Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
IKT 310 MONETARY POLICY
HANDOUT FOR WEEK 1
(February 23, 2023)
BANKING: MANAGEMENT AND PERFORMANCE
THE BANK AS A COMMERCIAL BUSINESS
A bank, more precisely, a financial intermediary that accepts deposits, is an institution that
creates money while performing its functions. Naturally, the fact of "creating money" here does
not mean that the institutions in question print money in their own name in a printing house.
The money created by banks is nothing more than deposits and hence accounting records.
Therefore, the money created by banks is called deposit money or deposit money. The practice
called partial reserve banking lies behind the banks' ability to create deposit money. In order to
understand what partial reserve banking means, it is useful to outline how a bank works and
how its basic activities are reflected in the bank's financial statements.
CHARACTERISTICS OF A BANK BALANCE SHEET
In order to understand how a student is performing in a semester, we need to examine that
student's transcript. It shows us which courses the student took in that term, his performance in
these courses and his general success. Similarly, we understand how an economy performed in
a period from the GDP calculations that summarize the economic picture for that period. GDP
gives information about the activities of the economy during that period and their results; we
can make use of this information to evaluate the performance of the economy. We can see the
summary of the activities of a business, which is a part of the economy, in the financial
statements of it. As a commercial enterprise, the way to evaluate how banks operate in a given
period and how they perform in relation to their purposes is to examine the financial statements
of banks. As you know, the most important two of these financial statements are the balance
sheet and the income statement.
The best way to understand how a bank works is to examine the bank's balance sheet
summarizing its assets and liabilities. As you may recall from your accounting courses, as a
requirement of the double-entry system, the balance sheet is based on a known basic identity:
Assets
Debts  Capital

  

Assets
Liabilities
When the above basic identity is evaluated from another perspective, the liabilities of the
balance sheet indicate the sources of funds for this enterprise (i.e. from which sources this
enterprise obtains funds), while the asset of the balance sheet expresses how the funds collected
from various sources are used. Funding sources are basically divided into two groups: Equities
and foreign resources. A bank, as a money-trading institution, is an institution that uses foreign
resources as its main source of funds, not its own resources. In this context, banks collect funds
by selling (issuing) deposits and borrowing. These collected funds are used by acquiring assets.
Among the assets obtained with the funds collected, the most important ones are loans and
securities. The bank earns a profit by generating more income through the assets compared to
the cost of these resources. If you wish, let us detail our explanations based on a sample bank
balance sheet. Table 1 shows the consolidated summary balance sheet of the Turkish banking
system. Now let's briefly examine the assets and liabilities items in this balance sheet.
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
TABLE 1: Turkish Banking System Consolidated Summary Balance Sheet
(as of 31/12/2019)
ASSETS
RESERVES
Required Reserves
Excess Reserves
SECURITIES
Government
Other
LOANS
Short term
Long term
OTHER ASSETS
TOTAL ASSETS
%
14
9
5
19
16
3
64
51
13
3
100
LIABILITIES
DEPOSITS
Demand Deposits
Time Deposits
NON- DEPOSIT RESOURCES
Interbank market
Central Bank of the T. R.
International Markets
Securities Issued
OTHER LIABILITIES
CAPITAL
TOTAL LIABILITIES
%
63
7
56
16
4
0
8
4
10
11
100
Liabilities
A bank obtains funds by issuing (selling) liabilities, and therefore the liability of the bank
balance sheet shows us the sources of funds. These funds, which are obtained by creating or
selling liabilities, are used to purchase income-generating assets (such as loans and securities).
In general terms, as of 2019, 11% of the total resources of the Turkish banking system consists
of equities and 89% consists of foreign resources.
Deposits: As we discussed earlier; deposits are funds deposited in the bank to be withdrawn at
any time or at the end of a certain maturity. When evaluated from the perspective of the bank,
deposit refers to the debt the bank receives from depositors. When evaluated in terms of
depositors, the deposit can be considered as the loan given to the bank by the depositor. Legal
regulations in the country may cause deposits to be classified in different ways. For example,
in our country, deposits are divided into four in this classification: Saving deposits, commercial
deposits, official deposits, and interbank deposits. In general, savings deposits are deposits
belonging to real persons, commercial deposits are deposits belonging to commercial
enterprises of real persons, official deposits are deposits belonging to public institutions and
legal entities providing public services, and interbank deposits are deposits that banks deposit
to each other.
