each bank’s
net liquidity position at any moment in time. That net liquidity position at time is as
follows:
Supplies of Liquidity Flowing into the Bank
A bank’s net Incoming
liquidity
deposits
position ( ) (inflows)
=
Revenues
Customer loan Sales of
Borrowings from
from the
repayments
bank
the money
sale of nonassets
market
+
+
+
+ deposit
services
Demands on the Bank for liquidity
Deposit
Volume of
Repayments
withdrawals acceptable
of bank
- (outflows) - loan requests
- borrowingsMBA Vũ Thị Thùy Linh
Other
operating
expenses -
Dividend
payments to
bank
stockholders
185
MEASURING RISK IN BANKING
Liquidity risk
 THE DEMAND FOR AND SUPPLY OF BANK LIQUIDITY
- When the bank’s total demand for liquid exceeds its total supply of
liquid ( < 0), management must prepare for a liquidity deficit,
deciding when and where to raise additional liquid funds.
- On the other hand, if any point in time the total supply of liquid to
the bank exceeds all of its liquidity demands ( >0), management
must prepare for a liquidity surplus, deciding when and where to
profitably invest surplus liquid funds until they are needed to cover
future liquidity demands.
MBA Vũ Thị Thùy Linh
186
MEASURING RISK IN BANKING
Liquidity risk
 THE DEMAND FOR AND SUPPLY OF BANK LIQUIDITY
The essence of the liquidity management problem for a bank may be
described in two succinct statements:
1. Rarely are the demands for bank liquidity equal to the supply of
liquidity at any particular moment in time. The bank must
continually deal with either a liquidity deficit or a liquid surplus.
2. There are trade-off between bank liquidity and profitability. The
more bank resources are tied up in readiness to meet demands for
liquidity, the lower is that bank’s expected profitability (other factor
held constant).
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187
MEASURING RISK IN BANKING
Liquidity risk
 THE DEMAND FOR AND SUPPLY OF BANK LIQUIDITY
Suppose that a bank faces the following cash inflows and outflows
during the coming week: (a) deposit withdrawals are expected to total
$33 million, (b) customer loan repayments are expected to amount to
$108 million, © operating expenses demanding cash payment will
probably approach $51 million, (d) acceptable new loan requests
should reach $294 million, (e) sales of bank assets are projected to be
$18 million, (f) new deposits should total $670 million, (g) borrowing
from the money market are expected to be amount $43 m, (h)
nondeposit service fee should amount to %27 m, (i) previous bank
borrowings totaling $23m are scheduled to be repaid, and (j) a
dividend payment to bank stockholders of $140 m is scheduled. What
is this bank’s projected net liquidity position for the coming week?
MBA Vũ Thị Thùy Linh
188
MEASURING RISK IN BANKING
Liquidity risk
 WHY BANK FACE SIGNIFICANT LIQUIDITY PROBLEMS
1. Bank borrow large amounts of short-term deposits and reserves
form individuals and businesses and from other lending institutions and
then turn around and make long-term credit available to their
borrowing customers. Thus, most banks face some imbalances
between the maturity dates on their assets and the maturity dates
attaches to their liabilities. A problem related to the maturity mismatch
situation is that banks hold an unusually high proportion of liabilities
subject to immediate payment.
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189
MEASURING RISK IN BANKING
Liquidity risk
 WHY BANK FACE SIGNIFICANT LIQUIDITY PROBLEMS
2. Another source of liquidity problems is the bank’s sensitive to
changes in interest rates. When interest rate rise, some depositors will
withdraw their funds in search of higher return elsewhere. Many loan
drawings on those credit lines that carry lower interest rates. Thus,
changing interest rates affect both customer demand for loans, each of
which has a potent impact on a bank’s liquidity position. Moreover,
movements in interest rates affect the market values of assets the bank
may need to sell in order to raise additional liquid funds, and they
directly affect the cost of borrowing in the money market.
