Lectures 6-7: Chapter 9 Banking and the Management of Financial Institutions Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2011 11-2 © 2013 Pearson Education, Inc. All rights reserved. Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2006 11-3 © 2013 Pearson Education, Inc. All rights reserved. General Principles of Bank Management • • • • • • 11-4 Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk © 2013 Pearson Education, Inc. All rights reserved. Liquidity Management: Ample Excess Reserves Assets Liabilities Reserves $20M Deposits Loans $80M Bank Capital $10M Securities $100M $10M Assets Liabilities Reserves $10M Deposits Loans $90M Bank Capital $10M Securities $100M $10M • Suppose bank’s required reserves are 10% • If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet 11-5 © 2013 Pearson Education, Inc. All rights reserved. Liquidity Management: Shortfall in Reserves Assets Liabilities Assets Reserves $10M Deposits $90M Reserves Loans $80M Bank Capital $10M $10M Loans Securities Securities Liabilities $0 Deposits $90M Bank Capital $10M $90M $10M • Reserves are a legal requirement and the shortfall must be eliminated • Excess reserves are insurance against the costs associated with deposit outflows 11-6 © 2013 Pearson Education, Inc. All rights reserved. Liquidity Management: Borrowing Assets Reserves Liabilities $9M Deposits $90M Loans $90M Borrowing $9M Securities $10M Bank Capital • Cost incurred is the interest rate paid on the borrowed funds 11-7 © 2013 Pearson Education, Inc. All rights reserved. $10M Liquidity Management: Securities Sale Assets Reserves Loans Securities Liabilities $9M Deposits $90M Bank Capital $90M $10M $1M • The cost of selling securities is the brokerage and other transaction costs (+ cost of selling at a low P) 11-8 © 2013 Pearson Education, Inc. All rights reserved. Liquidity Management: Federal Reserve Assets Reserves Liabilities $9M Deposits Loans $90M Borrow from Fed Securities $10M Bank Capital • Borrowing from the Fed also incurs interest payments based on the discount rate 11-9 © 2013 Pearson Education, Inc. All rights reserved. $90M $9M $10M Liquidity Management: Reduce Loans Assets Reserves Liabilities $9M Deposits Loans $81M Bank Capital Securities $10M $90M $10M • Reduction of loans is the most costly way of acquiring reserves • Calling in loans antagonizes customers • Other banks may only agree to purchase loans at a substantial discount 11-10 © 2013 Pearson Education, Inc. All rights reserved. Asset Management: Three Goals • Seek the highest possible returns on loans and securities • Reduce risk • Have adequate liquidity 11-11 © 2013 Pearson Education, Inc. All rights reserved. Asset Management: Four Tools • Find borrowers who will pay high interest rates and have low possibility of defaulting • Purchase securities with high returns and low risk • Lower risk by diversifying • Balance need for liquidity against increased returns from less liquid assets 11-12 © 2013 Pearson Education, Inc. All rights reserved. Liability Management • Recent phenomenon due to rise of money center banks • Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) • Checkable deposits have decreased in importance as source of bank funds 11-13 © 2013 Pearson Education, Inc. All rights reserved. Capital Adequacy Management • Bank capital helps prevent bank failure • The amount of capital affects return for the owners (equity holders) of the bank • Regulatory requirement 11-14 © 2013 Pearson Education, Inc. All rights reserved. Capital Adequacy Management: Preventing Bank Failure High Bank Capital Assets Low Bank Capital Liabilities Assets Reserves $10M Deposits $90M Reserves $10M Deposits Loans $90M Bank Capital $10M Loans $90M Bank Capital High Bank Capital Assets 11-15 Liabilities $10M Deposits Loans $85M Bank Capital © 2013 Pearson Education, Inc. All rights reserved. $4M Low Bank Capital Liabilities Reserves $96M Assets $90M Reserves $5M Loans Liabilities $10M Deposits $96M $85M Bank Capital -$1M Capital Adequacy Management: Returns to Equity Holders Return on Assets: net profit after taxes per dollar of assets net profit after taxes assets Return on Equity: net profit after taxes per dollar of equity capital ROA = ROE = net profit after taxes equity capital Relationship between ROA and ROE is expressed by the Equity Multiplier: the amount of assets per dollar of equity capital EM = Assets Equity Capital net profit after taxes net profit after taxes assets equity capital assets equity capital ROE = ROA EM 11-16 © 2013 Pearson Education, Inc. All rights reserved. Capital Adequacy Ratio, loss provision & fire sales PA or if mortgagees stop paying installment, loss provision → K (K/A = 8%) → either inject K, or sell A (difficult to raise K in Crisis) → every $1b loss provision, need to sell $12.5b Asset → PA substantially, need to make more loss provision … … cycle repeat 11-17 © 2013 Pearson Education, Inc. All rights reserved. Capital Adequacy Management: Safety • Benefits the owners of a bank by making their investment safe • Costly to owners of a bank because the higher the bank capital, the lower the return on equity • Choice depends on the state of the economy and levels of confidence 11-18 © 2013 Pearson Education, Inc. All rights reserved. Application: How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis • Shortfalls of bank capital led to slower credit growth – Huge losses for banks from their holdings of securities backed by residential mortgages. – Losses reduced bank capital • Banks could not raise much capital on a weak economy, and had to tighten their lending standards and reduce lending. 11-19 © 2013 Pearson Education, Inc. All rights reserved. Managing Credit Risk: Overcoming AS and MH • Screening and Monitoring – Screening – Specialization in lending – Monitoring and enforcement of restrictive covenants 11-20 © 2013 Pearson Education, Inc. All rights reserved. Managing Credit Risk (cont’d) • Long-term customer relationships • Loan commitments • Collateral and compensating balances • Credit rationing 11-21 © 2013 Pearson Education, Inc. All rights reserved. Managing Interest-Rate Risk First National Bank Assets Rate-sensitive assets Liabilities $20M Rate-sensitive liabilities Variable-rate and short-term loans Variable-rate CDs Short-term securities Money market deposit accounts Fixed-rate assets $80M Fixed-rate liabilities Reserves Checkable deposits Long-term loans Savings deposits Long-term securities Long-term CDs $50M $50M Equity capital • If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits 11-22 © 2013 Pearson Education, Inc. All rights reserved. Off-Balance-Sheet Activities • Loan sales (secondary loan participation) • Generation of fee income. Examples: – Servicing mortgage-backed securities – Creating SIVs (structured investment vehicles) which can potentially expose banks to risk, as it happened in the global financial crisis A super senior tranche B senior tranche C mezzanine tranche D E 11-23 © 2013 Pearson Education, Inc. All rights reserved. equity tranche Off-Balance-Sheet Activities (cont’d) • Trading activities and risk management techniques – Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market and speculation. – Principal-agent problem arises 11-24 © 2013 Pearson Education, Inc. All rights reserved. Off-Balance-Sheet Activities (cont’d) • Internal controls to reduce the principalagent problem – Separation of trading activities and bookkeeping – Limits on exposure – Value-at-risk – Stress testing 11-25 © 2013 Pearson Education, Inc. All rights reserved.