It is also possible to classify deposits as demand and time deposits in terms of their maturities.
Deposits made at banks to be withdrawn at any time are called demand deposits, and deposits
made at a certain interest rate to be withdrawn at a certain maturity are called time deposits.
Based on these definitions, demand deposits are generally deposits held in the banking system
for transaction purposes. Moreover, being able to write checks and use credit cards on these
deposits makes their liquidity closer to cash. Therefore, demand deposits are a mobile and cheap
source for banks. In recent years, commercial banks have been trying to attract more demand
deposits to their banks by diversifying the services they offer to depositors (such as automatic
bill payment, credit cards, expanding the ATM network). Notice that the purpose here is to
reduce the resource cost. Due to the structure of time deposits, they represent an expensive
resource for banks since the interest rate is higher than demand deposits. Generally, the reason
for keeping time deposits in the banking system is savings. Due to the fact that they can be
taken back at the end of a certain period (such as 1 month, 3 months, 6 months, 1 year and
longer), time deposits are subject to higher interest payments reflecting the cost of foregoing
liquidity. As can be seen from Table 1, the total resources of commercial banks operating in
Turkey about 2/3 is composed of deposits. Considering the types of deposits, approximately
56% of total resources consist of time deposits. If you remember that deposits also constitute a
source for loans, this indicates an expensive resource cost.
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
Another fund source that can be used in demand deposits in recent years should be mentioned
separately. These so-called floating funds are funds that enter banks' vaults and wait for a few
days. In this way, banks collect a significant amount of funds at very low cost. For example,
services such as depositing employees 'salaries and wages into bank accounts, banks' collecting
periodic bill payments such as electricity, telephone, natural gas, actually provide banks with a
significant amount of floating funds and have a decreasing effect on the average resource cost.
Non-Deposit Resources: Another foreign resource that banks can use is to obtain funds by
borrowing. Banks can do this in four different ways. First of all, the bank can borrow by issuing
bonds and bills, however, due to the high inflation experienced for many years in our country,
the share of the funds provided by the Turkish banking system through this method in total
resources is around 4%. Another way for banks to borrow funds is to borrow from the central
bank. The share of this fund source, called discount loan, in the total resources of the Turkish
banking system is quite low. As a result of the changes regarding the use of monetary policy
tools carried out by the Central Bank of the Republic of Turkey (CBRT), the share of the funds
used by the banks from CBRT in total resources decreased to 0.2%.
Another way that banks can use to provide funds is to borrow from other banks in the system.
These resources provided through interbank markets are generally short-term resources. In fact,
it is necessary to evaluate the funds obtained from this source as resources used to meet the
reserve deficits and urgent cash needs of banks rather than creating resources for loans.
The most important non-deposit resource that has come to the fore for banks in recent years is
the loans obtained from international markets. According to Table 1, approximately 8% of the
total resources in the Turkish banking system consists of loans obtained from international
markets. Most of these loans are syndicated loans. A syndication loan is a loan given to a bank
by a group of banks formed by various sized banks in international markets under the leadership
of a consortium leader. The most important factors in the emergence of this result are the
strengthening of the tendency to open up to international markets in Turkish banking, the
removal of the obstacles to capital movements, and finally the globalization tendency
experienced all over the world. However, it should not be overlooked that this situation also
increases the exchange rate risk on the Turkish banking system.
Other Liabilities: The share of this liability item in total, which includes taxes to be paid, other
provisions and resources that cannot be included in the above classification, is around 10%.
Capital (Equity): The last item on the liabilities side of the balance sheet is the item that is
collected under the title of capital and expresses the resources of banks consisting of equities.
These include the bank's paid-in capital, reserve funds (retained earnings), revaluation funds
and finally the period profit. When evaluated in this way, capital is considered as the net value
expressing the difference between the bank's assets and debts. This ratio is around 11% in the
Turkish banking system. The capital of a bank, or more accurately, its net worth, is an assurance
against a fall in the value of the assets because the decline in the value of the bank's assets may
cause the bank to go bankrupt if the bank does not have sufficient capital. This item becomes
an extremely important resource especially in financial crises and when faced with bad loans.