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190
MEASURING RISK IN BANKING
Liquidity risk
 WHY BANK FACE SIGNIFICANT LIQUIDITY PROBLEMS
Beyond these factors, a bank must give high priority to meet demands
for liquidity. To fail in this area may severely damage public confidence
in the institution. We can imagine the reaction of bank customers if the
teller windows and teller machine had to be closed one morning
because the bank was temporarily out of cash and could not cash
checks or meet deposit withdrawals. One of the most important tasks
of a bank’s liquidity manager is to keep close contact with the bank’s
largest depositors and holders of large unused credit lines to determine
if and when withdrawals of funds will be made and to make sure
adequate funds are available.
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191
MEASURING RISK IN BANKING
Liquidity risk
 STRATEGIES FOR LIQUIDITY MANAGERS
Over the years, experienced liquidity managers have
developed several broad strategies for dealing with
bank liquidity problems:
1. Providing liquidity from assets (asset liquidity
management)
2. Relying on borrowed liquidity to meet cash
demands (liability management)
3. Balanced (asset and liability) liquidity management
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
Several methods have been developed in recent years for
estimating each bank’s liquidity requirements:
1. The sources and uses of funds approach
2. The structure of funds approach
3. Use probabilities in deciding how much liquidity to hold
behind their deposits and loans.
4. The liquidity indicator approach
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
1. The sources and uses of funds approach
The sources and uses of funds method begins with two simple
fact:
- Bank liquidity rises as deposits increase and loan decrease
- Bank liquidity declines when deposits decreases and loans
increase
Whenever sources and uses of liquidity do not match, the bank
has a liquidity gap
Liquidity gap =
�
MBA Vũ Thị Thùy Linh
� �
−
�
� �
194
MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
1. The sources and uses of funds approach
Liquidity gap =
�
� �
−
�
� �
- When (1) < (2), the bank faces a negative liquidity gap, or
liquidity deficit. It now must raise funds from the cheapest
and most timely sources available.
- When (1) > (2), the bank will have a positive liquidity gap.
Its surplus liquid funds must be quickly invested in earning
assets until they are needed to cover future cash needs.
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
1. The sources and uses of funds approach
The key steps in the sources and uses of funds approach are as
follows:
- Loans and deposits must be forecast for a given liquidity
planning period.
- The estimated change in loans and deposits must be
calculated for that same planning period.
- The liquidity manager must estimate the bank’s net liquid
funds, surplus or deficit, for the planning period by comparing
the estimated change in loans to the estimated change in
deposits.
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
1. The sources and uses of funds approach
Estimates change in total loans for the coming period is a
function of:
- Projected growth in the economy that the bank serves (i.e.,
the growth of gross domestic product of business sales)
- Projected quarterly corporate earnings
- Current rate of growth in the nation’s money supply
- Projected prime bank loan rate minus the commercial paper
rate
- Estimated rate of inflation
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
1. The sources and uses of funds approach
Estimates change in total deposits for for the coming period is a
function of:
- Projected growth in personal income the bank serves
- Estimated increase in retail sales
- Current rate of growth in the nation’s money supply
- Projected yield of growth of the nation’s money supply
- Estimated rate of inflation
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
1. The sources and uses of funds approach
Using the forecasts of loans and deposits generated by the
foregoing models, management could then estimate the bank’s
need for liquidity by calculating
Estimated liquidity
Deficit (-) or surplus (+) =
For the coming period
loans
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Estimated
change in
total deposits
Estimated
change in
total
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
1. The sources and uses of funds approach
Suppose that a bank estimates its total deposits for the next six
months will be, respectively, $112, $132, $121, $147, $151, and
$139, while its loans will total in estimated $87, $95, $102,
$113, $101 and $124, respectively, over the same six months,
(All figures are in million of dollars). Under the sources and uses
of funds approach when does this bank face liquidity deficits, if
any?
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
1. The sources and uses of funds approach
Time
period
Estimated
total
deposits
Estimated
total loans
Estimated
deposit
change
Estimated
loan
change
Estimated
liquidity
deficit (-)
or surplus
(+)
January
$112
$87
$___
$___
$___
February
132
95
+20
+8
+12
March
121
102
-11
+7
-18
April
147
113
+26
+11
+15
May
151
101
+4
-12
+16
June
139
124
-12
+23
-35
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
2. The structure of funds approach
In the first step, the bank’s deposits and other funds sources are
divided into categories based on their estimated probability of being
withdraw and therefore lost of the bank. As an illustration, we might
divide the bank’s deposit an non-deposit liabilities into three
categories:
- “Hot money” liabilities – deposits and other borrowed funds that
are very interest sensitive or that management is sure will be
withdraw during the current period.
- Vulnerable funds – customer deposits of which a substantial portion
(perhaps 25 or 30 percent) will probably be removed from the bank
sometime during the current period.
- Stable funds – funds that management considers most unlikely to
be removed from the bank (except for a minor percentage of the
total)
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
2. The structure of funds approach
Second, the liquidity manager must set aside liquid funds
according to some desire operating rule for each of three kinds
of funds sources listed above.
For example:
- Hot money funds: 95%
- Vulnerable funds: 30%
- Stable funds: 15%
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
2. The structure of funds approach
Thus, the liquidity reserve behind the bank’s deposit and nondeposit liabilities would be as follow:
Liabilities liquidity reserve = 95% x (Hot money funds – Legal reserves held)
+ 30% x (Vulnerable funds – Legal reserves held)
+ 15% x (Stable funds – Legal reserves held)
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
2. The structure of funds approach
In the case of loans, the bank must be ready at all times to
make good loans. The bank must have sufficient liquid reserves
on hand because, once a loan is made, the borrowing customer
will spend the proceeds usually within hours or days, and those
funds will flow out to other banks. However, the bank does not
want to turn down any good loan, because loan customers
bring new deposits and normally are the principal source of
bank earnings from interest and fees.
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
2. The structure of funds approach
Combining both loan and deposit liquidity requirements, the
bank’s total liquidity requirement would be:
Total liquidity requirement = 95% x (Hot money funds – Legal reserves
held)
+ 30% x (Vulnerable funds – Legal reserves held)
+ 15% x (Stable funds – Legal reserves held)
+ (Potential loans outstanding – Actual loans
outstanding)
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
2. The structure of funds approach
For example, First National Bank has broken down its deposit and non
deposit liabilities into hot money, vulnerable funds, and stable (core)
funds, amounting to $25 million, $24 million, and $100 million,
respectively. Bank management wants to keep a 95% reserve behind
its hot money deposits and non deposit liabilities, a 30% liquidity
reserve behind its core deposit and non deposit funds. The legal
reserves requirement behind many of these deposits is 3%. The
bank’s loans total $135 million but recently have been as high as
$140 million, with a trend growth rate about 20 percent a year. The
bank wishes to be ready at all times to honor customer demands for
all those loans that mean its quality standards. Please determine the
banks total liquidity requirenment.
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
2. The structure of funds approach
Suppose a bank’s liquidity division estimates that it holds $19
million in hot money deposits against which it will hold an 80
percent liquidity reserves; $54 million in vulnerable funds
against which it plans to hold a 25 percent liquidity reserve, and
$112 million in stable or core funds against which it hold a 5
percent liquidity reserve. The bank expects its loans to grow 8
percent annually; its loans currently total $117 million but have
recently reached $132 million. If reserve requirements on
liabilities currently stand at 3 percent. What is this bank’s total
liquidity requirement?
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
 3. Use probabilities in deciding how much liquidity to hold behind
their deposits and loans:
 Under this refinement of the structure of fund approach, the liquidity
manager will want to define the best and the worst possible liquidity
position the bank might find itself in and assign probabilities to as
many of these situations as possible. For example:
 - The worst possible liquidity position for the bank: suppose deposit
growth falls significantly below management’s expectations.
Moreover, suppose loan demand from qualified credit customers rises
significantly above management’s expectations.
 - The best possible liquidity position for the bank: Suppose deposit
growth turns out to be significantly above management’s
expectations. Suppose loan demand turns out to be significantly
below management’s expectations.