Assets
The funds obtained from the sources whose distribution we have seen above are used by the
bank to purchase income generating assets. Therefore, the asset side of the bank balance sheets
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
shows the bank's fund usage structure. The positive difference between the income obtained
from the said assets and the fund costs incurred due to liabilities constitutes the profit of the
bank. The laws that regulate the banking system in the country have a great effect on shaping
the fund utilization structure of the banking system. For example, in our country, it is possible
to generalize the usage of funds in the form of reserves, loans, securities and other assets.
Reserves: All banks keep some of the funds they obtain from various sources in cash or assets
that are easily convertible to cash. There are two reasons for banks to behave this way. First of
all, banks are obliged by law to keep a portion of the deposits they collect in a central bank
account (required reserves). The required reserve ratio, which is the basis for the calculation of
such reserves (also known as “zorunlu karşılıklar” or “munzam karşılıklar” in Turkish) is
determined by the central bank. Second, banks hold additional reserves called free (or excess)
reserves. Banks prefer to use some of the funds they collect in assets that can be easily converted
into cash or cash in order to meet their urgent cash needs and to make use of the profitable
opportunities they may encounter in the market. The bank itself decides what the ratio of free
reserves to total resources will be.
Loans: In order to fulfill the fund transfer function, which is the main function they undertake
in the financial system, banks transfer the funds they collect from those with surplus of funds
to economic units with deficit of funds. One of these transfer mechanisms is to purchase
securities issued by units in need of funds, and the other is to extend loans to them. Therefore,
while the loan is a debt for the person or institution using it, it is a claim or asset for the bank.
Loans are the ones with the lowest liquidity among all assets. On the other hand, loans have the
highest default risk among all assets. As can be seen in Table 1, the share of loans in the Turkish
banking system in total assets is quite high. Banks convert 64% of the funds they collect from
various sources, especially deposits, into loans. Considering that this rate is around 60% in
developed countries, this rate should be considered quite high. Considering that this ratio was
around 25% 15 years ago, this is an important indicator of the transformation in the Turkish
banking system. It is possible to mention three different reasons for the emergence of the
situation experienced in the past. First of all, the banking system operating under imperfect
competition caused limited loans extended in terms of profit maximization. Second, due to huge
budget deficits of the public sector in Turkey, a high financing need (i.e. the high borrowing
requirement) became attractive high interest rates and low risk securities issued by the public
sector. Thus, funds that could be used as loans for the private sector were transferred to the
public sector. Thirdly, the crises in banking and recession in the economy during the
aforementioned period caused banks to act prudently and operate with high reserves. While the
share of free reserves in total assets was 18% in 2002 after the 2001 crisis, this ratio decreased
to 5% at the end of 2019. All of these factors listed caused the loan volume to remain limited.
The improvements made in these factors in the last 15 years are the main factor that caused the
increase in the share of loans in total assets. On the other hand, if you consider that
approximately 80% of the current loan volume consists of short-term loans (such as consumer
loans), you can evaluate the shallowness in the credit volume.
Securities: The second type of asset after loans, among the income-generating assets of the
bank, is the securities in the bank's portfolio. All of the securities mentioned here are bonds and
bills that express debt (that is why they are generally called fixed income securities).
Regulations in many countries have prohibited or significantly restricted banks from creating
stock portfolios. Moreover, since the stocks are in the category of securities expressing
ownership, they are considered not within the securities of the bank but among the bank's
affiliates.
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
It is possible to examine debt-denominated (fixed income) securities in two groups: Public and
private sector bonds and bills. As you can see from Table 1, the amount of private sector bonds
and bills held by the banking system is only 3% of the total assets. A much greater portion of
the resources (about 16%) are transferred to government bonds and Treasury bills. We
discussed the reasons for this above. However, it should be noted that, for the Turkish banking
system, the presence of such a high ratio of public sector securities in total assets also creates a
serious interest risk, a concept that we have learned in our Monetary Theory lectures.