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
 3. Use probabilities in deciding how much liquidity to
hold behind their deposits and loans:
 Calculate the bank’s expected liquidity requirement,
based on the probabilities they assign to different
possible outcomes.
 Bank’s expected liquidity requirement = Probability
of Outcome A * (Estimated liquidity surplus or deficit
in Outcome A) + Probability of Outcome B *
(Estimated liquidity surplus or deficit in Outcome B)
+ ….+ ….
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
 3. Use probabilities in deciding how much liquidity to hold behind
their deposits and loans:
 For example, suppose the liquidity manager considers the bank’s
liquidity situation next week as likely to fall into one of three possible
situations: (1) the best possible liquidity position, this is judged to
have only a 15 percent probability of occurring; (2) liquidity position
with the highest probability of occurrence, with a management
estimated probability of 60 percent; (3) the worst possible liquidity
position, this least desirable outcome is assigned a probability of only
25 percent. Average volume of deposits next week is $170 million,
$150 million, $130 million respectively. Average volume of acceptable
loan next week is $110 million, $140 million, $150 million
respectively. What is the bank’s expected liquidity requirement?
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MEASURING RISK IN BANKING
Liquidity risk
 ESTIMATING A BANK’S LIQUIDITY NEED
Possible
Liquidity
outcomes for
next week
Estimated
Average
volume of
deposits next
week
(millions)
Estimate
Average
volume of
acceptable
loans next
week
(millions)
Estimated
liquidity
surplus or
deficit
position next
week
(millions)
Probability
assigned by
management
to each
possible
outcome
Best possible
liquidity
position
(maximum
deposits,
minimum
loans)
$170
$110
+$60
15%
Liquidity
position
probability of
$150
$140
+$10
60%
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MEASURING RISK IN BANKING
Liquidity risk
ESTIMATING A BANK’S LIQUIDITY NEED
4. Liquidity indicator approach:
Many banks estimate their liquidity needs based on experience and
industry average. This often means using certain bellwether financial
ratios or liquidity indicators. For example:
- Cash position indicator
Cash position indicator =
ℎ
�
- Liquid securities indicator
Liquid securities indicator =
�
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�
�
�
�
�
�
� �
213
Interest rate risk
 The potential loss from unexpected changes in interest rates which can
significantly alter a bank’s profitability and market value of equity.
 Financial institutions can lose income or value from assets no matter
which way interest rates go (ex: losses on security instruments and
fixed rate loans)
 interest rates risk can lead to an increase in the cost of capital.
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Effects of Interest rate risk
 Rising rates can lead to losses on security instruments and fixed rate
loans as the value of these instruments fall. Rising rates can also cause
a loss to income if the bank has more rate sensitive liabilities than
assets
 Falling interest rates can lead to capital gains but could lead to losses if
there are more interest rate sensitive assets than liabilities
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NET INTEREST MARGIN (NIM)
�
=
�
−�
The net interest margin measure how large a spread between interest revenues and interest
costs management has been able to achieve by close control over the bank’s earning assets
and the pursuit of the cheapest sources of funding.
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NET INTEREST MARGIN (NIM)
 Stabilize NIM will help the banks to stabilize net earning
 However, if interest rate fluctuates frequently, the NIM will be squeezed
 The gap between interest revenue & interest expenses is never
constant
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Goal of Interest Rate Hedging
 One Important Goal of Interest Rate Hedging is to Insulate the Bank
from the Damaging Effects of Fluctuating Interest Rates on Profits
(NIM)
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Problem
 If interest revenues are $63 million, interest costs are $42 million,
earning assets are 700 million. What is the NIM? If interest costs and
interest revenues double while its earning assets increase by 50% what
will happen to NIM?