Other Assets: Banks do not only have assets in the form of loans and securities. Fixed assets
that cannot be included in this classification (such as buildings, computer systems) and other
assets owned, primarily affiliates, are included in this item.
BANK MANAGEMENT: GENERAL PRINCIPLES
After seeing a bank's balance sheet and its main activities by using this balance sheet, we can
examine the process of deciding how this balance sheet will be shaped. This process in banking
is called general management principles. A bank manager takes into account four key factors
when deciding how the assets and liabilities of the balance sheet will be shaped. First of all, it
is necessary to decide how much free reserves the bank should keep in order to meet the
demands of the customers when a deposit outflow is encountered. The process of deciding how
much cash or assets that can be easily converted into cash will hold in return for a bank's liability
in the form of deposit is called liquidity management. Second, bank management should
diversify assets with the lowest risk. The process of deciding how much risk the bank will take
on due to its assets is known as asset management. Third, bank management has to decide how
resources can be obtained at the lowest cost, and this process is called passive management.
Finally, the bank management must decide what amount of capital the bank must maintain and
how this capital will be raised. This process is called capital management. We will briefly
discuss these general management principles below.
Liquidity Management
Liquidity management is defined as the process of deciding how much free reserves banks will
keep in return for their deposit liabilities. A bank holding insufficient free reserves against
deposit outflows has to finance the said net reserve deficit (the reserve deficit calculated as a
result of the adjustment made according to the change in the required reserve amount after
deposit withdrawals). There are four types of financing that the bank can use to finance this net
reserve deficit: The bank can borrow from the central bank’s discount window or from the
interbank market. On the other hand, the bank may sell some of securities in the portfolio under
market conditions or call on loans (ask for payment before maturity). Since each of these
financing methods will bring a cost to the bank, the bank should operate with a high free reserve
that will not create the problem of reserve deficit. However, holding reserves means that the
bank is giving up an amount that it can lend as a loan or buy securities, that is, it can earn
interest income instead of holding free reserves. In other words, there is an opportunity cost of
holding free reserves, and this cost can be measured by interest foregone. Therefore, the more
free reserves the bank holds, the higher the opportunity cost it will incur and its profitability
will remain low. Here, the bank management has to consider these two issues while deciding
how much free reserves the bank will hold: Keeping free reserves at a level that does not reduce
profitability and does not create additional resource costs in an emergency.
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
Asset Management
Asset management is defined as the process of deciding how a bank can use its resources to
achieve the highest return with the lowest risk. In fact, asset management is deciding how to
shape the fund utilization structure since, in order to maximize its profit, the bank should
distribute its resources among the usage areas that will provide the highest return with the
lowest risk and have the opportunity to retain the liquidity it needs in this process. Banks
achieve these goals with four asset management principles:
•
•
•
•
Finding customers who will pay the highest interest on the loans to be opened and have
the lowest risk of default.
Prefer the securities with the highest return and lowest risk in the securities to be
purchased.
Diversification among assets in a way that minimizes risk.
Working with free reserves that will not reduce the profitability of the bank.
Banks can facilitate this process, which seems complicated according to the explanations above,
by using the duration concept. Since similar but opposite principles will also apply to liabilities,
we will discuss how banks can use the duration concept for this purpose, after seeing the
principles of liability management.
Liability Management
The proliferation of alternative sources from which banks can obtain funds brought along the
problem of how much funds a bank should collect from which source and led to the importance
of liability management policies. Among the main reasons for this development are the rapidly
growing interbank markets, especially as a result of the rapid development in technology, and
the more intensive use of international markets as a result of the loosening of restrictions on
international capital movements. Deciding to what extent a bank will benefit from these
alternative resources at the lowest cost, that is, how the bank's fund resource structure will be
shaped, brings up risk management in liabilities.
The analysis conducted to determine the extent to which the bank will be affected by interest
rate changes due to assets and liabilities is called gap analysis. The gap analysis is carried out
in two dimensions: income gap and duration gap.
How much the bank's net income will be affected by changes in interest rates is measured by
the concept of income gap. The income gap is the difference between interest sensitive assets
and interest sensitive liabilities. If we show interest sensitive assets with RSA and interest
sensitive liabilities with RSL, income gap (GAPI) will be:
GAPI = RSA – RSL
For example, if the total interest sensitive assets of the bank are 378 million and the total interest
sensitive liabilities are 472 million TL, the income gap is obtained as:
GAPI = 378 – 472 = -94 million TL
Once the gap value is known, we can easily calculate how interest rate changes will affect the
bank's net interest income using the equation below:
I  GAPI  i
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
In this equation, ΔI denotes the change in the interest income of the bank and Δi denotes the
change in the interest rate. For example, when the interest rate falls from 20% to 17% in the
economy, the change in the bank's interest income will be calculated as follows:
I   94   0,03  2,82 milyon TL
Hence, falling interest rate leads to an increase in net interest income as the bank's income gap
value is negative in our example. Conversely, if the interest rate for example increased from
20% to 22%, the change in the net interest income of this bank would be a loss:
I   94 0,02  1,88 milyon TL
This means that the profitability of the bank decreases. If the bank management expecting a
change in the interest rate knows its gap value, it will have the opportunity to increase the net
interest income or minimize the loss it will incur by changing the interest-sensitive aggregates
in the assets and liabilities.
In the gap analysis above, it is determined how much impact interest rate changes will have on
the bank's net interest income. However, interest rate changes will also affect a bank's net worth.
The gap concept which allows determining the impact of how much interest rate changes will
have on the net worth of a bank, is called the duration gap. Duration is defined as the weighted
average maturity of a security. Although it is possible to talk about different duration concepts
(such as Macaluay, Modified Macaulay and effective duration), here we will only consider this
concept in its simplest form (Macaluay duration). You will discuss this technique, which is
especially important in terms of interest rate risk management in fixed income securities, in
your Financial Economics course.
The Macaulay duration measure, developed by economist Frederic Macaulay in 1938, is the
most widely used technique to calculate the effective maturity of a bond. In this technique, the
weighted average time that will pass before the cash flows to be obtained from the bond is
measured. Therefore, it is used by fixed income securities portfolio managers to measure risk.
In fact, measuring the Macaulay Duration is based on a simple logic. The cash flows to be
provided from the bond are weighted according to the period until they are obtained and divided
by the current market price of the bond:
𝑘
𝐶𝐹𝑛
𝑡𝑛
𝑛×
𝑖
𝑃𝑉
𝑛=1 (1 + )
𝑘
𝐷𝑈𝑅 = ∑
where DUR
CF
i
k
tn
PV
: Macaulay Duration measure
: Amount of cash flows
: Annual market interest rate
: Number of terms in a year
: Remaining time until cash flow is obtained
: Present value of all cash flows (market value of the bond)
This seemingly complex calculation technique is actually quite simple. Let's try to put forward
with an example and calculate the Macaulay duration measure in an environment where the
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
market interest rate is 10% for a TL 1000 nominal value government bond with a 3-year
maturity every 6 months (twice a year) with an annual coupon payment of 10%. For this, we
need to calculate the present value of the cash flows to be obtained each period. Since the annual
coupon rate for this bond is 10%, it is 1000 × 0.10 = 100 TL. In our example, since the bond
will pay interest twice a year, the cash flow to be obtained every 6 months is 100/2 = 50 TL.
Cash flow will be provided as 50 TL interest income from the bond every 6 months for 3 years.
Since the bond will also expire in the last payment, 1000 TL principal repayment will also be
made, so the payment in the 6th period will be 50 TL interest payment + 1000 TL principal
repayment = 1050 TL. What we're going to do now is to calculate the present value of the cash
flows from this bond as the present value (PV) we saw in the Monetary Theory course.
𝑃𝑉 =
𝐶𝐹𝑛
𝑖 𝑛
(1 + )
𝑘
Considering i = 0.10 and k = 2 in our example, the present value of the first 50 lira is:
𝑃𝑉 =
50
= 47.62 𝑙𝑖𝑟𝑎
(1 + 0,05)1
The present value of 50 lira to be obtained in the second period is:
𝑃𝑉 =
50
= 45.35 𝑙𝑖𝑟𝑎
(1 + 0,05)2
The third column of the table below shows the present value of cash flows for all periods.