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Interest Sensitive Gap Management
 Interest sensitive gap management performs analysis of
maturities and re-pricing opportunities associated with interestbearing assets and interest-bearing liabilities
 Interest-sensitive gap (R) = interest-sensitive assets –
Interest-sensitive liabilities
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220
Repriceable vs Nonrepriceable
Repriceable
assets
Repriceable
liabilities
Nonrepriceable
assets
Nonrepriceable
liabilities
Short-Term Securities
Issued by the
Government and Private
Borrowers (about to
mature)
Borrowings from Money
Markets (such as federal
funds or RP borrowings)
Cash in the vault and
deposits at the Central
Bank (legal reserves)
Demand deposits (which
pay no interest rate or a
fixed interest rate)
Short-Term Loans made
to Borrowing Customers
(about to mature)
Short-term savings
accounts
Long-term loans made
at a fixed interest rate
Long-term savings and
retirement accounts
Variable-Rate Loans and
securities
Money-market deposits
(whose interest rates are
adjustable every few
days)
Long-term securities
carrying fixed rates.
Buildings and
equipment
Equity capital provided
by the financial
institution’s owners
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Interest Sensitive Gap Management
 What happen when the amount of repriceable assets does not equal
the amount of repriceable liabilities?
 R = 0: a bank relatively insulated from interest rate risk
 R > 0: positive gap (asset sensitive gap)
 R < 0: negative gap (liabilities sensitive gap)
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222
Cha ge i the a k’s et i terest i o e
 Change in the bank’s net interest income = Overall change in
interest rates (in percentage points) x Size of the cumulative
gap (in dollars)
 Cumulative Gap: The Total Difference in Dollars Between Those Bank
Assets and Liabilities Which Can be Repriced over a Designated Time
Period
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223
Gap Positions and the Effect of Interest Rate
Changes on the Bank
 Asset-Sensitive
 Interest
Bank
Rates Rise -> NIM Rises
 Interest Rates Fall -> NIM Falls
 Liability-Sensitive
 Interest
Bank
Rates Rise -> NIM Falls
 Interest Rates Fall -> NIM Rises
 Zero
Interest-Sensitive Gap
When Interest Rates Change in Either Direction - NIM is Protected and Will Not
Change
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224
NIM Influenced By:
 Changes in Interest Rates Up or Down
 Changes in the Spread Between Assets and Liabilities
 Changes in the Volume of Interest-Sensitive Assets and Liabilities
 Changes in the Mix of Assets and Liabilities
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225
Important Decision Regarding IS Gap
 Management Must Choose the Time Period Over Which NIM is to be





Managed
Management Must Choose a Target NIM
To Increase NIM Management Must Either:
Develop Correct Interest Rate Forecast
Reallocate Assets and Liabilities to Increase Spread
Management Must Choose Dollar Volume of Interest-Sensitive Assets
and Liabilities
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Aggressive Interest-Sensitive Gap Management
The risk
Possible management
reponses
Interest sensitive assets > interest
sensitive liabilities
Losses if interest rates fall
because NIM will be reduced
1. Extend asset maturities or
shorten liability maturities
2. Increase interest- sensitive
liabilities or reduce interestsensitive assets
Interest sensitive assets < interest
sensitive liabilities
Losses if interest rates rise
because NIM will be reduced
1. Shorten asset maturities or
lengthen liability maturities
2. Decrease interest- sensitive
liabilities or increase interestsensitive assets
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227
Items
7 days
8-30 days
31-90 days
After 90 days
Loans
100
94
119
156
Secutities
30
15
20
7
Current
accounts
198
60
-
-
Time
deposits
75
55
159
37
Fed funds 31
purchased
10
 What would happen to the net interest income of the bank if the market
interest increases 15% compared to the initial interest of 7%? In this
case, how will the board of management take action to reduce the risk of
rising market interest rates?
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Problems with Interest-Sensitive Gap
Management
 Interest sensitive gap is based on the book value accounting cash flow
analysis of repricing gap.
 Interest sensitive gap only looks at impact of changes in interest rates
on net income and does not take into account the impact of interest
rate changes on the market value of the bank’s equity position.
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Measuring interest rate risk
Duration gap
 Duration is the Weighted Average Maturity of a Promised Stream of
Future Cash Flows that considers the timing of all cash inflows and all
cash outflows. It is a direct measure of price risk.