Term
(1)
Cash Flow
(2)
1
2
3
4
5
6
Total
50
50
50
50
50
1050
Present Value of
Cash Flow
(3)
47.62
45.35
43.19
41.14
39.18
783.53
1000
Column 1 x
Column 3
47.62
90.70
129.58
164.54
195.88
4701.16
5329.48
After preparing this table, it is extremely easy to calculate the duration. For this, it is enough to
divide the 4th column total by the 3rd column total:
DUR = 5329.48/1000 = 5.33
The effective maturity (duration) for this bond we are dealing with is 5.33 years. After knowing
the duration of the bond, it is possible to calculate the change in the market value of this bond
that will occur when the interest rate changes and manage the interest risk accordingly. We can
calculate the change in the price of a bond (%ΔP) that interest rate changes will cause as
follows:
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
i
1 i
%ΔP : the rate of change in the price of the bond
DUR : duration (or effective maturity)
Δi
: interest rate change
i
: initial interest rate
%P   DUR 
where
For example, if you expect the market interest rate to increase from 10% to 12% annually in
the near future, the rate of change in the market value of the bond will be:
0.02
1  0.10
%P  0.0969
%P  5.33 
An increase of 2 percentage points (or 200 basis points) in the interest rate will lead to a 9.69%
decrease in the market value of the bond. The change in the market value of the bond if the
interest rate decreases from 10% to 7% will be:
%P  5.33 
 0.03
 0.1454
1  0.10
A 3 percentage points (or 300 basis points) decrease in the market interest rate causes %14.54
increase in the bond price. Naturally, the concept of duration can be calculated not only for
the items in the assets side, but also for the liabilities side of the balance sheet. Using the
average duration of assets (DURA) and the average duration of debts (DURL) on the bank's
balance sheet, a bank manager can calculate the duration gap (GAPDUR) using the following
formula:
L

GAPDUR  DURA    DURL 
A

In addition to those previously described, L in the above formula denotes the sum of debts (i.e.
the value of "Assets - Capital") and A is the sum of assets. For example, the average duration
of the assets of a bank is calculated as 1.80 years and the average duration of the liabilities as
1.15 years while values of total assets and total liabilities are 250 and 210 million TL,
respectively. Summarizing the information, we can calculate the duration gap for this bank as
follows:
Average duration of assets:
Average duration of liabilities:
Total liabilities:
Total assets:
DURA
DURL
L
A
= 1,80 years
= 1.15 years
= 210 million TL
= 250 million TL
 210

GAPDUR  1,80  
 1,15  0,834 years
 250

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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
Once the duration gap is known, the impact of changes in interest rates on the bank's net worth
can be easily determined. We can write the equation that the bank manager can use for this
purpose as follows:
i
1 i
: rate of change in the bank's net worth
: duration gap
: interest rate change
: starting interest rate
%N  GAPDUR 
where
%ΔN
GAPDUR
Δi
i
Turning to the bank manager above, we have already calculated the effective maturity gap as
0.834 years. In an environment where the interest rate is expected to decrease from 20% to
17%, the change rate that will occur in the net value of the bank will be:
%N  0,834 
0,03
 0,02
1  0,20
The decrease that will occur in the interest rate causes a decrease of approximately 2% in the
net worth of the bank. If you remember, the assets of the bank were 250 million and its liabilities
were 210 million TL. Accordingly, the initial net worth of the bank, as a requirement of the
Assets  Liabilities + Capital
identity, is 40 million TL. Since a 3 percentage point decrease in the interest rate will reduce
the bank's net worth by 2%, the net worth of the bank will decrease by 0.8 million lira (40 ×
0.02) to about 39.2 million lira (40-0.8).
As can be seen, the concepts of both effective maturity gap and income deficit are important
technical tools for bank managers in shaping the bank's assets and liabilities, that is, in asset
and liability management.
Capital Management
Banks have to decide how much capital they will have for three reasons. First, the bank's capital
removes any imbalances that may arise between the bank's assets and liabilities. From this
perspective, the capital of a bank is a safety valve that prevents bankruptcy. If you remember,
we have stated that if the bank cannot meet its debts with its assets, it will go to bankrupt since
this means that the bank's net worth turns into negative. Therefore, the higher the bank's capital,
the less likely the net worth will turn into negative. Secondly, the amount of capital of the bank
closely affects the return of the bank owners, that is, those who hold the shares of the bank.
Finally, the minimum capital requirement imposed by laws and regulations must be respected.
Let's try to explain what these three reasons mean and why capital management is important in
banking.
First, let's show how bank capital can prevent bankruptcy with a simple example. Consider
banks A and B that have the same asset structure but differ in their liabilities due to their
different capitalization. Among these banks, bank A operates with a capital up to 10% of its
total assets, and bank B with a capital of 5% of its total assets. For the sake of simplicity, let's
assume that the balance sheets of these two banks are as follows:
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
BANK B
BANK A
Reserves
Loans
10
90
Deposits
Capital
Reserves
Loans
90
10
10
90
Deposits
Capital
95
5
Let's assume that after an economic crisis, both banks faced a bad loan problem of 6 million
lira due to bankruptcies in the economy. In such a case, this amount must be written off from
assets as the said receivables become worthless. Therefore, while the other conditions are fixed,
the value of the assets of both banks and therefore their net values will decrease by 6 million
liras each. According to this new situation, the new structuring of the balance sheets will be as
follows:
BANK B
BANK A
Reserves
Loans
10
84
Deposits
Capital
Reserves
Loans
90
4
10
84
Deposits
Capital
95
-1
As Bank A operates with high capital, it still has a positive net worth (4 million TL), even
though it suffered losses from this bad loan problem. The losses incurred in this bank are fully
borne by the shareholders. Whereas, since bank B has a low capital, despite facing the same
amount of bad loan problem as bank A, its net worth turned into negative. So bank B went
bankrupt. As can be seen, bank B has gone bankrupt due to the bad credit problem as a result
of working with insufficient capital. Therefore, banks should have enough capital to reduce the
possibility of going bankrupt.
To understand how bank capital affects the return on investment of bank partners (owners) in
the bank, we can use the ratio analysis you see in your Accounting courses. The shareholders
of the bank can use return on assets ratio (ROA), which is a measure of management
effectiveness, to see if their bank is well managed. This ratio shows how much net profit after
tax for a lira of assets is obtained and is calculated with the help of the following equation:
ROA 
AfterTaxNe t Pr ofit
TotalAssets
Return on assets ratio (ROA) is a measure of the efficiency of a bank's operations. According
to this definition, it is desired that the return on assets ratio is as high as possible.
The main concern of bank owners is the return on their investment in this bank. This information
can be obtained through the return on equity ratio (ROE), a measure of profitability:
ROE 
After Tax Net Pr ofit
Capital
As can be seen from its definition, the higher this ratio, which shows the profit obtained for one
lira of equity, the happier the partners of the bank will be.
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
Although these two ratios described above appear to be independent of each other, they are
actually directly related. This link between return on assets (ROA) and return on equity (ROE)
is established through a magnitude called financial leverage. Financial leverage (FL) is defined
as follows:
FL 
Total Assets
Capital
Let's rewrite the return on equity ratio to see what leverage means:
ROE 
After Tax Net Pr ofit
Capital
If we multiply the numerator and denominator of this equation by the total assets, the result will
not change:
ROE 
After Tax Net Pr ofit  Total Assets
Capital  Total Assets
Rearranging this equation yields:
ROE 
After Tax Net Pr ofit Total Assets

Total Assets
Capital
Notice that the first term on the right hand side of the above equation refers to return on assets
ratio and the second term refers to leverage. Accordingly, return on equity ratio can also be
defined as:
ROE = ROA × FL
Now let's go back to the example for banks A and B that we gave earlier. Assuming that these
banks are managed with the same efficiency, let's assume that the after tax net profits of both
banks are 1 million TL. Accordingly, return on assets ratios, return on equity ratios and financial
leverage values to be calculated for the said banks will be as follows:
1
1
 0,01
ROAB 
 0,01
100
100
100
100
FL A 
 10
FLB 
 20
10
5
ROE A  0,01  10  0,10
ROEB  0,01  20  0,20
Although both banks are managed with the same efficiency, since bank B operates with a lower
capital, its leverage value and accordingly the return on equity ratio are higher. As can be seen,
the shareholders of the bank B with low capital are happier because they have made higher
profit per unit of capital they put into the bank. To sum up, at a certain level of return on assets
ratio, the lower the bank's capital, the higher its profitability will be.