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230
Duration gap measurement
 It is the difference between the duration of a bank’s assets and the
duration of its liabilities
 The duration of the banks assets can be determined by taking the
weighted average of the duration of all assets in the portfolio
 The weight is the dollar amount of a particular type of asset out of the
total amount of assets
 The duration of liabilities can be determined in a similar way
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231
Duration gap
Use of Duration Analysis to Hedge Interest Rate Movement
Calculate the dollar-weighted average duration of the bank’s earning assets and liabilities from
the following:
t * CFt

t
t 1 (1  YTM)
D n
CFt

t
t 1 (1  YTM)
n
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MEASURING RISK IN BANKING
Interest rate risk
DURATION GAP
Use of Duration Analysis to Hedge Interest Rate Movement
Dollar-weighted
Duration gap = duration of asset
portfolio
MBA Vũ Thị Thùy Linh
Dollar-weighted
- duration of bank x
liabilities
233
Duration of a bank loan calculation
 Loan term 5 years. Annual interest rate payment is 10% (similar to
coupon rate on a bond). The face value of the loan is $1,000, which is
also its current value because the yield to maturity on the loan is also
10%. What is the loan’s duration
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234
Cha ge i the Value of a Ba k’s Net Worth
ℎ
�
′
ℎ
= − Average duration of assets × �
−
�
−Average duration of liabilities ×
MBA Vũ Thị Thùy Linh
ℎ
+
ℎ
+
�
�
�
× Total assets
� �
�
×
�
���
235
Cha ge i the Value of a Ba k’s Net Worth

 

i
i
NW  - D A *
* A - - D L *
* L
(1  i)
(1  i) 

 
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236
MEASURING RISK IN BANKING
Interest rate risk
DURATION GAP
Use of Duration Analysis to Hedge Interest Rate Movement
For example, suppose that a bank has an average duration in its assets of three years, an
average liability duration of two years, total liabilities of $100 million, and total assets of $120
million. Interest rates were originally 10 percent, but suddenly they rise to 12 percent.
In this example:
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237
MEASURING RISK IN BANKING
Interest rate risk
DURATION GAP
Use of Duration Analysis to Hedge Interest Rate Movement
Dollarweighted
asset portfolio
duration
= σ�=
MBA Vũ Thị Thùy Linh
�
�
ℎ
ℎ
�
×
�
�
ℎ
ℎ
�
238
MEASURING RISK IN BANKING
Interest rate risk
DURATION GAP
In summary, the impact of changing market interest rates on a bank’s
net worth is indicated by entries in the following table:
If the Bank’s Duration Gap
is
Positive (
�
>
∗
�
Negative (
�
<
∗
�
Zero (
�
=
∗
�
�
�
�
�� �
)
�� �
�� �
MBA Vũ Thị Thùy Linh
And if Interest
Rates
The Bank’s Net Worth
will
Rise
Fall
Decrease
Increase
Rise
Fall
Increase
Decrease
Rise
Fall
No change
No change
239
MEASURING RISK IN BANKING
Interest rate risk
DURATION GAP
Of course, more aggressive mangers may not like strategy of
Portfolio immunization (duration gap = 0). They may be willing to
take some chances to maximize the shareholders’ position.
Expected Change in
Interest Rates
Management Action
Possible Outcome
Rates will rise
Reduce � and increase
(moving closer to a
negative duration gap)
Net worth increases (if
management’s rate
forecast is correct)
Rates will fall
Increase � and reduce
(moving closer to a
positive duration gap)
Net worth increases (if
management’s rate
forecast is correct)
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240
MEASURING RISK IN BANKING
Interest rate risk
DURATION GAP
1. Suppose that a bank has an average asset duration of 2.5 years and an average liabilities
duration of 3.0 years. If the bank holds total assets of $560 million and total liabilities of
$467 million does it have a significant duration gap? If interest rates rise, what will happen
to the value of the bank’s net worth?
2. Stilwater Bank has an average asset duration of 3.25 years and an average liability
duration of 1.75 years. Its liabilities amount to $485 million, while its assets total $512
million. Suppose that interest rates were 7 percent and then rise to 8 percent. What will
happen to the value of the Stilwater bank’s net worth?