ROAA 
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
MEASURING BANK PERFORMANCE
In order to evaluate the performance of a bank, we need to examine the income statement, which
defines the sources that generate income and expenses that directly determine the profitability
of the bank. Table 2 below shows consolidated and summarized income statement of
commercial banks in Turkey as of the end of 2019.
Table 2: Consolidated and Summarized Income Statement of Commercial Banks in Turkey
(as of 31/12/2019)
Income/Expense Items
Interest Income
None Interest Income
Total Income
Interest Expenses
None Interest Expenses
Total Expenses
Net Income
(-) Allowance for bad claims
Profit Before Tax
(-) Taxes to be paid
Profit After Tax
Amount
(billion TL)
388.4
80.6
469.0
237.2
114.4
351.6
117.4
67.0
50.4
9.4
41.0
Operating Income
Operating income representing the total income of a bank consists of two main items. Interest
income and non-interest income generated as a result of the bank's activities. While a
considerable part of total income (approximately 83%) consists of interest income, it is
subdivided into interest income from loans, securities portfolio and interbank transactions. As
we have seen while examining the balance sheet structure, the main source of interest income
in the Turkish banking system is interest income from loans and public sector bonds and bills.
Non-interest income constitutes approximately 17 of the total income. Income items that are
among non-interest income have sub-distinctions such as commission income, foreign
exchange income, income from capital market transactions, income from subsidiaries. As you
can immediately guess, the most important share in non-interest income is the foreign exchange
income item, which reflects the income obtained due to exchange rate changes or the loss
incurred.
Operating Expenses
Approximately 67% of the operating expenses, which represent the costs incurred by the bank
while carrying out its banking activities, consist of interest expenses. The interest cost incurred
by the bank consists of the interest paid on the deposits and the interest paid by the bank for the
loans used. In our country, since deposits constitute 2/3 of total bank resources, approximately
90% of interest expenses are also composed of interests paid to deposits.
Non-interest expenses, which constitute approximately 23% of total expenses, consist of items
such as payments made by banks to personnel, tax, rent and depreciation expenses. The most
important share among these items is the expenses of the personnel.
The difference between the operating income of banks and their operating expenses represents
the net income. Profit before tax is obtained by deducting the “allowance for bad claims” item
set aside for loans with doubtful repayment (i.e. bad loans) from this net income. Taxes payable
are deducted from this value and the after tax profit amount of the bank is calculated.
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Prof. Dr. İlyas ŞIKLAR Monetary Policy Lecture Notes (2022-2023)
Bank Performance Criteria
Although the net profit after tax of a bank is a measure in itself to evaluate the performance of
the bank, it does not take into account the size of the bank and prevents comparison with other
banks. The most important performance indicator, which also takes into account the asset size
of banks, is the return on assets ratio (ROA), which we have seen before:
ROA 
AfterTaxNe t Pr ofit
TotalAssets
This ratio is regarded as an efficiency criterion for bank management, as it indicates the
effectiveness of bank assets to generate profit. It is desirable that the rate of profitability per
asset to be calculated is high or increases from year to year.
Although return on assets ratio is a useful indicator of the profitability of the bank, the
shareholders (owners) of the bank are more concerned with the profitability of the capital they
put in the bank. This is calculated with a profitability indicator we call the return on equity ratio
(ROE) as follows:
ROE 
After Tax Net Profit
Capital
This ratio is a basic profitability criterion since it shows the profitability of the capital invested
in the bank. A high return on equity ratio to be calculated is a desirable result for partners.
Another criterion used extensively in evaluating the performance of a bank is the ratio, called
the net interest margin, which refers to the net interest income earned for a unit of asset. Net
interest margin is calculated as follows:
Net Interest Margin 
Interest Income  Interest Expenses
Total Assets
Since the high net interest margin to be calculated will positively affect the profitability of the
bank, it also indicates the success of the bank management in applying the principles of asset
and liability management. Therefore, the net interest margin should be evaluated as a measure
of both profitability and management efficiency.
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