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241
MEASURING RISK IN BANKING
Interest rate risk
 DURATION GAP
3. Calculate the duration of a bank’s assets and liabilities (dollars in
million)
Composition
of Assets
(uses of
funds)
Market
Average
value duration of
each
of
Assets category of
assets
(in years)
Composition of
Liabilities and
Equity capital
(sources of
funds)
Marke
t
value
of
Liabil
ities
Average
duration
of each
liability
category
(in years)
Treasury
securities
$90
7.490
Negotiable CDs
$100
1.943
Municipal bonds
20
1.500
Other time deposits
125
2.750
Commercial loans
100
0.600
Subordinated notes
50
3.918
Consumer loans
50
1.200
Stockholders’ capital
25
Real-estate loans
40
2.250
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242
Measuring interest rate risk
Derivative instruments
 A Derivative is Any Instrument or Contract that Derives its Value From
Another Underlying Asset, Instrument, or Contract, Such as Treasury
Bills and Bonds and Eurodollar Deposits
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Derivatives Used to Manage Interest Rate Risk
 Financial Futures Contracts
 Forward Rate Agreements
 Interest Rate Swaps
 Options on Interest Rates
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1. Organizing and developing bank network
2. Human resource management
and development
3. Planning marketing strategy
CHAPTER 4: RESOURCE MANAGEMENT
OF COMMERCIAL BANK
Organizing and developing bank network
4.1.1. ESTABLISHING NEW BANKS
 Why is the creation (chartering) of new banks
closely regulated?
 Who charters new banks in Vietnam?
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Organizing and developing
bank network
4.1.2Establishing branches, in-store branching
and banking services
Expected Rate of Return
The Decision of Whether to Establish a Branch Office is
a Capital Budgeting Decision. The Present Value of
the Net Future Cash Flows Should Be Larger Than the
Initial Outlay
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Organizing and developing
bank network
Establishing branches, in-store branching and
banking services
Geographic Diversification
Reducing a Bank’s Overall Risk Exposure to its Total
Return By Establishing Service Facilities in Different
Market Areas Whose Individual Returns are Not Highly
Correlated with the Returns from a Bank’s Existing
Market Locations
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Organizing and developing
bank network
Establishing branches, in-store branching and
banking services
Limited-Service Facilities
Point of Sale (POS)Terminals
Automated Teller Machines (ATMs)
Home and Office Banking
Telephone Banking and Call Centers
Internet-Banking
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Organizing and developing
bank network
Establishing branches, in-store branching and
banking services
Services Provided Through the Internet
Verify Real-Time Account Balance
Move Funds Instantly Among Accounts
Confirm Deposits Made, Checks Cleared and Online
Transactions Have Taken Place
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Organizing and developing
bank network
Establishing branches, in-store branching and
banking services
 What factors are often considered in evaluating
possible sites for new branch offices?
 What services do ATMs provide? What are the main
advantages and disadvantages of ATMs as a service
provider? Should ATMs carry fees?
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Organizing and developing
bank network
4.2 Acquisitions and mergers in financial
services management
Motives for acquisitions and mergers
- Rescue of Failing institutions from dissolution or
bankruptcy
- Risk reduction
- The cost savings, profit potential and efficiency
motive
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Organizing and developing
bank network
Acquisitions and mergers in financial services
management
Regulation rules for bank acquisitions and mergers
- Bank Acquisitions
- Bank Mergers
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Human resource management
4.3.1. Definition:

Planning → Organizing → Staffing →
Managing → Inspecting.
4.3.2. The role of HR management
Human resource management has
important impact on the performance in
the banking industry.
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Human resource management
4.3.3 How to manage human resources
 Arranging the right people for the right position
 Training and retraining the people to improve work
performance
 Explain the policies and procedures of the organization to
the employees.
 Performance measurement (the most important area of
Human Resource Management) which work on goal
setting, potential appraisal of performers and developing
a talent pipeline.
 Promotion policy, Transfer policy, Talent management,
Communication, Managing people separation / exit, etc…
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